QE: Are You A Victim Of Its Myths? Get Help Here
How Is Money REALLY Created? The Basics: Bank Reserves
For something as important to daily life as money, very few people know how it is actually created. And, no, money isn’t created via fractional reserve banking.
It is actually, literally, created from nothing.
Before we get to explaining just how such a feat is possible, we have to cover a few basics, beginning with Bank Reserves.
What are bank Reserves? Simply put, bank Reserves are how banks settle transactions (bank transfers from one client to another) between each other.
When a customer deposits $100 in Bank A, Bank A’s total Reserves increases by $100, and its liabilities increase by $100. Deposits are liabilities from a bank’s perspective because deposits are funds that they owe to customers:
Now, when the customer transfers $100 to a friend who holds an account in a different bank, Bank B, Bank A has to transfer its Reserves to Bank B:
This transfer is done via the Fed, where US banks have accounts holding Reserves for just this purpose – to settle transactions amongst themselves. Banks in other countries will have accounts with their own domestic Central Banks, with their own domestically denominated Reserves.
Different Central Banks have different policies, but in general, banks do not transfer reserves between each other every time a transaction is initiated.
Instead, they do it on a net basis at the end of the day, simply because it is a lot more convenient. This practice means that individual banks in the financial system will have vastly differing needs for Reserves at the end of each business day.
These differing needs create demand and supply in the domestic interbank market for Reserves, where banks lend/borrow Reserves from each other in order to meet their daily business needs. Naturally, such a market will have its prevailing interest rate, a good example of which is the Fed Funds target rate that market folks always talk about.
Since domestic banks must have Reserve accounts with their respective Central Bank in order to settle transactions with their counterparty banks, Central Banks can, and do use Reserves as a means to achieve their respective monetary policies.
For example, they can create them by purchasing assets from domestic banks, a la QE, or destroy them by selling assets to domestic banks.
This ability to create Reserves has led many to believe that Central Banks can create money at will, and is hence at the root of the hysterical chorus of “hyperinflation is coming” with each new iteration of QE (The hysteria is unfounded).
Some Central Banks also have a Reserve Requirement Ratio (RRR), which requires banks to hold a certain percentage, say 10%, of their deposit liabilities in their accounts at the Central Bank.
Different Central Banks implement such a rule for different reasons , some, such as the People’s Bank of China (PBoC), uses the RRR as an important tool to manage their domestic money supply. Other Central Banks have given up on the RRR altogether, setting them at zero, including the Bank of England (BoE) and more recently, the Fed.
So why the differing approaches?
This is where the role of Reserves in the financial system and wider economy becomes a little bit more complex, and a lot more misunderstood, which will be explained in further detail next.
To be continued…
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How Is Money REALLY Created? NOT Fractional Reserve Banking
Ostensibly, the Reserve Requirement Ratio (RRR) was created to provide a liquidity buffer to ensure that a bank had Reserves to cover customers rushing to move their funds out of that bank, in other words, a bank run.
This is possible because banks in this day and age are theoretically “supposed” to be lending out their Reserves in order to create money in the economy.
The theory goes that a bank takes $1000 in deposits, keeps 10% to fulfill the RRR, and loans out the remaining $900.
The loan increases the money supply in the system by $900, since the initial depositor still has $1000, and the loanee has $900.
The bank, by originating a loan, has created $900 in new money.
Now, the $900 is spent by the loanee and deposited into a second bank. This second bank keeps 10% of the $900, which is $90, and loans out the remaining $810.
In originating this second loan, the second bank creates another $810, thereby increasing money supply again.
This goes on until the theoretical maximum of the money multiplier, defined as 1/RRR, in money is created.
The theoretical process described above is known as Fractional Reserve Banking; fractional because a fraction is kept in reserve and the remainder loaned out. As such banks are susceptible to runs since they never hold the full amount of Reserves that its customers have deposited.
However, while the RRR is an important part of how Fractional Reserve Banking works, it isn’t the foundation upon which the model is built upon.
Instead, the foundation of Fractional Reserve Banking is the underlying assumption that Reserves are loaned out; because if this assumption were proved to be false, then money simply will not be created in the banking system and wider economy.
And…unfortunately for the multitude of people who believe that money is created via Fractional Reserve Banking, Reserves are not loaned out.
The next instalments in this series will deal with the many questions, ramifications, and explanations that the above statement will have elicited.
To be continued…
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How Is Money REALLY Created? Banks Do NOT Lend Reserves
The Fractional Reserve Banking (FRB) model is very deeply ingrained in today’s mainstream economic thinking.
This model is taught in introductory macroeconomic classes across the globe, and has been for years. Which means that every graduate, regardless of their degree, has at least heard about this if they took intro econ classes.
That’s a lot of graduates.
Now, you may be asking: Isn’t it good that many people are familiar with Fractional Reserve Banking? Isn’t it better for society if more people are familiar with how economic policy makers think?
Well the answer to the second question is yes.
The answer to the first question however, is a resounding no.
As it turns out, Fractional Reserve Banking is not what actually happens in the real economy, because banks do not lend Reserves.
This is very important and bears repeating; banks do not create new money through the process of Fractional Reserve Banking, at all.
This, of course, begs the question: How then is money created in the banking system and economy?
The answer is … ex nihilo. Which is Latin for “from nothing”. Here’s the accounting:
Like in Fractional Reserve Banking, lending is the mechanism through which money is created; unlike Fractional Reserve Banking, Reserves are not loaned out.
In fact Reserves are not present anywhere in the accounting for new loans. This is important because for Fractional Reserve Banking to work, banks must loan out Reserves, which means that Reserves should appear somewhere in the accounting.
But they do not.
Instead, when a new loan is made, the bank creates a new asset for the loan, since they will be earning interest on it. They balance this by increasing the deposit balance of the client who took out the loan.
From the client’s perspective, their deposits increase by the amount of the loan, and their liabilities increase by the same amount, since they now owe the bank the amount of the loan.
As can be seen, Reserves are not part of the process at all. Instead, when a new loan is originated by a bank, money is created through making the appropriate balance sheet entries – from nothing.
At this point, it would be completely understandable if you think that everything written above is incorrect, or some sort of misguided attempt at creating fake news. So don’t take our word for it; here’s the Bank of England explaining it in a research paper.
Of course, this new understanding of how money is actually created raises a lot of questions. What use do Reserves have since they aren’t lent out? Doesn’t this invalidate QE? What does this mean for modern monetary policy?
If you feel like your head is spinning, remember that not knowing is a good thing.
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How Is Money REALLY Created? Why QE Does NOT Work
Modern monetary policy is based largely around Central Banks expanding/contracting the amount of Reserves in the banking system.
This is done through smaller open market operations to influence overnight interest rates for borrowing/lending Reserves, and larger operations like QE.
But this doesn’t work!
The logical basis for these operations is that if the Central Bank increases/decreases the amount of Reserves held by banks, then banks will in turn loan more/less of these Reserves out into the economy. In doing so, the Central Bank influences economic growth and manages the level of inflation.
But, if Fractional Reserve Banking does not work because banks do not lend Reserves, doesn’t that mean Central Bank policy, i.e. QE, does not work as advertised?
Unfortunately for all of us, the answer to the above question is Yes.
Take a moment and consider the ramifications of this – that 1) Central Banks do not understand how money is created, or 2) they do understand it but are not tailoring their policies to reality.
If 1) is true, then what good are these QE loving Central Banks doing?
If they do not understand the very basics of how the system they are overseeing works, that means all their future monetary policies are dead on arrival, not to mention the decade(s) already gone.
If 2) is true, then it begs the question – Why?
A possible reason is that Central Banks feel the need to be actively doing something, which is after all a very normal emotional reaction all humans have in times of crisis. After the rubicon of implementing QE for the first time is crossed, each subsequent iteration then becomes easier to implement; it becomes a convenient solution of sorts.
There is of course, an even scarier reason. Central Banks actually think that QE works. Inflation and the labor market will beg to differ. Of course, stock markets and other risk assets won’t!
Although, it must be asked, if QE works… then why are Central Banks doing it for a 2nd, 3rd, 4th… nth time?
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You Need To Know Why QE Did NOT, And Does NOT Work
First, we need to define what is meant by QE “didn’t work”.
QE as a policy is meant to generate inflation in the economy by printing money. On the surface, this sounds simple enough, after all everyone has a pretty good notion of what “printing money” means.
Unfortunately, the only simple part of that two word phrase is the word “printing”.
It turns out that Money, in this modern age, is not that easy to define.
Putting it very simply, money is anything that anyone accepts as payment for goods or services. Conversely, it follows that if not enough people accept something as payment, then it cannot be considered to be money.
Hold this thought while we dive a little deeper into the mechanics of the Fed’s QE programs.
In every iteration of QE, the Fed pays for the assets it purchases in bank reserves. Recall that bank reserves are not money.
However, the Fed thinks it is (they have yet to indicate otherwise).
Trillions of USDs worth of reserves have been pumped into the financial system as a result, simultaneously withdrawing the same notional amount of US Treasuries, mortgage backed securities, etc.
Hence, QE is nothing more than an asset swap, since banks are transferring fixed income instruments from the asset side of their balance sheet in exchange for reserves, which also sit on the asset side.
Nothing is created in the financial system in such a transaction – it’s pretty much the equivalent of moving stuff from one’s right pocket to their left one.
The reason the Fed continues these asset swaps is seemingly because of the incorrect mainstream belief that new money is created in the economy by banks loaning out bank reserves.
Banks do not loan out bank reserves, instead, banks create money in the economy ex nihilo .
Now, remember that these fixed income instruments, especially US Treasuries, are what the financial system uses as money. Given this new understanding, is it that surprising a decade of QE has not generated inflation meaningful enough for the Fed to hit its 2% target?
Using the Fed’s preferred inflation indicator, the PCE index (Personal Consumption Expenditure Chain Type Price Index), we can see that inflation has never really consistently come in above the target level of 2%.
Instead, after a promising sustained move higher post ‘08 and into mid 2012, the PCE has only been above 2% for two short stretches, in 2017 and 2018.
Even as bank reserves continue their upward trajectory with the Fed’s endless QE, inflation as measured by the PCE is stuck in a downtrend that began pre-2008.
Clearly ever more bank reserves are not the answer to the US economy’s problems, which begs the question: How can there be meaningful inflation as long as global central banks cling to QE as their savior?
Note: If “money”, what constitutes “money”, and how it is used and moved around the economy and financial system is a topic that interests you, it is well worth doing extensive further research. It will not take long before you realize that money is a much more intangible concept than the vast majority of people think it to be.
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