Schrödinger's Bank Reserves

Photo by Bank Phrom on Unsplash

During a recent appearance on CBS News's 60 Minutes show, Federal Reserve Chair Jerome Powell acknowledged that it was fair to say that the Fed "had flooded the system with money" through its "ability to create money digitally".

However, is it really accurate to claim that the Fed is flooding the system with newly-created money?

Yes and no, as we shall see.

What is money?

There is no clear definition of money. Similarly, there is no single measure of the money supply.

What may seem strange to outside observers is a common fact among central bankers: each institution uses its own definitions and measures for its purposes, including periodic adjustments of their methodologies. [1]

A common approach is to define and compute several monetary aggregates composed of specific types of financial instruments (e.g. see O'Brien 2007 for a comparison between OECD countries). This not only implies the presence of different types of money that are in circulation, but also the existence of different issuers.

In a fiat monetary system, the central bank creates the base money (M0 or MB), which consists of currency – physical coins and notes accessible to the general public – as well as (central) bank reserves – essentially deposit accounts of select banks at the Fed. Financial institutions also create money in the form of private credit: commercial banks through the extension of loans (narrow money) and other market participants via the issuance of securities (broad money: e.g. money market fund shares, certificates of deposit, commercial paper, and other debt securities).

There is a natural hierarchy inherent to every monetary system: while base money represents the ultimate medium of settlement, private credit is widely circulating in various forms in the financial system as money substitute(s). The line between "money" and "credit" is blurry: what is considered "money" generally depends on (i) one's position in the hierarchy and (ii) the general level of confidence in the market.

Does the Fed print money?

When Chair Powell says the Fed creates money digitally, he refers to the expansion of the Fed's balance sheet through the creation of bank reserves [2].

As per the hierarchy above, these reserves represent the "purest" form of money, together with physical currency. In practical terms, however, they currently also represent (one of) the least useful and usable form(s) of money.

Let me explain.

Unlike physical cash, bank reserves are only available to a small privileged club of commercial banks and primary dealers. These reserves are confined to an internal, closed-loop system outside of which they have no use – they are conceptually similar to "laundromat tokens", as Emil Kalinowksi has aptly described.

During normal times, banks and dealers can put reserves to productive use by extending credit to the rest of the financial system and the real economy, thereby increasing the broader money supply. In times of crisis, however, this transmission mechanism is broken: reserves sit idle on banks' balance sheets.

We thus end up with a bizarre situation where bank reserves are simultaneously money and not money: money because they are the ultimate medium of settlement on top of the pyramid; not money because they can't be used as a medium of exchange for practical purposes by the rest of the financial system and the real economy.

Hence Schrödinger's bank reserves, an allusion to Erwin Schrödinger's famous thought experiment involving a cat that, paradoxically, is simultaneously dead and alive.

The role of credit markets

How is this possible?

A major reason has been the growing role of debt capital markets and the shadow banking system in the creation of private money, an evolution that has largely taken place outside the purview and control of central banks and regulatory authorities since the 1970s. As a result, central banks – and the Fed in particular – have gradually lost much of their power to influence the broad money supply. [3]

Despite the Fed's (digital) printing press running at full speed, money in the financial system is tight and quickly drying up. The unlimited creation of bank reserves will increasingly appear a desperate because ultimately futile attempt at compensating the massive destruction of credit that is occurring in the offshore/shadow banking system, unless these funds will find their way directly to those who need it most (#CBDC anyone?).

Clashing views on money: academics/policymakers vs. practitioners

In some ways, this reminds me of previous clashes between different views on how money works: the academics (and occasionally policymakers) against the practitioners (mostly bankers and bill brokers). Historical examples include William Lowndes's futile battle against public intellectual John Locke in the 17th century (see Faye 1933), and The Economist editor Walter Bagehot successfully taking on the fight against the conventional view of the classical school (promoted by the likes of Adam Smith, Jean-Baptiste Say, and John Stuart Mill) in the 19th century. [4]

In other ways, the current situation is different: academics and policymakers as well as practitioners agree that the Fed creates money, but seem to have different views on its ability to control and influence the broader money supply.

History shows that when in doubt, one should listen to the practitioners (albeit some caution and healthy skepticism are advised): they are best placed to know what is the currently-prevailing "definition" of money in the markets. In the end, the banking sector is the ultimate arbiter of what counts as money – and bank reserves do not seem to be part of it right now.

Footnotes

[1] Wikipedia provides a great overview of the various definitions and measures used by the major central banks.

[2] This is currently done via the practice of quantitative easing – large-scale asset purchases in exchange for newly-created reserves.

[3] The Fed even more so given the USD's status as the world's undisputed reserve currency that underlies the vast majority of world trade and financial transactions. It is worth distinguishing here between the "domestic dollar" and the "international dollar": the Fed has limited control over the former and practically no control over the latter.

[4] Felix Martin's excellent book Money: The Unauthorised Biography provides an excellent description of both episodes.