TJP

At the midpoint of the 2008 recession, the level of total reserves held in depository institutions (DIs) in the United States (US) increased from around $48 billion to over $1 trillion. More than 90 percent of the increase was in excess reserves. Excess reserves are bank cash in excess of reserve requirement set by the Federal Reserve (Fed).

The bulk of the increase in excess reserves stems from the Fed providing funds to banks. Banks' excess reserves are the “raw material” used to create loans (credit). Loans or new money increase aggregate demand, employment and, if unchecked, inflation.

Previous to October 2008, bank reserves held at the Fed earned no interest. Therefore, it was costly for banks to hold reserves. As a result, banks had to invest excess reserves in interest earning assets (investments, and loans to the public) in order to make a profit. Otherwise, they would incur significant opportunity cost by forgoing potential profits.

In March of 2001, Board of Governor Lawrence Meyer argued that financial innovations had lowered bank reserves and advocated paying interest on reserves (IOR). Accordingly, IOR would allow the Fed to hit the federal funds rate target.

In 2006 Congress granted the authority to pay IOR. The new policy was to become operational at the beginning of 2011. However, the start date was accelerated and became effective in October of 2008. With the ability to pay IOR, the Fed would have greater control on keeping the fed funds rate close to its target, a process known as inflation targeting.

Thus, the rate at which the Fed lends to the banks (discount rate) would become an effective ceiling and the interest it paid on reserves would become the effective floor. The floor, however, did not materialized; the federal funds rate is actually zero.

Government (the Fed) payment of interest on bank reserves, however, created a disincentive for banks to lend excess reserves to the public. Thus, the Fed preoccupation with inflation targeting continues to adversely affect the supply of credit; it restricts credit, output and employment.

Whenever, an administration allows the Fed to restrict credit, the inevitable result is a high level of unemployment.

For instance, the Eisenhower administration concentrated its efforts on fighting inflation, which led to the recessions of 1957-1958 and 1960-1961. Likewise, the Nixon administration inherited the inflation of the last Johnson years and in fighting inflation produced the recessions of 1970-1971. Similarly, the Bush administration allowed the Fed to restrict the money supply from 2003 until the fourth quarter of 2008 leading to the recession of 2008.

The Fed, irrational implementation of inflation targeting to counter non existing inflation restricted the real money supply and the economy's ability to achieve full employment. Thus, the Fed's policy of inflation targeting was the primary reason for the recession of 2008. By restricting the the money supply (see the flatness of M1 in the graph bellow preceding recent recessions), it created an imbalance between the demand and supply for real money balances.

When an outside economic disturbance, such as unusually high energy prices cause the stock of real money balances to decrease, in the absence of an increase in the real money supply, the demand for real money balances will exceed the supply of real money balances. As a result, the supply of real assets will exceed the demand for real assets and asset prices will fall (housing deflation).

The Fed's inflation targeting policy caused the economy to operate far below full employment. Furthermore, it has created an economy that forgoes valuable output by being unable to accommodate all available labor. The inability to accommodate available labor leads to psychic discomfort and distress of the unemployed, as well as political consequences for the Democratic Party and the Obama administration.

Banks hold reserves to meet demands for cash, loans or payments to other banks. Their choice of reserve ratio is contingent on required reserve (r_R) set by the Fed, the uncertainty of net deposit flow (σ), the cost of borrowing (i_D ) set by the Fed, and interest gained by holding reserve (i), set by the Fed. So, the required reserve is a function of:

                                    r = r(i, i_D , r_R, σ)

An increase in the interest rate paid by the Fed on reserves, i, creates a disincentive for banks to lend excess reserves; an increased in the discount rate (i_D), causes banks to hoard reserves; likewise an increase in required reserve ratio also causes banks to hoard reserves.

Thus, all the variables that causes banks to hoard reserves, except for the uncertainty of net deposit flow, are controlled by the Fed. Clearly then, the Fed is in full control of the United States economy's liquidity problem, because it determines if banks can lend reserves. Therefore, the lack of U.S output and employment is principally a function of the Fed.

It is time for Democrats, the administration, and the American public to understand the game. If the Fed does not increase the money supply, output and employment will not increase.

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