The Money Multiplier -- an urban legend?

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The Money Multiplier -- an urban legend?

Oh no-o-o-o-o -- one of the basic theories upon which fractional reserve banking (and hence the Federal Reserve) is founded, has come under attack. And the attackers are two researchers within the Fed itself -- Seth B. Carpenter and Selva Demiralp -- plus a legion of pilers-on. 

As summarized by Ed Harrison, their answer to the question 'Does the Money Multiplier Exist?" is 'Yes -- but only as an ex post accounting identity.' Oh, my! As the Chrysler ads used to assert, 'This changes everything!'

Here is Marshall Auerbach's take on the issue, as quoted by Harrison:

[If a] bank does not have sufficient reserve balances to cover the [loan] withdrawal, the Fed provides an overdraft automatically, which the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.

The point 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.

Ed Harrison sums up:

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.

So will QE2 aka QE-lite work? The short answer is no.

http://www.creditwritedowns.com/2010/08/does-the-money-multiplier-exist.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+creditwritedowns+(Credit+Writedowns)

What I suspect is that bank reserves do serve as a constraint in expanding, inflationary economies, but not in stagnant, deflationary ones, such as the one we're in now.

This being the case, quantitative easing won't help, except to the extent that it creates inflationary expectations. Any inflationary signal from QE is being mitigated by the deflationary signals sent by scary-low interest rates and stagnant bank lending. 

Extraordinary measures which might actually work include buying more gold, devaluing the dollar, and directly monetizing federal deficit spending (the functional equivalent of helicopter drops).

To paraphrase Confucius -- 'He who push string for too long, might pull rope with own neck.' Or something like that. Undecided

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Re: The Money Multiplier -- an urban legend?

No, they do exist. You find money multipliers on the back streets of New York operated by seedy men. You put $1 in the machine, turn a lever and $10 comes out. The guy will then sell you the machine for only $100.  Laughing

Where do you think Ben Bernanke apprenticed before getting his own machine? Surprised

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Re: The Money Multiplier -- an urban legend?

This sounds very similar to something I posted from Steve Keen in my Where's the Beef? thread a while back. The basic premise that the Fed supplies seed money, and then this seed (or base) money is multiplied in the Fractional Reserve Banking system was proven empirically false in the 1979 paper The Endogenous Money Stock (title page) by Basil J. Moore. Dr. Keen quotes from this paper when he writes:

This first major paper on this approach, “The Endogenous Money Stock” by the non-orthodox economist Basil Moore, was published almost thirty years ago.[4] Basil’s essential point was quite simple. The standard money multiplier model’s assumption that banks wait passively for deposits before starting to lend is false. Rather than bankers sitting back passively, waiting for depositors to give them excess reserves that they can then on-lend,

“In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.[5]

Thus loans come first—simultaneously creating deposits—and at a later stage the reserves are found. The main mechanism behind this are the “lines of credit” that major corporations have arranged with banks that enable them to expand their loans from whatever they are now up to a specified limit.

...

Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve.

Central Banks around the world learnt this lesson the hard way in the 1970s and 1980s when they attempted to control the money supply, following neoclassical economist Milton Friedman’s theory of “monetarism” that blamed inflation on increases in the money supply. Friedman argued that Central Banks should keep the reserve requirement constant, and increase Base Money at about 5% per annum; this would, he asserted cause inflation to fall as people’s expectations adjusted, with only a minor (if any) impact on real economic activity.

Though inflation was ultimately suppressed by a severe recession, the monetarist experiment overall was an abject failure. Central Banks would set targets for the growth in the money supply and miss them completely—the money supply would grow two to three times faster than the targets they set.

Link

Thus, the fact that the Fed has "gone nuclear" with the base money supply over the last few years, is actually a result of the ginormous credit-money expansion in the FRB system of the last decade, and doesn't actually portend a FRB money-multiplier fueled explosion of credit money in the future. 

Will QE work? Dr. Keen's answer:

If neoclassical theory was correct, this increase in the money supply would cause a bout of inflation, which would end bring the current deflationary period to a halt, and we could all go back to “business as usual”. That is clearly what Bernanke is banking on:

“The conclusion that deflation is always reversible under a fiat money systemfollows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days.

What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation…

If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.” [8]

However, from the point of view of the empirical record, and the rival theory of endogenous money, this will fail on at least four fronts:

However, from the point of view of the empirical record, and the rival theory of endogenous money, this will fail on at least four fronts:

1. Banks won’t create more credit money as a result of the injections of Base Money. Instead, inactive reserves will rise;

2. Creating more credit money requires a matching increase in debt—even if the money multiplier model were correct, what would the odds be of the private sector taking on an additional US$7 trillion in debt in addition to the current US$42 trillion it already owes?;

3. Deflation will continue because the motive force behind it will still be there—distress selling by retailers and wholesalers who are desperately trying to avoid going bankrupt; and

4. The macroeconomic process of deleveraging will reduce real demand no matter what is done, as Microsoft CEO Steve Ballmer recently noted:  “We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy”.[9]

The only way that Bernanke’s “printing press example” would work to cause inflation in our current debt-laden would be if simply Zimbabwean levels of money were printed—so that fiat money could substantially repay outstanding debt and effectively supplant credit-based money.

Measured on this scale, Bernanke’s increase in Base Money goes from being heroic to trivial. Not only does the scale of credit-created money greatly exceed government-created money, but debt in turn greatly exceeds even the broadest measure of the money stock—the M3 series that the Fed some years ago decided to discontinue.

...

To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels. That US$20 trillion truckload of greenbacks might enable Americans to repay, say, one quarter of outstanding debt with one half—thus reducing the debt to GDP ratio about 200% (roughly what it was during the DotCom bubble and, coincidentally, 1931)—and get back to some serious inflationary spending with the other (of course, in the context of a seriously depreciating currency). But with anything less than that, his attempts to reflate the American economy will sink in the ocean of debt created by America’s modern-day “Roving Cavaliers of Credit”.

Unless Bernanke's plan for QE 2.0 is to physically print $20+Trillion in FRNs and drop them from a fleet of Antonov An-225s, QE has no chance to dig the country out of its deflationary hole.

This is not to say that the inflation-trade won't be a major factor periodically in the future, but this will have more to do with the pursuit of profit than with macroeconomics.

Best....Jeff

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Re: The Money Multiplier -- an urban legend?

JAG,

Thanks for reposting this.  I do not recall the graph from the first time around.  Definitely help put things in perspective.

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Re: The Money Multiplier -- an urban legend?

Well, the "loan first, reserves second" model makes perfect sense and reveals how bankers scratch each others backs.  If bank A makes a loan they know perfectly well that the proceeds from that loan will, typically within seconds of being made and lent out, end up back somewhere in the banking system, perhaps at banks B, C and D.

This means that any time a bank makes a loan the needed cash reserves are somewhere in the system and redistributing them is the function of the bank overnight lending system.  In bad moments of weakness and fear, banks won't lend to each other creating sketchy situations which is when the Fed steps in to rescue the day with their discount window treatment, er, program.

So as long as the whole system is expanding together, everything works out on average.

The potential future problems, as I see them, are twofold:

  1. Now that all that base money is out there the Fed could only reel it back in with a lag due to operational difficulties involved in unwinding their massive balance sheet with reverse repos.  So if banks suddenly fired up the loan particle accelerator, they could conceivably ignite a conflagration of self-sustaining inflation before the Fed could pull up its operational drawers and buckle its belt.  This is why Hoenig was out with his bullhorn today warning about the need to begin unwinding the gigantic balance sheet of the Fed; he knows that there's a significant lag to be accounted for and worries about waiting for the "all clear" sign to begin draining the punch bowl.
  2. Inflation is not just a simple matter of money in relation to goods and services, it is also a matter of expectations, psychology and preferences.  I assure you if everybody had my expectations about the future worth of US government paper, we'd have rip roaring inflation no matter how much or little demand existed in the economy for goods and services.  Right now the Fed is stuck trying to operate a 48 track mixing console while wearing boxing gloves resulting in some very conflicting signals.  They've rammed interest rates to ultra low levels to stimulate borrowing but, as MH has pointed out, this has also served to set people's expectation dials to "deflation" which is really not helping anything.  Who borrows in a deflation?  
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Re: The Money Multiplier -- an urban legend?

If the credit-first, reserves-later mechanism is correct, deflation seems like a foregone conclusion.  And government borrowing to "stimulate" the economy is only going to create conditions for further deflation by reducing the capacity of individuals and corporations to borrow.  This is because since more of their revenues will go to cover taxes (which goes to cover the added borrowing), they will be left with a smaller revenue stream, capable of supporting less debt. 

Of course, it could be argued that government borrowing instananeously increases reserves as well, since the moment they spend the loan, it winds up at a bank.  However, what loans would be made off this reserve base?  Surely not anymore individuals and companies that would have borrowed otherwise, especially since if the credit-first, reserves-second model is correct, they could have borrowed before the government spending took place. 

If credit-first, reserves-second is right, then government spending could reduce credit demand in two ways:  in the long run, by reducing revenue streams as described above; and in the short run, when the money is first injected, it relieves cash flows of debtors, momentarilly reducing the need for any more borrowing.

Great job guys!  I couldn't have thought of a more screwed-up, destined to fail system if I tried with all my might!

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Re: The Money Multiplier -- an urban legend?

If I understand Dr. Keen correctly, his four points above all revolve around the premise that the Fed can issue money/credit but if there are no takers then deleveraging/deflation will inevitably result.

Gary North addresses this point here: http://www.lewrockwell.com/north/north788.html

The deflationists argue that the FED can pump up the monetary base by purchasing assets, but it has no control over the size of M1, which is the real money supply. This is because M1 depends on commercial banks making loans, thereby taking advantage of all those extra reserves that the FED's newly created reserves make available. The commercial banks instead deposit the money with the FED as excess reserves. So, M1 has not grown to match the more than doubling of the monetary base. The FED therefore has no control over M1. It cannot control what bankers do with available reserves.

This is the deflationists' bottom line: "The FED cannot force bankers to lend money."

 

 

This is so utterly nonsensical that it boggles the imagination. The FED could get every banker in the country to pull back all excess reserves ($1 trillion these days) tomorrow and lend the money. It does not have to issue an edict. It does not have to take over the banks. All it has to do is charge 10% per annum on all excess reserves. Probably 1% would do the trick.

Banks are paid zero interest on these excess reserves today: whatever the federal funds rate pays. Federal funds are overnight bank-to-bank loans: the shortest of short-term loans.

Banks must make their money from lending, and a trillion dollars are not making banks any money today. If the FED imposed a fee (a negative interest rate), the banks would all lose money – big money – on their excess reserves.

The FED could experiment at the rate required. It could keep raising the "digit-storage fee" until the banks had no more excess reserves on deposit. This would double M1. This would double most prices. Simple. No compulsion. No directives. Just raise the price of not lending until banks are fully lent out.

 

This is so obvious that only a self-blinded deflationist refuses to see it, acknowledge it, or reply to me. I have been pointing out this out potential strategy for months. On September 18, I wrote:

The FED can get banks lending again simply by charging banks a storage fee on their excess reserves. Put differently, the FED pays negative rates. At some point – probably around 1% – the banks will pull their money out of their excess reserves account and lend it to the Treasury at 0.1%. That's a better rate than negative 1%.

There is no problem with getting banks to lend – nothing that a 1% negative interest rate would not cure in 24 hours. If I am wrong, then the FED can hike the fee to 2%.

The FED's problem is this: as soon as the banks pull out their money and start lending, the fractional reserve process takes over. The doubling of the FED's monetary base, September to December, 2008, will lead to a doubling of M1 and a move of the M1 money multiplier into positive territory.

We would get mass inflation, then hyper-inflation. The FED has no intention of getting either one. So, it pays banks 0.1% on their excess reserves, leaving Keynesians to get all in a dither over the liquidity trap and zero-bound interest rates.

They refuse to respond . . . all of them. That is because, logically, there is no answer. So, all of them are playing "Let's pretend." Let's pretend there is no economic logic. Let's pretend that no one has mentioned this obvious policy. Let's pretend that an increase of the Federal Reserve balance sheet has nothing to do with the money supply. Let's pretend that Murray Rothbard was pathetically shortsighted when he wrote his textbook on money and banking in 1983, The Mystery of Banking. He just did not understand that deflation is inevitable. Poor Rothbard. All that brainpower, so little understanding!

Here is my advice:

Until a deflationist responds specifically to my argument, using both the logic of profit and loss (commercial bankers' self-interest) and the logic of fractional reserve banking as presented by Rothbard and all other trained economists, you should dismiss the entire deflationist position as crackpottery.

The deflationists can run, but they can't hide . . . from basic economic logic.

What is the deflationist camps' counter to this? This seems like a valid point from here in the cheap seats, but I dunno what to think. I'm just hangin' on!

 

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Re: The Money Multiplier -- an urban legend?
earthwise wrote:

What is the deflationist camps' counter to this? This seems like a valid point from here in the cheap seats, but I dunno what to think. I'm just hangin' on!

Of the top of my head, I see a glaring discontinuity with Mr. North's logic:

If the Fed were to charge banks for holding excess reserves, and the banks responded to this by putting their reserves into treasuries, how does this boost lending to the economy? How does this engage the FRB credit-inflation machine, as all the money is invested in Treasuries?

And of course, if the economy is saturated with debt already, who are the banks going to lend to without loosing their shirt? 

And its hard to take Mr. North's argument seriously when he closes with "Until a deflationist responds specifically to my argument, using both the logic of profit and loss (commercial bankers' self-interest) and the logic of fractional reserve banking as presented by Rothbard and all other trained economists, you should dismiss the entire deflationist position as crackpottery."

Here is a post from Mish that provides some related discussion on this topic as well:

Will Quantitative Easing Spur Inflation? Job Creation? Credit Expansion? Do Anything?

 

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Re: The Money Multiplier -- an urban legend?

In response to earthwise's Gary North piece, the main problem with that argument is that lending is a two-party system.  The banks cannot lend money if borrowers are all tapped out and unwilling to take on more debt.  With base interest rates at zero already and mortgage rates at historic lows, yet outstanding credit still declining, I have little reason to believe the public will take on more debt just because interest rates decrease a little more. 

The second problem is we live in a globalized economy.  If the Fed is going to charge to hold money, why can't banks just park their reserves in Australian, British, German, Japanese, or Chinese Treasuries and the central banks thereof?  

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Re: The Money Multiplier -- an urban legend?

 

Borrowers are never tapped out. They will borrow to infinity if there are lenders. And the Fed forcing money out of it's piggy bank would tend to push banks into lending. "Never underestimate the ability of the American public to spend money it doesn't have." (That's an old saying that I just made up).  We have debt saturation because of a tendency to live beyond ones means. We see this at all levels from the consumer all the way up to the US government. To say it won't continue is like saying Rosie O'Donnell won't eat just one more piece of pie. 

I don't remember where I saw this, it might have been here at CM, but there were writings that one of the reasons that we're bound up with 'economic slows' is that the massive borrowing because of debt and deficits of the US government has sucked all the oxygen out of the economy prohibiting business from obtaining financing. If bank reserves were used to buy Treasuries, wouldn't that free up money/credit that would then flow into the economy, thus causing increased velocity?

If the Fed really, really wants to get money into circulation and there are credit junkies out there, from my perspective it seems like keeping all that money (credit) bottled up would be like squeezin' cheeks when ya got the squirts.

I guess the best way for that to happen is like this from Farmer Brown:

If the Fed is going to charge to hold money, why can't banks just park their reserves in Australian, British, German, Japanese, or Chinese Treasuries and the central banks thereof?

That might work.

Just some more musings from the cheap seats.

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Re: The Money Multiplier -- an urban legend?

Earhwise,

So to expand on your thought process here, is there theoretically no limit to the amount of debt an economy can take on? I'm not sure I would "buy" such an argument, even if I had an unlimited supply of borrowed money, lol. 

As Dr. Keen pointed out, in order for $1 Trillion of base money injected into the system by the Fed to be "multiplied" by the Fractional Reserve Banking system, the private sector would need to take on an additional $9 Trillion in debt to hypothetically satisfy the proverbial 10 to 1 loan/reserve ratio.  Thus, in a credit-money system like ours, monetary inflation is directly correlated to amount of debt in the economy.

While I agree with you that a significant component of the consumer population will enthusiastically maximize their debt load, I do think there is a realistic limit to how much debt their lifestyles can effectively service. Whether or not that limit has been reached in aggregate already I cannot know for sure, but there are certainly signs in the economy that suggest that it has.

Best...Jeff

(edited for math mistake)

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Re: The Money Multiplier -- an urban legend?

 

More musings from the cheap seats:

If the Fed and the government really wanted to get money into the economy (which they obviously do given QEII) then how about forgive that portion of  mortgages of those who are upside down which is above the appraised value. This was the trial balloon floated last week or so. Now this in itself wouldn't put money into circulation, but it would make the insolvent solvent again. And now they can spend again. And it will improve banks balance sheets which should embolden them enough to lend. And just to make things fair, those who were responsible with their mortgage debt, re-jigger their loans to a lower rate, from their current 5 1/2 to 6 1/2% down to todays rates. Lower payment equals more money to spend.

If that's not enough then how about making consumer interest tax deductable again. Credit cards, auto loans, Helocs you name it. That'll get the masses spending again. But why would lenders lend? Well, we'll make interest income non-taxable. Tax-free income, that'll get 'em lending again. This could all be funded by the Treasury borrowing as a result of the Fed forcing bank reserves out into the open per Gary North.

There's got to be all kinds of ways to wring that sponge out.

Besides, why would the banksters be afraid to lend? They're to big to fail, right? They've got a government guarantee, moral hazard be damned.

 

 

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Re: The Money Multiplier -- an urban legend?
JAG wrote:

So to expand on your thought process here, is there theoretically no limit to the amount of debt an economy can take on?

The limit is determined by how many fools are willing to lend. If there are lenders then there will be borrowers.

JAG wrote:

Earthwise,

While I agree with you that a significant component of the consumer population will enthusiastically maximize their debt load, I do think there is a realistic limit to how much debt their lifestyles can effectively service.

I would have thought, in a sane world, that the same would apply to the US Government, but obviously not.   In a Ponzi economy, one can service old debt with new debt and party on! If Uncle Sam can do it, why not Joe Sixpak? What a country!

In regards to your numbers, who says they the Fed has to get a trillion into the economy right off the bat? Why not start with $100 billion which, when  the 'money multiplier' is applied, would expand the economy by a trillion-that's about 8% of GDP? Quite a boost and that's chump change for these guys. Then, if that's not enough do another $100 billion and so on.

Bottom line is, I think the so-called money trap can easily be broken by a determined Fed.

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Re: The Money Multiplier -- an urban legend?

The Money Multiplier -- an urban legend?

Should we call it what it really is?  The Debt Multiplier - a real world experience.

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Re: The Money Multiplier -- an urban legend?

Earthwise,

There is only so much debt any economy can take on compared to its GDP/base money ratio, aka money velocity.  This is because the velocity of the money places a hard limit on the average weighted interest rate being paid throughout the economy to service the money that was created in the first place via debt.  Yes, more borrowing can "smooth" over shortfalls between what the economy is producing and what is required by the debt load, but the extent to which debt can be added has an eventual limit and fate.  This is because every time debt is added simply for the purpose of servicing old debt, it adds to the total debt service, but produces no new value that would be measurable by money velocity.  If all you're doing is increasing total money and total debt, but the velocity stays the same or decreases, interest rates must also fall to adjust for the shortfall in production.  Interest rates are already near zip, so our limit has been or will soon be reached.

As for your proposal to have debt forgiven, that would actually work to stimulate the economy big time.  Of course, it is not politically feasible, at least not now.  We have three ways out of this:  debt default, debt forgiveness (which is the same exact thing as debt default, except you keep remaining equity, if any, and don't get to go to jail), or debt default via zimbabwe-style hyperinflation (the kind Keen argues is the only kind of inflation that could work).  You'll note all three have as their purpose the destruction of debt, and that's because it is the debt that is the reason for why we are where we are.  If debt could be accrued forever, as you suggested, it would never be a problem.  Unfortunately, it is.

 

 

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Re: The Money Multiplier -- an urban legend?

 

Earthwise,

Conveniently enough, Sprott's most recent  piece touches exactly on the debt endpoint (though he calls it the Keynesian Endpoint).  The relevant section is below and the whole article is here:  http://www.zerohedge.com/article/eric-sprott-we-are-now-paying-funeral-keynesian-theory

If we use the Fed’s own numbers, the impact of debt on GDP is even more dismal. In Chart B below, we present the marginal impact of debt on marginal GDP since 1966 using data from the Federal Reserve. Deficit spending, which has generated smaller and smaller increases in GDP over time, is now generating a negative impact on GDP due to the costs of servicing the debt. The chart suggests we have already entered what PIMCO refers to as the "Keynesian endpoint", where the government can no longer afford to increase debt levels.10 No debt = no stimulus. No stimulus = ???

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Re: The Money Multiplier -- an urban legend?
Farmer Brown wrote:

Earthwise,

There is only so much debt any economy can take on compared to its GDP/base money ratio, aka money velocity.  This is because the velocity of the money places a hard limit on the average weighted interest rate being paid throughout the economy to service the money that was created in the first place via debt.  Yes, more borrowing can "smooth" over shortfalls between what the economy is producing and what is required by the debt load, but the extent to which debt can be added has an eventual limit and fate.  This is because every time debt is added simply for the purpose of servicing old debt, it adds to the total debt service, but produces no new value that would be measurable by money velocity.  If all you're doing is increasing total money and total debt, but the velocity stays the same or decreases, interest rates must also fall to adjust for the shortfall in production.  Interest rates are already near zip, so our limit has been or will soon be reached.

As for your proposal to have debt forgiven, that would actually work to stimulate the economy big time.  Of course, it is not politically feasible, at least not now.  We have three ways out of this:  debt default, debt forgiveness (which is the same exact thing as debt default, except you keep remaining equity, if any, and don't get to go to jail), or debt default via zimbabwe-style hyperinflation (the kind Keen argues is the only kind of inflation that could work).  You'll note all three have as their purpose the destruction of debt, and that's because it is the debt that is the reason for why we are where we are.  If debt could be accrued forever, as you suggested, it would never be a problem.  Unfortunately, it is.

 

 

Your points are valid, but only in a sane world where there are no "Too bigs to fail", no 'Ninja' borrowers and resultant sub-prime crisis, no trillion dollar bailouts, no $1.5 trillion yearly deficits, and entitlement program (health care) on top of entitlement program, etc., etc., etc.

Your points presume a governing body that sincerely wants to fix the problem. In reality they are the problem. Therefore, when you point out that:

.....but the extent to which debt can be added has an eventual limit and fate.

it seems that you overlook the possibility that eventual means nothing to them, so again, party on, we'll fix it later! Hence, QEII and inflation via the route described by North. Neither I (nor he, I presume)  think it's the best way forward, only that it's possible to produce the outcome (inflation) being pursued by TPTB. 

Sorry if I seem too cynical, but given the current state of affairs, I think I should be forgiven.

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Re: The Money Multiplier -- an urban legend?
earthwise wrote:

If I understand Dr. Keen correctly, his four points above all revolve around the premise that the Fed can issue money/credit but if there are no takers then deleveraging/deflation will inevitably result.

Gary North addresses this point here: http://www.lewrockwell.com/north/north788.html

On September 18, I wrote:

The FED can get banks lending again simply by charging banks a storage fee on their excess reserves. Put differently, the FED pays negative rates. At some point – probably around 1% – the banks will pull their money out of their excess reserves account and lend it to the Treasury at 0.1%. That's a better rate than negative 1%.

What is the deflationist camps' counter to this? This seems like a valid point from here in the cheap seats, but I dunno what to think. I'm just hangin' on!

It was only a few years ago that the Fed started paying interest on reserves held at the Fed. Traditionally, reserves earned nothing. Now, they are already backtracking on this policy change. One of the discussion points at the last FOMC meeting concerned cutting the 0.25% interest on reserves back to zero. As Dr. North proposes, nothing is stopping them from charging a fee (negative interest) to hold reserves.

But as he also adds, most banks would flee reserves for the safe harbor of Treasurys. And this is really no different than the Federal Reserve buying Treasurys directly in a QE program -- in both cases, there is no money multiplier.

We can't overlook regulation as a constraint, either. For instance, the recently enacted financial reform act requires lenders to verify the income of mortgage borrowers. So even if banks wanted to go back to making no-doc loans -- they can't. And banks are hardly going to recommence sending out new unsecured credit cards, when they still have a pile of defaulting credit card debt to write off.

As other posters mentioned, paying off underwater consumer debt with government funds (basically transferring debt from private to government hands) would open up fresh borrowing capacity. But there are already complaints of inequitable treatment from those who borrowed prudently, or who have no debt. The other option is sending out debt-financed checks to everyone. But these one-time bonuses are not every effective.

Hmmm -- back to the drawing board! Surely great minds can crack this conundrum.

 

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Re: The Money Multiplier -- an urban legend?
machinehead wrote:
earthwise wrote:

If I understand Dr. Keen correctly, his four points above all revolve around the premise that the Fed can issue money/credit but if there are no takers then deleveraging/deflation will inevitably result.

Gary North addresses this point here: http://www.lewrockwell.com/north/north788.html

On September 18, I wrote:

The FED can get banks lending again simply by charging banks a storage fee on their excess reserves. Put differently, the FED pays negative rates. At some point – probably around 1% – the banks will pull their money out of their excess reserves account and lend it to the Treasury at 0.1%. That's a better rate than negative 1%.

What is the deflationist camps' counter to this? This seems like a valid point from here in the cheap seats, but I dunno what to think. I'm just hangin' on!

It was only a few years ago that the Fed started paying interest on reserves held at the Fed. Traditionally, reserves earned nothing. Now, they are already backtracking on this policy change. One of the discussion points at the last FOMC meeting concerned cutting the 0.25% interest on reserves back to zero. As Dr. North proposes, nothing is stopping them from charging a fee (negative interest) to hold reserves.

But as he also adds, most banks would flee reserves for the safe harbor of Treasurys. And this is really no different than the Federal Reserve buying Treasurys directly in a QE program -- in both cases, there is no money multiplier.

We can't overlook regulation as a constraint, either. For instance, the recently enacted financial reform act requires lenders to verify the income of mortgage borrowers. So even if banks wanted to go back to making no-doc loans -- they can't. And banks are hardly going to recommence sending out new unsecured credit cards, when they still have a pile of defaulting credit card debt to write off.

As other posters mentioned, paying off underwater consumer debt with government funds (basically transferring debt from private to government hands) would open up fresh borrowing capacity. But there are already complaints of inequitable treatment from those who borrowed prudently, or who have no debt. The other option is sending out debt-financed checks to everyone. But these one-time bonuses are not every effective.

Hmmm -- back to the drawing board! Surely great minds can crack this conundrum.

 

 Machinehead (and JAG & Farmer Brown)

I'm sure you're correct on all your points. It just seems counterintuitive to me to think that the Fed would be stymied in their attempts to flood the market with cold hard cash if they really wanted to. Got helicopters?

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Re: The Money Multiplier -- an urban legend?

machinehead opened this thread with the question "The Money Multiplier -- an urban legend?"

I suggest that the answer is no.  The Money Multiplier is used to determine how much Fed reserves, held by the Fed in bank accounts, may be expanded by banks through loans. 

The legend is that bank held reserves are the basis for determining how much money banks may loan.  Often this is referred to as "fractional reserve lending" which is a myth.

Reserves are without a doubt, the most misunderstood part of the Federal Reserve system.  This is no surprise as the system is full of misleading terms and double speak.  To explain the answer to machinehead's question, I think I first need to try and clarify exactly what reserves are and how they really work - in general terms.

To make things easier, and to avoid a lot of typing, I created a chart that will hopefully explain much.  The Fed system of usury has two tiers of reserves; Fed reserves and bank reserves as shown in the chart.  The chart also shows the mathematical flow of reserves to the potential to create money through loans. 

The left side (Fed reserves) represent what may happen but the right side (bank reserves)  has virtually no impact in calculating how much a bank may lend.

Note:  "Quasi Liability"  - I use this term as "liability" alone doesn't adequately explain what occurs.  Fed reserves are a liability to the Fed and an asset to the banks.  But, unlike the real world, the Fed's promise to pay is accepted as the payment.

1)  "Reserve Requirement %” erroneously suggests that banks must keep a portion of their customer checking accounts (demand deposits) as reserves

First, banks can only lend money if they are solvent. Commercial banks are obliged to balance their books and defaults are subtracted from assets which may make the bank insolvent.  Second, I think capital ratios and leverage ratios determine how much money a bank may create through loans.  I think it is accurate to say that banks are capital constrained and not reserve constrained.

machinehead wrote:

Here is Marshall Auerbach's take on the issue, as quoted by Harrison:  '[If a] bank does not have sufficient reserve balances to cover the [loan] withdrawal, the Fed provides an overdraft automatically, which the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed."

I agree, the banks may circumvent any notion of holding adequate reserves which makes them useless.  So, why do we have a "reserve requirement %"? - on to number 2...

2)  A "Money Multiplier" is used to determine the potential for banks to create new loans from Fed reserves (high powered money).

The "Money Multiplier" is calculated as the reciprocal of the "Reserve Requirement %" (example from the above chart, 10% reserve requirement = money multiplier 10).  It looks as though the only function of reserve requirements is to calculate the money multiplier.

The extra step of the reciprocal conversion can be very misleading.  For example, conventional wisdom is that banks are safer with higher reserve requirements (20% is safer than 10%).  The thinking is it reduces bank leverage.

But, if reserve requirements are increased the potential for creating new money through loans may also increase.  Excess Fed reserves are just over $1 trillion. With a 10% reserve requirement, the $1 trillion has the potential to create $10 trillion dollars.  If the reserve requirement is increased to 20%, the $1 trillion in reserves has the potential to create $20 trillion.  This is counter intuitive; my cynical side tells me that the system is designed to confuse.  

3)  Excess Reserves (held by banks at the Fed) may be used for bank expenses, investments and to create “High Powered Money.”  Or, they may be left in the account to draw .25% Interest.

I suggest that reserves held at the Fed are free money for the banks.  If they aren't lending money, why do they need more Fed reserves?  This adds debt burden on the economy while increasing the need for taxes.  It is counterproductive.

Carmen Pirritano "Money & Myths" wrote that 30% of money created by banks in 2006 (I think) were used for their own investments (Federal Reserve H.8, the ration of loans to investments was 7 to 3, so 30%).  What a deal!

If the governBank were sincerely interested in helping our economy, they would find ways to increase employment and balance our trade without adding to our debt.  Instead of discussing the real economy, we are forever trying to figure out the latest scheme.  It is no coincidence that the people who crashed the system are getting rich.  The percentage of financial sector profits to corporate profits recently peaked at 41%, from a long run average of less than 16%.  We are being looted.     

4)  Reserves enable the international bank cartel to bilk their client states; through their franchises (in our case the Federal Reserve).

The governBank seems to be constantly changing the rules to add new things to buy in order to increase Fed reserves.  In addition to U.S. securities and U.S. guaranteed debt, they may buy from other governments and other central banks and who knows what else. 

Our money may used for the benefit of other client states or other central banks.  We think of ourselves as being financially independent but as you can see, our national needs come secondary to the wants of the power hungry, greedy, privately owned and operated, mostly non-American, international bank cartel.

Larry

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Re: The Money Multiplier -- an urban legend?
machinehead wrote:

Hmmm -- back to the drawing board! Surely great minds can crack this conundrum.

Question: How to effectively set up a money multiplier?

1. Start a civil war, destroy lots of infrastructure, initiate massive borrowing to rebuild infrastucture and restock munitions. Its one of the few things the US is capable of doing, although its usually restricted to offshore application.

2. Alternatively avoid the civil war and start a government work programme to build 21st century green infrastructure.

Unfortunately TPTB have captured government and will support #1 but not #2. Considering how much profit can be made from war, especially if you finance both sides, its quite clear that we're completely screwed by the global hierarchy. 

Blathering output from a feeble but curious mind.Foot in mouth

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Re: The Money Multiplier -- an urban legend?

From where I sit from the perspective of small business, the problem is largely miscast as one of capital availability and I disagree with this, it is not that money is not available, or that money is cheap or not cheap, it is that there are simply no customers.

It may seem like a difference in semantics, but the difference is profound. Many on the conservative right argue vociferously that simply providing small business access to cheap capital and reduced regulation will pull the country out of the depression- a contention I vigorously disagree with. This goes back to first year business school, where economic theory and modern business management elevate the position of capital availability to near spiritual proportions. It is true that without capital, business cannot operate, but it is equally true that even with plentiful capital no business can operate without customers.

Sometimes it takes actually running a business to see how the theoretical deviates form the pragmatic. Under this analysis, the macroeconomic focus on money multiplier effect falls flat.

With respect to many businesses, there are just no customers. Much of our business economy is based on consumerism, which is just another way of characterizing spending discretionary income on non-essentials. When discretionary income drops, either from unemployment, reduced income from saving or stocks, or tapping out all the equity from an asset (such as a home), the money is simply gone. And the businesses that were created to cater to this source of discretionary income are also gone. Providing access to cheaper expansion capital to these type of businesses, in effect addressing the supply side of this conundrum is simply foolish.

There just aren’t any more customers in this class of spending, they are gone and they aren’t coming back.

Keens’ work shows that providing stimulus to the supply side of the problem as the neoclassical Keynesians are wont to do, does not work, it in fact creates the easily predictable (and currently in evidence) condition of credit freeze or as it was know in the 1930’s Great Depression, the so called “capital strike”. 

The response to this predictable and repeatable event is not to free up the capital by forcing (or incentivizing) banks to lend, it is to redeploy the stimulus to the demand side, as Keens’ work also shows, and ignore the so called money multiplier effect. An example might be to use the FRE and FRM nationalized mortgage institutions to offer below market rates on home loans, such as 1% 30 year fixed on re-fi’s. Put this measure in place and watch the consumer trend turn around with the average homeowner having hundreds of dollars more in monthly discretionary income to spend (frivolously, which they no doubt will). Forget extra borrowing, focus on the spending side by recapitalizing the loans they already have.

I do understand that this to some degree is just kicking the can down the road, but as I see it, it is a virtual sure cure to the current malaise and will in fact jump start the economy, at least temporality.

There are some formidable political and ideological constraints to demand side stimulus given the current political climate. Although I’ve come to recognize that the stimulus packages (both Bush’s initial $700 bn and Obama’s subsequent package) are really a function of the Keynesians predilection and are not specifically partisan, it is a much easier “sell” to the right to bias supply side stimulus spending to banks and other business interests than to directly stimulate the consumer (demand) side.

I think it is pretty clear that giving homeowners access to low cost, near zero percent fixed mortgages for the purposes of re-financing and new home purchasing would have a vibrant and profound effect (for the positive) on the economy, and the mechanism to provide this is largely in place, save the discounted rates.

If such a move is to be contemplated, I would expect a rather severe regulatory environment to try and prevent a reoccurrence of the inevitable liar loans, and consumers glomming on to such a program to once again refinance their only asset for the purposes of pulling out cash (non-productive lending) or even speculative borrowing, which again as Keen shows, will certainly torpedo any benefits of such a program by abuse and greed.

The combination of demand side stimulus spending coupled with a strict regulatory environment is not likely to sit well with certain ideological belief systems, and will likely be vigorously opposed. The American public is simply not (yet) ready to be told that there are limits and conditions to borrowing money that may be external (and incremental) to the lenders’ requirements.

Nevertheless, expect to see a significant component of the next round of quantitative easing applied directly to the demand side of the economy, and watch for the fireworks.

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Re: The Money Multiplier -- an urban legend?
DrKrbyLuv wrote:

The "Money Multiplier" is calculated as the reciprocal of the "Reserve Requirement %" (example from the above chart, 10% reserve requirement = money multiplier 10).  It looks as though the only function of reserve requirements is to calculate the money multiplier.

Excess Fed reserves are just over $1 trillion. With a 10% reserve requirement, the $1 trillion has the potential to create $10 trillion dollars.  If the reserve requirement is increased to 20%, the $1 trillion in reserves has the potential to create $20 trillion.  

3)  Excess Reserves (held by banks at the Fed) may be used for bank expenses, investments and to create “High Powered Money.”  Or, they may be left in the account to draw .25% Interest.

I suggest that reserves held at the Fed are free money for the banks.  If they aren't lending money, why do they need more Fed reserves?  This adds debt burden on the economy while increasing the need for taxes.  It is counterproductive.

As you noted, the Money Multiplier is the reciprocal of the reserve requirement. At 10% reserves, the money multiplier is (1 / 0.1) = 10. At 20% reserves, the MM is (1 / 0.2) = 5. So with a 20% reserve requirement, $1 trillion of reserves can support $5 trillion of deposits.

Since 1994 when the Fed approved overnight sweeps, reserve requirements have been lowered rather than raised. Savings accounts have no reserve requirements because they are not 'demand' deposits -- banks can limit savings withdrawals. In a Cinderalla-like feat, banks 'sweep' checking accounts into savings accounts overnight to escape reserve requirements. Then they wave a magic wand the next morning and turn them back into demand deposits. The fraud on depositors is that if a global financial meltdown happens overnight, their putative 'demand deposits' might get stuck in 'savings account' mode the next morning, and not be available on demand as promised.

'Your passbook, please.'  LaughingSurprised

The New York Fed estimated in 2002 that as a result of sweeps, only 30% of banks were even bound by reserve requirements anymore. For the other 70% (including, to be sure, the 'too-big-to-fail' giants), reserve requirements were simply a non-issue.

http://www.ny.frb.org/research/epr/02v08n1/0205benn/0205benn.html

With big banks unbound by reserve requirements, it's hard to believe that QE was even intended to spur lending. Its main effect was to put a floor under the prices of Treasurys and MBS, and to push interest rates down. Ballooning reserves were simply an unavoidable side effect.

Consider how the vast level of excess reserves happened. When the Fed bought $1.3 trillion of securities from dealers, it paid $1.3 trillion into their bank accounts by creating new reserves for the banks which hold the dealers' transaction accounts. Normally banks want to invest reserves at a higher interest rate to earn a spread. But when attractive lending opportunities are limited, or the regulatory climate is restrictive, holding Treasury securities is a low-risk default stance. Under the Basel rules, 'risk-free' government securities aren't included when calculating the required capital ratio (of equity capital, a different issue than reserves).

Currently, with the 12-month T-bill yielding only 0.23%, earning 0.25% on reserves at the Fed is more attractive than holding T-bills. Fed reserves offer instant liquidity, whereas T-bills have to be sold or repo'd to raise cash.

The Fed only started paying interest on reserves from 6 Oct 2008 (see linked announcement). This was a greedy move by the banksters -- with the crisis already underway -- to cadge a little extra income, and it's already blown up in their face as T-bill yields crashed.

http://www.federalreserve.gov/monetarypolicy/20081006a.htm

Ending payment of interest on reserves (for now) is not likely to solve the 'pushing on a string' problem, though. If Gary North's plan of charging banks negative interest on reserves was implemented, banks might look to developing economies such as China and Brazil for borrowers (not unlike the 1970s, when the vast supply of petrodollars was 'recycled' to the developing world). Then there would be no domestic stimulus. Dr. North seems to forget about the potential for overseas leakage in a globalized economy.

 

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Re: The Money Multiplier -- an urban legend?

Gary Dorsch describes the pathological process of Japanese debt deflation:

Japan's 10-year yield has tumbled to the psychological 1% level, down from 1.40% three months ago. Most remarkably, JGB yields are tumbling to historic lows, even though Japan is the second most heavily indebted industrialized country in the world. Japan's $8.73-trillion of debt is almost double its $4.9-trillion in annual gross domestic product. And its budget deficit is projected to swell to 57.3-trillion yen ($610-billion) in the year starting April 2011. Yet the massive increase in supply hasn't stopped the sharp slide in JGB yields.

Instead, JGB's are supported by strong demand from domestic banks that are flush with yen due to sluggish appetite for new loans. Also, the Bank of Japan buys 1.8-trillion yen of JGB's each month, monetizing half of the government's budget deficit this year. The BoJ is trying to counter a shaky economic recovery at home, stymied by deflation and a strong yen. The US-dollar's slide towards 85-yen, a 14-year low, is squeezing Japanese exporter profits, adding to deflationary price pressures, and pinning the Nikkei-225 in the mid-9,000 range.

On August 11th, Japan's Ministry of Finance sold 2.4-trillion yen ($28 billion) of five-year JGB's with a 0.30% coupon, the lowest in seven years. The auction attracted bids that were 4.7-times the offer, the highest since 2005. That compares an average bid-to-cover ratio of 3.47 from the past 12-auctions.Beijing has been a buyer of 1.7-trillion yen ($20-billion) of JGB's so far in 2010.

http://www.safehaven.com/article/17815/japanese-style-deflation-strikes-global-bond-markets

Think about it -- a $10,000 investment in 5-year JGBs would earn you a pathetic $30 a year in annual interest -- hardly enough even to recoup the transaction cost.

From Dorsch's description, one could infer a circular Ponzi process at work in Japan. The BOJ monetizes half the government's deficits by purchasing JGBs. This drives up the price of JGBs, lowering their yields, and creates new reserves for the Japanese banking system. The risk-averse banks in turn do their own buying of JGBs.  Few would want to sell JGBs short in the face of this orchestrated program of official buying. The Bubble potential of such a one-sided market, managed by a single monopoly supplier, is obvious.

Yet it can't continue forever -- in principle, as Japan's government becomes more heavily indebted, it should be paying ever-higher interest rates to compensate for the rising default risk. Yet JGBs are still being priced as absolutely risk-free -- at 0.3% a year, there is no compensation at all for default risk -- only for the storage and insurance cost of holding cash as an alternative.

As the Greek debt crisis illustrated, markets tend to 'wake up' to risk overnight, instead of adjusting gradually. The steady rise in Japanese rates which ought to be occurring is being suppressed by official buying in a managed JGB market. When something finally spooks this market -- say, a drastic rating cut -- prices could crash, and yields soar.

As Dorsch details with numerous charts, the pathological process of government borrowing and money creation pushing yields down instead of up is happening in the US and Germany as well. To the extent that it has Ponzi characteristics -- namely, using the monopoly currency-creation privilege to Bubble up the price of one's own debt instruments in a captive market -- it is extraordinarily dangerous.

Given that such a process is inherently unsustainable, it is likely to end with an appalling bang when it is pushed beyond the limits. We don't know what those limits are -- only that they are out there, lurking like hungry hyenas in the dark beyond the campfire light.

 

"Mmmmm -- 'JGBs tartare' for breakfast! And 'Treasurys carpaccio' 'for lunch! WOOF! Life is good!"

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Re: The Money Multiplier -- an urban legend?

Hello machinehead,

You opened this thread with the question "The Money Multiplier -- an urban legend?"  The answer is no.

And I went on to say "The legend is that bank held reserves are the basis for determining how much money banks may loan. Often this is referred to as "fractional reserve lending" which is a myth."  I think we agree on this?

machinehead wrote:

As you noted, the Money Multiplier is the reciprocal of the reserve requirement. At 10% reserves, the money multiplier is (1 / 0.1) = 10. At 20% reserves, the MM is (1 / 0.2) = 5. So with a 20% reserve requirement, $1 trillion of reserves can support $5 trillion of deposits.

Thanks for correcting my math, you're right.  But to further clarify things; your statement "So with a 20% reserve requirement, $1 trillion of reserves can support $5 trillion of deposits" is a bit off the mark.  The 20% reserve requirement enables banks to potentially create $5 trillion in loans or they may use the money in various ways.  My point is that it is free money for the banks.

A major problem is that banks may only create more debt.  We can keep giving them trillions of dollars but unless someone wants to borrow, it's a waste.  We're past peak debt as we owe more than we can pay which is destroying the productive part of the economy.

The system is the problem.  If it isn't fixed, the economy can only get worse which will cause immeasurable suffering and eventually, the loss of what little sovereignty we have left.

Larry

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Re: The Money Multiplier -- an urban legend?

I was using 'deposits' and 'loans' interchangeably, since the actual mechanics of making a loan mean that the bank credits the borrower with a deposit in the amount of the loan. 

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