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The Endless Demand for US Treasuries

by on February 1, 2015

Guest post by Laura Elizabeth Teller

I hear people’s worries that, one day, nobody will want to buy Treasury debt – that “other opportunities” will be more attractive, and Treasuries will be left sitting on the shelf at Fed auctions, with no interested buyers.

That, basically, is impossible. Here’s why:

When the federal government spends money in deficit, it (simplistically) writes a check without having money in any bank account anywhere.

The recipient of that check deposits it into a bank account. The depositor’s bank then creates a liability balance for itself by increasing the depositor’s bank balance (if you haven’t ridden in this rodeo before, a bank deposit is a liability of the bank – the bank’s promise to pay the depositor cash, or to make any ATM or check payments the depositor may want to make with that balance).

The bank now needs an asset which it can use to honor its promise to its depositor. It presents the check to the Fed which, as fiscal agent for the Treasury, it has to honor. The Fed then creates a liability for itself, a deposit balance in the depositor’s bank’s reserve account with the Fed.

The balance in the reserve account is now an asset of the depositor’s bank, and can be used to make any interbank check or ATM payments that the bank needs to make on the depositor’s behalf.

The bank has a little problem, though. The Fed requires that the bank maintain reserve balances as a percentage of the demand deposits (like checking deposits) it has on hand. That requirement is between 0% and 10% of deposits, depending on the total value of the bank’s demand deposit liabilities.

So the bank has all of these reserves on hand, the vast majority of which it doesn’t need in order to meet reserve requirements, which pay a meager 0.25% interest, which is less than the bank’s cost of maintaining and administering the depositor’s money. The bank is losing money by accepting the depositor’s deposit. No, the bank can’t lend the deposit. It’s a bank liability. You can’t lend out your liabilities, or promises, to other people. That deposit has to stay on the bank’s books, right where it is.

The bank can’t do anything with these reserves. It has no “investment opportunities”. It can’t turn them into cash, it can’t buy stocks or derivatives with them, and it can’t lend them to customers. Reserves are purely an interbank scrip used to settle interbank payments. They aren’t accepted anywhere else in the economy, and the Fed does not allow them to be removed from their books.

But Congress gives the bank an option to make a little more money: it issues Treasury securities, which pay a little better interest rate. The bank would definitely rather have Treasury securities which pay a little interest than reserves, which pay virtually none. So it is guaranteed that the bank will buy Treasuries when they are offered by the Fed.

Treasuries are issued in quantities matching deficit spending – this assures that, as they are issued, there will be banks who suddenly find themselves with excess reserves from that deficit spending which they would prefer to trade for something with a higher interest rate – and the ONLY thing they can buy with them is Treasuries.

There is ZERO possibility that the Fed cannot find buyers for all Treasuries issued by the government, because the banks who cash government checks have no other opportunities to invest the reserves they receive in trade for government checks.

Fret not. There will always be buyers for as many Treasuries as government cares to issue.

  1. Auburn Parks permalink

    Nice article, just one problem, the banks can definitely buy things with their reserves. In fact, unless the seller of something banks at that particular bank, reserves are the things that banks generally use to buy things from other banks’ customers as Chase doesnt want Bank of America IOUs, Chase wants third party IOUs, primarily from the Govt (reserves).

    Any individual bank can get rid of its reserves, its the banking system as a whole that cannot, so there was a little fallacy of composition going on with that part of the post.

    E.G. If Chase buys google shares on the secondary market from a seller who banks at Bank of America, Chase settles this payment with reserves, so it is clearly not the case that Chase cant buy things with its reserves.

  2. That’s correct, but the issue isn’t whether individual banks can sell things to each other using reserves, the issue is how member banks as a whole can get out of 25 points into something better – and the only option is to purchase tsys. In the aggregate, the demand for tsys will be sufficient to absorb whatever supply is offered.

  3. It would have been better had I framed that more clearly.

  4. “Reserves are purely an interbank scrip used to settle interbank payments.”

    Sorry but I cannot find anything anywhere that corroborates this “settlement function” of reserves. Neither the Fed or the NSS (National Settlement Service) mention reserves being used in this manner. Do you have a source for this?

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