Reserve Balance Misconceptions

June 3rd, 2013
in Op Ed, syndication

by Dan Kervick, New Economic Perspectives

Mark Thoma, writing in the Fiscal Times, has called for the Federal Reserve to take “bold, creative moves” to alleviate unemployment. Thoma’s suggestions contain nothing novel, and I suspect Thoma is fully aware that what our economy really needs is a fiscal expansion from the federal government. But perhaps these tired calls for additional central bank string-pushing deserve some sympathy. Many have concluded that the attempt to get Congress and the White House to act to increase government spending are futile, since the elected branches of our government seem unwilling to do what needs to be done out of some combination of incompetence, iniquity, ignorance, ideology and insanity.

Follow up:

But Thoma’s argument contains a few puzzling passages that repeat and reinforce some common misconceptions about the relationships among spending, bank lending and bank reserves; and it is worth spending a few words to challenge these misconceptions once again, because to the extent that they still have wide currency they stand in the way of a clear grasp of the nature and limits of monetary policy options. Thoma first makes the following claims about bank reserves:

One of the main ways the Fed stimulates the demand for goods and services is by giving the banks more money to lend through what are known as open market operations. But if this money simply piles up in banks as excess reserves instead of being used to make new loans to consumers and businesses, it won’t have any effect on the demand for goods and services and it won’t cause prices to rise.

Excess reserves are, in fact, piling up in banks – from near zero before the recession to around $1.75 trillion today – instead of flowing into the economy and offsetting the fall in demand from the recession. Because of this, demand is too low, unemployment is too high, and inflation has consistently been running below the Fed’s two percent target.

He then goes on to suggest that the Fed should impose a negative rate of interest on excess reserves:

But now, when unemployment is the problem, the Fed seems unwilling to push the limits to the same degree. For example, the Fed could charge banks for holding excess reserves instead of paying them interest on those reserves as it does now. With such a penalty in place banks would have a much larger incentive to make loans, and some of the piled up reserves would leave banks and turn into new demand for goods and services. That’s just what the economy needs.

Let’s set aside for now the questions of whether the Fed can do anything in the present environment to stimulate demand and hiring, and whether setting a negative interest rate on excess reserve balances would help accomplish those ends. Those have been persistently controversial questions. But what should not be controversial is that the picture Thoma paints of excess reserves piling up in reserve accounts instead of “leaving” the banks and “flowing into” the economy is very inaccurate. This is easy to see by considering a few hypothetical examples.

Suppose Maple Valley Bank makes a new $100,000 loan to Granite Construction.  The bank creates a new demand deposit account for the construction company, and credits $100,000 to that account. In exchange, it receives from Granite Construction a promissory note promising the return of the $100,000 plus a certain amount of interest to be paid over a defined period of time. At this point Maple Valley bank’s total reserves have not changed at all.

Now suppose Granite Construction begins to spend the $100,000 it has been loaned, mainly by writing checks against the new account. Some of those checks are written to other companies and individuals who also bank at Maple Valley Bank. When those checks are deposited back at Maple Valley Bank, and the payments are settled and cleared, the result is that the deposit accounts of the payees are credited by the appropriate amounts and the deposit account of Granite Construction is debited by exactly equal amounts. Again, there is no change in Maple Valley Bank’s reserves.

However, some of those checks will go to companies and individuals who bank at other banks. Suppose Granite Construction issues one check to Seacoast Cinder Blocks for $25,000, and another check to Rob Handy, a temporary day laborer, for $200; and suppose that both of these payment recipients bank at Ridge Bank, another local bank, where they deposit their checks. This time, when the payments are settled and cleared, a payment has to be made from Maple Valley Bank to Ridge Bank for $25,200. At the regional Federal Reserve Bank where both banks hold their reserve accounts, the reserve account of Maple Valley Bank is debited by $25,200 and the account of Ridge Bank is credited by $25,200. But note that while the reserve balances of the two banks have changed, this operation obviously does not reduce the total reserves of the banking system at all.

Now, some of the total reserves held by banks are held in the form of vault cash, and it is possible for those reserves to temporarily leave the banking system entirely. For example, Rob Handy now has $200 more in his account at Ridge Bank. Suppose he withdraws $40 in cash to meet his out of pocket expenses. The total reserves of Ridge Bank have been reduced by $40. Over the next few days, Rob buys some doughnuts at the Donut Kettle, a couple of lunches at the Sally’s Sandwich Nook and few groceries at Biddleford’s Supermarket. Those local businesses collect the cash payments and deposit them the next day at their banks, where the money goes right back into bank reserves as part of vault cash.

So cash withdrawals made for the purpose of spending also do not change the level of bank reserves, since that cash is continually flowing both out of some bank vaults and into other bank vaults as the spending takes place. Now, it is always possible that Rob puts the cash under his mattress or leaves it on top of his dresser for an extended period of time. To the extent that this might happen on a widespread basis over some period of time, it is possible that aggregate bank reserves might be reduced for that period of time. But then the expansion of lending would be having no effect on spending. If an increase in lending actually stimulates spending, cash withdrawals are always making their way back into bank cash reserves in very short order.

So even if some bolder form of monetary policy can be effective in stimulating more lending and spending, one should not expect to see the impact of that stimulatory policy show up in the form of overall reductions in bank reserves, with excess reserves flowing out of reserve accounts and bank vaults and “into” the economy. And by the same token, one should not look at the phenomenon of bank reserves “piling up” as evidence of the failure of monetary policy to cause those reserves to be loaned out. Reserves in the aggregate are not loaned out. Apart from relatively small fluctuations in the amount of physical cash being held by the public, bank reserves don’t leave the banking system.

I really think it is important here for pundits and informed members of the public not to lose hope about the possibility of fiscal expansion. We have had four years of confusion and time-wasting debate about various misguided austerity theories, but those theories are now in the process of crashing and burning. We have yet to see what can happen if economists, economics bloggers and the public begin to mobilize a call for intense political pressure on Washington (and other governments) to reverse the austerity push and expand spending.

The US government is an extremely  large public enterprise, and a tremendously important part of our national economy. It produces a great number of public goods and services and employs millions of people, and it also helps fund state and local governments. It is a consumer, investor and employer. But throughout the Obama administration, and especially following the election of the reactionary Republican Congress in 2010, we have seen a massive decrease in government consumption and gross investment, and unprecedented reductions in government employment. Public enterprise is collapsing at a time when we need it most, both to help stabilize the economy and to drive the next stage of national development and progress. The best way for government to stimulate demand is to expand its role as a demander. The largest potential customer in the known universe – the United States government – has to step up its purchases, step up its hiring and step up its leadership role in the economy.

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