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Wondering about "inside" and "outside" money....

Hey Cullen,

Put your "Pragmatic Capitalism" book down just about five minutes ago.  It's a great book, but one of your arguments repeatedly made in the book, and emphasized by you during a recent podcast interview, has my mind going around in circles.  Hopefully an exchange here in the forum can help clarify things.

You say that a bank's reserves do not play a significant role in the money supply that flows through an economy day-to-day.  This point underpins your other points about how Federal Reserve monetary policy does not play the insidious "money-printer" role that many believe it does.

How can this be true though if a bank can call on its bank reserves to satisfy deposit withdrawal requests from its customers?  If so many deposits are demanded at a single time that the bank has to draw on its reserves, and the Federal Reserve can be a lender of last resort to ensure those reserves are not depleted to a "dangerous" extent, then how could it be said that Federal-Reserve-overseen bank reserves ("outside money") don't much affect loans/deposits ("inside money") in the private sector economy?  As long as the Federal Reserve continues to backstop the reserves of its constituent banks through lending and/or asset purchases, how could it be said that Federal Reserve monetary policy does not much affect "inside money" that private banks create/control day to day?

I guess you could respond to these questions by repeating your statement that banks are not "reserve constrained" they are "capital constrained".  But, if the Federal Reserve is the arbiter of whether a bank is "solvent" or not (i.e. whether it has sufficient capital), and their monetary policy backs up that bank's reserves, I think my questions above still stand.

What's to stop a bank from just assuming that they can pretty much loan out money (inside money creation) to their heart's content, as long as they meet "solvency" requirements set by the Federal Reserve and other regulators?

In other words, don't people have a point when they say that the Federal Reserve's monetary policies can have a direct effect in the broader economy, and that the Federal Reserve's monetary policy could directly lead to an environment of artificially low interest rates which leads to mal-investment?  I of course take your point that the Federal Reserve is not always the cause of these problems, as some people claim.

Help me understand why bank reserves and the Federal Reserve's support of those reserves does not have a big effect on the "inside money" of our day to day economy.

Thanks for any response or references you can spare.  Really enjoyed the book!

Those are good questions and I will wait for Cullen's response.  In the mean time, two things come to mind.  First, I don't think there is anything stopping a bank from loaning out money to their heart's content - except the desire to make profitable loans and, as you mention, meet regulatory requirements.  The banks have a responsibility to their shareholders, right?  If a bank makes too many risky loans, then is forced to set aside high levels of loan loss reserves when some of those risky loans start going bad, then shareholders will be unhappy and for a publicly traded bank, the stock price will go down.  Loan growth since the great financial crisis hasn't been super strong because - I believe- loan demand hasn't been that strong.  Banks are also probably a bit gun shy still - and want to make mostly "safe" loans.

Second, you mention a possible run-on-a-bank (my words) scenario, where a bank has to call on its reserves to meet customer demands for withdrawals.  What I'm not sure about is if you mean cash withdrawals - real paper currency and coins, or just checks that will be deposited in another account at a different bank.  Bank reserves move around, for the most part, in the "closed" reserve system - between banks.  Actual cash at a given bank at any given time is a very small part of the total (I think).  People today are so used to paying bills online and/or writing checks that it's hard for me to imagine a significant number of people demanding their bank balances in actual cash.

Hi @luna2

You are correct that the Fed is the arbiter of solvency. And solvency is the arbiter of lend capacity. So, if the Fed determines that an insolvent bank is solvent then they will support their balance sheet in any capacity necessary to meet their regulatory needs. So there's a necessarily subjective determination of "solvency" in all of this.

I don't mean to imply that the Fed is powerless or that the Fed cannot impose harsh restrictions on banks that limit their capacity to lend. I mean that a solvent bank is not reserve constrained. An insolvent bank absolutely is reserve constrained. Since almost all lending is done by firms that are objectively solvent the Fed mostly operates to support these firms so that they can meet whatever regulatory needs are imposed on them.

One other point I've made over the years that might jibe with your thinking is that I think the Fed is VERY powerful in exigent circumstances. That is, when a firm is insolvent the Fed can be very powerful by imposing very extreme measures (like a direct lending program). Or, if inflation is very high the Fed can raise rates in a way that makes it very difficult for banks to earn a high net interest margin. But on average the Fed is mostly just processing payments and making sure the system works smoothly.

Does that answer your question?

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche