Does the Money Multiplier Exist?

Editor’s Note: Do not confuse the use of the term ‘loanable funds’ used here with the theory of loanable funds which implies government spending crowds out private spending because of a limited pool of ‘loanable funds’ in an economy. The term is the same but the meaning here is different.

The Federal Reserve Board’s Seth B. Carpenter and Selva Demiralp have a great paper out on the economics of bank reserves (hat tip FT Alphaville and Pragmatic Capitalism). The question: Does the Money Multiplier Exist? The short answer: yes, but only as an ex-post accounting identity!

Since 2008, the Federal Reserve has supplied an enormous quantity of reserve balances relative to historical levels as a result of a set of nontraditional policy actions.  These actions were taken to stabilize short-term funding markets and to provide additional monetary policy stimulus at a time when the federal funds rate was at its effective lower bound.  The question arises whether or not this unprecedented rise in reserve balances ought to lead to a sharp rise in money and lending.  The results in this paper suggest that the quantity of reserve balances itself is not likely to trigger a rapid increase in lending.  To be sure, the low level of interest rates could stimulate demand for loans and lead to increased lending, but the narrow, textbook money multiplier does not appear to be a useful means of assessing the implications of monetary policy for future money growth or bank lending.

Basically

Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending.

Let me break the argument down for you in layman’s terms.

Once upon a time economists believed there was this thing called the market for loanable funds. According to this theory, a central bank controlled the creation of credit by increasing or decreasing the supply of reserves or loanable funds available to depositary institutions.

So, for example, if the Federal Reserve sold Treasury bonds to a primary dealer – say Kidder, Peabody to use a now extinct and uncontroversial example -  in exchange for money, the supply of loanable funds would shrink. This would, in theory, decrease available credit and cool off an overheated economy.  According to this theory, the reverse would also be true, namely that the Fed’s buying assets with money it printed out of thin air would increase the supply of credit.

The monetarist history of the Great Depression by Milton Friedman and Anna Schwarz uses the loanable funds theory to argue that the Great Depression was all the Fed’s fault because it was too restrictive. Had the Federal Reserve been more expansionary in its monetary policy, there never would have been a Great Depression or so the theory goes.

As it turns out, this is total baloney. There isn’t a finite pool of funds which can move around "demanding" higher interest rates.

  1. In practice, banks don’t wait for the reserves to be available to issue loans. They make loans first and then borrow the reserves in the interbank market. The loans come first, not the reserves. A small private bank in Kansas can’t turn into Bank of America overnight. There is a limit to lending. The limit on bank lending is not reserves but capital and leverage! Ask the Canadians who have no reserve requirement.
  2. If you haven’t noticed, banks’ excess reserves are piling up at the Federal Reserve right now. The ‘loanable funds’ are there waiting to be used. Why aren’t they using them?  Because there aren’t enough creditworthy borrowers or well-capitalized lenders to increase credit significantly right now. This was exactly the same spectacle we witnessed during the Great Depression, by the way.

Marshall Auerback puts it well:

In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed’s stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.

The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank’s ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.

What is required to drive lending is a creditworthy borrower on the other side of the bank lending officer’s desk, which means an employed borrower, whose income allows him to sustain regular repayments. Absent that, there will be no lending activity. It is pointless to blame the evil bankers for this of state affairs, since they don’t control fiscal policy, which is the remit of the Treasury.

For all the talk from policy makers about not repeating the mistakes of Great Depression, we seem to be perilously close to doing precisely that. This is largely based on a poor understanding of the economic dynamics of that period, even by that noted scholar of the Great Depression, Ben Bernanke.

The Real Reason Banks Aren’t Lending

I am reminded here of Ray Dalio’s term ‘the D-Process’ which describes a long-term debt cycle which ends in default and bankruptcy. He says:

The reason [credit easing] hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

A conversation with Bridgewater Associates’ Ray Dalio

Now, the money multiplier – which is the mathematical ratio of base money to larger monetary aggregates like m2 m3 or MZM – exists. It’s just that the Fed doesn’t control it. They can print all the money they want, but if creditors and debtors aren’t solvent there isn’t going to be any additional lending. They are pushing on a string (see Pushing on a string and similar notions on monetary policy ineffectiveness from December 2008 when the Fed first tried QE).

So will QE2 aka QE-lite work? The short answer is no. See the long answer here.

Source: Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist? (pdf) – Federal Reserve Board

30 Comments
  1. gnk says

    Ed – What was Bernanke’s real goal with QE1? Was it to restart lending, or was it to help recapitalize the banks – i.e. address the solvency issue?

    Bernanke basically gave the banks close to a trillion and a half dollars, in return for crap assets whose values were marked to “fantasy.” The banks then purchased treasuries and recieved a no-brainer guaranteed rate of interest. Thus, the US Treasury Market continued to function, rates were pushed down due to “demand,” banks somewhat recapitalized. Mission Accomplished.

    As for Main Street – I just don’t see how a central bank can make a difference. Let’s be honest with oursleves, the priority of a central bank is to address the follies of their shareholders (banks) while main street must abide by the darwinistic rules of Capitalism.

    Gee, I wonder who wins in the end?

  2. Luis Enrique says

    Can these arguments be reconciled with the existence of credit-worthy borrowers who are being turned away by banks?

    Unfortunately all the evidence I’ve seen in anecdotal, so potentially one gigantic sampling error, but the newspapers (in the UK) are full of stories about perfectly sound businesses suddenly finding their banks withdrawing support, and (UK) politicians are citing these stories when they talk about the need to “get the banks lending”.

    Is there any reason why the the banks wouldn’t be lending other than “those demanding loans are in fact not creditworthy”?

    1. Edward Harrison says

      @Luis Enrique, when I say “The ‘loanable funds’ are there waiting to be used. Why aren’t they using them? Because there aren’t enough creditworthy borrowers or well-capitalized lenders to increase credit significantly right now.” I am talking about BOTH demand and supply side constraints. Banks can’t lend when they are capital constrained. Just because their accounts say they are well-capitalized doesn’t mean they are – it’s accounting gimmickry. If banks were so well capitalized, why aren’t they paying a larger dividend. Even JPMorgan Chase has yet to restore it’s dividend to a proper level.

      1. Luis Enrique says

        Thanks v much. I’m afraid I don’t understand the difference between looking well capitalized according to the accounts and being capital constrained in a real sense. Nor am I sure how to reconcile the idea that a bank’s ability to make a loan has nothing to do with its reserves, with the idea of real capital constraints. I guess the answer to the last one is that while there’s nothing to stop the bank making a loan, it may not want to whilst it is trying to rebuild its capital position. I’d be very interested in finding out about the accounting v real disparity – have you written a past post on that topic?

        1. Edward Harrison says

          I have written on this a number of times in the past. Probably the best recent example is here:
          https://pro.creditwritedowns.com/2010/04/jpmorgan-is-not-substantially-increasing-lending-anytime-soon.html

          Note that Bill Black was out saying similar things here:
          http://finance.yahoo.com/tech-ticker/bill-black-u.s.-using-%22really-stupid-strategy%22-to-hide-bank-losses-535317.html

        2. Edward Harrison says

          Luis Enrique, I have a fuller reply now up as a new post. I hope that explains better

          https://pro.creditwritedowns.com/2010/08/hiding-bank-losses.html

          P.S. the same is largely true in Spain and the UK too.

      2. Marshall Auerback says

        Actually, the description is good, but I wouldn’t use the term “loanable
        funds”, which refers to a theory implying a finite use of funds (and, hence,
        the mistaken “crowding out” theory invoked by those who oppose additional
        government fiscal stimulus). A sovereign government can always create new
        net financial assets via the electronic crediting of bank accounts, so to
        speak of a finite pool of funds or a “natural rate of interest” (as Greenspan
        used to frequently evoke) is nonsensical. If you believe in loanable
        funds, it invariably conditions you to think the problem is the “size” of the
        public deficits and the growing ratio of public debt to GDP but a considered
        reflection leads one to conclude these are not problems at all. The
        movements in these aggregates tells us about other problems – pertaining to the
        real economy – but in and of themselves they present no issue that is worth
        a moment’s thought, especially given the lack of a constraint on the
        government to fill in the declining private sector output gap.
        The problem for the public debate though – in terms of moving it in a
        direction that will address the actual underlying issues such as weak aggregate
        demand and persistently high unemployment and rising long-term unemployment
        – is that these commentators are stuck in mindless obsessive warp about
        these financial ratios. They cannot see beyond them and they cannot see how
        meaningless their daily obsessions are.

        In a message dated 8/13/2010 05:35:31 Mountain Daylight Time,
        writes:

        Edward Harrison wrote, in response to Luis Enrique (unregistered):

        @Luis Enrique, when I say “The ‘loanable funds’ are there waiting to be
        used. Why aren’t they using them? Because there aren’t enough
        creditworthy borrowers or well-capitalized lenders to increase credit significantly
        right now.” I am talking about BOTH demand and supply side constraints. Banks
        can’t lend when they are capital constrained. Just because their accounts
        say they are well-capitalized doesn’t mean they are – it’s accounting
        gimmickry. If banks were so well capitalized, why aren’t they paying a larger
        dividend. Even JPMorgan Chase has yet to restore it’s dividend to a proper
        level.

        Link to comment: http://disq.us/kajr6

  3. fresnodan says

    I saw this theory about lending coming first and reserves second a couple of years ago by an Australian economist named Keen. It seems like this theory is gaining traction. Max Planck said, “Science advances funeral by funeral.” (by this he meant that old scientists don’t accept new accurate ideas but as they dide they are replaced by new scientists who aren’t invested in the old ideas).
    I agree with the comment about there being a lot of stories that credit worthy borrowers can’t get loans. I wonder how much is due to credit standards changing.
    Finally, I would say it should be obvious that if people have too much debt, even a 0% loan doesn’t make their circumstance better, it makes it worse.

    1. Gbgasser says

      All I would say is “credit worthy” is in the eye of the beholder.

      People who were credit worthy 2 years ago and are at the same income level now, are not necessarily viewed in the same light today. Are they employed in a sector that is subject to volatility? Are their positions safe in the current environment? These are all questions that loan officers will ask themselves before extending credit to someone. Knowing that reserves follow loans doesnt mean that everyone who wants a loan gets one (I know this is obvious) but its still important to dismiss the loanable funds theory as bunk. Getting the direction right is always important.

  4. Arthur Cutten says

    You may wish to include this paper in your reading as well

    http://www.newyorkfed.org/research/staff_reports/sr380.pdf

    Some of these arguments are ‘chicken and egg’ and terminology and concept can be a misleading trap.

  5. Justin Weleski says

    Interesting analysis: reserves don’t play the role we think they do and capital, leverage, and credit worthy borrowers are the primary determinants with regard to bank lending.

    I would disagree with one aspect of Auerback’s analysis, however. He argues that “What is required to drive lending is a creditworthy borrower on the other side of the bank lending officer’s desk,” but that is clearly not the case in light of our recent sub-prime mortgage bubble. There was an extreme lack of credit-worthy borrowers, but banks were throwing money out the door as quickly as they could.

    Thus, a lack of credit worthy borrowers may be a convenient explanation (by banks) as to why they are not lending, and it may truly be a deterrent in this post-apocalyptic financial landscape, but it does not provide a limit in less rational, more exuberant times.

    1. Justin Weleski says

      Then again, a bank can never truly determine whether a borrow is credit worthy (not unless they can correctly predict the future), so what seems to matter is the APPEARANCE of credit worthiness. For example, an individual making $35,000 per year may not initially strike us as the best candidate for a $100,000 home equity line on his $150,000 home. Then again, when housing prices are skyrocketing and very few can even imagine a nationwide housing bust, our $35,000 man looks quite credit worthy.

      In this sense, it could be said that one of the primary determinants with regard to bank lending is nothing more than the prevailing sentiment about the market. To paraphrase some rich, self-important financial executive; “When the music is playing, you dance.” By this reasoning, it doesn’t really matter if the borrowers are credit worthy, or if your bank is already leveraged to the max, or even if your capital is at critical levels; you can continue to dance and rake in the profits so long as the music is playing.

      1. Marshall Auerback says

        All very astute observations, Justin, but of course, if a borrower is
        making regular payments in a timely manner, and has a steady income (which can
        be easily assessed via income tax returns and the like), then a banker can
        make a reasonably sensible judgement about the borrower’s creditworthiness.
        What happened in the latter part of the last decade was the fact that
        bankers stopped doing their due diligence. Another problem was that the credit
        intermediation process changed substantially due to securitisation.
        When a commercial bank makes a loan, the loan officer wonders “how will I
        get repaid”. Because the loan is illiquid and will be held to maturity, it
        is the ability to repay that matters—and it is most prudent to rely on
        income flows rather than potential seizure and forced sale of the asset at some
        time in the possibly distant future and in unknown market conditions. On
        the other hand, when an investment bank makes a loan, the loan officer
        wonders “how will I sell this asset”. The future matters only to the degree
        that it enters the value of the asset today because it will be sold
        immediately. Even the buyer of the asset need not worry about the distant future
        because the liquid asset can be unloaded quickly. Especially when confidence is
        high and euphoria reigns, it is easy to sell assets whose value is
        disproportionately determined by expected asset appreciation (and goodwill). The
        sky is the only limit to how much an asset’s value might rise, hence no
        euphoric expectation can be easily dismissed. And any debt ratio can be
        justified as sound because it will automatically fall as the asset appreciates. As
        late as spring 2007, Fed economists were still giving papers (at the Levy
        Institution’s annual Minsky conference) denying that real estate was over
        valued and that there was a credit bubble—the vast majority of economists
        were similarly in a perpetual state of denial—because real estate values
        would continue to rise, validating the debt. As Greenspan said during the
        dot-com boom, how can one argue with the wisdom of tens of millions of market
        players? My friend Jamie Galbraith nicely captures the circularity of such
        group-think: “It is difficult not to marvel at the imagination which was
        implicit in this gargantuan insanity. If there must be madness something may be
        said for having it on a heroic scale.”

        _[_ (aoldb://mail/write/template.htm#_ftnref1) :18:34 Mountain Daylight
        Time, writes:

        Justin Weleski (unregistered) wrote, in response to Justin Weleski
        (unregistered):

        Then again, a bank can never truly determine whether a borrow is credit
        worthy (not unless they can correctly predict the future), so what seems to
        matter is the APPEARANCE of credit worthiness. For example, an individual
        making $35,000 per year may not initially strike us as the best candidate
        for a $100,000 home equity line on his $150,000 home. Then again, when
        housing prices are skyrocketing and very few can even imagine a nationwide
        housing bust, our $35,000 man looks quite credit worthy.

        In this sense, it could be said that one of the primary determinants with
        regard to bank lending is nothing more than the prevailing sentiment about
        the market. To paraphrase some rich, self-important financial executive;
        “When the music is playing, you dance.” By this reasoning, it doesn’t
        really matter if the borrowers are credit worthy, or if your bank is already
        leveraged to the max, or even if your capital is at critical levels; you can
        continue to dance and rake in the profits so long as the music is playing.

        Link to comment: http://disq.us/kbabt

      2. Ken Smith says

        What makes the “credit worthy” debate a bit of a red herring is (knowing how) both asset based lending versus credit based lending (or expected changes in cash flow) requires at least a small level of predictive ability on the part of the lender. If the lender’s “margin” of loan losses is magnified by leverage you begin to see the banks real problem is ITS (the banks’) current solvency. Current cash flow matters on what loans can be made. Lenders bets are on the loan being repaid, not the borrowers business’ success. When (like the current US real estate market) bankers become major buyers (lenders for) and sellers of assets used as collateral, they are in the feedback loop of their own prior loan analysis’ accuracy. A few too many no money down loans going south can ruin a well capitalized lender real fast. Banks profit margins are the rate differences, not asset sales prices.

    2. Marshall Auerback says

      Yes, you are correct, Justin. That often happens at the end of a bubble.
      And there is the role of securitisation, and I was describing a typical
      bank loan process.

      In a message dated 8/13/2010 10:04:01 Mountain Daylight Time,
      writes:

  6. Charlier says

    I don’t buy this. The banks are not lending because THEY are in bad shape. Maybe I misunderstand this, but I am under the impression they can put their Fed-provided reserves on the books, making them look healthy. They don’t want to give this away in exchange for ANY risk, so “creditworthiness” of customers is not a reasonable term. If this is wrong, please explain why you think so.

    1. Marshall Auerback says

      You are incorrectly conflating two distinct issues. The banks probably
      are in bad shape. But why are they in bad shape? In part because they hold a
      lot of toxic debt on their books, but much of that debt became toxic due
      to a substantial collapse in aggregate demand. One of Minsky’s key insights
      over 50 years ago was that policies that encourage full employment help to
      mitigate financial fragility because it means you have an environment where
      borrowers are able to service debts and banks, as a consequence do not have
      to write them down, meaning their balance sheets are not as impaired.

      The second issue relates to the reserves themselves, and the idea that bank
      lending is not reserve-constrained; never has been since the development
      of the Fed funds market and the Eurodollar market, in the context of repeal
      of Regulation Q.
      Rather bank lending is a function of demand given rates and underwriting
      terms, in the context of the banking system’s capital (not reserve)
      constraints.
      When in a liquidity trap, as we are, the effectiveness of QE is a function
      of whether it is accommodating (monetizing) pro-active fiscal stimulus,
      not just passive automatic fiscal stabilizers.
      The “right” policy mix is the one Bernanke proposed for Japan in spring
      2003, which I detailed in my July 2009 GCBF, “What If?” (attached).

      In a message dated 8/16/2010 16:07:13 Mountain Daylight Time,
      writes:

  7. Wondering says

    What do the readers think of this? My wife and I have over 100,000 in cash, no debt, and we want to buy a 450,000 house in a highly reliable market (an upscale, central NJ town on a popular commuter rail line). My wife and I earn together 180,000/yr. (That’s real money – W-2s.) My last credit rating from Experian (provided free by my CC company) was 725. However, I do have a mark on my credit. I refuse to pay a physician bill due to a dispute with a physician. I believe he owes ME money based on a verbal contract (the insurer is not involved in this). I don’t want to hire a lawyer to resolve a 2K dispute. That’s insane. Now, bank officers look at my credit record and say I am either unqualified, or deserve a higher rate. Why, I ask, does that relate to my ability and likelihood of repaying a MORTGAGE? Does the lender plan on cheating me? Are they worried I will not pay my mortgage based on a dispute? I suggest such a theory is bizarre. Yet, highly paid bank officers look at credit sheets like mine and treat people like me quite differently from other reasonably capitalized people with good income, ignoring the fact that sometimes CIRCUMSTANCE can affect a credit record, not quality of a persons character. Here I am, with nearly enough for 20% down, and they claim they can’t find lenders but are not realistic about them IMHO. Screw the system – I’m gonna keep renting and watch the housing prices fall. What do you think?

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