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 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.
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.