Assuming no last-minute surprises, it seems like we might be getting a debt ceiling deal in the US, which means you should be prepared to get overwhelmed by financial commentators' takes about 'liquidity.'
The very unnuanced story goes like this: The government needs to rebuild its Treasury General Account (TGA) buffer at the Fed, so it issues bonds and it drains 'liquidity' from the 'system.'
And here, I can picture you guys thinking: What the heck does that mean? And is it true?
Monetary mechanics are best understood through the use of good old T-accounting.
In our stylized model, we will assume 5 players (government, Fed, commercial banks, money market funds, and households) and mimic each monetary transaction – colors will help you "follow the flow of money."
Before we go to the post-debt-ceiling TGA, rebuild, let's start with bond issuance to fund deficit spending.
BLUE: The government spends $100 (deficit spending), and it injects net worth into the private sector (household’s equity) and so households now have $100 more bank deposits. These bank deposits end up as a liability for banks, and the corresponding increase in assets is a boost of $100 in bank reserves.
GREEN: The government "has" to issue $100 in bonds to "fund" its deficit spending, and banks use some of their increased reserves to buy $100 in bonds.
There is no reduction in bank reserves when the government issues bond to 'fund' deficit spending.
But what happens instead if the government issues bonds solely to refill its Treasury General Account as in a typical post-debt-ceiling-deal period?
RED: The government issues $100 in bonds without spending anything in the real economy, and banks have to absorb the new bond issuance by depleting existing bank reserves ($ -100).
GREEN: The government refills its Treasury General Account (TGA), and that is reflected in the composition of the Fed liabilities: TGA up $100, bank reserves down $100.
This is how a TGA rebuild drains 'liquidity' (e.g., reserves) from the financial system.
If the government issues bonds without spending real economy money and banks/private sector must absorb the new issuance without any fresh new resources, bank reserves take the brunt.
But why are bank reserves referred to as 'liquidity' in the first place?
Bank reserves are money for banks: They use reserves to transact against each other and with the Fed, and you can think of them as the lubricant of the monetary mechanics pipes – the more reserves out there, ceteris paribus, the easier for banks to engage in repo markets and provide liquidity to market participants.
Reserves are also part of banks' high-quality liquid assets (HQLA), and hence a bigger reserve balance might encourage banks to take more risks in their liquidity portfolio, for instance, by buying corporate bonds – this compresses credit spreads and enacts a more favorable environment for equity investors.
On the contrary, fewer reserves are often associated with banks taking a more defensive investment stance and providing markets with less liquidity.
So, is it as easy as saying that the TGA rebuild will for sure drain liquidity from the financial system?
We will have to wait and see.
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