The Money Multiplier In Banking

You may have heard the term 'money multiplier' before without ever having given it much thought. It isn't often regarded as being an issue that a society should have much of an opinion about one way or another. But what if it just so happens to be the single biggest cause of instability in our economies?

In my opinion, and in the opinion of the Austrian School of Economics, the money multiplier is exactly that. It is the reason why the fractional reserve banking system has the power to create such huge amounts of credit and loans, and the extra spending that follows from that is the primary reason for the boom & bust business cycle.

On this page I'm going to explain just how destabilizing the current banking system has been over recent decades, with regard to its influence on the money supply, and what can be done to resolve the problem. From the information given I think you'll begin to appreciate that something will have to change eventually, because we cannot go on forever moving in the direction that we are currently headed, it is simply unsustainable.

The alternative that I set out on a separate page is called the full reserve banking system, and it completely negates the money multiplier. It is a system that has been supported by many of our greatest economists at one time or another, and especially by the late great Irving Fisher.

Irving Fisher
(1867-1947)

Irving Fisher

Irving Fisher was no fan of the fractional reserve banking system, and he recognized how destabilizing it is to an economy and its money. His preferred solution was to abolish it, and replace it with a full reserve banking system, thereby eliminating any possibility of system failure due to bank-runs.

Unfortunately, his recommendations were not acted upon and instability due to credit booms have persisted to this day, most notably in the 2008 financial meltdown.

One reason Fisher was overlooked was because of his failure to predict the great depression, after which John Maynard Keynes became much more influential. Nonetheless, he is regarded as being one of the greatest economists ever to have lived, and his ideas have gained new respect following the 2008 meltdown.

What is the Money Multiplier?

Imagine that $100 is added to the money supply e.g. a government welfare payment to someone. That $100 will be used by the recipient to purchase something e.g. food from the grocery store. The grocery store owner then has $100 which he deposits in his bank account. The bank now has an initial money deposit of $100 which it can lend out. The recipient of the loan now purchases something and the seller of whatever was purchased will deposit that money at the bank, which then lends it out again to another person and so on.

That same $100 dollars will be spent, deposited into a commercial bank account, and lent out again multiple times, and so it has a multiplied impact on the economy.

The bank knows that it can keep lending the money to new customers because it knows that only a very small fraction of its total customers will want to withdraw their money at any given time, and so why not earn some interest by lending out that money rather than keep it within the banking system earning almost nothing?

Of course, if enough of the bank's depositors turned up at once to withdraw their money then there would be a big problem because the bank has lent most of the money out to other customers. This is the essence of fractional reserve banking i.e. that only a small fraction of demand deposits are actually held in reserve for customer withdrawals, the rest is loaned out.

The smaller the proportion of its checkable deposits that the bank holds in reserve, the bigger the money multiplier will be. In practice this 'cash reserve ratio' can easily go below 5%, meaning that the other 95% or more is loaned out (assuming that the demand for loans is there at an interest rate that makes it worthwhile for the bank).

At times when commercial banks are reluctant to increase their money lending, perhaps because the system has entered a liquidity trap, they will instead invest their excess reserves in various interest earning financial assets. Any given bank can lend its excess reserves to another bank at the Federal funds rate, and the banking system as a whole can lend to the Federal Reserve Bank earning interest on excess reserves (referred to as IOER), a process known as the reverse repo.

In normal times, with a reserve ratio of 5%, the money multiplier would work out at 20, meaning that the initial $100 injection of cash would have a $2,000 impact on the overall level of spending in the economy as the $100 base money circulates from one person to the next.

Simple Money Multiplier Formula

The money multiplier formula can be expressed as one of the simplest equations in Economics:

Money Multiplier = 1/r

(Where r is the banking system reserve ratio expressed as a decimal)

So, if the banking sector has a reserve ratio of 8%, i.e. 0.08, the money multiplier would be 1 divided by 0.08, which equals 12.5. But, if the banking sector then lowered its reserve ratio to 4%, the money multiplier would double to 25, and the economy's money supply would also double.

This demonstrates the fact that commercial bank money has enormous power in the economy to manufacture spending increases/decreases by adjusting the reserve ratio by a few percentage points. At one time commercial banks were subject to a government mandated required reserve ratio, but now there is no such reserve requirement, only a somewhat arbitrary 'capital adequacy ratio' following the Basel 3 regulations.

The Money Multiplier effect on the economy

Opinions diverge among economists as to the whether or not the benefits of the fractional reserve banking system outweigh the costs, but there is little doubt that the main consequences for the economy relate to the money multiplier effect.

The fractional reserve system has a major consequence in terms of divorcing the supply and demand for credit from the price at which it is available. As with any other market for any other product, credit has a price. That price is the interest rate payable on credit, and the consequence of being able to create credit in abundance means that interest rates are typically lower than they would otherwise be.

So, the main money multiplier effect is on the credit market, and whilst it may seem like a good thing to be able to borrow money at a cheap interest rate, the news is not so good for lenders who have little incentive to save money. The artificially cheap price of credit that results from fractional reserve banking has the effect of subsidizing borrowing to increase consumption today at the cost of a reduced saving rate.

In an aging society with a pensions crisis looming, this might not be the best idea.

One serious side-effect of pushing for more consumption right now, rather than saving, is that a sizable proportion of the extra spending goes towards purchasing foreign imports. In the long-run this is another unsustainable trend that will need to turn around. Domestic consumption of foreign imports far exceeds foreign consumption of our exports, with the consequence that we are once again living beyond our means.

The graph below shows how the UK and US trade balances have moved sharply into deficit territory since the 1980s.

UK & US Trade deficit

Milton Friedman has argued that there is no problem with a trade deficit, but this is one issue on which I cannot agree with him. He argues that the excess money that foreigners are making ends up being reinvested back into our economies, and he is right.

The problem is that those investments then earn a profit for foreigners, a profit that can be used to pay for a permanent stream of our goods being sent overseas i.e. the temporary surplus of products that we now enjoy from our profligate spending habits will ultimately be replaced by a permanent flow of products being sent in the opposite direction.

There is actually an entry on the capital account of the Balance of Payments that measures the net value of domestic investments held overseas. Since the 1980s this has nosedived deep into negative territory in both the UK and the USA, meaning that foreign investors have a substantially bigger investments in our economies than we have in theirs.

Japan and Germany, the two strongest manufacturing (exporting) countries in the developed world are notable exceptions, with a huge net surplus of foreign investments, and both with a strong historical preference for a relatively high level of saving. In the developing world, China is becoming a massive net owner of foreign assets, and has a very strong saving rate and a much more reserved consumption rate.

A serious question arises from this as to the sustainability of those western currency exchange rates that are experiencing  persistent trade deficit. They have, for too long, been offset by excessive borrowing on the capital account of the Balance of Payments. Our governments are they key culprit and have racked up so much debt that our foreign creditors may well lose confidence in our ability to repay. At that point there will be a currency crisis.

Is Fractional Reserve Banking Fraudulent?

One of the fractional reserve banking system's biggest critics, Murray Rothbard, has made credible claims that the banks are actually committing fraud. The reason for this claim is that the banks, when taking receipt of our cash deposits, make a promise to return our money to us immediately upon demand.

However, as explained above, the banks know that only a very small proportion of their money deposits is needed to be kept ready for withdrawals at any given time, and they lend out the rest. This means that if enough of the bank's depositors presented themselves at any given moment demanding their money back, the banks would not be able to pay.

In effect, the banks are promising us something that they cannot deliver, or at least not in certain situations where demand for withdrawals of money is unusually large. This is precisely how banks fail... or how they get government bailouts at the taxpayer's expense!

The counterclaim has been made by some economists that this is not fraud because everyone knows how the system works and they willingly partake. It seems to me that this counterclaim amounts to a declaration that it is okay for the banks to lie to us because we know that they are lying - which I find wholly unsatisfactory to say the least. It's also a false counterclaim, because some people absolutely do not know that the banks are making promises that they cannot always keep.

Housing Market Booms & Busts

The main thrust of the Austrian Business Cycle Theory is that the boom & bust nature of the economy is either caused by, or worsened by, the excessive money creation and money multiplier effect of the fractional reserve banking system, because interest rates end up being much lower than their market clearing rate.

The accusation is based on the fact that there is no automatic stabilization of credit booms via free-market rationing of credit. New credit and money lending will occur without any extra saving to offset inflationary pressures. This usually results in an unsustainable boom in spending, and an accompanying bust some time later.

For example, when an economy starts to overheat, i.e. when spending levels start to exceed productive capacity, this will most easily be seen in the housing market. This is because better housing is one of the first things that people want when the economy is growing, and none of it can be produced overseas - house building is entirely a domestic industry.

When an economy overheats, it is domestic industries that experience inflation.

A short-run increase in consumption of imported goods does not cause inflation or overheating at all, because the world economy has massive spare capacity to increase production to satisfy any extra domestic demand.

The domestic economy on the other hand can only increase production at a manageable rate, and that rate is slower than required in a system that creates excess spending via practically limitless credit booms. To see how well the housing market predicts overheating in an economy, see the UK & USA examples below.

In the graphs below, the blue lines show the real inflation rate of housing i.e. house price inflation minus general CPI inflation. The flat orange lines show the average house price inflation over the period, and act as a balancing items to show when house prices are rising faster/slower than the long run average.

The Business Cycle in the UK

Since the beginning of the 1970s until 2018, the UK has experienced 4 main recessions i.e. the mid 70s, early 80s, early 90s, and the 2008 financial collapse. The graph below shows how inflation in the housing market has always exceeded its long run rate in the years prior to these recessions.

UK house price inflation

There were, of course, many other specific factors that influenced the boom & bust cycle during these recessions e.g. oil price rises in the 1970s, the dot.com Asian financial crisis, membership of the ERM (which forced an artificially high exchange rate) and so on. However, it's quite clear that the housing market is a good estimator of credit levels in an economy (due to people borrowing for mortgages, extra furniture, decorating costs, legal fees, landscaping and so on).

The Business Cycle in the USA

Almost exactly the same pattern is evident in the USA where the major recessions of the period were also in the mid 70s, early 80s, early 90s, and the 2008 financial crisis.

US house price inflation

The particular influences on the US economy during the period were similar in some respects to those which affected the UK, and completely different in other respects, but through it all the credit booms initiating an overheating housing market predicted all these recessions.

It would seem to be an uneasy balance of incompetence and negligence that has led our governments to discard the predictive power of the housing market with regard to the business cycle, but at the same time I recognize that there's little anyone can do to prevent these money multiplier induced booms under our current banking system.

Monetary Policy Vs. The Money Multiplier

A big part of the problem with the fractional reserve banking system is the unfounded confidence that is placed on central banks like the Federal Reserve (or on governments directly) to manage the boom and bust cycle via effective monetary policy, i.e. by managing a monetary aggregate target. History has provided little to no evidence of any central bank having the competency or the will to act in such a way that the business cycle is smoothed out.

Now, I do understand the claim from monetarists that an interest rate hike ahead of a boom will pull money out of the economy, reducing the monetary base and making mortgages either completely unavailable to some people, or if available then only at significantly lower amounts. But this claim includes three serious errors:

  1. It assumes that the Federal Reserve significantly reduces the total money supply by raising interest rates at just the right moment to mitigate any overheating.
  2. It assumes that demand for credit is interest rate sensitive, which it isn't at times when the housing market is overheating and buyers are desperate to get on the property ladder before they are priced out of the market altogether.
  3. It underestimates the ability of the modern fractional reserve banking system to create money regardless of the central bank.

On the first point, you might be very surprised to discover that real interest rates (i.e. nominal rates minus the CPI inflation rate) have actually been gradually lowered in the UK, the USA, and most of the developed world since the 1980s. There is no evidence in the data of any kind of proactive attempt by a central bank to cool down its economy ahead of a recession by significantly raising interest rates, monetary policy has been extremely loose for decades.

Real Interest Rate

If interest rates were pushed higher in an attempt to avert a recession, it would be politically unpopular, and so governments typically prefer an attempt to boost their way out of a recession once the economy has sunk into one.

They do this by lowering interest rates and/or printing money, which can be seen in the graph above with lower rates during the recession periods of the mid 70s, early 80s and early 90s. By the time of the 2008 financial crisis, nominal interest rates were already so low that lowering them further was not feasible. Money printing, i.e. quantitative easing, therefore became the favored option at that time.

Unfortunately, these lower interest rate & money printing tactics are a little like trying to force the economy to continue producing at an overheated level regardless of it causing ever growing national debt levels and ever growing trade deficits i.e. we are living beyond our means and the federal reserve system seems intent on keeping it that way.

Moreover, the attempt to increase bank lending (and thus spending) by lowering interest rates might even fail if the credit market is supply driven i.e. if it causes banks to reduce their lending due to low profitability from low interest rates. The Federal Reserve tends to think credit creation is purely demand driven with high street banks willing to play along at any interest rate, but recent experiences since 2008 paint a different picture, with the US and UK both experiencing a liquidity trap problem.

Ultimately this nonsense will fail.

On the third point above, regarding the money supply, the prospect of huge banking sector profits during a property market boom have proven to be an enticement too powerful to resist. The retail banking sector usually reacts by lowering its reserve ratio (increasing the money multiplier), and loosening their risk assessments enough to approve these extra mortgage loans, and thereby expand credit (boosting the money supply) in the economy.

In other words, the retail banking sector can massively increase or decrease the money supply independently of central bank money (or base money as it is called).

What is particularly disgusting is the fact that they do this in the secure knowledge that if the worst comes to the worst they can walk away with a government bailout to solve any potential balance-sheet difficulties. In other words, they gamble with other people's money and collect any winnings for themselves whilst letting regular people pay the costs if they fail.

Key Lesson: How To Eliminate The Money Multiplier

The best alternative to the money multiplier problem, in my opinion, is to adopt a system of full reserve banking. In a system of full reserve banking, the money multiplier would be equal to one. You can see this by referring  to the simple money multiplier formula above, only this time r=1.

This system also nullifies the fraud claim, because money lending would not be allowed if it meant that bank reserves fell below bank deposits, meaning that they would always have access to the full amount of their depositors' money and could always pay out in the event of a bank-run.

People sometimes worry that there would be insufficient credit in a full reserve system, but this is a misunderstanding, it is only excess credit growth during a boom that is eliminated.

The full reserve banking system would restore the free-market's ability to determine how much credit there is in the system at any given time, because the interest rate would be allowed to fluctuate to whichever rate brought equilibrium i.e. an interest rate that induced just the right supply of saving to match the demand for borrowing. Overall spending would be extremely stable, because for extra borrowing to occur, extra saving must also occur to balance it out.

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