THE MYTH OF THE MONEY MULTIPLIER: A FOLLOW-UP

I have referred to this often in the last few months, but it’s such a fundamentally important topic that it’s worth rehashing here.  We have all been taught in school that the money multiplier is economic law.  Banks get reserves and essentially leverage them up and economic activity picks up and inflation ensues.  Of course, this was what Ben Bernanke had in mind when he embarked on his great monetarist gaffe.  Unfortunately, this recession has turned much of modern economics on its head as the very rare balance sheet recession shows that your textbooks lied.  The following is courtesy of Warren Mosler who summarizes a recent Fed paper admitting that the money multiplier is indeed a myth:

Did Hell freeze over and I missed it??

Seth B. Carpenter and Selva Demiralp, recently posted a discussion paper on the Federal Reserve Board’s website, titled Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?

The authors note that bank reserves increased dramatically since the start of the financial crisis. Reserves are up a staggering 2,173% from $47.3bn on September 10, 2008, just before the financial crisis began, to $1.1tn now. Yet M2 is up only 11.4% since September 10, 2008, and bank loans are down $140.2bn. The textbook money multiplier model predicts that money growth and bank lending should have soared along with reserves, stimulating economic activity and boosting inflation. The Fed study concluded that “if the level of reserves is expected to have an impact on the economy, it seems unlikely that a standard multiplier story will explain the effect.”

That not only repudiates the textbook money multiplier model but also raises lots of questions about the goal of the Fed’s quantitative easing policies.

The Carpenter/Demiralp study quotes former Fed Vice Chairman Donald Kohn saying the following about the money multiplier in a March 24, 2010 speech (here):

“The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. . . . We will need to watch and study this channel carefully.”

Here are more shocking revelations from the study under review: “In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found.

Banks are never reserve constrained.  They are always capital constrained.  Reserves are used for only two purposes – to settle payments in the overnight market and to meet the Fed’s reserve ratios.  Aside from this, reserves have very little impact on the day to day lending operations of banks in the USA.

The sad thing here is that there are people in the Fed who KNOW this.  They understand it.  Yet, here we are implementing policy that many of them know will never work.  It’s unbelievable.  In other words, QE will fail and the Fed will continue to push on a string.  The Fed is impotent.  I think they’re just jawboning at this point.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • mlb

    At best, the Fed is impotent. At worst they can destroy all confidence in the USD and give away reserve currency status. After that inevitable disaster, they will of course argue that no one could have seen it coming. Yet there will be no prosecutions and no one to answer to.

  • scharfy

    The Money Multiplier totally ignores the human aspect of bubbles and manias.

    Restated – when people want a loan, they want it at any damn price. When people don’t want a loan, they don’t want it at any damn price.

    Applying a neat and tidy model to human behavior kind of seems silly.

    The Fed is pouring lighter fluid all over the campfire now. But there’s no flame. Which means they really have the potential to do damage with QE forever policy.

    Gold is on the WARPATH!!!!!!!!!

  • Nico

    Could it be only a temporary effect (or lack thereof)? If eventually demand does pick up and the FED keeps carpet bombing with liquidity, would the multiplier suddenly kick in, this time in high gear?

  • isxcowpoke

    HAhaha. So true mlb:
    “No one could have seen it coming”

  • walden

    As the Oracle of Omaha is wont to say: when all you have is a hammer, everything looks like a nail. They’ve got nothing else. No one believes anyone anymore, and we’re probably just a couple of misunderstandings and bad import/export reports away from a currency war and a race to the bottom.

  • F. Beard

    What is with the freaking money multiplier anyway? Is it not just a holdover from the gold standard? Are paper money and electronic bookkeeping entries so expensive that they must be multiplied?

    Let’s have 100% reserve lending (after bailing out the population with new debt-free legal tender fiat) and leave the boom-bust cycle behind. Then let the US Treasury increase the money supply by about 3% a year till we figure out how to do money properly.

  • dis737

    I think the issue is more nuanced than that I am just speculating here, but I believe the multiplier works in a growing economy w/ loan demand. It does not work in a stagnant economy w/ weak loan demand like we are experiencing today. My guess is the Fed was hoping that the fiscal stimulus would provide enough “growth” for a multiplier affect to kick in. The are obviously underestimating how weak loan demand is, hence no multiplier affect.

  • F. Beard

    The Fed is impotent. I think they’re just jawboning at this point. TPC

    Well the Fed could charge a negative interest rate for those excess reserves (storage
    charge). That should make the banks start lending in a hurry. Or is the plan for the banks to buy US Treasuries with those reserves and then turn around and sell them to the Fed for a nice profit? And repeat till the banks are well capitalized?

  • http://www.pragcap.com TPC

    Wouldn’t work. It would be the same as a tax increase on the banks. The deficit would shrink marginally, bank capital would shrink marginally and at the end of the day the # of willing borrowers would remain exactly the same.

    Scott Fullwiler has pretty much debunked this one already:

    http://neweconomicperspectives.blogspot.com/2009/07/why-negative-nominal-interest-rates.html

  • F. Beard

    OK, I see, I think. Thanks.

  • F. Beard

    Returning to remedies for the economy, if the problem is a lack of spending, why not a simple payroll tax holiday, for example, as my fellow bloggers have proposed? Scott Fullwiler

    Yes, I like that; a form of “stimulus” that would go directly to the victims.

  • Bruce

    Nothing can be done prior to the elections. After the elections they will vote pn tax cut extensions and buy down rates via QE another 1% or whatever. The dollar will plummet. Other currency blocs will also stimulate to try and keep pace. Amongst this worldwide flood of liquidaty, asset prices will rise to impossible, nosebleed levels. Amazon at 100 p/ e, why not? Gold at 2500? Some of this incrediblea paper wealth will find it’s way into the real economy as increased spending.

    Then they just have to figure out to keep the asset markets levitated without a rush to the exits.

    Not saying it will work. But that’s the plan. Because there isn’t politically acceptable alternative.

  • http://www.3spoken.co.uk Neil Wilson

    It doesn’t work at all for the fairly obvious reason that banks lend on their capital, not on their reserves.

    A bank will lend to anybody who turns up who fulfil their risk and price criteria. The regulatory niceties are sorted out *afterwards*.

    They can *always* get the reserves to back fill any holes from the central bank, and it is the *price* of reserves at the central bank that gives the base for lending.

    There is a reason the central bank is ‘lender of last resort’.

    Reserves never affect lending. Capital does.

  • Andrew P

    The Fed is irrelevant to the longer term outcome. Right now they are pushing on a string, because the banks have a huge black hole to fill. Even when it is filled, it won’t matter. I still think we will hit the wall when permanent oil shortages produce hyperinflation. It hasn’t happened yet because fuel demand was depressed by the recession, and global oil production hasn’t fallen all that much – yet. But when the supergiant Saudi oilfields collapse, all hell will break loose. There is no alternative for vehicle fuel in the forseeable future, especially for heavy trucks. In an era of permanent and ever worsening shortage, the price of oil can increase without limit. Eventually, OPEC and Russia get sick of inflated dollars and demand payment in gold bullion. And that is when the USA hits the wall.

  • PS

    MONEY MULTIPLIER IS TOTAL NONSENSE. ANOTHER PSEUDO ANGLE FROM THE DEFLATIONISTAS.

    MARK MY WORDS – A WILLING GOVERNMENT AND CENTRAL BANK CAN ALWAYS CREATE INFLATION BY PRINTING MONEY, ALWAYS. MONEY MULTIPLIER BE DAMNED!

    A STRONG ECONOMY IS NOT REQUIRED FOR INFLATION OR HYPERINFLATION.

    GO ASK MR. MUGABE HOW STRONG HIS ECONOMY WAS WHEN HE DESTROYED HIS CURRENCY!?

    THE PERMA BEARS AND DEFLATIONISTAS WILL LOSE THEIR SHIRTS IN THE NEXT 3-4 YEARS.

    WAKE UP.

  • fresno dan

    Every time I look up “captical” versus “reserves” I get an incomprehensible explanation.
    Can you tell what the profound difference between “capital” and “reserves” is?

    I mean, if reserves are composed of “capital” than what are they composed of – strawberry jam?

  • Anonymous

    Haha, welcome to Mish’s world. He has been discussing this in the last couple of years. Steve Keen has also empirically shown that 1) bank credit leads; 2) the multiplier theory-implied ratio of reserves to moneatry aggregates does not hold.

    The only way the Fed can cause inflation is to step is as a direct lender in the place of the banks who nowadays control about 95% of money creation via FRB. Then the can hyperinflate as much as they want (or lose USD creditbility somewhere on road).

    InvestorX