The Fed, endogenous money and balance sheet constraints
I haven't been teeing up thought pieces on the financial system on Credit Writedowns for a while now. And that's a shame since this site's name owes to the role I believe balance sheets in the financial system play in business cycles.
So, let me tee up a shorter thought piece, piggybacking on the framework longtime readers know I use to think about the economy. And since this piece was inspired by something Jeff Snider told me on Real Vision last week, I will add a piece about that here as well.
The Central Bank and the Cartel
I think this all starts with the Fed or any other central bank. I think of the banking system at the center of our financial system as a cartel with the central bank acting as the 'enforcer'. Every bank in the system is the same in that they all issue their own liabilities 'out of thin air'. But the central bank is the only one that issues liabilities in the currency of account that can be used to expunge tax liabilities. The central bank is the designated agent of the central government - or in the case of the ECB, member governments. It has no ‘real’ independence, except to the degree operational independence convinces people that government won’t be reckless in creating government IOUs. And in its role as government agent, the central bank is tasked with controlling or regulating the financial system.
In the first instance, CBs do this by cartelizing banks, by transforming individual bank liabilities into fiat currency state liabilities. For example, there was a time in the US when banks issued their own bank notes. And these competed with each other in the market based on the creditworthiness of the issuing bank. That was a 'free market', organized chaos, if you will, where you knew that the money you were using was really an IOU of the individual financial institution. If that institution failed, your money could become worthless overnight.
Central banks work with system member banks with a quid pro quo that goes like this: ‘I will give you a license to bank in my jurisdiction - and with that license you are legally permitted to manufacture liabilities in the money of account instead of under your own name. People who withdraw demand deposits liabilities from your institution can do it in legal tender rather than your own bank notes. That gives them confidence because they know those state bank notes are good money since the central government is the most creditworthy borrower in our system because of its ability to tax. But you have to subject yourself to our oversight. You must hold reserves against your liabilities. And we can withdraw your charter at any time if you get out of line.’
That creates a system with the government's monetary agent, the central bank, at the core, with all other banks issuing state money as liabilities in exchange for submitting to central bank oversight. The legal tender veil of this system is only apparent during bank runs because that's when you realize individual banks are giving you bank IOUs, not state money. If they run out of state money to back their IOUs and you aren't far enough up in the queue to make your claim, you are out of luck. You are left with a worthless bank IOU when the bank fails.
Central banks don't have this problem. Just like any other bank they can manufacture IOUs in infinite amounts. But the problem isn’t manufacturing IOUs, it’s getting those IOUs accepted by others. Only the central government and the central bank’s IOUs are legal tender. And only their IOUS can be used to expunge tax liabilities. Everyone else wants their IOUs to make transactions. Everyone else needs their IOUs. The only question for the central bank is how much each unit of IOU legal tender is worth, not whether it must be used for transactions.
When a bank makes a loan, it also creates a deposit. As the Bank of England explained it in 2014:
Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.
Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.
This is what is called endogenous money. The supply of money is determined endogenously — meaning it is the result of transactions rather than an outgrowth of some exogenous actor like an external authority such as the central bank.
Every bank creates money by granting a loan because a deposit is simultaneously created with the loan. And the cartel structure of the financial system transforms that bank liability into state money that can be withdrawn on demand, transferred to another institution, used to pay a tax liability or used to expunge another private sector liability.
So, the central bank isn't 'in control' of the money supply since most money is created endogenously by financial institutions. In fact, because modern central banks, as monopoly supplier of reserves, target the interest rate at which those reserves are borrowed, they don't even control the level of reserves. They have to supply the amount of reserves the financial system desires to make loans at the given reserve rate target they want to hit. A monopolist can control price or supply. And for innumerable reasons, modern central banks know controlling the 'price' of reserves is easier than controlling the supply.
Balance sheet constraints
Given the lack of constraints here, the natural question is "what is the check on money creation?" In the past, I would have said equity. I would have said that banks are not reserve-constrained but equity-constrained. And that's because the central bank must supply the system with the reserves it desires to hit the specific overnight interest rate target it has set. If it doesn't, it won't hit the target.
By the way, right now, we are awash in reserves. So, barring the Fed's paying interest on excess reserves (IOER), the interest rate would fall to zero. That's why IOER existed as the Fed tried to get off the zero lower bound despite all the excess reserves in the system.
The point here is that financial institutions want to remain profitable. They also want to keep their charter. So, they can't lend recklessly to borrowers who are not creditworthy. The constraint then is equity. They need to consider how many loans they can make profitably, cognizant that credit writedowns could wipe out their equity and render them insolvent.
I was talking to Jeff Snider about this equity constraint. And he told me he thinks of it as a balance sheet constraint. And that made a lot of intuitive sense to me because equity is a residual; it is what remains after you subtract liabilities from assets. And how those assets and liabilities are valued is crucial. For example, in the Great Financial Crisis, suspension of mark-to-market rules for many mortgage-backed securities stopped the credit writedowns that had eviscerated bank equity as house prices in the US plummeted. So, it's the balance sheet that matters, the value of both assets and liabilities, not the equity.
Why this matters
The crucial issue in all of this is that there is no direct line from large scale asset purchases by central banks aka quantitative easing to money growth. What if banks see bad assets on their balance sheet and stop making loans to protect their balance sheet? What if companies and households are so indebted already that they aren't willing to risk taking on more debt in a poor economy? In both those cases, quantitative easing won't matter. It might displace investors from the Treasury market and push them out the risk curve into equities or junk bonds. But it's not going to make financial institutions lend. And it's not going to make businesses and households borrow.
So, when you hear that the Fed's 'printing money' and buying up assets is inflationary, think again. They want you to believe it's inflationary. But, the truth is that the situation is more complicated than that. For inflation to become embedded because of demand-driven causes, you need demand to outstrip supply. And right now, we have the opposite problem. I don't care how many assets the Fed and other central banks buy; until you get more money into people's pockets and into businesses coffers, you are not going to see a durable inflation impulse anytime soon.