09 Apr 2020

Do the Econ Textbooks Get Money & Banking Backwards?

All Posts, Banking, Economics, Money 5 Comments

The latest installment in my series on Understanding Money Mechanics for the Mises Institute. Once I dove into this one, the solutions seemed pretty obvious. Tell me what you folks think. An excerpt:

In chapter 5 we reviewed the textbook analysis of how a central bank buys government debt in “open market operations” to add reserves to the banking system, with which commercial banks can then advance loans to their own customers. In this respect we merely summarized the textbook explanation that economists have given for decades. However, over the years a chorus of critics has alleged that this orthodox view is, if anything, backwards, and that in reality commercial banks take the lead in making loans without regard to their reserves.

In order to have a concrete example of this rival perspective, we will draw on a 2014 report issued by the Bank of England entitled “Money Creation in the Modern Economy.”1 Coming from the UK’s central bank—their counterpart to the United States’s Federal Reserve—this is an authoritative example of the critique of the orthodox explanation for money and banking.

For our purposes in the present volume, we will select three of the alleged “myths” of money creation that the Bank of England report seeks to correct. (The serious student should of course read the original report for a full understanding of the challenge.) Our goal here is neither to affirm the orthodox explanation nor to concede its defeat, but rather to use the Bank of England’s commentary as a springboard for ensuring that current readers truly understand how central banks and commercial banks work together in a fiat-based system to create money.

5 Responses to “Do the Econ Textbooks Get Money & Banking Backwards?”

  1. Transformer says:

    Bob states:

    ‘any individual bank can go to the federal funds market and borrow enough reserves to satisfy its individual requirements’


    ‘In order to maintain its target, the Fed would [] engage in open market operations, in which it would buy new assets and create more reserves’

    I think these 2 statement lead to the conclusion that it is not mere semantics to say ‘Banks Don’t Lend Out Reserves’ and ‘Banks Don’t Worry About Reserve Requirements When Making Loans’.

    Here is my thinking:

    Take a contrived example of an economy with a single bank (and no central bank) where gold is used as money. It operates 100% reserve. The bank has to attract borrowers in order to lend money out. It very clearly is lending out reserves and does have to worry about reserve requirements when making loans.

    Then a central bank is created and the system switches to CB issued fiat money. The central banks operates a policy where it will lend any amount of fiat money to that one bank at 5%. This is a game changer for the bank. It still has to worry about lending as it doesn’t want its borrowers to default. But it will be prepared to make any loans to credit-worthy customer at 5% (adjusted for risk and profit margin) as it knows it can always maintain its 100% reserve by borrowing them from the CB. It will still borrow from sources other than the CB when it can attract lenders at less than 5% but I think it would true to say this bank is no longer truly lending reserves and certainly not worrying about reserve requirement when making loans.

    Introduce more banks into the system who now compete with each for both lenders and borrowers as well as lending to each other via an inter-bank market. The CB rather than lending directly to banks at 5% achieves exactly the same effect by adjusting the quantity of base money to make sure than the going rate on the inter-bank market is 5%. An individual bank in this competitive scenario is in exactly the same position as the single bank in the initial example where it can borrow direct from the CB.

    Finally, remove the 100% reserve assumption. If the reserve requirement is set by the CB to something less than 100% then this just reduces pro-rata the amount of reserves needed by the system. If there are no reserve requirements so that banks just keep reserves that are operationally optimal then again having a guaranteed borrowing rate on the inter-bank market would still appear to free banks from having to worry about reserve requirement when they make loans and this that means they are not actually lending out reserves in the first place.

    • Transformer says:

      To put the case in a different way:

      If someone offers to lend me unlimited amounts of dollars at 5% then I have a business model open to me where I can sell IOUs for present money in exchange for future money. As long as I can find borrowers at a rate above 5% who are sure to pay me back then I am guaranteed to make money even I start out broke. Every time someone comes to me to redeem one of my IOUs I just borrow the money to pay them with from my guaranteed loan source (and pay it back when my borrowers pay me back). I am neither lending reserves nor do I care about reserves. If someone insists that I keep a proportion of my loans as reserves then I just have to borrow sooner than otherwise but this just reduces but does not eliminate my profit.

      I know this is an oversimplification but is this not the situation that commercial, banks more-or-less are in ?

      • Tel says:

        As long as I can find borrowers at a rate above 5% who are sure to pay me back then I am guaranteed to make money even I start out broke.

        Incorrect. The central bank normally only offers very short term loans (can be as short as only 1 day) and it changes interest rate at will, for what might be economic or political reasons or no reason at all.

        You however need to lend for a longer term, and if you have mortgage contracts, etc then it’s physically impossible to liquidate that type of debt at short notice. As a consequence you are not guaranteed to make money, you can get stuck between a rock and a hard place. In some cases banks pass that pain onto the mortgage holder (variable rate mortgages) or they might have a go at using political leverage to control what the central bank does with interest rates.

        There’s also taxation and running costs at every level, and the banks need sufficient liquidity to maintain day to day clearing operations else they cease trading.

        • Transformer says:

          ‘Incorrect. The central bank normally only offers very short term loans (can be as short as only 1 day) and it changes interest rate at will, for what might be economic or political reasons or no reason at all.’

          Well I did say my example was as oversimplification !

          However I think the fact that the CB offers only short term loans is irrelevant for my point – as long as the CB uses OMO to maintain its target rate then individual banks and the banking system as a whole will be able to make new loans without needing to worry that a shortage of reserves and upward pressure on interest rates will be created (which is not to say that in reality banks will not still be competing to find depositors),.

          The fact that the CB may change its target rate may affect bank profitability if they lend without bearing this possibility in mind and get caught out, but again I think this is irrelevant to the real point which is about the role reserves play for banks making loan decision under the current Fed system.

  2. Tuppenceworth says:

    Very clear — think I git it.

    Rookie question probs, but is there any reason why central banks don’t just lend to commercial banks directly by undercutting the inter-bank rate? Why do they buy completely different debt and let the sellers in turn deposit the new money in the banks in exchange for modest interest rates?

Leave a Reply