## Thursday, October 13, 2011

I don't know how I ended up writing several in a row on the money multiplier and its components. (As I said, I woke up thinking M1>GDP in Japan and Base>M1 in the USA. By the time I had Blogger on-screen I had four posts in my head. I love mornings like that.) Anyway, I would say I don't give a sh*t about the money multiplier, except I don't use the word sh*t.

A while back, I looked at what Bill Mitchell and Steve Keen said about the money multiplier. Mitchell said the money multiplier is

not even a slightly accurate depiction of the way banks operate in a modern monetary economy characterised by a fiat currency and a flexible exchange rate.

Keen called the money multiplier

I don't give a sh*t.

The money multiplier is a number, not "an explanation". Not a "depiction of the way banks operate". It is a ratio that shows how much M1 money there is, for each dollar of base money in the economy. It is a number, and it changes. Obviously.

Keen and Mitchell (see my old post) both review in excessive detail the process of figuring out how much money can be created from one new dollar. There is an easy way to figure that out, as I showed at the time. And it gives a true and accurate result. But remember: That result does not tell you how much money *is* created from each new dollar. It tells you the absolute maximum amount of money that *can be* created from a dollar. It depends entirely on the reserve requirement. It's simple arithmetic.

The purpose of that story, as I recall, is to convince people new to economics that money is created by the act of lending. That's the concept that I had trouble with when I was new to economics. And it was an explanation identical to the one that Mitchell and Keen use, that convinced me that lending creates money. But it was the easy way to figure it, that really convinced me. Simple math.

The fact is, the calculation (how much money can be created from one dollar) only sets the theoretical maximum. Sort of like a speed limit. But how much money is actually created is another matter altogether. Sort of like driving.

The best story I've seen on this topic is Matt Rognlie's peanut-butter machine story.

Actually, just the peanut-butter machine story. Pay no heed to the rest of Rognlie's post. He starts out misinterpreting the phrase the breakdown of the standard money multiplier. John Williams uses that phrase to mean the ratio no longer behaves as expected. Rognlie does a straw-man interpretation. What's significant is that the multiplier number has changed.

Yeah, and skip over the part where Rognlie says that having a reserve requirement costs banks money. Get over it, Rognlie. That's just part of the cost of doing business. It's a service charge -- 0.4% each year in Rognlie's example -- for the right to use and inflate the standard of value established by the U.S. government. A service charge for legalized counterfeiting, essentially. Not that there's anything wrong with that. But the cost should have been a much higher, and fixed, and permanent policy.

So, just the peanut story. You'll love it.

Greg said...

Art

Here's why I think getting the notion of the money multiplier correct matters.

The money multiplier theory essentially starts with deposits/savings. It takes money that people dont want to spend now and says that they lend it to others via the banking system. It models the banking system as simple intermediaries, connecting the savers with the borrowers. It sees the solution to banking crises as providing more capital to lend. It encourages MORE saving during a downturn so there will be money to lend to others. It sees the problem now as people hoarding their money and not wanting to lend because they are uncertain.

Thing is banks do not need depositors to lend. They first acquire capital by getting investors and then they find credit worthy borrowers and start lending away, creating the deposits when the loan is closed on.

So deposits are not multiplied via the loaning process and if you dont have it modeled correctly you will never find the right solution to the banking problem. Weve spent almost four years thinking we have a banking sector problem and govt debt problem when we in fact have a household sector and personal debt problem and holding to a "money multiplier" theory of banking/ loan creation is a huge impediment to getting the answer correct.

The Arthurian said...

"The money multiplier theory essentially starts with deposits/savings."

Yeah, that's what I thought, too. But my recent thoughts have it different. I now think the money multiplier starts with the issue of new money, I'm gonna say by the central bank specifically. Because if ONE dollar can be turned into N dollars by lending, then we cannot start with the Nth dollar or the "i"th dollar. We have to start with the FIRST dollar. I don't know if I'm saying it well, but I think this has to be right.

"Thing is banks do not need depositors to lend. They first acquire capital..."

I understand that the economy is shifting toward "capital requirements" and away from "reserve requirements". I'm sure it will be another 20 years before I understand that.

In the meantime I would say that the shift is part of the evolution toward further financialization. Yet it remains very clear to me that a reserve requirement limits the amount of money that can be created from a dollar.

"Thing is banks do not need depositors to lend."

Nonetheless, they have depositors. I have seen the thought before that I quote from you here, but I have not seen that thought brought to conclusion, I think.

Oh wait! I am shortening this, but you write:
Thing is banks ... find credit worthy borrowers and start lending away, creating the deposits when the loan is closed on.

Okay, the loan agreement creates the deposits. But then you say:

So deposits are *not* multiplied via the loaning process...

and now I am confused. Perhaps I emphasize the wrong part of your remarks? So, correct the emphasis for me, if you would.

Greg said...

I think the best way to look at it is that banks leverage our incomes into loans, not our deposits.

When I go to a bank and deposit 1000 dollars they do not leverage that money into 10,000 of loans.

What they do is find someone whos income supports say a 10,000\$ loan at x% and then they create a 10,000\$ deposit for them to access and spend from. Of course at the same time they have a 10,000 deposit they also have a 10,000 liability. But they could just as easily find someone whos income supports a 100,000\$ loan. Even if they still only have my 1,000 deposit.

Money multiplier people work from a paradigm where depositors bring money to a bank and the bank is allowed to multiply that money into 10x the amount. It works form the notion that my bank savings are necessary for loans to be created, which is false.

Calgacus said...

The point of the money-multipier story being wrong is that it reverses the causation.

That result does not tell you how much money *is* created from each new dollar. It tells you the absolute maximum amount of money that *can be* created from a dollar.

(Bank) Money is NOT created from every new Fed dollar. The new Fed-printed dollars are created because governments dictate they are needed (for company) by the already-created bank money, which the government says will feel lonely without knowing some reserves are out there somewhere. :-)

People once understood this better. The "loans create deposits" story was once the mainstream. Think of things in terms of old-fashioned banknotes, which are exactly equivalent to bank deposits.

When you get a loan from the bank, you are getting some banknotes that the bank just printed up. When you make a cash deposit, you are just exchanging your Federal Reserve Notes for banknotes the bank printed up. The bank can print as many as they want. The requirements come afterward - and the Fed is forced to lend at the discount window to any bank that needs to meet reserve requirements.

A bank is essentially a Barony that the King decides to give the privilege of coining money to - under some restrictions - and whose coin the King backs by saying the Baron's coin is as good as the King's coin. Nice work if you can get it. Today's financial crises are just the Barons getting uppity, corrupting the idiot King whose grant of power they depend on & oppressing us peasants.

"Thing is banks do not need depositors to lend."

Nonetheless, they have depositors.

Some countries have zero-reserve requirements. And some, like France, have banks which do not have depositors. To get required reserves, they borrow from the central bank or from banks that do accept deposits (caisses d'epargne iirc). Marc Lavoie has some good papers on this. It's good to understand this because the Continental practice tends to be closer to "what really happens" everywhere, while the Anglo-American (& German?) practices make it look like something different, something commodity-money-theoretic (false, false, false) is happening.

nanute said...

Reserve Requirements and Money Creation
Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a \$100 deposit may lend out \$90 of that deposit. If the borrower then writes a check to someone who deposits the \$90, the bank receiving that deposit can lend out \$81. As the process continues, the banking system can expand the initial deposit of \$100 into a maximum of \$1,000 of money (\$100+\$90+81+\$72.90+...=\$1,000). ...

In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States. Reserve Requirements and Money Creation
Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a \$100 deposit may lend out \$90 of that deposit. If the borrower then writes a check to someone who deposits the \$90, the bank receiving that deposit can lend out \$81. As the process continues, the banking system can expand the initial deposit of \$100 into a maximum of \$1,000 of money (\$100+\$90+81+\$72.90+...=\$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial \$100 deposit into a maximum of \$500 (\$100+\$80+\$64+\$51.20+...=\$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States. Reserve Requirements and Money Creation
Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a \$100 deposit may lend out \$90 of that deposit. If the borrower then writes a check to someone who deposits the \$90, the bank receiving that deposit can lend out \$81. As the process continues, the banking system can expand the initial deposit of \$100 into a maximum of \$1,000 of money (\$100+\$90+81+\$72.90+...=\$1,000)....
In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. ...(source Federal Reserve Bank of NY)

nanute said...

Art,
I'm sorry for the convoluted post above. I tried to edit the post to conform to limits on html, and ended up duplicating segments of the quote from the Federal Bank of NY. Is there a way to edit after posting? Sorry for the mix up.

Greg said...

Thanks Calgacus

Your explanation is more comprehensive and clear.

The Arthurian said...

Nanute, there is no editing after posting with Blogger. You can re-work the text in Notepad or something, delete the convoluted version and post a new one.

Try it a couple times, if you want. When you delete them, Blogger leaves a one-line statement that an item was deleted. I can go in later and delete the one-line statements.

I did get confused by the repetition, but before that I thought it was pretty interesting. Paste in the URL too if you still have it. Thanks.

Calgacus, I'll get back to you in a bit. I have to go work out my thoughts in Notepad first.

The Arthurian said...

Calgacus, your "direction of causation" view is nothing but the old "you can't push on a string" thing.

I think we agree that fractional reserve banking creates money. As I said in the post above, it was an explanation identical to the one that Mitchell and Keen use, that convinced me that lending creates money. This is the value of the "explanation" that Keen and Mitchell reject. For if someone cannot see that lending creates money and paying down debt destroys money, then there is no sense even discussing the direction of causation.

On the other hand, since you admit that reserves are required, whatever the reason, then in fact the banks cannot create money without having reserves at the ready. I think it was a Randall Wray article I read at New Economic Perspectives a while back, he said the banks have like two days to get the required reserves. I forget the specifics, and certainly the bank can complete the loan transaction *first* and follow-up by getting the reserves *second* -- it would be foolish to turn down business just because the reserves are not in the cash drawer at the moment -- but nevertheless, the reserves are required, for "transaction account" balances at least.

Some countries have zero-reserve requirements. And some, like France, have banks which do not have depositors. To get required reserves, they borrow from the central bank or from banks that do accept deposits (caisses d'epargne iirc). Marc Lavoie has some good papers on this. It's good to understand this because the Continental practice tends to be closer to "what really happens"...

But Cal, "what really happens" is a result of excessive financialization of our economy!