Initial creation of reserves

Economics Asked by Mapa on December 12, 2020

I am currently reading the book “Where does money come from?” which is co-authored by Richard Werner after I took the “Money and Banking”-class in coursera by Perry Mehrling.

There are certain questions which always pop up in my mind and which I find them either to remain unanswered or I simply don’t understand the procedures.

I assume that Banks do not function as financial intermediaries as in neoclassical economics, which has been proven wrong by Richard Werner in his 2014 empirical study at the latest (but was well known to specialized economists, central bankers and bankers whose daily business are money market operations). Instead, I assume that money is created at the push of a button by a bank deciding to grant a loan to a customer. From this follows, that money in the form of cash/reserves is equally accepted by other agents as deposit accounts, which is why they are exchanged at par (i.e. at face value).

Now, as long as customers make electronic transactions within their bank or to other banks, the reserves of the respective bank remain unchanged. It is only when the customer withdraws cash that the reserves of the bank have to be converted to cash for the case that the bank doesn’t hold enough.

There exists basically two ways of a bank accessing reserves (at least in the Euro-area, the UK and the US):
1) Borrowing reserves in the interbanking market at the Fed Funds Rate (US), the LIBOR rate (UK), the EURIBOR rate (Euro-zone)
2) By selling government securities to the central bank (or doing repos)

So far, I get the part with the interbanking market and why it works. What I don’t understand is the following:

1) If a bank is selling government securities to the central bank in order to get reserves (or making a repo), where does this government security come from?
It is obvious that the security is issued by the government, but the government issues the security against receiving liquidity from the bank that buys the security. However, at the initial stage the bank doesn’t have other liquidity than being able to open a deposit for the government to the amount of bought securities that the government in turn can access. Let’s assume the government would like to access instantly the account of, say, 1 bn Euros and to withdraw the money in cash – will the central bank provide this 1 bn Euros without any discount?

2) As a follow up question: How could money be created if a government does not issue securities?

Thanks in adanvace.

2 Answers

Asking how the system could bootstrap itself into existence using current rules is ahistorical. There are two ways of answering this.

Historically, the developed countries evolved from various versions of the Gold Standard. The money stock was generated by buying gold (monetising it), and the banking system was private (central banks were nationalised generally around World War II). Meanwhile, governments borrowed within this more private system, so bonds pre-existed. As such, there was a pre-existing money supply and bond debt before current operating procedures came into existence.

If we ask how a hypothetical country using modern operations rules could bootstrap a new monetary system into place (without inheriting an existing currency), the following possibilities can be used to stock the monetary base.

  1. Minting banknotes and coins.
  2. Fiscal arm of government spends by running an overdraft at the central bank.
  3. Central bank buys existing assets (foreign currency, gold) from government/private banks.
  4. Central bank lends money to private banks so that they can buy government bonds.

Other than the minting option, requires central bank lending or buying of assets. This is because the central bank essentially has the monopoly on the creation of instruments in the monetary base.

Answered by Brian Romanchuk on December 12, 2020

The current international monetary system based on pure fiat currency is a post-1970s system. For a long time before that most of the international monetary system was based on the gold standard. With the gold standard, governments issued currency relative to the amount of gold they held or they pegged their currency to another currency that was backed by gold. Hence, the bootstrapping issue you point out wasn't an issue. Note while current central banks often use government securities and bonds as assets to back the issuance of their currency, there is no rule that the asset needs to be a security (it could be gold like before) or that there even needs to be an backing asset at all (at risk of inflation).

Answered by Kent Shikama on December 12, 2020

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