David R. Henderson  

A Problem With Minimum Requirements

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"To rely upon a reserve requirement for the meeting of cash-withdrawal demands of banks' customers is analogous to trying to protect a community from fire by requiring that a large water tank be kept full at all times: the water is useless in case of emergency if it cannot be drawn from the tank."

Armen A. Alchian and Willam R. Allen give this unsourced quote on p. 708 of the first edition of their modern classic, University Economics. BTW, I lost my copy of the third edition in my 2007 fire and my friend, Gloria Valentine, Milton Friedman's long-time assistant, gave me Milton's autographed copy. It's inscribed, "To Milton, Herein--somethings old, somethings new, somethings good--borrowed straight from you. Armie."

I was reminded of this when I read Russ Roberts' post in which he quoted from an article in The Economist. For days, the Japanese government kept to its policy of requiring that oil refiners keep a minimum of 70 days' supply in reserve. Specifically:

When the crisis hit, there was a law on the books requiring energy companies to keep 70 days of petrol in reserve. This was quickly lowered by three days, but that did not help. And there is the outrage. It was not until March 21st, ten days after the crisis, that the limit was lowered to 45 days.

See the problem?



COMMENTS (6 to date)
Phil writes:

Hilarious! A rainy-day fund that can't be used even when it's raining.

Bob Murphy writes:

They should have just issued unlimited paper tickets entitling people to one gallon of petrol upon demand. Problem solved.

A different Phil writes:

The problem is not the presence of a minimum, it is a rational risk mitigation strategy. The problem is with the absence of a policy for accessing the reserve in the event the triggering event occurs.

Grant Gould writes:

Moreover if the companies expect that the requirement is going to go back up to 70 days in the future (which it presumably is), they have to price in replacing that extra fuel at whatever that unknown future price is. Assuming that the current price reflects information about future prices, companies will sell from their reserves only well above the current market prices. We should expect a temporary relaxation of the limit to have a substantial effect only in an inefficient market, which is a bad way to bet.

Tom West writes:

We should expect a temporary relaxation of the limit to have a substantial effect only in an inefficient market, which is a bad way to bet.

Aren't all investments essentially bets that the market is inefficient and hasn't priced in something?

In the case of reserves, I'd call them insurance against temporary fluctuations. In such cases, the price *doesn't* reflect future demand, it reflects current demand vs. current supply.

Methinks writes:

Aren't all investments essentially bets that the market is inefficient and hasn't priced in something?

No.

There are very good reasons to buy assets you think are priced at fair value - you like their return with respect to the level of risk, for instance.

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