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Are Banks buying Treasury Bonds using money created by fractional reserves?

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Hi Cullen–It’s been awhile. I asked this question 4 years ago here and the response more or less avoided my question so here is something from Rothbard via Zerohedge this morning under mythbusting that answers this question directly : “In recent decades we always have had federal deficits. The invariable response of the party out of power, whichever it may be, is to denounce those deficits as being the cause of our chronic inflation. And the invariable response of whatever party is in power has been to claim that deficits have nothing to do with inflation. Both opposing statements are myths.

Deficits mean that the federal government is spending more than it is taking in in taxes. Those deficits can be financed in two ways. If they are financed by selling Treasury bonds to the public, then the deficits are not inflationary. No new money is created; people and institutions simply draw down their bank deposits to pay for the bonds, and the Treasury spends that money. Money has simply been transferred from the public to the Treasury, and then the money is spent on other members of the public. On the other hand, the deficit may be financed by selling bonds to the banking system. If that occurs, the banks create new money by creating new bank deposits and using them to buy the bonds. The new money, in the form of bank deposits, is then spent by the Treasury, and thereby enters permanently into the spending stream of the economy, raising prices and causing inflation. By a complex process, the Federal Reserve enables the banks to create the new money by generating bank reserves of one-tenth that amount. Thus, if banks are to buy $100 billion of new bonds to finance the deficit, the Fed buys approximately $10 billion of old treasury bonds. This purchase increases bank reserves by $10 billion, allowing the banks to pyramid the creation of new bank deposits or money by ten times that amount. In short, the government and the banking system it controls in effect “print” new money to pay for the federal deficit.

Thus, deficits are inflationary to the extent that they are financed by the banking system; they are not inflationary to the extent they are underwritten by the public.”

Is this statement valid in your opinion? Particularly the part where the purchasing bank uses it’s ability to create the deposits it’s using for the purchase of gov’t bonds out of thin air (reserves multiplied by ten in this proposed scenario). No one has ever been able to satisfy this question and before you refer me to a past article know I have read you ALOT. I think this question is fundamental to the monetary system and glossed over by many. What say you and your esteemed readers?

http://www.zerohedge.com/news/2017-02-22/ten-great-economic-myths

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Posted by Kevin Cotter
Posted on 02/23/2017 8:30 AM
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It makes more sense if you see the Treasury as the creator of the first of the financial assets in the process, rather than the commercial bank. The Treasury creates “low liquidity money” – Treasuries. The banking system creates “high liquidity money” – deposit accounts for the recipients of government spending , in return for having the Treasury bonds on their balance sheet.

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Posted by Dinero
Answered on 02/23/2017 12:27 PM
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    I’m no expert on this topic, but I’m not sure what Kevin means when he says banks “create deposits”. Loans create deposits. A bank can also attract deposits with CD (certificate of deposit). How else can a bank “create” deposits? Also, if we agree that loans create deposits – that does not mean that the bank that issued the loan gets the deposit, right? If I borrow money to XYZ bank to buy a car but the car dealer deposits the money in ABC bank, then XYZ bank didn’t create a deposit – it increased an asset (I think).

    The primary dealers take care of the Treasury auctions, but don’t most of those new issues end up with pension funds, mutual funds, insurance companies, wealthy investors, etc. — all secondary market transactions?

    I’m not grasping the idea that increases in bank reserves allow a bank to “pyramid” the creation of new deposits. I say this because Cullen has shown us research (his own and from other credible sources) that banks don’t lend reserves (except to other banks). Don’t regular loans (to businesses and individuals) create most deposits, which means most of the “new” money is created by the private sector (banks)?

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    Posted by Steve W
    Answered on 02/23/2017 4:06 PM
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      Primary Dealers at Treasury auctions are mostly market makers. In other words, they’re not trying to ever be net long or short of T-Bond exposure. They are simply buying and then reselling hoping to make a spread on fees paid by the Fed and their buyers. In this case, most bond purchases are used with existing money. That is, even if the bank creates money to initially buy the bond at auction they will be net flat once they resell the T-bond. So, although there isn’t any net new “money” in the system during this process there is a net new financial asset (the T-Bond). Can we call T-Bond issuance “money printing”. Sure, in the same way that stock issuance or corporate bond issuance is “money printing”. Is it inflationary? Well, it certainly could be I guess, but that depends on many other factors.

      I think we have to be careful with this idea that more financial assets necessarily means higher inflation. I mean, if I borrow $100 to build a new widget then there is more money bidding on widgets. But that does not necessarily mean the price of widgets will rise. After all, what if we find cheaper and more efficient ways to build widgets? Well, then the increase in money is more than offset by the increase in the quantity of widgets and prices might actually fall. In fact, we’d hope that this is precisely what happens in a productive capitalist economy. We would hope that competition drives productivity which drives down costs. That’s basically what we see happening with technology today.

      So, the bottom line is that you have to be careful with this Austrian and Monetarist idea that more money equals more inflation. It’s more complex than that.

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      Cullen Roche Posted by Cullen Roche
      Answered on 02/23/2017 5:24 PM
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        The simple answer is yes , when the buyer of a Treasury bond is a bank rather than a bank deposit holder , then the amount of overall bank liabilities increase. But there is nothing inequitable about this particular transaction as the underlying financial asset is the treasury bond and Banks create credit on assets that is their usual business.

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        Posted by Dinero
        Answered on 02/23/2017 8:53 PM
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          Sorry, but I had to edit that last answer by Dinero because it will confuse the reality. The reality here is that banks do not, FROM START TO FINISH, expand their balance sheets to buy T-Bonds. Most of the expansion here is done using overnight repos and are intended to keep the bank relatively flat (ie, having no market exposure). So it is totally wrong to say that the financing of T-Bonds by Primary Dealers results in an increase in the money supply that will be inflationary.

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          Cullen Roche Posted by Cullen Roche
          Answered on 02/23/2017 10:12 PM
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            I am humbled by the responses and thank you all so much for your time. None of you have answered my question or understand why or what I am asking. I am sure the fault is mine. Henry Hazlitt in his “Science of thinking” says that economic thought is algebraic– the answer is always IMPLIED in the equation if the question is properly framed. Thank you for helping me clarify the question in my mind. So one last stab at it: IF a bank that can loan ME $100,000 and charges me 10 percent interest but only has to have $10,000 in reserve (CREATING the other 90%–or more realistically creating 100% of the loan out of thin air and THEN getting any reserve they need as they need it) are they not getting 10 times the ACTUAL return on their $10,000 for a $100,000 loan? That is fractional reserve banking, no?

            Rothbard (I am not a Austrian… I’m not anything! It’s just this huge puzzle that no one person or point of view can see or explain it’s entirety) says it as plain as I have heard any major economist. He at first states that public buying of govt’ debt is dollar for dollar and separates this from the banks buying because: “By a complex process, the Federal Reserve enables the banks to create the new money by generating bank reserves of one-tenth that amount. Thus, if banks are to buy $100 billion of new bonds to finance the deficit, the Fed buys approximately $10 billion of old treasury bonds. This purchase increases bank reserves by $10 billion, allowing the banks to pyramid the creation of new bank deposits or money by ten times that amount. In short, the government and the banking system it controls in effect “print” new money to pay for the federal deficit.”

            That was my question four years ago and my question today. I am not asking about inflation. Do banks under the fractional reserve system that they operate in use their 10 to 1 leverage on treasury purchases like they do on ANY loan creation. I had pretty much giving up trying to understand this process because it made no sense to me until I read that piece this morning and it made me think of our long ago conversations. This just seems so critical to me and no one else seems to give a shit so I will not pester you all any further (maybe another 4 years ;-)~ Dinero you rock brother! You were closest after noodling it all day–some day I’ll be smart enough to get censored here– Thank you Cullen

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            Posted by Kevin Cotter
            Answered on 02/23/2017 11:55 PM
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              Hi Kevin,

              I think the problem might be that you’re using a fractional reserve concept in a system that isn’t fractional reserve. The regulars here all know this so people like Dinero and myself are disagreeing on a whole different concept using a different framework. Dinero, by the way, is very good on this stuff….

              Anyhow, the key point here is that banks NEVER multiply a fraction of their reserves. Banks do not lend their reserves (except to other banks). When banks need reserves to meet reserve requirements then make loans and find reserves after the fact. The entire fractional reserve framework gets the orders of operation wrong.

              So no, a bank that makes loans is not reaping the benefits of some system whereby they were granted the ability to make 10X more loans. Banks make new loans which create new deposits when there is demand for their loans from creditworthy customers. And they obtain the necessary reserves after the fact in order to meet reserve requirements.

              make sense?

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              Cullen Roche Posted by Cullen Roche
              Answered on 02/24/2017 12:14 AM
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                Your up late my friend and thank you again for your time. I have read you a lot as I stated before and accept your views on banking almost across the board (the elegant idea of “moneyness” varying from the most liquid hi-velocity exchange medium–cash today–to deposits, stocks, debt instruments, and finally the outer layers of financialization (ill-liquid almost NO velocity derivatives and such)). I don’t know if you could accept originating that idea but no where else had I read it so thoroughly stated in a way so easily understood. Thank you all again for your responses!

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                Posted by Kevin Cotter
                Answered on 02/24/2017 8:01 AM
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                  [apologies for a lengthy post]

                  In addition to Cullen’s works, may I also suggest

                  – “Where Does Money Come From?” (https://www.amazon.com/Where-Does-Money-Come-Ryan-Collins-ebook/dp/B00FFAKEQU)

                  by Richard Werner & Co, 2013. It explores modern money creation processes very thoroughly and without needing the “moneyness” scale (with all due respect to Cullen). It also covers the existing reserve and capital adequacy constraints on banks and shows their relative regulatory impotence.

                  This gem of a book was listed as a reference by the famous BoE 2014 papers

                  – “Money in the modern economy: an introduction” (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q101.pdf)
                  -” Money creation in the modern economy” (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf)

                  which officially brought central banks’ view of the monetary theory more in line with MMT and similar schools of thought.

                  Richard Werner is not a member of the MMT camp, AFAIK, but he has been fighting the orthodox economic views for decades, starting with the 2003 “Princess of the Yen” (https://www.amazon.com/Princes-Yen-Central-Bankers-Transformation/dp/0765610493) and the 2005 “New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance” (https://www.amazon.com/New-Paradigm-Macroeconomics-Macroeconomic-Performance/dp/1403920745).

                  He also witnessed first-hand the distortion and mis-application of his original Quantitative Easing idea (he invented the original Japanese term) and predicted the corresponding “monetary non-event” in Japan in the early 2000s: http://webcache.googleusercontent.com/search?q=cache:Ip8yAeZixxgJ:www.res.org.uk/view/art5jul13features.html

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                  Posted by vlad
                  Answered on 02/26/2017 1:41 PM
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                    There are two separate topics in the original question.

                    1. Are commercial Bank deposits created by multiplying central bank reserves.

                    2. Does the acquisition of Government bonds by commercial banks result in the creation commercial bank deposits.

                    To the first I say no.
                    To the second I say yes.

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                    Posted by Dinero
                    Answered on 02/27/2017 11:11 AM
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                      Dinero, you seem to be comparing apples and oranges.

                      (1) Deposits are banks’ liabilities. Central bank reserves are the central bank’s liabilities and the commercial banks’ assets. Unless your first question is worded incorrectly, it is an obvious “no”: you can’t “multiply” an asset and turn it into a liability. The commercial bank deposits are created during the process of new loan issuance, which is the main process of money creation these days. This process is somewhat constrained by the capital and liquidity requirements but these regulatory constraints are weak (especially post-QE). The main constraint on money creation is lack of sufficiently creditworthy borrowers that could obtain new loans.

                      To put it shortly, the commercial banks can almost always create new deposits, but they need to find borrowers first.

                      (Also, there are no “multipliers” in modern monetary systems. The only modern system where reserve constraints are effective is (perhaps) China.)

                      (2) Again, financial assets like government bonds are, well, *assets* of the commercial banks — they can’t result in new deposits (*liabilities*) for the same reason as in (1). When a commercial bank purchases a gov bond, it is the same as if the commercial bank obtained a new “savings account” with the Fed (e.g. by converting another asset, say, cash, into the gov bond asset). There are no new retail deposits created in the process. The second answer is also “no”.

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                      Posted by vlad
                      Answered on 02/27/2017 12:06 PM
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                        > Vlad

                        My comment is response the the original posters question at the top of the thread.

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                        Posted by Dinero
                        Answered on 02/27/2017 1:12 PM
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                          If a commercial bank buys a government bond from a bondholder, that bondholder then has more in their deposit account. Or if If a commercial bank buys a government bond from the government Treasury, via a primary dealer, the government spends the proceeds they get from that with a bank deposit holder and they have more deposits.

                          And so the amount of commercial bank deposits are increased when commercial banks buy government bonds.

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                          Posted by Dinero
                          Answered on 02/27/2017 1:26 PM
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                            Dinero, I understood that. I don’t think, however, that your answers are correct.

                            The OP quoted this scenario:

                            “On the other hand, the deficit may be financed by selling bonds to the banking system. If that occurs, the banks create new money by creating new bank deposits and using them to buy the bonds.”

                            This is nonsensical. What does “creating new bank deposits” mean here? The deposits are on the liability side of banks’ balance sheets, they can’t be used to “buy” anything.

                            I thought the OP could benefit from understanding the existing monetary systems, either by reading Cullen’s book or other resources I’ve linked to above (some of them pre-date Cullen’s book).

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                            Posted by vlad
                            Answered on 02/27/2017 1:29 PM
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                              I agree it is nonsensical to say banks “buy bonds with deposits”.
                              However, if you observe that what they actually buy the bonds with is reserves, and if you follow the process through to the end and include the government spending, then you see there are more deposits than before.

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                              Posted by Dinero
                              Answered on 02/27/2017 1:39 PM
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                                Central bank reserves are used only for inter-bank settlement, they can’t be used to transact with anyone who is not in the Fed system. So, I am not sure it is correct to say that a commercial bank can “actually buy the bonds with its reserves” either.

                                However, if we consider a transaction whereby a commercial bank acquires a gov bond from some bondholder and pays them by creating a deposit account for them (valued at the bond’s market value) and adding the bond as the bank’s new asset, then yes the net result will be an increase in the deposits. But I don’t see what significant role is played by the central bank reserves in this transaction…

                                Furthermore, I think the OP wanted to understand whether such a transaction was *inflationary* and whether it was somehow *amplified by the 10x reserve “leverage multiplier”*. The answer to both is “no”:

                                – the bondholder’s purchase power has not increased; it decreased slightly (an interest-bearing asset got replaced by a demand deposit);
                                – the US reserve ratio of 10% is not involved in the purchase, so there is no “multiplier”; in some countries the reserve ratio requirement is 0% (e.g. Canada), yet they don’t seem to have exploding inflation or money supply due to an “infinite multiplier” :)

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                                Posted by vlad
                                Answered on 02/27/2017 2:27 PM
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                                  The OP stated in a follow up that they are not enquiring about price inflation.

                                  The point is, deposits are increased .

                                  I picked up on the operational aspect of the question.

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                                  Posted by Dinero
                                  Answered on 02/27/2017 2:42 PM
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