On Halloween, the Wall Street Journal reported the frightening news that the government’s money machine, the Federal Reserve, has been losing money. “How is this possible?” you ask in wonder. How can an institution that creates money out of thin air for politicians to spend like drunken sailors on leave be losing money?
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| Federal Reserve Policy Roadmap |
The answer is quite simple: neither the government nor Federal Reserve officials really understand how a central bank is supposed to operate, what it is supposed to do, or are even clear on what a bank is or even what money is. If you have a very powerful tool that you don’t know how to use, you have the potential to cause a great deal of damage and, yes, “lose money.”
There is a little good news. The money isn’t really lost. Even the Federal Reserve knows exactly where it’s going. It’s being paid out to depositors (commercial banks) as interest on deposits. The Federal Reserve could stop the outflow almost immediately by doing the job it was designed and intended to do.
Specifically, according to the Wall Street Journal, the Federal Reserve is engaged in some “obscure monetary plumbing.” Following the 2008 financial crisis, the Federal Reserve began following other central banks in trying to “[control] short-term [interest] rates by paying interest on bank reserves.”
Say what? Do the people coming up with these ideas even know what bank reserves are? Paying interest on reserves doesn’t even make sense in classic banking theory, and it argues that the world’s bankers aren’t too clear on what a bank is or how it operates — or is supposed to operate.
First, of course, reserves are a bank’s equivalent of a business’s till cash or your “walking-around money.” Reserves are held for only one purpose: to meet a bank’s obligations when presented for payment and carry out transactions. Reserves are not an investment, nor does a bank make loans out of reserves.
The amount of reserves is set by law presumably to ensure that a bank will have a reasonable amount of uncommitted cash that it can pay out to customers and depositors on demand. The whole idea of having a Federal Reserve System is so that a bank that needs cash to pay out can get it immediately to prevent the bank from going under if it can’t meet its obligations.
That is why “reserves” are defined as vault cash and a commercial bank’s demand deposits (checking accounts) at the Federal Reserve. If a creditor of the bank presents an obligation of the bank for payment, the bank must meet that obligation by giving the creditor reserve currency (cash), draw on its demand deposit at the Federal Reserve and giving the creditor a check drawn on the Federal Reserve (legally the same as cash), borrow cash from another bank either directly from the other bank or through the Federal Reserve and meet the obligation either in cash or with a check drawn on the Federal Reserve, or borrow money from the Federal Reserve and issue a check drawn on the Federal Reserve to the creditor.
Because reserves are expected to be immediately liquid at all times, they are not an investment. A commercial bank does not “invest” in reserves by depositing cash at the Federal Reserve, it is warehousing it in a convenient place from which it can be drawn on immediately on demand. If anything, the commercial banks should be paying a fee to the Federal Reserve, not the other way around.
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| Nice, but not an economic program. |
Of course, since the commercial banks are legally required to keep reserves, it would be unfair for the Federal Reserve to charge for the service (especially since commercial banks are also required to be members of the Federal Reserve if they want to stay in business), but then it is ludicrous for the Federal Reserve to pay commercial banks interest on reserves. It’s as if someone paid you for the privilege of mowing your lawn, giving you a new car, buying you a house, or anything else. Someone is providing you with a good or service, so you should pay for it, not be paid for it.
None of this would even be an issue if the Federal Reserve understood money, credit, and banking. We briefly described the role of reserves above, but there is a much bigger and fundamental problem here. That is the plain and simple fact that most of today’s bankers have no idea what they’re doing, due to a weird theory called “The Currency Principle.” This is the fixed belief that you need “money” before you can produce, distribute, or consume anything.
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| Adam Smith |
No, what you need before producing, distributing, or consuming anything is the ability to produce, distribute, or consume. This ability does not come from money. No, money comes from this ability. Put another way, since you cannot distribute or consume something that hasn’t been produced, and (as Adam Smith put it) “Consumption is the sole end and purpose of all production,” we can say that production doesn’t come from money, money comes from production. In other words, cutting to the chase, commercial banks don’t lend money out of accumulated reserves (that is the job of banks of deposit, not commercial banks), they create money by accepting something of value and “monetizing” it.
True, this can give the illusion that a commercial bank is making a loan out of reserves, especially if it hands over banknotes to the borrower instead of creating a demand deposit (checking account). What really happens, however, is that a bank accepts a contract called a bill of exchange from a borrower and issues a promissory note that obliges the borrower to repay the amount of the loan plus a service fee. Money has been created the moment that the borrower signs the promissory note; the promissory note is “money” . . . but is not in a form that the borrower can use very easily.
That being the case, the bank very nicely either creates a new demand deposit for the borrower, making it possible for the borrower to write checks that others will accept as “money,” or hands over a sheaf of banknotes that the borrower can spend. The bank creates the new demand deposit by entering it on the bank’s books directly by debiting assets and crediting liabilities (a checking account is the borrower’s asset, but the bank’s liability) — increasing both liabilities and assets by the same amount — or by debiting loans (an asset) and crediting cash) also an asset), increasing one asset and decreasing another by the same amount.
The result is the same. This is because eventually the people to whom the borrower wrote checks will present the checks for payment, whereupon the bank credits cash and debits the borrower’s checking account. Obviously, all cash paid out by the bank comes out of its reserves, but it should be clear that the loans themselves are not made out of reserves, but by the promissory note signed by the borrower. Reserve cash is only a convenient and usable substitute for the promissory note.
Of course, that’s just on the level of a single transaction. When multiplied by the thousands, and adding in the fact that other banks and borrowers are doing the same thing, the need for cash reserves goes down dramatically. For example, if another bank presents $1,000,001.00 of the bank’s obligations for payment, but the bank at the same time presents the other bank with $1,000,000.00 of that other bank’s obligations for payment, how much does the bank take out of its reserves to meet its obligations to the other bank? $1.00. The offsetting balance takes care of the rest.
There were, of course, other problems noted in the Wall Street Journal article . . . although they didn’t recognize them as problems. These include the tpes of securities the Federal Reserve has been meddling with and the way it has confused open market operations and discounting, but that’s something to discuss another time. Right now we need to stop the foolishness of treating bank reserves as if they were investments.
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