Reserve Balance Misconceptions

By Dan Kervick

Mark Thoma, writing in the Fiscal Times, has called for the Federal Reserve to take “bold, creative moves” to alleviate unemployment.   Thoma’s suggestions contain nothing novel, and I suspect Thoma is fully aware that what our economy really needs is a fiscal expansion from the federal government.  But perhaps these tired calls for additional central bank string-pushing deserve some sympathy.  Many have concluded that the attempt to get Congress and the White House to act to increase government spending are futile, since the elected branches of our government seem unwilling to do what needs to be done out of some combination of incompetence, iniquity, ignorance, ideology and insanity.

But Thoma’s argument contains a few puzzling passages that repeat and reinforce some common misconceptions about the relationships among spending, bank lending and bank reserves; and it is worth spending a few words to challenge these misconceptions once again, because to the extent that they still have wide currency they stand in the way of a clear grasp of the nature and limits of monetary policy options.  Thoma first makes the following claims about bank reserves:

One of the main ways the Fed stimulates the demand for goods and services is by giving the banks more money to lend through what are known as open market operations. But if this money simply piles up in banks as excess reserves instead of being used to make new loans to consumers and businesses, it won’t have any effect on the demand for goods and services and it won’t cause prices to rise.

Excess reserves are, in fact, piling up in banks –– from near zero before the recession to around $1.75 trillion today  –– instead of flowing into the economy and offsetting the fall in demand from the recession. Because of this, demand is too low, unemployment is too high, and inflation has consistently been running below the Fed’s two percent target.

He then goes on to suggest that the Fed should impose a negative rate of interest on excess reserves:

But now, when unemployment is the problem, the Fed seems unwilling to push the limits to the same degree. For example, the Fed could charge banks for holding excess reserves instead of paying them interest on those reserves as it does now. With such a penalty in place banks would have a much larger incentive to make loans, and some of the piled up reserves would leave banks and turn into new demand for goods and services. That’s just what the economy needs.

Let’s set aside for now the questions of whether the Fed can do anything in the present environment to stimulate demand and hiring, and whether setting a negative interest rate on excess reserve balances would help accomplish those ends.  Those have been persistently controversial questions.   But what should not be controversial is that the picture Thoma paints of excess reserves piling up in reserve accounts instead of “leaving” the banks and “flowing into” the economy is very inaccurate.  This is easy to see by considering a few hypothetical examples.

Suppose Maple Valley Bank makes a new $100,000 loan to Granite Construction.  The bank creates a new demand deposit account for the construction company, and credits $100,000 to that account.  In exchange, it receives from Granite Construction a promissory note promising the return of the $100,000 plus a certain amount of interest to be paid over a defined period of time.  At this point Maple Valley bank’s total reserves have not changed at all.

Now suppose Granite Construction begins to spend the $100,000 it has been loaned, mainly by writing checks against the new account.  Some of those checks are written to other companies and individuals who also bank at Maple Valley Bank.  When those checks are deposited back at Maple Valley Bank, and the payments are settled and cleared, the result is that the deposit accounts of the payees are credited by the appropriate amounts and the deposit account of Granite Construction is debited by exactly equal amounts.  Again, there is no change in Maple Valley Bank’s reserves.

However, some of those checks will go to companies and individuals who bank at other banks.  Suppose Granite Construction issues one check to Seacoast Cinder Blocks for $25,000, and another check to Rob Handy, a temporary day laborer, for $200; and suppose that both of these payment recipients bank at Ridge Bank, another local bank, where they deposit their checks.  This time, when the payments are settled and cleared, a payment has to be made from Maple Valley Bank to Ridge Bank for $25,200.  At the regional Federal Reserve Bank where both banks hold their reserve accounts, the reserve account of Maple Valley Bank is debited by $25,200 and the account of Ridge Bank is credited by $25,200.   But note that while the reserve balances of the two banks have changed, this operation obviously does not reduce the total reserves of the banking system at all.

Now, some of the total reserves held by banks are held in the form of vault cash, and it is possible for those reserves to temporarily leave the banking system entirely.  For example, Rob Handy now has $200 more in his account at Ridge Bank.  Suppose he withdraws $40 in cash to meet his out of pocket expenses.  The total reserves of Ridge Bank have been reduced by $40.  Over the next few days, Rob buys some doughnuts at the Donut Kettle, a couple of lunches at the Sally’s Sandwich Nook and few groceries at Biddleford’s Supermarket.  Those local businesses collect the cash payments and deposit them the next day at their banks, where the money goes right back into bank reserves as part of vault cash.

So cash withdrawals made for the purpose of spending also do not change the level of bank reserves, since that cash is continually flowing both out of some bank vaults and into other bank vaults as the spending takes place.  Now, it is always possible that Rob puts the cash under his mattress or leaves it on top of his dresser for an extended period of time.  To the extent that this might happen on a widespread basis over some period of time, it is possible that aggregate bank reserves might be reduced for that period of time.  But then the expansion of lending would be having no effect on spending.   If an increase in lending actually stimulates spending, cash withdrawals are always making their way back into bank cash reserves in very short order.

So even if some bolder form of monetary policy can be effective in stimulating more lending and spending, one should not expect to see the impact of that stimulatory policy show up in the form of overall reductions in bank reserves, with excess reserves flowing out of reserve accounts and bank vaults and “into” the economy.  And by the same token, one should not look at the phenomenon of bank reserves “piling up” as evidence of the failure of monetary policy to cause those reserves to be loaned out.   Reserves in the aggregate are not loaned out.  Apart from relatively small fluctuations in the amount of physical cash being held by the public, bank reserves don’t leave the banking system.

I really think it is important here for pundits and informed members of the public not to lose hope about the possibility of fiscal expansion.   We have had four years of confusion and time-wasting debate about various misguided austerity theories, but those theories are now in the process of crashing and burning.  We have yet to see what can happen if economists, economics bloggers and the public begin to mobilize a call for intense political pressure on Washington (and other governments) to reverse the austerity push and expand spending.

The US government is an extremely  large public enterprise, and a tremendously important part of our national economy.  It produces a great number of public goods and services and employs millions of people, and it also helps fund state and local governments.  It is a consumer, investor and employer.  But throughout the Obama administration, and especially following the election of the reactionary Republican Congress in 2010, we have seen a massive decrease in government consumption and gross investment, and unprecedented reductions in government employment.   Public enterprise is collapsing at a time when we need it most, both to help stabilize the economy and to drive the next stage of national development and progress.   The best way for government to stimulate demand is to expand its role as a demander.  The largest potential customer in the known universe – the United States government – has to step up its purchases, step up its hiring and step up its leadership role in the economy.

140 responses to “Reserve Balance Misconceptions

  1. golfer1john

    Well, the elephant in the room regarding reserves is that banks don’t need them to make loans. They make loans whenever they find a creditworthy borrower who is willing to pay a profitable interest rate. They worry about getting the reserves later, and reserves are always available, if not from other banks, then from the Fed at the discount rate.

    Even now, and throughout the “recovery”, banks are more than willing to lend to creditworthy borrowers. If a negative interest rate on reserves would force them to lend more, it would be to less creditworthy borrowers, which is not a good thing, and is how we got into the GFC in the first place.

    Besides, powering a recovery from bank lending is unsustainable. The recovery must be powered by increasing incomes, the result of more employment and production, which is the result of increasing sales. It is, as you say, a fiscal problem not a monetary one.

    • A “recovery” fueled by artificial asset bubbles seems to be much more palatable for Washington than scary deficits and socialist Obamabucks these days sadly..

    • “Besides, powering a recovery from bank lending is unsustainable. The recovery must be powered by increasing incomes, the result of more employment and production, which is the result of increasing sales. It is, as you say, a fiscal problem not a monetary one.”

      Quite so. Almost a matter of a society engaging in “procedural fairness” you might say!

      • golfer1john

        No, I wouldn’t say that. I don’t see any relationship.

        • “No, I wouldn’t say that. I don’t see any relationship.”

          Here’s a little help:-

          http://www.newamerica.net/files/Thomas_Palley_America%27s_Exhausted_Paradigm.pdf

          • golfer1john

            I don’t see the phrase “procedural fairness” in that document. According to Wikipedia, procedural fairness is

            “A dispute resolution concept which provides an employee a fair process in resolving disputes. The concept requires transparency, equal communication and fairness in allocation of resources used to resolve the dispute. Also called procedural justice.”

            My impression is that it means the employee gets the same caliber of high-priced legal representation that the company or union has.

            I don’t see how this relates to MMT, or deficits, or bank lending. And surely not to Palley’s diatribe.

      • A lending recover is theoretically possible.
        If loans are made to expand business and that succeeds then once the loan is repaid there is still the extra activity of the new or expanded business. More jobs and more demand / supply for things.

        Sadly Banks don’t like lending to industry, it’s risky and the profits are limited by actual profits. They vastly prefer lending to inflate assets. Which does nothing for the economy other than raise prices. Potentially slowing things down and making it worse.

  2. golfer1john

    A bold move by the Fed would be to allow state and local governments to borrow at the discount window. They would for sure spend the money, or use it to reduce taxes so that their citizens could spend. That is the sort of thing needed to ward off the oncoming recession.

    • Sunflowerbio

      Golfer, I’m not sure states like mine that are in the full grip of the austerians would borrow from the Fed even at zero interest rate. They want to reduce spending, shrink government, and try to steal businesses from other states with a race to the bottom of taxation. Why a business would want to move to a state with no services, lousy schools, and crumbling infrastructure is another question.

      • golfer1john

        States don’t have the option of unlimited deficit spending. They have to (some by constitution) balance their budgets, and limit spending to income. They do, however, issue bonds, and being able to borrow from the Fed at low rates would enable them to refi their existing debt, which would be attractive to the austerians, and help the rest of us as well.

        • sunflowerbio

          You are right that refinancing existing debt at lower interest rates is attractive even to austerians and might be mildly stimulative in allowing additional spending from the savings, but the projects funded by the original bonds are probably already completed and paid for. Austerians are not as interested in new government funded projects for the most part, with a few notable exceptions. If the will is not there to spend, whether by borrowing or taxing, low interest rates will have little effect.

          • golfer1john

            You’re right, the effect at the margin will not be for the States to immediately start new projects, but only to avoid tax increases or spending cuts that would otherwise be needed to support the current debt service costs. As their fiscal condition improves, though, the will may return.

            It would be totally equivalent to a revenue-sharing grant from the Treasury, with no strings attached. One of MMT’s core ideas.

    • charles fasola

      State and local governments being monetarily non-sovereign gain nothing from borrowing, The sort of thing needed is for our monetarily sovereign federal government to provide state governments with adequate finances to serve public needs. That is a bold move; your suggestion is more of the same tired thinking. Lending at interest to monetarily non-sovereign entities eventually ends in failure, unless free lunch offsets the negatives.

      • golfer1john

        Lending at 0.25% interest, or any rate below what they would pay otherwise, is a plus for the non-monetarily sovereign governments. It’s the way the Fed can help. The Fed doesn’t control the tax cuts or revenue-sharing that would really help.

  3. if the Fed charged banks for holding “excess” reserve balances then they would just withdraw them as cash and stick the cash in a vault.

    • golfer1john

      No, vault cash counts, too. But I’m sure some non-bank would step up and borrow excess reserves overnight at a negative interest rate that was lower than what the Fed charged, to get the banks off the hook.

      Or a game could spring up, like the snipers on Ebay, where a bank employee borrows millions of dollars, and at the last second transfers it to his account in the rival bank, and sticks them with the negative interest charge.

      • Apparently the fed is not authorized to pay interest on reserves for vault cash:

        http://www.federalreserve.gov/monetarypolicy/ior_faqs.htm

      • “No, vault cash counts, too”.

        really? do you know where I can read up on that?

        • golfer1john

          I only meant that vault cash is part of a bank’s reserves. I don’t have a specific reference handy, but maybe some of Mosler or Wray’s writings about the banking system. Maybe Fulwiler, too. Reserves are vault cash plus balances at the Fed.

          I guess, though, if the Fed doesn’t pay interest on vault cash, maybe they wouldn’t charge interest on vault cash even if they charged interest on Fed balances, so your idea could work. It might make bank robbery (the old-fashioned way) more profitable, too.

      • If the fed charges a negative interest rate, this would probably also get passed on, in part, to bank depositors. Meaning that they would be the ones to withdraw their balances as cash, rather than banks.

        This is worth a read:

        http://libertystreeteconomics.newyorkfed.org/2012/08/if-interest-rates-go-negative-or-be-careful-what-you-wish-for.html

        • Exactly, the interest banks pay on term deposits always has to be lower than the lending rate, otherwise depositors could simply borrow money, deposit it in their accounts, earn the interest, repay the loan, and make money from the bank on the spread. If interest on reserves were negative, competitive pressures would push the lending rates down toward negative territory, but the deposit rate can’t go much below zero or else everybody would withdraw their money. (But I suppose people might be willing to accept a slightly negative rate as a fee for convenience, storage and payment services.)

          • golfer1john

            Some people have for a long time accepted a zero nominal interest rate, coupled with fees for bank services such as writing checks, doing an ATM transaction or seeing a teller, even when other banks and credit unions were paying 3-6% on NOW accounts with no fees for such ordinary activities. I always switch banks when that happens.

        • golfer1john

          Interesting thoughts in that link. By force of habit, mostly, I still practice the techniques I adopted in the late 1970’s to accelerate receipts and delay payments, and make sure most of my cash stays in the savings account until needed in checking, even though it doesn’t matter much anymore. It would be a big change to go the other way!

  4. Jerry Brown

    Now I am confused a little. When Maple Valley makes that first loan to Granite Construction don’t they then have to ensure that their reserve balance at the Fed will cover that loan (up to the reserve requirement on a demand deposit of $100,000)? I realize that there is a lag as to exactly when the reserve balance would have to exist, but, if Maple Valley did not already have any excess reserves prior to the loan, couldn’t the creation of excess reserves by the fed be considered mildly stimulative? I mean that Maple Valley knows going in to the loan that it has excess reserves already and that therefore it will not have to borrow anything to cover the reserve requirement, either from other banks or from the fed itself. So it may be willing to loan at a lower interest rate than otherwise, which in turn may lead Granite Construction to borrow at the lower rate rather than not borrow at all.

    • golfer1john

      Under “normal” conditions, the Fed funds rate is their “cost of funds” for the loan. Today, it is the interest on reserves rate instead. Either way, they know going in what their margin will be on the loan. When the Fed lowers the funds rate, banks lower their interest rates. Usually the prime rate is what gets lowered by the big NYC banks, and the others add a relatively fixed margin to that based on the credit rating of the borrower. At least that’s how it used to work.

      So, yes, lowering the Fed Funds rate (and maybe even charging negative interest on reserves) does encourage borrowing, because the rates businesses pay are tied to it. But that does not create more creditworthy borrowers. And small changes in interest rates won’t cause businesses to wholesale change their strategy from “try to hang in there” to “all in” expansion, or vice verse. Mainly, businesses borrow when they need to for business purposes, like to finance their inventory, or to acquire more plant, and the cost is a secondary consideration at best. (Although lately some are borrowing to refinance higher-rate loans, or to fund stock buybacks.)

      Your understanding is the basis for Fed policy, and why they think it is counter-cyclical to lower rates when the economy is doing poorly, and raise them when it is doing better. It is so effective 😉 that it is called “pushing on a string”. And lower rates have a pro-cyclical impact because they remove interest income from the private sector.

      • Jerry Brown

        Thank you golferjohn. That is exactly what I meant by saying mildly stimulative. Pushing on a string is a better analogy, I agree. My main concern was if I had misunderstood something in my previous readings. As far as you know, is my previous comment/question inaccurate? If I have something wrong there I want to know, thats why I was confused.

        • golfer1john

          It’s a subtle point, I guess. The decision process of the bank is based on the margin, the difference between their cost of funds and the interest rate on the loan. Whether they have to borrow in order to meet the reserve requirement, or they will not be able to lend their excess reserves, their cost of funds is the same. Without the Fed paying interest on reserves, excess reserves in the banking system would drive the Fed funds rate to zero. Since they do now pay interest on reserves, the Fed funds rate goes to the IOR rate, and that is the cost of funds to an individual bank contemplating a loan.

          So, an individual bank having excess reserves wouldn’t influence their decision to lend, or the interest rate they would charge. Changing the Fed funds rate and IOR rate would cause banks to change their loan rates. QE does not. QE is not directly stimulative to the economy at all, in way a tax cut would be. It stimulates prices of bonds, and investment alternatives such as stocks, and there may be a secondary “wealth effect” as people see their 401(k)s going up. But it also removes interest income from the private sector.

          • reve_etrange

            I guess it’s potentially stimulative over a finite time, if the deficit reduction that accompanies QE convinces Congress to increase spending, just like spending revenue from a redistributive wealth tax.

    • If the banks were lacking excess reserves, and if that were inhibiting them from making loans they would otherwise want to make, then any actions taken by the Fed to reduce the cost of borrowing reserves should stimulate lending. But that picture doesn’t seem to be true of the current situation, since banks already have reserves far in abundance of what they need to expand their lending.

      Note that what Thoma is suggesting is a negative rate of interest on reserves. (Presumably, he is suggesting that the Fed also set the discount rate at some amount not much higher, and target a negative Fed Funds rate that is in between the rate of interest rate on reserves and the discount rate.) He’s not arguing that this will be stimulative because it will reduce the cost of additional funds, because most banks already have all the funds they need. He’s arguing that it will be stimulative because it will increase the cost of holding reserves they already have.

  5. E.G. 'Gerry' Spaulding

    Dan is correct about the nature of these reserve transactions, which shows that the idea of reserve-basing any monetary policy activity is akin to pushing a string up the hill.
    The most noteworthy aspect of Thoma’s idea is that these excess reserves have already been used to improve the balance sheet positions of these banks with regard to the Fed’s new asset holdings. So the banks are already in a win-win situation, even with a modest haircut.
    The Fed will be obliged to book a loss (the balance of the market-book price haircut) whenever the asset swap is reversed.
    Then the fun begins for the taxpayers.
    The idea that economic growth will happen through increased lending is pure folly.
    The bankers know that there is not enough ‘money’ in the economy to make the debt-service payments on the debt already in existence.
    What is needed is demand stimulated by money without debt.
    That is, more money without more debt.
    Only the government itself can do that.

  6. Ironic for an article under a site called ‘The Fiscal Times’ to promote a clearly flawed “solution” through monetary operations.

    The austerity and debt hysteria does seem to be dying down a bit from where it was – probably because deficits are falling – but I’m not at all confident of the “absence of a negative” being turned into a positive, politically speaking. Right around when people stop worrying about the debt is probably right before we walk into another recession, and then we are back to where we started. *sigh*

    • I am sympathetic to that view. But perhaps we will be saved by some combination of credit expansion (improved housing?),and businesses seeing lower demand and profits. We can only hope that stimulates some action.

  7. Jamie Walton

    Good post Dan,
    I made a comment on one of Mark Thoma’s blogs last year pointing out what you have so eloquently laid out above, but I got no response. Oh well…? (I don’t know how to get through to economists like Mark Thoma – any ideas anyone?)

  8. Ben Johannson

    Is it not accurate to simply classify reserves as the asset offsetting the liability of the deposit? When Maple Valley Bank extends credit it gains an asset (loan) and a liability (demand deposit). When the accounts for Ridge Bank are credited for $25,200, the bank gains a liability in the form of the new deposit, but now requires an asset to balance the books. That asset is the reserves transferred from Maple to Ridge.

    • Not all reserve balance assets correspond to an offsetting liability. Also banks don’t want their books to balance in the sense that assets=liabilities. They want their assets to be greater than their liabilities, so that they are profitable. Financial assets and liabilities only balance for the financial system as a whole, since everyone’s financial liability is someone else’s financial asset.

      • Ben Johannson

        But isn’t that then really the issue, that reserves actually perform no necessary function? Reserves don’t become the deposit, as most people think, they simply follow the deposit around as the asset of the bank forced to create the liability because that’s what the Fed requires. Those reserves exist primarily on hard drives at the Fed as an exercise in book-keeping, only acting as money when purchasing cash or government securities.

        Agreed that any bank with sense wants more asses than liabilities, but isn’t it plausble that a bank creating a deposit in response to another bank’s loan is simply receiving a counter-balancing asset when reserves are transferred and that this is the proximate reason for the transfer in the first place?

        • golfer1john

          Reserves have a necessary function, to make sure the bank has enough liquid assets to meet the withdrawal demands of their customers, and to do normal day-to-day clearing of checks and other transfers.

          It is capital, not reserves, that (legally) limits the bank’s ability to make loans.

          Accounting note: capital, or owner’s equity, or shareholder’s equity goes on the liability side of the balance sheet. Assets = liabilities + capital. Profits add to capital, losses subtract. Banks do want increasing capital, not increasing assets for their own sake, but the hope is that the assets (loans) are profitable, so more is better as long as that holds true. When borrowers default (the assets are not profitable, the loans are said to be “non-performing”), capital goes down, and when capital becomes negative the bank is said to be “insolvent”.

          When a borrower misses a payment, the bank’s reserves do not change.

          “any bank with sense wants more asses (sic) than liabilities”

          OTOH, the asses that caused the GFC were the banks’ greatest liabilities 😉

          • Ben Johannson

            But the only reserves used in withdrawals is for cash, a tiny amount. Furthermore, given that your bank will deposit your check into your account before receiving reserves from the originating bank, “clearing” of payments is just a book-keeping measure. Reserves do not enable the bank to credit the account, they merely act as the paper trail of credits and debits. Again, a nice book-keeping feature, rarely anything more.

            • golfer1john

              Well, the reserve requirement comes into play for bank A on which the check is drawn, not bank B into which it is deposited. In order to clear the check, reserves (Fed balances) must transfer from A to B. That’s why A needs reserves for clearing.

            • The clearing is an actual transfer of assets from one bank to another, so it makes a real difference. If the bank credits your account it has added a liability. If the check is big enough and it credits you before collecting the reserve assets from the other bank, then in principle it could have insufficient reserves depending on its prior reserve position.

              Reserves are not just bookkeeping. They are assets. Just like your deposit balance at your bank is your asset and the bank’s liability, the bank’s reserve balance at the Fed is the bank’s asset and the Fed’s liability. Banks can create liabilities from thin air, so to speak. but they can’t manufacture their own assets from thin air.

            • Ben Johannson

              Dan,

              We’re talking in circles. I stated in my original comment that the reserves are the asset offsetting the liability, which we both agree on. But beyond double-entry book-keeping requirements, we seem to have established only that reserves are required because Fedwire requires them.

              It seems to come down to one’s point of view, as do so many things.

              • I’m ot sure if this is going on here, but there seems to be a persistent confusion about financial assets balancing or offsetting financial liabilities. In a closed economic system as a whole financial assets must equal financial liabilities, because for everyone who is in possession of a promise for $X, there must be someone else who has promised the $X.

                But no individual firm wants to have their assets balancing their liabilities. They want to have assets in excess of liabilities, so that the owners of the business are making money. The balances in the bank reserve accounts don’t just “offset” the bank’s liabilities. Those balances are the bank’s assets and the Fed’s liabilities. The balances in the bank’s deposit accounts, on the other hand, are the depositors’ assets and the bank’s liabilities. These amounts need not balance or offset, and rarely would.

                Banks can’t just “create” their own assets. They have to acquire them from elsewhere, in the same way you and I have to acquire assets.

                It’s not just a case of Fedwire “requiring” the reserve assets, and its not just a matter of double-entry book-keeping conventions. The fact is that if you have a debt, you can’t pay that debt unless you also have some assets. That’s true of you and me; and it’s also true of banks. If you go to buy a car, and pay $20,000 by check, it would sound odd for you to say, “Well yes, I have $20,000 in the bank, but that’s just a formal requirement because the payment system’s bookkeepers require that that amount be there.” The fact is that if you don’t have any monetary assets with which to pay, you can’t buy the car because you have nothing of value to trade for it.

                The same is true of the bank. Banks have debts; lots of them. They constantly have to make payment on these debts. To make those payments they need payment assets. And they have to acquire those assets by exchanging something of value for them.

  9. Isn’t it true that once you make a loan excess reserves change down? So make lots of loans and the excess goes away?

    • When the bank makes the loan, its reserves don’t change. If the borrower then uses the account to withdraw money or make payments to depositors at other banks, its reserves will be drawn down. But the reserves of other banks will be augmented.

    • Yes, this is true. Key word: “Excess.”

    • “Isn’t it true that once you make a loan excess reserves change down?”

      Yes (ceteris paribus), because banks have reserve requirements on certain deposits. If the loan increases a bank’s reservable deposits, then the quantity of “excess” reserves will decrease.

      The point is that banks don’t necessarily make more loans just because they have more reserves. Nor does having more reserves necessarily mean the are able to make more loans.

      • Thanks. Next questions. If the bank has excess reserves, I understand that to be deposits at the fed? What stops the bank from withdrawing that money and buying say other assets that pay a higher return than excess reserves? If they can what stops them once those reserves get high enough?

        • Nothing really stops them. But they would have no reason to withdraw the reserves unless for some strange reason they want to buy those other assets with cash. To buy the assets they would write a check to the seller of the asset (or initiate some other payment procedure). When that payment is processed, the reserves will move from their account to the account of the seller’s bank.

          • golfer1john

            Exactly. The reserves move from bank to bank, they don’t disappear from the system.

            What stops them (if banks in fact do this) is that the prices of the other assets increase to the point where their risk-adjusted (and/or time-adjusted) return is the same as the risk-free return of interest on reserves.

            And, perhaps, that bankers – the commercial type – are very conservative investors by nature. They like a very sure, though small, return. The investment bankers that caused the GFC prefer high-risk, high return stuff. That’s the reason those two very different businesses should not be allowed to be combined.

          • Thanks. I think I got it.

            • “If the bank has excess reserves, I understand that to be deposits at the fed?

              Yes, or vault cash. Deposits at the Fed are basically Federal Reserve notes in electronic form. Bank ‘reserves’ are vault cash + Fed deposits (referred to as ‘reserve balances’).

  10. True Story

    Dan, good sir, a good article on reserves in the banking system, but let’s remember:

    Even if the author to whom you are responding is using incorrect terminology, the banks still aren’t lending that money. The multiplier is low. Negative interest rates seek to increase the multiplier, not reduce the total reserves. You can forgive the author for using wrong terminology to illustrate something connotatively correct.

    • OK, fair enough. I had a longer version of this post in which I tried to work through the details of the potential impact of going to a negative rate of interest on reserves and a negative Fed Funds rate. But I thought the post was getting to long, and so I decided to make only a more limited point here. I thought it was a point still worth making since the claim that an increase in lending will lead to reserves flowing out of the banking system is still made frequently.

      • Sunflowerbio

        It is so lame to try to increase economic activity by manipulating interest rates on reserves (pushing the string) when just taking hold of the damn thing and pulling (increasing demand) would be so much simpler and effective.

    • golfer1john

      And why aren’t the banks lending the money? Is it because they’ve given up on banking, and are trying to make profits in other ways? I don’t think so. It’s because their creditworthy customers are not asking to borrow. Lowering the rate by a fraction of a % isn’t going to change their minds. Businesses are not going to hire or invest in new plant unless they see a possibility of increased sales. Zero nominal interest rates (and negative real rates) haven’t changed that. I see no reason to believe that a slightly negative FFR would do so either, although it might bring about some other significant behavioral changes that could become very disruptive. See this link posted by Y above:

      http://libertystreeteconomics.newyorkfed.org/2012/08/if-interest-rates-go-negative-or-be-careful-what-you-wish-for.html

      • And the last time I looked, the corporate sector is itself sitting on a large volume of cash-like assets. They don’t need to borrow.

        At the end of the day, the economy is built on real non-financial assets, and financial assets can only generate wealth if enough people can exchange them for productive real assets. If a company can produce marketable value by buying capital goods and employing labor, they will do so. If their customers are too poor to buy more of the stuff they sell, then they won’t.

  11. Mile Kimball has a post today on a proposal to eliminate the zero bound by setting an exchange rate for conversion of electronic deposits that effectively eliminates what he calls the “withdrawal discount” for currency. Basically, he is trying to come up with a way of pegging the interest rate for holding currency to the interest rate for having an electronic account, so that a negative interest rate on electronic balances would be transmitted into a negative rate on holding any kind of money.

    Too supply-side oriented if you ask me, but here it is anyway:

    http://blog.supplysideliberal.com/post/51048739791/how-to-set-the-exchange-rate-between-paper-currency-and

    • golfer1john

      I’ve read the link, and I think you’ve misstated his idea, but essentially he is saying that even lower interest rates, if they could be negative, can still help stimulate the economy. According to MMT, that’s just backwards.

      • Isn’t he saying that if you impose an appropriate charge for converting an electronic balance into currency, then that will offset the ability to escape from a negative interest rate on an electronic balance by converting it into a 0% nominal rate piece of currency?

        • golfer1john

          Yes, I would agree with that, if you specify “converting at par“.

          But he would impose, not eliminate, a withdrawl discount, albeit a negative one. I think.

          And I don’t see what it has to do with supply side. I think it might appeal to Krugman.

  12. “Suppose Maple Valley Bank makes a new $100,000 loan to Granite Construction. The bank creates a new demand deposit account for the construction company, and credits $100,000 to that account. In exchange, it receives from Granite Construction a promissory note promising the return of the $100,000 plus a certain amount of interest to be paid over a defined period of time. At this point Maple Valley bank’s total reserves have not changed at all.”

    Are you assuming a 0% reserve requirement?

    JKH has agreed with me when I say the demand deposit gets a reserve requirement “attached” to it and the promissory note (the loan part) gets a capital requirement “attached” to it. If the reserve requirement is positive, then the new demand deposit could cause a system wide shortage of reserves causing the fed funds rate to rise.

    • I’m not sure I have a clear idea what “attached to” means in this context. But two things are relevant here: First, in the current environment in which most banks and the system as a whole are carrying reserves far in excess of the requirement, a new $100,000 loan is not likely to cause a reserve shortfall at the bank itself or system-wide. Reserve requirements are not attached to individual loans; they are attached to

      But second, even if the bank was short reserves after making the loan, they have the whole period of the calculation period and compliance period during which to acquire the additional reserves. So the reserve balance is not going to change at the time the loan is made. Or if it does, that’s a coincidence.

      I think it is a little bit misleading to see the capital requirement as “attached” to the promissory note. The capital requirement is imposed on the entirety of the ratio of capital to risk weighted assets. When the loan is made, then the bank’s liabilities, assets and risk-weighted assets change at the same time. But again whether they have adequate capital as a result depends in part on the situation before they made the loan. It also depends on the size of the loan, not just the size and type of the promissory note.

      • “Reserve requirements are not attached to individual loans; they are attached to ”

        Is there something missing after the to?

        • Sorry, yes. Should be “They are attached to the total amount of the bank’s deposit liabilities.”

          • I said “the demand deposit [a deposit liability] gets a reserve requirement “attached” to it”

            As long as each demand deposit gets the same % requirement, total and individual % should be the same.

            • All I’m saying is that the reserve requirement is imposed with respect to the bank’s deposits in the aggregate, not with respect to individual deposit accounts or balances. It’s not as though every time a bank credits a deposit account by another $X it has to acquire another $(X/10) in reserves. If the bank has excess reserves than it can credit deposit accounts without acquiring additional reserves.

              • That sounds more like a timing question. The central bank reserves for the demand deposit(s) can be created before the loan is made or after the loan is made.

                For me, converting an excess central bank reserve to a required one is still “attaching” it to the demand deposit.

  13. Accounting question:

    Is there an accounting identity that says for every $1 borrowed there’s $1 lent? Thanks!

    • For the financial system as a whole, sure. If I have borrowed $1 then someone must have lent it to me.

      • How about this example?

        Let’s say I save $100,000. Someone else wants to start a new bank. They sell me a $100,000 bank bond (bank capital). The reserve requirement is 0%, and the capital requirement is 10%. Can the new bank now make 10 (ten) $100,000 mortgage loans?

        If so, I saved $100,000. I lent $100,000 to the bank, and the bank borrowed $100,000. The bank lent $1,000,000 to ten other people, and the ten other people borrowed $1,000,000. The bank lent $1,000,000 to ten other people, however, it only borrowed $100,000 from me.

        Is that scenario correct?

        • golfer1john

          You can’t start a bank by borrowing money. The bank has to be capitalized by selling stock, or by capital contributions from private owners of the bank. If a bank were to be started by borrowing your $100,000, it would have $100,000 of assets (cash) and $100,000 of liabilities (it’s debt to you) and no capital.

          • That is just going to make my example more complicated. I was hoping I would not have to.

            • golfer1john

              Well, to simplify it, let’s suppose someone else starts a bank by selling you all it’s stock (aka capital stock, BTW) for $100,000. The bank, a corporation, created the stock out of nothing, and now has $100,000 in assets and no liabilities, so $100,000 in capital (shareholders’ equity – your equity ownership of the banking corporation). Go from there: the bank lends $100,000 each to 10 people, etc. All the lending equals all the borrowing. Specifically, the bank’s lending equals the people’s borrowing. The people’s lending ($0) doesn’t equal their borrowing ($1M), and the bank’s borrowing ($0) doesn’t equal its lending ($1M).

        • golfer1john

          Back to the first question, it is totally possible for you (or the bank) to lend $1 and borrow $1o, or lend $10 and borrow $1. There is no accounting identity that says a single entity’s lending must equal its own borrowing.

          But every time someone lends, someone else borrows the same amount. That is an accounting identity.

          • Some economists use $ borrowed = $ lent to say that banks can’t increase “money” in the macroeconomy, only the central bank can. Is that correct?

            • Most of what we use for money in our economy consists in bank debts. If you have $10,000 in a demand deposit account, that means your bank has a $10,000 debt to you. When your bank creates that deposit account for you, that is no different in principle than if I issue a $10,000 negotiable IOU to you. The only difference is that way more people trust the bank’s IOU than trust my IOU, so you can use the bank’s IOU to buy things from people who might not accept my IOU.

              All of those bank IOUs are money. Can banks create more money? Sure. They can issue more IOUs, and there will then be more bank IOUs in circulation with which people can buy things. But these IOU’s constantly have to be redeemed, routinely, every day. Sometimes they are redeemed in the form of cash – which is an IOU of the government that banks can acquire but that they don’t create. And sometimes they are redeemed via a transfer of reserve balances from one bank to another – and these balances are also IOUs of the government that banks can acquire but don’t create. So while banks can issue more IOUs to the public, if the central bank is not continually accommodating that expansion by concurrently issuing more government IOUs to banks, the banks will in short order be unable to make their payments. They will be broke.

              Now since these bank IOUs are a genuine liability of the banks, banks don’t issue IOU’s to people for nothing. They demand something in return – namely the borrowers IOU for a somewhat greater amount to be paid in the future. Similarly, the government often emits its IOUs in exchange for a greater IOU from the bank that borrowed it – namely at the discount window. But since the government is not a profit-making enterprise and does not have to have financial assets greater than financial liabilities, it sometimes just gives its IOUs away or trades them for IOUs of less value.

              • I don’t get the whole IOU stuff.

                Here is a sample of what I see at other places.

                “$ borrowed = $ lent systemwide” so …

                “Who are we all borrowing from? The Martians? Though when it comes to banks, we are, in aggregate, borrowing from ourselves. Because there are two sides to a bank’s balance sheet. When we both lend to banks and borrow from banks, we are converting illiquid into liquid (monetary) assets and liabilities. Someone has both a mortgage (where he borrows from the bank), and a checking account (where he lends to the bank). It is as if he lends to himself, via an intermediary.”

                To me that looks like someone is assuming the capital requirement is 100%. If the capital requirement is 100%, then does $ borrowed = $ lent systemwide?

                • golfer1john

                  Is someone saying that $lent by banks = $ borrowed by banks?

                  That need not be true, and I would say probably is not true, not even close. I would think that banks lend a lot more than they borrow, that is, they have more loans outstanding (assets) than they have deposits (liabilities).

                  If “systemwide” means all the banks (as opposed to the economy as a whole), there is no accounting identity, and no logical reason for banks to borrow as much as they lend.

                  If “systemwide” means the whole economy, the banks and the households and businesses together, then for every $ lent by a bank to households and businesses there is $1 borrowed by households and businesses, and for every $ borrowed by a bank from households and businesses there is $1 lent to banks by households and businesses. It’s like saying that for every $1 of spending on bubble gum there is exactly $1 of sales of bubble gum. The lending and borrowing are opposite sides of a single transaction. It could not be otherwise.

                  What you describe as lending to ourselves, using banks as the intermediary, sounds like it might be the “loanable funds” model, which has some advocates, but is rejected by MMT. Banks don’t lend deposits, loans create deposits.

                  • They may not call it “loanable funds”, but I believe that is what they mean. It seems to me “loanable funds” means a 100% capital requirement.

                    Thoughts?

                    See below for $50,000 to $1,250,000 and part of Dan Kervick’s post:

                    “The bank borrowed $50,000 and lent $1,250,000. That creates “money”, meaning $ borrowed not equal $ lent systemwide.

                    Whether or not a bank can do this, if the bank borrowed $50,000 then there are obviously some lenders who lent the bank the $50,000; and if the bank lent $1,250,000 then there are obviously some borrowers who borrowed the $1,250,000. So total dollars borrowed do equal total dollars lent.”

                    But the bank borrowed only $50,000 and lent $1,250,000. Systemwide (whole economy) $ borrowed not equal $ lent?

                  • Just above?

                    ““The bank borrowed $50,000 and lent $1,250,000. That creates “money”, meaning $ borrowed not equal $ lent systemwide.

                    Whether or not a bank can do this, if the bank borrowed $50,000 then there are obviously some lenders who lent the bank the $50,000; and if the bank lent $1,250,000 then there are obviously some borrowers who borrowed the $1,250,000. So total dollars borrowed do equal total dollars lent.”

                    But the bank borrowed only $50,000 and lent $1,250,000. Systemwide (whole economy) $ borrowed not equal $ lent?”

                    There is some kind of multiplier there. I need the proper way to describe it so $ borrowed = $ lent does not apply. Banks create “money” thru “actual” borrowing.

                  • System wide, dollars borrowed equals dollars lent. But money is created. Money is only the stuff on the liability side of bank balance sheets (including the central bank’s). When you pay someone, what you pay them with is a liability of your bank.

                • I’m not sure I follow the speaker’s meaning in that paragraph, but in our system, the banks are not self-funding in the aggregate, so to speak, from their own loaned money.

                  We could have a system like that, but we don’t. For example, suppose that we had only a single, government-run monopoly bank, and that it was responsible for all lending and all deposit accounts. Suppose that bank issues the physical currency notes too. Suppose all domestic payments are carried out either with these notes or via deposit accounts at the bank. Essentially, I’m asking you to imagine that all that the Fed is the only bank; that there are no commercial banks at all; and that everybody banks directly with the Fed rather than banking at intermediary banks that bank at the Fed.

                  Finally suppose that there were a federal law that stated that this central bank’s loan assets must always exceed its total liabilities in the form of notes and deposits. So the public must always be in a state of net indebtedness to the central bank.

                  This central bank could still supervise a growing economy that had a growing money supply. The bank could constantly be loaning additional money into the economy in quantities sufficient to pay off all existing debts owed to the bank. I don’t think this would be a terrific system, but it is a possible system.

                  Some people think this is the way our monetary system actually works, but with commercial banks in the aggregate playing the role of of the monopoly central bank of the imagined example. They think that banks make loans by issuing their own soi-disant liabilities “from thin air”, and that the borrowers pay back those loans with interest by using the liabilities issued by the same or other commercial banks – and that it is all a self-contained circle.

                  This may be a possible system, but it is not the system we actually have. The liabilities issued by commercial banks are actual debts, the discharge of which are made with actual assets that the bank itself does not create and does not control. It is true enough that you can pay your loan debt to Bank A by giving Bank A a check drawn on your account at Bank B. But Bank A then collects the Bank B debt represented by the check on a Bank B account. Bank B has to pay up. And it doesn’t pay up just by swapping a new liability that it issues on the spot for the other liability – the check. It pays up with an asset that it did not create: a balance in it’s reserve account. Just as you can pay your debts to businesses and associates with a third party debt, i.e the liability of the bank – so the bank pays its debts to other banks with liabilities of the US government.

                  But here’s the difference: the liability of the US government is fully discharged by that instrument itself. If you have a dollar issued by the government, the government doesn’t have to pay up with anything other than another so-called liability of the government that the government itself issues and controls. But if you posses a liability of a commercial bank, you can demand that the bank pay up – either you directly or someone of your designation. And to pay up it has to have in its possession an asset that it did not and cannot create.

                  • “I’m not sure I follow the speaker’s meaning in that paragraph, but in our system, the banks are not self-funding in the aggregate, so to speak, from their own loaned money.”

                    The person is trying to argue that monetary policy does not work by increasing actual borrowing.

                    “We could have a system like that, but we don’t. For example, suppose that we had only a single, government-run monopoly bank, and that it was responsible for all lending and all deposit accounts. Suppose that bank issues the physical currency notes too. Suppose all domestic payments are carried out either with these notes or via deposit accounts at the bank. Essentially, I’m asking you to imagine that all that the Fed is the only bank; that there are no commercial banks at all; and that everybody banks directly with the Fed rather than banking at intermediary banks that bank at the Fed.”

                    I think the example of the gov’t, a central bank, and one commercial bank would be more interesting. That way there is no settlement of central bank reserves to worry about. Checking accounts are marked up and marked down, but the central bank reserves don’t need to move from commercial bank to commercial bank.

                    “The liabilities issued by commercial banks are actual debts”

                    I do not consider that debt, but that is too long of a story to get into.

                  • If there is only one commercial bank, then it is true there would be no movement of reserves. But that commercial bank would serve no conceivable useful purpose. It would be totally redundant middle man taking a cut but providing no added economic efficiency. The whole point of having a bunch of competing commercial banks and not a single state-run bank is supposed to be that the banks are under pressure to compete for customers by offering better services at lower prices, or by offering unique specialized services that their competitors can’t, and are driven as a result to seek efficiencies that don’t happen when there is a monopoly.

                  • “If there is only one commercial bank, then it is true there would be no movement of reserves. But that commercial bank would serve no conceivable useful purpose. It would be totally redundant middle man taking a cut but providing no added economic efficiency. The whole point of having a bunch of competing commercial banks and not a single state-run bank is supposed to be that the banks are under pressure to compete for customers by offering better services at lower prices, or by offering unique specialized services that their competitors can’t, and are driven as a result to seek efficiencies that don’t happen when there is a monopoly.”

                    Let’s assume a benevolent commercial bank monopoly. Its purpose would be to create more medium of account (MOA) and medium of exchange (MOE) to prevent price deflation. It does this by creating more debt (demand deposits and loan).

                    “then it is true there would be no movement of reserves”

                    Exactly. Now debt dynamics can be focused on.

            • golfer1john

              If it was an MMT economists who said that, then I think you misunderstood him.

              There is a lot of MMT writing about money, starting with its origins as debt. Very interesting stuff.

              MMT describes a hierarchy of money. When a government issues currency (bills), that is a debt of the government. On a gold standard, it is an IOU for some amount of gold. If it is fiat money, it is a promise to redeem your tax liability, and there is no promise to exchange it for anything but itself.

              Banks also issue money. Bank money is a debt of the bank. If you have $100 “in your account”, they have promised to give you $100 when you want it. If they go broke, and there is no such thing as FDIC insurance, your $100 is gone. But banks get some special treatment and regulation, and there is FDIC insurance, so the bank’s promise is just as good, generally, as the government’s promise. So bank money exchanges at par with government money.

              One economist (I forget which) that MMTers like to quote said “Anyone can issue money. The trick is to get it accepted.” You and I can issue IOUs, but if I give you my IOU you can’t take it to the grocery store and exchange it for a banana like you can an IOU of a bank.

              What the central bank / government can do that no private bank can do is to increase the net financial assets of the private sector. That is because the government is outside the private sector and the bank is not, but even if you divided the private sector into a) businesses and households, and b) banks, banks could not sustainably increase the net financial assets of the business and household sector because they would run out of their own financial assets, and they would not do it anyway because they would not make money by doing that. The banks drain financial assets from the business and household sector by charging more interest on their loans than they pay on their deposits.

              Net financial assets means financial assets minus financial liabilities. When a bank creates money by making a loan, and adding money to your deposit account, the net financial assets of the private sector do not change. You have an additional asset, but also an equal liability, and so does the bank. When government creates money by buying something from you or paying you for your labor, you exchange a real asset for a financial asset, and your net financial assets goes up, and the private sector net financial assets goes up by the same amount. Government can do that indefinitely by deficit spending (taxing removes net financial assets from the private sector) because, being the creator of fiat money, it can never run out.

              So that is the difference between “money” and “net financial assets”, and between what government can do to them and what banks can do to them.

              • It wasn’t an MMT economist.

                “When a bank creates money by making a loan, and adding money to your deposit account, the net financial assets of the private sector do not change.”

                But the “money” can affect the prices of goods/services and the prices of financial assets like stocks, bonds, real estate, etc. By “money” here, I mean demand deposits. I consider them to be both medium of account and medium of exchange.

                • golfer1john

                  Yes, all true. Bank loans do create money. More money can influence production (which it would do now, as we have so much excess capacity) and prices (which would happen as full employment is approached).

                  But for every penny of money created by a bank loan, there is a penny of debt also created. Net worth, or net wealth, or net financial assets, does not increase. Only deficit spending by government creates net financial assets in the private economy (as well as creating money).

                  I have to go back to your definition of “system-wide”. Borrowing and lending are two sides of one transaction. They must be equal by definition, if both sides of the transaction are included in the “system”. If not, then there is nothing to say that any person, or any bank, or any collection of persons or collection of banks, even all the people or all the banks, must have equal borrowing and lending. One can lend more than it borrows, and the other can borrow more than it lends. There is nothing mysterious about a bank borrowing $50,000 and lending $1.25M.

                  Perhaps specific only to your example of a new bank, if the bank does not have reserves to clear the checks drawn against the $1.25M deposits it created, then it must borrow those reserves. But in our banking system (normally) the Fed always supplies whatever reserves are needed at the price it sets. And it does so by buying Treasury securities, which adds reserves to the system without banks having to borrow them, in the aggregate. If it did not do so, the Fed funds rate would climb to infinity, as banks bid up the price of required reserves that did not exist.

                  But even if your new bank borrowed reserves from another bank, that other bank would then have lent more than it borrowed. So, “system-wide”, it makes no difference.

                  If the answers you’re getting here don’t seem to answer your question, perhaps it would help to know the theoretical context in which the statements were made, maybe even a link. “Loanable funds” is an economic model, it has more meaning than just what the words themselves imply. If your reference doesn’t use those words, then it’s probably not the right context.

        • I’m a bit lost. For one thing, mortgage loans aren’t the same thing as regular loans that you make just by giving someone a deposit account with a balance in it, right? With a mortgage loan, the bank doesn’t only create a new liability for itself in the form of an account balance. It actually has to cut a check and pay out the loaned amount on the spot – it has to give actual assets to the borrower in exchange for the borrower’s note, which is presumably an asset of somewhat greater value to the bank. So to get started in that business it will have to start with more reserves. And I also don’t know what you mean about saving $100,000.

          Also, the capital requirement is not simply a percentage of the loans. A 10% capital requirement means that the ratio of bank capital to its risk-weighted assets is no less than 10%. For example, suppose a bank has starts with $2 million in cash assets from issuing stock. It makes 10 mortgage loans of $1,000,000 each and thus gives those borrowers $100,000, leaving it with only $1 million in cash assets, but giving it $1,000,000 worth of promissory notes which it receives in return. (Forget about interest, to keep it easier.) Now suppose it makes another $1 million in ordinary loans by creating demand deposit accounts with a total balance of $1,000,000 (but issuing no cash) and again receiving in return promissory notes worth $1,000,000. So here are the bank’s assets and liabilities at that time:

          Assets

          Cash: $1,000,000
          Mortgage Notes: $1,000,000
          Ordinary Notes: $1,000,000

          Liabilities

          Deposit Balances: $1,000,000

          The bank’s capital consists of its assets minus its liabilities, and so is equal to $2,000,000.

          However, to see whether the bank has met its capital requirement, we have to compute its risk-weighted assets. The risk weight for ordinary loans for cash is 0, for mortgage loans is .5 and for ordinary loans is 1. So the bank’s risk weighted assets are:

          0($1,000,000) + .5($1,000,000) + 1($1,000,000) = $1,500,000

          If the capital requirement is 10%, then that means the ratio of total capital to risk weighted assets must be at least 10%. In this case, that ratio is $$2,000,000/$1,500,000 = 1.33. So no problem. (By the way, I believe the Basel II requirement for total capital is actually 8%)

          But suppose the bank had only started with $1,000,000 in cash and thus has no cash left after making all those loans. Then its total capital would only be $1,000,000, and its risk-weighted assets are still $1,500,000. So the ratio is only .67.

          Finally, suppose that it started with $100,000 in cash, and makes $2,000,000 in ordinary loans. Now we have:

          Assets

          Cash: $100,000
          Ordinary Notes: $2,000,000

          Liabilities

          Deposit Balances: $2,000,000

          Capital:

          $100,000

          Risk-weighted Assets:

          $2,000,000

          Ratio of Total Capital to Risk-weighted Assets:

          .05

          So the bank is now not meeting its total capital requirement.

          • “And I also don’t know what you mean about saving $100,000.”

            I save $100,000 in currency. That means I did not spend it on consumption goods and did not spend it on investment goods.

            I’m just going to put this example up and see what happens.

            Let’s say I save $100,000 in currency. Someone else wants to start a new bank. They sell me $100,000 of bank stock (bank capital). The reserve requirement is 0%, and the total capital requirement is 8%. I believe that means the capital requirement is 4% for mortgages and is 8% for ordinary loans. This example will be all mortgages.

            Assets new bank = $100,000 in currency
            Liabilities new bank = $0
            Capital new bank = $100,000 of bank stock

            I’m going to leave the currency there for simplicity.

            The bank now makes 25 mortgages for $100,000 each.

            Assets new bank = $100,000 in currency plus $2,500,000 in loans
            Liabilities new bank = $2,500,000 in demand deposits
            Capital new bank = $100,000 of bank stock

            $100,000 / ($2,500,000 * .5) = .08

            The home builder sets up a checking account at the new bank. So 25 checking accounts at the new bank were marked up and then marked down by $100,000 each, while the home builder’s checking account was marked up by the $2,500,000.

            The home builder allocates as follows:

            $2,000,000 in a savings account and $500,000 in a 7 year CD. Bank is funded for now, and the reserve requirement for savings accounts and CD’s is zero so that takes care of a positive reserve requirement.

            Assume the interest payments for mortgages are paid out as a dividend so there are no retained earnings that could be used as tier 1 capital.

            I think the bank can now sell a subordinated term debt instrument (bond) of $50,000 as tier 2 capital. Rerun the scenario so that the $50,000 becomes $1,250,000 of demand deposits. The bank borrowed $50,000 and lent $1,250,000. That creates “money”, meaning $ borrowed not equal $ lent systemwide.

            Notice the .5 times 8% equals the capital requirement for mortgages, 4%.

            Thoughts?

            • Assets new bank = $100,000 in currency plus $2,500,000 in loans
              Liabilities new bank = $2,500,000 in demand deposits
              Capital new bank = $100,000 of bank stock

              Where did the demand deposits come from? If you borrow $100,000 in the loans to buy a home, you don’t just get a demand deposit account with $100,000 in it. The seller of the home gets a check for $100,000 and so the bank has to use some assets to pay that seller. If the loans were mortgage loans, the bank didn’t just create demand deposit accounts.

              But let’s just skip the mortgage loans, which don’t seem to be playing any essential role, and skip right to the home-builder. Let’s assume the bank loans $2,500,000 to the home-builder to finance the builder’s business, and the bank then receives a promissory note in return from the builder for $2,500,000.

              Now in your example, curiously, this so-called home-builder doesn’t seem to be using the money to build any homes. He moves his deposit to other interest-earning vehicles offered by the same bank. I assume that in the real world, the bank would do more due diligence before making the loan, and have the option to call the loan if they discovered the builder was a scammer. Also, for simplification’s sake, we have been disregarding the interest on these loans. But in the real world the builder has to repay the loan with interest, and the interest is such that the builder can’t make money from the bank just by swapping the loaned amount for other bank vehicle that pays interest.

              The bank borrowed $50,000 and lent $1,250,000. That creates “money”, meaning $ borrowed not equal $ lent systemwide.

              Whether or not a bank can do this, if the bank borrowed $50,000 then there are obviously some lenders who lent the bank the $50,000; and if the bank lent $1,250,000 then there are obviously some borrowers who borrowed the $1,250,000. So total dollars borrowed do equal total dollars lent.

              • golfer1john

                “Now in your example, curiously, this so-called home-builder doesn’t seem to be using the money to build any homes.”

                I think you misunderstood. The 25 borrowers each paid the home builder $100,000 for the home they bought from him. He didn’t borrow from the bank to fund his business, he deposited his $2.5M sales receipts in the bank. (Maybe he self-financed, or borrowed from another bank to fund his business.)

              • golfer1john

                So, this new bank with only $100,000 cash as reserves makes $2.5M of loans, and cuts 25 checks to the homebuilder for $100,000 each. If the homebuilder deposits them into savings and time deposit accounts at that bank, then all is fine.

                But suppose the homebuilder deposits them into his checking account at the new bank, and uses all the money to pay his employees and suppliers and his kids’ tuition, and none of the payees have accounts at this new bank. In a day or two, the checks clear and the Fed moves reserves from the new bank to the other banks. Ooops. The new bank has no reserves at the Fed. They borrow from the Fed at the discount rate. They now still have their $100K cash, and $2.5M of mortgage notes, and they owe the Fed $2.5M. (They might just as well have borrowed form other banks at the Fed funds rate instead.)

                Over time, they pay their 0.25% or 0.75% interest to the Fed, and they collect their 3.75% interest from the homeowners. Gradually their reserves increase as they profit from the spread. After a while, they become “old” banks with excess reserves to lend to other banks.

                Likewise for the $1.25M in ordinary loans. To the extent that the borrowers caused checks to be drawn against their accounts, the bank would need to borrow reserves in order for the Fed to clear those checks. But they are collecting more interest on the loans than they pay on the borrowed reserves and the $50k bond, so they profit and over time become an “old” bank with excess reserves.

                • See my 11:11 p.m. comment below. Plus, …

                  If the loans perform, then the bank will make the spread between its assets (the loans) and it liabilities. I’m pretty sure retained earnings can used for the capital account. Can it be used for the “reserve balance” account? Not sure, but my guess would be yes.

                  • golfer1john

                    Reserves are vault cash plus Fed balances. The bank can transfer from one to the other as it needs to, in order to keep the right amount of vault cash to meet the demands of its customers.

                    When the books close each quarter, profits add to retained earnings, which is one of the accounts that make up the bank’s capital. In the electronic age, the profits probably showed up as reserve balances at the Fed. For instance,

                    Customer makes a mortgage payment by check drawn on another bank. ($1000)
                    Banks deposits the check at the Fed, recording the reduction to principal of the loan ($900), and the interest received ($100), against the “cash”received ($1000).
                    The Fed transfers reserves from the other bank to this bank. ($1000)
                    From that $100 interest, the bank paid $90 of expenses (teller salaries, etc.) and had $10 profit.
                    Assets go up by $10 ($100 interest – $90 expenses)
                    Liabilities don’t change.
                    The loan asset goes down by $900, offset by the $900 cash asset increase.

                    Capital goes up by $10 (retained earnings), reserves go up by$1000 in the Fed account, but go down by $90 paid out in expenses (could be paid in vault cash, or in a reserve account transfer. Or could have gone into the employees’ checking account, which would be a bank liability increase instead of an asset decrease, and in that case reserves would not be affected.)

                    As you can see, there is no direct tie between these things. Depending on how the transaction ( a simple loan payment) is accomplished, it may affect reserves or not, may affect Fed balances or not. Consider what happens to the bank’s reserves, and the cash account, when

                    a) the borrower walks into the branch and hands 10 $100 bills to the teller
                    b) the borrower logs on to the web site and transfers $1000 from his checking account to pay his mortgage

                    instead of the example above, where he writes a check against a different bank. There are still the same effects on profits, expenses, retained earnings and capital, but not the same effect on reserves. a) changes vault cash (reserves), but b) does not change reserves at all.

                • “Likewise for the $1.25M in ordinary loans.”

                  Just to clarify, those were $1,250,000 in mortgage loans.

              • “Where did the demand deposits come from? If you borrow $100,000 in the loans to buy a home, you don’t just get a demand deposit account with $100,000 in it. The seller of the home gets a check for $100,000 and so the bank has to use some assets to pay that seller. If the loans were mortgage loans, the bank didn’t just create demand deposit accounts.”

                The demand deposits came out of “thin air”. I believe the buyer’s demand deposit (checking) account did get marked up $100,000 (one way to think about it). It is a liability to the new bank and an asset to the buyer. Let’s assume everyone verifies what needs to be done. The buyer writes a check, and the seller deposits it in a different bank. The buyer’s checking account gets marked down by $100,000 at the new bank, and the seller’s checking account gets marked up by $100,000 at the different bank. The central bank reserves get transferred from the new bank to the different bank. The new bank then borrows the central bank reserves back in the fed funds market.

          • golfer1john

            I don’t think there’s any difference between a mortgage loan and any other loan, except the type of collateral. If I own a house, and go to the bank to get a mortgage, I think they would put the money directly in my account (or if not, I would do so on the spot), just like if a business took out a secured or unsecured “ordinary” loan.

            When a bank makes a mortgage loan in conjunction with the sale of a house, they cut a check to the seller, not to the borrower, and that is so that they are sure their collateral will really belong to the borrower. It’s just due diligence. They could just as well mark up the seller’s deposit account, if the seller happened to have an account in the same bank.

            It makes sense that the risk weighting depends on the collateral, I’m not disputing that. But cutting a check or not doesn’t change the bank’s reserve requirements for the transaction.

            • Yes, but I wasn’t looking at the legal reserve requirement, but the practical need for reserves. I see you are right that if the seller happens to bank at the same bank, the seller can be paid with a deposit balance. But if not, then when the issued check is deposited at some other bank, then reserves leave the lending bank. Fed Up was describing a hypothetical situation in which there is a 0% reserve requirement, and where a bank has only $100,000 in initial reserves, and then makes $2,500,000 in mortgage loans. My claim is that even if the bank were not required by law to have a higher balance of initial reserves, as a practical matter it cannot make these loans since those loans are going to require it to immediately pay out a lot of money (unless all of the sellers happen to bank at that bank.)

              Perhaps though the bank can make the loans and then immediately pledge them in the Fed Funds market to borrow the needed reserves?

              • golder1john said: “So, this new bank with only $100,000 cash as reserves”

                Dan Kervick said: “where a bank has only $100,000 in initial reserves”

                First, I think (but do not know) that the capital account of the new bank and the “reserve balance” account of the new bank are managed separately. When the loans are made, the capital account of the new bank has $100,000 in it. The “reserve balance” account of the new bank has $0 in it.

                Dan Kervick said: ” My claim is that even if the bank were not required by law to have a higher balance of initial reserves, as a practical matter it cannot make these loans since those loans are going to require it to immediately pay out a lot of money (unless all of the sellers happen to bank at that bank.)”

                I think it can make the loans. If all $2,500,000 of demand deposits leave the bank, then the “reserve balance” account of the new bank is negative $2,500,000. It will need to attract demand deposits, borrow in the fed funds market, or borrow at the discount window. It should be able to do one or both of the first two. I chose a 0% reserve requirement so that the banking system as a whole would not be short of “reserves”.

                • golfer1john

                  Reserves consist of vault cash and Fed balances. I’m assuming that the initial $100,000 used to start the bank is still there as vault cash, when the loans are made.

                  You can think of it as the bank adding $100,000 to the buyer’s account, and the buyer writes a check to the seller. In my experience, the bank cuts a check to the seller, but the effect is the same.

                  Yes, reserve balances are “managed separately”, and you cannot generally deduce what they are based on other accounting system balances, except from knowing the actual amount of vault cash and Fed balances. Knowing capital, or profits, or assets or liabilities doesn’t help.

                  The bank can make loans, up to its limit based on capital. It can always get reserves. The Fed makes sure of that, it’s how they must operate if they wish to maintain a target interest rate.

                  • “Assets new bank = $100,000 in currency”

                    I’m trying to say the $100,000 in currency (vault cash) is allocated to the bank capital account.

                    The “reserve balance” account for the new bank is $0. I think I’m saying the”reserve balance” account is vault cash plus fed balances (central bank reserves).

                    Does that sound right?

                  • golfer1john

                    “I’m trying to say the $100,000 in currency (vault cash) is allocated to the bank capital account.
                    Does that sound right?”

                    No. Accounting doesn’t work that way. The cash could go away, for instance if the bank buys a check sorter, or any other asset, but the capital account is unchanged.

                    “reserves” is not an account on the bank’s books. It doesn’t get debited and credited when transactions occur. It’s just what it is.

                  • “I think I’m saying the”reserve balance” account is vault cash plus fed balances (central bank reserves).”

                    It seems like that is not entirely correct because I allocated the $100,000 in currency (vault cash) to the capital account just above.

                  • golfer1john

                    “I allocated the $100,000 in currency (vault cash) to the capital account”

                    There’s no such thing in accounting. The statement is meaningless.

                  • “Assets new bank = $100,000 in currency plus $2,500,000 in loans”

                    If the capital requirement is 4% or more for all loans, then the bank can’t add any more assets, including new loans, because its capital (the $100,000 in currency) is used up. My terminology may need to be cleaned up.

  14. Dan,

    Thanks. Necessary and informative article. I just passed it by the 16-year-old I’m educating about MMT and someone in their 70s. Both choked here at these two places where I indicate a few more words as a segue. They felt there was a leap, and they couldn’t follow.

    A segue between these two sentences:

    To the extent that this might happen on a widespread basis over some period of time, it is possible that aggregate bank reserves might be reduced for that period of time. [HERE] But then the expansion of lending would be having no effect on spending.

    And a segue here:

    And by the same token, one should not look at the phenomenon of bank reserves “piling up” as evidence of the failure of monetary policy to cause those reserves to be loaned out. [HERE] Reserves in the aggregate are not loaned out. [OR MAYBE HERE.]

    The latter was because the reserves can make it into another bank and into the economy was the argument. I’m just reporting reactions here.

  15. The funny thing is that a negative interest rate on excess reserves is akin to increasing taxes on a bank. I can’t see how anyone would say that increasing taxes on a bank would stimulate it to lend more money.

    At a ZERP interest rate policy, if there is deemed insufficient lending by banks the best policy to incent more lending is to incent banks to reduce their underwriting standards to allow more people to qualify for loans. That of course assumes the banks are also well capitalized and have capacity to lend.

    A negative interest rate on excess reserves only increases a banks cost of doing business, it’s a margin squeeze. A bank will respond by trying to return to its prior level of profitability which means it will likely try to increase its margins by dropping rates on deposits, increasing loan interest rates and or increasing banking fees.

    A loan create a deposit, that is true in aggregate, however no individual bank knows where and how the final deposit will be made and therefore it has no idea if the addition of a new loan will consume any excess reserves via the reserve requirement which only applies to transactional deposits. Therefore there is almost zero likelihood that a bank would try to lend its way out of paying fees due to a negative interest rate on excess reserves.

  16. Maybe banking system should be characterized as two tier system where one tier consist of reserve balances that banks exchange betweem themselfs and between reserve account and interest rate maintenance accout, while the second tier would be complete separate system that makes bank loans to the public. One sort of money that banks use in dealings between eachother and government, and other sort of money that rest of us use. Maybe two tier explanation would make banking system easier to understand.

    • Yes, I think that’s fine as long as we don’t fall into the trap of thinking of commercial bank-issued money as a kind of independent “fiat” money.

      Fed-issued money is classified as a liability of the US government, and its useful to think of it that way for various accounting purposes, but its status as a genuine liability is iffy. You can’t demand anything in exchange for it other than more of the same stuff. You can use it to extinguish your tax obligation, but those obligations are themselves imposed by government fiat. So to the extent that government-issued money is a liability, it is a liability for an asset that the government itself manufactures at negligible cost and controls entirely

      Commercial bank-issued money, on the other hand, is not just a liability in that weak, formal sense. It is genuine bank debt that the bank can only discharge on balance with government-issued money.

      So the two kinds of money are part of a single hierarchical system in which the government-issued money is supreme.

    • Yes, I think that’s fine as long as we don’t fall into the trap of thinking of commercial bank-issued money as a kind of independent “fiat” money.

      Fed-issued money is classified as a liability of the US government, and its useful to think of it that way for various accounting purposes, but its status as a genuine liability is iffy. You can’t demand anything in exchange for it other than more of the same stuff. You can use it to extinguish your tax obligation, but those obligations are themselves imposed by government fiat. So to the extent that government-issued money is a liability, it is a liability for an asset that the government itself manufactures at negligible cost and controls entirely.

      Commercial bank-issued money, on the other hand, is not just a liability in that weak, formal sense. It is genuine bank debt that the bank can only discharge on balance with government-issued money.

      So the two kinds of money are part of a single hierarchical system in which the government-issued money is supreme.

  17. It want to bring up a point brought up earlier, because it’s something that occurred to me before reading all the comments here. (I had a feeling someone would have mentioned it before I thought of it, and it turns out someone did.) But MMT, from my previous readings of it, seems to recognize and point out regularly that loans create deposits. If that is so, increasing loans will reduce excess reserves, even if it has no net effect on total reserves. Some reserves that were once in the excess pile move over to the required pile, even though the sum of the two piles remains the same.

    Now, assessing negative interest on excess reserves may be wrongheaded. But reducing excess reserves while total reserves remain unchanged (the banks haven’t bought any more bonds) means that the required-reserves portion of total reserves went up. Short of the required-reserve ratio changing, that means deposits went up and more money is in actual circulation among businesses and households.

    What I’m making here is a very limited point, which is that the problem here isn’t that bank reserves at the fed would be unchanged. That doesn’t matter, because excess reserves would change as the result of deposits being created (if the Fiscal Times article weren’t wrong about other things), deposits that would represent money in real circulation facilitating the exchange of goods and services.

    Say what you will about a system that is so utterly dependent on credit money and the sustainability of such a system. Say what you will about the specific stimulative effect of paying negative interest on excess reserves. But the point about total reserves being left unchanged isn’t where you should be plunging your knife.

    • Short of the required-reserve ratio changing, that means deposits went up and more money is in actual circulation among businesses and households.

      But the deposits don’t go up because reserves moved from the excess reserve pile to the required reserve pile. The causation goes the other way: some reserves are re-classified from excess reserves to required reserves because the deposits went up.

      • Sorry for not posting my last comment at 12:50 as a direct reply to yours, Dan. So I’ll add this, now that I am replying: the reason I bothered to comment at all about excess reserves becoming required reserves as the result of deposits going up because of loans being made is that you spent a good bit of your post on demonstating that making loans doesn’t change total reserves. Now, if you had demonstrated instead that, even if banks in aggregate made new loans amounting to the total excess reserves in the system, excess reserves would only drop by some relatively small percentage, based on the required reserve ratio, that would have been different.

  18. But the deposits don’t go up because reserves moved from the excess reserve pile to the required reserve pile. The causation goes the other way: some reserves are re-classified from excess reserves to required reserves because the deposits went up.

    I know that. I wrote that, not in so many words.

  19. This might be a stupid question. You wrote, “This time, when the payments are settled and cleared, a payment has to be made from Maple Valley Bank to Ridge Bank for $25,200. At the regional Federal Reserve Bank where both banks hold their reserve accounts, the reserve account of Maple Valley Bank is debited by $25,200 and the account of Ridge Bank is credited by $25,200. ” I’m confused about the reserve account – is a dollar for dollar credit/debit required in the reserve accounts (in this case, $25,200)? I thought we have a fractional reserve banking system. Am I confusing two different concepts here?

    • Hi Joe,

      It all depends on how much the banks owe each other. The system is “fractional reserve” in the sense that the quantity that the bank holds in its own reserve account at the Fed needs only be a fraction (10%) of the quantity that the bank’s customers have in their deposit accounts at the bank. But if one bank owes money to another bank, it has to pay that bank the whole amount.

      The banks may also use the net settlement system CHIPS. That means that they do not pay each other throughout the day, but only make a single settlement at the end of the day. For example, if Maple Valley Bank owes Ridge bank $25,200, but Ridge Bank owes Maple Valley Bank $10,000; then the net obligations between the banks can be settled by a single payment of $15,200. CHIPS has its own reserve account, collects beginning of the day payments from participants in the system, makes end of the day disbursements at the end of the day, and collects additional funds from banks whose total net obligation for that day exceeded its initial pay-in.

    • I think so.

      Transfers between banks are 1 to 1 (not fractional).

      It seems to me we have a fractional reserve banking system and a fractional capital banking system in regards to debt creation thru banks and bank-like entities.

      Not a stupid question.

  20. From above:

    “Just above?

    ““The bank borrowed $50,000 and lent $1,250,000. That creates “money”, meaning $ borrowed not equal $ lent systemwide.

    Whether or not a bank can do this, if the bank borrowed $50,000 then there are obviously some lenders who lent the bank the $50,000; and if the bank lent $1,250,000 then there are obviously some borrowers who borrowed the $1,250,000. So total dollars borrowed do equal total dollars lent.”

    But the bank borrowed only $50,000 and lent $1,250,000. Systemwide (whole economy) $ borrowed not equal $ lent?”

    There is some kind of multiplier there. I need the proper way to describe it so $ borrowed = $ lent does not apply. Banks create “money” thru “actual” borrowing.”

    Dan Kervick said: “System wide, dollars borrowed equals dollars lent. But money is created.”

    I think I’m starting to see both parts there. However, I think I need more of a concrete example to be able to explain that to someone else.

    • Well, if I’m a bank and I put $10,000 in a demand deposit account for you, and in exchange you give me a promissory note for $10,500, what’s the result:

      Bank:

      Assets:

      $10,500

      Liabilities $10,000

      You

      Assets:

      $10,000

      Liabilities:

      $10,500

      I have net assets of $500, and you have net liabilities of $500. So system-wide, assets = liabilities.

      But there is more money now. Promissory notes aren’t usually classified as money; but bank demand deposit balances are. While promissory notes can’t be bought and sold, and might even be negotiable, they are not as liquid and negotiable and generally accepted as bank demand deposit balances, so they aren’t classified as money.

      The transaction between you and the bank, at this initial stage is a swap of debt for debt, a promise for a promise. But when we speak of “borrowing” and “lending”, we are usually focused only on the money dimension. The amount that was loaned in this case was $10,000. And that is also the amount that was borrowed.

      • Sunflowerbio

        Dan, didn’t you mean to say, “While promissory notes can be bought and sold,…..”? That’s what the secondary mortgage market is all about.

  21. Paul Krueger

    Dan, all of your reserve accounting is of course correct, but I wonder if you didn’t miss the point of Thoma’s suggestion. Sure, the TOTAL reserves in the system do not change as a result of issuing new loans, but the total reserve requirements certainly do (when that happens is only relevant for computation of the amounts and doesn’t disprove the factual matter of the increased reserve requirements). Therefore, unless the Fed buys more bonds, the reserve EXCESS over and above those requirements will shrink as the result of an increase in loan issuance. If banks are charged on the basis of the magnitude of that excess (rather than on the basis of their total reserves as you seemed to assume) then there is definitely a financial incentive to issue more loans isn’t there?

    Obviously you would also have to assure that the system couldn’t be gamed in some of the ways that others have suggested. Since the Fed determines the total level of reserves, they could manipulate balances any way they want to increase or decrease the resulting expense to banks. That could provide them with quite a bit of leverage I would think, although the banks would undoubtedly cry fowl and perhaps balk at selling more bonds to the Fed.

  22. From above and expanding it:

    I’m just going to put this example up and see what happens.

    Let’s say I save $100,000 in currency. Someone else wants to start a new bank. They sell me $100,000 of bank stock (bank capital). The reserve requirement is 0%, and the total capital requirement is 8%. I believe that means the capital requirement is 4% for mortgages and is 8% for ordinary loans. This example will be all mortgages.

    Assets new bank = $100,000 in currency
    Liabilities new bank = $0
    Capital new bank = $100,000 of bank stock

    I’m going to leave the currency there for simplicity.

    The bank now makes 25 mortgages for $100,000 each.

    Assets new bank = $100,000 in currency plus $2,500,000 in loans
    Liabilities new bank = $2,500,000 in demand deposits
    Capital new bank = $100,000 of bank stock

    $100,000 / ($2,500,000 * .5) = .08

    The home builder sets up a checking account at the new bank. So 25 checking accounts at the new bank were marked up and then marked down by $100,000 each, while the home builder’s checking account was marked up by the $2,500,000.

    I believe the $2,500,000 of the home builder is considered by the other person to be lending to the bank and borrowing by the bank.

    The home builder allocates as follows:

    $2,000,000 in a savings account and $500,000 in a 7 year CD. Bank is funded for now, and the reserve requirement for savings accounts and CD’s is zero so that takes care of a positive reserve requirement.

    Assume the interest payments for mortgages are paid out as a dividend so there are no retained earnings that could be used as tier 1 capital.

    I save $48,000 more in currency. I think the bank can now sell a subordinated term debt instrument (bond) of $48,000 as tier 2 capital. It could issue up to $50,000 as tier 2 capital.

    Assets new bank = $100,000 in currency plus $2,500,000 in loans plus $48,000 in currency
    Liabilities new bank = $2,500,000 in demand deposits
    Capital new bank = $100,000 of bank stock and $48,000 of bank bond(s)

    I’m going to leave the currency there for simplicity.

    The bank now makes 12 mortgages for $100,000 each.

    Assets new bank = $100,000 in currency plus $2,500,000 in loans plus $48,000 in currency plus $1,200,000 in loans
    Liabilities new bank = $2,500,000 in demand deposits plus $1,200,000 in demand deposits
    Capital new bank = $100,000 of bank stock plus $48,000 of bank bond(s)

    $148,000 / ($3,700,000 * .5) = .08

    The home builder has a checking account at the new bank. So 12 checking accounts at the new bank were marked up and then marked down by $100,000 each, while the home builder’s checking account was marked up by $1,200,000.

    I believe the $3,700,000 of the home builder is considered by the other person to be lending to the bank and borrowing by the bank.

    The home builder allocates as follows:

    $2,000,000 in a savings account and $500,000 in a 7 year CD (the same) plus an additional $1,200,000 to the savings account. Bank is funded for now, and the reserve requirement for savings accounts and CD’s is zero so that takes care of a positive reserve requirement.

    Assume the interest payments for mortgages are paid out as a dividend so there are no retained earnings that could be used as tier 1 capital.

    Notice the .5 times 8% equals the capital requirement for mortgages, 4%.

    Let’s look at what happened with the $48,000 tier 2 capital bond that was issued.

    I saved $48,000 in currency. I lent $48,000 to the bank, and the bank borrowed $48,000 from me. The bank lent $100,000 each to 12 other people, and the 12 other people borrowed $1,200,000 from the bank. I think the other person would say that the home builder lent $1,200,000 to the bank thru the checking account and the bank borrowed $1,200,000 from the home builder.

    The bank borrowed only $48,000 from me and lent $1,200,000 for the mortgages at one step without the bank needing to borrow from some other entity.

    That looks to be true.

    Overall, lending is $48,000 plus $1,200,000 plus $1,200,000.
    **** borrowing is $48,000 plus $1,200,000 plus $1,200,000. $ borrowed = $ lent

    I said above that systemwide (whole economy) $ borrowed not equal $ lent?

    That looks wrong.

    Now have the home builder demand the $1,200,000 in currency. The new bank should be able to get currency from the fed. $48,000 in currency went into the new bank, and $1,200,000 was withdrawn. I think the $48,000 is still at the new bank.

    Next, take the capital requirement to 100% for all loans including the mortgages.

    Assets new bank = $100,000 in currency plus $100,000 in loans plus $48,000 in currency plus $48,000 in loans
    Liabilities new bank = $100,000 in demand deposits plus $48,000 in demand deposits
    Capital new bank = $100,000 of bank stock plus $48,000 of bank bond(s)

    The bank borrowed only $48,000 from me and only lent $48,000 for the mortgages at one step without the bank needing to borrow from some other entity.

    If the capital requirement is less than 100%, then someone can’t say monetary policy does not work by increasing actual borrowing.

    Thoughts?

    • sunflowerbio

      All of this borrowing depends on demand for new housing. The fact that money is available does not in itself create the demand. People must feel that they can make the payments from their income or they won’t borrow (excluding fraudulent loans), no matter how much money the banks have available.

      • “People must feel that they can make the payments from their income or they won’t borrow (excluding fraudulent loans),”

        I’d say people are making assumptions about the future when borrowing. Those assumptions may or may not come true.

        “no matter how much money the banks have available.”

        I’d rather say even though the banks are under their capital requirement.

  23. Pingback: Dan Kervick: Reserve Balance Misconceptions « naked capitalism

  24. golfer1john

    “$2,000,000 in a savings account and $500,000 in a 7 year CD.”
    “Liabilities new bank = $2,500,000 in demand deposits”

    It’s probably a typo, but savings accounts and CDs that have no reserve requirements are not demand deposits, they are time deposits. Checking accounts are demand deposits, and create a reserve requirement, I think.

    “monetary policy does not work by increasing actual borrowing.”

    Is this the crux of your question? MMT generally doesn’t think monetary policy (setting interest rates) has much effect on the real economy, and that the effect it does have is the opposite of what is generally thought.

    Beyond that, the statement is still ambiguous. I wonder what “actual” borrowing is, and what part of “borrowing” is excluded from “actual borrowing”. It’s not a generally-used term in economics.

    Ignoring the “actual”, the statement could mean any of the following:

    “Monetary policy might increase borrowing, but that is not how it affects the economy”
    “Monetary policy has no effect on borrowing, it works in other ways”
    “Monetary policy just doesn’t work”

    Perhaps if you stated how this person thinks monetary policy does work? Or if it does work?

    • “monetary policy does not work by increasing actual borrowing.”

      Is this the crux of your question? MMT generally doesn’t think monetary policy (setting interest rates) has much effect on the real economy, and that the effect it does have is the opposite of what is generally thought.

      Beyond that, the statement is still ambiguous. I wonder what “actual” borrowing is, and what part of “borrowing” is excluded from “actual borrowing”. It’s not a generally-used term in economics.”

      Yes, that is the crux of my question.

      The bank borrowed only $48,000 from me and lent $1,200,000 for the mortgages at one step without the bank needing to borrow from some other entity.

      I consider demand deposits both medium of account (MOA) and medium of exchange (MOE), just like currency. $1,152,000 of MOA/MOE were created ($1,200,000 minus $48,000). I think that is “actual” borrowing. If the capital requirement was 100% then the banks could not create more MOA/MOE.

      I think the other person/people is/are saying that banks can create demand deposits but $ borrowed = $ lent means there is no actual borrowing (no increase in MOA/MOE). I think they believe only currency or currency plus central bank reserves is “money”. Monetary policy does its job by increasing spending, not borrowing. The fed buying a bond gets more “money” in circulation.

      I think the other people are living in a 100% capital requirement world. Even if the capital requirement is not 100%, they still think $ borrowed = $ lent means it still acts that way.

      • golfer1john

        I’m not sure what world they live in, but the terminology is unfamiliar to me. MMT takes a different view of it, not opposite, but from a different angle.

        Currency and Fed reserves are the top level of the pyramid of money. They are government money.

        When banks make loans they create deposits, and that is also money, bank money. Bank money trades at par with government money.

        The capital of a bank may consist of a variety of assets, not just government money. It may own some T-bills, for instance. If it does, and if there were a 100% capital requirement, and the bank’s assets exceeded its liabilities by $1M, then I think the bank could make loans up to $1M. That would create money, because the bank had none to start with, and it created a deposit for the borrower, which is new money that did not exist before.

        You and I can create money, too. I could buy your car and give you a promissory note. You could take that note to the grocery store, and if the store owner were my brother, maybe he would give you some groceries for it. Or not. As they say, the trick is to get it accepted. Banks can do that trick, most of us cannot, generally.

        When the Fed buys Treasuries, that is an asset swap. Treasuries are not “money” as such. Money does not pay interest. But short-term (overnight) T-bills do trade essentially at par with money, and are highly liquid. That asset swap does nothing to add to the spending power of the private sector, nor to the lending power of banks. Its purpose is to control the overnight interbank interest rate, called the Fed Funds rate, by adding to (in the case of a purchase) aggregate bank reserves, to the extent that banks need them to meet their reserve requirements, so that the rate does not rise. Or it may buy Treasuries to prevent the rate from falling below the target, if there are excess reserves. (Currently, the Fed pays interest on reserves, so even with massive excess reserves the FF rate will not fall below the IOR rate.)

        That is how MMT views “monetary policy”.

        Bank lending is determined by the economy itself (“endogenously”). The government cannot control it, not by capital requirements or interest rates or reserves (although interest rates can influence decisions to borrow and spend, or to save). What the Fed is doing now, buying up interest-bearing assets (QE), is not creating any demand or incentive to lend or borrow. It is removing interest income from the economy. It is stepping on the brake, not on the gas.

        Government can increase demand by spending more than it taxes. Either the extra spending adds directly to demand, or the reduced taxing is an increase in income for the private sector, and they can either spend it or save it. To the extent they spend it, it adds to demand. Increased demand means increased sales for businesses, which will respond by increasing production: hiring more people, or investing in more capacity. It is fiscal policy that influences incomes and spending and borrowing, not the Fed’s “monetary” policy.

        I’m going to retire from this conversation now, since I’ve already told you more than I know about bank operations. I looked for a good reference for you, I know I have seen it somewhere in the MMT blogosphere, but I can’t find it now. You should take that as gospel, if it conflicts with anything I have said here.

        • You and I can create money, too. I could buy your car and give you a promissory note. You could take that note to the grocery store, and if the store owner were my brother, maybe he would give you some groceries for it. Or not. As they say, the trick is to get it accepted. Banks can do that trick, most of us cannot, generally.

          Yes. Precisely.

          • Looking at the Maple Valley Bank example above, isn’t it about getting the demand deposit accepted, not the promissory note (the loan part)?

            • Don’t follow you. Isn’t what about getting the demand deposit accepted?

            • Looking at the Maple Valley Bank example above, isn’t creating “money” about getting the demand deposit accepted as medium of account and medium of exchange, not the promissory note (the loan part)?

              • The money banks “create” is a liability, a debt of the bank that creates it. So they aren’t going to issue money unless they get something for it in return.

              • Assets new bank of ME= $0
                Liabilities new bank of ME= $0
                Capital new bank of ME= $0 of bank stock

                The new bank of ME now makes 1 car loan for $10,000 to you.

                Assets new bank of ME= $10,000 in loans (promissory note)
                Liabilities new bank of ME= $10,000 in demand deposits
                Capital new bank of ME= $0 of bank stock

                You get $10,000 in demand deposits and give them right back for the car. I accepted them as medium of exchange (MOE).

                I now go to the grocery store. The grocery store won’t accept the demand deposits/check because they won’t clear at its bank. I also can’t get the demand deposits redeemed for currency. I ask the grocery store about accepting the loan (promissory note). They say definitely not. We only accept demand deposits/check that will clear at its bank and/or currency in exchange for real goods/services.

                Notice it is the demand deposits that are moving or trying to move. They are the MOE.

              • “You and I can create money, too. I could buy your car and give you a promissory note.”

                I think a step or so was skipped there. You give me a promissory note (loan) for the car loan, and I give you demand deposits. You give me the demand deposits back, and I give you the car.

    • “$2,000,000 in a savings account and $500,000 in a 7 year CD.”
      “Liabilities new bank = $2,500,000 in demand deposits”

      It’s probably a typo, but savings accounts and CDs that have no reserve requirements are not demand deposits, they are time deposits. Checking accounts are demand deposits, and create a reserve requirement, I think.”

      The 25 people borrowed $2,500,000 from the bank. It got deposited into their checking accounts. The $2,500,000 got moved to the home builder’s checking account. The home builder then moved the $2,500,000 to the savings account and CD’s.

      “Checking accounts are demand deposits, and create a reserve requirement, I think.”

      That sounds good if there is a positive reserve requirement.

  25. This link should be useful.

    http://www.cnbc.com/id/100497710

    Basics of Banking: Loans Create a Lot More Than Deposits