What does attitude have to do with anything? For a modern Economist or central banker (same thing), it’s everything. Expectations-based monetary policy calls for, and depends upon, manipulating emotions. But just whose emotions are the intended target?
You and me, to begin with, but then our employers and the corporate managers who run the firms particularly their hiring and investing staffs. Traders at the NYSE. The Federal Reserve, as the ECB or Bank of Japan, wants to get the whole lot to believe in what it is doing. If all of us in it think the agency is printing money, then we are expected to act in accordance.
Inflation is actually projected to result from this, rather than derives from any effective money being printed.
The issue, and the confusion, surrounds bank reserves. And not just in the modern sense, but also in how the modern view of them has turned a (very) blind eye to their historical precedence. Another example, in a long list of them, where central bankers having once been bankers makes a difference.
Not that the results were any better, but at least when there was disaster the nature of it might have been honestly evaluated and more realistically pinpointed; the very opposite of what goes on today under the disingenuous canvass of Positive Economics, its econometrics offspring, and all the Economists who treat these statistical equations as the ultimate truth – even when, especially when, reality turns out to be in stark contrast to them.
Everyone knows, as has been historically established, that printing money leads to inflation. Currency debasement, another term for it, has been tied to the general rise of consumer prices in every possible setting through time, many times getting out of hand leading to total currency collapse.
Is this one of those times? Bank reserves once again are making a lot of people nervous.
Hardly anyone, especially Economists, thinks much about what currency might have to be printed in order to effectively trigger this historic relationship. Currency as well as money have taken on many forms through the centuries, and many more during the latter half of the 20th Century.
During last century’s first half, monetary formats weren’t taken so much for granted even if there hadn’t been nearly as many of them as now. In its exhaustive volumes on money and bank statistics from the early years of the Federal Reserve’s operations, 1914-41, the US central bank acknowledged that, only fourteen years after the collapse into the Great Depression (the volume printed in 1943), how:
“Currency…includes coin and paper money issued by the Government and by banks. It represents a relatively small part of the total money supply of the United States, as most money is held in the form of bank deposits and most money payments are made by check.”
This cuts directly against the usual caricature of currency debasement, images and cartoons depicting harried money-holders trotting desperately to rid themselves of wheel-barrows full of tangible cash, the literal product of physical printing, before they might need to figure out how to acquire a second just to pay the risen price of the intended purchase. The Weimar stuff, the travails of Zimbabwe.
By and large, and this applies to both early 1920’s Germany as well as middle 2000’s Zimbabwe, money and currency are first and foremost bank issues. As the 1943 Fed spells out, literally bank issues.
It’s not difficult to see why when going back over the statistics contained within that very volume. From the founding of the Federal Reserve, and even before, money had slowly but relentlessly transitioned from a public matter (as in, holdings by the public) to a banking matter (as in, held and more importantly transformed by the banking system).
This was as natural as evolutionary technology in communications; in fact, the two very much related. What goods producer or services provider wants to sit around and wait for a customer to physically deliver cash for payment along with all the risks attributable to waiting for that cumbersome process to fully play out? Instantaneous or nearly so via bank payments processing capabilities (the correspondent system) brought about by the potential for real-time interactions had left no doubt as to where the world actually stood, and stands, on such matters of effective currency.
As the Fed wrote nearly eight decades ago, everyone just writes a check. Now, we pay with our phones. Same thing.
This naturally places monetary supremacy in the banking system’s hands – not the central bank’s - as had once been commonly known. This idea of the Federal Reserve alone atop the monetary pyramid is a relatively recent invention, a fiction spun to make expectations policy first possible and then, for a time, seemingly more effective (the so-called Great “Moderation”).
The early numbers bear this out; right up to and into the Great Depression. In 1915, the first full year of the Fed’s operation, member banks had created about $8.7 billion in total monetary deposits out of $1.62 billion in total reserves. The vast majority of the latter, $1.33 billion, was in the form of vault cash; wheel-barrow ready. Only $295 million had been some kind of procedure (open-market operations) between member bank and Federal Reserve bank (branch) which resulted in what’s called bank reserves.
In other words, in 1915 there had been $6.40 of private member bank deposits backed by $1.00 in cash, coin, and private bank/correspondent reserves (reserves that were not “bank reserves” held at the Fed). Of this central bank kind, these were nothing more than ostensibly clearinghouse certificates giving the holder the right to convert what was another deposit balance – with the Federal Reserve - into cash under specific conditions.
The proportion and composition of total reserves changed radically due to World War I, when not only did gold flow heavily into the United States, the rules (specifically Federal Reserve Act 13.8) were changed such that the Federal Reserve could indirectly finance the government issuance of Liberty Bonds bought heavily by member banks.
By allowing those Liberty Bonds to be used as collateral in rediscounting (open-market) operations at the Federal Reserve, instead of the original real bills doctrine demanding real economic collateral, the banking system between June 1917 and August 1918 experienced a massive drawdown of $730 million in vault cash; about 45%!
Yet, there was no deflationary depression since, while that cash flowed into the government’s hand, those and many other bonds were rediscounted by the Fed leading total reserves massively higher; those bank reserves from less than $300 million to more than $1.9 billion by the end of 1919. From the public’s perspective in those early days, what was the difference? So far as anyone knew, “reserves” of all kinds had greatly expanded – as would consumer prices.
The mix of currency in the banking system, however, had been radically altered and it would only keep going in this direction throughout the Roaring Twenties. The massive quantitative reserve growth of the prior decade gave way to more and more of this qualitative growth in the deposit to cash multiplier.
By 1929, the public’s deposits among member banks had quadrupled from their 1915 levels; rising to more than $36 billion as highly favorable bank attitudes prevailed. Supporting those deposits, however, was mostly “bank reserves” as the Federal Reserve had often encouraged (through setting branch discount rates) the banking system to pile on more of what came to be known as “borrowed reserves.”
In fact, the level of true vault cash had declined throughout the twenties even as overall total reserves came to be more than $3 billion by decade’s end, and just about $3.5 billion on the October ’29 eve of disaster. To put it into those same terms as before, for every $1 in actual vault cash and coin in possession just prior to the Great Collapse, the bank system had piled onto it $43.47 in deposit balances.
Big problem if the public comes knocking on your door demanding hard cash. What good are these open-market operation bank reserves in that situation?
Including the Fed’s created bank reserves only made it sound less ridiculous. But it was also an error of operation, as the Fed would acknowledge after-the-fact by 1943:
“The aggregate amount of reserves of all member banks in relation to aggregate reserve requirements, or in relation to borrowings necessary to maintain reserves at the required level, is a dominant factor in the trend toward credit expansion or contraction. There are important differences in cost, in liability, and in attitude of the banks between reserves obtained at the banks' initiative by discounting paper and reserves obtained through open-market operations by the Reserve Banks, the inflow of gold from abroad, or other means outside the control of the member banks themselves.” [emphasis added]
In other words, having money come into a bank’s hands through organic processes of ordinary bank business – including the use of real bills as collateral in open-market operations triggered by banks - is treated very differently by that bank than when reserves might come from the other direction, the Federal Reserve hoping to desperately catch up to systemic inelasticity via post hoc open-market operations.
Simple, intuitive, and yet lost to history in the modern view which treats bank reserves – from any open-market operation, including QE – as the perfect equivalent to natural bank-driven currency.
Attitude is everything, and in this case, rather than the typical expectations policy framework, this has historically meant banks first before ever getting to consumers and employers.
Has that changed over the decades in between? Of course not. It’s only the post-Great Inflation story of an all-seeing, omniscient technocracy by which you’re led to believe it has. Bank reserves haven't changed, a legend surrounding them has been created to accommodate the fiction.
The first Global Financial Crisis begun in 2007 and lasting through the first three months of 2009 were a particularly powerful example of this great distance between what we’ve been told and what really happens; no matter what the Fed did, the crisis raged anyway. People all said “abundant reserves” and yet currency inelasticity was so easily observable all over the world. Following it, more bank reserves and yet less of the anticipated results from them being “printed.”
Like the worst parts of the 2008 crisis, bank reserves had been “abundant” in 1929 and 1930. Didn’t matter. Currency, as the old Fed came to understand, had been an issue of banks and particularly their monetary “attitudes.”
Faced with gross monetary uncertainty, the level of bank reserves created by open-market operations are not going to be treated the same way. Instead, regardless of those operations, the banking system, the genesis of currency in the modern economic format, will keep hard and fast to only the safest and most liquid financial instruments.
It had been that way during the 1930’s, as evidenced by falling interest rates especially for top-tier bond credits, and it has been the same way since 2008. The banking system during these periods puts on display its very own attitude about currency reality. No debasement.
What’s changed, then, is how the public is made to perceive all this – leaving the vast majority of it confused and often very angry. We’ve been conditioned to believe wholeheartedly and without question how the Federal Reserve and its open-market operations rule everything.
Never standing still, bank currency and even the money multiplier have evolved fantastically since 1943. Whereas there may have been some minimal use for bank reserves in the sense of functional currency back in the twenties, in the back half of the last century the supremacy of the banking system had meant still more changes along the same prior lines – to the point where physical currency itself, cash and coin, had been deemphasized near entirely.
As I wrote a little over four years ago, borrowing from a lesser-known work of Dickens:
“The phrase Charles Dickens used to describe insurance companies can be refashioned to quite well characterize this monetary arrangement; a bank that holds no dollars gets another bank that holds no dollars to guarantee that everyone has dollars. It’s all a lie, but it works because nobody ever demands to be presented with dollars. Transactions are simply settled and worked out in the format consistent with that; Bank B used to have a number that said Bank B was owed a certain amount of dollars but then Bank B lent that number to Bank C so that Bank C could claim an ability to get dollars when neither bank has any interest in obtaining dollars just the whatever transformation that results from that transaction. Dollars are purely theoretical; thus ‘dollars.’”
In this post-modern tangle of currency-less currency, the virtual strings or chains of bank liabilities include things like derivative transactions and, importantly, repo collateral. Bank reserves simply don’t play; bank attitudes are drawn almost exclusively from these other formats.
Importantly, these mindsets are very often very different than those espoused supposedly on the system’s behalf. JP Morgan CEO Jamie Dimon, for example, has expressed numerous times his utter disdain and distaste for the safety and liquidity parameters featured in US Treasury securities – famously in the middle of 2018 claiming the yields on them were ready to move substantially upward because the bank reserves of QE had finally done the trick.
Instead, interest rates went much, much lower and as it turned out JP Morgan had been one of the heaviest bidders of that buying trend even if it had undercut the CEO presumably speaking on its behalf (Dimon is, after all, an Economist).
We think of, and are taught, how progress only goes in one direction – forward. Time and again where monetary economics has been concerned it’s very clear instead knowledge regression has taken place. It’s in large part due to the (over)use of statistical regressions that first treat the monetary system as some monolithic plaything of sagacious central bankers wielding the most money form of money ever conceived.
They knew all the way back in 1943 that, at minimum, it’s a hell of a lot more complicated than that. And it’s only gotten a whole lot more complicated since.
