Historically, individual banks held reserves, primarily as cash or gold, in their vaults to cover depositor withdrawals. However, banks often mismanaged these reserves, leaving themselves vulnerable during periods of high withdrawal demand. When customers lost faith in a bank’s stability, they would rush to withdraw their funds, leading to bank runs and, in many cases, the bank’s failure.
The establishment of central banks was intended to prevent these failures by providing a safer and more controlled system for managing reserves. Central banks took on the responsibility of holding significant portions of commercial banks’ reserves in centralized accounts. This arrangement allowed central banks to oversee and protect reserves, ensuring that these funds were not used by banks for everyday operations or speculative activities. Instead, the reserves were held specifically as a safeguard, only to be adjusted by the central bank in cases of interbank transactions or as a last resort during crises.
In the domestic banking system, reserves play an essential role in safely settling payments between institutions. When banks need to transfer funds, they do so by adjusting reserves in their accounts at the central bank, eliminating the need to physically move cash or assets. This method offers a high level of safety, as transactions occur within a secure, centralized framework managed by the central bank. This electronic transfer process minimizes the risk of asset loss, ensuring that even large transactions settle efficiently and securely.
What is the Reserve Barrier?
The design of central bank reserves creates a structural separation we will call the “reserve barrier,” between central bank-created money and the money generated by commercial banks. This barrier operates as an iron wall that keeps central bank reserves, or central bank-created money, from directly intermingling with the commercial bank money circulating within the general economy. Because commercial banks don’t directly contribute their own funds into reserves, and central bank-created money doesn’t circulate openly throughout the economy, these two types of money exist within distinct spheres.
The rationale behind maintaining separate spheres for central and commercial bank money lies in the stability it provides. By keeping central bank reserves independent of funds contributed by commercial banks, the central bank retains the flexibility to act as a lender of last resort during times of crisis. If central bank money relied on commercial banks placing funds into reserves, the central bank’s ability to inject emergency liquidity would be constrained by existing reserves. This separation ensures central bank independence and the system’s resilience.
Central bank actions, however, are still intended to influence the amount of money available within the economy at large. To achieve this without direct transfer, central banks use a method where reserves are “reflected” into the economic sphere. This reflection process enables central banks to inject money into or withdraw money from the economy indirectly. Commercial banks are intermediaries responsible for making the adjustments on the customer-facing side of the barrier.
When the central bank wishes to increase the money circulating within the economy, it might purchase a security, such as a treasury bond, from a private party. This transaction adds reserves to the commercial bank that holds the seller’s account, with the central bank placing the payment directly into that bank’s reserve account. The commercial bank, in turn, reflects this reserve increase on the economic side by crediting the seller’s bank account with the corresponding amount. This account credit allows the seller to spend the money into the economy, effectively circulating newly created central bank money without it crossing the reserve barrier directly.
Conversely, if the central bank wants to reduce the money circulating in the economy, it can sell a security to a private buyer. When the buyer’s commercial bank processes the payment, the central bank reduces the reserves in that bank’s reserve account. The commercial bank, reflecting this reserve reduction, then debits the buyer’s account, which removes that amount from circulation in the broader economy. The effect is a reduction in available money for economic transactions, achieved without any direct movement of central bank-created money into or out of the general economy.
In this way, the reserve barrier maintains the separation between central bank reserves and commercial bank money, yet it allows central banks to indirectly regulate the amount of money circulating in the economy. Through these reflective transactions, central bank policies influence economic liquidity and overall money supply while preserving the functional distinction between reserve money and the money available for everyday use.
Destruction of Bank Reserves
Reserves held at the central bank are not permanent; they can be destroyed under certain conditions, maintaining balance in the reserve system. The most common way reserves are destroyed is through the repayment of loans. When a commercial bank customer repays a loan, the money used to create the reserves is removed from circulation. Similarly, when a central bank loan, such as a treasury security, is repaid, the reserves created by that loan are reduced. Once the debt that originally created the reserves is settled, the reserves are canceled, effectively removing that amount from the central bank’s balance sheet. This process mirrors the reserve creation mechanism but operates in reverse, ensuring that reserves are removed by repayments.
Another significant mechanism for reserve destruction comes through foreign trade imbalances. When a country runs a trade deficit, it spends more on imports than it earns through exports, leading to an outflow of dollars to foreign entities. As these dollars accumulate in foreign banks, they are submitted to foreign central banks. The Federal Reserve, in turn, transfers reserves from U.S. banks’ reserves to the foreign central banks, thus reducing U.S. reserve levels. This is one way that international trade deficits directly impact the U.S. reserve system.
Foreign Direct Investment (FDI) further complicates the relationship between reserves and international transactions. When foreign entities invest in the U.S., whether by purchasing real estate, acquiring companies, or investing in infrastructure, they bring foreign-held dollars back into the U.S. banking system. These investments often replenish reserves domestically as foreign dollars re-enter the U.S. economy, contributing to economic activity and short-term reserve inflows.
However, the reverse also occurs when U.S. entities engage in foreign direct investment. U.S.-based companies and investors frequently allocate capital to foreign countries, whether by acquiring assets or establishing operations abroad. In these cases, dollars are sent out of the U.S., causing reserves to leave the domestic banking system and flow into foreign markets. Over time, the profits from these foreign investments may be repatriated back to the U.S., but the initial outflow reduces U.S. reserves.
Both inbound and outbound FDI affect reserves. When profits generated from foreign investment by U.S. companies are repatriated, it can cause further inflows of reserves as foreign banks settle these earnings with the Federal Reserve. Conversely, when profits from foreign investments within the U.S. are sent back to their country of origin, U.S. reserves are once again reduced as foreign central banks settle these payments.
The bidirectional nature of FDI means that reserves are constantly in motion, affected by the flow of investments across borders. Although FDI can temporarily increase reserves when foreign capital enters the domestic economy, the long-term effects, including the repatriation of profits and outbound investments, often result in a drain on reserves. This dynamic contributes to the complexity of maintaining balance in the reserve system as international investments and profits continuously flow in and out of the U.S. economy.
Excess reserves in one country, particularly when a trade deficit exists, often seek higher yields. This creates opportunities for arbitrage in the financial markets, where imbalances in reserve levels between countries lead financial institutions to exploit these discrepancies. Essentially, reserves that have accumulated domestically can “bleed out” through international financial markets as they chase better returns in foreign markets, gradually lowering the domestic reserve levels.
By understanding these dual mechanisms for the destruction of reserves, through both domestic loan repayments and international trade imbalances, one can see how the reserve system maintains balance while also interacting with the global economy. Excess reserves don’t simply disappear but instead find ways to exit through repayments or international flows, keeping the financial system in equilibrium.
Interest Crossing the Reserve Barrier
When the central bank purchases bundled assets like Mortgage-Backed Securities (MBS) from federal agencies such as Freddie Mac or Fannie Mae, it injects newly created money into reserves. The agencies that sell these securities to the Fed receive funds in their accounts at commercial banks, which are reflected as reserve increases at the banks holding those accounts and the banks increase the agencies’ bank accounts. The agencies can use this money for further lending or operations.
As homeowners make their monthly mortgage payments, which include both principal and interest, their payments are funneled through the commercial banks and eventually to the agencies that originally packaged the loans. These payments, in turn, flow back to the Fed as the MBS matures. The repayment process mirrors the initial loan creation but with a critical difference: the total repayment includes both the original principal and the accumulated interest.
The difference between the original MBS purchase amount and the payments of principal and interest means more money is removed from bank reserves than was originally placed in reserves during the purchase. This is reflected into more money deducted from the commercial bank accounts than were originally provided. Essentially, the interest portion of the payments transferred across the reserve barrier.
There is a complication to this process. Since there is no corresponding new loan created to offset this interest accumulation, the reserves continue to build up on the Fed side of the barrier without a clear mechanism to destroy them. This accumulates year after year as the Fed purchases more assets.
Over time, this accumulation leads to a growing pool of reserves that cannot be easily reduced, especially as cash withdrawals, historically a way to reduce reserves, become less common in an increasingly digital economy. This accumulation presents a challenge, as these reserves remain trapped on the central bank’s balance sheet and continue to grow unless further central bank actions are taken.
The repayment process for government-issued debt, such as Treasury securities, operates differently. When the central bank purchases a Treasury bond from a private party or a financial institution, it credits the seller’s commercial bank account, injecting reserves into that bank. As with MBS purchases, this reserve injection allows money to enter the economy on the commercial bank side of the barrier, but the reserves themselves remain on the central bank’s side.
However, when it comes time for the Treasury to repay the debt, the process becomes more intricate. The Treasury doesn’t generate income like a private borrower; instead, it relies on taxation to raise the funds necessary to repay its obligations. When taxpayers pay their taxes, these payments are collected and funneled into the U.S. Treasury General Account (TGA), which is held at the Fed. This taxation process removes money from taxpayer accounts and simultaneously reduces the reserves held by commercial banks, effectively moving funds across the barrier into the TGA.
When the Treasury repays the Fed for the matured Treasury securities, the principal payment reduces the reserves that were originally created by the security purchase. However, as with the MBS example, the repayment also includes interest, which was not part of the original reserve creation. The interest remains on the Fed side of the reserve barrier, accumulating as a result of the repayment process.
Though this process is indirect, since the Treasury raises funds through taxation and the money moves into the TGA as it crosses the reserve barrier, the result is the same as with private debt: interest payments cross into the central bank’s reserves, increasing the reserve balance without a means of destroying those reserves. The difference here is that the source of the repayment is the broader economy via taxation, meaning that the public effectively finances the interest payments, which are then locked into the Fed’s reserves.
Both processes, whether through private debt like MBS or government debt like Treasury securities, lead to the same outcome: interest payments accumulate on the central bank’s side of the reserve barrier without any mechanism to reduce these reserves. Unlike principal repayments, which cancel out reserves by repaying the debt that created them, interest payments have no counterpart on the liability side to offset their accumulation. Over time, this dynamic leads to a growing pool of reserves that remain locked on the central bank’s balance sheet.
This growing reserve accumulation has significant implications for the economy. With physical cash becoming less relevant in economic transactions, banking sector has limited means of reducing reserves. Instead, these reserves remain trapped on the Fed’s balance sheet, growing exponentially with each round of interest payments. As reserves accumulate, commercial banks, viewing these reserves as assets, are incentivized to seek higher returns on them, driving the financial sector toward speculative activities and contributing to the financialization of the economy, a theme we will explore in the next chapter.”
The Government and the Reserve Barrier
When the government borrows, it issues a loan document (Treasury security) specifying the amount and repayment terms, then offers it for auction through the Fed. The winning bidder authorizes a funds transfer from their bank, and the Fed debits reserves from the bidder’s bank’s reserve account, crediting the Treasury General Account (TGA) so the government has funds to spend. Simultaneously, the bidder’s bank account balance is reduced by the same amount.
When the government spends, the Fed transfers money from the TGA into the vendor’s bank’s reserve account, and the vendor’s bank credits their customer’s account. If borrowing and spending are equal, total bank reserves remain unchanged, and the winning bidder holds a Treasury security.
Upon repayment, if taxes fund the payment, the government collects enough for both principal and interest, debiting taxpayer banks’ reserves and crediting the TGA. The Fed then transfers money from the TGA back to the winning bidder’s bank’s reserve account, and the bank credits the bidder’s account, fulfilling the debt.
The cumulative process, borrowing, spending, and repaying principal plus interest, leaves total reserves in the banking system unchanged and the total amount of money circulating in the economy is likewise unchanged. Provided the Treasury security stays on the economic side (not sold to the Fed), no interest accumulates on the Fed side of the reserve barrier.
The reserve barrier complicates any attempt by the government to introduce debt-free money. Without borrowing, the Treasury itself would act as a bank, creating money without a debt instrument. When the government writes a check to a vendor, this action would create the money, credited to the vendor’s account for spending.
However, the vendor’s bank must now provide these funds. To compensate, the Treasury would need funds in its TGA to transfer to the bank’s reserve account. The Fed, needing assets to balance its books, would ultimately require a debt instrument from the treasury, returning to the original borrowing scenario.
In Chapter 11, we’ll explore proposals allowing sovereign governments to introduce debt-free money into the economy.
Summary
In this chapter, we explored the reserve barrier, focusing on the U.S. financial system but recognizing that this same structure exists globally. Nearly every country’s monetary system operates with a reserve barrier that separates central bank-created reserves from the money circulating in the productive economy. While the specific mechanisms and flows may vary slightly between nations, the fundamental dynamics of reserve accumulation and their impact on financialization are consistent across the world.
We examined how reserves are created in the U.S. through central bank lending, and how these reserves are typically destroyed when loans are repaid. We also introduced a second mechanism for reserve destruction, foreign trade. Trade imbalances, particularly trade deficits, lead to reserves flowing out of a country’s economy as dollars or other currencies move overseas to settle transactions. Although this outward flow appears to offer a way to reduce reserves, the reality is more complex. These reserves are not permanently removed; they merely circulate between countries, adding to the reserve balances of foreign central banks.
Globally, the monetary system is structured similarly. Countries that have adopted an “ample reserve” environment, like the U.S., have built up massive reserves, making it difficult to remove or reduce them without destabilizing their economies. The accumulation of reserves in central banks, both domestically and internationally, contributes to the growing financialization of the global economy. This reserve accumulation incentivizes financial institutions to seek returns on excess reserves, driving speculative activity and the growth of financial markets that are increasingly detached from the productive economy.
As a result, the reserve barrier has become a significant force pushing countries further into financialization, where the movement of money and financial assets grows at a faster pace than the productive activities that generate real wealth. This process, repeated across the globe, has created a global economic environment where reserves build up, but financial circulation of money dwarfs the circulation of productive economies. This global dynamic will set the stage for the deeper discussion of financialization in Chapter 9.