Where does money come from? No, I mean currency, where does currency come from? You can go to the bank and cash a check and the bank will give you greenbacks. Currency. Base money.
Yeh, you could cash a check at the local Mom-n-Pop. But the currency you get from them was already in the economy before you wrote the check. So, cashing a check at the Mom-n-Pop doesn't increase the amount of currency in the economy.
Cashing a check at the bank does increase the currency in the economy. That's the only legal way I can think of, to increase the currency.
When you do that, when you cash a check at the bank, the bank takes money out of the "vault" to pay you. Vault cash is "reserves". So when you cash a check at the bank, currency comes out of reserves and goes into your pocket. Goes into the economy.
When you cash a check at the bank, the amount of money called "reserves" decreases and the amount of currency increases.
On Graph #1, the blue line is currency. The red line is vault cash and other reserves:
For a very long time, until 2008, currency was larger than reserves, and growing faster than reserves. So how is it that Steve Roth can say
Reserves can’t leave the system, whether in a flood or a trickle.The blue line going up is reserves leaving the system. The blue line shows how much was taken out of reserves, over the years. A lot, actually.
All of the increase in cash in the economy, represented by the blue line, had to come out of vault cash, had to come out of reserves. If we just got it from Mom-n-Pop, the blue line would have stayed flat. The cash came out of banks. It came out of reserves.
Obviously, the Fed compensated for all that check-cashing by creating new reserves, so the red line never went to zero.
Steve Roth writes:
The banking system can’t remove reserves from the system by transferring them to the nonbank sector in exchange for bonds, drill presses, or toothpaste futures.
Maybe not. But anyone cashing a check at a bank removes reserves from the system.
Circulating currency increased from about 2½ times reserves (1960) to about 17½ times reserves (2008). This difference is not trivial.
I'm not entirely sure of why you want to look at circulating cash. You cant do anything different with circulating cash than you can do with demand deposits.
ReplyDeleteChanging all demand deposits to cash tomorrow does nothing to spending power. It would signal a lack of faith in our banks maybe (likely). In fact, buying large ticket items would be much more difficult with all cash it seems to me.
Yes vault cash is part of reserves but reserves are not just or simply vault cash.
I wonder if your cash to reserve ratios between 1960 and 2008 can be attributed to changes in reserve ratios required by fed to a large degree?
Circulating cash is one part of "base money" and reserves are the other part. I am looking at circulating cash because withdrawing money in that form reduces reserves. Steve Roth says reserves can't leave the system, but obviously they can.
ReplyDeleteIf money is withdrawn as currency from reserve accounts at the Fed, I think it must become "vault cash" because only banks have reserve accounts at the Fed. The transfer from reserve account to vault cash does not reduce the level of reserves, does not change the quantity of base money, and does not change the quantity of circulating currency. But withdrawals from vault cash do change reserves (down) and circulating currency (up).
I am looking at circulating cash because withdrawing money in that form reduces reserves. Steve Roth says reserves can't leave the system, but obviously they can.
Still wonder what that means though. The reserves are there originally as a reflection of the demand deposit, which then gets reduced when cash is withdrawn. Its the demand deposit reduction that drives the reserve change so to speak, but this is all due to fed rules about reserve ratios and the sort as I understand it.
ReplyDeleteI think Steve is making his point in response to people who think that increasing reserves in the system will be inflationary because these new reserves will eventually get loaned out or make there way into the economy creating hyperinflation. But reserves, in the form of cash as you are examining it, only come out when someone has a demand deposit account they decide to liquidate. The demand deposit account is already there and was not created because the reserves increased. So the demand deposit leaves the system and the reserves follow, so to speak. Thats how I try and look at it anyway. I dont think its just wordplay either because getting the direction right matters I think. I sense you are making a little bit of a monetarist error and putting too much emphasis on reserves, as if they are a driver, when they are a passenger.
If everyone liquidated their demand deposits tomorrow of course there wouldnt be reserves because there would be any need for banks anymore to settle payments, we'd all be doing it ourselves with little pieces of paper.
Thats why we have fed deposit insurance so people will leave money in demand deposit accounts and not kill off banking by using all cash.
Ill just add though that much of banking needs to be killed off!
ReplyDeleteWell yeah, there would have to be money in a checking account (aka "demand deposits") in order to cash the check and receive the currency. (Goes without saying?? Guess not!)
ReplyDeleteBut I don't think I'm putting too much emphasis on reserves. I'm trying to put emphasis on what I see as false statements by Steve Roth. If he thinks fears of hyperinflation are wrong, that's fine with me but he ought not use bad arguments to try and shoot them down.
Interestingly, with a reserve requirement of 10% (and no excess reserves) one guy cashing a $1 check creates a $9 imbalance. Either nine additional dollars of demand deposits have to go out of existence, or 90 cents must be dug out from under couch cushions and put into the vault.
Alternatively, I suppose, $9 could move out of checking and into savings, where the reserve requirement is zero.
"The reserves are there originally as a reflection of the demand deposit..."
I like that.
I wish I could find it again but years ago I read something about how when we were on gold standard countries used to have to ship boats with gold to settle payments with other countries. This was obviously fraught with potential hazard so the international financial system came up with a way to track and account for gold payments at some remote location. Each country had a % of their gold there and gold was moved around form Frances vault to Germanys vault or Canadas vault when a transaction took place. This was a kind of reserve accounting system.
ReplyDeleteNow we have the Fed which tracks each individual banks deposits and is the central scorekeeper for these transactions between banks. So when a banks deposits increase (when a loan is made) the reserve must increase to reflect that potential payment down the road. A lot of the 2008 increase, as I understand using this mental framework, could best be understood as the fed preparing for an increase in not just number but nominal amounts of transactions due to potential parties looking to liquidate positions in contracts like CDSs or MBSs or any other number of exotic financial instruments that have been priced and sold they no longer wish to "hold" but want to sell for cash. Its been speculated that there are over 50 trillion in various contracts which could be liquidated so the reserve system must now increase its levels to prepare for this.
Of course if these all try to liquidate in short order many will be worthless so it must be a slow unwinding to avoid price collapse.
So thats where I get the "as a reflection of".
Reserves are used to settle deposit payments. When one party to the settlement is outside the banking system, reserve levels go down.
ReplyDeleteWhere does that leave the bigger point of the relationship between reserves and money you can spend and whether reserve issuance constitutes "printing money"? There's this:
"Well yeah, there would have to be money in a checking account (aka "demand deposits") in order to cash the check and receive the currency. (Goes without saying?? Guess not!)"
I'm glad you said it. Deposits are what gets spent. Until a deposit transaction requires them for settlement, reserves are inert. Reserve levels could sit anywhere from zero to infinity with no consequence because they only exist to settle demand deposits. Adding more reserves doesn't leave anyone with more money to spend.
Most deposit transactions get cleared without ever involving reserves for settlement at all as banks net them out internally or between one another in clearinghouses.
"Interestingly, with a reserve requirement of 10% (and no excess reserves) one guy cashing a $1 check creates a $9 imbalance. Either nine additional dollars of demand deposits have to go out of existence, or 90 cents must be dug out from under couch cushions and put into the vault."
The Fed is the couch. If the system needs 90 cents, the Fed provides it, at some cost.
"Reserves are used to settle deposit payments. When one party to the settlement is outside the banking system, reserve levels go down."
ReplyDeleteHi Gee. I like that. It makes a lot of sense to me. I was saying there are two parts to base money. The two parts are the "outside the banking system" part (currency) and the inside the banking system part (reserves). I like it.
And then reserves are further subdivided into the "outside the Fed" part (vault cash) and the "inside the Fed" part...
Symmetry.
Cullen Roche talks about outside money and inside money. All bank loan created money (which is most of the money in our system) is inside money, everything else is outside money. The outside money is the much smaller amount yet somehow gets focused on the most.
ReplyDeletegee
ReplyDeleteHow often is a party to a settlement outside the banking system?
"You cant do anything different with circulating cash than you can do with demand deposits".
ReplyDeleteActually you can. All sorts of things. Also, deposits only have value as long as the bank in which they are held remains solvent. When a bank goes bust its deposits cease to have value as 'money-things'. Cash, on the other hand, would continue to exist as money even if every bank went bust.
"The reserves are there originally as a reflection of the demand deposit"
Incorrect. There is no 'reflection' of anything. Reserves are simply bank assets - money that banks own - and deposits are simply bank liabilities - money that banks owe. It's that simple.
".. the demand deposit, which then gets reduced when cash is withdrawn".
Not necessarily the case. For example, if I receive a check from the government and then cash it at my bank, no bank deposits are reduced or created. It's a simple check-cash transaction, with no bank deposits involved.
"Its the demand deposit reduction that drives the reserve change so to speak"
That's nonsensical. If you have a $100 bank deposit this simply means that your bank owes you $100. If you withdraw $100 from your bank in cash, your bank then no longer owes you $100. As such it debits your deposit account by $100. It's very simple.
"But reserves, in the form of cash as you are examining it, only come out when someone has a demand deposit account they decide to liquidate".
Wrong. See above.
"The demand deposit account is already there and was not created because the reserves increased".
Not necessarily. For example: say the Treasury sells bonds to banks and deficit spends. Reserves increase and bank deposits also increase as a result of the deficit spending.
"So the demand deposit leaves the system and the reserves follow, so to speak"
Wrong. Demand deposits don't "leave the system" when cash is withdrawn. They are simply *deleted*. They cease to exist.
"I dont think its just wordplay either because getting the direction right matters I think"
But you're not getting "the direction" right.
"I sense you are making a little bit of a monetarist error and putting too much emphasis on reserves, as if they are a driver, when they are a passenger".
"driver" and "passenger" are meaningless metaphors in this context.
"If everyone liquidated their demand deposits tomorrow of course there wouldnt be reserves"
If literally everyone withdrew their money from the banking system then the banking system would be bankrupt. However, banks would continue to exist as the government would necessarily nationalize some of them.
Also, commercial banks aren't the only organizations that hold accounts at the Fed, and demand deposits aren't the only kind of bank deposits that exist.
"Thats why we have fed deposit insurance so people will leave money in demand deposit accounts and not kill off banking by using all cash".
We have deposit insurance to provide a degree of security for the population, and to reduce the likelihood and severity of systemic banking crises. If there was no federal deposit insurance, banks would still exist, but the system would be much more unstable and insecure.
"Deposits are what gets spent. Until a deposit transaction requires them for settlement, reserves are inert"
ReplyDeleteCash also gets spent. Reserves are used to make payments between commercial banks and any other organizations that hold accounts at the Fed, such as foreign central banks and the US treasury. These payments do not necessarily have anything to do with commercial bank deposits.
"Reserve levels could sit anywhere from zero to infinity with no consequence because they only exist to settle demand deposits".
No they don't only exist to "settle demand deposits". That's also an incorrect description. Reserves settle payments, not "demand deposits".
Reserves could not "sit anywhere from zero to infinity with no consequence". An infinite amount of reserves would mean an infinite amount had either been lent or spent by the government.
"Cullen Roche talks about outside money and inside money"
ReplyDeleteInside and outside money are very old, very well-known concepts. Cullen didn't invent them. I hope you're aware of that.
"The outside money is the much smaller amount yet somehow gets focused on the most".
Anyone who leaves out 'inside money' (bank credit) from their analysis is silly. However the fact that there might be more 'inside money' in existence than 'outside money' doesn't somehow mean that 'inside money' is more "important".
Under the gold standard system, in which gold was a form of "outside money", there was far more 'inside money' in existence (in the form of bank credit, bank notes, etc) than there was gold. Which was more "important"?
'Inside money' is a promise to pay 'outside money'. This is the case whether the outside money in question is gold coins, federal reserve notes, or reserve balances.
Hey James
ReplyDelete" deposits only have value as long as the bank in which they are held remains solvent. When a bank goes bust its deposits cease to have value as 'money-things'."
Only for those over $250,000... per bank. Not really an issue in most cases, banks go bust every day. and virtually no one loses their deposits. Equity position?..... yes. Not depositors
"If literally everyone withdrew their money from the banking system then the banking system would be bankrupt. However, banks would continue to exist as the government would necessarily nationalize some of them."
They might "exist" but if no one is using them, depositing in them or taking loans from them they arent making any profits. This is certainly an extreme example but with no one taking loans or making deposits there would be no reserves. what point would they serve?
Again, an all cash economy doesnt need banks which is one reason why we are encouraged to keep our money in banks by getting the protection of deposit insurance. its there to protect banks too.
"An infinite amount of reserves would mean an infinite amount had either been lent or spent by the government. "
Reserves arent lent or spent by the govt. You are making an error that exogenous money people make.
Im quite aware that Cullen wasnt the inventor of the inside outside money nomenclature but he is the first I had really heard talk about it.
I dont beleive I used the term more important when talking about inside money, but it IS the predominant form of money so therefore it is the place where most transactions take place. Outside money should be understood but not overemphasized if one wants to understand the monetary factors which affect our macroeconomic metrics.
"Only for those over $250,000... per bank"
ReplyDeleteInsured depositors are made whole by the government, not by the bust bank.
"with no one taking loans or making deposits there would be no reserves. what point would they serve?"
Well for one thing people would still have to pay taxes, and the government would still have to make payments. It's not going to start doing it all in cash is it.
"Again, an all cash economy doesn't need banks which is one reason why we are encouraged to keep our money in banks by getting the protection of deposit insurance"
Banks existed before federal deposit insurance.
"Reserves arent lent or spent by the govt".
Yes they are. The central bank lends reserve balances and purchases assets with reserve balances, the treasury spends reserve balances. Reserve balances are just cash or currency in electronic form.
"it IS the predominant form of money"
What do you mean by "predominant"?
"Outside money should be understood but not overemphasized if one wants to understand the monetary factors which affect our macroeconomic metrics".
But what do you actually mean by that? It just sounds vague and meaningless.
Hello again James!
ReplyDelete"Insured depositors are made whole by the government, not by the bust bank. "
My wording was sloppy 250,000$ per person, per bank. I can have 250,000 at ten different banks and have 2.5 million insured that way. But...... in a sense banks pay because they pay into the FDIC insurance even though its not enough in cases of disaster.
"Well for one thing people would still have to pay taxes, and the government would still have to make payments. It's not going to start doing it all in cash is it."
Actually in my extreme example.... yes, it would be all cash. Reserves are a banking system thing. King issued coins and tariffs dont require a reserve system.
"Banks existed before federal deposit insurance."
Of course they did! But our modern banking system would fall apart without deposit insurance. You think the people today would accept their deposits being risked in case of bank failures? The only entity that Congress might be more trusted than is big banks... and Congress has a less than 30% approval rating. For modern banking to be profitable consumers must NEED it to secure loans and must use it to store their savings. If neither of those conditions is met..... bye bye banking! Not a likely scenario I agree but using the extreme to make a point that all cash economies dont need banks and deposit insurance is a way to keep people from abandoning bank deposits.
"Yes they are. The central bank lends reserve balances and purchases assets with reserve balances, the treasury spends reserve balances. Reserve balances are just cash or currency in electronic form."
Thee are all intrabank transactions with very little affect on real activity and prices under most conditions
"What do you mean by "predominant"?"
Do I really need to answer that?
"But what do you actually mean by that? It just sounds vague and meaningless."
Our macroeconomic metrics of output, employment, and inflation are most affected by our inside money system. Its banking activity, generated by private sector agents, which has the largest influence on output, employment and inflation.
First of all, if everyone tried to take all their money in cash it would take years for the bureau of engraving to print up all the notes.
ReplyDeleteSecond, it would not "kill the banks". The banks would have to borrow all the currency from the FED instead of from depositors and would pay the interest to the FED. Banks would still have their interest income from loans. The banks balance sheet would not be impaired. Banks could continue to make loans (in cash).
It is the non-banks that would be in a mess. Where to store all the money and keep it safe? The velocity of transactions would slow down as every transaction required the physical exchange of money.
"in a sense banks pay because they pay into the FDIC insurance even though its not enough in cases of disaster".
ReplyDeleteFDIC has the value it has because it is backstopped by the state, not because banks pay into it.
"Reserves are a banking system thing".
Reserve balances are deposits held at the central bank. They are simply currency or cash in electronic form. Banks are not the only organizations that hold deposits at the central bank.
"Actually in my extreme example.... yes, it would be all cash".
No it wouldn't because government transactions amount to trillions of dollars per year.
"...there is a continuous flow of funds from private depository institutions to the TGA [Treasury General Account at the Fed] and back again. During fiscal year 2010, $11.6 trillion flowed into, and then out of, the TGA".
www.newyorkfed.org/research/current_issues/ci18-3.pdf
If in an imaginary extreme scenario the entire banking system completely collapsed, the government would nationalize banks and use them at the very least to collect taxes and make payments.
During the recent financial crisis governments around the world partly or completely nationalized many banks, as well as supporting the banking system by other means.
"all cash economies dont need banks and deposit insurance is a way to keep people from abandoning bank deposits".
If there was no FDIC banks would still exist.
"Thee are all intrabank transactions with very little affect on real activity and prices under most conditions"
No they are transactions between the state, the banking system, and the wider economy.
Government spending has a direct effect on real activity. The central bank has an effect on real activity via interest rates, among other things.
When the Treasury spends, its account at the Fed is debited and a reserve account at the Fed is credited.
"Do I really need to answer that?"
I didn't mean "what does predominant mean".
I meant "what do you mean when you say that inside money is the predominant form of money".
"Our macroeconomic metrics of output, employment, and inflation are most affected by our inside money system. Its banking activity, generated by private sector agents, which has the largest influence on output, employment and inflation"
All you're really trying to say is that in the US the private sector is larger than the public sector. I think people know that already. You're getting that confused with vague talk about banks and inside money.
How often is a party to a settlement outside the banking system?
ReplyDeleteIt would be cash withdrawals by private actors or payments to the government. So, often... but not a big amount compared to the total and most of that cash comes right back into deposit accounts which is why circulating cash tends to get reduced to a footnote.
More generally on the topics touched on in this series of posts, Scott Fullwiler really clarifies and nails down what's going on in the plumbing here:
An Endogenous Money Perspective on the Post-Crisis Monetary Policy Debate
It's by far the best source I've come across.
Compare Fullwiler's scholarly text to the infantile gibberish Cullen Roche comes out with.
ReplyDelete