No, it doesn’t. Instead, it creates something called bank reserves. But are bank reserves money?
They’re a bit more complex than that yet nearly everyone equates these things with money. They are the reason why so many have been confused and left wrong-footed on everything from inflation risks to economic growth potential from the very first QE. Let’s dive into the history and purpose of bank reserves to help set the record straight. Bank reserves are often mistaken for “base money,” but their relevance to the banking system and monetary policy is much more nuanced. This thread will unpack their origins, evolution, and current role. The story starts back in 1907, during a banking panic in the US. To prevent a depression, a mix of private and public funds, including $25M from J.P. Morgan and $36M from the US Treasury, were injected into banks in the nick of time. The largest lifeline came from the Clearing House Associations, issuing $256M in loan certificates. These weren’t cash but allowed banks to settle with each other without depleting their vaults, acting as a quasi-money substitute.
This system inspired the creation of the Federal Reserve in 1913, aiming to provide a public utility form of this private banking support system. The Fed’s chief tool? Bank reserves, similar to those Clearing House loan certificates. Neither those certificates nor bank reserves are actual money. They are interbank tokens whose role is largely to free up the use of vault cash for other purposes. However, the role of cash was already declining by then. As banking evolved, the need for a tool to substitute cash in vaults diminished, too. Ledger (bank) money came to predominate along with increasingly sophisticated interbank payment systems, reducing the reliance on hand-to-hand currency. Even by 1941, the Fed itself noted that most money was in bank deposits, and payments were mainly made by checks.
The role of bank reserves shifted from being a base money substitute to a regulatory tool for controlling bank credit expansion to influence bank credit expansion by linking reserve holdings to legal requirements. Despite this shift, over the coming decades (the Eurodollar Age) the banking system found numerous ways around reserve requirements, especially with the rise of the eurodollar market and innovations like money market funds, further sidelining the role and use of bank reserves as they related to credit creation. In one last-ditch attempt to end the Great Inflation, which came about because of so much uncontrolled money/credit expansion in these non-traditional eurodollar methods, the Fed made bank reserves extremely expensive hoping to restrict credit therefore slow the economy and bring down inflation. It didn’t work; bank reserves simply didn’t matter.
Between then and the 21st century, bank reserves dwindled in importance as the banking system continued to evolve and kept on going. By the early nineties, Alan Greenspan lamented how little influence the Fed had on anything apart from the federal funds rates. Bank reserves wilted showing how little relevance they had to the globalized eurodollar system.
The 2008 financial crisis and subsequent QE programs showed that, despite increases in bank reserves, their impact on the broader economy was limited. Today, bank reserves serve specific functions, like supporting individual banks during crises, but as a tool for “printing money” or significantly influencing the banking system? Not so much. They’re a relic of a past financial era.
The real takeaway? The banking and monetary system is complex, and the role of the Fed and bank reserves within it has evolved dramatically. Understanding this history helps demystify some of the misconceptions about how money and banking work today.