I recently wrote a post about the massive excess reserves that have been built up by the commercial banks.  The increase in excess reserves since 2008 has closely correlated the increase in the adjusted monetary base.  In response to that post, I received the following comment/ questions:

“If the banks are simply holding so much of the new money in reserves, what is the point of the Fed giving it to them?  To keep them solvent?”

I think the comment/ question is on the right track, but it is important to clarify what is happening.  Currently, the Fed is adding approximately $85 billion per month to the monetary base.  This consists of $40 billion in mortgage-backed securities and $45 billion in government bonds (longer-term).

The Fed’s purchasing of $40 billion per month in mortgage-backed securities is a bank bailout.  The banks are not netting $40 billion per month, but some percentage of that.  We cannot know the exact number because we don’t know the free market value of the securities that are being bought.  But we can be fairly certain that the Fed is buying the mortgage-backed securities for more than what they would be worth in the open market.

The Fed’s buying of mortgage-backed securities is not typical.  Prior to 2008, the Fed mainly purchased government debt.

The $45 billion per month that the Fed is buying in government debt must be understood.  The banks are not really being “given” this money.  Certain financial institutions act as brokers in selling government treasuries to the Fed.  They make a commission or some kind of fee on this.  In addition, the banks are being paid a quarter of one percent interest on their excess reserves.  In addition, these reserves do help capitalize the banks and make it less likely for bank runs to cause insolvency.

But I keep hearing this common theme that the Fed is “giving” money to the banks.  In the case of the mortgage-backed securities, this is probably true.  But in the case of the Fed buying government debt, it is not really the case.

When the Fed buys government debt, it is creating digital money out of thin air and this money is going to the government to spend.  The government can spend this money on virtually anything.  Money is fungible, so we can’t identify where specific monetary inflation is being spent.  It is all part of the government spending, whether it is on food stamps, Social Security checks, military equipment, salaries, or any number of other things.  But this new money ends up in the hands of individuals and corporations and most of this ends up in a bank account somewhere.

So it is important to understand that most of the money being held by banks, even the money in excess reserves, is somebody else’s money.  It is money deposited by an individual or some type of corporation (or I suppose a government).  The excess reserves simply means that this money is not being lent out.  It does not mean it is “owned” by the banks.  It is money that is available to the depositors who deposited it.

So to answer the questions above, I think keeping the banks solvent is certainly one of the major reasons for the massive monetary inflation.  And with the banks building up their excess reserves, this has helped to prevent severe price inflation.  But it is important to know that just because excess reserves are going up, it does not mean that the banks are being “given” this money.  It is other people’s money.  The banks are being given money when the Fed buys mortgage-backed securities that would be worth less in the open market.  When the Fed buys government debt, it is not directly giving money to the banks, but it is helping to keep them solvent.