Reserves before the Crisis

Total Reserves relative to GDP:

Graph #1: Total Reserves as a Percent of GDP

Falling. From about 3¾ cents per dollar's worth of GDP in the late 1950s, to less than half a cent in the 2000s. After that came the big spike that was the Fed's response to the financial crisis. (Only the very beginning of that spike is shown on this graph.)

I want to point out a slight high spot in the downtrend, a double-hump that is over and done with by 1975. Nothing to do with Paul Volcker.

And I want to point out the hump after 1985 and another one, crossing 1995. These two humps I have discussed before.

(The humps are not part of the current topic.)


Same graph, multiplied by prices instead of by 100:

Graph #2: Start with Graph #1 and Multiply by the Price Level

Graph #1 is all downhill. Graph #2 is a lot more horizontal, until 1995 anyhow. Almost looks like the Fed could have been using Graph #2 as a guide to keep reserves in a target window.

But Graph #2 is of course identical to Graph #3, where instead of dividing by GDP and multiplying by prices, we reduce two steps to one and divide by so-called "real" GDP:

Graph #3: Total Reserves as a Percent of Inflation-Adjusted GDP

Because inflation remains in the numerator but is removed from the denominator, the plotted line is reluctant to fall. The inflation remaining in the numerator on Graph #3 pushes the line up. The only difference between Graph #1 and Graph #3 is that Graph #3 has inflation removed from the denominator.


If the Federal Reserve was using one of these three graphs as a guide for setting the growth of Reserves, it would have been Graph #3, where the victim is divided by a denominator that has inflation stripped away, so that the inflation which remains in the numerator distorts the resulting values by pushing them up.

In the case of Graph #3, the distortion pushes the Graph #1 values up just enough to keep the plotted line relatively flat until 1995 -- and again, from 2000 to the crisis.

But let me ask a question.

I don't know what is the "best" level of reserves. But there must be such a level. For the sake of argument let's say the "best" level is the first value shown on the graphs.

You could pick any level. For me, the first value is the easiest to think about. And it is the same amount of reserves at the start, no matter which graph we look at. The same amount at any moment, no matter which graph: The y-axis numbers are different, and the plots are different, because we're dividing by different things. But the amount of reserves is the same on all these graphs no matter what the reserves are divided by.

So here's the question: What is the right thing to divide by?

We want a level of reserves that stays more or less in proportion to the quantity of money, and a quantity of money that stays more or less in proportion to GDP. So reserves should stay more or less in proportion to GDP. But which GDP? Nominal or Real? Actual-price GDP, or inflation-adjusted?

The denominator should be actual-price GDP, like Graph #1. Why? Because the amount of money we need depends on the actual purchase price of GDP. If prices go up, then we need more money to buy the stuff. This is true, no matter the cause of inflation.

Reserves must remain in proportion to actual price GDP.

Graph #1 shows a long-term decline in reserves, as total reserves increased more slowly than actual-price GDP. For all that time the quantity of money was restricted: Reserves were restricted to fight inflation. For all that time, actual-price GDP increased faster than reserves, forcing the line down. The result was we had less and less money to buy the stuff we were producing.

If inflation was the result of too much money -- or too much reserves -- the decline of reserves would eventually have stopped inflation. Somewhere along the path from almost 4% of GDP to 2% of GDP to 1% of GDP to less than half a percent of GDP, the decline of reserves would have brought inflation to a halt.

But inflation never did come to a halt. The quantity of reserves continued to decline relative to GDP until the crisis, but the decline never brought inflation to a halt.

If "too much money chasing too few goods" was the problem -- if too much reserves was the problem -- then the decline of the line shown on Graph #1 would have fixed the problem, and eventually the line would have gone flat.

The line never went flat.


Here's another look at reserves as a percent of actual-price GDP, like Graph #1. But this time the graph also shows the Fed's response to the financial crisis:

Graph #4: Total Reserves as a Percent of GDP (thru September 1, 2012)

From the 1950s to the crisis of 2008, the Federal Reserve responded to inflation by reducing reserves relative to GDP. The Fed did this continually, repeatedly, over and over, no matter how low the level of reserves fell.

But then there was the financial crisis, and suddenly they changed their mind.

Here's the thing: If the quantity of reserves (or the quantity of money) was the true cause of inflation, then reducing reserves relative to GDP (as on Graph #4 before 2008) would have been the right thing to do. It would have worked. Sooner or later, it would have stopped inflation.

But it didn't work. And now we no longer even try to stop inflation. We just try to keep inflation stable. This is an extraordinary failure of policy. The failure shows that the quantity of money and reserves was not the true cause of inflation.

The Federal Reserve reduced reserves continuously relative to GDP for half a century. The policy did not stop inflation. It only stopped the economy.