Monetary Realism Means Choosing Knowledge Over Ideology

“skate where the puck’s going, not where it’s been”. – Wayne Gretzky

There’s a famous saying that’s repeated on rare occasion when the fiscalist view of the world dominates policy – “we’re all Keynesians now”.  It’s generally a misleading way of labelling an entire population and such declarations are usually the views of biased policy thinkers.  Now, I am not in the business of labelling other people, but I am in the business of understanding the macro environment so that I can help other people make smarter financial decisions.  And I see a trend developing in the fields of finance and economics that will dramatically alter the landscape – anyone who wants to better understand the financial world for what it is (as opposed to the ideological view of what they want the world to look like) will veer towards Monetary Realism and a Post-Keynesian view of the world.

I can’t stress how important it is that we not confuse many of the principles of Post-Keynesian economics with some sort of ideology, however.  It’s unfortunate that the term “Post-Keynesian” has the word “Keynes” in it because that word tends to induce a vomiting reaction for half of the population.   And that really misses the point of the PKE school.  Post-Keynesian does not mean that you automatically favor government spending or socialism.  Yes, it is based, in part on understanding effective demand (which any business owner should accept) and the idea that the economy doesn’t naturally veer towards full employment (again, a concept we should all acknowledge given the extraordinarily high unemployment rates in recent history).  But PKE is much more than that.  PKE really means that you understand and accept the foundation from which the PK school works from.  And this means you focus on stylized fact, operational reality and the institutional design of the monetary system.  Therefore, you understand things like the following:

  • Double entry bookkeeping.
  • Understanding sectoral balances and the flow of funds in the system.
  • Accounting identities based on an operational understanding.
  • We have a fiat money system and not a commodity money system, therefore, understanding fiat money matters!
  • Banks matter in an economic model because they issue most money.
  • Understanding reserve accounting.
  • The money multiplier is a myth because banks aren’t reserve constrained.
  • The central bank and the government are highly involved in the economy (this is our reality, not necessarily the world we envision).
  • The private sector dominates economic activity.

When you tie all of these understandings together you work from a better foundation for understanding the monetary system.  And the proof is in the pudding.  After all, look at this all-star list of predictions that PKers got right in the last 5 years:

  • We knew that the expansion of QE wouldn’t cause hyperinflation or even high inflation.
  • We knew that the USA wasn’t going to suffer from a Greek crisis.
  • We knew that Europe was screwed.
  • We knew the stimulus wasn’t nearly as “stimulative” as most presumed.
  • We knew monetary policy would likely come up well short.
  • We knew interest rates weren’t going to rise.
  • We knew corporate profits were going to boom due to the government’s deficit.

These are the kinds of things that should make every single economist stand up and say “wow, what kind of performance enhancing drugs are those guys on?”  But it doesn’t require performance enhancing drugs to understand the PK foundation.  It just requires a bit of open-minded thinking.  All joking aside, these were big time predictions.  And they weren’t based on guesses or ideology or preference for policy.  They were based on the above understandings like double entry bookkeeping, flow of funds, sectoral balances, institutional design, etc.

The PKE school is not necessarily based on ideology and policy preference.  And no, you don’t have to be a socialist to understand Post-Keynesian economics.  You just have to be willing to wade into the waters of double-entry bookkeeping, accounting, sectoral balances, flow of funds, etc.  In other words, you have to be willing to understand things that are operational truth based on the way our financial world actually works.  Unfortunately, it also means you will have to set aside your preferred ideologies for PKE is primarily about understanding the world that is and not the world we necessarily want.  And that’s the biggest hurdle here.  But I see a trend developing – the PKE school and Monetary Realism will increasingly grow in influence as more and more people choose knowledge over ideology.  After all, if you want to make better financial decisions you need a better understanding of the world that IS and not the fictitious world you WANT.



Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.
Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

More Posts - Website

Follow Me:

  • Johnny Evers

    Beware of anybody saying that their program/statements/lectures are not an idealogy.
    Just one example, Marxism for a long time was cloaked as historical fact.
    And let’s not extrapolate from a few succesful predictions about (which may or may not be related to what you ‘knew’, and which other who subcribe to different idealogies also predicted) that PK can continue to predict the future.
    And many of us can no doubt agree with vanilla statements like ‘the private sector dominates economic activity’ and ‘banks matter …’ and still disagree about what will happen next and what needs to be done.

  • InvestorX

    “Yes, it is based, in part on understanding effective demand (which any business owner should accept) and the idea that the economy doesn’t naturally veer towards full employment (again, a concept we should all acknowledge given the extraordinarily high unemployment rates in recent history).”

    This unemployment thing is new to me. Of course there is frictional UE and technological UE, but other than that? The current UE levels are more a result of a hidden depression and moving the burden from the people who f§$%ed up at the top to the common man.

  • Cullen Roche

    Sure, but many of our predictions were based on facts that can be verified. For instance:

    1) When people said reserve increases would lead to hyperinflation people like me said that’s not how banking works and that banks don’t lend reserves which wouldn’t lead to high inflation.

    2) We understood the Kalecki equation and that Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends. This meant a trillion dollar deficit would be a huge benefit to corporate profits.

    3) We knew that Europe’s monetary system was flawed by design and rendered the countries susceptible to bond vigilantes because they have a solvency constraint just like a household.

    4) We knew the USA had a different monetary design that meant, in a low inflation environment, that the central bank could control interest rates.

    These weren’t based on ideology. They were based on a better understanding. That’s all. Of course we can’t totally eliminate politics from economics, but we can do better than we’re doing.

  • Johnny Evers

    All of those are debatable.
    Other factors contribute to the run-up in corporate profits. Europe is messed up for many reasons, and a central bank issueing bonds to bail out Greece is no more likely than a U.S. central bank issueing bonds to bail out Detroit. Central banks can control inflation … until the point when they can’t.
    Most of us can agree on ‘facts’ (realizing that in economics today’s facts can change overnight) but we shouldn’t claim that our intrepretation of events are themselves factual.

  • Jay

    Great post, Cullen.

  • Cowpoke

    George Gilder was on the radio yesterday, he just wrote a book on Knowledge and Power: The Information Theory of Capitalism and How it is Revolutionizing our World
    I have not read the book yet but his concepts seem to allign in some regards to Prag Cap thinking of the human can do spirit and using information theory.
    Here’s part of a review from Amazon:

    “Knowledge and Power George Gilder applies a deep understanding of communication theory to economics. Economic systems, in an analogy to communication systems, can be divided into content and conduit; that is, divided into the information or knowledge (content) and the means for delivery (carrier or conduit). The conduit is the transport mechanism; it has to be predictable and reliable for the most efficient transfer of content. If the conduit is noisy, unreliable, or if its function varies with time, then its ability to transport content degrades. For economic systems, conduit includes such things as stable currency, property rights, modest taxes, and rule of law. The content is the exchange of information and goods. If the conduit elements of the system aren’t reliable, predictable, and stable, then the flow information and goods is degraded or even perverted. Valuable human intelligence (the ultimate resource) is diverted to compensate for or even to exploit noise in the conduit. People choose careers in currency trading, regulatory agencies, tax consulting, government, and law instead of science, engineering, and business and we are all poorer as a result. “

  • Cullen Roche

    So, you’re basically claiming that all of these predictions were based on luck? Okey dokey.

  • SMOB

    Great post that has so many points in it many more posts could arise from it or even a book! Though one thing is eating away at me, what does Socialism have to do with Keynes, Lerner or Minsky! I added Lerner and Minsky as its the natural development to what today is PKE and MMT.

    When we talk about Socialism we tend to mean USSR! Monetary Realism leads to realising that Reganomics of markets know best, deregulation and privatisation ‘to-the-max’ are ideologies and philosophies detached from the real world we live in.

  • Johnny Evers

    I’m saying that a short-term succesful set of predictions does not mean that your assessment of events is necessarily factual.
    After all, goldbugs were kicking ass until a year ago, but that doesn’t mean their assessment of events was factual.

  • wkevinw

    Many reputable economists have said that the inflation caused by all the stimulus and monetary fiddling by the central banks will occur in the 2nd half of the decade.

    We are not there yet, so it’s a little soon to celebrate.

    I would advise a diversified portfolio with some hedging/weighting/insuring based on various outcomes; one of which is larger inflation in the future.

  • Cullen Roche

    I used the term socialism because that’s the vomit induced reaction that many in the USA naturally have when they read anything about Keynes. The term “keynesian” has been turned into a pejorative term in many circles. This is deeply misleading.

  • GLG34

    Cullen has navigated the last 5 years with a lot more accuracy and factual understanding than 99% of the people out there. I think he deserves a little more credit than you’re giving him.

  • SMOB

    I apologise in my post I confused ‘Socialism’ with ‘Communism.’

  • Tyler

    I’m having a very hard time believing the whole bit about how excess reserves don’t essentially do anything.

    Did you see this article:

    “Commercial banks are required to hold reserves equal to a share of their checkable deposits. Since reserves in excess of the required amount did not earn any interest from the Fed before 2008, commercial banks had an incentive to lend to households and businesses until the resulting growth of deposits used up all of those excess reserves.”

    Don’t you basically teach that excess reserves can’t really be used for anything in the economy?

  • Kid Dynamite

    “I’m saying that a short-term succesful set of predictions does not mean that your assessment of events is necessarily factual.”

    that’s correct, so which of Cullens realities above do you think is not factual? that’s the question…

    is he wrong about reserves and how banking works?
    is he wrong about the balance of payments equation?
    is he wrong about Europe’s monetary design?
    is he wrong about the central bank’s ability to control rates in the U.S.?

    I don’t think he is. I think, to use your example, Goldbugs were wrong about more than one of these things, which is why in the end, they could only be right on price direction out of dumb luck. Eventually, dumb luck fails, of course, as you saw.

  • Cullen Roche

    No, reserves help banks settle payments and meet their reserve requirements. But bank lending is not reserve constrained as the money multiplier teaches most of us. In fact, in a system like canada, there are not reserve requirements and banks can still make loans.

    The point is that focusing on the amount of reserves misunderstands the way banks make loans. Solvent banks make loans based on their capital levels and the creditworthiness of customers. Reserves are simply one component of the asset side of a bank balance sheet in the solvency equation. A bank with lots of reserves can be totally insolvent and unable to make loans.

    My paper on the monetary system and banking touches on this:

  • Geoff

    I agree that knowledge should trump ideology, and that the PKers are the most knowledgeable school around. However, I don’t necessarily see a trend of people actually choosing knowledge over ideology. Maybe I’m just not travelling in the right circles. Cullen, what is this trend of which you speak?

  • Cullen Roche

    For instance, I think the idea of endogenous money is becoming more mainstream. Even Scott Sumner recently said that bank lending is not reserve constrained. And I see Krugman moving increasingly towards a PK position.

    It’s baby steps, but I really think it’s happening. I have a feeling much of this thinking will be adopted as fact over the next 10 years and embedded into the views of current economics as though the concepts were already known….In other words, many people will adopt components of the PK thinking without exactly acknowledging that they’re using PKE.

  • Johnny Evers

    Reserves and banking — agree.
    The balance of payments equation measures what happened but doesn’t help when making policy. For example, let’s say exports are down, so you want to add exports — how do you add exports? The sectoral equation lends itself to lazy solutions, imo. A lot of people look at it and say, ‘Just add deficit spending for growth’ for example.
    We all know Europe’s monetary design is screwed up, no matter what school you are in. How do we fix it?
    I suppose central bank can control rates, although history shows they sure do fluctuate, but the question is, ‘What is the cost to that.’ Or, ‘What should rates be.’
    Those are the interesting questions, imo, and that’s when the fur begins to fly.

  • Geoff

    I hope you’re right! If so, the future looks much, much brighter.

  • Geoff

    Regarding the inflation scenario, the Treasury inflation protected notes (aka TIPs) have certainly cheapened up over the past couple of months. I’m not necessarily recommending them but they might be worth investigating for anyone who is concerned about inflation.

  • jaymaster

    And some have been predicting stimulus-based inflation in Japan for the last 25 years.

    They might eventually be able to say “See, I told you so”, assuming they’re not dead by then!

  • jaymaster

    And just to clarify, I DO believe (and I think MR supports this as well), that excess deficit spending/fiscal stimulus, can indeed lead to inflation. But not QE.

    In fact, I’m still open to the theory that QE in its present form might actually be net deflationary.

  • bart

    None of that means that MR and especially PK aren’t ideologies.

  • bart

    That’s by far the biggest issue with the field called economics – it fails to account for actual humans and their reactions, and the other fields like sociology, psychology & anthropology.

  • Boomer

    Cullen, you’ve got the greatest blog going and it shows in the comments. For the most part SMART PEOPLE read your stuff and SMART PEOPLE reply. Don’t get discouraged by the the occasional troll and keep up the great work.

  • Lee Colville

    Your understanding of the economy/markets is great imo and that must hopefully help in investing.

    But will Monetary Realism gain influence?

    MR is correcting some important misunderstandings out there and on those points hopefully MR becomes more widely accepted.

    In wider sense though knowledge doesn’t trump ideology. Ideology should be based on knowledge but it also uses that knowledge to inform and assist the making of various decisions and value judgements.

    While sometimes I dispear at what comes out of various economists, the field of economics is much deeper and richer than just monetary policy. Is Monetary Realism also prepared to go further… I think you would make a good fist of it :)

  • Dan

    I see no reason to “beware” of Cullen or MMR, but I do think it’s odd to conflate a “descriptive” system (which is the noble effort of Cullen and MMR) and “non-ideological.” I don’t believe that the one necessarily entails the other and there may be some subtle danger in thinking so. Complex systems lend themselves to lots of different kinds of descriptions. In linguistics we teach different “descriptions” of the language (traditional, structural, transformational, etc.) and all three claim to be “mere descriptions” but we favor one description over another for reasons that are sometimes political or ideological. They all have ideological dimensions that are not their fault or intention.

    It does seem like most ideologies at least begin by claiming they are “merely describing the way things are in fact.” Perhaps that’s not really true. But anyway, my point I guess is that it seems to me that our appeal should be, not to “facts” or some ideal disinterested perspective, but to the adequacy, applicability, and predictive value of the systematic description–not to some absolute “fact.” So in that sense MMR seems to be the best description of the facts we have–I suspect it can even be improved upon over time–which is something we can claim without saying that the description itself is “factual” as opposed to “ideological.” It just seems like an unnecessary appeal. It seems quite enough to say it is adequate (it is robust enough to explain all aspects of our economic system) it is applicable (its descriptions are not mere theory but have application), and that it can reliably predict economic events or behavior.

    Perhaps I’m off base here or missing the point of the thread.


  • JK

    Hey Cullen,

    I think it would be very helpful if you would do an extensive write up on Reserves in the banking system. In discussing banking with people, and being humble about my own limited understandings, I find Reserves to be the trickiest part of the whole story. It’s especially difficult for people not in the economics and finance fields to conceptualize exactly what Reserves “are” … and exactly how they can and cannot be used by banks.

    If you’re going to do a write on Reserves, I suggest you imagine that you’re explaining it to someone who has never considered how banking works. i.e. how would you explain Reserves to my grandmother? :)

  • Tom Brown

    Tyler, looking at that quote you provide, I don’t think they’ve got that quite right. Prior to 2008, the Fed actively removed any excess reserves from the banking system with open market operations (OMOs). Prior to 2008 the Fed controlled the federal funds rate (FFR) by three mechanisms:

    1. Announcing the FFR
    2. Backing up that announcement with OMOs
    3. Providing reserves through the discount window at the FFR

    No IOR was paid. How did they hit their OMO target? Well, first of all, the fact that they announced it meant that most banks knew it was foolish to “fight the Fed” so they didn’t. But beyond that, if the overnight rate started to creep up above their target FFR, then the Fed would inject reserves into the banking system via a kind of OMO called open market purchases (OMPs) wherein they essentially bought Tsy debt. Conversely, if the overnight rate started to fall below the target FFR, they would remove reserves from the banking system with a kind of OMO called an open market sale (OMS). So by using OMS and OMP operations, and by providing reserves through the discount window at the FFR if needed, they could set the rate. As a by-product, the level of excess reserves in the system was essentially $0.

    With the FFR set by the Fed, the private economy determined the amount of money in the system through private bank loans. There was still outside money in the private economy (cash) but again the amount was completely determined by private entities choosing to withdraw or deposit cash from their bank accounts. The bank accounts themselves were mainly determined by bank lending activities, which was in turn influenced by the FFR. Prior to 2008 the bulk of outside money (reserves + cash) was actually cash! That is no longer true.

    Now, however, the Fed has flooded the banking system with reserves well above the required reserve ratios on demand deposits. This puts downward pressure on the FFR despite what the discount window rate is or the Fed announcement. In other words, the Fed has done way too many OMPs to set the rate in the usual fashion, and in fact w/o IOR the rate would essentially be 0%. With IOR, the rate naturally rises to the IOR rate.

    So if IOR were removed, the most likely outcome is not that the banks would suddenly start making so many loans that all the excess reserves out there are transformed into required reserves… instead, all that would happen is that the effective FFR would drop to 0%.

    Think about the amount of lending that would need to take place to convert all existing excess reserves into required reserves: The required reserve ratio is 10% for demand deposits (checking accounts) ONLY! The the actual rate on ALL deposits (time deposits such as savings accounts + CDs + demand deposits) is less than 10%. I don’t know what it is, but say it’s 5%. Then the banks would have to loan out about 20x the amount of the excess reserves on their books… or about $60T! This amount is as estimate, but the real amount could be no less than $30T (assuming all loans ended up as demand deposits). Those are HUGE numbers! That represents very nearly all the private assets held in the US. I doubt very much that a drop of 0.25% in the FFR would result in this gigantic uptick in lending activity or demand for loans.

    Reserves can only go three places:

    Reserves CAN be thought of as bank money with which they can pay salaries, their electric bill, office supplies, etc. But that is only necessary when the recipients of those funds have accounts at other banks (otherwise the bank can simply credit their bank deposits to pay them). Here’s an example of two ways a bank can pay (w/ & w/o reserves):

    Notice that private non-banks never get their hands on the reserves in either case.

    QE adds excess reserves in a one to one ratio with short term demand liabilities (demand deposits). Now some of those deposits may be transferred to time deposits of some kind, but in general, the growth in the banks’ balance sheets does not improve their capital position much or at all, thus they are not induced to go hog wild writing dividend checks to their shareholders… nor are they allowed (by existing capital requirements) to use the excess reserves to make risky investments. They are pretty much forced to at most buy other low risk or zero risk investments such as Tsy debt… assuming that’s more attractive than just collecting the IOR:

  • Tom Brown

    JK, allow me to take a crack at it. There’s two kinds of out-of-thin-air created dollar denominated “money”: inside money and outside money. These are not MR terms: they are used by the Fed, economists, bankers, etc.

    What do I mean by “out-of-thin-air” created money (“ex-nihilo” for short)? I mean that this money is essentially in the form on an IOU. You and I can write IOUs too… but not everybody takes them seriously. the Fed and the banks have charters which make their IOUs the same as money.

    Fed IOUs are called Fed deposits and are liabilities to the Fed (not assets!). Bank IOUs are called bank deposits and are liabilities to the banks. These two forms of deposits live in different worlds:

    Fed deposits can be assets to:
    The Treasury Dept. (TGA account)
    Government sponsored enterprises (GSEs)
    Foreign central banks (the equivalent of our Fed)
    Some international organizations (IMF and others)

    Fed deposits CANNOT be assets to you or I or any private individual or non-bank businesses or most organizations. Instead all those entities can have bank deposits as assets.

    Reserves are a kind of Fed deposit. They are the Fed deposits that banks hold.

    There is one exception to this idea that money is simultaneously an asset to someone and a liability to someone else (just like an IOU), and that is coins. Coins are an asset to whoever holds them from the day they are minted. This is not true of paper money (reserve notes). Paper money is a liability of the Fed just like electronic Fed deposits … as long as it’s not warehoused at the Fed. Paper notes warehoused at the Fed don’t appear on anybody’s balance sheet as either assets or liabilities and are not money. Think of paper notes as paper IOUs. They have no value when they are with their “creator.” In fact their creator (the Fed) may decide to destroy them rather than let them go back into circulation with almost no downside to it’s own balance sheet (“almost” because the Fed must pay the production cost to Tsy for their replacement).

    Cash (paper notes and coins) can be a form of reserves too. This form of reserves is called “vault cash.” Banks can trade their Fed deposits for vault cash or vice versa. This does not change their reserve levels. If cash is withdrawn by a bank deposit holder it is no longer considered to be reserves…. until it is re-deposited. Banks do not get paid IOR for vault cash.

    So there are four basic physical forms of money in our system:

    bank deposits (inside money)
    Fed deposits (outside money)
    Reserve notes (outside money)
    coins (outside money)

    Here’s a chart and accompanying table illustrating the relationships (and how reserves fit into the picture):

    Here are a few more examples of how reserves are used in our system:

    BTW, the reason outside money is called “outside” money is because it is created outside the private economy, and thus appears as an asset to all private enterprises or individuals. Inside money, in contrast, is created inside the private economy and thus is an asset to one private entity and a liability to another. In a sense, coins are even further outside than are paper notes and Fed deposits because they are assets to the Fed (a public/private hybrid) as well! In fact they are an asset to every entity, including the Tsy which mints them!

  • Charles Fasola

    “After all, if you want to make better financial decisions you need a better understanding of the world that IS and not the fictitious world you WANT”.

    You seem to focus here,almost entirely, on the financial sector. However, the world outside of the financial bubble seems to be moving, at light speed, toward economic and societal collapse. Those whose world consists of the relentless quest more and more money may be in for a very rude awakening. Many in the financial world had better take your advice and acquire a “better understanding of the world that IS and not the fictitious world you WANT”. Only persons of ideological conviction may bring about a reality based economic system. Your financial world is intertwined with the ordinary old world, whether accepted or not. Otherwise I find your assessments of the actual financial and money creating systems flawless.

  • jaymaster

    To save Cullen some typing over a nitpick, it’s actually MR, not MMR.

    MMT is certainly MMT.

    I pity the fool who combines the two and discovers MR T!


  • Tom Brown

    I’m OK with an ideology which values truth, full disclosure, skepticism, and a continual willingness to change one’s beliefs given the evidence. This is also the ideology of the scientific method. The opposite of the scientific method is dogmatism. Dogmatic beliefs are often evidence free, not open to question, based on the words of so called “authorities” and often result in the twisting of truth to fit the dogmatic’s pre-determined “correct” view of the world. The more obsessed with “purity” a dogmatic is, the scarier he/she is!

  • JK


    Thanks for the comment. I appreciate it. But… you kinda missed the meat of what I was asking. What I’m looking for clarification on is exactly what Reserves “are” (which you briefly discussed) and EXACTLY how Reserves can and cannot be used. For example, I understand that Reserves are not loaned out to me if I take out a bank loan. I understand that Rerserves are loan/borrowed between banks to meet their Reserve Requirement. And I understand that Reserves are used by banks to purchase Treasuries during Open Market Operations (and also to purchase Treasuries when new ones are created and sold by the TreasuryDepartment?).

    Is there anything else Reserves can be ‘used’ for? For example, how are Reserves related to financial instruments other than Treasuries, e.g. Mortgage Backed Securities, etc. When the Fed is performing QE, and purchasing financial assets ‘other’ than Treasuries, how are Reserves related or used in this process? …and so on.

    If you want to continue this, I’m interested. I’ll check out your links right now.

  • Tom Brown


    I don’t know if anyone actually uses this much, but there’s also MCT (Monetary Circuit Theory). They have an article on Wikipedia. I see that at one end of the post-Keynesian spectrum (MCT) and Chartalists at the other (state money people). MCTers see bank created money as the end all and be all of money. I think you could have claimed that Steve Keen was effectively an MCTer at one time. That’s my take anyway… I haven’t really dug into that much though.

  • Geoff

    Excellent, Tom!

  • John Daschbach

    Getting back on my soapbox, I think it’s important for people to realize that economics in a developed economy operates far from equilibrium. PKE and MR provide a framework for understand operationally how our economy is behaving. Many in the ideological camps fail at this basic understanding. But the flows of work and money that roughly define economics in our view are potentially easily overwhelmed by psychology.

    But it’s important to get the operational details correct, even if someone has an idealogical bias. A problem we face is that most people in the vocal ideological fringes have no understanding of the operational details of our system as it exists here and now. Being a scientist, the natural approach is to understand things in the limit, and if you look at our monetary system and conceptualize that there is only a single bank then you understand the monetary system pretty well. The MR approach describes how the multiple bank approach is derived from the single bank model, but to understand the basics of credit and money creation it’s best done from the single bank model.

  • Geoff

    BTW, I appreciate the quote from the Great One who was one of my childhood heroes :)

  • Tom Brown

    Sorry I missed! I have a habit of going off on tangents a bit. I think a couple of my links might help above. Here’s another that’s similar to the “The Three Places Reserves Can Go” post, which was my first attempt at this concept, but because I distinguished between inside and outside the banking system it was a bit more complicated (a longer list):

    So between those two lists that might answer your questions.

    Regarding QE, reserves are used the same way as for Tsy debt. You could just replace the Tsy debt with MBSs in this example and it would still hold:

    Just keep in mind that not all Fed deposits are “reserves” … only those held by the banks.

    Ignoring cash for the moment: because reserves are ALWAYS Fed Deposits, that means they are always a liability of the Fed. They are the Fed’s IOUs. The Fed can use these IOUs to purchase a limited set of financial assets, but banks can use them to obtain anything at all — should it be necessary: i.e. if the bank must deal w/ another bank in obtaining “anything at all” (see my Example #5 above).

    Banks have an even more limited set of items they can buy with their IOUs (bank deposits): namely loan agreements from private entities. And in some cases Tsy debt (look up TT&L accounts).

    Ignoring cash for the moment, if you think of bank deposits as asset-money for private non-banks (i.e. you and me and most businesses), then Fed deposits are asset-money for banks. By “asset-money” I mean money that comes from outside the banks and appears as an asset on their balance sheets. Bank deposits themselves don’t fill this role for banks because bank deposits are always liabilities for banks*. Banks can use Fed deposits as money, but they can also interface with us and our bank deposit money through the liabilities side of their balance sheets. Just as the Fed can interface with banks directly through the liabilities side of its balance sheet. If you wanted to carry the analogy one step further, you could say that the Fed in turn sees coins minted at the Tsy’s mint in a light similar to how banks see reserves, and banks see reserves as we see bank deposits. Banks effectively have a foot in both the inside and outside money worlds, and thus they act as an interface between the two. Reserves come into play in many cases that banks use “money” as an asset.

    *not completely true! but close enough.

    Here’s another attempt to look at it. We could add a couple of extra levels to the inside/outside money breakdown (like Russian nesting dolls!):

    Let’s define the most “inside” part of the economy as non-bank private sector entities. Then for us private non-banks ALL money is outside money, because it all comes from outside the non-bank private sector. It’s an asset to the holder an a liability to nobody on the “inside.”

    Now let’s include the banks as “inside.” Then we have the usual definition of “inside” and “outside” money: reserves and cash are outside for us and the banks. Bank deposits are “inside” because banks (now on the inside) can make them.

    Now let’s include the Fed on the “inside.” Now only coins remain as outside money, and the other components of reserves (paper notes and electronic reserves) are “inside.” Why? Because the Fed, now on the inside, makes paper notes and reserves (or at least imparts “value” to them, in the case of paper notes).

    Final step: include Tsy (and in particular its Mint) on the “inside.” Now all money is inside money…. except foreign currency!

    I hope at least part of that made sense!

  • JK

    TomBrown. I’m following you. I liked your last few paragraphs here. They are something I’m going to tinker with in my mind. Also, some of your linked-posts are very helpful too. Particularly I like the List of Ways Reserves Leave The Banking System. YES… this is what I’m trying to get at. I’m reading through you and Phil’s back and forth. Doing so helps to flesh out nuances.

    Let me try to pull you back into focus… Reserves…

    1) Exactly what can the Fed purchase with Reserves?
    2) Exactly what can banks purchase with Reserves?

    *Note: I use the word ‘purchase’ and what I mean by that is ‘swap for’ (kinda like I can purchase a popsicle with my dollar bill, or I can ‘swap’ my dollar bill for a popsicle.)

    To repeat: what EXACTLY can Reserves be ‘used for’ by both:

    1) The Fed
    2) Banks

  • Cullen Roche

    I’ll have to get back to you. Tom has really grasped my position on most of these items so I trust MR is in good hands until I respond. Happy 4th everyone. :-)

  • Tom Brown

    1. The Fed can purchase Tsy debt and MBSs by crediting the balances of Fed deposit holders (and thus increasing the Fed’s liabilities). Of course these Fed deposit holders are banks in this case, so the Fed is crediting their Fed deposits with reserves. If the sellers of Tsy debt or MBSs were non-banks, the banks still get credited with reserves, but then in turn the banks must credit the non-banks’ bank deposits. I believe there are some restrictions (now!) on the quality of the MBSs the Fed can purchase. During the 1st round of QE, these requirements were less strict. Also I think that at the height of the crisis the Fed was permitted to make some direct equity “injections” in certain companies (i.e. buy a special non-voting kind of stock). But that was an unusual circumstance. Here’s more info:

    Also, I think that the Fed can purchase foreign currency. I’m not too clear on that though, so you might wan to check that out.

    2. Banks can purchase anything at all with reserves (donuts, electric bills, rent, employee salaries, dividend payments, office supplies, Tsy debt, MBSs, reserve loan agreements from other banks, etc) but they may not need to use reserves to do this: if the seller of what they are trying to purchase holds their deposit with the bank in question, then the bank simply credits the seller’s deposit without using any reserves. Reserves really only come into play when:

    A. Purchasing something from a private sector seller or paying someone in the private sector (such as an employee or a shareholder) whom holds a deposit at another bank, or IS another bank. For example, a bank could use reserves to purchase mortgages from another bank or Tsy debt or a reserve loan agreement (what I mean by this last one is simply that a bank can lend reserves to another bank).

    B. Purchasing something from the Fed (say Tsy debt or an MBS).

    C. Paying interest on reserve loans to other banks or the Fed.

    D. Complying with a request by Tsy to transfer the contents of Tsy’s TT&L account held at the bank to the Treasury General Account (TGA) which is Tsy’s Fed deposit and the only account from which Tsy can spend. TT&L deposits are special bank deposits created for Tsy: either in exchange for Tsy debt or to temporarily hold tax receipts collected by the bank.

    E. Purchase or loan to other Fed deposit holders? GSEs, foreign central banks, the IMF, etc… I’m not sure if this happens though.

    So basically a bank can purchase anything with reserves. Reserves are 100% money in that regard. It’s just that there’s a bit of weirdness involved because of the limited set of entities which have Fed deposits. So sometimes the payment made with reserves is indirect (e.g. the payee’s bank is credited w/ reserves and then it in turn credits the payee). This is fine an dandy, but what about the case when the non-Fed-deposit-holding payee holds a bank deposit at the bank that’s making the payment? No problem: no reserves are needed at all: the payee’s deposit is simply credited directly by the bank making the payment.

    OK, a bit redundant, but that’s everything I know!

    One interesting tidbit, not directly having to do with “reserves” is that long ago I learned from Joe in Accounting (a sometimes commentator here who’s profession is bank auditor) that there’s such a thing as a “correspondent” (or “correspondence?”) bank.” So I think I mentioned in one comment here that banks don’t have bank deposits except as liabilities. That’s not completely true: a bank can indeed have a bank deposit at another bank… its correspondent bank. This deposit can be used to pay for stuff like office supplies. Correspondent banks, however, are not required… reserves can be used directly instead.

    Here’s where Joe 1st mentions the correspondent banks:

    Joe has a LOT of good comments on that page. You might want to check a few of them out. I also provide a couple of links to especially pertinent ones from Joe (from that same page) at the very bottom of my Example #5.

    Hope that helps!

  • JK

    TB, appreciate it.

    1. So, the Fed can purchase Tsy debt, and MBSs, and at the height of the crisis it was permitted to purchase some stock, and maybe foreign currency as well… is that it? What about Gold? Or Coffee or any commodity? What about Equities in the stock market? If IBM issues a bond, what about that? How about municipal bonds? etc. … Is there any resource to know *exactly* what the Fed is able to create Reserves in order to purchase?

    2. What you said is challenging what I thought I knew. My understanding was that Reserves are used by banks to settle transactions between banks in interbank market, and between banks and the Fed. … But you’re saying Reserves can be used by banks to purchase Real goods anf services, like donuts and bicycles?

    I guess this raises a new question I have then: if I open a new checking account at a bank, and I deposit $10,000… the bank can then use my $10,000 to purchase anything? Effectively, I’ve loaned the bank $10,000 and they are required to meet my withdrawals on demand, but otherwise they can freely spend however much I have in my account? Something seems odd about this.

  • InvestorX

    The current ideology / dogma of MR is:

    – the current system is the only worth studying, because this is the one we have
    – everything is explained from the view of the current system, although other angles may be even more valid
    – the current system is the best
    – the current system has some nasties, but they are ok because of the above

  • Tom Brown

    1. Yes, as far as I know, only Tsy debt and MBSs. But I don’t really know what the law actually states. The various Federal Reserve websites do have a pretty good set of information on them. I tried looking for the obvious “What assets is the Fed legally allowed to purchase?”… and there are some leads there, but I didn’t see a direct answer. So if the Fed wanted to start buying stocks or groceries… at the very least that’s not a *traditional* purchase and it would probably raise some eyebrows amongst the media, politicians, etc… but I don’t know if they’d have to get special dispensation from congress to do so… I really don’t know how that legally works. My guess is they would need congresses’ approval. I think some restrictions were legally placed on them after Maiden Lane by congress. Here’s a couple of things I found w/o much effort, but again not a definitive answer:

    and here’s a paper from 2001 written for the Fed:

    So based on the 1st link, I’m not sure the difference between LSAP and SOMA, but here’s some on SOMA:

    Which seems to divide the Fed’s permanent purchases into Tsy debt and “agency” MBS. What’s the “agency?”… well there’s this:

    “Only fixed-rate agency MBS securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are eligible assets for purchase.”

    So if you poke around there a bit, you can find info directly from the Fed on Maiden-Lane, etc. If you figure it out, let me know!

    2. Reserves are primarily used to settle payments between banks and for trading with the Fed during OMOs, etc. That’s really the best way to look at it. If you follow that thread I posted wherein Joe responds to my quest to figure out how a bank buys donuts, my conclusion is that they *can* use reserves. It makes sense.. What other kind of money does a bank have? Like Joe says, they partition their Fed deposit in order to do that.. perhaps have a separate partition just for making purchases for the bank (donuts, office supplies, etc). Or they can have that correspondent bank arrangement w/ another bank. But in the end reserves get moved to the vendor/contractor/employee/shareholder’s bank (should it be another bank), and the vendor/contractor/employee/shareholder’s bank deposit is credited. It doesn’t change the reserve levels in the aggregate banking sector.

    So I wouldn’t worry to much about your $10k deposit. That deposit represents an inflow of $10k in reserves into the bank from some other institution or directly from you (should you bring a bag of cash with you)… and currently that just adds to the excess reserve glut currently at the bank. It’s not going anywhere. Prior to 2008, it would probably be immediately offered up on the intra-bank market to loan out to other banks, or used on the other side of Fed OMOs.

    In either case (pre-2008 or now) the bank should have no problem coming up with the reserves needed (should they be needed) should you decide to move your deposit to yet another bank or purchase something with it, or withdraw it in cash, etc.

    The point is that given the proper collateral (loan assets, etc.) a bank has no trouble finding reserves to borrow at the FFR. There’s literally an endless supply of them!

  • Tom Brown

    I didn’t mean to imply that MR was equivalent to the scientific method. It’s pretty difficult to use the scientific method on some of this stuff. But I think the scientific method is a good ideology to strive for.

  • Cullen Roche

    This might help:

    Also, this quote:

    For individual banks, reserve accounts also serve as working balances.(2) Banks may
    increase the balances in their reserve accounts by depositing checks and proceeds
    from electronic funds transfers as well as currency. Or they may draw down these
    balances by writing checks on them or by authorizing a debit to them in payment for
    currency, customers’ checks, or other funds transfers.
    Although reserve accounts are used as working balances, each bank must maintain, on
    the average for the relevant reserve maintenance period, reserve balances at their
    Reserve Bank and vault cash which together are equal to its required reserves, as
    determined by the amount of its deposits in the reserve computation period.


  • jt26

    It’s not just ideology that needs to be overcome but morality as well. Behind the ideology is the endemic “moral superiority” that CEOs deserve rewards for their hard efforts and borrowers in a tough situation are lazy profligate scammers. Michael Pettis has used the accounting realities to expose the flaws in the “Germany” vs. “Spain” morality tale. MR could lean a bit more in that direction as well, like the Amazing Randy exposing psychic fraudsters.

  • Geoff

    To follow up on the discussion between JK and Tom Brown, reserves can indeed be used by the banks to buy anything. However, this doesn’t mean that the banking system can conjure up “money” out of thin air and spend it wildly in the real economy. Banks still have capital constraints. When reserves are created as an asset of a bank, a liability is created simultaneously in the form of a deposit. Therefore, the net worth of the bank, i.e. their true ability to spend (or to lend), remains unchanged.

  • LVG

    I think it’s easiest to think of reserves as money for banks. So, bank deposits are money created by banks for use by the general public. And reserves are money created by the central bank for use by the banks.

  • Tom Brown

    Perfect… that answers a lot.

  • Tom Brown

    Good point. However, I was just thinking that I really don’t know the restrictions on what a bank can credit a deposit for. I’m not talking about reserves here, I’m talking about inside money. I’ve been under the assumption that banks can only create bank deposits in exchange for loan agreements from borrowers (i.e. make a loan)… in a manner analogous to how the Fed “buys” Tsy debt and MBS during QE: by crediting some entity’s Fed deposit (the seller’s or the seller’s bank’s). Thus you could view a commercial bank as “buying” loan documents from a borrower by crediting their deposit. However, once a deposit is there, then it seems to me the bank has a great deal of flexibility in continuing to credit or debit the deposit. I’m not saying they necessarily violate any capital or reserve constraints in doing this.

    For example, say the electric company does their banking at the bank. Now when the bank pays their electric bill they could do so by crediting the electric company’s bank deposit, correct? In that case it’s a simple matter of the bank needed enough extra capital (beyond the requirements) to do this.

    However can the bank actually pay for ANYTHING in this manner? I doubt it, but here’s what I’m thinking. Suppose the bank were to purchase some assets (that would sit on the assets side of their balance sheet… much like loans do) by creating and crediting bank accounts for the sellers of these assets. For example, suppose the bank decided to corner the market in some commodity by buying ALL of it in this manner, hopping that once they controlled all access to that commodity they could raise the price and then increase their equity. Would it be technically legal for a bank to attempt such a move? Is it explicitly prohibited by law, or is it just practically prohibited by the usual regulations (RR, CAR, CAMELS)? So you see the idea would be it wouldn’t necessarily violate their capital requirements since after they cornered the market, their assets would rise in value thus pushing their equity up enough to raise their capital above the regulatory minimum.

  • Tom Brown

    I agree, that’s a nice succinct, useful, and easy to understand way of looking at it. However, it does leave a few loose threads: what’s money for the Fed then? Well, I’d say Fed deposits are still money for the Fed, even though they are created by the Fed as Fed liabilities. In an analogous manner, banks can “buy” loans (loan agreements) from borrowers by creating their own liabilities (bank deposits) for the borrowers. The analogy in both cases is writing an IOU to buy something: those IOUs are Fed deposits in the former case and bank deposits in the latter. I explore this more in this comment (specifically I wonder what the legal limits of this means of purchasing is for banks):

  • Geoff

    I don’t know the answer, Tom, but regarding rising asset values, I believe there are some accounting restrictions preventing the marking up of assets on bank balance sheets. Writedowns are of course OK, but writeups I think are another matter.

  • Johnny Evers

    The idea of making a loan and calling yourself even because the action creates an asset and a debit is what brought down the European banks, isn’t it?
    Euro banks created money to buy newly issued Euros and called themselves even. But when the market reduced the value of the Euros the banks had a negative position.
    Didn’t the same happen here with mortgage bonds. Bank borrows money to buy an MBS and other levered mortage instruments, real estate prices slump, debt instruments crash (leverage magnifies losses), banks now near insolvency.
    Central banks in each case are asked to save the day.

  • Geoff

    Johnny, you make my point. It’s all about capital. Banks must make prudent decisions or they’re capital quickly suffers.

  • InvestorX

    I am just saying that MR is not yet clean of dogma and ideological biases, and it is not a bad idea it becomes.

    Or at least one needs to have better objective explanations for some of the dogmatic statements, as shown above.

  • jt26

    Dodd-Frank probably limits the amount of assets that can be purchased under the rubrik “trading, hedge fund/PE investments, …”. Remember, the whole point of D-F was to eliminate proprietary trading. Also, if you look at the FDIC charges for asset types, you won’t see assets like “bags of dirt from Cullen”. In principle, banks should now be predominantly deposit taking institutions, making loans, or buying loans, and fostering world piece, protecting baby ferrets …

  • jt26

    BTW there still is the problem of the bank making a loan to a “company” (owned by the CEO of the bank!) that specializes in buying dirt from Cullen and reselling on eBay as a collector’s item, but regulators should already be aware of that trick … of course that’s what we say every 20-30 years when another S&L-like crisis emerges.

  • Mr. Market

    MR is more realistic than MMT. But MR still cherishes the myth that banks create money. They don’t. Banks create both credit & debt at the same time.

  • Tom Brown

    Ah, but that is the definition of inside money! The money “nets to zero” INSIDE the private sector. Fed deposits and reserve notes do NOT net to zero inside the private sector and thus they are “outside” (but they do net to zero on the “outside”… whereas coins do not: but coins are “outside” as well).

    The following quote is from a Fed publication defining “inside” and “outside” money:

    “Money is an asset that serves as a medium of exchange. Outside money
    is money that is either of a fiat nature (unbacked) or backed by some asset that is not in zero net supply within the private sector of the economy. Thus, outside money is a net asset for the private sector. The qualifier outside is short for (coming from) outside the private sector. Inside money is an asset representing, or backed by, any form of private credit that circulates as a medium of exchange. Since it is one private agent’s liability and at the same time some other agent’s asset, inside money is in zero net supply within the private sector. The qualifier inside is short for (backed by debt from) inside the private sector.”

    The key part of this quote from the Fed defining money is that money “circulates as a medium of exchange.” Which is what bank created inside money does as well as outside money! In fact that’s pretty much the defining characteristic of money that almost everyone agrees one (although some people claim it must be a store of value as well).

    And BTW, it’s not just MR or PKE that defines inside money in this way or that acknowledges that banks do indeed create this form or money: Obviously the Fed does as well, but so does the branch of neo-Classical economists known as Market Monetarists (Nick Rowe, David Glasner, and Scott Sumner to name just three that have specifically addressed this issue), and Austrians (Murray Rothbard for example). Even Krugman finally came around (although he’s a neo-Keynesian neo-Classical). Now Austrians like Rothbard are not happy that banks create money, and they don’t really get the details correct (they often incorrectly think that we have a “fractional reserve” system and that the so-called “money multiplier” is still in effect: a mistake the PKEers and MMists no longer make in general). Here’s an article by Jeremy Hammond (and Austrian) which nicely summarizes Rothbard’s view of bank created money as “legalized counterfeiting” (he provides quotes and links to Rothbards original writings):

    Plus there’s these common definitions of M1 and M2 (which make up part of the “broad money supply” which the US government keeps track of):

    “M1: The total amount of M0 (cash/coin) outside of the private banking system plus the amount of demand deposits, travelers checks and other checkable deposits
    M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000).”

    Summary: bank deposits contribute to both M1 and M2 (demand and time deposits respectively).

    And of course the much cited paper from economist James Tobin from 1963 (long before MR was even a twinkle in Cullen’s eye… in fact I suspect long before Cullen ever existed):

    If you’re interested in where the MMists state that banks create money, I can dig up quotes from all three I listed (Rowe, Glasner, and Sumner).

  • Tom Brown

    Here’s the Fed publication from which the quote above (defining outside and inside (i.e. bank created) money) came from:

  • Tom Brown

    If we include the Fed on the “inside” then it’s clear that the money it issues (Fed deposits and reserve notes) are exactly analogous to bank issued money (bank deposits): in both cases the money issuing institution (Fed & banks, resp) issues the money as a liability on its balance sheet (similar to an IOU) in exchange for (mostly financial) assets: The Fed issues it in exchange for reserve loan agreements (from banks), for Tsy debt (loans to Tsy), or MBS (bundled loans for houses), while banks issue it for all those same things plus other assets such as individual mortgages, consumer loans, car loans, home equity loans, etc.

  • Tom Brown

    I like to think of each individual bank as a miniature “Fed”… all at the same level, all issuing a common “inside money” (though individually issued). While the Fed sits outside them, doing almost exactly the same thing, except issuing Fed deposits instead of bank deposits, and where Fed deposits (being created “outside”) are necessarily NOT liabilities to any entity on the inside (including the banks). Fed deposits are thus ONLY assets to any entities on the inside allowed to hold them (i.e. the banks).

  • Joe in Accounting

    1. The current system has been established through 2000 years of evolution in banking and commerce and in the US through 200 years of legislation and legal precedents in a democratically elected republic. MR is an analysis of this evolution development as well as where this system is headed. See TDC and the TC rule on the MR site.

    2. Every angle is discussed here but whether its valid or not always come down to the accounting entries. If the journal entries don’t make sense or the t accounts don’t balance then it won’t work in the real world because in the real world we need accurate books.

    3. Never seen that from MR.

    4. Contradicts point 3, and again the system is an amalgamation of evolutions of banking, government, currency and trade. It’s what society has given us and it will always continue to evolve as society evolves. Even accounting standards evolve, but there always will be two entries for each transaction.

  • Tom Brown

    Hi Joe! Nice to see you here again. Let me know if you come across a concept here that I’ve mangled.

  • Cullen Roche

    MR definitely does not say the current system is the “best”. It just describes what is.

  • Joe in Accounting

    Banks create deposits which are used as money in our bank centric society. By all social measurements their deposits are the most widely used form of money so I thinks important to understand how deposit creation works and its effects on economic activity.

    As usual, mr. Market is being ambiguous regarding his definition of money and its creation and therefore us “savers” have no clue what direction he’s going with this post.

  • InvestorX

    Look Joe, society and its evolution has given you Hitler and Stalin, so this is a weak argument. All the people that followed their orders were acting legally, but then see the Nuremberg trials.

    The system is not so benevolent (anymore) as some of the angles used to describe it.

    And the so called democratically elected governement is a joke in reality. Everyone is for sale and you know who are the highest bidders.

    So instead of focusing on how the system could work for the benefit of society, why not look at how it actually works? The pendulum has swung too much in one direction. And the issues are systemic. You at least need a reset and in best case a system less prone to moral hazard and systemic risk concentration.

  • Mr. Market

    “Ambiguous” ? Not at all. I am just laying out the basics. Yes, banks create deposits but those deposits are actually debts (to the bank). Nothing more, nothing less. You’re reading too much into it.