MMT - Chap 3 - The Domestic Monetary System: Banking and Central Banking

In this chapter, the author presents an analysis of the operation of today’s monetary system.

IOUs denominated in the national currency

Government IOUs

Assets and liabilities are denominated in the national currency which is chosen by the national government. To drive the usage of national currency the government imposes tax liability on the citizens which can be discharged by delivering the national currency. When a country adopts a floating exchange rate regime, the government’s own IOUs i.e the national currency is non-convertible. It means that the government does not promise to convert them to precious metals or foreign currencies or anything else. The government just promises to accept its own IOU in payments made to itself. This ensures that there will be a demand for government IOUs at least to the extent required to make tax payments.

To increase the acceptability of its IOUs, the government can make it convertible into precious metal or foreign currency. But the trade-off here is that if the government issues more currency without first holding the reserves of precious metals or foreign currency then there is a possibility that it may not be able to meet the demand for conversion. Hence, a convertible currency imposes limits on government spending.

Private IOUs  

Just like the government even private persons can issue their own IOUs and accept them to discharge payments due to them. For example, if a household has a loan outstanding from the bank, they can pay it back by writing a cheque on their deposit account at the same bank. In this case, the bank accepts its own IOU (demand deposit) in payment of the outstanding loan.

Leveraging

There is one big difference between government IOUs and private IOUs. Private IOU issuers like banks promise to convert their liabilities to something. You can present a cheque at the bank in return for a payment in currency. You can also withdraw cash from the ATM. In either case, the bank IOU is converted to a government IOU. Banks only hold a relatively small amount of currency in their vaults to handle these conversions. If they need more, they ask the central bank. Bank do not keep a lot of cash on hand as holding reserves of currency does not earn a profit. Bank prefer to hold loans as assets because debtors pay interest on these loans. Banks leverage their currency reserves, holding a very tiny fraction of their assets in the form of reserves against their deposit liabilities. As long as only a small percentage of their depositors try to convert deposit to cash on any given day, this is not a problem. However, if a large number of depositors try to convert on the same day, the bank will have to obtain currency from the central bank.

Clearing accounts extinguishes IOUs

Banks use government IOUs to clear account. Hence, they keep some currency on hand in their vaults or maintain reserve deposits with the central bank. Additionally, they can access more reserves either through borrowing from other banks or through borrowing from the central bank. When Bank A receives a cheque drawn on Bank B and the cheque is presented for clearing the central bank debits the reserves of Bank B and credits the reserves of Bank A. This reduces Bank B assets and liabilities by the same amount.

Pyramiding currency

Private financial liabilities are not only denominated in the government’s money of account, but they also are, ultimately, convertible into the government’s currency. Banks explicitly promise to convert their liabilities to currency. By issuing a cheque to make a payment, other private firms essentially use bank liabilities to clear their own accounts. Thus, there is a pyramiding of financial liabilities. Household IOUs are at the bottom of the pyramid and the Government IOUs are at the top. People who are lower in the debt pyramid use the IOUs of those higher in the debt pyramid to clear their accounts.

Central bank operations in crisis: lender of last resort

The most common role of Fed lending on a typical day is through intraday overdrafts which banks are required to clear by end of the day. Banks typically clear these overdrafts by borrowing reserves overnight in the private “fed funds” market. If no funds are available then the Fed lends temporarily by discounting eligible assets.

In a crisis, banks are wary of lending to each other which can cause the overnight rate to spike way above the target. So, the fed steps in by lending but the rate would be higher than the target rate. Thus, it acts as a lender of last resort when no one else is willing to lend by discounting eligible assets.

Balance sheets of banks, monetary creation by banks, and interbank settlement

A typical bank balance sheet looks like this

  

Liabilities	Assets
Savings Accounts	Loans (Advances)
Checking Accounts	Reserves
Capital	Securities

 

The checking and savings accounts are liabilities for the bank. Loans given are the assets. Banks promise to convert balances in checking and savings account into cash on demand.

Banks do not need cash beforehand to make a loan. They create money supply when they make a loan. For example, let’s start with a very simple bank balance sheet. New Bank is a newly created bank. It has not yet started operations, hence it has only two items on its balance sheet. Building and Capital.

  

Liabilities	Amount	Assets	Amount
Capital	$100	Building	$100

 

 It receives its first customer Mr A who want to borrow $300 to purchase a car. The bank reviews his application and grants him the loan. The balance sheet of the bank looks like this.

Liabilities	Amount	Assets	Amount
Capital	$100	Building	$100
Checking Account of Mr A	$300	Loan to Mr A	$300

 

The bank just created $300 of money tokens (deposits in checking account of Mr A in return for Mr A promise to pay $300). The bank just created new money supply out of nothing. The did not have any prior deposit or cash in the vault nor does it need them. The bank’s act of lending is just an electronic record creation. The bank does not need actual cash deposits until Mr A withdraws the balance from the checking account to purchase the car. When he does make the withdrawal, the bank can approach the Central Bank to discount eligible assets (Loan to Mr A) and get the required cash to honour its obligation to convert Mr A’s checking account balance into cash.

The success of banking operations (lending by accepting an IOU and creation of a demand deposit) depends on the creditworthiness of the borrower and the bank’s capacity to acquire reserves at low cost. If Mr A cannot make payments, or if the bank cannot access reserves as required, then the bank gets in trouble; it can become insolvent or illiquid. Thus, although banks can create unlimited amounts of deposits, they do not usually do so because it may either be unprofitable or it can expose them to both insolvency and illiquidity risks.

My thoughts after reading the chapter

This is a fairly technical chapter which explains the mechanics of the domestic monetary system. For me, the biggest insight from this chapter is the fact that banks do not need cash deposits beforehand to make loans. I was always under the impression that a bank cannot lend if they do not have cash beforehand. Other than that I guess it is fairly straight forward.

Stay tuned for subsequent chapters. Please let me know in the comments section about your thoughts on this chapter. Please subscribe to my blog to get notified when I finish writing the summary of the next chapter.

Until next time,

Nirav Gala.