Friday, March 22, 2013

List of Ways Reserves Leave the Banking System

First of all, we need to define what is meant by reserves in the banking system. In the US this commonly includes reserves in the private banks' central bank (Federal Reserve Bank or just "Fed") reserve accounts (these are the only accounts on which the Fed pays "interest on reserves" (IOR)). It also includes "vault cash" which is physical currency/cash (paper bills and coins) stored at the private banks. It does not include the Federal government's Fed reserve account (the Treasury General Account (TGA)). It also does not include anything the Fed itself holds as an asset: reserves are never a Fed asset; they are always a Fed liability. All Fed reserve accounts are electronic. The Fed is an independent hybrid public/private institution, and thus not strictly part of the government. Of course the Treasury Department (or just "Treasury") is part of the federal government. We also need to consider other government agency Fed accounts (government sponsored enterprises, or GSEs).

Here, then, is the list of ways in which reserves leave the private banking system:
  1. When entities pay taxes/tariffs/fees/fines (and those payments are transferred to the TGA or GSE Fed accounts)
  2. When Treasury or GSEs auction bonds (and the proceeds are transferred to the TGA or GSE Fed accounts)
  3. When private non-banks withdraw paper bills and coins (physical cash or currency) from their private bank deposits
  4. When private banks repay reserve loans or advances (principal and interest) made to them by the Fed
  5. When foreign central banks or institutions (e.g. the IMF) receive funds in their Fed reserve accounts
  6. When the Fed/Treasury/GSEs sell assets (typically Treas. bonds, but also could include foreign currency, TARP assets, etc.) to private entities, for example during Fed Open Market Sales (OMSs)
First of all notice that "loaning out reserves to private non-banks" is not on the list. That's an incorrect way to think of reserves. Only chartered banks, Treasury, and certain GSEs, foreign central banks, and institutions (IMF, World Bank, etc.) can hold Fed reserve deposit accounts. Individuals, non-bank businesses, and most organizations cannot hold Fed reserve accounts. Reserves can be loaned by individual banks to other banks, and they can be transferred between banks to back/clear purchases or payments between private entities including when the purchasing entities are the banks themselves (e.g. to pay bank employee salaries, or to buy office supplies for the bank), but these events do not cause reserves to leave the banking system as a whole.

I've not made a distinction between excess reserves (ER) and required reserves (RR) in the above, although you can take the list to apply to ERs since RRs are of course required (by regulation), and thus are only absent (below their required levels) for brief periods of time. There are other ways in which, in aggregate (i.e. taking all banks as a whole), excess reserves can be converted to required reserves (and thus in that sense "leave the banking system"), but those are not covered by the above list since it makes no distinction between reserve types. Of course there are other ways reserves can leave, come into, or be converted from excess to required status by individual banks (as opposed to the banks in aggregate).

Of the six entries on the list, the first two and the interest component of the fourth* are typically reversed when the Federal government spends money. The third is reversed when currency is re-deposited in private banks by private entities. The principal component of the fourth is reversed by the Fed loaning out reserves (note that reserve loans are typically made on the inter-bank market, but the Fed stands ready as a lender of last resort, thus the bulk of Fed reserve loans are typically repaid in short order when replacement reserves are obtained from other entities). The fifth is reversed when funds exit these foreign central banks and institutions (note that foreign owned private banks are part of the banking system). The sixth is reversed by Fed Open Market Purchases (OMPs). Together OMSs and OMPs constitute Fed Open Market Operations (OMOs). So in terms of reserves permanently leaving the banking system, this only happens when the Federal government starts accumulating money in the TGA (i.e. running a surplus), when currency is permanently kept, destroyed or lost by the private sector, when Fed reserve loans are repaid, or when OMSs are not eventually reversed by OMPs. Government surpluses have historically been rare and comparatively little currency is kept, destroyed or lost by the private sector. Net "permanent" Fed reserve loans are really only made to the aggregate banking system to support reserve requirements (typically ~10% of bank demand/checking deposit liabilities). This leaves OMSs as the main way in which reserves leave the banking system most of the time. Conversely, OMPs are the main way reserves are injected into the banking system most of the time. OMPs are how "Quantitative Easing" (QE) is accomplished. Federal government deficit spending does NOT inject reserves into the banking system. Instead it injects net financial assets (i.e. Treasury bonds) into private hands, and at the same time takes the proceeds from the bond auctions and spends them back into the private sector. Thus the Federal government obtains and spends private bank created money (inside money) when it deficit spends. Of course what counts as money can be debated. In our system, bank deposits have a very high degree of moneyness.

Only to the extent that the Fed holds Treasury bonds as assets can you say that private bank deposits in the private sector are backed by "loans to the government" (Treasury bonds) rather than "loans to private entities." If the Fed holds $X in Treasury bonds, then $X in privately held bank deposits (assuming the TGA is empty... not a terrible assumption given government deficit spending) is based on loans to the government rather than private bank loans to private entities. Most deposits in the private sector are based on private bank loans to private entities. All dollar denominated money, however, is based on one of these two kinds of loans. Loans to the government held by private entities (i.e. privately held Treasury bonds) do not contribute to privately held bank deposits based on loans to the government. This is because (as is the case for all Treasury bond auctions) the deposits used to purchase the bonds already existed. The difference is these deposits are not replaced with deposits backed by reserves the Fed creates out of thin air, as it does when making OMPs. Note that I'm simplifying a bit here by glossing over the process by which Treasury Tax and Loan (TT&L) accounts are created as an intermediate step before transferring funds to the TGA -- this transfer being necessary before the funds can be spent by the government.

These JKH and Ramanan comments at monetaryrealism.com provides further insight

*Note that almost all the interest paid to the Fed for its reserve loans is remitted by the Fed to Treasury, and thus will almost certainly be spent again into the private sector.

39 comments:

  1. Very interesting and helpful info Tom! I was particularly intersted in your explnation of the difference between deficit spending and increasing reserves in the banking system.

    There's a lot of confusion about what govt deficit spending is-and isn't. If you have anything further to elaborate on this or know sources that do it'd be appreciated.

    I recall how in the 80s everyone thought that Reagan's huge military Keynesian infused deficits-really they were the products of both the military buildup and the huge tax cuts-would lead to "galloping inflation."d

    Of course, nothing of the kind happened. I think that's a related matter that gets confused a lot: what causes and doesn't cause inflation. Whatever you think of huge deficits-my trouble with Reagan's deficits are allocational; they were fueled by the tax cuts and military buildup- they don't cause inflation.

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    1. Mike, that bit on deficit spending is pure Cullen Roche! He likes to put it as "gov deficit spending is just redistributing inside money (from Peter to Paul) and issuing an NFA in the process (to Peter)."

      It only occurred to me later to qualify that a little bit. I make an attempt at that in the 2nd to last paragraph above starting with "Only to the extent that..."

      Actually I thought a little bit more about that today. In that paragraph you'll notice that I qualify my conclusion by assuming the TGA is empty. I'm trying to come up with a more general way to state the idea there. In our system there's only two entities capable of actually creating dollars "ex-nihilo" (out of thin air) (I'm ignoring the fact that Treasury mints physical cash... since the Fed is the institution that trades it to/from the banks). Those entities are the private banks, through creating loans, and the Fed through purchasing (or perhaps lending too... not sure about this). Thus these dollars created must equal the sum total of dollars "out there" (both in and outside of the banking system). In particular this includes the TGA + private bank deposits + cash + money banks hold. I'm not sure how to handle "money banks hold" since banks are unique in the way they purchase items (see my Example #5). Joe in Accounting (on pragcap) has pointed out that sometimes banks make use of "correspondent banks" to handle their own purchases, but I concluded that those could safely be ignored, since it's not required, and it doesn't change the big picture.

      Anyway, as you can see I haven't fully fleshed this idea out yet, but you'll notice that what's missing here is the government creating dollars ex-nihilo. The government ends up USING dollars either created by the banks or the Fed (mostly the banks), but it doesn't create them. It can, however, create T-bonds which are not dollars (they fall a little further down the scale on Cullen's "moneyness" spectrum).

      Anyway, if you make a few simplifying assumptions (TGA = $0, and ignore banks' "own money"), I think my 2nd to last paragraph is basically correct in the post: That is: only to the extent that the Fed holds treasuries, can you trace dollars in the private sector to gov debt. All the rest is bank created. So if the Fed didn't hold any treasuries, all our $ would be bank created, regardless of how big the gov debt was.

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  2. Tom, nice blog - useful and clear.

    I disagree with some of the points in the above post, however...

    1) "The Fed is an independent hybrid public/private institution, and thus not strictly part of the government"

    The Fed is actually part of the government:

    http://www.usa.gov/Agencies/Federal/Independent.shtml

    Here's what the Fed says about itself:

    "The Federal Reserve System is the central bank of the United
    States. It was founded by Congress in 1913 to provide the
    nation with a safer, more flexible, and more stable monetary
    and financial system."

    “The Federal Reserve System is considered to be an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive branch of government. The System is, however, subject to oversight by the U.S. Congress. The Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government; therefore, the description of the System as “independent within the government” is more accurate”.

    “Congress designed the structure of the Federal Reserve System to give it a broad perspective on the economy and on economic activity in all parts of the nation. It is a federal system, composed of a central, governmental agency—the Board of Governors—in Washington, D.C., and twelve regional Federal Reserve Banks”.

    “The Board of Governors of the Federal Reserve System is a federal government agency. The Board is composed of seven members, who are appointed by the President of the United States and confirmed by the U.S. Senate”.

    “Congress chartered the Federal Reserve Banks for a public purpose. The Reserve Banks are the operating arms of the central banking system, and they combine both public and private elements in their makeup and organization. As part of the Federal Reserve System, the Banks are subject to oversight by Congress”.

    http://www.federalreserve.gov/pf/pdf/pf_complete.pdf

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    1. Thanks phil. I won't argue w/ your quotes above. I think what I'm getting at is that there is a designed in separation between the Fed and the (rest of) government. As it stands now the Fed cannot directly purchase bonds from Treasury, nor can it forgive the principal for the T-bonds it does acquire (it does remit the interest payments). The econviz website has an example of a hypothetical means of government self financing where the Fed is allowed to purchase Treasury bonds directly. That's on their "macro" page under "Government Spends (Without Borrowing)" operation. They stress that's only a hypothetical operation and doesn't correspond to anything that actually happens.

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    2. Phil, there's also this (very short write up):

      http://www.federalreserve.gov/faqs/about_14986.htm

      So the member banks own stock in the Fed, and they must as a requirement of membership. It is unusual stock though. I accept this "independent within government" description. So you can strike my "hybrid" comment if you wish, but I think it helps get the independence of the institution across. I think that's certainly the way the Fed has behaved over the past few decades: it's hard to argue that it isn't there to serve the interests of the private banks given this behavior.

      Also keep in mind that I consider the whole point of this post to be a little bit arbitrary: what's in and outside the banking system has more to do with arbitrary definitions than anything else. The really important points I'm trying to get across to people is that reserves don't flow into the general public. For that to happen the general public would have to be allowed to have reserve accounts. The other point is in my final paragraphs concerning the origin of "money out there in the economy." The VAST majority of that money can be said to have originated from private debt. Say there's about $65 T of dollars in existence in the economy, and the TGA is always running on empty (and again I'm ignoring TT&L) due to deficit spending. Then public debt doesn't matter. What matters is the $ of public debt owned by the Fed. They own about 10% (of the total public debt), or about $1.6T or so. Thus only about 2.5% of "money out there in the economy" can be said to have originated from PUBLIC debt! The other 97.5% is money that originated from private debt! So when a private individual buys a T-bond (say through Treasury direct), then the money that gets recycled back into the economy through the process of deficit spending was, on average, 97.5% privately created.

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    3. "it's hard to argue that it isn't there to serve the interests of the private banks given this behavior".

      That doesn't contradict it being a part of the government. Government policy is currently to let the Fed try and "macro-manage" the economy by playing around with interest rates and quantitative easing, and to keep the banking sector afloat at all costs.

      "reserves don't flow into the general public"

      My understanding is that reserves are basically federal reserve notes in electronic form. Banks withdraw their deposits from the Fed as cash (notes), and the public withdraws cash (notes) from their banks... so the public gets its hands on "reserves" in the form of cash.

      another comment follows...

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    4. You write: "Banks withdraw their deposits from the Fed as cash (notes), and the public withdraws cash (notes) from their banks... so the public gets its hands on "reserves" in the form of cash."

      My understanding is that vault cash held at banks are considered reserves. Once the public withdraw portions of their deposits as cash, this cash ceases to be reserves. So yes, that's true. In that sense reserves do flow into the public through that channel. That's #3 on my list. So perhaps that statement is too broad. But people aren't withdrawing any more cash than is convenient to do. My argument is that this escape route for reserves is minor and does not represent a major pathway. That pathway is reversed when cash is re-deposited back at the bank, and thus re-acquires its reserve status.

      The point is that all those excess reserves (in electronic form) due to QE do not flow out to the public. For that too happen the public would have to have reserve accounts. In other words, other than the amount withdrawn as cash, banks don't "lend out" those excess reserves to the public. That's a common misconception people have and is what really inspired this post.

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    5. "Thus only about 2.5% of "money out there in the economy" can be said to have originated from PUBLIC debt!"

      The non-bank public can buy government bonds if it wants to, but logically the means to purchase those bonds must be provided by either Fed lending or purchases, or by previous Treasury spending. In fact, the only way the non-govt can own reserves, with which it can purchase bonds, is if the government has previously spent in deficit. Otherwise the non-govt simply has to borrow from the Fed.

      So essentially what happens is that banks either borrow from the Fed or use the proceeds from previous government spending to buy govt bonds.

      Government spending then results in a credit to bank reserve accounts and to non-bank deposit accounts.

      The non-bank agents receiving this spending then usually spend their deposits. At some point some other non-bank agent then decides to save, perhaps by buying a government bond (from a bank).

      So, government spending initially results in credits to bank reserve accounts and to non-bank deposit accounts. Those that receive this money then decide what to do with it. Either they spend it, or decide to save it (perhaps by buying a govt bond).

      At any point in time, however, those bank deposits in existence which can be said to be 'backed by government spending' will generally be equal, I think, to the quantity of bonds or reserves held by banks.

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    6. "My understanding is that vault cash held at banks are considered reserves. Once the public withdraw portions of their deposits as cash, this cash ceases to be reserves".

      You're right, cash in bank vaults counts as bank reserves.

      If banks have more paper/coin cash reserves in their vaults than they need, they can deposit them at their local Fed bank (just as we can deposit cash at our local bank). And they can also withdraw their deposits from the Fed in the form of cash (just as we can withdraw our deposits from our banks as cash).

      In general the non-bank paper/coin cash requirement is pretty constant, so excess bank reserves at the Fed don't stimulate the public to take out more money from the ATM.

      However, if the Fed were to impose a negative interest rate on excess bank reserve balances (as some have suggested they should), then banks would probably just withdraw more of their Fed deposits as cash and just keep it in their vaults (if they were allowed to of course).

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    7. "At any point in time, however, those bank deposits in existence which can be said to be 'backed by government spending' will generally be equal, I think, to the quantity of bonds or reserves held by banks".

      Actually, thinking about it, this is incorrect. At the same time I'm pretty certain that "only to the extent that the Fed holds Treasury bonds as assets can you say that private bank deposits in the private sector are backed by "loans to the government" is also incorrect. It would be useful to get some actually statistics on this, as it seems like 'murky water' to me.

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    8. phil, I had a response written but then erased it because I can't recall exactly where I saw that $65T in $ in the private sector figure. It occurred to me to check the following chart (linked to at the bottom of Example 4):

      http://www.zerohedge.com/news/2012-12-26/record-2-trillion-deposits-over-loans-feds-indirect-market-propping-pathway-exposed

      The 1st chart on that page (for some reason the page doesn't come up for me right now). The ~$9T in deposits they show there jives with this chart:

      http://upload.wikimedia.org/wikipedia/en/5/58/MB%2C_M1_and_M2_aggregates_from_1981_to_2012.png

      So was the $65T a measure of M3 or M4... I'm not sure!

      The point is I'm suddenly a little uncertain about my 2.5% figure, but regardless of the actual percentages, this is my reasoning, based on the idea that all dollar denominated money comes from debt:

      Banks have a charter to issue dollar denominated deposits which act as money for most of us. Of course there's cash too, but more and more deposits are being used directly. The debt which created that money is clearly the bank loan. Every time you swipe your credit card this kind of money/debt pair is created. Buying a house or car with borrowed funds is the same.

      Now the only other entity which can create money out of thin air like that is the Fed. The Treasury can create bonds out of thin air (as do businesses), and they are certainly low risk, but the bonds are not the same as money. The Fed creates perfectly liquid money through a debt mechanism very similar to how private banks do:

      The Fed either creates it by loaning it as reserves, or purchasing assets with it (typically Treasuries). In either case there's a debt instrument they can put under their assets column when they do that, perfectly offsetting the freshly created reserves.

      The government does not have a mechanism for doing precisely this (ignoring coins). Only the banks and the Fed can create money this way. Ignoring physical cash for the moment, the difference is that the Fed creates money to be used by only the banks and the Treasury (reserves), and the banks create money for the rest of us (deposits).

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    9. For simplicity lets create a world with no required reserves, a single commercial bank, and no taxes or government spending, and no physical cash. The entire private sector can run just fine without any reserves at all. There's really no purpose for them: The bank just credits and debits its customers' deposits to realize all payments between customers. Of course all the deposits were originally loaned into existence to another set of customers. Now fold in a second bank, and suddenly SOME payments require the Fed to TEMPORARILY loan reserves, but its balance sheet can be clear again by the end of each day (See my examples #1 and #1.1). The money supply expands and contracts according the the $ amount of outstanding loans the private banks have. Now let's add to this world government taxing and spending. Still no problem. Again the Fed must jump in to facilitate the process, but assuming the gov spends every dollar it taxes, then the consolidated balance sheets look exactly the same before taxing as they do after spending. Now lets add in gov deficit spending. Again the sector consolidated balance sheets (think econviz) look exactly the same before and after the process except that private non-banks now have T-bond assets from the gov... but the amount of dollar denominated MONEY still matches precisely the principal amount of the outstanding private bank loans (assuming the banking sector essentially operates for free and doesn't collect retained earnings). All through these steps the Fed acts as a facilitator and its balance sheet is clear before and after each operation. Only during intermediate steps is its BS populated. That changes when the Fed buys T-bonds from the public. Now the deposits held by the public grows, but this growth is exactly offset by T-bonds sold to the Fed. Suddenly the dollar denominated deposits used by the public can be said to be a mix of Fed created money and bank created money: The amount that's Fed created is exactly equal to the value of the bonds it holds. The amount that's bank created is the same as it was before the Fed bought T-bonds. The amount created by the Fed can be said to have originated in government debt... but only that debt held by the Fed. The rest of the deposits in the private system were created by private debt (loans) held by the banks. It's a given, of course, that the total amount of T-bonds out there must exceed the amount held by the Fed, but other than that the total $ amount of T-bonds has no influence on the amount of actual $ denominated money in the system. Again every time I'm stopping the system to examine it here are times at which the TGA = 0 again (as it originally did all the time before we added gov spending). I think that's the clearest time to sample.

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    10. Tom,

      "Banks have a charter to issue dollar denominated deposits which act as money for most of us. Of course there's cash too, but more and more deposits are being used directly."

      Even if the whole world stopped using cash, this wouldn't change the "hierarchical" nature of the monetary system. The quantity of cash in circulation is not really relevant.

      "The Treasury can create bonds out of thin air (as do businesses), and they are certainly low risk, but the bonds are not the same as money".

      Currency is a debt of the government, and bonds are a debt of the government which pays interest. Federal Reserve notes and Treasury bonds are both US government securities. There is no involuntary default risk on US government bonds. They are widely referred to as "cash- equivalents", "money-good", or even just "cash". They are among the most liquid assets in the world. Saying they are not money is rather pointless. The reality is that Treasuries are for all intents and purposes savings accounts at the Fed.

      Also, if you agree with the idea that there is a sliding scale of "moneyness", then Treasuries must be a form of money.

      "The government does not have a mechanism for doing precisely this (ignoring coins). Only the banks and the Fed can create money this way"

      The Fed is part of the government. Its power to issue currency comes from Congress. The currency it issues is a liabiltiy of the government.

      The government has the power to create money at will if it wants to, but it limits what the Treasury can do in this regard. The Treasury creates notes and coins, but only issues coins. The Treasury does have a mechanism for creating money - coins. There is no reason to ignore this.

      Government spending is logically money creation. The money the government spends ('outside money) is a liability of the government. This means the government issues/creates liabilities (money) when it spends, and extinguishes liabilties (money) when it taxes.

      "Ignoring physical cash for the moment"

      Why do you ignore whatever doesn't fit with your argument? Physical cash exists, there is no need to ignore it.

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    11. I agree that Treas bonds have a high degree of moneyness, but still are not precisely money. We could do an experiment purchasing items from brick and mortar and internet businesses... with credit cards, personal checks, cash, and Treasury bonds. Which do you think would be accepted as money the least?

      OK, fine I was using "government" as shorthand for non-Fed government. The currency and reserves the Fed issues show up on the Fed's balance sheet as liabilities don't they? Not the non-Fed government's balance sheet.

      Ignoring coins: fine, don't ignore the coins. I still think they are relatively insignificant in the grand scheme of things.

      "Government spending is logically..."

      I think it's more clear to separate the Fed, which keeps its own balance sheet, from the rest of government (the non-Fed gov... and assume "Treasury" keeps it BS). Treasury thus spends from its assets (reserves) not by creating liabilities. It cannot spend if it has no reserve assets. The Fed, however, can buy assets by creating reserves as liabilities from thin air. When the Fed sells assets, the reserve liabilities it created out of thin air are extinguished. When the non-Fed gov taxes, private bank deposits are debited by the same amount that Treasury reserve assets and increased. The private bank is on the hook for coming up w/ the reserves to transfer to Treasury. If it doesn't have the reserves it can borrow from other banks or the Fed to do this. If it borrows from the Fed, the Fed actually CREATES reserve liabilities (on its BS) to do this, while taking the loan to the bank (for the reserves) as an asset on its BS. In either case, no reserves are "extinguished" when the non-Fed gov taxes. If the bank has the reserves or borrows them from another bank, those reserves are TRANSFERRED to Treasury! If the bank borrows from the Fed, the Fed CREATES them and then transfers them to Treasury.

      "physical cash": OK, fine, don't ignore it.

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    12. phil, take a look here:

      http://econviz.org/macroeconomic-balance-sheet-visualizer/

      and run the operations "Government Taxes" and "Government Spends"

      With the former you'll see the following (and ONLY the following):

      Household deposit-assets decrease by $30
      Banks reserve-assets decrease by $30
      Treasury's reserve-assets increase by $30

      No reserve-liabilities are "extinguished" in this process. In this case the "banks" had enough reserves to back the tax payment, so no borrowing from the Fed was required, and the "Central Bank" balance sheet remains unchanged.

      The exact mirror image of this operation is the latter ("Government Spends"). Run it and you'll see the following:

      Household deposit-assets increase by $30
      Banks reserve-assets increase by $30
      Treasury's reserve-assets decrease by $30

      No government government liabilities are "created." In particular, the central bank's balance sheet is again completely unchanged. Treasury reserve-assets decrease.

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    13. I shouldn't have said "and ONLY the following," because, of course, the banks' deposit-liabilities change the same amount and direction as the banks' reserve-assets, and the households' equity changes the same amount and direction as the households' deposit-assets. That goes for both the "Tax" and "Spend" operations.

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    14. "We could do an experiment purchasing items from brick and mortar and internet businesses..."

      Can you use a $100 note to buy a chocolate bar? In most cases, no. The Fed used to issue $10,000 notes - could you use these in a shop? No. That doesn't mean they're not money. Bonds aren't used as money in small denomination transactions, but they are equivalent to money within certain markets, and can be converted into bank deposits or 'cash' at a moment's notice. Treasury bills in particular have such a high degree of liquidity that the distinction between them and 'cash' in this regard is largely irrelevant, hence they are usually referred to as cash-equivalents. To large financial institutions and foreign governments T-bills are basically just 'cash'.

      http://www.investopedia.com/terms/c/cashequivalents.asp

      According to JKH, short-term US Treasuries are actually more liquid than reserves:

      "short term debt and reserves at the Fed are not perfect substitutes. Short term debt is more liquid. Banks can’t “sell” reserves to non-banks. The market for bills is much broader than the market for bank reserves."

      http://www.interfluidity.com/v2/3694.html

      If we define "moneyness" as liquidity, this would mean that T-bills actually have a higher degree of "moneyness" than reserves.

      Whether you call Treasuries money or not, of course depends on how you define ‘money’. If you take a very narrow and conventional view, then they are not. If you take a slightly broader view, then they are.

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    15. phil, thanks for the links/quotes. I did, however, already agreed with you that there's a "moneyness" scale and that Treasuries do rank high on that scale. I agree with most of what you say here. For a bank, sure I can see that short term debt is "more liquid." Of course they can't directly clear payments with them or transfer them to the TGA, but you're correct that they can easily sell them for reserves before doing that. In regards to JKH's quote "Bank's can't *sell* reserves to non-banks" ... that's true, but banks can transfer reserves to the banks that non-banks bank at to pay for things that non-banks are selling! (See my example #5) ... which of course increases the non-bank's deposits at their (reserve receiving) banks too.

      I still think that at MOST businesses that we private non-bank individuals, businesses and organizations purchase items from, you'll find that Treasury bonds would be the least accepted as money (from my list). I would guess in fact that either checks or credit cards would be the MOST widely accepted as money. You already outlined why physical cash isn't always accepted by businesses in large denomination bills. I don't even think the IRS or the states accept physical cash for tax payments, do they?
      And yes I know not all businesses accept personal checks or credit cards. I forgot to mention bank cards (debit cards). You can use those at an ARCO station or COSTCO but not a VISA or Mastercard card!

      Personally I use bank cards, credit cards, and cash mostly... and rarely a personal check. None of them are PERFECT money, but they all have higher "moneyness" than T-bonds. If you want to argue that T-bonds have a higher moneyness than reserves... fine. I still think there's an argument against that, however bank deposits and physical cash are really king, aren't they? When was the last time you made a purchase with a T-bond? Ever had a direct deposit from your employer made in T-bonds? I don't think if I asked a 100 friends, family and acquaintances if they'd ever purchased anything or accepted payment from anything in T-bonds that any of them would say "Yes." So lets start with you: Have you ever paid or been paid in T-bonds? Perhaps I'll start with my morning coffee purchase today... I'll ask if I can pay with T-bonds. What kind of a response do you think I'll get? When I make purchases for my work, I sure don't use T-bonds either. Everything I and everybody I know use on a daily basis is either physical cash (obtained mostly from bank deposits: i.e. ATM machines), or a bank deposit related mechanism: credit card, debit card, or personal check. Occasionally I use a money order or get one for payment.

      You helped me make my point about reserves actually, because the majority of entities don't use them as money (physical cash outside the bank, remember is NOT reserves), nor do they accept T-bonds as money. However, regarding *accepting* reserves as money, the public probably does w/o knowing it: every time a bank pays for something or when you get a tax refund check from the gov, or when the gov or bank pays it's employees. To the public those payments look like payments into their bank deposits.

      I think Cullen's "moneyness" scale has a reasonable ordering, although I know some items are debatable. I'd like to see it presented more in a table format... with each kind of money on a different row and green check boxes in columns representing where that money is recognized as such.

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    16. Economist JP Koning (from whom Cullen got the idea of "moneyness"), argues that Treasury bonds are money. Both he and economist Stephen Williamson agree with JKH that T-bills are more liquid than reserve balances (I assume this is a broadly held understanding), which by JP Koning's definition means that they have more "moneyness" than reserves.
      It's important to note however that people define "moneyness" in slightly different ways. JP Koning defines it simply as liquidity:
      http://jpkoning.blogspot.co.uk/2013/03/ranking-moneyness.html
      whilst economist Perry Mehling describes it as the 'quality' of a given type of credit within a gradated hierarchical structure, in which "What looks like money at one level of the system looks like credit from the standpoint of the level above":
      ieor.columbia.edu/pdf-files/Mehrling_P_FESeminar_Sp12-02.pdf
      (Mehrling's paper is really worth a read by the way. He also discusses inside and outside money).
      "The currency and reserves the Fed issues show up on the Fed's balance sheet as liabilities don't they? Not the non-Fed government's balance sheet".
      Fed liabilities are counted as assets on the Treasury's balance sheet, but they are also liabilities (referred to as obligations) of the US government, so this is slightly misleading. When the Treasury has a positive balance in its account at the Fed, the US government is holding its own liability, but this is shown as an asset on the Treasury's BS and a liability on the Fed's BS. Basically the two are different sides of a consolidated government balance sheet, in which the asset and liability net to zero. The balance in the Treasury's account can be thought of as showing how many government liabilities have been returned to the government, i.e. extinguished, (through taxes, etc). (I say extinguished because when you return a liability to the issuer the liability is extinguished).

      Now this seems a bit too conceptual for some people, but it’s perfectly logical, and factual. Fiat money is fundamentally some sort of liability, obligation, or other such “promise” of the government or State. Different countries account for this in slightly different ways, but this basic fact is always the same. In the US this fact is made clear within the legal definition of terms, but is obscured slightly by institutional arrangements. For example, in the US the Treasury is required by the government to have a positive balance in its account before it spends, and to account for this balance as an “asset”. This doesn’t change the fact that the balance represents a government obligation by definition.

      As far as I’m concerned the statements “the Treasury needs to get money before it can spend” and “the government creates money when it spends” are completely compatible. They are different ways of describing the same thing.

      By the way Brad Delong (economist and former assistant deputy secretary of the Treasury) agrees with the description that government spending "creates money" and taxes "destroying" money: http://delong.typepad.com/sdj/2013/03/bill-black-is-justifiably-irate-monday-hoisted-from-comments-weblogging.html


      “fine, don't ignore the coins. I still think they are relatively insignificant in the grand scheme of things”

      You’re right that the role of coins in the economy today is minor. Originally, however, coin was considered the “ultimate” form of money, with everything else just a form of credit. As it says in the Constitution: “The Congress shall have Power To… coin Money, regulate the Value thereof”.

      Congress could issue coins of any denomination if it wanted to, and the Treasury is currently legally permitted to mint platinum coins of any face value. As such, though coins are generally only used as small change, they remain a form of money which shouldn’t be ignored.

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    17. Sorry I posted the above comment before I'd seen your comment!

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    18. "I still think that at MOST businesses that we private non-bank individuals, businesses and organizations purchase items from, you'll find that Treasury bonds would be the least accepted as money (from my list). I would guess in fact that either checks or credit cards would be the MOST widely accepted as money"

      You're using a particular definition of money or moneyness. As I said people don't use T-bonds in small transactions, but to large financial institutions and to wholesale money markets T-bills are basically "money". To everyone else they are "cash equivalents" which can be converted at the drop of a hat into cash/deposits, as they are extremely liquid.

      Usually, checks and credit cards are not considered to be "money", though checks do occasionally circulate as currency substitutes. You don't give someone a credit card in payment, rather the credit card instructs your bank to pay on your behalf (as does a check). But again this is a matter of definitions in which you have both narrow conventional views and broader views.

      Money is a complex phenomenon and there is a lot of disagreement over the terminology surrounding it. What you call "money" or how you define "moneyness" depends on your theoretical framework and what you are trying to explain, so different views can potentially be compatible if they are taken in context.

      Similarly, any "rankings" of money or "moneyness" will depend on your definitions. Cullen's scale is based on his own particular view, which is not necessarily shared by economists who have written on the subject. For example JP Koning doesn't provide a definitive "ranking" of moneyness; as he says: "Moneyness, after all, is subjective... While market prices are surely the best way to build moneyness rankings, the problem is that markets rarely provide the prices to facilitate the analysis... There is no independent moneyness market in which an asset's liquidity services can be sliced away from all the other services, thereby allowing those liquidity services to be bought, sold, and priced".

      http://jpkoning.blogspot.co.uk/2013/03/ranking-moneyness.html

      And as I said other economists define moneyness differently.

      During the gold standard era, most of the currency in circulation was banknotes, and banks also created credit money on their books as they do today. So did banknotes or accounting entries have more "moneyness" than gold coins or gold bullion? Cullen would say that they did. Again, it depends on how you define moneyness.

      During the gold bullion standard gold didn't circulate at all within the economy, but the currency was still pegged to gold and gold was used in international transactions between national central banks. According to your definition, gold in this case had almost zero moneyness! Yet it was at the very center, and the foundation of, the entire monetary system.

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    19. phil, OK lets take your position and consolidate the Fed and Treasury balance sheets. This changes nothing about the econviz operations I referred you to. All you need to do is change the name from "Treasury" to "Consolidated Fed/Treasury" and everything else is the same. It's still the case that "Government Spends" results in "Consolidated" assets going down with no new liabilities created. And "Government Taxes" results in "Consolidated" assets increasing with no liabilities extinguished. This is exactly what happens in the "Federal Government Sector (aggregate)" balance sheet above both the Fed and Treasury on econviz. I agree w/ econviz here.

      I expect that your response will be that to truly consolidate/aggregate the balance sheets you must do some cancellations: reserves on the assets side must be cancelled with reserves on the liabilities side. Yes if you do that, what you say is correct.

      It comes down to what we view as what's "obscuring" what's going on. I'll grant you that viewing the Fed/non-Fed as a unified consolidated whole and aggregating the balance sheets in the way I'm supposing you would want results in your view. However, I think viewing it in that way obscures the very different nature of the Fed and non-Fed sides of things and their designed in separation,... and it obscures the reason why the Fed wasn't just created as a desk in the Treasury Dept. I think its more useful to view them as separate entities and you don't. That's where we disagree.

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    20. "Usually, checks and credit cards are not considered to be "money", though checks do occasionally circulate as currency substitutes. You don't give someone a credit card in payment, rather the credit card instructs your bank to pay on your behalf (as does a check). But again this is a matter of definitions in which you have both narrow conventional views and broader views."

      Of course! You don't think I meant that people circulate the physical checks or physical credit cards as a form of money do you?

      And I agree about the subjective nature. I think Cullen's moneyness scale is reasonable and you probably disagree.

      Gold bullion days: Yes, I suppose you are correct. It would be viewed as lower on my moneyness scale. It would be higher back when it actually circulated amongst the bulk of the population.

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    21. "I'll grant you that viewing the Fed/non-Fed as a unified consolidated whole and aggregating the balance sheets in the way I'm supposing you would want results in your view."

      You can consolidate the Fed and Treasury into one general government balance sheet, but you don't have to do that for the statement "government spending creates money" to make sense. If "outside money", or fiat money is a government obligation/liability (which is what it is - or at least the "outside money" which the government receives and spends is), then when the Treasury receives money (through taxes, etc), government obligations are simply returned to the government. This means that those government obligations are extinguished.

      Look at it this way:

      1. Write "IOU $10" on a piece of paper, then give that piece of paper to someone.

      2. Take your IOU back from that person.

      Your IOU has now been extinguished. The piece of paper still exists, but the IOU has been cancelled. The "money" is the IOU promise, not the piece of paper on which that promise is written.

      You're right that the Fed and Treasury are seperate entities, and that the Treasury has to have a positive balance in its account before it is allowed to spend. This is a government-imposed constraint on Treasury operations which doesn't change the above logic.

      A way of describing this is to say that the government has imposed upon itself the requirement that it only create as much money through Treasury spending as it has destroyed through taxes and bond sales.

      Alternatively you could say that the Treasury gets money and then spends it, given that the Treasury is a government department and not "the government".

      Both are different ways of describing the same process. To the Treasury the credits in its account are money which it gets and spends. To the government they are obligations which are destroyed and created. But they are only 'money' in the first place because they are government obligations.

      An important question is whether this constraint on Treasury operations places a limit on the government's ability to spend. The answer is that it doesn't (you seem to agree with this given that you're into MR). If for some reason it did, then it wouldn't exist for long if the government needed or wanted to spend. It's self-imposed.

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    22. Of course if you define Treasury bonds as a form of 'money' - which follows if you see money as a "scale of moneyness", even if you argue that bonds have less "moneyness" than deposits/cash/reserves - then the Treasury does also create 'money' when it issues bonds.

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    23. Tom,

      perhaps we should agree to disagree on the above and move on to the other points, if you're still interested in discussing them?

      Regarding your comment re the econviz "government taxes and government spends" demo:

      If the banks have reserves with which to pay taxes, then where did they come from?

      For the banks to own reserves which aren't simply borrowed from the Fed, either the govt has to have previously deficit spent, or the Fed must have purchased assets from the private sector.

      In either case, the government, either through Fed lending or purchases, or through previous deficit spending, has to provide the funds which are then used to pay taxes or to buy Treasury bonds.

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    24. phil,

      "perhaps we should agree to disagree on the above and move on to the other points, if you're still interested in discussing them?"

      Yes, lets do that.

      "For the banks to own reserves which aren't simply borrowed from the Fed, either the govt has to have previously deficit spent, or the Fed must have purchased assets from the private sector."

      "...borrowed from the Fed.": Check. I agree.
      "...Fed must have purchased...": Check. I agree.
      "...deficit spent...": I don't agree w/ that one.

      Again I'm defining deficit spending (as econviz does in it's "Government Spends (Consoliated)"), from the bond auction all the way through the proceeds (every $) being spent by Treasury (I'm tired of writing non-Fed gov, so I'm using "Treasury" for that concept from now on). Look at the econviz balance sheets. Reserve levels do not change for anybody. If you define "deficit spending" in another way (with different start and/or stop points), then perhaps it's different. I prefer the econviz definition. The consequences of that definition are plain to see on econviz.

      If the real point of your comment is to say "reserves must have come from the Fed" I completely agree. That's the ONLY place they could possibly come from. And I agree that they are always a Fed liability. Every reserve dollar out there is a Fed liability.

      Again, I think this just gets back to our view of the Fed vs Treasury. You see them as the same thing with one big consolidated balance sheet, and consolidated in such a way that reserves in the asset column must cancel reserves in the liability column, and I'll grant you that there's justification for seeing it that way, and if you do see it that way (most) of what you write here makes perfect sense! I prefer to see them as separate entities which maintain separate balance sheets. Viewed that way you cannot escape the consequences. I don't think we've really "moved on" here... the issue is the same. It all goes back to that one issue.

      Do you agree that my view is consistent w/ the econviz view? If you do, are you saying the econviz view is incorrect? If so, what in particular is wrong with it? How would you change it to correct it? That's the part I'm not getting. I think if you grant me that the Fed and Treasury are separate, then nothing I've written here is inconsistent with that econviz tool and it's easy enough to run it and see the consequences. In particular, my view leads to the conclusion that ONLY the Fed can create reserves. The Treasury and private banks can only USE reserves. The one exception being coins perhaps... yes I know Treas mints them and issues them as opposed to paper money which it mints and gives to the Fed to issue. I figured this peculiarity must have some historical basis as you stated in another comment... So I'll grant you that coins (not paper money) are a chink in the "armor" of my argument, but I still maintain they're an insignificant "chink" ... unless of course we do that $1T coin thing, which nobody seems terribly interested in doing (yet).

      So in summary, the special case of coins is not enough of a factor for me to abandon my view. When we start churning out $1T coins on a regular basis to fund Treasury, I'll be happy to change my view. Or if the Fed is fully stripped of its (semi) independence and it buys its stock back from the private banks, and it becomes just a desk at Treasury I will change my view. I think my view is perfectly consistent w/ the econviz view, and I think there are significant advantages to seeing it that way. So we're back to where we started I think. We just need to agree to disagree on that point and move on (which is the same point as before really!).

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  3. 2) "Federal government deficit spending does NOT inject reserves into the banking system"

    This seems to contradict your earlier statement:

    "Here, then, is the list of ways in which reserves leave the private banking system...

    2. When Treasury auctions bonds (and the proceeds are transferred to the TGA)"

    If reserves leave the banking system when the treasury sells bonds, then logically reserves must enter the banking system when the government deficit spends.

    Pre-QE (when banks did not hold ‘excess’ reserves and instead lent them to each other at a positive rate of interest) government deficit spending would create excess reserves within the banking system, meaning that the Fed would have to sell govt bonds to banks (to drain reserves) if it wanted to maintain its interest rate target.

    3) "Thus the Federal government obtains and spends private bank created money (inside money) when it deficit spends."

    How? Can you do a balance sheet example which shows this?

    Private bank liabilities cannot 'go into' the TGA. The TGA cannot 'obtain' private bank liabilities. But as we know the government spends from the TGA. So, logically, the government cannot "obtain and spend" private bank liabilities in the way that you suggest.

    The government does however obtain bank liabilities when its TT&L accounts are credited. These bank liabilities are loans from the Treasury to the banks at which the TT&L accounts are held. When the Treasury calls in these TT&L deposits, the bank's liability is extinguished and its reserve account is debited. Payment to and from the TGA is made with reserves - i.e. Fed liabilities - not with private bank liabilities.

    Furthermore, the idea that a bank takes someone's deposit and puts it into the TT&L account doesn't really make much sense. Bank deposits are basically debts owed by a bank to its depositors.

    Say Mr.A pays $100 tax. His bank debits his account and credits the TT&L account (before payment is made by the bank to the TGA at a later time or date). The bank now no longer owes Mr.A $100. Instead it now owes the Treasury $100. It makes little sense to describe this process as 'taking Mr.A's deposit and giving it to the government'. The bank's debt to Mr.A (Mr. A’s deposit) has simply been extinguished.

    Discuss?

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  4. phil, you write:

    "If reserves leave the banking system when the treasury sells bonds, then logically reserves must enter the banking system when the government deficit spends."

    Yes, however in this context "deficit spending" is meant to encompass the whole process 1) Treas auctions bonds 2) Gov spends proceeds from TGA. I'm skipping over the TT&L account business, but you can assume that's part of getting the funds into the TGA account. I'm also assuming all the proceeds are spent. My argument here is exactly parallel to the operation entitled "Government Spends (Consolidated)" on this website:

    http://econviz.org/macroeconomic-balance-sheet-visualizer/

    Sorry that wasn't clear, but I thought it was implied by "deficit" which implies the bond sales.

    You write:

    "Pre-QE (when banks did not hold ‘excess’ reserves and instead lent them to each other at a positive rate of interest) government deficit spending would create excess reserves within the banking system, meaning that the Fed would have to sell govt bonds to banks (to drain reserves) if it wanted to maintain its interest rate target."

    Again, if by deficit spending we include the whole process from selling the Treasury bonds to spending all the proceeds of the bond sales, that's not true. I agree that in isolation government spending (of any sort) puts reserves back into the banking system.

    You write:

    "How? Can you do a balance sheet example which shows this?" Yes, I think I can. But such an example already exists on the econviz.org website. Again it's the "Consolidated" spending. You can do all the operations of the "Consolidated" spending individually there as well. As far as I can tell, everything there is correct.

    Re: your comments on TT&L accounts. Yes, I agree that I'm skipping over the mechanics of how these accounts fit into the picture. Again the econviz site breaks each step out in isolation. I consider those to be unimportant details for the big picture however. To create an example around your comment (I'm changing Mr. A to Mr. X to keep with my usual naming conventions):

    Say Mr. X borrows $100 from Bank A to pay his tax with.

    Fed and Treasury: blank balance sheets

    Bank A:
    Assets: $100 loan to x
    Liabilities: $100 deposit for x

    Person x:
    Assets: $100 deposit at A
    Liabilities: $100 borrowing from A

    Now after the tax has been paid and the TT&L account has been credited and the funds transferred to the TGA account we have:

    Fed:
    Assets: $100 loan to A
    Liabilities: $100 reserves in TGA

    TGA:
    Assets: $100 reserves
    Liabilities: $0

    Bank A:
    Assets: $100 loan to x
    Liabilities: $100 borrowing from Fed

    Person x:
    Assets: $0
    Liabilities: $100 borrowing from A

    Now suppose the gov spends all $100 on Person x's services, and Bank A uses the reserves (transferred from the TGA as part of the gov's payment to x) to pay back its loan from the Fed. Now we're back to our original set of balance sheets. The Fed and TGA have clear sheets and it looks exactly like Person x just took a loan from Bank A.

    I'm using "Person x" as a stand in for all non-bank individuals and private businesses and I'm using "Bank A" as a stand in for all private banks.

    Now this example was NOT deficit spending, but we could do a similar set for deficit spending in which case Person x would end up with a $100 T-bond. See my Example 6 for a equally over-simplified example of deficit spending. Think of the "bond auction" as a Treasury direct sale, in which case I don't think the TT&L accounts come into play. That's a nice way to avoid those details. Perhaps I should demonstrate those details in an example, but I wouldn't be adding anything that econviz hasn't already covered.











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    1. The TT&L accounts aren't necessary in a basic description, as you say they are an intermediate step.

      "Again, if by deficit spending we include the whole process from selling the Treasury bonds to spending all the proceeds of the bond sales, that's not true".

      Pre-QE banks didn't hold excess reserves. Which means that they didn't have any excess reserves with which to buy government bonds. If banks were to use whatever reserves they had to buy government bonds, this would raise the interbank interest rate as reserves left the banking system by going into the TGA. So the Fed had to provide the reserves to settle bond auctions if it wanted to hit its target rate. The way it generally did this is by buying bonds from banks (usually with a repo agreement). This provided the banks with the needed reserves to purchase the govt bonds.

      Then, at a later time, when the Treasury spent, the banking system would get excess reserves. So the Fed would have to sell bonds to the banks to drain those reserves, if it wanted to hit its target interest rate. In the case of a repo agreement, this would be pre-arranged.

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    2. I say "pre-QE" because things are a bit different now, given that banks hold a massive amount of excess reserves.

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    3. In your example above, Mr.X is currently in debt to bank A and bank A is in debt to the Fed. As it stands, neither Mr.X nor bank A can repay their debts.

      But this is somewhat besides the point as nowhere in your example have you shown that the Treasury has obtained or spent private bank deposits. It has simply obtained a deposit at the Fed.

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  5. phil, you write:

    "The TT&L accounts..."

    Yes, I agree, but at the end of this process you state the Fed sells bonds back to the banks to drain the reserves to hit its interest rate target. Yes I skipped over that bit too in the interests of simplicity. I just depicted this as the Fed loaning the reserves out. But at the conclusion of this process I think you and I agree: no excess reserves.

    You write:

    "I say "pre-QE" .... "

    Yes, but the result is the same. Once the spending has been done, no net excess reserves have been added. Some were taken away temporarily but then spent right back into the banking system by the gov.

    "In your example above..."

    True, Treasury has not spent private bank deposits in a very narrow technical way of seeing it. But I still claim that the vast majority of money used to fund the treasury ultimately originated from private loans. If the Fed held no Treasury bonds, then ALL of it could be traced to private loans. I understand the Fed has a role here in either case in loaning reserves to facilitate the process, but those reserves are repaid at the end of the process. I think this is a forest for the trees disagreement.

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    1. Keep in mind that the majority of Treasury bonds are held by the investing public, and thus the banks are really acting as intermediaries most of the time. That's important to point out. That public can't borrow reserves from the Fed to finance their bond purchases... they had to acquire their funds (again, ~97.5% of which originated from private loans to private individuals) with which to purchase the bonds through other means. So what I'm saying is that when private non-bank investors purchase bonds the bulk of the money they're using originated from private bank loans to private non-bank entities. A lot of technical details happen between that purchase and when the government ultimately spends the money, but in the end the composition of the money spent by the government back into the economy doesn't change: it can be traced (mostly) to private loans. If the Fed doesn't hold any Treasuries permanently, then ALL of it can be said to have originated from private loans. This is a little bit like a chicken and the egg kind of argument I think. You're pointing out technical details, which are good to point out... but ultimately are factored out of the equation (from my point of view anyway). At the end of my example, the Fed and gov balance sheets are clear again. There's $100 of deposit money in the system and $100 of a private bank loan from whence it came. You can divide the example up into more actors (add more people and more private banks), but the conclusion would be the same. Some people would be holding a total of $100 in bank deposits, and some people would be borrowing a total of $100 from the banks. If all money is based on debt, then its pretty clear what debts the money came from. Now if the gov runs a surplus, then yes, money is getting sucked out of the system and accumulating in the TGA. And if the gov runs a deficit, then Treasury bonds are accumulating with the public. Ultimately though I view the Fed as providing a facilitating role. I think the natural place to "sample" this process is when the Fed's balance sheet is empty! You could choose to sample it other places (as I gather you do), but to me that doesn't provide much clarity about what is ultimately going on.

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    2. "True, Treasury has not spent private bank deposits in a very narrow technical way of seeing it".

      Leaving aside the technical description, it seems to me that the idea of the government 'obtaining and spending' bank deposits doesn't make much sense in a general sense either (though you may disagree).

      Bank deposits (liabilities) are promises to pay government/ central bank liabilities (cash/coin/reserves).

      So if the government were to "spend a bank deposit" it would be spending a promise to pay its own liability. Similarly, if the government "obtains a bank deposit" it is obtaining a promise to pay its own liability.

      This is like you giving someone a promise to pay your own IOU, or "obtaining" a promise to pay you your own IOU.

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    3. "So what I'm saying is that when private non-bank investors purchase bonds the bulk of the money they're using originated from private bank loans to private non-bank entities".

      The point I would make is that government bonds can't actually be purchased with bank deposits. The money paid into the TGA can only be a liability of the Fed.

      The movement of bank liabilities within the private sector is relevant to how different private sector agents finance their own positions, but it doesn't ultimately have anything to do with how the Treasury finances its own operations. The Treasury basically receives and spends Fed liabilities.

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    4. "The point I would make is that government bonds can't actually be purchased with bank deposits. The money paid into the TGA can only be a liability of the Fed."

      Agreed. But I still think that's missing the bigger picture. I see the Fed's role as that of an intermediary between bank created money and the TGA. The Fed reverses this intermediary role when the gov buys goods and services from the private sector via the TGA account: it not only credits the payee's bank's reserve account, it also instructs the bank to credit the payee with a bank deposit. The exact mirror image of how money flows into the TGA (via taxes). And as you point out, that's exactly when those reserves will be used to repay the Fed's loans to the banks as well. So to summarize a complete cycle:

      Money flows into TGA from private sector (by taxes):

      bank deposit goes down
      Fed loan of reserves to banks goes up
      TGA account goes up

      Money flows out of TGA back into private sector:

      TGA account goes down
      bank deposit goes up
      Fed loan of reserves to banks gets repaid

      The Fed's hand is forced in this process. It's the gov that taxes and spends.

      Now if it's deficit spending we're talking about, there's an added twist:

      Money raised by Treas bond sale goes into TGA account:

      bank deposit goes down but bond holdings go up
      Fed loan of reserves to bank goes up
      TGA account goes up

      The spending process is the same (see above), so overall the only difference is the private sector is left with a net financial asset (NFA) in the end, i.e. the T-bond. Otherwise the process is the same as through tax and spend. The Fed's intermediary role is identical, and they are again forced into it. It's the gov that decides to sell the bond and spend the proceeds, and it's the private sector which decides to buy the bond.

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  6. Hi Tom, thanks for pointing me to your blog from Cullen's page.

    I don't know if you've seen it, but this publication from the NY Fed is what really helped me to understand how reserves work: http://www.newyorkfed.org/research/current_issues/ci15-8.pdf

    What I can't get my head around is how excess reserves would ever leave the private banking system and cause inflation. I am thinking of inflation in terms of the general public having more money to spend, which would cause prices to rise and the value of the dollar to decrease. How does the public get the money in their hands?

    Consider:

    The only way for money to exit the private system is to either go back to the Fed/Treasury (1,2,4 and 6 in your example, although 1, 2 and 6 are recycled back into the private system, i.e. redistributing to Paul); to be withdrawn in the form of hard currency (minimal); or to be transferred to an international bank.

    Is this correct? If so, (and ignoring hard currency withdrawals), how could excess cash from QE ever cause inflation? I mean, presuming that the excess cash all stays inside the larger banking system (only moving from bank to bank)? The Fed is paying IOER, which means the banks don't loan their excess reserves to each other, which means interet rates can't go below the floor set by the Fed. The Fed could also sterlize (mop up) the excess money by selling assets and then.....just remove the proceeds from the system (? I assume they can do this).

    I have done a ton of reading on this and this is the last bit that I'm not clear on. You, Cullen and others have well established that excess money does not necessarily lead to inflation (because it's not "new" money going into the system, but an asset swap), but how COULD it lead to inflation? What would be the mechanism for this happening? This is driving me nuts.

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  7. NWH, thanks for the link and the comment. That's an EXCELLENT question you pose! Yes, I think that excess reserves don't necessarily cause inflation. A lot of people thought they would, but they've largely been wrong. Peter Schiff for example has been famous for predicting year after year that we'd have high inflation or hyperinflation. Even at least one of his fellow Austrians has ridiculed him for that (Mish Shedlock). Some people have pointed out that QE is like "pushing on a string" regarding getting anything useful, or anything at all for that matter, to happen.

    I'm REALLY not an expert, so I'm flattered that you thought to ask me, so I'm just telling you my views here. But here's another take: QE in the US has been just an asset swap, however it's true that INDIVIDUAL banks can use those reserves to purchase other assets (if they maintain Good CAMELS scores, etc.) because QE grows there balance sheets. Additionally the former non-bank T-bond holders will have more deposits after QE. The Market Monetarists claim this causes ALL financial asset prices to rise, and the risk adjusted rate of return of financial assets to decrease, thus making it marginally more likely that investors will put their money in something other than financial assets. Perhaps build that new factor or buy a Ferrari. A guy on Scott Sumner's site took some time to explain this view to me. Here you are:

    http://www.themoneyillusion.com/?p=19141#comment-225110

    I think Cullen states that QE (as practiced in the US) can cause "distortions" in the market. I personally would LOVE a concrete example of that!... but I don't really have one.

    QE in Japan, however, is a different beast. There the BOJ is actually purchasing a lot more than government bonds I understand. Even the Market Monetarists here (e.g. Scott Sumner) say the Fed has the ability to "buy the whole world" if need be (which would CLEARLY cause inflation! Ha!), but that it would never need to because it can threaten to (by saying they'll do what's required to raise inflation) and that will suffice.

    "The Fed could also sterlize (mop up) the excess money by selling assets and then.....just remove the proceeds from the system (? I assume they can do this). "

    Yes, that is OMS (open market sales). So rather than being transferred to an international bank (a bank which as a Fed reserve account), I think OMSs are the MAIN way in which reserves leave the banking system "permanently."

    So... ultimately I don't really have a good answer for you! Sorry! Let me know if you ever find a satisfying answer!

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