Tuesday, June 19, 2012

IOR Killed the Money Multiplier

Following yesterday’s post that the SNB Massively Increases Monetary Base to Maintain Currency Floor, I became engaged in some back and forth dialogue through the comments at FT Alphaville. In response to a suggestion that the SNB had given up control over interest rates by instituting the currency floor, Philip Pilkington (Naked Capitalism) said:
They could easily maintain control over interest rates by paying a set rate of interest on reserves, just like the US/UK/Japan do with their base rate.
Paying a positive rate of interest on reserves (IOR) would provide a huge incentive for Swiss banks to hold reserves instead of short-term government securities. This swap would move rates on government debt towards the IOR rate (although given the currency floor, Swiss debt may still trade at a relative premium). This discussion of IOR got me thinking:
if the SNB chose to pay IOR, wouldn't that to some degree tighten monetary policy (by making credit more expensive relative to money-like instruments)? If so, might this policy increase deflation and thereby put further upwards pressure on the CHF?
Philip responded:
Maybe. Depends if you think that low interest rates in a ZIRP-like environment actually stimulates demand. I don't think they do to any significant extent. This was shown in the Godley/Lavoie computer simulated models. The effects on investment are short-term -- in the long-term they take away interest income which decreases consumption.
With regards to monetary policy, my views are closely aligned with Philip’s. The strengths of monetary policy are alleviating financial illiquidity and encouraging investment (largely housing) by holding down the long end of the curve. At the moment, US financial markets are highly liquid and housing investment remains constrained by excessive household/mortgage debt, underwater borrowers, foreclosure errors and shadow inventory. Altering rates slightly, in either direction, at such low levels is therefore unlikely to have much impact.  

Moving beyond the economic impact of paying IOR, I decided to pose a question previously alluded to in Permanent Zero: Record Low Treasury Yields and Banking Instability:
Given the amount of excess reserves, will it be easier for central banks to adjust interest targets using the rate of IOR rather than reduce excess reserves back to a level that manages the interest rate target?
Philip confirmed my views noting:
It would, I think, be a great deal easier to use IOR rather than OMO when there are massive amounts of excess reserves (wow, I hope no one ever quotes that sentence!). When/if the recovery happens the central banks may choose to do this instead of engaging in OMOs to soak up the QE-induced reserves. It would be a great deal less hassle provided that central bankers can get over their irrational fear of excess reserves. It would also likely mean that a lot of civil servants currently engaged in OMOs might lose their jobs -- that may sound trivial, but it puts extra pressure on the IOR proponents.
If the central banks did this and conducted their interest rate policy in terms of IOR, the money multiplier would have to die. No longer could any serious economist maintain the myth. But, as I and others have argued in the past, 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.
(Philip - My apologies for including that quote)
These comments on the end of the money multiplier brought me full circle to my first encounter with interest on reserves (IOR) back in 2010, when I discussed how the Fed Stands in Own Way on Monetary Policy. In that post I presented the following quote from a  New York Fed report on Why Are Banks Holding So Many Excess Reserves?, by Todd Keister and James McAndrews:
if the central bank pays interest on reserves at its target interest rate,..., the money multiplier completely disappears.
So the money multiplier is dead and even members of our central bank are aware of this fact. Now if only most economists would start accepting this reality...

Update: Ramanan (in the comments) directs us to a power point by Marc Lavoie on Changes in central bank procedures during the subprime crisis and their repercussions on monetary theory. Lavoie provides an important correction to Keister’s views noted above (emphasis mine):
You seem to imply that the textbook multiplier still applies when reserves earn no interest. I think that this is a misleading statement. It implies that there is a bunch of agents out there,
waiting for banks to provide them with loans, but that there are being credit rationed because banks don’t have access to free reserves. ...Rather what happens when excess reserves are being provided with no remuneration of reserves is that the fed funds rate drops down, as banks with surplus reserves despair to find banks with insufficient reserves, having no alternative but a zero rate. The drop in the fed funds rate may induce banks to lower their lending rates, and hence induce new borrowers to ask for loans or bigger loans, but it really has nothing to do with the standard multiplier story. If there is no change in the lending rate, new creditworthy borrowers just won’t show up. There is never any money multiplier effect.


  1. Keister and McAndrews' views are wrong. The supply of credit is demand determined.

    You may want to read about Keister and McAndrews in this ppt by Marc Lavoie - on his exchange of email

    toward the end here (page 22)

    1. @Ramanan

      Thanks for the link. If I read Lavoie correctly, Keister and McAndrews's views are wrong because the money multiplier simply doesn't exist in a fractional reserve system.

      I completely agree with your statement that "The supply of credit is demand determined." My intent in disproving the money multiplier was to show the ineffectiveness of QE, but obviously my portrayal left open the possibility that without IOR it would exist.

      Thank you for the comment/pointer since it's important (to me at least) that the best information is presented.

    2. Yes doesn't exist - it should be seen as a credit divisor.

      i.e. the correct framing is that there is still a multiplier but the causality is from M to B.

      There are various levels in which people understand this and one has to be careful in getting it right. Some people may appreciate that the multiplier concept is flawed but in the end unconsciously end up making the mistake - as for example several central bankers.