Mish on the Fic­tional Reserve Sys­tem

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Mike Shed­lock (“Mish” as he is known to all) has writ­ten an excel­lent piece on the defla­tion-infla­tion debate, focus­ing on the Achilles Heel of the latter–the fact that it is based on the belief that we live in a “frac­tional reserve bank­ing” mon­e­tary sys­tem. He offered to let me cross-post here, and I’ve repro­duced it in its entirety below (there’s only one point I’m not sure on–the com­ment that there are no reserve require­ments for sav­ings accounts. From my read­ing of the foot­notes to Table 12 in this Fed­eral Reserve paper, that’s true of cor­po­rate accounts but not indi­vid­ual ones).

Also, there is an excel­lent arti­cle in the Guardian “The global economy’s decade of debt-fuelled boom and bust” by Larry Elliott (repro­duced in the Fair­fax press) that puts the debt-defla­tion and delever­ag­ing case very well.  Do read it.

And now, over to Mish!

Fictional Reserve Lending And The Myth Of Excess Reserves

In A Case for the Infla­tion Camp Robert P. Mur­phy asks When Will the Infla­tion Genie Get Out of the Bot­tle? Murphy’s con­cern is over “excess reserves”.

My rea­son for expect­ing large-scale price infla­tion is fairly straight­for­ward: I see no coher­ent strat­egy for Bernanke to remove the excess reserves from the bank­ing sys­tem. …

After review­ing the evi­dence and the the­o­ries offered by the two camps, I still believe that Bernanke’s unprece­dented infu­sions of new reserves will lead to rapid price increases. These increases may not show up in the price of US finan­cial assets, but they will rear their ugly heads at the gas pump and gro­cery check­out. More­over, I think the genie may already be slip­ping out of the bot­tle. His escape will only be has­tened once the year-over-year CPI fig­ures show mod­er­ate infla­tion.

Steve Saville’s Con­cern Over Excess Reserve 

Steve Sav­ille expresses his con­cern over excess reserves in Bank Reserves and Infla­tion.

The rea­son that bank reserves aren’t added to the money sup­ply is that they do not con­sti­tute money avail­able to be spent within the econ­omy; rather, they con­sti­tute money that could be loaned into the econ­omy or used to sup­port addi­tional bank lend­ing in the future.

Bank lend­ing in the US has declined on a year-over-year basis, so we know that the spec­tac­u­lar increase in reserves has not YET con­tributed to mon­e­tary infla­tion.

If the pri­vate banks were to join the infla­tion party then the risk of hyper­in­fla­tion would greatly increase, and hyper­in­fla­tion — lead­ing to what Mises called a “crack-up boom” — would be the worst of all pos­si­ble out­comes. In par­tic­u­lar, it would be an order of mag­ni­tude worse than the defla­tion that many peo­ple still seem to be wor­ried about.

So, let’s hope that the banks don’t start lend­ing out their excess reserves. The sit­u­a­tion is bad enough already.

Gary North’s Con­cern Over Excess Reserves

Inquir­ing minds note Gary North’s con­cern over excess reserves in The Fed­eral Reserve’s Self-Imposed Dilemma.

The Fed­eral Reserve Sys­tem faces a dilemma of its own cre­ation: the dou­bling of the mon­e­tary base.

The only thing that is keep­ing this from cre­at­ing mass infla­tion is the deci­sion of com­mer­cial bankers to deposit the bulk of this increase with the Fed­eral Reserve. The banks are not lend­ing out this money. Nei­ther is the FED. This money does not legally belong to the FED.


There is an easy solu­tion to this prob­lem. The Fed­eral Reserve knows exactly what the solu­tion is. Nobody men­tions it. The sug­ges­tion that the Fed­eral Reserve would attempt it would prob­a­bly bust the bond mar­ket. The Fed­eral Reserve would announce that, from this point on, all money deposited by banks as excess reserves will be charged a stor­age fee. This fee could be 2%.

Not only would banks not make any inter­est on the money deposited with the Fed­eral Reserve, they would begin suf­fer­ing a loss of 2% per annum on the money held as excess reserves. …

Lots of Con­cern Over Excess Reserves

That’s a lot of con­cern over excess reserves. And if I looked around, I am quite sure I can find even more con­cern over excess reserves.

Here is a cur­rent chart that shows what every­one is con­cerned about.

Reserve Bal­ances with Fed­eral Reserve Banks

click on chart for sharper image

Money Mul­ti­plier The­ory

The chart shows an unprece­dented amount of excess reserves, almost $1.2 tril­lion.

Accord­ing to Money Mul­ti­plier The­ory (MMT) and Frac­tional Reserve Lend­ing, this amount may be lent out as much as 10 times over and when it does, mas­sive infla­tion will result.

Money Mul­ti­plier The­ory Is Wrong

The above hypothe­ses regard­ing “Excess Reserves” are wrong for five rea­sons.

1) Lend­ing comes first and what lit­tle reserves there are (if any) come later.
2) There really are no excess reserves.
3) Not only are there no excess reserves, there are essen­tially no reserves to speak of at all. Indeed, bank reserves are com­pletely “fic­tional”.
4) Banks are cap­i­tal con­strained not reserve con­strained.
5) Banks aren’t lend­ing because there are few credit wor­thy bor­row­ers worth the risk.

Let’s explore each of those points in depth.

1: Lend­ing Comes First, Reserves Sec­ond

Aus­tralian econ­o­mist Steve Keen has made a strong case that lend­ing comes first and reserves later in Rov­ing Cav­a­liers of Credit. I dis­cussed that at length in Fiat World Math­e­mat­i­cal Model.

That point alone should seal the hash of the debate but it keeps com­ing up over and over. So let’s try one more time.

Inquir­ing minds are read­ing BIS Work­ing Papers No 292, Uncon­ven­tional mon­e­tary poli­cies: an appraisal.

Note: The above link is a lengthy and com­plex read, rec­om­mended only for those with a good under­stand­ing of mon­e­tary issues. It is not light read­ing.

The arti­cle addresses two fal­lac­ies

Propo­si­tion #1: an expan­sion of bank reserves endows banks with addi­tional resources to extend loans

Propo­si­tion #2: There is some­thing uniquely infla­tion­ary about bank reserves financ­ing

From the arti­cle.…

The under­ly­ing premise of the first propo­si­tion is that bank reserves are needed for banks to make loans. An extreme ver­sion of this view is the text-book notion of a sta­ble money mul­ti­plier.

In fact, the level of reserves hardly fig­ures in banks’ lend­ing deci­sions. The amount of credit out­stand­ing is deter­mined by banks’ will­ing­ness to sup­ply loans, based on per­ceived risk-return trade-offs, and by the demand for those loans.

The main exoge­nous con­straint on the expan­sion of credit is min­i­mum cap­i­tal require­ments.

A strik­ing recent illus­tra­tion of the ten­u­ous link between excess reserves and bank lend­ing is the expe­ri­ence dur­ing the Bank of Japan’s “quan­ti­ta­tive eas­ing” pol­icy in 2001–2006.

Japan’s Quan­ti­ta­tive Eas­ing Exper­i­ment

click on chart for sharper image

Despite sig­nif­i­cant expan­sions in excess reserve bal­ances, and the asso­ci­ated increase in base money, dur­ing the zero-inter­est rate pol­icy, lend­ing in the Japan­ese bank­ing sys­tem did not increase robustly (Fig­ure 4).

Is financ­ing with bank reserves uniquely infla­tion­ary?

If bank reserves do not con­tribute to addi­tional lend­ing and are close sub­sti­tutes for short-term gov­ern­ment debt, it is hard to see what the ori­gin of the addi­tional infla­tion­ary effects could be.

There is much addi­tional dis­cus­sion in the arti­cle but it is clear that MMT the­ory as espoused by Mur­phy, Sav­ille, North and oth­ers did not hap­pen in Japan nor is there any evi­dence of it hap­pen­ing in the US, nor is there a sound the­o­ret­i­cal basis for it.

In fiat based credit sys­tems, lend­ing comes first, reserves come sec­ond, and extra reserves do noth­ing much except pay banks to sit in cash in cases where inter­est is paid on excess reserves.

I will touch more on reserves com­ing after lend­ing in the dis­cus­sion of points 3 and 4 below.

2: There Are No Excess Reserves

Let’s now turn our atten­tion to the idea there are excess reserves. To do that, let’s con­sider non­per­form­ing loans, total loans and leases, and allowances for loan and lease losses.

Total Non­per­form­ing Loans

click on chart for sharper image

The above chart is from St. Louis Fed based on Reports of Con­di­tion and Income for All Insured U.S. Com­mer­cial Banks.

Per­cent­age of non­per­form­ing loans equals total non­per­form­ing loans divided by total loans. Non­per­form­ing loans are those loans that bank man­agers clas­sify as 90-days or more past due or nonac­crual in the call report. 

Non­per­form­ing loans have soared to a record five per­cent for this series.

The above chart just gives a per­cent. We need to quan­tify the amount. The fol­low­ing chart will help do just that.

Total Loans and Leases of Com­mer­cial Banks

The above chart of total loans and leases shows a total of nearly $7 tril­lion, of which five per­cent is non­per­form­ing. In other words there is about $350 bil­lion of non­per­form­ing loans on the books of banks (that are admit­ted to).

That last part about admit­ted to is cru­cial. Non­per­form­ing loans do not include off bal­ance sheet garbage, var­i­ous swaps with the Fed, or ridicu­lous mark-to-fan­tasy val­u­a­tions of assets held on the books.

Total Loans and Leases of Com­mer­cial Banks Per­cent­age Change

On a per­cent­age basis the drop in loans and leases is unprece­dented.

But wait. Banks might have made pro­vi­sions for those loan losses already, might they not? Well … in a sin­gle word, No (as the fol­low­ing chart shows)

Assets at Banks whose ALLL exceeds their Non­per­form­ing Loans

The above chart cour­tesy of the St. Louis Fed.

Because allowances for loan losses are a direct hit to earn­ings, and because allowances are at ridicu­lously low lev­els, bank earn­ings (and cap­i­tal­iza­tion ratios) are wildly over-stated.

Excess Reserves? You still think so?

3: Bank reserves are “Fic­tional”, there are essen­tially no reserves at all.

To see if we can prove this state­ment we can look at total lend­ing vs. base money sup­ply and M2.

Karl Den­ninger at Mar­ket Ticker has a nice chart of total lend­ing based on Fed­eral Reserve Z.1 Flow of Funds data.

Cumu­la­tive Debt

click on chart for sharper image

Base Money Sup­ply

Note the ram­pant increase in base money which is the source of those so-called excess reserves.

Let’s do a lit­tle math.

There is 2,000 bil­lion base money.
There is 52,000 bil­lion lend­ing.
The ratio of base money to lend­ing is 3.8%

Prior to the ramp in base money (which by the way was the Fed’s fee­ble attempt to sup­ply reserves after the fact), there was $800 bil­lion base money sup­port­ing $52,000 bil­lion in lend­ing. Not too long ago, the ratio of base money to lend­ing was a mere 1.5%.

Want to use M2 instead?

M2 Money Sup­ply

click on chart for sharper image

Using M2 as money sup­ply avail­able for lend­ing makes the ratios bet­ter. How­ever, the largest com­po­nent of M2 is sav­ings accounts at almost $5 tril­lion of that $8.5 tril­lion M2.

How­ever, money in sav­ings accounts is not there. Reserve require­ments on sav­ings accounts are zero. It has all been lent out. More­over, Greenspan autho­rized sweeps in 1994 to specif­i­cally allow banks to “sweep excess reserves” from check­ing accounts into sav­ings accounts so the money could be lent out.

There is no money in sav­ings accounts or check­ing accounts other than an elec­tronic mark that says there is. Both con­tain money only in the­ory. That money that has already been lent out and rede­posited, over and over and over.

Reserves? There are no reserves. Indeed, reserves are best thought of as neg­a­tive.

Frac­tional Reserve Lend­ing is really Fic­tional Reserve Lend­ing.

4: Banks are cap­i­tal con­strained not reserve con­strained

Num­ber four gets down to the heart of the mat­ter. Banks are not lend­ing because they are cap­i­tal con­strained, not because of any reserve issues.

The Bank of Inter­na­tional Set­tle­ments (BIS) sets stan­dards that per­tain to asset qual­ity and required cap­i­tal that the banks must hold.

Here are some resources:

The first doc­u­ment is a whop­ping 284 pages long while the sec­ond is 150 pages long. I do not advise read­ing either. I include them for com­plete­ness.

Cap­i­tal require­ments

Wikipedia explains Cap­i­tal Require­ments and Cap­i­tal Ade­quacy Ratio in brief form but the arti­cles need work. Nonethe­less, they seem to be a rea­son­able although com­plex overview.

From Wikipedia: The cap­i­tal ratio is the per­cent­age of a bank’s cap­i­tal to its risk-weighted assets. Weights are defined by risk-sen­si­tiv­ity ratios whose cal­cu­la­tion is dic­tated under the rel­e­vant Accord.

Here is a chart on risk weight­ings. Remem­ber what hap­pened to those AAA rated loans?

Risk Weight­ings

Fed Can Pro­vide Liq­uid­ity Not Cap­i­tal

Flash­back March 01, 2008: Poole, Paul­son, Bernanke on Bailouts and Bank Fail­ures

Fed Gov­er­nor William Poole on Moral Haz­ards:

I am more skep­ti­cal of the finan­cial strength of the GSEs, and believe that we could see sub­stan­tial prob­lems in that sec­tor. Accord­ing to the S&P Case-Shiller home value data released ear­lier this week, as of Decem­ber 2007 aver­age prices had declined by 15 per­cent or more over the past 12 months in Phoenix, San Diego, Miami and Las Vegas. We can add Detroit to the dan­ger list as the home price index for that city is down by almost 19 per­cent over the 24 months end­ing Decem­ber 2007. With house prices falling sig­nif­i­cantly in a num­ber of large mar­kets, many prime mort­gages issued a few years ago with a loan-to-value ratio of 80 per­cent may now have rel­a­tively lit­tle home­owner equity, which increases the prob­a­bil­ity of default and amount of loss in event of default.

As I have empha­sized before, the Fed­eral Reserve can deal with liq­uid­ity pres­sures but can­not deal with sol­vency issues. I do not have any infor­ma­tion on the GSEs that the mar­ket does not also have. Nev­er­the­less, in assess­ing the risk of fur­ther credit dis­rup­tions this year, I would put the GSEs at the top of my list of sources of poten­tially seri­ous prob­lems. If those prob­lems were real­ized, they would be a direct result of moral haz­ard inher­ent in the cur­rent struc­ture of the GSEs.

First Nation­al­ized Bank Of Fan­nie

Poole hit the nail on the head. Fan­nie Mae and Fred­die Mac blew up and were nation­al­ized. They did not run into reserve con­straints. They ran smack up against cap­i­tal con­straints.

Also note that the Fed did not bail them out. Tax­pay­ers did, autho­rized by Con­gress. The losses might hit $400 bil­lion.

Fan­nie Mae is not a bank, but for all prac­ti­cal pur­poses it may as well be. Much lend­ing growth comes from the GSEs. Money (credit really), is bor­rowed into exis­tence, and rede­posited else­where, and lent out over and over again.

When Fan­nie Mae and Fred­die Mac ran into prob­lems, cap­i­tal was pro­vided after the fact, not by the Fed but by tax­pay­ers. The same applies to Cit­i­group, Bank of Amer­ica, Wells Fargo on down the line.

In the March 2008 Poole post, I also com­mented on Bernanke.

Bernanke Expects Bank Fail­ures

Tes­ti­fy­ing before Con­gress on Thurs­day, Bernanke stated Banks should seek more cap­i­tal.

Among the largest banks, the cap­i­tal ratios remain good and I don’t antic­i­pate any seri­ous prob­lems of that sort among the large, inter­na­tion­ally active banks that make up a very sub­stan­tial part of our bank­ing sys­tem,” he said in response to a ques­tion dur­ing semi-annual con­gres­sional tes­ti­mony.

They have already sought some­thing of the order of $75 bil­lion of cap­i­tal in the last quar­ter. I would like to see them get more,” Bernanke said.

They have enough now cer­tainly to remain sol­vent and remain … well above their min­i­mum cap­i­tal lev­els. But I am con­cerned that banks will be pulling back and not mak­ing new loans and pro­vid­ing the credit which is the lifeblood of the econ­omy. In order to be able to do that … in some cases at least, they need to get more cap­i­tal,” Bernanke added.

Bernanke cer­tainly blew it about the large banks being well cap­i­tal­ized. How­ever, he was cer­tainly cor­rect with “In order to be able to [lend] … in some cases at least, they need to get more cap­i­tal

Note that this was a cap­i­tal con­cern not a reserve con­cern.

Cap­i­tal Is The Prob­lem At Vir­tu­ally All Banks

Flash for­ward August 19, 2009: Emails from a Bank Owner regard­ing FDIC and Under-Cap­i­tal­ized Banks.

Here is an inter­est­ing fol­lowup email from ABO [a Bank Owner and CEO] regard­ing bank cap­i­tal.

ABO Writes:

I talked to a friend this morn­ing who is retired from both the Fed­eral Reserve of Kansas City and RSM McGladrey. He now does con­sult­ing work with the FDIC, due dili­gence and other reg­u­la­tory work. He said the pic­ture he is see­ing is worse than at any time in his life and CAPITAL is the prob­lem with vir­tu­ally all banks.

Inquir­ing minds will also be inter­ested in an August 24, 2009 post Crit­i­cally Under-Cap­i­tal­ized Banks Direct Result of “Won­der­ful Chain of Stu­pid­ity”. That post also shares some emails with “ABO” includ­ing …

Hid­ing The Losses

ABO Writes:

Take a look at how the FDIC is sell­ing failed banks. It is a lit­tle dif­fer­ent than in the past. The FDIC is using a loss shar­ing agree­ment that is usu­ally around 80–20 and has cer­tain guide­lines on tim­ing of the losses. I would guess that the losses on the failed banks are dragged into the future some­what rather than being rec­og­nized at the time the bank is closed. This method would be less of an imme­di­ate hit to the fund and would prob­a­bly cre­ate a con­tin­gent lia­bil­ity rather than a direct one. The banks that agree to this loss shar­ing plan are rely­ing on the promise of the FDIC to make good on future guar­an­tees for losses. The losses are not backed by the full faith of the gov­ern­ment.

The Fed and FDIC always want to delay address­ing the prob­lems, hop­ing they will go away. Such struc­tural prob­lems sel­dom do.

Amaz­ingly Finan­cial Group was con­sid­ered “well cap­i­tal­ized” right up to the brink of fail­ure. When the bank did fail, the hit to FDIC was not imme­di­ately taken but stretched into the future.

The WSJ arti­cle notes ‘There are 1,400 banks that own mort­gage-backed secu­ri­ties that aren’t backed by gov­ern­ment-related enti­ties such as Fan­nie Mae and Fred­die Mac.” What we don’t know is how many of those banks are lev­ered up enough in garbage mort­gages to fail.

Note too that those garbage trust-pre­ferred secu­ri­ties prob­lems are on top of the widely expected fall­out from com­mer­cial real estate prob­lems affect­ing small to medium-sized regional banks. Thus, bank­ing woes are much deeper in many areas than either the FDIC or Fed is admit­ting.

FDIC Allows Banks To Hide Insuf­fi­cient Cap­i­tal

Let’s flash for­ward once again.

Date­line Decem­ber 15, 2009: FDIC Approves Giv­ing Banks Reprieve From Cap­i­tal Require­ments

The Fed­eral Deposit Insur­ance Corp. gave banks includ­ing Cit­i­group Inc., Bank of Amer­ica Corp. and JPMor­gan Chase & Co. a reprieve of at least six months from rais­ing cap­i­tal to sup­port bil­lions of dol­lars of secu­ri­ties the firms will be adding to their bal­ance sheets.

Bank reg­u­la­tors includ­ing the FDIC and Fed­eral Reserve want to per­mit a phase-in of cap­i­tal require­ments that rise start­ing next month under a change approved by the Finan­cial Account­ing Stan­dards Board. The rule, passed in May, elim­i­nates some off- bal­ance-sheet trusts, forc­ing banks to put bil­lions of dol­lars of assets and lia­bil­i­ties on their books.

Exec­u­tives from Cit­i­group, JPMor­gan, Bank of Amer­ica, Wells Fargo & Co., Cap­i­tal One Finan­cial Corp. and the Amer­i­can Secu­ri­ti­za­tion Forum met FDIC offi­cials Dec. 2 to dis­cuss cap­i­tal require­ments related to the FASB mea­sure.

The exec­u­tives pro­posed that “the tran­si­tion period should extend beyond 2010 to a point in the econ­omy where unem­ploy­ment is lower and issuers are less cap­i­tal-restrained from grow­ing their bal­ance sheet and pro­vid­ing credit,” accord­ing to a paper the ASF pre­sented the FDIC.

Cit­i­group sug­gested three years to off­set assets and lia­bil­i­ties brought onto bal­ance sheets, Chief Finan­cial Offi­cer John Gerspach said in an Oct. 15 let­ter to reg­u­la­tors. Requir­ing banks to “assume the risk-based cap­i­tal effects imme­di­ately, or even over one year, is an unde­ni­ably severe penalty,” he wrote.

Fic­tional Cap­i­tal

Not only are there no reserves, the above should prove with­out a doubt there is insuf­fi­cient cap­i­tal for banks to lend.

Amaz­ingly, the Fed and banks have the gall to pro­claim banks are well cap­i­tal­ized.

Global Impli­ca­tions Of
Stronger Cap­i­tal Rules From Basel

Just to prove cap­i­tal is not just a US con­cern, please con­sider Japan Banks Fall on Stronger Cap­i­tal Rules From Basel.

Global reg­u­la­tors have been wrestling with plans to tighten bank super­vi­sion fol­low­ing the worst eco­nomic cri­sis since World War II. The Basel Com­mit­tee said yes­ter­day banks’ core cap­i­tal should exclude stock or instru­ments that may require lenders to make pay­ments to third par­ties, as these could reduce reserves needed for meet­ing losses.

The tight­en­ing of Tier 1 qual­ity stan­dards is over­all neg­a­tive for the Japan­ese banks because they have weak Tier 1 qual­ity,” said Stephen Church, a research part­ner at Japan­in­vest KK, an inde­pen­dent research firm, in Tokyo. “The stock mar­ket is dif­fer­en­ti­at­ing between those banks which have stronger Tier 1 and those which are weaker.”

The com­mit­tee also said banks should have an “appro­pri­ate” period of time to replace such instru­ments.

Hope­fully that proves beyond a shadow of a doubt that banks are cap­i­tal restricted. Thus, even if banks had excess reserves (which they clearly don’t), banks would not be lend­ing any­way.

Of course, the idea that banks need reserves in the first place is fal­la­cious.

Let’s tie a bow on this five point pack­age with …

5: Banks aren’t lend­ing because there are few credit wor­thy bor­row­ers worth the risk.

Even if banks had the cap­i­tal to dra­mat­i­cally increase lend­ing (which they don’t), banks would still have to make the deter­mi­na­tion they want to lend.

Back­drop Banks Face

If you were a bank would you be anx­ious to lend into that? If you were a busi­ness would you want to expand into that?

Please con­sider the lat­est Fed Senior Loan Sur­vey.

Demand for C&I loans from small firms

Lend­ing Stan­dards For Small Firms

85.5% of banks respond­ing to the sur­vey have lend­ing stan­dards that basi­cally remained the same yet 44.6% of banks report mod­er­ately weaker demand for loans, with only 8.9% report­ing mod­er­ately stronger demand for loans.

In spite of all the claims that banks are not will­ing to lend, the data sug­gests that the pre­dom­i­nant fac­tor is there are fewer busi­nesses want­ing loans.

Arguably (but there is no way to tell from the tables) fewer still credit wor­thy busi­nesses want loans.

Those who want banks to increase lend­ing, I have to ask “For What? To Who? At What Rate?”

There are actu­ally plenty of rea­sons for banks not want­ing such as ris­ing unem­ploy­ment, ris­ing taxes, uncer­tainty over health care costs, pro­posed cap-and-trade costs, increas­ing con­sumer fru­gal­ity, ram­pant over­ca­pac­ity, and boomer demo­graph­ics.

One Unad­dressed Point

Gary North pro­poses Bernanke can force banks to lend. Really? When Bernanke knows banks are cap­i­tal con­strained? When it is obvi­ous that it would be sui­ci­dal?

Bear in mind that Bernanke has recently talked about upping the inter­est on reserves, not mak­ing it neg­a­tive. More­over, by pay­ing inter­est on reserves, the Fed can very slowly recap­i­tal­ize banks over time while simul­ta­ne­ously and sub­tly sug­gest­ing that banks not take excess risks.

With that in mind, let’s try and stay within the solar sys­tem of 99.9% prob­a­bil­ity rather than the uni­verse of the­o­ret­i­cally pos­si­ble neg­a­tive 2% rates on reserves.

Excess Reserve Recap

1) Lend­ing comes first and what lit­tle reserves there are (if any) come later.
2) There really are no excess reserves.
3) Not only are there no excess reserves, there are essen­tially no reserves to speak of at all. Indeed, bank reserves are com­pletely “fic­tional”.
4) Banks are cap­i­tal con­strained not reserve con­strained.
5) Banks aren’t lend­ing because there are few credit wor­thy bor­row­ers worth the risk.

Reserves? There are no reserves. Indeed, reserves are best thought of as neg­a­tive. Instead, in cases of “too big to fail”, cap­i­tal (not reserves), is sup­plied after the fact by tax­pay­ers (not the Fed).

Thus, con­cern that excess reserves will lead to lend­ing and infla­tion is totally unfounded in the­ory and prac­tice.

Frac­tional Reserve Lend­ing is really Fic­tional Reserve Lend­ing. In prac­tice, the major con­straints to lend­ing are insuf­fi­cient cap­i­tal and will­ing­ness of credit wor­thy bor­row­ers to seek loans.

Mike “Mish” Shed­lock

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  • dvd_cec­ca­relli

    Thanks Mr Keen. I’m read­ing this paper and I’ll wait other works tomor­row which explain the para­me­ters used.

  • NaiveAm­er­i­can

    Very infor­ma­tive; I’m glad I found this. How­ever, Mish has said (in Sept of 2010) the fol­low­ing:

    What is quan­ti­ta­tive eas­ing going to do in the face of 54 tril­lion dol­lars (U.S.) worth of debt out there? The Fed prints another tril­lion dol­lars, [and] it’s just sit­ting as excess reserves on the bal­ance sheets of banks.”

    The pod­cast from which this is taken is here:


    This doesn’t fit with point 3, ‘Not only are there no excess reserves, there are essen­tially no reserves to speak of at all. Indeed, bank reserves are com­pletely “fic­tional”.’