The Money Multiplier…and Other Myths about Banking

What people think banks do: The money multiplier and other myths

The previous section looks at how banks actually operate in the real world. The following section looks at some of the common misconceptions surrounding banks, including the favourite of economics textbook writers everywhere, the money multiplier model.

Perception of Banking Number 1: The ‘Safe Deposit Box’

Most of us had a piggy bank when we were kids. The idea is really simple: keep putting small amounts of money into your piggy bank, and when a rainy day comes along, the money will still be sat there waiting for you. For a lot of people, this idea of keeping your money safe sticks with them into adult life. A poll done by ICM on behalf the Cobden Centre found that a third of the UK public still believe that this is how banks work.

However, your bank account isn’t a safe deposit box. The bank doesn’t take your money, carry it down to the vault and put it in a box with your name written on the front. And it doesn’t store it in any digital equivalent of a safe deposit box either. What actually happens is that when you put money into a bank, that money becomes the property of the bank. Because it becomes their property, the bank can use it for effectively anything it likes.

But what are those numbers that appear in your account? Is that not money? In a legal sense, no. Those numbers in your account are just a record that the bank needs to repay you at some point in the future.  In accounting terms, this is known as a liability of the bank. So the balance of your bank account doesn’t actually represent the money that the bank is holding on your behalf. It just shows that they have a legal obligation – or liability – to repay you the money at some point in the future.

Perception of Banking Number 2: The Middle-Man.

The other two thirds of the UK public have a slightly better understanding of how banks really work.

They believe that banks take money from savers and lend it to borrowers – i.e. banks borrow money from people who want to save it, such as pensioners and wealthy individuals, and they then use that money to lend it to people who need to borrow, such as young families that want to buy houses or small businesses that want to invest and grow. The banks make their money by charging the borrowers slightly more in interest than they pay to the savers. The difference between the interest rates – known as the spread – makes up their profit.

In this model, banks just provide a service by getting money from people who don’t need it at the time, to people who do. The Cobden Centre poll mentioned earlier asked people if they were worried about this process: around 61% of people said they didn’t mind so long as they get some interest and the bank isn’t too reckless.

The implications of this theory are that if there’s no-one who wants to save, then no-one will be able to borrow. That means it’s good for the country if we save, because it will provide more money for businesses to grow, which will lead to more jobs and a healthier economy. This is the way that a lot of economists think as well. In fact, a lot of economics courses at universities still teach that the amount of investment in the economy depends on how much we have in savings. But this is completely wrong, as we’ll see shortly.

Perception of Banking Number 3: The Money Multiplier

Most economics and finance students have a slightly better understanding of banking. They get taught about something called the ‘money multiplier’. The money multiplier story says that banks actually create much of the money in the economy.

Here’s how the story goes: A man walks into a bank and deposits his salary of £1000 in cash. Now the bank knows that, on average, the customer won’t need the whole of his £1000 returned all at once. He’s probably going to spend a little bit of his salary each day over the course of the month. So the bank assumes that much of the money deposited is ‘idle’ or spare and won’t be needed on any particular day.

It keeps back a small ‘reserve’ of say 10% of the money deposited with it (in this case £100), and lends out the other £900 to somebody who needs a loan. So the borrower takes this £900 and spends it at a local car dealer. The car dealer doesn’t want to keep that much cash in its office, so it takes the money back to another bank.

Now the bank again realises that it can use the bulk of the money to make another loan. It keeps back 10% – £90 – and lend out the other £810 to make another loan. Whoever borrows the £810 spends it, and it comes back to one of the banks again. Whichever bank receives it then keeps back 10% i.e. £81, and makes a new loan of £729.

This process of re-lending continues, with the same money being lent over and over again, but with 10% of the money being put in the reserve every time. Note that every one of the customers who paid money into the bank still thinks that their money is there, in the bank. The numbers on their bank statement confirm that the money is still there. Even though there is still only £1000 in cash flowing around, the sum total of everyone’s bank account balances has been increasing, and so has the total amount of debt.

Supposedly this process continues, until only a penny is being relent. By now, the sum total of all bank accounts adds up to about £10,000. So the multiplier model that is still taught in many universities implies that this repeated process of a bank taking money from a customer, putting a little bit into a reserve, and then lending out the rest can create money out of nothing, because the same money is double-counted every time is it relent.

You can imagine this model as a pyramid. The cash is the base of the pyramid, and depending on the reserve ratio the banks multiply up the total amount of money by re-lending it over and over again.  More advanced treatments include the concept of ‘central bank reserves’ as well as cash, however the basic message is the same.

Problems with the money multiplier model

The money multiplier model of banking has several implications:

1. Firstly, this  model implies that banks have to wait until someone puts money into a bank before they can start making loans. This implies that banks just react passively to what customers do, and that they wait for people with savings to come along before they start lending.

2. Secondly, it implies that the central bank has ultimate control over the total amount of money in the economy. They can control the amount of money by changing either the reserve ratio or the amount of ‘base money’ – cash – at the bottom of the pyramid.
   For example, if the Bank of England sets a legal reserve ratio and this reserve ratio is 10%, then the total money supply can grow to 10 times the amount of cash in the economy. If the Bank of England then increases the reserve ratio to 20%, then the money supply can only grow to 5 times the amount of cash in the economy. If the reserve ratio was dropped to 5%, then the money supply would grow to 20 times the amount of cash in the economy.
   Alternatively, the Bank of England could change how much cash there was in the economy in the first place. If it printed another £1000 and put that into the economy, and the reserve ratio is still 10%, then the theory says that the money supply will increase by a total of £10,000, after the banks have gone through the process of repeatedly re-lending that money. This process is described as altering the amount of ‘base money’ in the economy.

3. Thirdly, it implies the money supply can never get out of control, unless the central bank wants it to.

Unfortunately, the money multiplier model of banking is completely wrong. Professor Charles Goodhart of the London School of Economics and an advisor to the Bank of England for over 30 years described this model (in 1984) as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.” Why is this?

Firstly, the underlying concept of the money multiplier is that in order to make loans banks first require people to deposit money. However, this is simply not true. In actual fact when banks lend they create deposits:

“This paper contends that the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Under a fiat money standard and liberalized financial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulfill the demand for loans if it wishes to.”

– Piti Distayat and Claudio Bori, Bank for International Settlements (2009).

Nor do banks need reserves in order to make loans. As Alan Holmes, who was senior Vice President of the Federal Reserve Bank of New York at the time remarked:

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

– Alan Holmes, then Senior Vice President, Federal Reserve Bank of New York (1969).

The vice president of the ECB had something similar to say:

“It is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.”

– Vitor Constancio, vice president of the ECB (2011).

Of course, this is just two men’s opinion, albeit men who should know what they are talking about. Thankfully empirical work has been carried out on this subject by Nobel prize winners Finn Kydland and Ed Prescott of the Federal Reserve bank of Minneapolis, who find that:

“There is no evidence that either the monetary base or M1 leads the [credit] cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit] cycle slightly.”

– Nobel prize winners Finn Kydland and Ed Prescott , Federal Reserve bank of Minneapolis (1990).

What they are saying here confirms Alan Holmes quote above. Central bankers not only reject the money multiplier story due to their understanding of how banks operate, but also because of the empirical evidence.

There are also other reasons why the money multiplier is not a good model of how banks actually operate. For example, there’s no reserve ratio in the UK anymore, and there hasn’t been for a long time. While reserve ratios might be useful for other reasons, it is almost impossible for the central bank to use reserve ratios (or limit reserves held by banks in other ways) to restrict credit creation by banks. There are several reasons for this, not least because “banks extend credit, creating deposits in the process, and look for the reserves later”.

Of course, the central bank could choose not to provide a bank with extra reserves when requested. However, if the bank in question had extended credit and requested reserves in order to make a payment on behalf of a borrower, by not providing the reserves the central bank could create a problem for the bank in question.

For example, in a banking system with a reserve ratio the denial of reserves to a bank (which causes their reserves to fall below the regulated amount) will result in one of three outcomes:

1. The bank may attempt to borrow the reserves from another bank. However this is likely to place upward pressure on the interest rate at which banks lend reserves to each other on the interbank market. If the central bank wishes to maintain this rate then in all likelihood it will have to provide further reserves to the banking system – undermining its efforts to restrain lending through restricting reserves.

2. The central bank may allow the bank to break the rules, and operate with a reserve ratio of less than the required amount.

3. The central bank may deny the bank the ability to make payments until its reserve ratio increases up to the required amount. If the bank is also unable to borrow the reserves either from the central bank or other banks this could create a liquidity crisis, as the bank in question will not be able to make the payment. This could then potentially lead to a solvency crisis and/or a financial crisis.

Therefore if the Central bank wants to restrict private bank money creation supply by using reserve ratios or by restricting the amount of reserves availability to private banks, it must be willing to either allow large fluctuations in the interest rate or alternatively intermittent liquidity crises. Due to the potential for liquidity crises to turn into solvency crises, and because a solvency issue at one bank can cause a cascade of bankruptcies throughout the entire banking system, the central bank are unlikely to pursue the second option. Indeed, it goes against one of the central bank’s core functions – its mandate to protect financial stability.