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Reserves Do NOT Allow Banks to Make More Loans

I must apologize in advance. This article will sound repetitive to regular readers. Sadly, because the message is not getting out I keep repeating the point….

If you wanted real-time evidence of my “vacuum problem” in economics (my theory that much of economics is tested in a vacuum and never properly translated to the real world), well, here it is. In a piece published today Martin Feldstein writes that all those Central Bank reserves that were added via QE should have created sky high inflation. He calls this “the inflation puzzle”.  But this isn’t a puzzle at all if you understand how banking works in the real world.  He writes:

When banks make loans, they create deposits for borrowers, who draw on these funds to make purchases. That generally transfers the deposits from the lending bank to another bank.

Banks are required by law to maintain reserves at the Fed in proportion to the checkable deposits on their books. So an increase in reserves allows commercial banks to create more of such deposits. That means they can make more loans, giving borrowers more funds to spend. The increased spending leads to higher employment, an increase in capacity utilization, and, eventually, upward pressure on wages and prices.

To increase commercial banks’ reserves, the Fed historically used open-market operations, buying Treasury bills from them. The banks exchanged an interest-paying Treasury bill for a reserve deposit at the Fed that historically did not earn any interest. That made sense only if the bank used the reserves to back up expanded lending and deposits.

A bank that that did not need the additional reserves could of course lend them to another bank that did, earning interest at the federal funds rate on that interbank loan. Essentially all of the increased reserves ended up being “used” to support increased commercial lending.

The emphasis is mine. Do you see the flaw there? As I described in my link on “The Basics of Banking” a bank does not lend out its reserves except to other banks. That is, when a bank wants to make new loans it does not calculate its reserves first and then lend those reserves to the non-bank public. It makes new loans and then finds reserves after the fact. If the banking system were short of reserves then the new loan would require the Central Bank to overdraft new reserves so the banks could meet the reserve requirement.

The key point here is the causation. The Central Bank has very little control over the quantity of loans that are made. As I’ve described before, new lending is primarily a demand side phenomenon.  But Feldstein is using a supply side money multiplier model where banks obtain reserves and then multiply them up. He has the causation precisely backwards! And if you get the causation right then it’s obvious that there isn’t much demand for loans. And there isn’t much demand for loans because consumer balance sheets have been unusually weak. It’s not a puzzle if you understand how the monetary system works at an operational level.

This is scary stuff if you ask me. We’re talking about a Harvard economist who was President Emeritus of the National Bureau of Economic Research and chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. His theory of how the banking system works is not just wrong.  It is demonstrably wrong.  And it has led to all sorts of erroneous conclusions about how things might play out. Even more scary is the fact that he’s far from alone. Just look at the list of prominent economists who have said almost the exact same thing over the years:

“But as the economy recovers, banks should find more opportunities to lend out their reserves.”

   –  Ben Bernanke, Former Fed Chairman, 2009

“Commercial banks are required to hold reserves equal to a share of their checkable deposits. Since reserves in excess of the required amount did not earn any interest from the Fed before 2008, commercial banks had an incentive to lend to households and businesses until the resulting growth of deposits used up all of those excess reserves.”

   – Martin Feldstein, Harvard Economics Professor, 2013

– “[The Fed knows] that if there is an opportunity cost from these massive reserves they’ve injected into the system, we are going to have a hyperinflation.”

   – Nobel Prize Winner Eugene Fama on why the Fed is paying interest on Reserves, 2012

“the Fed is paying the banks interest not to lend out the money, but to hold it within the Fed in what are called excess reserves.”

   – Laurence Kotlikoff, Boston University Economics Professor, 2013

“Notice that “excess reserves” are historically very close to zero. This reflects the tendency (assumed in textbook discussions of “open market operations”) for commercial banks to quickly lend out any reserves they have, over and above their legally required minimum.”

   –  Robert Murphy, Mises Institute, 2011

“In normal times, banks don’t want excess reserves, which yield them no profit. So they quickly lend out any idle funds they receive. “

   –  Alan Blinder, Princeton University Economics Professor, 2009

“given sufficient time, [banks] will make enough new loans until they are once again reserve constrained. The expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates.”

   –  Art Laffer, Former Reagan Economic Advisor, 2009

“First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air”

   –  Paul Krugman, Nobel Prize Winner & Princeton University Economics Professor, 2012

“Ohanian points out that the Fed has done a lot already, having increased bank reserves from $40 billion to $900 billion. But this liquidity injection was not what it seems — indeed, if it was, we’d now have hyperinflation. In reality, the Fed completely neutralized the injection by starting a new policy of paying interest on reserves, causing banks to simply hoard these “excess reserves,” instead of lending them out. The money never made it out into the economy, so it did not stimulate demand.”

  –  Scott Sumner, 2009

This isn’t some minor flaw in the model. It’s the equivalent of our foremost experts in automobiles thinking that, if we pour gasoline into cup holders, that this will allow our cars to move forward. If this doesn’t make you deeply question the state of economics then I don’t know what will….