The Money Multiplier: How Banks Operate In The Land of Make Believe

M = 1/RR

A simple little expression. It says that the money multiplier (M) equals one divided by the reserve requirement (RR). For those of you mathematically inclined, it says that the money multiplier is the inverse of the reserve requirement. This cute little expression and the concept that it describes is taught to economics students. You will find a description of the concept in most Economics 101 textbooks and much like the Energizer Bunny, the teaching and reinforcement of money multiplier in the minds of students goes on and on and on throughout their undergraduate career. By the time they enter graduate school, they are “firm believers” in the holy word of the Church of Economic Nonsense.

The money multiplier exists only within a theoretical model of how banks operate in a fractional reserve system. In the case of the US, M = .10 since the Federal Reserve requires 10% held back. The theoretical model says that banks open their doors and wait. Yes, they wait around for you to show up and deposit some “money”. When you make a deposit, the bank’s reserves rise. But it’s not yet enough. They need more “money”. They wait around a while longer until more people come in and deposit their “money”. When enough deposits have been collected, the bank employees put on their party hats and scream, “It’s time to make some loans!”

The bank is required to hold 10% of deposits behind, so it lends out the other 90% of your deposit. We will assume a $1,000 deposit. The bank holds $100 in reserve and lends out $900 to a Wall Street executive who needs some new shoes, because Hillary Clinton will be speaking at an event his firm is hosting. The $900 loan becomes problematic at this point, because now, mainstream economists need the money supply to increase and kill us all. So, they derive:

M = m(MB)

Lots of M’s. They need M’s. What this cute equation says is that for every $1 that is deposited by a customer, assuming the reserve requirement is 10%, then the money supply will grow $10. In other words, banks will wave their magic wands over the $1 and it will suddenly multiply by $10. Hence, “The Money Multiplier”. We can rewrite this equation as:

Ds = m(MB)

Where death on a stick (Ds) equals the multiplier times the monetary base (MB).

Anyway.

So then, the Wall Street executive buys his Italian leather shoes and that $900 gets deposited in another bank. That bank holds back 10% and loans out the other 90% which gets deposited in another bank and so on and so forth, until the money supply has grown exponentially and the United States becomes Zimbabwe (formally known as Rhodesia and known today as the macroeconomics theme-park, “Hyperinflationland”). Time to put the screws to this puerile nonsense.

How Banking Works

As you can probably tell from the above heading, the description of banking prior to the heading is pure drivel. In addition to economics students, the general public hears this pure drivel on TV or reads it in newspapers, magazines, blogs, or wherever “very important persons” wish to frighten the public away from government spending. To understand what is actually going on, we need to look at two separate operations: federal spending and bank lending.

There are two types of transactions: vertical and horizontal. Vertical transactions are where the US government issues currency into the non-government sector. Horizontal transactions are bank lending. The first is the creation of US dollars and the second is the leveraging of US dollars for profit. To understand the latter, let’s detail the former.

Vertical Transactions

The US dollar is just a number with a “$” symbol in front of the number. The US government issues these numbers at will by crediting a bank account somewhere with them. For instance, if it wished to give Boeing $1 billion for a new jet fighter that cannot fly, it will go into Boeing’s bank account and type the number 1,000,000,000 and the $1 billion exists, where before there wasn’t $1 billion. All federal spending is done this way. There are no tax dollars funding that spending. When the federal government does this, it is injecting US dollars into the banking system. So, US dollars are created by vertical transactions between the government and non-government sector. US dollars are destroyed in the same manner, mainly through taxation. When the federal government taxes someone, it removes US dollars and those dollars are destroyed. Because the US dollar exists, banks will try and profit from it.

Horizontal Transactions

As I’ve mentioned many times, the US dollar has a symbol “$” which is what we call “the unit of account”. In the UK, the pound is just a number with a “£” symbol in front of the number. The “£” symbol is the unit of account in the UK. So, in the US, banking is done using the US dollar. What banks do is they leverage the unit of account to try and earn a profit. This is commonly known as “lending”, but factually, no US dollars are being lent out. That’s not how banking works.

Banks cannot and do not lend out reserves to customers. See any of my recent articles on the subject. Reserves operate the payments system. So, if banks do not have the ability to lend out actual US dollars, what then are they “lending”? Banks do something special. They create a bank IOU, denominate it in the unit of account and then offer it to you. Huh? It’s really quite simple.

Banks cannot issue US dollars. That power is reserved for the US government alone. A US dollar is the US government’s IOU, which it credits bank accounts with when it wishes to spend. Since the US dollar exists, a bank can create IOUs too. The problem is that a bank’s IOU is worthless to everyone, unless it can be turned into “money” that is accepted by everyone. To achieve this, a bank creates its own IOU and then “pegs” it to the US dollar. In other words, it denominates that IOU in US dollars. When it does this, the bank IOU can then be exchanged on demand for actual US dollars. To see the “lending” process in action, we will detail it by stages.

Stage One

The bank, let’s say, Chase advertises to the public, “Hey! We’re lending. Need a car or house? Come to us.” The bank wishes to lend to any creditworthy customers it can find. Each bank sets a different standard on what they are willing to deem as “creditworthy”. Hence, Chase might not give you a credit card, but Capital One will. In walks a customer who wishes to buy a new car. Chase then runs the customers credit and makes a determination whether or not they wish to make an offer to the customer. Let’s suppose that the customer passes muster.

Stage Two

Chase informs the customer that he/she is approved for a $30,000 car loan at 5% APR for 72 months. Great. The customer is happy and heads to the Chase. Chase now makes the offer and outlines the terms of agreement. The customer agrees to the bank’s terms and signs the agreement.

Stage Three

Chase now creates a $30,000 “loan” and at the same time, it creates a new deposit of $30,000. The deposit is the Chase’s IOU of 30,000 numbers and it denominates those IOUs in US dollars, hence the “$” symbol. Chase is now ready to swap its IOU with the customer’s IOU.

Stage Four

The customer heads to the car dealership and proudly announces that he/she will take the $30,000 car. The dealer smiles. Paperwork is signed. The keys are handed to the customer. What happens next is simple.

Stage Five

Chase’s IOU is accepted by the car dealership as payment for the $30,000 car, because it is denominated in US dollars. The car dealership heads to its bank, Bank One, and deposits the $30,000. When this occurs, $30,000 of actual US dollars sitting in Chase’s reserve account held at the Federal Reserve shift to Bank One’s reserve account at the Federal Reserve. Bank One now has $30,000 more in reserves and the car dealership’s account rises by 30,000. On the other hand, Chase has $30,000 less in reserves. However, as long as Chase is not too short of reserves and can still operate the payments system, Chase doesn’t care at the moment. Later, if Chase is short, it will head to the interbank market to get more reserves, or use the Fed’s discount window. So, what we see is that Chase’s IOU became “money” in the private sector, only because it was denominated in the unit of account, that being the US government’s currency: The US Dollar.

Chase will now hold customer’s IOU, until he/she pays back the loan. For the privilege of using Chase’s IOU to purchase a car, the customer is charged a fee (interest). That fee is how Chase will profit from leveraging the US dollars flowing into the banking system by the vertical transactions (The federal government issuing currency). When the customer pays back the “loan”, the $30,000 that Chase created is destroyed forever. The process also gives us further insight: The Federal Reserve doesn’t control the “money supply”.

The money supply today is driven by demand. Customers demand bank credit and banks provide the credit. When loans are made, the “money supply” expands and when loans are paid off, the “money supply” shrinks. The Federal Reserve controls the price of this “money”, but clearly not the supply as it cannot control the volume of deposits. So, banks create money, yes. However, they do not create currency. Only the US government can create currency.

When the US government spends, it is manufacturing US dollars. Those US dollars created are an asset without a corresponding liability attached to them. In other words, when the federal government gives you $1,000 you don’t have to pay it back. On the other hand, when banks create IOUs, that “money” created is an asset with a corresponding liability. In other words, if a bank “lends” you $1,000 then you have to give all $1,000 back. This gives us another insight: Private debt.

Private Debt Expansion

An actual US dollar created by the US government is a net financial asset. It can be net saved. The economy depends on the US government spending US dollars. The way the federal government adds US dollars to the non-government sector is by spending more than it taxes. In other words, deficit spending. If the deficit is being reduced and at the same time, imports are greater than exports, then the only thing left available to keep aggregate demand up and keep everyone employed is bank credit. But this is a band-aid for the economy and an expensive one.
When the non-government sector cannot take on any more private debt from bank credit, spending will contract. If the US government doesn’t immediately step in with deficit expansion towards employment, then aggregate demand will collapse, jobs will be lost and a recession will occur. Up, down, up down. Now you understand why the economy does this. Deficit reduction.

Concluding Remarks

Where does this leave the poor money multiplier? I think the answer to that question is more than obvious. It is a fantasy. Banks don’t lend out reserves. They create credit. Reserves never enter the economy. They stay at the Federal Reserve. Because of that, there’s nothing to multiply. The money multiplier exists only in a theoretical model of a fictional banking system. The money multiplier is a myth. So, yes, if you’re an economics student, feel free to burn your textbook. Of course, you don’t have to take my word for it, even though I assure you that I know what I am talking about. Read this paper by the Federal Reserve.

And that’s plenty for today. Oh, if you see Paul Krugman, do tell him to sit down and be quiet. He doesn’t know what he’s talking about.