A Weekly Dose of Hazlitt: Inflation Arithmetic

Inflation Arithmetic” is the title of Henry Hazlitt’s Newsweek column from February 10, 1958. Here Hazlitt shows how inflation can be caused by lower reserve requirements rather than by the fed lowering the discount rate.

Most of us still give lip service to the ideal of preventing
further inflation; yet we advocate the very policies
that increase inflation. Even the banking community
is not exempt.

A few weeks ago, the Economic Policy Commission
of the American Bankers Association proposed a general
lowering of reserve requirements against deposits.
The reserve requirements against checking deposits
are now 20 percent for banks in “central reserve” cities
(New York and Chicago); 18 percent for banks in 48
“reserve” cities; and 12 percent for “country” banks. The
ABA recommends that these be reduced eventually to
only 10 percent against demand deposits for all member
banks no matter where located. In addition, it recommends
that reserves against time deposits be reduced
from 5 percent to 2 percent, and finally that vault cash
be counted as part of required reserves.

Fed Plans

The member banks are not alone in such recommendations.
Serious Washington reports indicate that
the Federal Reserve Board is planning to increase the
nation’s supply of bank credit sharply by reducing bank
reserve requirements, and has failed to reach agreement
merely about the exact timing of the announcement and
the specific plan. It is meanwhile significant that the
cut in the Federal Reserve discount rate from 3. to 3
percent in mid-November was followed by a further cut
in late January to 2. percent.

The huge inflationary potential in the ABA proposal
can be seen from a simple calculation. On Dec. 25, the
required reserves of all Federal Reserve member banks
came to $18.9 billion. Calculating these respectively
for central reserve city banks, reserve city banks, and
country banks, we find that they would have permitted
the member banks to make sufficient loans and investments
to create demand deposits totaling about $117
billion. In other words, the average required reserves
worked out to about 16 percent of demand deposits. If,
now, the member banks are allowed to keep reserves
of only 10 percent against demand deposits, they could
create demand deposits of $189 billion—an increase of
more than 60 percent in this part of the money supply.

We have still to consider the existing inflationary
potential of the Federal Reserve Banks themselves.
At one time they were required to keep gold and cash
reserves of 35 and 40 percent against deposit and note
liabilities respectively. But since 1945 they have been
required to keep only 25 percent reserves in gold certificates
against deposit and note liabilities combined. On
Jan. 29, they kept a gold certificate reserve of $22 billion,
or 47.3 percent, against combined note and deposit
liabilities of about $46.7 billion. If they increased their
own liabilities to reduce their gold certificate reserves to
only 25 percent, those liabilities would go to some $88
billion. Depending on the percentage of the increase
that went into creating deposits for the member banks,
those deposits could increase from the present $19 billion
to $40 billion or even to $60 billion. If the member
banks then kept only 10 percent reserve against deposits,
their demand deposits would increase from the present
$117 billion to $400 billion or even $600 billion!

Potential Inflation

Several conclusions are suggested by these theoretical
calculations. There are enormous inflationary potentialities
even under the present Federal Reserve law. These
inflationary potentialities could and should be cut off
by a change in the law. If the private banking community,
the Federal Reserve authorities, or Congress want
to cut off these possibilities, this is the place to begin.
The big city banks are right when they argue that the
present differentials in reserve requirements are obsolete
and unfair. But the way to cure this discrepancy
is not to lower the reserve requirements for everybody,
but to equalize them (over a long period) at the present
average level.

The agitation for lower reserves shows the inflationary
psychology that follows when the gold standard is
abandoned. If the reserves themselves are only paper,
even bankers begin to wonder why it is necessary to
keep them at all.

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