Did Doubling Reserve Requirements Cause the Recession of 1937-1938?

In an amazing paper, Charles Calomiris, Joseph Mason, and David Wheelock kind of refute the lessons from economic history.

In a widely accepted theory, Friedman said there was double dip recession in 1936-37 as Fed raised reserve requirements on banks. This led to lower supply of credit pushing a fragile economy back into a severe recession. Needless to say, same lessons were even repeated and appreciated in this crisis as well. Central Banks have been resisting pressures to tighten their rates etc for a year now citing the very example of Great depression.

Calomiris et al say this was not really the case. Fed raising reserve ratio implies supply of reserves. They look at the demand for reserves by banks and show reserves rose because of structural needs of banks. It had little to do with rising reserve ratio. In other words, reserves would have been higher anyways:

In this paper, we take a microeconomic approach to gauging the effects of doubling reserve requirements in 1936-1937, and in particular whether they represented a tightening of monetary policy and thereby were a likely cause of the recession of 1937-1938. If the increase in reserve requirements  reduced the supplies of credit and money, they would have done so by increasing the demand of Fed  member banks for reserves. We estimate the demand of Fed member banks for reserves during this  period to gauge whether the increase in reserve requirements increased reserve demand, and through that increase, caused a reduction in the supplies of credit and money. We find that reserve  requirements were not binding on bank reserve demand, and thus the increase in reserve requirements  had little if any effect on the money multiplier and the supplies of money and credit.

The study looks at banks books

Ours is the first study to examine reserve demand directly at a disaggregated level to see if Fed member banks actually increased their reserve demands in response to the increases in reserve requirements. We use microeconomic data on Fed member banks from 1934 and 1935 to model reserve  demand, and find that various alternative measures of demand are highly predictable as a function of  bank-specific and location characteristics.  

Based on the model estimated using data from the 1934 and 1935, when reserve requirements clearly were not a binding constraint on bank reserve demand, we simulate reserve demand for 1936-1938 for 15 mutually exclusive aggregates of Fed member banks (New York City central reserve city  banks, Chicago central reserve city banks, reserve city banks in each of the 12 Fed Districts, and country  banks located in smaller cities and towns). We find that to the extent that banks increased their reserve ratios during the period of reserve requirement increases, the increases in reserve demand between June 1936 to June 1937 reflected predictable influences related to the structure of the banks, and not increases in reserve requirements imposed by the Fed.

Hence, other factors are responsible for double dip recession:

This evidence lends support to the Fed’s interpretation of the effects of the reserve requirement increases, and casts doubt on the view that the doubling of reserve requirements caused the recession of 1937-1938. Other policy actions, speciallyreduced monetary base growth (due to the December 1936 sterilization of gold flows) and the 1936 tax rate increases, seem more likely culprits in causing the recession. 

This has important implications for current times:

There are important lessons from the experience of the mid-1930s for monetary policy today. U.S. banks now hold huge amounts of excess reserves. Total excess reserves in the banking system total  roughly a trillion dollars, and the largest four banks alone account for a quarter of that amount. As in the 1930s, these reserves are not “superfluous” balances; rather, they are held intentionally by banks as  ways of stabilizing their asset portfolios, reducing their risk and improving their liquidity.  As bank profits and loan opportunities increase, and as macroeconomic risks recede, banks will  reduce excess reserves to finance loan expansion. Still, the shedding of excess reserves is unlikely to be  uniform across the banking system; just as in the 1930s, changes in reserve preferences likely will  display substantial heterogeneity across banks.

Without an understanding of the microeconomic  foundations of the shifting demand for reserves, policy makers may be caught flat-footed when the  demand for reserves changes. A major reduction in reserve demand for even two of the largest banks in the system could imply substantial expansion of money and credit.

Some Fed officials have advocated raising interest payments on excess reserves to prevent too  rapid a contraction of excess reserves and increase in lending as reserve-demand preferences shift. That  approach may work, but its efficacy is limited by the ability of the Fed to gauge the interest elasticity of  reserve demand and raise interest rates accordingly. And, of course, the extent of feasible interest rate increases on reserves may be limited by the Fed’s need to maintain its own solvency. Clearly, the ability  to understand and anticipate changes in reserve demand preferences will be key to the successful  implementation of monetary policy in the coming years.

Turning the whole thing upside down. Most Fed officials indeed have been saying this- we will raise interest on reserves and that would work…But might not as the authors show..

Who said economic history is boring and remains in the past? It is ever-changing and highly dynamic. Just that papers like these make you revisit the lessons you just learnt…

3 Responses to “Did Doubling Reserve Requirements Cause the Recession of 1937-1938?”

  1. Jeff Says:

    I would suggest that we don’t actually know much of anything and this belief that the next great economic theory will allow the elites to once and for all “manage”
    the economy is simply nonsense …

    Stop trying to centrally manage what can’t be centrally managed …

  2. Happy New Year wishes to all and Mostly Economics 2011 in review « Mostly Economics Says:

    […] Did Doubling Reserve Requirements Cause the Recession of 1937-1938? 1 comment February 2011 […]

  3. Was Riksbank monetary policy in 1930s innovative? « Mostly Economics Says:

    […] ling felt that 1937-38 recession was caused by Fed doubling reserve requirement of banks. Calomiris showed banks maintained high reserves anyways. Douglas Irwin brings another insight saying sterlization […]

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