Moved From Comments: reserves/deposits and money creation
Hey great posts, great to find your blog and tweetstream. Here’s a Q I’ve been struggling with:
Commercial banks are chartered with a special privilege: they’re allowed to create (print) new M assets* for lending. (In return for that privilege, they accept tight monitoring and regulation.) It’s like legal counterfeiting! Of course they can’t print money for spending on goods and services. Just for (new) lending.
But my question: are they allowed to print money to buy existing bonds? I don’t think so. (New bond issuances? Ditto, I think.) This is why “(new) lending creates deposits” was pretty exactly true until 2008; it was the only thing that created deposits, M assets held by non-banks.
Now QE: it seems to have created a new (incentive?) mechanism whereby banks can print new money/deposits to buy existing bonds (then swap them with the Fed, for reserves). That solved a problem: the Fed can’t buy bonds from non-banks; they can only pay in reserves, which only exist in Fed accounts. Non-banks don’t have Fed accounts. So if the Fed wants to buy bonds from non-banks, the banks have to intermediate that: buy, then sell to the Fed.
Takeaway: this pretty byzantine mechanism (see Choulet’s explanation, involving eg foreign subsidiaries of domestic banks and vice versa) means that the Fed can, effectively, create bank deposits/M assets. Bank lending is no longer the only thing that creates those special fixed-price assets held by non-banks.
Thanks for listening, love to hear any thoughts. Thanks.
* a.k.a “bank deposits” or more broadly checking/saving/MM holdings. The defining characteristic of these special M assets/instruments: their price is institutionally hard-pegged to the unit of account, by multiple institutions. So synonym would be “fixed-price instruments/assets.)
Reserves are also (the ultimate) fixed-price assets, of course. But since non-banks can’t hold them, they’re utterly different in their mechanisms and effects from M assets held by non-banks. MB has very complicated relationships with M2. The two measures only overlap in that both include a fairly trivial amount of physical cash. Gesturing vaguely to “the money supply” without specifying which is just…incoherent. (Though that blithe usage does nicely perpetuate the childishly simplistic S/D beliefs about “demand for ‘money’.”)
Commercial banks print deposits when they make loans or purchase assets. Buying a Treasury security is the same as making a loan to the Treasury. Or equivalently, making a loan to Person A is the same as Person A issuing debt and asking the bank to buy it.
You are right that non-banks don't have reserve accounts, but the reserve assets of a bank are usually balanced by deposit liabilities. So when the Fed expands its balance sheet and creates reserves, it mechanically also expands commercial bank deposit liabilities. See here for more details.
Thanks for this blog feature, Joseph, this is great!
I believe that even when banks pay for non-bank assets, they also create new deposits to pay for them. This was mentioned in the BoE money creation article.