Banks don’t “lend out” excess reserves

I recently came across this S&P report by S&P’s Chief Global Economist Paul Sheard debunking common misunderstandings about the Federal Reserve, QE and excess reserves. I’m posting it here to clear up misinformation about what banks do with their excess reserves at the Fed. I’ve definitely been led astray in the past by economists regarding this matter.

The key point, however, is that the existence of excess reserves in the banking system does not loosen any reserve constraint on the ability of banks to lend because there was no reserve constraint to begin with (of course, the stance of monetary policy, notably the interest-rate policy decision, does affect the demand for bank lending and the willingness of banks to lend, but, to repeat, given the interest-rate setting, the central bank supplies whatever reserves are demanded).

It might be asked: if banks cannot lend the excess reserves that the central bank provides, what is the point of the central bank supplying them? The answer to that question is simply that QE does serve to ease financial conditions. Technically, QE allows the central bank to change the composition of the aggregate portfolio held by the private sector; the central bank takes out of that portfolio the government debt and other securities it buys and replaces them with reserves and bank deposits (the latter when it buys assets directly from the public or its nonbank financial intermediaries) (10). This has an easing effect via so-called “portfolio rebalance effects,” including but not limited to the associated downward pressure that QE puts on the yield curve (11).

When the Federal Reserve buys treasuries via open market operations, they credit the sellers’ accounts at the Fed in order to complete the transaction. This drives up the level of excess reserves participating banks have on account with the Fed. These reserves will never be lent out unless, for some strange reason, banks start handing out cash whenever they lend. This doesn’t happen because, as Sheard explains earlier in the essay, banks create credit out of thin air–not out of reserves. As he explains, “Loans create deposits, not the other way around.” The only way for reserves to shrink is for the public’s demand to hold physical cash increased.

Up stocks, down fixed-capital

Thad Beversdorf with a nice piece at Voices of Libertyon why the Fed is destroying the middle class.

However, we have to remember that at the end of the day corporations are just money allocators like any hedge fund or mutual fund manager. CEOs are sworn to maximize shareholder funds. Understanding this we must expect corporations to invest based on the best risk/reward scenario available to them as we do for any other investors. Herein lies the invalidity of the Fed’s assumptions.

The Fed assumed that low borrowing costs and high equity values would drive corporate fixed capital investment. It did drive investment, but not fixed capital investment. Corporations, like all other investors, realized the stock market was being backstopped by the Fed. This essentially gave all market long side participants a free put option. In other words, the Fed was protecting folks from any downside risk by explicitly stating they were targeting higher stock prices. Thus corporations and everyone else realized the smart money was directly tied to the market.

The result, Beversdorf argues, is inflated stock prices at the expense of fixed capital investments. This promotes economic stagnation–no real growth in job-creating, fixed capital investments concurrent with strong growth in financial markets.

Is the Fed Really to Blame?

bernankThis article was originally published at ValuesandCapitalism.com on August 14, 2012.

With the passage of Ron Paul’s “Audit the Fed” bill in the House recently, monetary policy is once again becoming a mainstream political issue. And it’s about time. For decades, Americans have stood idly by as inflation destroys the value of their hard-earned savings with the sole purpose of pushing economic problems further into the future.

But while Paul and many Republicans like to blame the Federal Reserve, the fact is that inflation has as much to do with your own personal spending habits as it does with Bernanke and his cohorts at the Fed.

According to the BEA, Americans saved an average of 3.9% of their income last May. Over the past several decades, this number has been steadily declining. Indeed, just 30 years ago, the personal savings rate was near 10%, meaning Americans saved almost three times more money than they do today.

While there are various explanations for this decline in personal savings, perhaps the most popular among conservatives is that reckless inflationary policies scare many would-be savers into spending more money to avoid higher prices in the future. Thus, the Fed and big government would be to blame, as only they have the power to legally create money out of thin air.

But another perspective on this decline—while less convenient—is equally plausible and decidedly more ominous. That is, Americans’ failure to save money left little reason for them to actively oppose the inflationary environment that government has always desired. Inflation, then, is a resultand not just a cause of Americans’ own personal financial irresponsibility.

For example, Americans who save a portion of their income every year have much to lose to inflation. Indeed, the more money they’ve put away in the past, the more loss they will experience as the Fed expands the money supply and devalues the dollar. Savings do not adjust for inflation.

On the other hand, Americans who do not save have virtually nothing to lose—they have no substantial wealth for inflation to diminish. Yes, their groceries might become more expensive. But wages adjust for inflation all the time, and inflation for spenders is simply nominal—very little happens to their levels of real wealth.

That said, as Americans continue to spend more and more, they will become increasingly less likely to vote against inflation, let alone actively oppose it. And the further they go into debt, the more an inflationary status quo will become desirable. Currently, levels of personal debt and spending in the US are so high that any serious attempt at curbing inflation through legislative means is probably unrealistic. The reality of inflation simply does not hit home for most Americans, despite the fact that its long-term consequences are disastrous.

Of course, Keynesian economists often welcome this increased spending. Too much saving, they argue, is an impediment to economic progress. But saving and investment are the true engines of economic growth, and without a private sector backed by financially sound individuals, sustainable progress over time will remain an economic fantasy.

No doubt, blaming “average Joes” for inflation isn’t as marketable as blaming Bernanke. But when Americans are saving less than four percent of their income, the effects of inflation become palatable—even attractive—to many Americans, and elected officials find the support they need to fund excessive spending with irresponsible inflation.

Congress and the Federal Reserve are not blameless, however. An audit of the Federal Reserve should have happened decades ago, and the ever-expanding government “safety net” discourages rainy day saving. But before you go marching on Washington, make sure your own financial house is in order.

As long as Americans continue to spend themselves into oblivion, inflation will continue to run its destructive course. We are a republic, indeed. Our elected officials must pass our test if they are to remain in power. Thus, as we seek to preserve capitalism, reexamining our own values and habits will be far more effective than blaming those to whom we ourselves give power. Indeed, how much we spend is ultimately up to us—a matter of personal responsibility.

In the end, Congressman Ron Paul puts it well:

We would like to think that all we have to do is elect the right politicians and everything is going to be OK. But the government is a reflection of the people and their values. That is why the burden is on people like you to make sure we have those values.

Read the rest at ValuesandCapitalism.com.