Tuesday, November 16, 2010

Quantitative Easing Explained (badly)



There’s a little video making the rounds on the Internet called, “Quantitative Easing Explained.” It’s cute, but don’t be fooled by the cuteness because it’s got pretty much everything all wrong. The video has two robot-like cartoon characters talking about quantitative easing and it starts off by saying that quantitative easing is nothing more than the Fed “printing a ton of money.” That’s the first dose of misinformation. Quantitative easing is NOT about printing money; but it IS about adding new reserves to the banking system. Moreover, reserves are not even part of the money supply and when they’re in the banking system they generally just tend to sit there earning some pittance of interest. There’s no “printing of money” going on; this is a huge misstatement.

Then the characters try to purport that deflation is good because it gives people more purchasing power, i.e. it lowers the cost of things and that allows consumers to buy more. Hell, if you listen to these characters you’d get the idea that all policy—monetary and fiscal—should be focused solely on creating massive deflation because everyone would somehow benefit. This is so wrong it’s ridiculous. What the robots ignore is that in a deflation wages are falling, too, so the real cost of goods and services actually rises. Debt becomes harder to service and asset prices fall (in the current reality home prices are falling, which are most household’s largest asset), so wealth falls. Less wealth means less ability to consume. You get poorer!

The characters try to refute the Fed’s claim that things are deflating by pointing out that prices for such things as food, gas, health care, tuition, taxes, subways, stocks and bonds are all rising. They’re trying to make the case that what we are really experiencing now is inflation, not deflation. Yes, some of those things are rising in price, but there are other items on the Consumer Price Index that are still falling, like housing, apparel and recreation. All told, inflation as measured by the CPI is up 1.1% versus last year. That’s not exactly some out of control hyperinflation.

The video then gets into an area where the full ignorance of its creators goes on display, when it starts talking about monetary operations. Monetary operations are mechanism by which the Fed sets rates or conducts quantitative easing. The characters say that the Fed executes QE by “printing money then buying the Treasuries.” In reality, it’s the total reverse: the Fed buys Treasuries by crediting reserve accounts, simple as that. In other words, reserves are a byproduct of asset purchases, in this case, Treasury purchases. There is no creating money and then buying of bonds.


Their confusion doesn’t end there. They say that the Fed could buy the bonds directly from the Treasury, but doesn’t. Instead, they go on to say, it buys from Goldman Sachs. (Goldman is used throughout the video as a metaphor for greedy Wall Street.)

The fact is, if the Fed bought from the Treasury it would have zero effect on reserve balances because the money would go into the Treasury’s account at the Fed rather than into the banking system, where the Fed wants the reserves to go. Therefore, in order for the Fed’s operations to have any chance of success it MUST buy bonds from the public and not the Treasury because it wants reserve credits to go into the banking system. You or I can buy bonds from the Treasury, but that’s a whole different thing. WE are not trying to affect monetary policy, the Fed is.

The video then makes the totally false claim that the Fed pays Goldman Sachs the worst price for the bonds. This is wrong, wrong, wrong. The way the Fed conducts monetary operations is that it will indicate its intentions and it will buy from dealers at the best price/lowest yield offered. What these guys say is all made up. They’re clearly on a propaganda mission here.

Toward the end they say that the Fed’s first quantitative easing program (QE1),conducted last year, was a failure because it didn’t create jobs or stop the housing market crisis. There’s probably some truth to that, however, it did stabilize the commercial paper market and other vital sectors of the capital markets and it probably helped boost stocks, which have climbed 80% since last year. Housing prices have stopped declining pretty much and the private sector has added about 1 million jobs. Much of this was due to the stimulus and automatic stabilizers, but to flat out state that QE1 was a failure, is just wrong.

The Internet is great, there’s a lot of good information out there, however, you have to be careful because it’s loaded with stuff like this: a lot of bad and misleading information that may be cynically designed to promote an agenda or advance someone's personal ideology. This clearly is an example.

41 comments:

Airelon said...

A-men ...

MT said...

just posted to my blog where we've been having a heated debate on such things as of late.

Great post...much needed these days!! Why don't you read it out to people on Fox next time!! haha!!

Like Dasan said yesterday...people seem to be mixing up their anger at FISCAL policy for the Fed's monetary policy.

welfarewarfare state said...

Mike Norman,

The new reserves do end up being money in most instances do they not? Answer: yes. It's really a game of semantics. The Fed has purposefully been pursuing a policy of inflation.

It looks like they have succeeded given the surge in commodity prices over the last year and a half. Retailers like GAP, J.C. Penny, Wal-mart, et al. have indicated that consumers should expect rising prices.

Didn't we see just this same scenario play out from 2002 to 2008 with price inflation? The price inflation courtesy of the Fed shows up first in commoditites traded on the world market then eventually rears its ugly head in consumer prices. Just imagine how much inflation had to be created in order for there to be any price increases given that we are in a depression.

Clothing retailers aren't the only ones who are raising prices. Food manufactures have also indicated that they will no longer be able to eat the rising costs of commodities as they have done for the last two years. I'm sure that economic illiterates will blame speculators, incompetent regulators, businessmen, unions, FoxNews (you know the usual rogue's gallery of people and institutions that we are taught to hate), but the real cuplrit is the Federal Reserve. Actually, incompetent regulators may not be to far off now that I consider it given that the Fed regulates the money supply and interest rates.

While it is true that "money printing" isn't exactly correct, it is a very useful rhetorical shorthand to explain what is going on to the American public. Do you really think that the American public is going to sit through an explanation of reserve requirements, open market operations, the discount window, "targeted" interest rates, etc.? "Money printing" gets their attention, and is close enough as far as I am concerned.

You guys can keep believing the government's phony CPI numbers, but the American people know that their dollar doesn't go as far as it used to.

By the way Mr. Norman, I think your perfectly predictable explanations for rising prices are "cute," too.

MT said...

Hi Welfare,

thanks for sharing your points of view and articulating yourself very well. I appreciate that very much.

Do you consider the serious commodity supply shortages around the globe to have any influence on prices right now?

Also are you stating that you feel the QE video Mike references in his blog is accurate or inaccurate in what it is saying?

I am very interested to hear your answers to these questions and I REALLY appreciate what you're saying about the 20-21 depression. I honestly didn't know any of that and when I can, I want to look into it further.

Thanks again and be well.

welfarewarfare state said...

MT,

Perhaps you are confusing scarcity with shortages. Scarcity is always present, but shortages are man-made. Shortages are caused by government price controls. Take rent controls for example: cities that have rent controls are always plagued by shortages, but when the rent controls go away, the shortages disappear, too.

I don't discount that world demand has escalated, but that can't alone account for the large run up in commodity prices. The increased demand for these goods means that the producers will seek to increase their supply until supply/demand is balanced once more. Many commodities have risen by more than 15% over the last 2 years. Are you telling me that that was solely driven by an increase in demand?

What really amuses me is that people like Paul Krugman and Mike Norman think that deflation (which I define as a decrease in the money supply) is the threat. We should be experiencing the effects of deflation--falling prices--right now. It is just that the market's 800 pound deflationary gorilla is going to be crushed by the Fed's 2,000 pound inflationary gorilla.

I disagree with Milton Friedman on many things, but he was spot on when he said that, "Inflation is everywhere and always a monetary phenomenon."

Lastly, Norman the Conquered attributes rising prices to dastardly speculators while you claim it is due to rising demand. Which is it? You guys need to get your story straight before next year because we'll be experiencing double digit inflation by the fall of 2011.

aliena said...

Mike, a counter video is due :-)

http://www.xtranormal.com/

Seething said...

Counter video, lol

Somebody already has one out for Sumner.

http://www.xtranormal.com/watch/7687255/

Seething said...

Looks like my link was cut off? Should be this at the end:

/7687255/

MT said...

welfare,

I am not talking about peak oil and the like...I am talking about russia holding its wheat supplies internationally and Brazil having literal fire tornadoes. I am also pretty sure, but can't recall at this time, that US farmers were hit hard weather-wise as well. Plus the dollar was in a downtrend for a fe months so prices will naturally (not abnormally) rise at that time too, which didn't help the situation. But yes the world demand is also increasing so that is a contributing factor too (as well as peak oil and all of that stuff too).

I see what you're saying in terms of commodity prices increasing over the past couple years however first off companies hedge themselves reasonably well in such times (as far as my limited understanding goes) and at least right now companies just do not want to pass on extra costs to consumers.

As far as speculators go and what Mike is saying there...I really don't know the details of that argument so I wouldn't say, but I am interested in that idea and would love to hear more. I am just myself...not Mike.

In terms of the Fed...based upon all that I can see they will be AMPLY able to unwind any inflationary effects of QE that may occur when we begin pulling out of this recession IF inflation actually becomes an issue...but hyper-inflation...please, don't even worry about it.

The bottomline: there is more than meets the eye going on with commodity prices AND I think you are forgetting all that the Fed can do to UNWIND things as the economy changes.

welfarewarfare state said...

Mr. Norman,

We don't advocate that government policy should be directed to promote falling prices. We're not arrogant central planners. We don't want an anointed elite meddling with prices at all. We view a falling price level as a naturally occurring phenomenon when productivity gains are being realized so long as the medium of exchange is sound.

The 19th century was a DEFLATIONARY boom period. The purchasing power of the money went up during this period while living standards rose dramatically. In fact, from 1788 (the creation of the Constitution) to 1913 (the inception of the Fed) the purchasing power of the money went up by 13%!

You remarked that wages, which are just prices, fall in a deflatinary enivronemnt. Yes, but so do counsumer, retailer, and producer prices. It is a wash. What really matters is real wages. The real harm of inflation is that it steals from the saver and discourages savings. Savings, i.e. delayed consumption, is the starting point for wealth creation. Any government policy that encourages consumption spending and discourages savings is counterproductive.

I suspect that the reason that so many people are seduced by inflation (including academics) is the word itself connotes expansion. The word deflation connotes contraction. These connotations are very misleading though. If one simply thinks of the effects of inflation as the purchasing power of the money going down, and deflation's effect as the purchasing power of the money going up then I think the truth is easier to see.

On second thought, I agree with Norman the Conquered. Let's just create a lot of inflation so we can all have "high wages." Why, we could all be millionaires if we simply inflated enough. Just think how much we could speed up the velocity of money. Yep, that's the ticket. How could I have been so blind to the truth of NormanLogic for so long?

cheers!

Matt Franko said...

Welfare,
"It looks like they have succeeded given the surge in commodity prices over the last year and a half."

Is this the part where they got oil from 150 to 80? Nat Gas from 13 to 3? Real Estate a drop of 35%, plywood from 50 to now 12? Etc...

This sure is some kind of inflation we're having!

MT said...

I know Matt. I was giving him the benefit of the doubt when looking on a weekly since 2005 you can see we're up by about 200 dollars or so...it's similar for many other grains...but yes the looming reality is that we're WAY DOWN since 2008. I probably should have explained myself more fully. Thank you!

MT said...

I was referring to wheat in that example btw

Marty Steinberg said...

Is this the part where they got oil from 150 to 80? Nat Gas from 13 to 3? Real Estate a drop of 35%, plywood from 50 to now 12? Etc...

There are lies, damn lies and statistics. I didn't come up with that. Someone wise did. You can make stats say anything you want it to say, in this case by cherry picking the dates. Is inflation usually measure over a 3 year time period?


Besides, We were told that inflation was tame, or next to nothing when Oil went from $10 to $147 and Natural gas went from $2 to $15, Dow went from 7700 to 14300 and Price of real estate went up 200%. Why should a fall in price of these items be considered deflationary?

googleheim said...

We already had inflation with the Bush years and it was artificial and real.

CDO's and all that were forms of printing money in the real economy outside of the Fed.

bubbleRefuge said...

The new reserves do end up being money in most instances do they not? Answer: yes. It's really a game of semantics. The Fed has purposefully been pursuing a policy of inflation.

This is the kind of hysterical incorrect neo-liberal analysis that is killing us. There is to much misunderstanding an mis-information about government finance and reserve accounting.

Again. As has been demonstrated by MMT, QE does not create more money! If you don't get that, you should be asking questions or asking where to find the literature that explains it?

bubbleRefuge said...

Is inflation usually measure over a 3 year time period?

Besides, We were told that inflation was tame, or next to nothing when Oil went from $10 to $147 and Natural gas went from $2 to $15, Dow went from 7700 to 14300 and Price of real estate went up 200%. Why should a fall in price of these items be considered deflationary?

You can quibble about how inflation is measured, but the bottom line is that we have not seen any major inflation ever in this country in the inflation indexes as a result of too much demand caused by government policy. Most of the inflation we've experienced in the inflation indexes can be attributed to supply side factors. Yes, fraud in mortgage industry of late and in IPO's in late nineties caused bubbles.

welfarewarfare state said...

Matt Frank,

Oil wasn't at $150 dollars a year and a half ago. Oil hasn't been near $150 dollar ssince the summer of 2008. that's over two years ago.

The run up in commodites renewed in the spring of 2009 after much of the deleveraging had been completed in the wake of the Fed's burst housing bubble. Is this the best that the Normanites can do? Try harder, come on!

welfarewarfare state said...

Bubblerefuge,

I'm sure you are aware that the T in MMT stands for theory,right? I think the term theory is far too generous in this case though. A theory is a hypothesis that has withstood all attempts to refute it by test. Given the events of the last decade and the events to come maybe MMT should be renamed Modern Monetary Hypothesis. Your so-called "theory" is crackpot.

Why are you guys so certain that you are right given how wrong you've been about economic events over the last 5 years?

Banking reserves do end up being credit money often times. That is a fact. Quantitiave easing is designed to keep interest rates artificially low and to create price inflation. Many incompetents at the Fed and in academia think that inflation will cure the unemployment problem. The seventies just called and said, "Nope!" The central planners are wrong now just as they were wrong about the effects of QE1.

By the way, you told me that you weren't going to respond to me anymore. What gives?

cheers!

welfarewarfare state said...

To all of you,

Can any of you show me a price chart of commodities over the last year and a half that shows falling prices in the aggregate? You guys want to use 2005 or 2007 as your baseline. This was before the housing collapse though wasn't it? The same thing that caused a run up in prices from 2002 to 2008 is the same thing that is causing a renewed run up in prices now: the monetary policy of the Fed.

It just takes more units of the currency to buy anything because the money has been debased by our gloriously incompetent twits at the Fed.

bubbleRefuge said...

Banking reserves do end up being credit money often times. That is a fact. Quantitiave easing is designed to keep interest rates artificially low and to create price inflation. No it is not a fact. How does it work if no new money is created? I keep asking you this and you refuse to answer the question because you can't because you are incompetent.

welfarewarfare state said...

Bubblerefuge,

What do you think the point of increasing reserves is if not to increase the credit money supply. Do you think the Fed's goal is to decrease the credit money supply by increasing reserves? The Fed has come out publicly and stated that they think that price inflation is too low. (This is like the New York police force claiming that the crime rate is too low.) They are deliberately pursuing an inflationist policy.

It's true that sometimes banks do not create new credit money with those increased reserves, but isn't that because the Fed is paying those banks a higher interest simply for holding those reserves than the banks think they can get by making risky loans?

Shouldn't you be off somewhere reading Modern Monetary Hypothesis anyway? My favorite genre is fiction, too, but on economic matters I much prefer the nonfiction section.

cheers!

Marty Steinberg said...

we have not seen any major inflation ever in this country

You have a weird sense of humor.

bubbleRefuge said...

What do you think the point of increasing reserves is if not to increase the credit money supply. Increasing reserves does not increase the credit money supply because reserves are not lent out. You are ignorant of the facts, as are most people and that is why we have such a big problem. Reserves are not lent out. Reserves are not lent out. Repeat after me. Reserves are not lent out.

Do you think the Fed's goal is to decrease the credit money supply by increasing reserves? The Fed has come out publicly and stated that they think that price inflation is too low. (This is like the New York police force claiming that the crime rate is too low.) They are deliberately pursuing an inflationist policy. But the fed is not creating inflation via money growth. They want to increase demand in the economy by reducing interest rates. This does nothing for demand because interest rates are already low enough. So its all a facade.

It's true that sometimes banks do not create new credit money with those increased reserves, but isn't that because the Fed is paying those banks a higher interest simply for holding those reserves than the banks think they can get by making risky loans?

Lending is not reserve constrained. Banks make money by making loans. Period.
Lets get our facts straight before we bash. There are some real smart guys that post here and on Warren's and Bill Mitchels site. Lots of recent posts on QE expalaining how it is useless because no money is actually created or lent out.

welfarewarfare state said...

Bubble Refuge,

The increased reserves enable the banks to lend out more money because they have more reserves on which to pyramid debt, i.e. credit money. Increased reserves tend to increase the credit money supply.

We have very different definitions of inflation. I define inflation as an increase in the money supply with the EFFECT being an increase in prices all else being equal. Classical economists were always more careful about the language used and were keen to use the terms deflation and inflation correctly. I sometimes fall into the bad habit of identifying the effects of inflation (price increases) with inflation (monetary expansion) itself, too.

We should be experiencing large decreases in prices right now given that we are in a depression. The market's deflationary forces are being overwhlemed by the Fed's inflationary efforts though.

You mentioned that banks make money by making loans. Yes, but they can make more loans when they have more reserves which is why increasing reserves or decreasing reserve requirements tends to increase the credit money supply.

Repeat after me: increases in reserves or decreases in reserve requirements tend to increase the money supply.

cheers!

DoggeyStyleMikey said...

What artificial lending standards are you talking about?!?!?!!?!?

bubbleRefuge said...

You mentioned that banks make money by making loans. Yes, but they can make more loans when they have more reserves which is why increasing reserves or decreasing reserve requirements tends to increase the credit money supply.
That's completely false. A bank makes a loan and can borrow reserves in the following accounting period to meet the reserve requirements. Not the current accounting period. This means the level of reserves a bank has does not limit its ability to make loans. The limiting factor is bank capital requirements and actual loan demand.

You are wrong and this debunks your argument that the fed is creating money and inflation. It is not. Just look at the state of things today. Despite all the efforts to the contrary from the FED, nobody is borrowing and nobody is lending compared to the past. Its because people are deleveraging and banks don't want to make bad loans in a bad economy. Nothing to do with reserves.

MT said...

welfare...bubble is correct here...and I myself never even considered that accounting technique so that is great to learn and know.

We have a DEMAND crisis not a credit crisis.

The Fed does QE to help offset a credit crisis while demand is lagging (at least that's how I understand it imo).

In this case of QE2...it seems to me at least that the Fed is attempting to create and maintain an environment that caters to people and their demands (aka low 10 year rates for a low mortgage at a great real estate buying opportunity)...if people bite at those seriously GREAT DEALS then that would be good for everybody.

Remember the FED CANNOT CREATE MORE JOBS!!! That's businesses, legislation, and government working with businesses...the Fed CAN create an attractive environment (aka set the stage) for when jobs do arrive on the scene.

Also do you understand that even if there WAS an inflation issue as we started to come out of this recession, the Fed has MANY, MANY PROVEN AND HIGHLY SUCCESSFUL WAYS of curbing that inflation?? They can VERY SUCCESSFULLY unwind these QE actions when the time is necessary. I think you fail to realize this or even admit this fact.

As for the inflation/deflation argument...I'm not even going there...I want to say that RIGHT NOW, like Mike says in this post, inflation is lagging and where it's climbing is in "odd" areas that are not CRUCIAL to our economy. The BIGGIES are in disinflation and/or deflation. Just imo!!!

Great discussion here none the less guys!! I like it! :D

welfarewarfare state said...

MT,

I really APPRECIATED your LAST post. I especially APPRECIATED how you CAPITALIZED every other WORD. No, REALLY, I mean IT.

In any event, government can't increase so-called aggregate demand. Demand doesn't create supply. It is supply that creates its own demand. Google Say's law for a complete expalnation. All government can do is transfer spending power away from the individual and to the state. The government is an ineffecient user of scarce reources because central planners lack mechanisms like a profti/loss test.

If spending were the magic elixir then our economy wouldn't be in the shape it is in now. Does anyone really think that the American citizen and government have been frugal for the last 20 years? We have spent our wad or consumed our seed corn if you will.

The problem with our economy is a lack of savings which directly correlates to artificially low interest rates. It is out of this savings that real credit for capital investment derives. Capital can't be replaced by artificial banking procedures.

Cheers!

raamaatmaj said...

Bubble Reguge you wrote...
>>Reserves are not lent out. Reserves are not lent out. Repeat after me. Reserves are not lent out.

>> Lending is not reserve constrained. Banks make money by making loans. Period.

So you are saying that reserves do not influence lending by a bank and therefore do not increase money supply. Is my understanding correct until here?

If yes, then

Q. why do we need reserves at all? Banks can keep on lending and since they make money by loans ..why do they need reserves?

You also said...
>>A bank makes a loan and can borrow reserves in the following accounting period to meet the reserve requirements. Not the current accounting period.

Q. Does this not establish a link between lending and reserves? Why do banks need to borrow in the next current accounting period if there is no connection between reserves and lending. And if there is a connection then it is clear that adding reserves enable more lending thereby increasing money supply.

You also said...
>>This means the level of reserves a bank has does not limit its ability to make loans. The limiting factor is bank capital requirements and actual loan demand.

How is this minimum capital that a bank needs to have to loan money is different than the reserves? What is reserves? Does a reserve not add to the capital of the bank there by increasing its capacity to lend more money?

I would be grateful if you could answer my questions to clear my doubts. thanks.

raamaatmaj said...

>>Reserves are not lent out. Reserves are not lent out. Repeat after me. Reserves are not lent out.

What is lent out? Is reserve not money? Is it not going to an institution that lends money? If reserves are not lent out why it is being added to banks...what good it is doing?

bubbleRefuge said...

Answers are in line and bold. Your questions are good and quite natural. Many people are unaware of the innards of government finance and banking. I've spent hundreds of hours reading white papers about it and it took me a while to get where I am and I'm still learning.
So you are saying that reserves do not influence lending by a bank and therefore do not increase money supply. Is my understanding correct until here? Yes

If yes, then

Q. why do we need reserves at all? Banks can keep on lending and since they make money by loans ..why do they need reserves?
They are used to settle payments between banks and between banks and the federal government.
Reserves are "federal money" so to speak. They are account balances at the US Federal Reserve( the FED) held by banks that are members of the federal reserve system. The US Treasury is a member and has an account there as well with a balance. Reserves are used to "settle payments" between banks. For example,if Person A from Bank A writes a check to Person B at Bank B for
100 dollars. 100 dollars in reserves are transferred from person Bank A's Federal reserve account to Bank B's federal reserve account. Also Person A's bank account is debited 100 and person B's Bank account is credited 100.


You also said...
>>A bank makes a loan and can borrow reserves in the following accounting period to meet the reserve requirements. Not the current accounting period.

Q. Does this not establish a link between lending and reserves? Why do banks need to borrow in the next current accounting period if there is no connection between reserves and lending. And if there is a connection then it is clear that adding reserves enable more lending thereby increasing money supply.
Let me drill down on that. Banks have reserve requirements imposed by the FED. Reserve requirements are a percentage of bank deposits. So, each time a new loan is created of say 1000 dollars in the banking system, a deposit is created in some bank and that bank is required to have 100 dollars more in its reserve account (10%). Because of the accounting period lag, those reserves can be borrowed in the following banking period either from the FED directly or from a participant in the Federal Funds Market ( other bank). Therefore, the banking system can create new loans irrespective of its reserve balances, because the reserves may be added in the following accounting period. Therefore the following statement is true: Banking lending is not constrained by reserve requirements and this is why Fed policies such as QE have not worked. They may have psychological value.

You also said...
>>This means the level of reserves a bank has does not limit its ability to make loans. The limiting factor is bank capital requirements and actual loan demand.

How is this minimum capital that a bank needs to have to loan money is different than the reserves? What is reserves? Does a reserve not add to the capital of the bank there by increasing its capacity to lend more money?
Capital is basically a banks assets (loans made) minus liabilities ( deposits). Reserves are a component of bank capital but banks profit by lending 'long' to the public and borrowing short 'reserves' to cover reserve requirements and settlements. Therefore reserves levels are endogenous based upon how much the level of government spending (which adds reserves) and aggregate borrowing which creates demand for reserves in the system.
Its important to distinguish between federal money(reserve account balances) and bank money(bank deposits ie checking accounts).


I would be grateful if you could answer my questions to clear my doubts. thanks.

bubbleRefuge said...

Answers are in line and bold. Your questions are good and quite natural. Many people are unaware of the innards of government finance and banking. I've spent hundreds of hours reading white papers about it and it took me a while to get where I am and I'm still learning.
So you are saying that reserves do not influence lending by a bank and therefore do not increase money supply. Is my understanding correct until here? Yes

If yes, then

Q. why do we need reserves at all? Banks can keep on lending and since they make money by loans ..why do they need reserves?
They are used to settle payments between banks and between banks and the federal government.
Reserves are "federal money" so to speak. They are account balances at the US Federal Reserve( the FED) held by banks that are members of the federal reserve system. The US Treasury is a member and has an account there as well with a balance. Reserves are used to "settle payments" between banks. For example,if Person A from Bank A writes a check to Person B at Bank B for
100 dollars. 100 dollars in reserves are transferred from person Bank A's Federal reserve account to Bank B's federal reserve account. Also Person A's bank account is debited 100 and person B's Bank account is credited 100.


You also said...
>>A bank makes a loan and can borrow reserves in the following accounting period to meet the reserve requirements. Not the current accounting period.

Q. Does this not establish a link between lending and reserves? Why do banks need to borrow in the next current accounting period if there is no connection between reserves and lending. And if there is a connection then it is clear that adding reserves enable more lending thereby increasing money supply.
Let me drill down on that. Banks have reserve requirements imposed by the FED. Reserve requirements are a percentage of bank deposits. So, each time a new loan is created of say 1000 dollars in the banking system, a deposit is created in some bank and that bank is required to have 100 dollars more in its reserve account (10%). Because of the accounting period lag, those reserves can be borrowed in the following banking period either from the FED directly or from a participant in the Federal Funds Market ( other bank). Therefore, the banking system can create new loans irrespective of its reserve balances, because the reserves may be added in the following accounting period. Therefore the following statement is true: Banking lending is not constrained by reserve requirements and this is why Fed policies such as QE have not worked. They may have psychological value.

bubbleRefuge said...

Answers are in line and bold. Your questions are good and quite natural. Many people are unaware of the innards of government finance and banking. I've spent hundreds of hours reading white papers about it and it took me a while to get where I am and I'm still learning.
So you are saying that reserves do not influence lending by a bank and therefore do not increase money supply. Is my understanding correct until here? Yes

If yes, then

Q. why do we need reserves at all? Banks can keep on lending and since they make money by loans ..why do they need reserves?
They are used to settle payments between banks and between banks and the federal government.
Reserves are "federal money" so to speak. They are account balances at the US Federal Reserve( the FED) held by banks that are members of the federal reserve system. The US Treasury is a member and has an account there as well with a balance. Reserves are used to "settle payments" between banks. For example,if Person A from Bank A writes a check to Person B at Bank B for
100 dollars. 100 dollars in reserves are transferred from person Bank A's Federal reserve account to Bank B's federal reserve account. Also Person A's bank account is debited 100 and person B's Bank account is credited 100.

bubbleRefuge said...


You also said...
>>A bank makes a loan and can borrow reserves in the following accounting period to meet the reserve requirements. Not the current accounting period.

Q. Does this not establish a link between lending and reserves? Why do banks need to borrow in the next current accounting period if there is no connection between reserves and lending. And if there is a connection then it is clear that adding reserves enable more lending thereby increasing money supply.
Let me drill down on that. Banks have reserve requirements imposed by the FED. Reserve requirements are a percentage of bank deposits. So, each time a new loan is created of say 1000 dollars in the banking system, a deposit is created in some bank and that bank is required to have 100 dollars more in its reserve account (10%). Because of the accounting period lag, those reserves can be borrowed in the following banking period either from the FED directly or from a participant in the Federal Funds Market ( other bank). Therefore, the banking system can create new loans irrespective of its reserve balances, because the reserves may be added in the following accounting period. Therefore the following statement is true: Banking lending is not constrained by reserve requirements and this is why Fed policies such as QE have not worked. They may have psychological value.

You also said...
>>This means the level of reserves a bank has does not limit its ability to make loans. The limiting factor is bank capital requirements and actual loan demand.

How is this minimum capital that a bank needs to have to loan money is different than the reserves? What is reserves? Does a reserve not add to the capital of the bank there by increasing its capacity to lend more money?
Capital is basically a banks assets (loans made) minus liabilities ( deposits). Reserves are a component of bank capital but banks profit by lending 'long' to the public and borrowing short 'reserves' to cover reserve requirements and settlements. Therefore reserves levels are endogenous based upon how much the level of government spending (which adds reserves) and aggregate borrowing which creates demand for reserves in the system.
Its important to distinguish between federal money(reserve account balances) and bank money(bank deposits ie checking accounts).


I would be grateful if you could answer my questions to clear my doubts. thanks.

bubbleRefuge said...

>>Reserves are not lent out. Reserves are not lent out. Repeat after me. Reserves are not lent out.
What is lent out? Is reserve not money? Is it not going to an institution that lends money? If reserves are not lent out why it is being added to banks...what good it is doing?
Thats kind of the whole point. Reserves are not money that banks can lend. For the most part, banks can always lend as long as people want to borrow and banks think the people are credit worthy. Banks don't lend reserves they lend bank deposits which are a different animal.

welfarewarfare state said...

bubble refuge,

You stated that a bank can borrow from the Fed directly irrespective of reserves held (so long as the Fed obliges). Yes, but the bank's reserves are then increased by the Fed when the Fed loans that bank money. The bank's account at the Fed will then show more reserves. It is out of these increased reserves that the bank wil then pyramid more debt. So: of course more reserves tend to increase the credit money supply which is the whole point.

You also wrote that the bank can participate in the Federal Funds Market. Right again, but the reserves borrowed from one bank were already in the banking system. One bank's gain in reserves is another bank's temporary loss in reserves. The net reserves in the banking system do not change when this operation is initiated though.

bubbleRefuge said...

You stated that a bank can borrow from the Fed directly irrespective of reserves held (so long as the Fed obliges). Yes, but the bank's reserves are then increased by the Fed when the Fed loans that bank money. The bank's account at the Fed will then show more reserves. It is out of these increased reserves that the bank wil then pyramid more debt. So: of course more reserves tend to increase the credit money supply which is the whole point I said a bank makes a loan irrespective of the amount of reserves it has. In the accounting period after the loan was made, the bank may borrow reserves in order to meet reserve deficiencies if any. Their is no reserve requirement for making loans. Reserve requirements are relative to deposits. Loans create new deposits. Reserves are used for liability settlement in the banking system.
Bank loans are not constrained by reserve levels because a bank can always borrow reserves later if needed. As I said before, aggregate reserve levels are endogenous: the more loans in the system, the more deposits, therefore more reserves are created. So quantity of reserves is irrelevant because reserves in an of themselves are available to banks in infinite amounts if the bank qualifies. QE increases levels of reserves because the fed is targeting long term interest rates by swapping new reserves for treasury securities. So in terms of quantity of money QE operations are a wash. In QE, the FED is increasing the banks reserve balance by swapping reserves for treasury securities in the banking system. It all nets to zero. That is why all the hysteria about QE is totally unfounded.

MT said...

bubble wow...great post here man.

I have a few questions for you on this...it's really all making alot more sense to me know hearing you explain this.

Okay so #1: What does the Fed do when they increase reserve levels NORMALLY for banks as more deposits (loans) are made? Do they just push a button on a computer?

#2. Are the reserves at the Fed backed up AT ALL by anything (even printed money if not gold/silver/etc.)? I ask this b/c essentially if reserves are endogenous then really is there ANYTHING that people would get if there was a run on the banks?

#3. The reserve levels will increase as the Fed buys these longer term T-bills b/c of the interest that they will accumulate on them correct from the US Treasury? (money which also comes from the Fed as well anyway! So it's like the Treasury's money at the Fed is going into the bank's money at the Fed...right? haha!!)

#4. You say that the fed is "swapping new reserves for treasury securities". Is this to mean that as new deposits (loans) are made from here on out...it is THOSE reserve increases that will purchase treasuries?

I hope these questions make sense to you and thanks again man! This is really a GREAT discussion!

bubbleRefuge said...

bubble wow...great post here man. Cool. Its fun. It helps me to run through all the logic.

I have a few questions for you on this...it's really all making alot more sense to me know hearing you explain this.

Okay so #1: What does the Fed do when they increase reserve levels NORMALLY for banks as more deposits (loans) are made? Do they just push a button on a computer?
Ceterus paribus, its automatic as far as I know. Ceterus paribus, member banks automatically go into over-draft when they are out of reserves. It makes sense if you think about it because otherwise the payments system could break down. But also reserves are added to the 'system' by deficit spending by the treasury. Reserves are removed from the system by taxation.

#2. Are the reserves at the Fed backed up AT ALL by anything (even printed money if not gold/silver/etc.)? I ask this b/c essentially if reserves are endogenous then really is there ANYTHING that people would get if there was a run on the banks?
No reserves are special electronic accounts used by banks and the treasury to settle payments.Once upon a time it was based upon gold.

#3. The reserve levels will increase as the Fed buys these longer term T-bills
Yes Ceterus Paribus. But, as above, aggregate reserve levels are endogenous. is based upon b/c of the interest that they will accumulate on them correct from the US Treasury? (money which also comes from the Fed as well anyway! So it's like the Treasury's money at the Fed is going into the bank's money at the Fed...right? haha!!) The Fed returns all of its profit from Treasury securities to the Treasury by law.


#4. You say that the fed is "swapping new reserves for treasury securities". Is this to mean that as new deposits (loans) are made from here on out...it is THOSE reserve increases that will purchase treasuries?
The Fed's QE2 program purchases treasury securities from the private sector in exchange for reserves not to exceed 600B.

bubbleRefuge said...

MT, also see the Univ of Missouri at KC economics blog. They wrote a blog
about it yesterday and there is a discussion in the comments.