Monday, December 22, 2008

instruments of fed policy

I've been reading about the 1907 financial panic, and once again it looks as though a period of good times leads to leverage which serves both to intensify the correction and to make it more painful. I've come to believe that, where the Fed does see something that looks like a bubble, it should try to take steps that to thwart its being facilitated by debt; if it has fundamental support, the worst that removing leverage would do is to slow the equilibration. Likewise, the point of having reserve requirements for banks is that they be able to absorb some losses of capital without going below zero, but if you keep reserve requirements fixed, those losses of capital will result in going below the reserve requirements — you've simply moved the baseline from that standpoint. Zero is undoubtedly a special number, and solvency an important characteristic regardless of regulatory compliance — especially in terms of systemic stability — but in a time when banks are increasingly risk-averse of their own free will and many of them, while still solvent, don't have money to lend even to low-risk potential borrowers, it seems like we could benefit from lower reserve requirements.

The fed occasionally changes reserve requirements, perhaps most notoriously in 1937, when it felt the need to "mop up excess liquidity". That history notwithstanding, I wonder whether some interesting research could be done on whether the fed could effect policy with any greater success if it regarded regular changes in the reserve requirements as a normal tool to put to that service.

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