OK so it took almost four decades but finally the mainstream is waking up to the fact that banks do not “lend out” reserves (except to one another in the fed funds market). The whole “deposit multiplier” story that was taught in every American money and banking textbook is wrong. Always has been wrong.
(Just an aside: the mistake was largely an American deal. British students got to use Charles Goodhart’s text, which always got it right. But generations of Americans as well as foreigners who studied in America were misled by our textbooks.)
If our policymakers who art in Washington understood this, we would not have got QE. Or all the hyperinflation hyperventilating by those who fear that the trillions of dollars of excess reserves will get “lent out” and cause prices to go to the stratosphere.
Banks do not “use” reserves as the raw material for loan-making. Rather, they lend out their own deposits, which are created by keystrokes. Post Keynesians have been saying this since a seminal piece by Basil Moore was published in 1979 (and it is easy to find early precursors all the way back to the dawn of time–as I demonstrated in my 1990 book, Money and Credit in Capitalist Economies).
S&P’s top economist, Paul Sheard, has written an excellent piece, Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves published here: http://www.standardandpoors.com/spf/upload/Ratings_US/Repeat_After_Me_8_14_13.pdf. The whole thing is worth reading. Here’s a snippet, along with the citations he offered in support:
The Money Multiplier View Of Credit Creation. What is the defunct idea here that has such a grip on the world? Almost anyone who has taken an introductory course in economics or who has consulted a textbook on the issue will have studied the “money/credit multiplier” or “fractional-reserve banking” theory of credit creation. The story line is essentially as follows. Under a fractional-reserve banking system (the system in operation virtually everywhere in modern developed economies), banks have to hold a fraction of their deposits (a liability for them) as deposits at the central bank (called reserves) (an asset for them), but they can “lend out” the remainder. Given these reserve requirements (set by the central bank) and the public’s preferences for holding cash, there is a fixed “money multiplier” (the ratio of broad money to central bank reserves), such that a given amount of reserves multiplies into a much bigger amount of bank lending. The central bank supplies reserves to the banking system via open market operations or discount window lending, so when it increases reserves, given the fixed money multiplier, bank lending and deposits (or the broader money supply) should increase as well (*)…..
But the money multiplier has not collapsed because it was never there in a meaningful sense to begin with. Rather a ratio of two loosely connected numbers has fallen dramatically because the denominator was dramatically increased.
So how does QE work, and why can’t banks “lend out” reserves, and why is it that, if the central bank so deems it, banks (in aggregate) have to “park” their excess reserves at the central bank–so no one should be surprised if that is exactly what is happening?
There are two pieces to the puzzle: one, what determines the amount of reserves on a central bank’s balance sheet or “in the banking system,” as it is equivalently described; two, how credit creation happens–that is, how banks lend. Let’s take them in turn. A key distinction to bear in mind (hinted at in the last previous paragraph) is between individual banks and banks in aggregate. Neither individual banks nor banks as a whole can “lend out” reserves, but individual banks can and do offload their reserves (particularly excess reserves) by lending them to other banks or by buying assets; but the banks in aggregate cannot do this–in such cases, the reserves that leave one bank’s balance sheet just pop up on another, remaining on the central bank’s balance sheet all the while.
Most importantly, banks cannot cause the amount of reserves at the central bank to fall by “lending them out” to customers. That possibility is not allowed for in the identity because bank lending does not enter into it. Assuming that the public does not change its demand for cash and the government does not make any net payments to the private sector (two things that are both beyond the direct control of the banks and the central bank), bank reserves have to remain “parked” at the central bank. To express wonder that banks don’t lend out their reserves or that they park them at the central bank is to fundamentally misunderstand the balance-sheet mechanics of credit creation and how QE works.
*Citations: Although the “money multiplier” view of central banking and credit creation is the dominant one, largely I would posit because its pedagogical attractiveness makes it a “dominant meme,” other schools of thought have long existed in economics and have come to the fore more recently in the guise of “modern monetary theory (MMT).” See, for instance, Wynne Godley and Marc Lavoie, 2007: Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth (Palgrave Macmillan); L. Randall Wray, 1998: Understanding Modern Money: The Key to Full Employment and Price Stability (Edgar Elgar); L. Randall Wray, 2012: Modern Monetary Theory: A Primer on Macroeconomics for Sovereign Monetary Systems (Palgrave Macmillan).
Nicely put, and cited. Would have been even nicer if he cited my 1990 book!