What’s Wrong with the Money Multiplier Model? (Banking 101 Part 2)
We’ve seen the two main ideas that the general public have about the way banks work. Both of them are wrong. That’s not too surprising, after all, unlike the Positive Money team most people don’t spend their time obsessing about how banks work. And banking is complex, which means that most people give up trying to understand it. But what about economics or finance students? Most of these students and graduates have a slightly better understanding of banking. They get taught about something called the ‘money multiplier’.
Proof & Further Reading:
Is the ‘Money Multiplier a Myth?’
From the Bank of England’s 2014 Q1 Quarterly Bulletin:
“Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 2)
“In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 2)
“Part of the confusion may stem from some economists’ use of the term ‘reserves’ when referring to ‘excess reserves’ — balances held above those required by regulatory reserve requirements. In this context, ‘lending out reserves’ could be a shorthand way of describing the process of increasing lending and deposits until the bank reaches its maximum ratio. As there are no reserve requirements in the United Kingdom the process is less relevant for UK banks.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 3, footnote 2)
From a Bank of England handbook for central bankers:
“If there is a shortage of liquidity [i.e. reserves], then the central bank will (almost) always supply the need…As regards a shortage of commercial bank reserves held at the central bank, the risk is that a shortage would mean payments could not be cleared at the end of the day.” [Our addition in square brackets] (Gray, S., Handbook No. 27 – Liquidity Forecasting. Bank of England Centre for Central Banking Studies. 2008).
From Professor Charles Goodhart, advisor to the Bank of England:
“Virtually every monetary economist believes that the central bank can control the monetary base [i.e. the stock of cash and central bank reserves]… Almost all those who have worked in a central bank believe that this view is totally mistaken.” [Our addition in brackets.] Goodhart, C. (1994). What Should Central Banks Do? What Should Be Their Macroeconomic Objectives and Operations? The Economic Journal, 104 (p. 427).
The money multiplier story
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 relending 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 after around 200 cycles, almost all of the original money is now in reserves, and only a fraction of 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. The model says that if the reserve ratio – that’s the percentage of customers’ money that the banks have to keep in a reserve – is 10%, then the total amount of money will grow to roughly 10 times the amount of cash in the economy. You can imagine this model as a pyramid. The cash is the base of the pyramid ,and then, depending on the reserve ratio, the banks multiply up the total amount of money by relending it over and over again.
An inaccurate and outdated way of describing how the banking system works
The fact is that what we’ve just shown you is completely wrong. It’s an inaccurate and outdated way of describing how the banking system works. In fact, banks in the UK haven’t worked like this for years. But despite that, this model is still used most of the time whenever people talk about how money is created, whether in universities or on videos on the internet. Before we spent 5 months researching exactly how the system worked, we used to think it worked like this too.
The fact that this pyramid model is still used is a problem for three reasons:
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. This is not how it really works, as we’ll see later.
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 – that’s the percentage of customers’ money that banks have to keep in reserve – 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.
But the most significant implication of this model is that the Bank of England, or the Federal Reserve or European Central Bank, has complete control over how much money there really is in the economy. If they change the size of the base – by pumping more ‘base money’ into the system – then the total amount of money should increase. If they change the reserve ratio, then the steepness of the sides of the pyramid will change. But eventually, the reserve ratio stops the money supply growing any further. At some point we reach the top of the pyramid and the money supply stops growing. So there’s absolutely no possibility that the money supply can get out of control. There’s just one small problem. Almost everything about this description of banking is wrong.
In fact, Professor Charles Goodhart, of the London School of Economics and an advisor to the Bank of England for over 30 years, described this model as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.”
It might be forgivable for textbooks to be out of date if the rules had changed in the last couple of years – after all, a lot of rules and regulations changed during the financial crisis. But Professor Goodhart actually said this in 1984. 27 years, later university students are still learning a description of banking that is completely inaccurate. This is a big problem. If these students then go on to become economists and advisors to the government, and they don’t even really understand how money works, then our economy could end up in a real mess. Oh wait…it already is!
Now, I have to point out that these videos do apply to the UK, and we haven’t had time to confirm exactly how things work in the USA and Europe. But for those of you in the US, a paper published in 1992 refers to a textbook still used in universities today – and states that “the multiplier model…is at best a misleading and incomplete model, and at worst a completely mis-specified model’. [Lombra, http://www.jstor.org/pss/40325454 ]
Here’s the bottom line when it comes to the ‘money multiplier’:
1) There’s no reserve ratio in the UK anymore, and there hasn’t been for a long time.
2) The Bank of England doesn’t have any real control over the amount of cash, or even electronic ‘base money’ (which we’ll talk about later).
3) And the Bank of England certainly doesn’t have control over how much money there is in the economy in total.
It’s not just economics graduates who have the wrong information. Even people working in the Treasury still believe it works according to the textbook. We’ve had letters from the Treasury saying things like this: “In this system, the Bank of England alone has control over the monetary base, which consists of currency (banknote and coins) and reserves held by commercial banks at the Bank of England. Commercial banks keep only a fraction of their deposits in reserve, lending out the remainder, while maintaining the simultaneous obligation to redeem all deposits upon demand.” Allowing people with an incomplete understanding of how money works to manage our economy is very dangerous. It’s like allowing engineering students who don’t understand gravity to build skyscrapers. People will suffer.
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