The Diminishing Marginal Utility of Excess Bank Reserves

This is not an argument for more quantitative easing, or QE3, as it would inevitably be called. Instead, this is about the logic of the argument for more quantitative easing. It is intended as a response to the oft-heard argument that more quantitative easing wouldn’t stimulate the economy because past quantitative easing hasn’t produced the desired results.

The answer is a simple economics concept, the concept of diminishing marginal utility. Other things equal, the more you have of something the less additional satisfaction comes from more of it.

Given the financial crisis, recession, slow recovery, and the pounding the banking industry has taken from all fronts, the banks have had a large appetite for excess reserves as a contingency. They may be excess in a technical sense, but they are not excess to the bankers under current circumstances. Therefore, the huge amount of reserves created by the Fed’s past open market purchases have largely ended up on banks’ balance sheets as excess reserves rather than being fully utilized to make money-creating bank loans and investments. A similar phenomenon occurred during the depression.

If the Fed had not engaged in aggressive open market operations to create reserves, chances are the banks would have tried to add to their reserves by shrinking their balance sheets. At this point, additional reserve creation may lead to more reserve hoarding, but, given the diminishing marginal utility of those reserve, at some point what can be done with additional reserves will become more attractive to banks than accumulating more reserves.

If a medicine has been sufficient to keep a patient from worsening, but not sufficient to restore his health, the answer may be to increase the dosage rather than remove the medicine altogether.

Don’t worry whether diminishing marginal utility is a Keynes or Hayek concept. It is neither. It is micro rather than macro.




Comments (2)

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  1. flow5 says:

    Wrong. QE is not ubiquitous.

  2. jgo says:

    Ask 10 economists to define “excess reserves” and you’ll get 20 answers.

    And that’s before you talk about how the bankers and much (but not all) of the public has caught onto the monetization of the governments’ debts. This introduces another layer of subjectivity (which fits right in with the Austrian school analysis) as what one government authority considers “excess” reserves prove inadequate for the withdrawal demands of a particular institution’s depositors as they attempt to defend themselves against the under-cutting of the value of their funds by shifting to harder assets, etc.

    Similarly, there was talk/were writings in the 1980s of “excess” investment in firms’ pension funds. Leveraged buy-outs in which such “excess” funds were shifted to other purposes were praised as releasing them to more productive purposes. It wasn’t very long into the 1990s that we started seeing news about firms whose pension fund investments had proven to be inadequate. By the time Bethlehem Steel was renamed, ripped apart, and the pension obligations dumped onto tax-victims, the story was that even the Pension Benefit Guaranty quango had been exhausted.

    But rather than shining bright lights on the edge cases in such instances, the financial media seem to eagerly join in on efforts to cloud the issues.