I have been analyzing various aspects of the government’s and the Federal Reserve’s responses to the current economic conditions, which were largely brought on by the government and the Fed in the first place.  For this post, I am going to discuss the Fed’s move to eliminate reserve requirements for banks that it announced on March 15, 2020.

This new policy almost slipped through the cracks with all of the major moves coming from the Fed.  It’s possible the move isn’t significant, but it’s also possible it is quite significant.  I tend to think it is significant because it wouldn’t make sense for the Fed to implement this new policy if it has no impact.

Before implementing this new policy, banks were previously required to hold 10% in reserves. In other words, if you deposit $1,000 into a bank, then the bank must keep at least $100 of that in reserve. The other $900 could be lent out. This is fractional reserve banking.

Austrian school economists differ on the policy of whether fractional reserve banking should be legal in a free society.  I take the position that it should be legal as long as the parties are consenting to it.  If a bank says it is keeping all checking deposits in reserve (like a storage facility) but then loans some of it out, then this would be fraudulent.  But if all parties agree to the terms of the contract and those terms are upheld, then I see no issue from a libertarian standpoint.

With that said, I take the view that Mises held that fractional reserve lending would be extremely limited in a system of free market money.  This would mean the non-existence of a central bank and the FDIC.

Given that we don’t have anything resembling a free market system in banking, it makes some sense for the banks to be required to hold reserves.  If the Fed is going to prop up and bail out the banks when needed, then it makes a certain degree of sense to require the banks not to be completely reckless.

Since the fall of 2008, commercial banks in the U.S. have largely increased their reserves in tandem with the Fed’s monetary inflation.  I believe this is one of the reasons that we did not see massive price inflation over the last decade.  The Fed was inflating the money supply, but it largely wasn’t being multiplied by the banks through fractional reserve lending.

The massive excess reserves started to fall in 2019 with the Fed’s mild deflation of its balance sheet.  Now that the Fed is creating money out of thin air like never before ($1.5 trillion over a three-week period), I expect that excess reserves will increase.  It appears that is happening already.

Banking Troubles?

It doesn’t make that much sense why the Fed would eliminate reserve requirements when there are already massive excess reserves held by banks.  In other words, it seems that most banks are well over the 10% threshold already, so why did the Fed eliminate the 10% requirement if it was easily being met?

The only thing I can conclude is that one or more of the major banks is on the verge of bankruptcy, or else the Fed is worried that the major banks will quickly deplete their excess reserves and possibly face bank runs.

I don’t think we are going to get bank runs as was seen in the Great Depression.  Most of our banking system is digital.  This doesn’t mean that you shouldn’t have a small amount of physical cash available just in case.

But the banks can experience a digital run, so to speak.  The Fed is obviously taking pre-emptive action to reduce this possibility.  We know that massive defaults are coming.  If there is 25% unemployment, that alone will mean massive defaults on mortgages and other loans.

With regard to the elimination of reserve requirements for banks, the obvious major fear is hyperinflation.  If banks can loan out essentially all of the money they receive for deposits, this can multiply the money supply almost infinitesimal.  This is why the Fed’s new policy makes no sense.

It says in its statement: “This action eliminates reserve requirements for thousands of depository institutions and will help to support lending to households and businesses.”

This is exactly the thing we should be afraid will happen.

As I have argued before, the Fed doesn’t want to see hyperinflation.  The people working at the Fed would be destroying their own power.  They would also be destroying their own dollar-based pensions.  But that’s not to say that the Fed couldn’t lose control of the situation and still destroy the dollar.

I was going to say that we need to keep a close eye on excess reserves held by banks, but then I realized that essentially everything the banks have will be considered excess reserves since the reserve requirement is now zero.  So I’m not sure how this will get measured.

My biggest fear coming out of all of this is that we face some kind of hyperinflation without any alternative functioning money in place.  I am a big fan of using gold as money (as was chosen by the marketplace for thousands of years), but it isn’t easy to just switch to gold overnight.

I fear hyperinflation because it could mean a major breakdown in the division of labor. It would make the last month look pleasant by comparison.

I am not predicting this will happen.  I hope the Fed’s move in eliminating reserve requirements was done for other reasons that I cannot see.  But forgive me for feeling a little anxious over the Fed giving a green light to banks to lend everything they have.  It’s something I am going to keep a close eye on.  Either way, we should prepare for massive price inflation ahead.