Some years ago on the Military Channel, I listened to General Norman Schwarzkopf compare the closing battle of Desert Storm to the Battle of Cannae (216BC), in which Hannibal wiped out a major portion of the Roman army. He noted that during a battle a commander has only one problem to consider: “When and where to commit the reserves?”
Yesterday, while googling “quantitative easing,” I came across a series of six very short but interesting videos by Chris Ciovacco who repeatedly posed the question: “When and where are the banks that have acquired [$1.6 trillion of] reserves through QE1 and QE2 going to ‘re-deploy’ them?” That reminded me not only of Schwartzkopf’s fundamental question, but also of the following two fundamental misconceptions about the financial reserves held at the Fed.
Misconception #1: Banks can only trade reserves among themselves, i.e., reserves are held at the Fed and can’t get out. In fact, however, reserves are readily exchangeable for cash, which can be deposited anywhere and used to pay for anything, including bonuses and dividends.
Misconception #2: Banks won’t just sit on their reserves. Eventually they’ll loan them out, which may restart the economy but also might kick off inflation. In fact, however, banks don’t loan out existing money. Rather, they create new money (credit in an account), whenever they make a loan. That credit is a liability, and the mortgage or whatever is the asset that balances it. To make a loans, what the banks need are credit-worthy borrowers (in an economy where even tenured teachers are losing their jobs).