Answers to readers' questions on "Why Did It Take Inflation So Long To Show Up?"
These questions deserve a full answer, so I'm answering them in a dedicated post
I received several great questions on my last article. The questions are reprinted here, with my replies in bold print. I appreciate the interaction, as discussion helps us understand money creation better.
Reader Duncan wrote:
“Thanks Jim, very informative.
“Question1 p16: After asset purchase, the commercial bank sees a 1:1 increase in reserves and deposits. Can the commercial bank then use those new reserves to potentially make 10x new loans (i.e., is there a multiplier effect due to min reserve requirements, and did commercial banks do this)?
The short answer is yes, but there is some nuance here. Until March of 2020, the Fed required that every US bank had to carry a minimum amount of bank reserves as a fraction of its loans - a “reserve requirement ratio.” If the bank’s reserves fell below the RRR (which was much less than 10%), the bank would have to go to another bank and borrow enough reserves to maintain its minimum. However, in March 2020 the Fed reduced its RRR to zero. This new policy matched the zero RRR in some other countries, such as the UK and Canada, which have not required reserve minimums for many years. The important point here is, bank regulators (in our case the Fed) could specify a minimum level of reserves to constrain loan formation, but, in fact, this has not been done for many years. Instead, central banks, including the Fed, have always supplied the banks with sufficient reserves to meet cash withdrawals as the commercial bank loans and deposits expand. So loan growth has determined reserves, not the other way round. As the Bank of England article which I cited explains, reserves are not a constraint on loan formation. The major constraints on loan formation are market factors (mostly profit and loss) and regulatory factors, such as risk assessments.
“Question 2 p16: What happens when the government debt held by the Fed matures and rolls off? Does the process work in reverse: the commercial bank sees a 1:1 decrease in reserves and assets? (and can there potentially be a 10x decrease in commercial loans once those commercial bank reserves go down?) Or does the Treasury have an account directly with the Fed, and as the government debt rolls off, the assets and liabilities on the Fed's balance sheet go down with corresponding changes to the Treasury's balance sheet, with no impact on the reserves at the commercial banks?
When a bank loan or a bond held by a commercial bank is repaid, money, in the form of a bank deposit, goes out of existence. As you suggest, the process works in reverse of the process of money creation - there is a 1:1 decrease in bank liabilities (deposits, i.e., money) for every decrease in bank assets.
When the Treasury pays off a bond owned by the Fed, the Treasury, which holds its money at the Fed) reduces its deposits to extinguish its debt to the Fed, and the Fed asset disappears.
The Treasury does have an account with the Fed and holds its deposits in the form of reserves (obviously, not “bank reserves,” because the Treasury is not a bank). When we pay taxes to the Treasury, commercial bank deposits decline (money is “destroyed”), commercial bank reserves decline, and reserves held by the Treasury increase. The Fed’s reserves (liabilities) stay the same, they just shift from the commercial bank to the Treasury. Then when the Treasury spends money in the economy, bank deposits rise and reserves go back to the commercial banks. So the act of Treasury spending its money increases commercial bank assets (bank reserves) and liabilities (bank deposits - money) but does not change the Fed’s liabilities.
On the second part of your question, the loss of commercial bank reserves does not affect the bank’s ability to create new money (lend) because, as explained above, reserves are not a constraint on money creation. But it theoretically could be a constraint if the Fed were to reinstate its reserve requirements. Also, remember the main reason for the bank holding reserves: These reserves can be converted to currency on demand to meet withdrawals. Banks like to keep enough reserves on hand to avoid a run on the bank.
BTW, your question raises an interesting point about the definition of the money supply. M2, or spendable money, does not include the Treasury’s deposits at the Fed (called reserves) even though the Treasury can and does spend that money in the economy. This is why some measures of money supply, like the “Austrian Money Supply,” include these Treasury balances when calculating the money stock. I agree with the AMS definition on this point.
Comment regarding student debt: 92% of US student loans are federal loans, and 7.6% are private loans https://www.forbes.com/advisor/student-loans/average-student-loan-statistics/. After 2010 private loans were no longer underwritten and guaranteed by the Federal government; all guaranteed and subsidized loans are now processed and disbursed directly through the US Dept of Education http://www.collegescholarships.org/loans/guaranteed.htm . Conclusion: private banks were crowded out of student loans market 12 years ago, and clearly the blame for the explosion in education costs and student debt rests solely on the federal government.
Duncan Curry
Thank you for setting me straight on the guaranteed student loans - my information was clearly out of date! But, as you point out, student loans funded by taxpayers are still partially responsible for the soaring costs of college because this money creates demand for college services that would not normally exist. These kinds of transfer payments are not inflationary, because they do not create additional aggregate demand, they just shift demand from one place to another. So the price increase in college tuition would be offset by a price decrease somewhere else in the economy.
Best,
HardmoneyJim