Economics 101 | Central Banks (The Fed)

This thread is about central banks, but I’ll be focusing mostly on the Fed, because it’s the one I know most about. I am, of course, happy to hear about other central banks work, if they work differently.

First I want to revisit one point I made in the previous thread.

Commercial banks create a demand for money in the future, at the same time they create actual money in the present. Or, to put it differently, commercial banks create a demand for money in the present, because of the loans they made in the past. Commercial bank money, therefore, has a special feature: it creates a demand for itself, to the exact extent that people try to obtain money to pay off loans they’ve already taken out. Furthermore, the amount necessary to pay off a loan is always more than the loan itself: for example, if I was to take out a $200,000, 30 year mortgage at 5% interest, the amount I’d pay back would be about $365,000. Of course, like any business, banks have expenses. And those expenses get paid out of the interest and other fees banks generate. Nevertheless, there is a sense in which banks are in the business of continually creating more debt than there is money necessary to pay it off.

While the commercial bank way of creating money is sustainable for a time, it is inherently unstable: banks are susceptible to boom and bust cycles. When times are good, banks lend more than when times are bad. Unfortunately, bad times are exactly when people need the money banks are no longer willing to lend. Since the amount of money owed is more than the amount of money there is, some people or businesses inevitably default. When they default, that can and does lead to problems for banks. In some cases, banks fail. When that happens, the banks’ customers - people who have deposits at the banks - lose their deposits, meaning there’s that much less money in the economy, both for paying back loans, and for making daily transactions. People spend less, and when they spend less, they eliminate jobs for other people whose jobs depended on their spending. In the worst cases, the cycle ends up in something like the Great Depression.

Anyway, understanding how commercial banks work, and how they fail, is important in order to understand the significance of a central bank.

Central banks are different from commercial banks in a number of ways. One is that central banks produce currency and reserves. Commercial banks produce commercial bank deposits.

Another is that, unlike a commercial bank, the a central bank cannot fail. The reason is simple: central bank liabilities (reserves and currency) are not backed by anything.

While a commercial bank can be forced to close its doors, if too many depositors show up to demand their money, central bank liabilities are unredeemable. That means that if you were to show up at the Fed, for example, and demanded something in return for $1, the most you could expect to get newer $1 in return.

The fact that central banks can’t fail is important. It means, for one thing, there’s a sense of reliability about central bank liabilities - like dollar bills. It also means central banks always have the power, should they choose to use it, to stop financial panics. In the most recent financial panic in the US, the Fed chose to let Lehman Brothers fail. I won’t comment on whether that was a good decision or a bad one (since I don’t know), but the point is that the Fed had the power, should it have chosen to use it, to save Lehman, as it did other Wall Street banks.

Central banks also have the power to regulate commercial banks. They can set, or change, required reserves for example. Central banks also have the power to force commercial banks to adopt or adhere to capital requirements.

Furthermore, commercial banks use the Fed as their bank; the same way that you or I use Chase or Bank of America. They have deposits at the Fed, and use their Fed deposits to transfer money back and forth. The same way I might use my account at Wells Fargo to transfer money to a creditor, Wells Fargo uses its deposit account at the Fed to transfer money to other banks.

The Fed uses its power to destroy reserves in order to increase interest rates. In normal times (and these are not normal times) the Fed destroys reserves by selling assets in order to force interest rates to go up. Reserves, like everything else, are subject to the law of supply and demand. When reserves are plentiful, the price of reserves fall. Since the “price” of reserves is the cost to borrow them, that means the interest rate for borrowing reserves falls. When the Fed eliminates reserves - by selling assets - it reduces reserves. When reserves are scarce, the price of reserves increases: banks have to pay more interest in order to obtain them. Banks price all other interest rates based on the cost of reserves. (Banks can’t lend for less than the cost of obtaining reserves, because doing so forces them to operate at a loss: in other words, to lose money on every loan.)

Finally, a central bank of a country that has control over its own currency (like the US) and whose debts are denominated in the country’s own currency (like the US), can never involuntary go bankrupt. (It can, of course, choose to go bankrupt.) The Fed could purchase all US debt from every wiling seller, if it wanted to.

Over the course of the past several years, the Fed has purchased about $3.2 trillion of debt, increasing the size of its balance sheet from about $800 billion to about $4 trillion. During that same time period, unemployment has fallen from about 10% to close to 5%. The European Central Bank, on the other hand, has increased the size of its balance sheet only incrementally. EU unemployment now stands at about 11%.

Which demonstrates one more ability of a central bank: it can use its power to affect things like unemployment and economic growth, should it choose to do so.

Although hundreds of banks failed in the 2007-2010 crisis no depositor lost a dime of insured deposits. Contrast with 1929-1934 (although there was no FDIC then).

Bernanke got it right unlike how the Fed made things far worse in the Great Depression. Monetary theory has finally grown up.

Thanks for the primer, but what’s the question?

Economic witnessing.

Oh dear. Well, in that case, let’s throw some shit at the wall and see what sticks.

OP: The government’s published “unemployment rate” doesn’t cover a lot of people who are unemployed or underemployed. You need to look past the surface to something called the U-6 rate which gives a more accurate assessment of how many people aren’t working in the country – and that rate is more than one in ten.

Secondly, your terminology makes no sense to me. How does one “create a demand” aside from marketing? I’m pretty sure I haven’t seen any Federal Reserve commercials on Youtube lately. Maybe you mean to say that the central bank demands repayment of their loans in the present; loans which were taken out in the past? That doesn’t really fit a traditional economic definition of demand.

Finally, can you explain (in small words so I can understand) exactly what it means to “destroy reserves by selling assets”? The only thing I know of that the Federal Reserve sells is short term debt to financial institutions in various ways. Are you saying providing a loan is equivalent to destroying reserves? How does providing more loans increase interest rates?

The U-3 (official unemployment rate) is the most useful measure of unemployment. It provides the best historical and international comparisons because it matches the methodology most commonly used in the past and in foreign countries. I’d argue, too, that it’s the most sensible definition for most purposes. You can get on the U-5 or U-6 for merely evincing interest in getting a job, even if you have not once looked for work in the last ten months. You make the U-4 as well for saying that the reason you’re not looking is that the economy is so bad you don’t think you’d find one if you looked (even though you’re not looking and so don’t know that for a fact).

More than that, the difference between the U-3 and U-5 is only about a point. There aren’t a huge number of people right now who claim to want a job but aren’t actually looking for one. Most of the difference between the U-3 and the U-6, four points of the five point difference, comes from the underemployed: people who are actually working. The U-6 includes people who actually have a job but want to work more hours. These people are important. The U-6 is good, interesting data. But it’s simply not a measure of “how many people aren’t working” because it includes people that are working.

But your comment is not so good for another deeper reason.

Even if we were to use the U-6 as you suggest, then we need to be consistent about using it. It is worse than meaningless to state that the U-6 is more than 10% right now because there’s no standard for comparison. Compared to fucking what? What is the U-6 normally? What is the U-6 when pundits talk about how great the economy is? What is the U-6 internationally? The OP was using international comparisons to show the difference between US and EU, and the official rate is the perfect device for making that comparison. Then you mosey into the thread and criticize half the data while ignoring the other half of the comparison. Intentional or not, that means you’re inviting a comparison between the US U-3 and the EU U-6, and that comparison will not work. I have no problems with using the U-6 as long as it’s used in context. Without that context, it’s almost totally worthless. The same is true for even broader measures of the workforce like the Labor Force Participation Rate, which is currently at about 62.5%. Is that good or bad? It’s basically impossible to know that without having more context. But it suddenly becomes much more useful if we realize that it was at about 66.5% in 2007. It’s dropped four points. Part of that is demographic, as people who were about to leave the workforce anyway accepted the shove out of the door from the Great Recession. How much? Hard to say but researchers do try to untangle those numbers. They need context to do it.

If you’re going to suggest an alternative figure that’s “more accurate” than the official rate, then you need to provide the context that makes it legitimately useful for comparisons.

I agree that they did the right thing. I’d argue that Treasury deficit spending was also part of the answer. I’d also argue that had the Treasury and the Fed had done more, more quickly, the recovery would have happened faster.

The question is whether you agree. I made what I thought were some controversial statements, such as, “The Fed could purchase all US debt from every wiling seller, if it wanted to.” And that the US can’t go bankrupt. Sometimes those kinds of statements generate a lot of comments.

Yes, but wouldn’t that simply inflate our way out of debt and make our credit rating go in the crapper? That’s just a fancy way of saying that we can “print money.” If that’s the solution, we don’t need taxes at all.

Hellestal already commented on your first paragraph.

When I made the comment about “creating demand” I was referring to commercial banks: commercial banks create a demand for their product - money - by demanding repayment (+interest). Commercial banks do of course market their loans. But they’re supplying a product when they make loans. The product is money. The demand comes into play when banks collect on their loans.

The central bank is a little different. It does supply money central bank money, and collect it back. But it’s not a for-profit institution. It’s mission is to control inflation and to reduce unemployment. Some people - myself included - argue that it worries too much about inflation, and too little about unemployment.

The terminology is confusing.

Basically, when (for example) the US borrows money, the Treasury issues bonds. A bond is just an IOU. So if you lend to the US government, you’re giving them money, and getting an IOU in return. The IOU is an asset to you, and a liability to the government. When the Fed purchases bonds, it creates money (out of nothing) gives it to you, in exchange for your bond. After that, the Fed owns the bond. It can hold the bond for as long as it likes, and sell it whenever it wants.

The Fed is part of the US government. When one part of the government “owes” money to another part, it creates a sort of strange situation. For other people or organizations, lending to yourself, or borrowing from yourself, is a non-event. (If you lend $100 to yourself, you’re no richer or poorer than you were before.)

But for the government, it’s different, and the accounting gets complicated.

In any event, to answer your question, what it means to “destroy reserves by selling assets” is that when the Fed sells a bond (which is an asset to the Fed) it gets dollars back in return. Dollars are not assets to the Fed. They’re liabilities. So when the Fed gets dollars from selling bonds, it destroys the money it gets (except for profits, which it turns over to the Treasury). It just goes “poof” and ceases to exist.

The Fed does make short term loans. But it manipulates interest rates by buying and selling bonds. When it purchases bonds, it creates money in reserve accounts at banks. Banks need reserves to meet regulatory requirements, and to conduct business. Ordinarily, when they’re short on reserves, they borrow the reserves from other banks. When the Fed reduces the amount of reserves available to banks, that reduces the supply and drives up the price. The price of reserves is the cost of borrowing them. So when the Fed sells assets, it reduces reserves, and pushes up interest rates. Conversely, when it buys assets, it creates reserves, which allows interest rates to fall.