|Interest bank pays to depositors is close to FFR.|
Wednesday, February 8, 2012
Money, Banks, and National Debt Unmasked - III
This blog will look at how bank loans inject dollars into the economy. Anyone, who has had a mortgage, car loan, or credit card knows something about debt. With that in mind, it may seem strange that we can’t understand national debt without knowing about banks and the mechanics of bank loans.
Banks Create Money out of “Thin Air.”
Most of the money in circulation is from bank loans. Bank money, as it is sometimes called, is issued in US dollars, but lasts only until the loan is paid off. It follows that for the economy to prosper there must be ongoing business activity requiring loans. When that activity declines, for any reason, businesses lay off workers and the possibility of recession looms.
It is perhaps more interesting to find that bank loans can create money “out of thin air.” Where do they get it? New money has to come from the only entity that can create dollars, the US government. Yes, the government is involved at the very heart of our private enterprise system; it supplies the money.
Deposits Increase a Banks Required Reserves
The Fed, our central bank, charters certain banks that subscribe to rules about capital-to-loan-ratio requirements, and regulations that allow those banks to have accounts with the Fed. The balances in those accounts are called reserves, and they are oh so very important to the banking system.
Reserves are money that banks must have in their vaults or on deposit with the Fed to meet withdrawal demands.
We know that a bank is not a piggy bank that holds our money in a box. When Anne deposits her money in a bank account, it creates a liability for the bank, because the bank must honor immediately any cash or check withdrawals demanded by Anne. Savings accounts are not “demand” accounts as there can be a time lapse for large transactions before withdrawal. As soon as the demand is made, the bank must make that amount of reserves available in it’s reserve account at the Fed so the check will clear.
Throughout the banking system these reserves are clearing balances to assure that our checks don’t bounce. Thanks to the Fed’s reserve management system, a check presented to any bank will be honored by any other bank anywhere in the nation.
Loans Create Bank Deposits
A loan begins with a creditworthy customer, Anne, who signs the loan note and the bank deposits the loan amount in her account at the bank. Look at the way assets and liabilities balance. Anne has the bank deposit as an asset and the loan as an equal liability. The bank has Anne’s account as a liability and her loan note as an equal asset.
As Anne pays off the loan her liability vanishes as does the banks asset. As Anne draws down her account she diminishes her asset, as well as the bank’s liability, and reserves diminish accordingly. The reserve requirements are passed to the banks where Anne’s checks were cashed.
There is no lasting effect on the total amount of all reserves in the banking system. If everyone cashed all their checks in one day, there would be enough deposits to cover them to the penny.
If Anne made good use of her loan, she might have acquired real assets (land, a patent, donkey and gold pan, etc.) and increased her wealth.
Banks Borrow to Meet Required Reserves
It is often thought that banks loan only what they have on deposit. That’s not the case. The Fed will make reserves available “out of thin air,” at a price, after a loan is made. In lending, banks are not reserve constrained; they are constrained by bank capital (net worth).
Interbank trading of reserves occurs in the overnight funds market at loan rates determined by the Federal Funds Rate (FFR) that the Fed controls as a matter of policy. To carry out its Congressional mandate to maximize employment and restrain inflation, the Fed tries to regulate the economy by adjusting the FFR, which is the cost of money to banks. It is expected that by raising or lowering the FFR the Fed can discourage or encourage loan activity, respectively.
Reserves that are not required for a particular day or other accounting period, usually two weeks, are considered excess. Because reserves earn little or no interest, banks like to keep them at a minimum by loaning them to banks with deficient reserves.
If a bank can not borrow reserves from other banks, it can borrow from the Fed’s “discount window” at a slightly higher rate to meet its periodic reserve requirements.
Bank loans inject money into circulation until the loan is paid off. If loans are made faster than they are retired, business activity and, along with it, the money in circulation increases. Otherwise, money in circulation and business activity decreases.
The Fed sets the FFR as a matter of policy, not through external markets.
Contrary to the common perception that reserves are loanable funds, reserves are not loaned out of the banking system; they are loaned only to other banks!
If money entered the economy only through bank loans, there would always be reserves available to meet demand. That is, reserves would equal deposits. In the next blog, we look at how government spending and taxation affect this picture.
Thanks to Duane and Joanne, who helped make this topic more understandable.