Central banks pumped hundreds of billions of dollars of liquidity into banking systems recently. Unfortunately, most people don’t know what the heck that means or whether it is good or bad. You need a good Econ course to understand the process fully. But there are a few points one can get without that.
“Injecting liquidity” really means “increasing the money supply,” or at least that part of an increase in money that the Federal Reserve or any other central bank accomplishes itself. Only central banks can affect such immediate, discretionary increases in the money supply. That is their reason for existence.
The new money is just that: new. It does not come from anywhere else. It was not in some account earning interest or not. It was not appropriated by Congress. It does not depend on gold or anything else sitting in a vault. The Fed or European Central Bank or Bank of Japan creates money with a few keystrokes.
It sounds like voodoo, but the Fed can act so that, in the system as a whole, banks have more money to loan out without any single bank getting something for nothing.
The Fed creates new money by buying government bonds in the same open markets where insurance companies, pension plans and other investors buy them. (That is why they are called “open-market operations” and directed by an “open-market committee.”)
Laws prohibit commercial banks from lending out all of their deposits. They must keep a fraction in reserve. These reserves are kept at a Federal Reserve Bank. Such reserve accounts vary daily as deposits fluctuate and checks or electronic transfers flow to or from the bank.
When a pension fund buys a bond, it pays with a check that the bond seller deposits in its own bank. This bank sends the check to the Fed for clearing. The Fed adds the amount of the check to the seller’s bank’s reserve account. It then takes an equal amount out of the reserves of the bank where the pension fund has its checking account. That bank reduces the pension fund’s checking account balance. The cycle is complete.
When the Fed buys a bond, it essentially writes checks on itself. Whoever sells the bond deposits the check in its bank. That bank forwards it to the Fed for clearing. The Fed increases this bank’s reserve account. But that is the end. This increase in the seller’s bank’s account is not offset by a decrease anywhere else.
The Fed just waved its monetary wand and said, “Shazam, here is new money!” One bank has more money to lend and no other bank has any less. “There’s got to be a catch,” you say. There are several, but that is another column.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.