This post grew from a back-and-forth discussion with a commenter at Seeking Alpha. The commenter's position was that taking away the reserve requirement was an mistake, and in substituting quantitative control of bank reserves with control of interest rates instead, central banks ended up with a less useful control lever for money supply.
I believe that central banks cannot fully control the money supply, because private loan demand and government spending is what directly increases it. Central banks can indirectly control it by increasing the cost of credit, so that private loan demand plummets, or by decreasing cost, so private loan demand increases. But at this point in time, when people are already over-indebted and the cost of credit is already at zero, there’s not much more it can do to increase loan demand, and hence to increase money supply.
But just because the Fed controls the cost of credit doesn’t mean they should use it to mismanage the economy. Trying to stimulate more economic activity or bank lending by increasing reserves does not lead to more lending, and only results in fund misallocation, as investors who cannot earn positive income from investing in bonds allocate it to commodities instead (in the belief that inflation is just around the corner).
Now that rates are at the zero boundary, monetary experts insist that the Fed stimulate more activity by quantitative easing, or swapping government bonds held by banks with more reserves. At least when the Fed was controlling the rate of credit, they were able to encourage more lending or they were able to decrease it. Now that it is manipulating reserves, what has that done to increase lending? And if you disagree with Fed control of rates (a position I confess to identify with), why would you advocate Fed control of reserves? Why should the Fed limit all reserves, when their real constraint to lending is their capital?
Taking away restraint on reserves in no way affects the restraint of banks to lend, so bringing it back will not fully constrain it when conditions are right for more lending, and they have adequate capital reserves. In this scenario, all a high reserve requirement will lead to is an increase in interest rates as banks vie to borrow the reserves they need to make the loans they want to give.
With a return to contra of reserve requirements, do you think banks will lend every reserve because they can? Wouldn't it be better and cleaner just to securitize a loan, so no heavy capital requirement is necessary? Whether or not the banks have legal reserve management mandates does not constrain banks anymore. What constrains them more is complying with Basel capital standards. If they are unable to comply with Basel, having no required reserves will do nothing in this world to enable banks to lend.
The Real Use of Bank Reserves
Increasing levels of vault cash, ATM networks, retail deposit program have have made unprecedented demands on banks to have the necessary reserves when needed. Hence, there has been a pragmatic shift by central banks away from most reserve -- and reserve ratio -- restrictions. So why bring back a constraint on reserves? Why limit reserves when banks are just facilitating the various transaction needs of their customers? The level of reserves has no effect on a bank’s lending. It's completely separate and different field of activity from reserve gathering and management.