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David Andolfatto Gets Excess Reserves and Inflation Risk Right

This is a very good piece by David Andolfatto on excess reserves and the risk of inflation.  I highly recommend having a read.  He’s explaining his views relative to this piece by Paul Sheard which I discussed last year.  Anyone who’s read my paper on the monetary system will know all of this already, but I did want to reiterate the points Sheard highlights:

• Banks do need to hold reserves (as a liquidity buffer) against their deposits, and banks create deposits when they lend. But normally banks are not reserve constrained, so excess reserves do not loosen a reserve constraint.

• Banks in aggregate can reduce their reserves only to the extent that they initiate new lending and the bank deposits created as a result flow into the economy as new banknotes as the public demands more of them.

• QE does aim to ease financial conditions and spur more bank lending than otherwise would have occurred, but the mechanisms by which this happens are much more subtle and indirect than commonly implied.

• If the excess reserves created by QE were to be associated with too much credit creation, central banks could readily extinguish them.

The part I really like in the Andolfatto post was this explanation of bank notes and their existence relative to how we think of “money”:

“Now, individuals regularly make deposits and withdrawals of cash into and out of their bank accounts. The net flow of withdrawals minus deposits determines by how currency in circulation grows over time. Banks do not lend out their cash. When a bank makes a loan, it issues a deposit liability that is redeemable for cash on demand. The demand deposit liabilities can be used as a payment instrument (they constitute money, and are counted as part of a broader measure of money supply, e.g., M1). The key observation here is that the way currency enters the economy is through the net withdrawal activity of bank customers–it has nothing to dow with banks lending out their reserves.

Alright, so why is understanding all this important? Well, for one thing, it is an accurate description of the way money and banking actually works (as opposed to the traditional “money multiplier” story that is commonly told in undergraduate textbooks). It is the right place to start when thinking of policy questions.”

That’s perfect.  And it’s why I like to think of the monetary system in terms of “inside money” (bank created money like bank deposits) and outside money (notes, coins and reserves).  It helps to emphasize the fact that outside money is really a facilitating form of money that exists primarily to aid the existence of inside money in various ways.  In the case of cash it is simply something that exists to allow users of inside money to convert their deposits into cash for the purpose of transactions.   We get to the reality of the system where the “money” that exists starts primarily with the banking system and not with the government or the Fed through some “government money printing” process or a “money multiplier” process.  Instead, we throw the mainstream descriptions on their head and view the system through the banking system first and then understand how the government supports the private sector banking system in various ways.  Understanding the monetary system through this view has proven crucial for understanding many of the economic and policy outcomes from the last 5 years and also explained why so many of the high inflation or hyperinflation predictions were wrong.

David wraps up his post with a hypothetical situation where the Fed incurs capital losses as interest rates rise and depositors convert their holdings to cash and higher interest rates lead to a self fulfilling inflation:

“Now, higher inflation expectations on the part of the public may induce people to want to hold more currency (in nominal terms–the demand for real money balances may decline). This may be what could trigger a mass wave of redemptions. As people start withdrawing cash from their bank accounts, the banks start redeeming their reserves for cash to meet their customers’ demands. The spike in interest rates unplugs the Fed’s vacuum cleaner — people know that the Fed does not have the tools to buy back all of its reserve liabilities. The wave of redemptions proceeds unchecked, with the flood of currency generating an inflation that becomes a self-fulfilling prophesy.

Well, that’s just a story. I’m not sure if it hangs together logically…”

Yeah, I am not sure I love that part, but he’s obviously just toying around with the idea.  First, I don’t see any reason for the Fed to incur losses in the portfolio since they can hold their portfolio to maturity without having to worry about solvency.  Second, I don’t know why people would convert to cash in a rising interest rate environment (for instance, currency in circulation didn’t increase rapidly in the 1970’s).  And lastly, there’s no reason to assume that the Fed would lose control of the policy rate during a high inflation since it can now target the Fed Funds Rate by changing the interest rate it pays on reserves.  So I don’t think that this story hangs together.  In fact, I don’t know if there’s any real logical story about how high levels of reserves can lead to higher inflation.  It seems to be something that is based on misunderstanding the monetary system and little more….

Go have a read of David’s post.  It’s very good.  He’s great at explaining complex concepts so if you don’t read him and you’re trying to become nerdier than you are (ie, smarter), then add him to your reading list.


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