Understanding Money Mechanics

In chapter 4 we reviewed the textbook analysis of how a central bank buys government debt in “open market operations” to add reserves to the banking system, with which commercial banks can then advance loans to their own customers. In this respect we merely summarized the textbook explanation that economists have given for decades. However, over the years a chorus of critics has alleged that this orthodox view is, if anything, backward, and that in reality commercial banks take the lead in making loans without regard to their reserves.

In order to have a concrete example of this rival perspective, we will draw on a 2014 report issued by the Bank of England entitled “Money Creation in the Modern Economy.”1 Coming from the UK’s central bank—their counterpart to the United States’s Federal Reserve—this is an authoritative example of the critique of the orthodox explanation for money and banking.

For our purposes in the present volume, we will select three of the alleged “myths” of money creation that the Bank of England report seeks to correct. (The serious student should of course read the original report for a full understanding of the challenge.) Our goal here is neither to affirm the orthodox explanation nor to concede its defeat, but rather to use the Bank of England’s commentary as a springboard for ensuring that current readers truly understand how central banks and commercial banks work together in a fiat-based system to create money.

The Bank of England Wants to Overturn (Alleged) Textbook Myths

Below we provide two quotations from the Bank of England report to supply the fodder for the three (alleged) myths that we will discuss in this chapter:

a common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money—the so-called “money multiplier” approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending…. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves—that is, interest rates.

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them—which will, crucially, depend on the interest rate set by the [central bank]. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve…which is then, in normal times, supplied on demand by the [central bank]. [McLeay, Radia, and Thomas 2014, p. 15, bold added.]

And then later in the report the authors argue, “A related misconception is that banks can lend out their reserves. Reserves can only be lent between banks, since consumers cannot have access to reserves accounts at the [central bank]” (ibid., p. 16, italics in original).

(Alleged) Myth No. 1 Banks Lend Out Reserves

This particular “myth” is largely a matter of semantics, but the Bank of England treatment might mislead some readers. Here we will attempt to clarify what really happens when banks make new loans.

Suppose Acme Bank starts in a position where its existing customers have a total of $100 million on deposit with the bank. In other words, if you added up the checking account balances of all of Acme Bank’s customers the total would be $100 million.

At the same time, Acme Bank starts off with $10 million in reserves. These reserves consist of (a) $2 million in vault cash and (b) $8 million in Acme’s own account held with the Federal Reserve.

Now Acme Bank decides to grant new loans to business owners to the tune of $5 million. At the moment of granting these new loans, Acme Bank sets up the new customers with checking accounts, and the total amount on deposit in these accounts is $5 million. That means Acme’s total outstanding deposits now stand at $105 million.

It is certainly true that the act of granting new loans did not itself reduce the amount of Acme’s reserves. The bank still has $2 million in currency in its vaults, and the Fed still reports that Acme’s account with it contains $8 million.

However, the whole point of the public getting loans from Acme Bank is to spend the borrowed money. That is, the business owners who just got new loans from Acme will go around the community buying items for their businesses. They will either write out paper checks or swipe a plastic card tied to their new checking accounts with Acme.

In practice, some of the merchants and employees who receive these payments will themselves also be clients of Acme Bank. In that case, the spending of the newly loaned funds will not affect Acme’s overall accounts; it will just involve changing the numbers to reflect how Acme’s $105 million in total customer deposits is distributed among its customers.

However, most of the recipients of the new spending will typically be customers of other banks. Suppose that of the newly created $5 million, 80 percent of it—that is, $4 million—gets spent on goods and services provided by people who bank somewhere other than Acme. After Acme and the other banks in the community engage in clearing operations, Acme must “settle up” with them and transfer $4 million in its reserves, which we can assume happens by the Fed transferring the reserves in Acme’s account to the accounts of the other banks.

When the dust settles after this first round of spending, Acme Bank will only have $101 million in total customer deposits (because the other $4 million is now in the personal checking accounts of people who don’t bank with Acme), and Acme’s total reserves will only be $6 million. These $6 million in reserves consist of the original $2 million in vault cash but now only $4 million on deposit in Acme’s own account with the Fed ($8 million – $4 million = $4 million).

This type of process is what the textbook writers had in mind when they claimed that a bank would “lend out its excess reserves” by making new loans. There is a definite sense in which Acme’s decision to grant new loans to the public will—soon enough—lead to a drain of reserves from Acme.

Now, in fairness, the authors of the Bank of England study could clarify that even in our hypothetical story, the banking system as a whole didn’t “lend out reserves.” Remember, in our story the total reserves in the system were just rearranged among Acme and the other banks. When Acme granted $5 million in new loans, that action simply increased Acme’s outstanding deposits. And when $4 million of those newly created deposits were spent on clients of other banks, Acme simply transferred $4 million of its original reserves to those other banks, not to individuals in the community.

However, we can make just one little tweak to the story to show that there is an even more direct sense in which a commercial bank can “lend out its reserves.” Suppose that one of the business owners, after receiving a new loan from Acme, wants to withdraw actual currency in order to give several of her employees “petty cash” that they will need for their duties. (Perhaps these employees are going to an industry convention and need to be able to pay for cabs, tip the bellboy at the hotel, buy pizza and get it delivered to the hotel room, etc.) More specifically, suppose that after being granted a new loan from Acme and seeing how much she has in her new checking account, the business owner goes to the bank teller and withdraws a total of $10,000 in the form of five hundred $20 bills.

In this case, Acme’s vault cash—which, remember, started out at $2 million—has dropped to $1,990,000. That means that Acme’s total reserves have dropped by the $10,000 that its client withdrew from the bank after being granted a new loan. This is an even more direct way in which a commercial bank can “lend out its reserves.”

Now it’s true that even here the authors of the Bank of England study could object that we don’t call it “reserves” when a member of the public holds currency, even though those same $20 bills were considered reserves when they sat in Acme’s vault.

But this is obviously a matter of semantics, not economics. For an analogy, consider this puzzle: Would it be wrong to say that a department store “sells its inventory” to members of the public? After all, we only call it “inventory” when the store owns it—the “inventory” turns into “merchandise” when the customer walks out of the store. But clearly, there is nothing wrong economically with saying that a department store sells its inventory to the public. Likewise, there is nothing wrong with saying that a commercial bank, in granting new loans, lends out some of its reserves.

(Alleged) Myth No. 2 Banks Worry About Reserve Requirements When Making Loans

When disentangling this issue, again we must distinguish things from the perspective of an individual bank versus the entire banking system. As we showed in our hypothetical story above, it is true that an individual bank can grant a new loan simply by crediting a new checking account for a borrower. This action will increase the bank’s total outstanding deposits.

Now if the government/central bank has formal reserve requirements (which was true in the United States up until they were dropped in March 2020, amid the coronavirus panic2 ), an individual bank must ensure that it has enough reserves to meet the legal requirement. If the bank is short, it must go to the federal funds market and borrow the necessary reserves from other banks. Remember that the “federal funds rate” is the interest rate that banks charge each other for overnight loans of reserves. (These principles were described in chapters 4 and 6.)

So although any individual bank can go to the federal funds market and borrow enough reserves to satisfy its individual requirements, the banking system as a whole can’t create new reserves. If Acme Bank borrows $4 million in the federal funds market to replenish the $4 million in reserves that it lost in our story above, those reserves must have come from other banks that had excess reserves. When the commercial banks lend money among themselves, these actions don’t have the power to alter the total amount of paper currency or bank deposits with the Fed itself. In other words, only the Fed (in conjunction with the Treasury) has the legal power to create US dollars as part of the monetary base.

In any event, to show why, historically, the economics textbook writers assumed that under normal circumstances the banks would keep making new loans until the total amount of “excess reserves” dwindled away, consider the following chart:

Figure 1. Total and Required Reserves of US Depository Institutions, January 1959–February 2007

As Figure 1 shows, it was typical in the US for the banks to hold actual reserves very close to their legally required amount. And since the Fed itself ultimately controlled the quantity of actual reserves, the standard textbook story of open market operations was quite sensible.

However, the Bank of England authors are correct when they say that this textbook story assumes that banks make new loans up until the point when all of the excess reserves have been squeezed out of the system. In particular, we can see that since the financial crisis of 2008, the US banking system has been awash in excess reserves:

Figure 2. Total and Required Reserves of US Depository Institutions, February 2007–February 2020

What Figure 2 shows us is that in the wake of the massive rounds of QE (quantitative easing) following the financial crisis, US banks had the legal ability—at least with respect to formal reserve requirements—to create many trillions of dollars’ worth of new loans for customers. But they chose not to do so (for various reasons, some of which we will discuss in chapter 13), hence the amount of “excess reserves” in the entire system skyrocketed. We show this in Figure 3:

Figure 3. Excess Reserves of US Depository Institutions, February 1984–February 2020

As Figure 3 indicates, for most of the Fed’s history, the amount of excess reserves in the system was close to zero. (Technically this chart only goes back to 1984, but Figure 1 shows that the pattern holds back to 1959, and in fact it holds even further back.)

Although it is beyond the scope of the present volume, when discussing reserve requirements there are two other complicating factors: one is that governments/central banks may impose not only reserve requirements but also capital requirements; these regulations also influence how banks operate when making loans and holding certain assets.

A second complicating factor is that commercial banks need to hold reserves even when there is no legal requirement to do so. For example, banks need to honor the typical customer request to withdraw money from an ATM or at the bank counter, and so some vault cash—which counts as part of the bank’s reserves—must always be on hand, regardless of whether government regulations insist upon it.3

(Alleged) Myth No. 3 The Central Bank Controls the Amount of Base Money

With this final (alleged) myth, the dispute is again largely one of semantics. Here is what the Bank of England authors have in mind:

Before the financial crisis of 2008, a central bank would typically set policy by picking a target for the interest rate that banks charge each other for overnight loans of reserves—in the US, we would say that the Fed set a target for the federal funds rate.

Suppose the Fed target is 5 percent. If the economy is on an upswing and the commercial banks spot numerous profitable lending opportunities, they begin advancing more loans to new borrowers. Other things equal, more and more banks would find that they need extra reserves in order to satisfy their reserve requirements (or simply to bolster vault cash to accommodate the increased activity from more customer deposits).

If the Fed didn’t take any action, then the banks’ increased clamoring for reserves would push up the market interest rate on overnight loans of those reserves, perhaps to 6 percent. In other words, in an environment where the banks perceive new lending opportunities, their activity would tend to push the actual federal funds rate above the Fed’s desired target federal funds rate.

In order to maintain its target, the Fed would have no choice but to engage in open market operations, in which it would buy new assets and create more reserves, thus pushing the actual fed funds rate back down to the desired 5 percent target. This is the kind of mechanism that the authors of the Bank of England study have in mind, in which the central bank passively responds to the banks’ “needs” for reserves.

However, this is largely a matter of semantics. It is still the case that the central bank controls the total quantity of base money, and that the commercial banks can’t create new reserves. The textbook description is still correct: When the fed funds rate is 6 percent and the Fed wants to push it down to 5 percent, the Fed must buy assets and inject new reserves into the system.

Summary

After reading the orthodox discussion of money creation given in chapters 4 and 6 of the present volume, readers may find it helpful to read the alternative description given by critics of that textbook view. In this chapter, we have reviewed the critique offered by writers for the Bank of England.

Although most of the dispute hinges on semantics, there are some substantive differences in perspective. To avoid confusion and achieve better comprehension of the actual mechanics of central and commercial bank activities, readers should read both descriptions and understand the extent to which they are each correct.

• 1Michael McLeay, Amar Radia, and Ryland Thomas, “Money Creation in the Modern Economy,” (Bank of England) Quarterly Bulletin 2014 Q1, pp. 14–27, available at https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy.
• 2The Federal Reserve announced that it would abolish formal reserve requirements effective March 26, 2020. See “Federal Reserve Actions to Support the Flow of Credit to Households and Businesses,” Press Releases, Board of Governors of the Federal Reserve System, Mar. 15, 2020, https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm.
• 3Some economists argue that with the adoption of “sweep accounts” by US banks in the 1990s, the formal reserve requirements became inconsequential as banks could sweep their client deposits into non-reserve-required accounts each night. In practice, the banks could keep their reserves at whatever their vault cash needs dictated, and then use sweep accounts to reduce their apparent outstanding deposits such that their actual reserves (consisting mostly of vault cash) satisfied their postsweep reserve requirements. See George Selgin, “Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession” (Cato working paper, no. 50/CMFA no. 11, Center for Monetary and Financial Alternatives, Cato Institute, Washington, DC, Mar. 1, 2018, rev. Mar. 13, 2018), p. 10, available at https://www.cato.org/sites/cato.org/files/pubs/pdf/working-paper-50-updated-3.pdf, published as Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession (Washington, DC: Cato Institute, 2018).