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

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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