Wednesday, August 15, 2012

Fullwiler - "The main shortcoming of the money multiplier paradigm"

Economists and investors are once again getting excited about the potential for Bernanke to signal new monetary “stimulus” during his upcoming speech at Jackson hole. Calls for further action have been coming from all sides over the past few months, while the Fed has remained relatively passive. Although reasons behind the push are varied, many proponents still hold the misguided belief that balance sheet expansion (i.e. increasing reserves) will allow banks to increase the extension of credit. Though some mainstream (e.g. Simon Wren-Lewis) and heterodox (e.g Lars P. Syll and Marc Lavoie) economists have clearly portrayed the myth of the money multiplier, the concept lives on. Continuing my efforts to eradicate this theory, here is Scott Fullwiler from his exemplary paper on Interest Rates and Fiscal Sustainability:
This “money multiplier” view is still prevalent in virtually every economics textbook from the principles level on up to the doctoral level. The main shortcoming of the money multiplier paradigm has been recognized for some time by Post Keynesians and Circuitistes: reserve balances simply are not an operational constraint on bank lending. The money multiplier approach presumes that banks need reserve balances to make loans, but reserve balances can only settle a bank’s payments or aid the bank in meeting its reserve requirement. A loan, on the other hand, is created endogenously at the request of a creditworthy customer and creates its own deposit. As just one example, Moore (1988) notes that the substantial lines of credit banks pre-negotiate with their customers leaves the precise timing and size of their lending outside of their direct control. Again, as Moore explained, if loan creation or uncertain timing of deposit inflows has created an additional reserve requirement for a bank, the bank’s response is to borrow the additional required balances in the money markets. Whereas the money multiplier presumes that reserve balances set the limit on a bank’s lending or money creation, real-world banks instead and necessarily lend first and meet reserve requirements later. (p.12)
This myth is unlikely to go down quietly because, as Philip Pilkington makes clear:
if the money multiplier dies much of neoclassical economics goes with it. As endogenous money theorist Alain Parguez puts it: endogenous money destroys the concept of the scarcity of money, and without the notion of scarcity applied in every economic field neoclassical economics breaks down.
However, until these efforts prove fruitful, I will continue to provide examples to the contrary...


  1. Hi Woj. I think I understand the idea of endogenous money, but I still have trouble with strenuous objection to the "money multiplier".

    You write: "many proponents still hold the misguided belief that balance sheet expansion (i.e. increasing reserves) will allow banks to increase the extension of credit." I would say that of all the things that are (or may be) true about the money multiplier, that one is WAY down near the bottom. I think the people who support the Fed's balance sheet expansion are the ones who make money when it drives the stock market up.

    From your Fullwiler quote: "the substantial lines of credit banks pre-negotiate with their customers leaves the precise timing and size of their lending outside of their direct control." Sure, but that is mere clear evidence of the excessive reliance on credit. And that was back in 1988: Excessive reliance on credit, even then.

    Do you think that in a world of low & sustainable reliance on credit, it would be easier to see the "money multiplier" working, or would it still not be true, do you suppose?

    1. Art,

      Believe me, I'm still trying to completely grasp the ideas of endogenous money. Anyways, going back to an earlier post of mine on the subject, Ramanan offered work from Marc Lavoie which concluded, "There is never any money multiplier effect." In a Twitter exchange recently, Scott Fullwiler had a similar response.

      The money multiplier story implies that the Fed extends reserves, which then induces banks to make more loans. This is entirely opposite causation from the real-world, in which the Fed generally acts defensively in providing the necessary reserves to allow for smooth functioning of the payments system and to manage the federal funds rate. I don't think this direction of causation would change in a world with less reliance on credit (which we both favor).

  2. Woj,
    If I'm reading you right are you saying that reserve requirements have no bearing on how much banks can lend? It would seem to me that if a bank has serious liabilities that are subject to reserve requirements, this could have an effect on how much additional risk a lender would be willing to assume. The other consideration is the amount of interest lenders can charge under current conditions. While it is true that lenders can demand any rate of interest they choose, at current low rates, good risks won't pay much above the prime rate. (Not enough risk premium at these levels, which has led to more speculative buying of stocks and commodities instead of lending for market expansion.) It may well be that the multiplier is dead, but in my opinion, it it the velocity of money that matters. At current rates of interest, the only impact that QE has had is to create and excess demand for money.

    1. nanute,

      I'm not sure of all the details, but its important to note that reserve requirements only apply to certain types of bank deposits and in that sense clearly don't restrain all lending. To your question though, reserve requirements can restrict bank lending in the sense that banks must acquire the appropriate reserves after extending loans. If the Fed chooses not to increase the amount of reserves outstanding, then banks will have to borrow reserves on the interbank market, which will drive up the yield. This would not only increase the cost of lending to banks, but would also introduce uncertainty regarding the rate at which banks would be able to borrow in the interbank market.

      To avoid those outcome, which would restrict lending, the Fed always provides enough reserves to ensure the interbank rate does not deviate to far from the fed funds rate. Since the Fed acts defensively, in practice, reserve requirements do not limit bank lending.

      To your last points, I would agree that the velocity of money matters but would focus on broader measures of money that include bank credit. As for QE, a primary goal is clearly to reduce the premium on liquidity and pressure the private sector to increase holdings of less liquid assets. This has clearly worked, for the time being, with most asset prices rising. Unfortunately for the Fed, the earnings potential of the underlying assets has not been playing catch-up, which means further QE will be necessary to maintain the high expectations. (I've got a planned post on this in the near future).