Fear, Currency Holdings, and the Fed

The chart below shows the amount of currency held by the public through last Friday. Can you detect a pattern? When people get scared, as they are now, they pull money out of the bank, out of money funds, and out of their brokerage accounts and stick it under the mattress.

 
When this happens, the initial impact is to shrink bank reserves by draining off increases in the monetary base outside the banking system. This is important because (at least until 2 weeks ago)the monetary base was growing quite slowly. During the period 9/27/07 to 8/27/08 the monetary base increased at a 2.6% annual rate, while bank reserves increased by just 0.9%. Both are too low to allow banks to provide working capital to their growing business customers, let alone to solve a credit freeze. That’s why I have been complaining about the Fed’s sterilization policy and that’s why I have been advising the administration, in a series of White House conference calls, that the rescue plan cannot succeed unless it has the proper Fed policy to support it.

Over the past 2 weeks, of course, all this has changed. The Fed has nearly doubled reserves, from $98.3B on Sept. 10 to $166.3B on Sept. 24. It is too soon to tell if this is a new policy (i.e., if they have abandoned sterilization), or if it is a one-time hail Mary pass. It would help if the Fed would clarify this in writing.

The increase in currency holdings also highlights one more thing. I think it is dereliction of duty for policy makers and political leaders to use fear as a weapon. Can you imagine Winston Churchill, or FDR, or President Reagan intentionally scaring people? In my book, a real leader helps people remain calm in difficult situations and helps them marshall their energies to fix whatever issues need to be addressed. At least since 9/11, we have used fear as a tactic for mobilizing public support for various policies and for manipulating people’s behavior. But fear, over long periods of time, is physically and psychologically debilitating. And fear tactics undermine the public’s willingness to respond when there is a genuine problem. I can’t help wondering how much of today’s fear is a reaction to that history.
JR