A New Idiocy

Probably the most persistent financial idiocy is the notion of “cash on the sidelines.” But there is another that is rapidly catching up, which is the idea that the money the Fed is creating by buying bonds is “sitting idle in bank reserves” and not being lent.

Money the Fed creates – liquidity – can exist in only two forms, either as physical cash money or as deposits in Federal Reserve accounts. Liquidity is used to settle transactions, either by cash changing hands or by electronic transfer from one Fed account to another. That is it, there is no other way. Any payment method you see out there ends up as one or the other of those two methods, usually the latter. A bank must have enough reserves on deposit with the Fed so that it can settle its obligations as its customers transfer money to, or deposit checks at, accounts at other banks. If it doesn’t, it can borrow reserves from other banks or from the Fed itself. But so long as it has enough, there is no particular value to the bank in holding excess reserves other than the very small amount of interest that the Fed pays on the deposits.

The assets of the Fed are the securities – usually bonds, bills and notes – that it owns. The liabilities of the Fed are its deposit accounts (and a tiny sliver of capital). When the Fed buys more bonds it adds to the assets (taking delivery of the bonds or whatever) and to the liabilities (crediting payment to the seller’s bank’s account with the Fed). The asset and liability accounts must balance.

None of this has anything to do with lending money, a process which creates credit money (a bank deposit) rather than liquidity and does not depend in any way on cash or bank reserve accounts. You would think that folks who write for the financial press would take the trouble to understand the basic mechanics of the banking system, which is at the heart of all financial transactions. But apparently not.

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