THIRD QUARTER 2012
VIEW
OUR PERSPECTIVE ON ISSUES AFFECTING GLOBAL FINANCIAL MARKETS
The
of the
yth
M
Money
Multiplier
The
of the
yth
M
Money
Multiplier
Concerns about hyperactive central bank activities and
inflation have dominated media headlines. Will central
bank “money printing” revive lending? Will the overworked printing presses lead to rampant inflation?
These questions have anything but simple answers. Despite the complexity, academics and experts usually marshal a concept called the “money multiplier” to explain
the relationships between the central bank’s balance
sheet, commercial bank lending, the money supply and
consumer prices (See Figure 1).
Though it appears rudimentary, the money multiplier is
not so simple. Examining the curious interplay between
bank lending activity and reserve creation reveals that
banks lend first and worry about reserves separately.
fig. 1
TEXTBOOK MONEY MULTIPLIER MECHANICS
Central Bank
}
Commercial
Bank
}
Practically speaking, this means that the Federal Reserve, for example, can create as many reserves as it
pleases (i.e. it can “print money”), but so long as banks
are reticent lenders, lending will not increase—and by
consequence, money supply growth and inflation will be
modest. In fact, contrary to popular opinion, we suggest
that the textbook money multiplier is a myth.
The Fed creates bank reserves...
What The Textbooks Teach Us
Bank 1 receives new
deposits and creates $3 in
new loans.
}
Our textbooks tell us that the monetary authorities
(central banks) create money in a mechanical, monetary
sequence called “the money multiplier.” Put simply the
money multiplier posits a relationship between the central bank’s balance sheet (on which “bank reserves” are
a central bank liability) and lending activity (which has
consequences for prices—more lending increases prices)—for more information see Did you know? on page
3. Proponents sell the story as simple, logical, mechanical, elegant and irrefutable. In the words of James Tobin,
“the greatest moment of triumph for the elementary
Banks 2,3 & 4 each
recieve $1 on deposit
and in turn create $3
each in new loans...
Money Supply
1
“Ketchup Theory”
in the words of James
Tobin, “the greatest
moment of triumph for
the elementary economics
teacher” is laying out the
money multiplier.
One theory popular among investors (and even a few
FOMC members), is what we will call the Ketchup Theory. Think about a bottle of Heinz 57 sauce; as you labor to garnish your burger and fries, after a few shakes,
nothing emerges from the stubborn ketchup bottle. So
you shake again...and again...until...whoops! half the
bottle’s contents discharge on the food. Dinner ruined.
In other words, with the Fed enlarging the supply of reserves (pounding the ketchup bottle that is the banking system), banks will lend excessively (the ketchupy
mess erupts), which will bring about hyperinflation and
destroy the fixed income investors’ dinner (purchasing
power).
economics teacher” is laying out the money multiplier.2
Here is how it is supposed to work.
First, the central bank issues reserves to commercial
banks. Second, stocked with freshly-minted reserves,
commercial banks create new loans that become eventually become deposits at still other banks. Third, this
next set of “other” banks—to the extent they are not
fully “loaned up”—engage in their own lending. As
these banks loan to other banks and to customers, the
amount of money in circulation increases. This advance
in lending, so the theory goes, proceeds in snowball
fashion until the money supply balloons and inflation is
upon us (See Figure 1).
As much as we enjoy hamburgers this explanation has
proved inaccurate.
First, consider the recent credit boom in the United
States. The central bank’s balance sheet (“reserves”) did
not constrain the banking system in the production and
dispersion of money and credit. Indeed, on the eve of
the financial crisis in 2007, banks held only $20 billion in
reserves. Yet total credit in the US financial system exceeded $30 trillion. With a “t”. A rapid expansion of the
central bank’s balance sheet did not set the conditions
As a concept for understanding reserves, lending, and
prices, the money multiplier makes sense to many. For
example, in 2009, Princeton economist and expert Federal Reserve historian Allan Meltzer proclaimed: “...the
enormous increase in bank reserves—caused by the Fed’s
purchases of bonds and mortgages—will surely bring on
severe inflation if allowed to remain.”2
Did you know?
To better understand central bank balance sheet expansion,
it is helpful to examine the asset and liability structure of
a central bank. The central bank is a bank like any other-with one important distinction: its liabilities must be
held to meet a) legal reserve requirements (e.g., 10% of
deposits) and/or b) to meet clearing responsibilities at the
central bank (settling accounts on behalf of customers). In
fact, in the modern era, some central banks do not require
a specific level of reserves (e.g., the Bank of England).
But it has not. That is because there is a major problem
with this line of thinking.
In spite of his eminence, Mr. Meltzer appears to be missing something: the money multiplier is nowhere to be
found. Despite the Fed’s gigantic money printing operation (its balance sheet grew from $800 billion in 2007 to
nearly $3 trillion in 2012 financed by creating reserves),
the M1 money multiplier, which hovered between 1.6
and 1.8 from 2000 until 2008, has collapsed. The story is
similar in the euro area and the United Kingdom.
Just like a regular bank, a central bank’s balance sheet
also features assets, liabilities and equity capital. Its assets
consist of domestic and foreign assets.
Its liabilities comprise currency in circulation, bank
reserves, central bank securities, government deposits,
other non-monetary liabilities, and equity capital.
Equity capital represents accumulated profits as well as
paid-in capital. Policies that increase the size of central
bank assets entail corresponding increases in liabilities –
which can have important implications for the financial
system.
What happened?
2
to spark the credit boom; the private system took care
of that itself.
between several central bank balance sheets and consumer price inflation.
Second, according to empirical evidence, the key outside
constraint on bank lending seems to be capital requirements, not reserves. Indeed, banks could have always
borrowed an unlimited amount of reserves at the fed
funds rate (which the Fed pledged to maintain at a given rate), from the Fed’s discount window or from other
banks to meet reserve requirements.3
Our conclusion: there is no direct link between reserves
and money and credit creation and there does not appear to be a relationship between reserves and consumer price inflation (See Figure 2 again).
Why? The lending or credit creation activity precedes
reserve creation. Yes, you read that correctly. Based on
econometric research, data over the last 20 years suggest banks make loans first and worry about reserve
needs later.4
Beyond the reserves-to-loans connection, the reservesto-inflation connection is suspect at best. By taking several decades worth of data between central bank balance sheets and inflation as measured by core CPI, we
ask the reader to identify the relationship in Figure 2
fig. 2
The narrow textbook theory fails.
See a Relationship Between Central Bank Balance Sheets and Inflation?
A. UPWARD SLOPING
B. DOWNWARD SLOPING
C. VERTICAL
D. HORIZONTAL
United Kingdom
Year-over-Year Percent Change Core CPI
Year-over-Year Percent Change Core CPI
United States
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-50%
0%
50%
100%
Fed Balance Sheet Assets
Year-over-Year Percent Change
150%
Year-over-Year Percent Change Core CPI
Year-over-Year Percent Change Core CPI
Euro Area
2.5%
2.0%
1.5%
1.0%
0.5%
0%
20%
40%
60%
European Central Bank Balance Sheet Assets
Year-over-Year Percent Change
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-100%
200%
3.0%
0.0%
-20%
E. NO PATTERN
100% 200% 300% 400% 500%
Bank of England Balance Sheet Assets
Year-over-Year Percent Change
600%
700%
0%
20%
40%
60%
80%
100%
Swiss National Bank Balance Sheet Assets
Year-over-Year Percent Change
120%
Switzerland
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5%
-40%
80%
0%
-20%
SOURCE: Bank of England, ECB, SNB, Federal Reserve and Na tional Statitical Agencies
3
As the Bank of England’s Paul Tucker acknowledged,
“banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away
to wherever the borrower wants by the bank ‘writing
a cheque on itself’”. That is, banks extend credit (make
loans) by creating money, not by waiting for reserves to
then make a loan.
running back to the goldsmith to get hard currency for
transactions. Instead, the goldsmith would issue certificates that were redeemable on demand and much more
convenient. Further, by issuing banknotes to borrowers,
the goldsmiths financed economic activity.
Governments and economists, however, never much
liked this concept. Laws and regulations over the past
400 years reflect efforts to stamp out private banknotes
and enshrine one organization (the central bank or
monetary authority) as the monopoly issuer of notes.
This put in place the second major notion of the goldsmiths era: that the monetary authority controlled the
money supply by restricting note issuance.
Some central bankers know this, but others seem to
miss what is in plain sight. Where did the theory go off
track??
Your Friendly Neighborhood Goldsmith
Tracing the intellectual lineage of an idea is a bit like detective work. But, one place the money multiplier myth
may begin is with the London goldsmiths of the 17th
century.
Such a notion quickly proved to be false. Goldsmiths and
more recently, banks, circumvented this by issuing bank
deposits and other forms of credit money rather than
physical notes. The results are unequivocal: the banking
system found ways to economize on note issuance, by
continuing to create money and credit despite legal prohibition. Lending created deposits—not the other way
around.
That’s because 400 years ago in London, a discerning
consumer opted to store his or her gold (or silver) with
a goldsmith rather than braving the mean streets with
a pocket full of coin. The goldsmith, in turn, provided
a convenient service: issuing private promissory notes,
or bank notes, that circulated as money. In short, goldsmiths engaged in money creation.
Despite the Fed’s gigantic
money printing operation
the money multiplier has
collapsed.
However, in the annals of monetary history, historians’
portray goldsmiths as dishonest. This stems from the fact
that goldsmiths allegedly used client “deposits” as the
source for new lending to other clients. And, as a result,
this is the beginning of the idea—which has gripped
money and lending ever since—that deposits create new
lending.
In the case of the goldsmith the theory holds that, to increase lending, one must first increase deposits and surreptitiously use those deposits to finance lending. The
modern theory of the money multiplier is an outgrowth
of the early misconception: to increase lending, banks
must first increase reserves.
Tail Risks Ahead
Investors may ask, “Why is the money multiplier still so
enshrined in textbooks and the popular press?” Apart
from its elegance as a pedagogical tool, it stands as
structural pillar of the modern mainstream macroeconomic edifice.
But, does this accurately portray the goldsmiths’ actions?
What do we mean? A key assumption of the framework
is that the “money supply” is exogenous: that is, determined by the monetary authority (central bank).
In reality, goldsmiths economized on “coin” presented
as deposits. Instead of lending out gold, they issued private banknotes. The banknotes circulated and fueled
commerce. Indeed, a more thorough read of the historical record shows that the goldsmith provided a valuable
service. By issuing promissory bank notes, depositors
could trade and purchase without the hassle of always
Instead, as we have laid out above, if credit is created
endogenously by the financial system (in the modern era
just as it was in the goldsmith era), the system does not
depend on reserves to spark a credit boom.
4
Further, if the money multiplier does not explain how
the financial system operates, would its absence imply
that heightened inflation expectations driven by central
bank “money printing” may be misguided? Has the time
come to breathe a collective sigh of relief and dispel the
inflation mania?
Central bank policies around the world are unlikely to
spark new lending nor will they alone ignite inflation.
The money multiplier is a myth and a new explanation
is a return to the roots of understanding money and the
financial system: banks create money and credit.
Unfortunately the answer is not that simple. If the Fedinitiated money multiplier does not control lending and
inflation, it will not stop it either.
1 Tobin, James, “Commercial Banks as Creators of Money,” Cowles
Foundation Paper 205, Banking and Monetary Studies, for the
Comptroller of the Currency, U.S. Treasury, Richard D. Irwin, 1963.
That means the Fed’s much vaunted and self-promoted
inflation fighting power may be overestimated. Here is
Federal Reserve Chairman Ben Bernanke on the subject:
For controlling inflation, the key question is
whether the Federal Reserve has the policy tools
to tighten monetary conditions at the appropriate time so as to prevent the emergence of inflationary pressures down the road. I’m confident
that we have the necessary tools to withdraw
policy accommodation when needed, and that
we can do so in a way that allows us to shrink
our balance sheet in a deliberate and orderly
way.5
SOURCES
2 Meltzer, Allan H. “Inflation Nation”. New York Times. 3 May 2009.
3 Tobin, James, “Commercial Banks as Creators of Money,” Cowles
Foundation Paper 205, Banking and Monetary Studies, for the
Comptroller of the Currency, U.S. Treasury, Richard D. Irwin, 1963.
4Seth B. Carpenter and Selva Demiral, “Money, Reserves, and the
Transmission of Monetary Policy: Does the Money Multiplier
Exist?” Finance and Economics Discussion Series Divisions of
Research & Statistics and Monetary Affairs Federal Reserve Board,
Washington, D.C. 2010-41
5Ben Bernanke, “Five Questions about the Federal Reserve and
Monetary Policy,” Speech at the Economic Club of Indiana,
Indianapolis, Indiana, October 1, 2012.
But without the money multiplier, this false defence
does not hold. Reducing the Fed’s balance sheet (“removing reserves”) will have no effect on actual money
and credit in the system. The best the Fed can do is hope
to influence inflation expectations in the marketplace.
Another supposed Fed method of reining in runaway
prices is raising interest on excess reserves (IOER), an
administrative rate of remuneration the Fed pays to reserve holders. The money multiplier myth again haunts
this policy tool. The idea is that a higher rate of remuneration would entice banks to keep “cash parked at
the Fed” rather than using the reserves to make new
loans. But, again, if reserves do not cause new lending,
then policymakers might have a problem on their hands.
Once the credit boom begins it will not be enough to
simply raise the rate of remuneration on reserves to stop
inflation. Because banks are not reserve constrained the
process is beyond central bank control.
5