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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  • Hi John, and wel­come aboard.

    The asser­tion you dis­agree with wasn’t mine but Mish’s. I think Mish’s argu­ment gives grounds for argu­ing the reserves are com­pro­mised by the over­stated value of bank assets else­where, not that there are no reserves at all.

  • al49er


    Obvi­ously I didn’t pre­cis the “Auto­matic Earth” arti­cle well ( and only attempted to do so at all because every­thing in the site was slow whilst every­one was off eat­ing Christ­mas lunch etc) because we are at odds as to the points “they” are mak­ing, which I found inter­est­ing.

    That point was not that “..gov­ern­ment issu­ing less debt than the deficit..” was an issue and nor I would guess, is it likely that “…prob­a­bly there is some issue at the data col­lec­tion stage..” .

    Maybe the more end game point of what Sprott & Franklin are get­ting at through their appar­ently detailed study, is that the Fed is “….fak­ing the Treasury’s abil­ity to attract out­side cap­i­tal.” And the final sen­tence of the excerpt below. 

    Talk­ing about US Trea­suries, Cana­dian investor Eric Sprott has been try­ing to fig­ure out who bought them in 2009. In a report enti­tled Is it all just a Ponzi scheme?, Sprott and David Franklin sug­gest that it’s impos­si­ble to find who was the sec­ond largest buyer. Of the $1.885 tril­lion dol­lars in pub­lic debt the US added in 2009, $704 bil­lion (annu­al­ized) was bought by “Other Investors”, a col­lec­tion of buy­ers they find defined in the Fed­eral Reserve Flow of Funds Report as the “House­hold Sec­tor”. the $704 bil­lion is 35 times more than this sec­tor bought in the prior year, 2008, accord­ing to Sprott and Franklin. They phrase it like this:

    Amaz­ingly, we dis­cov­ered that the House­hold Sec­tor is actu­ally just a catch-all cat­e­gory. It rep­re­sents the buy­ers left over who can’t be slot­ted into the other group head­ings. For most cat­e­gories of finan­cial assets and lia­bil­i­ties, the val­ues for the House­hold Sec­tor are cal­cu­lated as resid­u­als. That is, amounts held or owed by the other sec­tors are sub­tracted from known totals, and the remain­ders are assumed to be the amounts held or owed by the House­hold Sec­tor. To quote directly from the Flow of Funds Guide,

    For exam­ple, the amounts of Trea­sury secu­ri­ties held by all other sec­tors, obtained from asset data reported by the com­pa­nies or insti­tu­tions them­selves, are sub­tracted from total Trea­sury secu­ri­ties out­stand­ing, obtained from the Monthly Trea­sury State­ment of Receipts and Out­lays of the United States Gov­ern­ment and the bal­ance is assigned to the house­hold sec­tor.”

    So to answer the ques­tion — who is the House­hold Sec­tor? They are a PHANTOM. They don’t exist. They merely serve to bal­ance the ledger in the Fed­eral Reserve’s Flow of Funds report.

    Our con­cern now is that this is all start­ing to resem­ble one giant Ponzi scheme. We all know that the Fed has been active in the mar­ket for T-bills. [..] they bought almost 50% of the new Trea­sury issues in Q2 and almost 30% in Q3. It serves to remem­ber that the whole point of sell­ing new US Trea­sury bonds is to attract out­side cap­i­tal to finance deficits or to pay off exist­ing debts that are matur­ing. We are now in a sit­u­a­tion, how­ever, where the Fed is print­ing dol­lars to buy Trea­suries as a means of fak­ing the Treasury’s abil­ity to attract out­side cap­i­tal. If our research proves any­thing, it’s that the reg­u­lar buy­ers of US debt are no longer buy­ing, and it amazes us that the US can suc­cess­fully issue a record num­ber Trea­suries in this envi­ron­ment with­out the slight­est hic­cup in the mar­ket.

    Trans­la­tion: the Sprott report accuses the US Trea­sury and/or the Fed of buy­ing US trea­suries them­selves, in much larger num­bers than they acknowl­edge.”

  • Ramanan/superpoincare


    I under­stood the point you are try­ing to make. How­ever this is a huge accu­sa­tion — you are accus­ing the biggest finan­cial insti­tu­tion of the world of a scam. The accu­sa­tion is that of mon­e­ti­za­tion with­out noti­fy­ing the pub­lic. That is a big claim. The only “proof” you have (the Sprott report) is the huge increase in the house­hold hold­ing of trea­suries seems incor­rect. What if the house­holds really pur­chased them ?

  • al49er

    Fair enough “Ramanan/S” I accept that you under­stand ( and dis­agree with ) the propo­si­tion.

    I will con­clude and await the proof ( one way or another ) of time and out­r­come just reit­er­at­ing, it is not MY accu­sa­tion ( I don’t have the knowl­edge and haven’t done the study), I just felt that the authors ( of the Sprott report) put an inter­est­ing and well argued propo­si­tion worth a bit of( fur­ther) expo­sure here , if not in ‘peak time’, cer­tainly dur­ing a lull.

    No doubt ‘ak’ , ‘btb’ and oth­ers will return soon to get back into the orig­i­nal think­ing.

  • mahaish

    ” I think Mish’s argu­ment gives grounds for argu­ing the reserves are com­pro­mised by the over­stated value of bank assets else­where, not that there are no reserves at all”

    just try­ing to get my head around this

    so when banks go on assett grab­bing exer­cises which cre­ate loans, they end up as deposits in the acounts of their new or exist­ing cusomers. if they sell or cre­ate too maany loans, the increases in deposits will mean their deposits to reserves ratio will be com­pro­mised, and given the poten­tial inelas­tic­ity of demand for reserves, if the inter­bank mar­ket can­not pro­vide the required reserves they have to go to the fed in order to com­ply.

    and given that the fed doesnt pay inter­est on reserves, and there is a two week lag in banks hav­ing to account for any defi­ciency, means that the fed funds rate amounts to a tax on reserves, which means there is con­sid­er­able incen­tive in the whole sys­tem for banks to play roulette with their reserve requirment. sell loans first and worry about any reserve requirment later

    on the right track?

  • mahaish

    just a fur­ther thought on the mat­ter,

    at the level of an indi­vid­ual bank

    even though this loan cre­ation can lead to a sys­tem wide increase in the deposit base, its very dif­fi­cult for indi­vid­ual banks to pre­dict the effect of this on their deposit base, thus they may miss their reserve requirment tar­get.

  • debtjunkies

    Best of the Sea­son to every­one.

    This is slightly off the cur­rent topic but there is a good arti­cle (front page) in the Sun­day Tele­graph today about debt and the heav­ily indebted Aus­tralian Econ­omy.

    Steve gets an hon­ourable men­tion and is well quoted. It was noted before that the busi­ness edi­tor, Nick Gard­ner under­stands the issues and its good to see acu­rate pub­lish­ing of steve’s posi­tion and data. 

    There is also a quote from Shane Oliver about debt being our achilles heel. 

    Maybe he is con­tem­plat­ing com­ing back over to the ‘dark side’ as he was a prop­erty and debt bear about 12 months ago.

    Well done Steve, even in the mid­dle of the hol­i­day sea­son you are hard at it.

  • Her­bert

    Yes, good to see the excess debt mes­sage get­ting some cov­er­age. The ver­sion I saw quoted “Mort­gages account for almost 90 per cent of annual GDP, up from 17 per cent in 1990”. How are mort­gages accounted for in GDP? Is it the cap­i­tal amount + the inter­est pay­ments. If the cap­i­tal amount is included, seems strange as its a one of item and rep­re­sents “money” that is essen­tially sta­tic and unpro­duc­tive.

  • That’s just awk­ward Eng­lish Her­bert. The expres­sion means a ratio of debt (a stock) to GDP (a flow). Com­par­isons like that are fine–notwithstanding igno­rant com­ments from some mar­ket econ­o­mists to the contrary–because they tell you how many years of GDP are needed to pay debt down to zero.

    It would on the other hand be a mis­take to add debt to GDP: then what you have to do is add the change in debt (a flow) to GDP (also a flow). The main rea­son why I iden­ti­fied this cri­sis and 99% of econ­o­mists were totally unaware of it is that my analy­sis focuses on the role of debt (and the change in debt) on aggre­gate demand, whereas con­ven­tional neo­clas­si­cal eco­nom­ics ignores pri­vate debt.

  • GSM

    al49er Steve and All,

    Best of the sea­son to every­one.

    al49er, I am cer­tain that one facet of the quid pro quo’s of all the opaque and smelly deal­ings between Wall St banks, The Fed and US trea­sury are com­plicit agree­ments to manip­u­late what essen­tially is the US Bond mar­ket- all under the aus­pices of “The President’s Work­ing Group on Finan­cial Mar­kets” or the PPT.

    Any body who believes this fraud is not pos­si­ble sim­ply does not under­stand the dire state of US finances- as an exam­ple look at how the US FASB was rolled to not enforce mark to mar­ket account­ing. Also the non report­ing of M3.When it comes to self preser­va­tion the US will not shy away from fraud­u­lent acts. You will also note that there has been no indict­ments what­so­ever con­cern­ing dodgy mort­gage issuance and the even more dodgy deriv­a­tives they have spawned.It is not rocket sci­ence as to why.

    It would be a very easy arrange­ment that would allow the US Fed to buy UST’s through it’s Pri­mary Bro­kers and con­ceal the pur­chase through dodgy accounting.It would seem that Sprott and other are onto it.There is also the per­spec­tive that after the tur­moil of 08/09 mar­kets just don’t want to know about such goings on in any case.

  • @Ramanan/superpoincare 53

    I under­stood the point you are try­ing to make. How­ever this is a huge accu­sa­tion – you are accus­ing the biggest finan­cial insti­tu­tion of the world of a scam.”

    Pre­cisely but this cabal is not just com­prised of finan­cial insti­tu­tions. Take a look at Argentina’s eco­nomic col­lapse in 2001 which wiped out the mid­dle class and raise the poverty level to over 50 per­cent. This could be our future.


    The accu­sa­tion is that of mon­e­ti­za­tion with­out noti­fy­ing the pub­lic. That is a big claim. The only “proof” you have (the Sprott report) is the huge increase in the house­hold hold­ing of trea­suries seems incor­rect. What if the house­holds really pur­chased them?”

    Talk­ing a fig­ure of 100 mil­lion Amer­i­can house­holds (3:1 per pop­u­la­tion). Each house­hold would had to have pur­chased US$7,040 in trea­suries. This is at the same time when each aver­age house­hold (3:1 per pop­u­la­tion) would have debt of approx­i­mately US$100,000.

    Of cause there no direct proof because any real inves­ti­ga­tion to ascer­tain the proof is blocked. Tak­ing one exam­ple which is to audit the Fed (HR1207) and Ben Bernanke’s defense against this action.


    It seems that Barack Obama would like us to take the blue pill and have us all go back to sleep.

  • Ramanan/superpoincare

    Alan Gres­ley,

    Hys­te­ria cre­ation! Argentina’s cur­rency was not sov­er­eign. T

    The net worth of house­holds and profit orga­ni­za­tions is around $53T in the US. http://www.federalreserve.gov/releases/z1/Current/z1.pdf

    So $100,000 debt per house­hold does not con­vey enough. 

    Maybe they just sold off some equity and bought the Trea­suries. Note the $700B is annu­al­ized so for this year it is actu­ally 3/4th of that since the lat­est data is till Q3. There is some­thing funny about the tables F.209 and L.209 but the lat­ter (lev­els as opposed to flows) gives a pic­ture which seems OK to me. 

    I don’t think they are so silly that they do a mon­e­ti­za­tion with­out noti­fy­ing the pub­lic or worse cook­ing up bal­ance sheet num­bers. At any rate, its com­pletely incon­se­quen­tial to me. I under­stand there are a lot of frauds there — Gov­ern­ment Sachs is run­ning the gov­ern­ment etc… a lot hap­pened unno­ticed with AIG and those are more impor­tant stuff. 

    M3 has no con­se­quence as hence the Fed stopped pub­lish­ing it. I feel I am talk­ing to a bunch of Aus­tri­ans.

  • @Christopher Dob­bie 24,

    The maker of Zeit­guist, Paul Joseph makes doc­u­men­tary about con­spir­acy the­o­ries.


    Get­ting pass the parts that are truth, fic­tion or some­where in between, the most star­tling part of this seg­ment of the orig­i­nal Zeit­geist doc­u­men­tary are Paul Joseph’s words.

    The most incred­i­ble aspect of all, these total­i­tar­i­an­ism ele­ments will not be forced upon the peo­ple, the peo­ple will demand them.”

    If we are to fol­low what hap­pened in Argentina in 2001 (see my pre­vi­ous com­ment 61), do you think that we would want to be kept safe from the mobs in the streets? Would we demand total­i­tar­i­an­ism ele­ments to arise?

    Steve Keen says in a video fea­tured on his lat­est blog, “Inter­view on Engineer.net” that the Great Depres­sion resulted in the rise of Fas­cist regimes that led to WW2. I agree with Steve Keen’s assess­ment of eco­nom­ics, pol­i­tics and his­tory of this period of time.

    My ques­tion is, is his­tory repeat­ing itself but now on a far larger scale? The rea­son that I con­tem­plate pois­ing such a ques­tion is the fact that some of those who are in power now (some dis­cretely) are descen­dants from those who were in power 80 years ago.

  • mahaish

    Pre­cisely but this cabal is not just com­prised of finan­cial insti­tu­tions. Take a look at Argentina’s eco­nomic col­lapse in 2001 which wiped out the mid­dle class and raise the poverty level to over 50 per­cent. This could be our future”

    hi alan,

    under­stand your con­cerns but the argies are a bad exam­ple.

    they had a cur­rency peg to the US dol­lar which brought them unstuck, because they didnt have the reserves to defend it. 

    fun­nily enough dubai has the same issue, but UAE reserves are more than enough to defend the peg for the time being.

    china’s in the same boat. it will be inter­est­ing to see how long these pegs last, whether changes in global trade flows espe­cially with the US will ulti­mately destroy these mech­a­nisms

    the main thing is that the argies got rid of the peg , gave the imf the two fin­gered salute, and under­took fis­cal expan­sion. cap­i­tal inflows dried up for a while, but even­tu­ally there econ­omy picked up as a con­se­quence which again made them a viable propo­si­tion in terms of for­eign per­cep­tions of their spend­ing power.

  • @Ramanan/superpoincare 62,

    Hys­te­ria cre­ation! Argentina’s cur­rency was not sov­er­eign.”

    Nei­ther were the own­ers of the Argen­tin­ian econ­omy sov­er­eign. If you watch part 2, 3 and 4 of the doc­u­men­tary, you will notice that this leads back to Wall Street. In this aspect, us first world nations face the same chal­lenges. We are los­ing our sov­er­eignty to an inter­na­tional group of banksters.

    The net worth of house­holds and profit orga­ni­za­tions is around $53T in the US.”

    The is accord­ing to the sub­jec­tive worth data gen­er­ated by the Fed on opaque analy­sis base on false eco­nomic data.

    So $100,000 debt per house­hold does not con­vey enough.”

    Enough of what? Are you say­ing this fig­ure should be upwards? I base this debt per house on this. Total house­hold debt US10T divided by 300 mil­lion peo­ple equals US$33.333. Using a ratio of 3 per­son per house­hold this cal­cu­lates to the value of US$100,000 per house­hold. The aver­age yearly inter­est alone could be 10 per­cent which equal US$10,000 per house­hold which is more than US$7,040 in US trea­suries. You can hide many fine details by using aver­ages.

    Maybe they just sold off some equity and bought the Trea­suries.”

    What per­cent­age of the pop­u­la­tion of the US has the spare cash to do this?

    I don’t think they are so silly that they do a mon­e­ti­za­tion with­out noti­fy­ing the pub­lic or worse cook­ing up bal­ance sheet num­bers.”

    If they were com­mit­ting fraud, then they would want to cook the bal­ance sheets.

    At any rate, its com­pletely incon­se­quen­tial to me. I under­stand there are a lot of frauds there – Gov­ern­ment Sachs is run­ning the gov­ern­ment etc… a lot hap­pened unno­ticed with AIG and those are more impor­tant stuff.”

    How many Gov­ern­ment Sachs employ­ees have or now work for the US Gov­ern­ment or the Fed?

    I feel I am talk­ing to a bunch of Aus­tri­ans.”

    I only knew of Aus­tri­ans eco­nom­ics last year (as well as those rumors of sin­is­ter con­spir­a­cies). Over 20 years ago at the time when I thought we lived under a full reserve bank­ing sys­tem, I knew that upon see­ing the data of trans­fer of wealth from the poor to the wealthy for the period from the 1960s to the 1980s, that this form of cap­i­tal­ism was not sus­tain­able since it was eat­ing away at the base of the pyra­mid. Even­tu­ally the bot­tom lay­ers and then the mid­dle lay­ers would fall and this would result in the whole sys­tem col­laps­ing like a house of cards.

    I was being a real­ist and at this time I said to myself that I would not acquire debt since I saw the bankster as fraud­u­lent gang­sters.

    Now I must go off and see what I can find in coun­cil road­side cleanups. See­ing what house­holds throw away first­hand allows me to imag­ine how to release my poten­tial of cre­at­ing true wealth or sav­ing. So far I may have saved the world US$100 mil­lion in web devel­op­ment cost for a period of maybe 10 years. Now my wealth cre­ation poten­tial could be over US$500 mil­lion dol­lars. In my time doing coun­cil road­side cleanups, I have seen imported goods of a value well into the mil­lions. Some of the major items are fur­ni­ture made out of chip­board, bed­ding mate­r­ial and cloths.

  • scep­ti­cus

    JKH @17 et al,

    Mish is an inter­est­ing hybrid of aus­trian and post keyn­sian.

    His evo­lu­tion away from ther for­mer and towards the lat­ter is most inter­est­ing. I have tried to point out to him that loan losses can’t be absorbed by reserves to no avail. 

    Mish’s ide­ol­ogy is aus­trian, but his eco­nomic under­stand­ing is increas­ingly at odds with that school. It’ll be inter­est­ing to see how he recon­cliles heart with head.

    I pre­dict that this moment of inter­nal con­flict will come when he has to admit to the objec­tive real­ity of the para­dox of thrift, which is the only pos­si­ble end­point of the line of eco­nomic rea­son­ing he has embarked upon.

  • Ramanan/superpoincare


    If you go to Mish’s web­site — there is a peti­tion for bal­anc­ing bud­gets!!!

  • scep­ti­cus

    ramanan, yes there is — how­ever he is the only promi­nent aus­trian type to deny the money mul­ti­plier.

    he also agrees that loans cre­ate deposits, which will sooner or later lead him to ques­tion his aus­trian ide­o­log­i­cal beliefs.

    I think the bat­tle is already being fought in his mind — it is begin­ning to spill into his posts.

  • pb

    If what the con­spir­acy the­o­rists say are true, then the infi­nitely pow­er­ful gov­ern­ment would ensure they do not get air­play.

    If they are wrong well that is prob­a­bly why they exist.

  • dvd_cec­ca­relli

    Hi, My name is Davide and I’m new in this blog. Firstly, I’ll want to say that this blog is fan­tas­tic and I’m learn­ing much things from Mr Keen and from other peo­ple who parte­ci­pate in the net­work. Sec­ondly, I’ll want to excuse me for my bad eng­lish but I’m an ital­ian stu­dent and I learned eng­lish only by read­ing aca­d­e­mic papers.
    Thirdly, I’ll want to raise a ques­tion about some results founded by Mr Keen in his aca­d­e­mic reaserch. Mr Keen empha­sizes, cor­rectly, in his Good­win-Min­sky model the impor­tance of debt and the role played by banks in cycli­cal process. But in his math­e­mat­i­cal model the debt GDP ratio is pos­i­tive! That is, the firms accu­mu­late assets and the banks play no role in the process. This is the oppo­site of Min­sky the­ory and results.

  • Wel­come aboard David,

    I think you are mis-read­ing the model some­what: in my mod­els I record debt as a pos­i­tive quan­tity, so that when it is greater than zero then some entity (the firm sec­tor) owes money to the banks.

    In some runs of the Good­win-Min­sky model I do get neg­a­tive debt lev­els, which means that firms accu­mu­late finan­cial resources and receive inter­est pay­ments from the banks. But in gen­eral I get pos­i­tive debt lev­els, and there­fore firms hav­ing a lia­bil­ity to the bank­ing sec­tor. In the Cir­cuit mod­els, debt always remains pos­i­tive and greater than the deposits of banks, in which case firms have a net lia­bil­ity to the bank­ing sec­tor. This is con­sis­tent with Min­sky (and some­what more impor­tantly in this instance, Schum­peter).

    All the best, Steve
    PS Your Eng­lish is excellent–far bet­ter than my (non-exis­tent) Ital­ian and the bare rem­nants of my school­boy French

  • dvd_cec­ca­relli

    Thanks a lot Mr Keen for your reply.
    I read some of your papers, but in the sim­u­la­tion mod­els à la Good­win-Min­sky I have seen always a neaga­tive debt gdp ratio. With the term sim­u­la­tion model I intend model not flow con­sis­tent such as Cir­cuit Mod­els. In these kind of mod­els I see always a neg­a­tive debt gdp ratio (for exam­ple in 1995 Jour­nal of Post Key­ne­sian model, in your PHD the­sis posted on this blog, and 2003 paper “Big Gov­ern­ment as an Acci­den­tal Con­troller in Minsky’s Finan­cial”). If you have a more recent sim­u­la­tion model (not stock-flow con­sis­tent) with a pos­i­tive debt GDP ratio, could you be so kind to sug­gest me the name of the paper? Thanks.

  • Hi David (#72), I think there’s still some mis-read­ing going no here, so I’ll send you a paper that’s a bit clearer via your email: the pre-Cir­cuit mod­els always had cor­po­rate debt as a pos­i­tive sum when firms owed banks money, and a neg­a­tive sum when banks owed firms. In the paper I’ll send you from Com­merce, Com­plex­ity and Evolution–which used the same model as in the JPKE paper–I show that the (unsta­ble for some para­me­ter val­ues) equi­lib­rium debt to out­put ratio is +7.02% (page 97) while in the sim­u­la­tions of a break­down from a dif­fer­ent set of ini­tial con­di­tions, debt to out­put reaches +3.75 in the final cycle.

    I’ll also put that paper up on the Research Tab here I haven’t had the time to organ­ise all my papers yet and that tab is a bit out of date and incom­plete!

  • dvd_cec­ca­relli

    Thanks Mr Keen! The model in this paper is dif­fer­ent from the model appeared in 2003 (Big Gov­ern­ment as an acci­den­tal con­troller in Minsky’s Finan­cial Insta­bil­ity Hypoth­e­sis) where debt gdp ratio was neg­a­tive. Infact I have founded Vis­sim files of 2003 paper which has a neg­a­tive debt.
    Another ques­tion: Could you be so kind to send me the para­me­ters val­ues (coef­fi­cients and ini­tial val­ues) used in the sim­u­la­tion reported in the paper which repro­duce a pos­i­tive debt? This is because now I’m excited and inter­ested in repro­duc­ing the results in Ven­sim soft­ware!

  • re #74 Mish. Ah! So that’s where you got the neg­a­tive from! Yes, in ear­lier papers I did that but I changed the con­ven­tion very early on.

    This paper has a table at the back that fully spec­i­fies the equa­tions and the para­me­ters and ini­tial con­di­tions used; and I’ll copy you some other work in my morn­ing tomor­row.