Tuesday, December 2, 2014

Unlearning Money: Part 1

What is money? I really don't have a clear-cut answer. But I don't think we need to define money to understand the intricacies of our economy. I would argue that to understand the modern economy, it helps to unlearn money, while at the same time keeping in mind how people perceive money. Let me explain.

To understand how the economy as a whole works, what can be called macroeconomics, we need to have a drastically different perspective on money than we have in private, microeconomic, matters. It takes some effort to develop this perspective, because what is needed is unlearning (often the hardest part) what one thought was money. After all, none of us are born monetary economists, and so we go through at least the first 20 years of our lives learning what I call the micro-view of money. Most of us have heard at one point in our life something along the lines "money is actually debt", but it remains more of a curiosity. Why? I think it is partly because it is hard to grasp -- it would take some unlearning as it is incompatible with our prevailing understanding. And perhaps people think it doesn't matter, that it doesn't have any practical meaning for them. And in private life, it rarely does.

But in monetary and macroeconomics, it is not a curiosity. There, modern day money (bank reserves, cash, commercial bank deposits) is nothing but an IOU. This I call the macro-view of money. In the following I will present my view on these three types of "money": bank reserves, cash and deposits.

Bank Reserves

In connection to Quantitative easing (QE), there has been a lot of talk about (central) bank reserves. Some people have suggested that the commercial banks should lend them out to the public, that the problem is that "banks are sitting on the reserves". But the thing is that they can't lend them out to anyone else than other banks. And the other banks don't want to borrow them.

Is it really so? Even Alan Greenspan, after 18+ years at the helm of the Federal Reserve, suggests in this interview (starting at 12:10, actual statement 14:02), with Gillian Tett of Financial Times, that Wells Fargo could lend its reserves ("cash") to IBM or U.S. Steel, or other businesses. But it just isn't so, and you don't need to look further than the New York Fed to figure it out:

"…the Federal Reserve’s new liquidity facilities have created, as a byproduct, a large quantity of reserves and these reserves can only be held by banks. […] The central message of the article is that the [excess reserves] only reflect the size of the Federal Reserve’s policy initiatives; they say almost nothing about the effects these initiatives have had on bank lending or on the level of economic activity." - "Why Are Banks Holding So Many Excess Reserves?", Staff Report, July 2009

To be fair to Mr. Greenspan, he is definitely not the only expert who has shown confusion when talking about money (more or less we all do, from time to time). I think we witness here a problem created by the incompatibility between views of, on one hand, money as a commodity (compatible with Loanable funds market), and on the other, money as an IOU. In my opinion it's the former view that needs unlearning. More broadly, this confusion might even have something to do with incommensurability. (I thank George Cooper for introducing me to this concept in his "Money, Blood and Revolution".)

Ok, back to reserves. Banks could also buy financial assets -- like Treasuries or mortgage-backed securities (MBS) -- with the reserves. But only from other banks that would then end up sitting on those reserves, or from the Federal Reserve in which case total reserves would, indeed, decline. The problem with this option is that the Fed has been more keen in buying than selling Treasuries and MBSs (selling would amount to "Quantitative tightening", if you will). So it seems no one really needs those reserves at the moment. For banks, there's not much use for the reserves they hold -- other than earning the 0,25 % p.a. interest, that is. Of course, a linguist will immediately spot a tautology here and point us to Merriam-Webster:


noun, often attributive : a supply of something that is stored so that it can be used at a later time

I might get back to that in a later post...

The big picture: the central bank creates the reserves, and the central bank can take them away. The amount of reserves tells us close to nothing about bank lending to businesses and households.


Deposit Accounts

But what about the public's (households and non-bank companies) money? The ones and zeros on our bank accounts -- if we overlook the physical currency, which we can fairly safely do for now (economists have actually already started to plan to get rid of cash). Can't banks lend the deposit money out, so it doesn't just sit there? No, they can't. Banks can only (literally speaking) lend out what is money for the banks, which is the reserves at the central bank. And like we saw earlier, they can't lend it to the public. Our, the public's, money is debt, a liability, to banks. And it just doesn't make any sense to lend out debt to anyone. "Hey, here's a note that says 'I owe my friend 100 dollars', would you like to borrow it? It's fine paper." No. It's only the public who can lend out the public's money -- the bank deposits. (Well, a bank can lend out a deposit it has in another bank, just like the public can...)

So, banks don't lend their assets, for instance bank reserves, to businesses or households, nor do they lend their existing liabilities to them. It wouldn't make any sense to lend one's own liability to someone else.


What about physical currency (notes and coins), i.e. cash? While in the bank, there is full interchangeability between cash and bank reserves. Banks usually deposit (a verb) any extra cash at the central bank and the central bank increases banks' reserves when it receives this cash. Cash, like the reserves, is an IOU of the central bank, and this explains how banks treat them. But, unlike reserves, the cash can find its way to the hands of the public. The interesting thing is that cash, for the public, is interchangeable with bank deposits. But bank deposits are not central bank IOUs, like cash is. So when you deposit cash into a bank, what really happens is this: You take your IOU from the central bank to the commercial bank and agree that from now on the central bank owes the commercial bank and the commercial bank owes you. The bank writes up both your deposit account and its own reserves (or vault cash), in other words, what the central bank owes it.

If reserves can be transformed into cash, can banks -- after all -- lend them out to the public? Only indirectly. They can convert reserves to vault cash, make a loan to a customer, write up the customer's deposit account when making the loan and then convert the deposit to cash (if the customer is willing to take cash) and give it out to the customer. So banks could, individually as well as in aggregate, lower the amount of reserves by pushing cash out to the public. But to do this, they don't need to make any additional loans. It's enough if their customers convert their deposits to cash, accepting a central bank IOU instead of a commercial bank IOU. So can banks lend out reserves or not? This is getting complicated, as you see. Pushing cash out to the public is not the same as lending cash out. It sounds suspiciously like a bank run. "We're not trustworthy -- and the ATM is soon empty" could work well as a slogan if banks wanted to reduce the amount of reserves.

Today very few borrowers take the loan out in cash, but this might be where the confusion with banking comes from. In the world of yesterday, it made slightly more sense to say that a bank keeps only a fraction of public's money (meaning cash here) in the bank, and lends out the rest of it. And we should not forget how children even in today's increasingly cashless economy, when they are learning the secrets of money and saving, take their piggy-banks to the bank branch office to make a deposit. It's only natural for the parents at one point to explain how most of the money doesn't really stay in the bank but is lent out to people and businesses. So what's wrong with this story?

As I explained above, cash very rarely flows out of the bank even indirectly as a consequence of a new loan made by the bank. Directly, cash flows out of the banking system, to the public, only through people's deposit withdrawals -- just the opposite transaction from making a deposit -- at the ATM or bank branch offices (mostly paper notes) or businesses' withdrawals of coins (for change money, as people usually pay with notes). The business, after having received payments in bank notes, usually takes them back to a bank where people can withdraw them from, again. And conversely, children take the coins back to the bank where businesses can withdraw them from. That's how cash flows mostly today: between individuals and businesses as depositors, not between depositors and borrowers.

The Source of Money

If it is only depositors who take out cash from a bank, doesn't the cash we, as depositors, take to a bank then stay there until we take it out again? If not in the individual bank, then at least in banking system as a whole? After all, if it's not lent out by the bank, where would it go?

The question is not where it would go, but whence it came. There is a big chance that none of the money you have on your deposit account right now is there as a direct consequence of you taking physical currency to the bank. Am I right?

Here is where most of the deposits come from: When a bank makes a loan to someone (an individual or a business), it creates "out of nothing" the deposit that will be used as a payment for whatever the borrower is buying. There is no "money" coming from somewhere else onto the borrower's account. The deposit is the money, it is what the bank owes initially to the borrower and later to the one he transfers it to. I can hear the bank manager telling the borrower (although I doubt they ever do): "We have a loan contract here. You owe us $10,000. Here's the repayment schedule. On our side, we write up on your account the $10,000 right away - that's a deposit, something we owe you. You owe us, we owe you. Is it a deal?" Yes, it's a deal. I owe you, you owe me. A thousand dollars. A million. A billion. You can play this game with your (non-bank) friend and logically there's no limit to how much you can owe each other. You can even write it down on a piece of paper. "I, Alyosha, owe Masha one million dollars." and "I, Masha, owe Alyosha one million dollars." (It is in writing, but if you want, you can read it out loud with a thick Russian accent...). Now, if Alyosha was a bank, then as a consequence of this little play Masha would have one million dollars on her account. Basically, it is as simple as that. That is why one of my favorite economists, J.K. Galbraith, has said:

The process by which banks create money is so simple that the mind is repelled.

So, to stress my point, the deposit is the money, and there is usually no other money that was deposited. It's best to forget the explanation how most of your money doesn't stay in the bank. Your money is the deposit and it doesn't go anywhere. It can be written up or down, and when you transfer money to someone else your deposit is written down and someone else's up. Forget the money behind the deposit. There isn't any. This is what I mean by unlearning money.

Actually, when one owes money to the bank, one never actually needs to pay money to the bank to repay the debt - it's enough if one is able to take posession of the bank's IOUs, its customer deposits (by, for instance, getting a salary paid on your account -- technically, a bank owes your employer, and your employer asks the bank to transfer this claim on the bank to you). If you owe the bank 100, then you repay by getting into a position where the bank also owes you 100, and asking the bank to write off these two balanced positions. That's how you repay debt: by having the bank simultaneously write off your deposit -- the bank's debt to you -- and your debt to the bank. Just like the bank wrote up your deposit and your debt to the bank when it made the loan to you.

Slightly confused? Out of initial confusion will emerge new understanding. I'm confused myself, but I'm working on it by unlearning and learning. You should have seen me 10 months ago! I felt I was dropped in the middle of a huge wilderness without a map. So many threats, so many possibilities... A brave new world. I still can taste the juicy ants, and in my dreams I swim in the ice cold water!

Some further (random) reading:

Bank of England: Quarterly Bulletin 2014 Q1

Monetary Reform – Be Careful what you aim for (George Cooper -- I also found his two books, The Origin of Financial Crises, and Money, Blood and Revolution, lucid and thought-provoking.)

Martin Wolf on Funny Money Creation (Izabella Kaminska @ FT Alphaville; free, but requires registration... I think)

Funny Money Debate Rumbles On (Izabella Kaminska @ FT Alphaville)

The Fed is not “Printing Money.” It’s Retiring Bonds and Issuing Reserves. (Steve Roth @ Angry Bear)


  1. Hi Peter,

    let me go directly to the point, where most of the confusion about money comes from. It comes from the misconception to see cash as an IOU from the central bank. This is due to the fact, that in former times cash or notes were a claim for a certain asset like gold or other commodities. In that times a gold deposit was accompanied with the emission of a bank note. In our times cash is emitted when the central bank honours an obligation to emit cash with delivering cash. The central bank has the unlimited right to serve its debts by handing out bank notes. This handout is recorded on the liability side and serves essentially as a memory about the amount of the issued cash volume. There is no more obligation connected because it is a documentation about fulfilled debts. The debts of the central bank - the reserves - are written down and the remaining position is the amount of paid debts, which is called the emitted currency.

    The background of this claim is the difference of the two spheres of every contract which are the level of commitment on the one side and the level of fulfillment on the other. Any contract between to parties originates two obligations (sphere 1) which have to be fulfilled with a handover of the items (sphere 2) which are contracted. The delivery of these items eradicates all obligations of that contract and do not leave any obligation behind. So if the central bank pays down some reserves it is no longer indebted with this debt.

    The fact, that the central bank has the unlimited right to pay down all the own currency debts with issuing notes is the reason why banks are satisfied with an incoming amount of reserves especially when a bank is obliged to accept an additional debt in favor of one of its customers. A bank will only accept a money transfer if it will get an unconditional access to reserves or cash in the amount of the additional obligation against its customer which receives the right to dispose over this money claim. Therefore the deposits alone are never accepted as payment which is the reason for the fact, that deposits (which are promises to pay) do not have the ability to settle any debts. Any money transfer has to be accompanied by a transfer of reserves - or cash.

    And this is the answer to the question of lending: every loan has a positive probability that the bank will face an outflow of reserves or cash. Therefore the liquidity management of a bank must look if the access to liquidity is sufficient to meet any outflow of liquidity. And this liquidity is only created if the central bank accepts a debt which are for the bank a claim to reserves or - maybe later - cash. So what the banks are doing when granting a loan is to promise to pay in a standard of payment which they cannot create by themselves.

    This is the true unknown secret of banking - not the error of Galbraith and others! The 'out of nothing' money is only a promise which must be fulfilled - usually with the standard of deferred payments!

  2. Hi Renée,

    I take this to be your main point: "Therefore the deposits alone are never accepted as payment which is the reason for the fact, that deposits (which are promises to pay) do not have the ability to settle any debts. Any money transfer has to be accompanied by a transfer of reserves - or cash."

    I will be straight-forward -- feel free to correct me if I have misunderstood.

    What you describe could be somewhat true for smaller, often specialized banks that are not able to rely mainly on "deposit financing" (as opposed to other forms of bank debt). Once a bank like this extends a loan, it is very likely that the deposit it creates will not stay with it. But even in this case, the bank often offers savings accounts with higher interest rate to lock in longer-term deposits so that it doesn't need to rely on other than short-term interbank lending. So yes, the deposit created with the loan leaves the bank, but if the bank is successful in attracting other deposits, its need for reserves remains low (as they are used for *net* interbank payments only). It gets new deposits daily, and these often replace most of the deposits that left it. You're right in arguing that the bank needs liquidity management, as the incoming and outgoing deposits are never in perfect balance.

    When we move towards "megabanks" like Wells Fargo, Bank of America and (JP Morgan) Chase, we see that the deposits created through lending either don't leave the bank at all (no reserves needed), or then the deposits circulate among these megabanks -- in which case there is also very little need for reserves as the interbank transactions "net out" to a large extent.

    I have touched this issue in this post:


    In it I write:

    "Reserve constraints, like capital constraints, pose a smaller problem when the banking system as a whole is increasing lending, i.e. there is aggregate credit growth. When Bank A makes a loan, a deposit created by it might end up being transferred to Bank B, but in similar fashion Bank A is a recipient of deposits created by other banks. This will lead to fairly small net payments between banks."

    So -- assuming I've understood you correctly -- I cannot agree with you. To me, your suggestion has its roots in our *need* to find "something" that is behind this "money out of nothing". You are right in looking for something -- there is something behind the deposit --, but it is not what you suggest here. To be fair, I think Wicksell and others made the same error. I'm sure you know very well that there is nothing new in saying that ultimately there is HPM (high-powered money) behind these deposits. As far as I know, this discussion first took place well more than 100 years ago!

    It's time for new thinking?