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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?

https://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
628 views
Private answer

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
          Private answer

          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” (https://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q101.pdf)
                  -” Money creation in the modern economy” (https://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: https://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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                                    I would say Dinero is 100% correct.
                                    Part of the question is misleading:
                                    “If that occurs, the banks create new money by creating new bank deposits and using them to buy the bonds”
                                    When a commercial bank purchases bonds directly from the Treasury, it does so by simply requesting the Fed to debit its reserve account by the purchase amount and credit the Treasury’s account at the Fed by the same amount. No new bank deposits are created to do this. The bank deposits are created when the Treasury starts to spend the proceeds of its bond sale. It does this by requesting the recipient’s bank to credit the recipient’s deposit account by the amount it spends and also asking the Fed to debit the Treasury’s reserve account by the amount spent and credit the recipient’s bank’s reserve account by the same amount. A commercial bank buying bonds from the Treasury will create new deposits, but only when the Treasury spends the proceeds of the bond sale (as it will surely do).

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                                    Posted by Robert Pearson
                                    Answered on 04/20/2017 10:29 AM
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                                      The question was whether a deficit is inflationary when it’s financed by a bank vs the non-bank public. The answer is that both cases are the same. When I buy a T-Bond I finance it by giving the Treasury deposits which it later spends into someone else’s account. There isn’t more money in the system after this. There are only more bonds. Is that inflationary? Well, presumably yes, to some degree since there are more financial assets financing the same amount of real goods and services. Or perhaps not if those goods and services are productive enough to put downward pressure on prices. It depends.

                                      If a bank buys the bonds the same basic facts are true. A bank that buys an asset like a T-Bond will probably finance it in the repo market. If they hold this bond they’ll almost certainly flatten their repo position in the near-term. The only balance sheet that expands and stays expanded from this process is the Govt’s.

                                      Now, QE is a unique position because the Fed has also expanded their balance sheet. However, this expansion is rather meaningless with regards to inflation because the Fed’s balance sheet is not an active private sector competing balance sheet. IE, they don’t buy groceries at WalMart.

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                                      Cullen Roche Posted by Cullen Roche
                                      Answered on 04/20/2017 11:29 AM
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                                        Thank you for responding Cullen. First time I’ve posted here, but have been following your writings for some time and have been pointing others in your direction. I am dismayed at the number of (educated, intelligent) people who have absolutely no idea where money comes from and how the banking system works. I do my best to educate them, as you do, but I feel that in a lot of cases, their views are just so deeply entrenched, they don’t want to be told to rip up their textbooks and start again.

                                        I’m not sure why you think banks would finance holdings of T-bonds in the repo market. If all banks bought T-bonds from the Treasury in proportion to their market share and the Treasury subsequently spread their spending around, creating deposits at all banks also in proportion to their market share, all the T-bond holdings of all the banks would be financed by the deposits created – no need to go the repo market. If the T-bonds stayed on the banks’ asset side of the balance sheet, deposits would remain on the liability side and the banks’ balance sheets would remain permanently expanded (at least until the T-bond matured). If a bank subsequently sold its holding of T-bonds to a non-bank customer, it would simply transfer title to the T-bond and debit the customer’s account. The bank’s balance sheet would shrink.

                                        I’ve often wondered why, given the really bad PR surrounding QE – in the UK, where I am from, 99% of the population believe that QE somehow involves giving ‘free money’ to banks – the BofE didn’t simply instruct banks to lend directly to the government at Bank Rate. It could have been sold to the public as banks being forced to lend to the government at a super low rate in order to atone for their sins. The Government could even have set up some special fund, to receive the money and announce any spending on new infrastructure projects or ‘good causes’ (which they were going to fund anyway) as having come from this ‘naughty bank fund’. The end result would have been the same – £400bn of new broad money would have been created, as has happened under QE. The Government wouldn’t have had to issue £400bn of Gilts they would otherwise have had to issue, which would help drive yields lower, as has happened under QE. The commercial banks would have ended up with loans to the Government on the asset side of their balance sheet rather than central bank reserves, but presumably the BofE would have been happy to purchase these loans or accept them as collateral in order to supply central bank reserves if required. Another PR benefit would be that nobody would be getting irrationally concerned that the central bank’s much expanded balance sheet was going to cause hyper-inflation as the reserves got ‘multiplied up’ (although that would be a downside for you, as QE has been an excellent way of demonstrating that the money multiplier is a myth).

                                        Anyway, those are my thoughts. I hope you don’t mind me posting here in future. Just tell me if I get annoying.

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                                        Posted by Robert Pearson
                                        Answered on 04/20/2017 12:43 PM
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                                          Hi Robert,

                                          The forum exists so people can comment! So comment away.

                                          In the case of financing Treasury auctions the repo market is a main source of financing. Funds are wired from the dealer’s account at its clearing bank to Treasury on issuance day. During the day, the clearing bank provides intraday credit to the dealer, so the dealer is borrowing from the bank. That same day, the dealer enters into a repo, pledging the newly acquired Treasury as collateral. The other side of the repo is likely to be a money market mutual fund or other money market investor. Therefore, by the end of the day, and for the overnight period, the money market investor is effectively funding the dealer’s position. Of course, there are a variety of ways in which positions can be funded, but the repo market is the key one.

                                          The key point regarding this specific question is that banks aren’t obtaining more buying power than they previously had just because of QE and their increased reserve position. In the aggregate banks can’t get rid of reserves since they can only transfer them among one another. So this is an asset that actually impedes the amount of risk that the aggregate banking system wants to be taking.

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                                          Cullen Roche Posted by Cullen Roche
                                          Answered on 04/20/2017 12:53 PM
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                                            I should probably add that a bank with a reserve balance after QE is a bank that doesn’t have the T-Bond it previously sold. In other words, they had to forego holding a different asset in order to sell the T-Bond to the Fed. In this case it’s a low interest earning reserve. This isn’t a great position for the banking system since they’re earning such a low NIM on this position. This is why we’ve seen bankers very vocally saying they want rate increases. They want to earn more on their reserves that they’re being forced to hold. So this isn’t “free money”. It’s actually a risk free position that they’re being foreced to earn very little interest on. It’s not really the ideal position for a bank to be in when net interest margins are so weak.

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                                            Cullen Roche Posted by Cullen Roche
                                            Answered on 04/20/2017 12:57 PM
                                              Private answer

                                              You talk about dealers purchasing T-bonds direct from the Treasury and having funds wired direct from the dealer’s account at a clearing bank, whereas I interpreted the question to be about the clearing bank itself purchasing T-bonds directly from the Treasury – the questioner actually referred to ‘the banking system’. If, as it is often useful to do, we treat the banking system as being just one big bank, it becomes clearer.

                                              Now, I know that if there is only one big commercial bank there is technically no need for a central bank and central bank reserves, but let us assume the Fed still exists and has two customer accounts – the one Big Bank and the Treasury. When Big Bank purchases newly issued T-bonds from the Treasury, it does so simply by asking the fed to debit its reserve account and crediting the Treasury’s reserve account. So far, no new deposits, just reserves moving from one fed customer’s account to another’s. The Treasury now has new spending power. It spends by instructing Big Bank to credit the customer accounts of those in receipt of the Treasury’s spending. It asks the Fed to debit its reserve account and credit Big Bank’s reserve account by the same amount.

                                              Big Bank’s balance sheet has expanded. It’s reserves position is now unchanged (its reserve balance went down when it purchased T-bonds and back up again as the Treasury spent money into the non-bank sector). It has a new asset (the T-bond it has bought), and new liabilities (it’s customers’ deposits). So, yes, when banks purchase T-bonds directly from the Treasury and hold them, new customer deposits and therefore new broad money is created (but only when the Treasury spends the proceeds of selling the T-bond).

                                              Is this inflationary? Possibly. Certainly central banks hoped it would be when they used QE to create new broad money. In the UK the BofE hoped to bring inflation back to their 2% target by increasing the amount of broad money in the system in the form of newly created bank deposits (I agree 100% that the reserves created by QE are simply a side-effect that serve no real purpose). Does increasing the amount of broad money in the system actually induce inflation? Intuitively, yes, it should, although it’s a bit like pushing on a piece of string. You can supply the money, but you can only encourage the holders of it to spend it, you can’t force them to.

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                                              Posted by Robert Pearson
                                              Answered on 04/20/2017 1:20 PM
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                                                Right. But you’re starting from step 2. Step 1 involves the process by which Big Bank gets the reserves in the first place. They didn’t just magically appear on Big Bank’s balance sheet. They had to do something to get them. In the case of QE the banking system obtains reserves by selling an asset to the Fed.

                                                The main point is that the quantity of net financial assets hasn’t changed from start to finish. The non-bank private sector sold a bond and got a deposit. The banking system then passed this bond onto the Fed and got a reserve. And the Fed holds the T-bond in what is essentially a black hole.

                                                The question as to whether reserves “finance” new govt spending is misleading because it starts at a point where the assumption is that the reserves were obtained without foregoing another asset in the first place.

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                                                Cullen Roche Posted by Cullen Roche
                                                Answered on 04/20/2017 1:35 PM
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                                                  I’m not sure exactly how QE works in the US, but in the UK the BofE were very clear that they weren’t going to buy assets from banks, but from non-bank financial companies such as insurance companies and pension funds. Of course, because they used the banks as agents when undertaking QE, they couldn’t be entirely sure whether banks were buying Gilts from pension funds and insurance companies and delivering them to the BofE and not simply selling the BofE their own holdings. But from the evidence I’ve looked at, before QE was announced banks had very small net holdings of Gilts and still have small holdings, so it seems the BofE’s plan worked and they did actually purchase from non-banks.

                                                  The reason they wanted to purchase from non-banks and not from banks was precisely because they wanted to expand the supply of broad money (the BofE knew that the resulting expansion in reserves that would also happen was simply a side effect and not important to the transmission process). If they had just bought from banks, there would have been no increase in broad money, just in the amount of reserves in the system. Now, of course there were some who believed that an increase in reserves would feed through to increased bank lending and thus money creation, but the BofE were fully aware that banks were not reserve constrained in their lending decisions and the multiplier was baloney, so they knew they had to buy from non banks in order to increase the supply of broad money.

                                                  What you say about banks crying out that low rates are killing their NIM I totally agree with. Unfortunately, there are still some out there who respond by saying that if banks don’t like earning 0.25% on their reserves they should ‘lend them out and stop hoarding them’ – aaaarggghhh!

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                                                  Posted by Robert Pearson
                                                  Answered on 04/20/2017 1:53 PM
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                                                    Buying from a non-bank means the bank just acts as an intermediary. If I sell my T-Bonds to a bank then I get a money market deposit credited to me. The bank might subsequently sell the bond to the Fed and they have more reserves as a result. In the end there aren’t more or less net assets in the non-bank private sector. Sure, there’s more broad money in the non-bank private sector, but there’s fewer T-Bonds. What’s the result of that? Obviously not much given the fact that QE doesn’t seem to have coincided with high growth or high inflation.The key point here is that a bank acting as an intermediary here isn't in a better position to finance anything. Their capital position is exactly the same as it was before QE. In fact, their incomes streams are probably weaker which makes them more risk averse. So no, more reserves aren't making banks more capable of lending. I'd actually argue the exact opposite.

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                                                    Cullen Roche Posted by Cullen Roche
                                                    Answered on 04/20/2017 2:04 PM
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                                                      I’m going to agree with nearly everything you say there….except for the bit about the non-bank private sector swapping long dated government debt for broad money in the form of deposits having no real effect. Sure, there’s been no net change in financial assets in the non-banks, but pension funds and insurance companies are not going to sit on their newly created low yielding deposits, but are going to want to rebalance by purchasing other longer dated assets and equities (and possibly newly issued Gilts). Now, it’s incredibly hard to prove one way or another whether the actions taken by the non-banks helped in any way the UK to avoid falling into deflation, but there is evidence that the non-banks used their new deposits to purchase newly issued corporate bonds, which if used for investment in new widget making plant should have helped. Unfortunately, there is also evidence that some corporates used the proceeds of these sales to repay existing bank debt, thus destroying the newly created deposits!

                                                      The BofE did try to trace what happened to the deposits created by QE, by actually asking the non-banks what actions they took and then trying to follow the money as far as possible – which can’t have been easy. They have published some of their research:

                                                      https://www.bankofengland.co.uk/research/Documents/workingpapers/2014/wp510.pdf

                                                      They have probably produced something more recently, I haven’t got round to looking for it yet.

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                                                      Posted by Robert Pearson
                                                      Answered on 04/20/2017 2:46 PM
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                                                        Oh, I actually agree with that part. QE probably induces some flight to yield. But at the end of the day these asset prices will be tied to their fundamentals and demand is a function of that. Think of QE like a stock buyback. Forcing the non-corporate sector to hold more cash via a buyback means there is less stock to be owned. Presumably, this would induce prices of remaining stock to rise. BUT, what if the fundamentals don’t justify it? What if the stock is actually a worse fundamental asset despite the buyback? In this case the supply reduction is meaningless as the fundamentals drive prices.

                                                        I’ve always argued that the same basic premise applies to QE. So the simple supply reduction argument is only part of the story.

                                                        Sorry I wasn’t clearer here before and thanks for probing as it helps establish a better understanding!

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                                                        Cullen Roche Posted by Cullen Roche
                                                        Answered on 04/20/2017 2:50 PM
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                                                          This might help as it shows the actual accounting

                                                          Exercising Currency Sovereignty Under Self-Imposed Constraints

                                                          https://heteconomist.com/exercising-currency-sovereignty-under-self-imposed-constraints/

                                                          1. Repurchase agreement. The Fed purchases already-existing treasuries from primary dealers with primary dealers promising to buy back at a later date. The effect of this step is to add reserves in exchange for treasuries in order to facilitate the non-government’s subsequent purchase of newly issued treasuries. This step, like later ones, can be represented in T-accounts. (A more sophisticated approach is taken by Scott Fullwiler in the paper linked to above.) It is arbitrarily assumed in the T-accounts that the amount of government spending involved is 10 (million, or perhaps billion) dollars. The repurchase agreement has effects on the T-accounts of the Fed, banks and primary dealers, but the overall impact on net financial assets is zero, since the step just involves an asset swap.

                                                          2. Treasury auction. New treasuries are offered to the non-government. For simplicity, we can assume they are purchased entirely by the primary dealers, but in general that need not be the case. For present purposes, this simplifying assumption makes no meaningful difference to the analysis. The auction will involve a depletion of reserves as primary dealers draw down bank accounts to pay for the treasuries, and will add balances to the Treasury’s account at the Fed. The action in this step affects the T-accounts of the Fed, the Treasury, banks and primary dealers. As with the first step, overall there is no impact on net financial assets.

                                                          3. Deposits in tax and loan accounts. The Treasury adds the balances received as a result of the treasury auction to its tax and loan (T&L) accounts held at various banks. This action therefore adds both to deposits held at banks and reserve account balances. There will be effects on the T-accounts of the Fed, the Treasury and banks. Here, too, the overall effect on net financial assets is zero.

                                                          4. Second leg of the repurchase agreement. This reverses step 1. Primary dealers buy back the treasuries that were sold to the Fed in step 1. The T-accounts of the Fed, banks and primary dealers will be affected. Since this is just the reverse of the prior asset swap, the overall impact on net financial assets is zero.

                                                          5.The Treasury calls in tax and loan balances ready to spend. This reverses step 3. There is a depletion of deposits held at banks and in reserve accounts, and effects on the T-accounts of the Fed, the Treasury and banks. Once again, the overall impact on net financial assets is zero.

                                                          6. The Treasury spends. The Treasury spends by drawing down its account at the Fed, resulting in a crediting of reserve accounts and a crediting of the bank accounts of spending recipients. The T-accounts of the Fed, the Treasury, banks and spending recipients will all be affected.

                                                          The aggregate levels of bank deposits and reserves remain unchanged as a result of steps 1 through 6. The increase in deposits for spending recipients is offset by a depletion of deposits held by the purchasers of treasuries. Even so, the non-government as a whole is better off. This is made clear by the fact that total deposits are unchanged but holdings of treasuries have increased. The effect of the government spending, as expected, is to increase net financial assets by the amount of the spending.

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                                                          Posted by Derek Henry
                                                          Answered on 04/23/2017 7:18 PM
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                                                            Derek,that’s right,but you have to be really careful following this line of thought from mmt people. When they say net financial assets and “better off” they are being a little sloppy. Adding nfa via gov’t spending does not automatically make the pvt sector better off. In fact,in many environments it is the extra deficit spending that makes everything worse.

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                                                            Cullen Roche Posted by Cullen Roche
                                                            Answered on 04/23/2017 7:26 PM
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                                                              Derek, thank you for your post. The OP referred to the Treasury selling bonds to the ‘banking system’ as opposed to the general public. He understands that the broad money supply is unchanged by the process of Treasury selling bonds to the public and the Treasury then spending the proceeds of the bond issuance with the public. He was actually asking if the broad money supply increases when the Treasury sells bonds to the ‘banking system’ and then spends the proceeds with the public.

                                                              Now, I guess the answer to that depends on what you understand the ‘banking system’ to be . For me, in the UK, it is clear that it is all Monetary Financial Institutions that have a reserve account at the BofE. It doesn’t include the Treasury, which also has a reserve account(s) at the BofE. What it also doesn’t include are other financial institutions that don’t have a reserve account at the central bank. These would make up the ‘financial system’, but are not included in the ‘banking system’.

                                                              In your step 2), you refer to primary dealers purchasing T-bonds directly from the Treasury, but you make it clear that primary dealers don’t have reserve accounts with the Fed, but have bank accounts at banks, just as the general public do. Your analysis will be the same therefore if it is a primary dealer purchasing bonds, or a housewife in Arkansas purchasing bonds.

                                                              If you repeat your analysis, but instead have a MFI (an institution with a central bank reserve account) purchasing the T-bonds, either instead of the primary dealer (if that is possible), or from a primary dealer, you will find there is an increase in bank deposits in the system.

                                                              A bank buying bonds directly from the Treasury is exactly the same as a bank lending money directly to the Treasury and, as we know, banks lending creates new deposits.

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                                                              Posted by Robert Pearson
                                                              Answered on 04/24/2017 9:19 AM
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                                                                Ught. What people really want to know is where inflation comes from. When you listen to theorists like Friedman or Rothbard stuck in the anarchronistic gold standard regime way of thinking, they will pronounce that any increase in the money supply is automatically inflationary (because back then, it was). And always from a central bank due to ideological reasons.

                                                                But in reality, the strongest correlation between the rate of inflation is… wait for it… unproductive government spending. This is because Congress authorizes spending first then the Treasury creates the money later on when it auctions off Treasury Bonds (and hence the never ending stupid debate about the debt ceiling). So if swapping Treasuries for existing resources is a net net, then the drag has to be on Congress financing unproductive capital investments or welfare transfer payments. Conservatives as a rule are dogmatically against any of this and don’t care about the spending quality that ultimately determines whether or not there will be net inflation. Now, granted, in the real world, government does very little right or productively but so long as the private sector is overwhelmingly free with choice and can innovative and be productive without government interference, the resulting deflation will keep the inflation in check.

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                                                                Posted by MachineGhost
                                                                Answered on 04/25/2017 6:01 PM
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                                                                  Which is why government monopolies providing products/services are always going up in price…. etucasion, sickcare, Amtrak, USPS, etc. It’s not rocket science. You need envy (greed) to enable productivity improvements to happen otherwise no one is motivated and will take the initiative. This happens in government agencies too to a certain extent (think DARPA), but the institutional framework is not fundamentally about responding to the consumer and using profit/loss as feedback mechanism for self-corrections; no, its about growing the institution’s political power and ever expanding its budget with very little care about the consumer.

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                                                                  Posted by MachineGhost
                                                                  Answered on 04/25/2017 6:05 PM
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