Why the Money Multiplier Remains so Low

Basel III, endogenous money, money multiplier, Quantitative Easing, reserve-deposit multiplier
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George Selgin’s latest monetary policy primer was a very good explanation of the money multiplier in fractional reserve banking systems. He also suggested that a number of factors may be affecting the current surprisingly low level of the multiplier; a fact that prompted a number of endogenous money theorists to (wrongly) assert that the multiplier was "dead."

In this post, I wish to elaborate on the reasons behind the low multiplier. And those reasons are, in my view, related to banking mechanics and regulatory dynamics.

Let’s first start with a little bit of history to put things in perspective. Some time ago, and following one of my blog posts on the topic, Levi Russel from the Farmer Hayek blog – who is much better than I am at manipulating FRED data – kindly sent me the following chart representing the M2 multiplier ("MM") since 1920:


As you can see, the MM also experienced a huge fall during the Great Depression. It then took about forty years for the MM to progressively get back to its pre-Depression level.

Independently of regulatory frameworks, there is a simple underlying reason behind this long recovery time: banking mechanics. As corporations, banks are subject to operating constraints that limit the short run supply of credit. Banks employ a number of bankers, analysts, risk experts and so forth that are in limited numbers and already working full time to extend loans to creditworthy customers in adequacy with the bank’s risk appetite. The client onboarding process, the analysis of his risk, as well as the negotiations of legal agreements, aren’t instantaneous. The funding process itself isn’t either: despite what endogenous money experts assert, extending new loans still require looking for additional non- central bank funding before or shortly after putting the credit line in place.

At any point in time, it is likely that banks are close to the microeconomic equilibrium ideal of having marginal revenues equal to the marginal economic costs of employing staff and retaining adequate levels of capital and liquidity, and that its managers decided not to extend credit further on purpose: additional revenues were not attractive enough to justify the costs of acquiring them.

The implication of a fall in the MM is that liquidity (under the form of bank reserves/high-powered money) is now abundant in the system relative to the amount of bank money in circulation. Liquidity cost not being an issue anymore, banks nevertheless remain subject to operational and credit risk constraints, implying that they cannot put this liquidity to work rapidly.

Indeed, this situation is amplified during a crisis, as the number of creditworthy borrowers falls and banks lay off some of their employees to offset the fall in revenues and rising loan losses. Moreover, liquidity costs also rise and banks decide to hold on to higher liquidity buffers than they used to, mechanically lowering the MM. Consequently, there is no way the MM can rapidly rise. It takes time.

And this was the mistake made by a number of economists who wrongly predicted that hyperinflation would strike in the years following the implementation of quantitative easing policies. Credit cannot mechanistically and instantaneously grow. The financial system is a source of sticky constraints and rigidities. Of course we did see periods of above average MM growth (like just before the Depression or between 1980 and 1987*). But even if those particular growth rates were applied to today’s world, it would take more than twenty years for the MM to get back to its pre-crisis level.

Some could reply that banks don’t need extra resources to invest their liquidity into government bonds. While this is true some constraints remain in place: 1. the supply of government bonds is limited, and buying large quantities of them would become uneconomical for banks’ margin as bonds yield fall towards zero; 2. only a handful of governments have top credit ratings, and this rating fall as they issue more debt; 3. banks want to diversify their portfolio and certainly do not wish to only be exposed to sovereign risk.

The description above effectively applies to banking systems free of exogenous regulations. But regulatory dynamics can dramatically hinder the money creation process and hence the return of the MM to more normal levels.

Following the 2008/9 crisis, the Western world has been quick at altering regulatory requirements despite the weak economic recovery. In the decade following the crash, Basel 3 (implemented in the US under Dodd-Frank and in the EU under CRD4) built on previous versions of the Basel framework to progressively tighten operating restrictions – thereby reducing banks’ ability to generate marginal revenues – as well as capital, liquidity and funding requirements.

This regulatory package made it even more complex for bank to engage in lending. These are some of the steps that bankers now typically have to take in order to set up a new committed credit line:

  1. Client onboarding/Know-Your-Customer, which is getting increasingly tightened by authorities due to international sanctions, tax evasion and terrorism
  2. Credit analysis/risk assessment facility type/comparison with risk appetite and internal risk management guidance
  3. Estimate what the regulatory liquidity (LCR) and funding (NSFR) requirements are going to be for this specific credit facility.
  4. Estimate the cost of getting hold of the specific liquid assets and funding instruments (which both are in limited supply on the market and hence costly to acquire) that rules require
  5. Estimate the amount of regulatory capital (also in limited supply) required for such a facility
  6. Estimate total risk-adjusted revenues of the new credit facility (plus any other revenues from this customer), deduct total costs, and compare with required regulatory capital
  7. If return on capital too low vs. management policy, decide whether or not to extend credit based on relationship
  8. Negotiate loan agreement/covenants

Those steps require human resources in relationship management, risk management, legal and treasury. As the process has been lengthened and complexified by Basel 3 in the post-crisis years, it is unsurprising that banks, already facing declining revenues and costs-cutting (i.e. staff), haven’t been able to grow their balance sheet as rapidly as bank reserves were flowing into the system. Moreover, faced with harsher capital regulations and unending litigation costs in a world of low or negative interest rates, banks found it extremely hard to find remunerative lending opportunities. Consequently, many banks have now entirely exited a number of lending products whose marginal costs have been pushed up by regulation above their marginal revenues. They have deleveraged in order to be compliant with capitalization rules rather than raise capital to avoid diluting shareholders already suffering from  zero return (therefore at risk of exiting their investment altogether). I guess I don’t have to explain that a deleveraging banking system is antithetical with a rising MM.

Finally, I shall include monetary policy in the "regulatory dynamics" category, and more particularly the decision by a number of central banks to pay interests on excess reserves. It is not the purpose of this post to focus on this rather strange monetary tool; George Selgin wrote plenty of excellent posts deconstructing its rationale.

A last note however. While we’ve mostly been describing the factors influencing the supply of credit, let’s not forget to factor in the other side of the equation: demand for credit. During or following a credit crisis, borrowers often attempt to repair their balance sheets by deleveraging, affecting the demand for new loans.

In the end, it looks unsurprising to see the money multiplier remaining so low and taking decades to recover following a rapid fall. As history shows, this is a recurring fact, dictated by the day to day operating rigidities of the business of banking, and with consequences for the bank lending channel of monetary policy. Our dear multiplier isn’t dead; it is just sleeping and merely unlikely to reach pre-crisis levels for another few decades.


*Such rapid growth rate in the 1980s is probably linked to banks trying to add more remunerative lending to their portfolio as rapidly as possible. This is because, as both nominal interest rates and inflation were shooting up, banks’ margins were becoming rapidly compressed due to legacy lending extended in earlier periods of lower nominal rates.

[This article originally appeared on Spontaneous Finance]

  • Benjamin Cole

    I enjoyed this post.
    Two thoughts:
    Commercial and industrail lending has been rising at double-digit rates for several years.
    Still, more than 80% of commercial bank lending is property lending in the US. To talk about banks is to talk about property markets.

    • Las Vegas has turned from an ownership town to a town of renters, Benjamin. I think that is happening in many places. Housing is picking up according to Business Insider, so, maybe lending standards have secretly been lowered.

    • Julien Noizet

      You are absolutely correct. Since the 1980s real estate lending has become the largest share of banks' loan books.
      This somewhat simplifies the steps highlighted above, at least for small residential property lending. Commercial real estate is another story. But regulation still bites, and I actually could have pointed out in the post the effects of the Basel 3 leverage ratio, on top of all the other new rules.

  • There is no such thing as the "money multiplier", it's a fiction that has been debunked by both the Fed and the Bank of England. Banks do not loan their reserves nor do the need reserves to make loans.
    Explained here: http://carl-random-thoughts.blogspot.com/

    Bank reserves, in total, are small percentage of demand deposits. Reserves held by the Fed consist of Mortgage Backed Securities, Treasuries and about $185-Billion in uncollateralized cash.

    The total U.S. legal tender money supply is currently $1.46-Trillion in circulation around the globe with about $280-Billion of that in circulation and in bank vaults within the U.S.

  • Spencer Hall

    Remunerating interbank excess reserve balances, IBDDs, has emasculated the Fed’s “open market power”, viz., the Central Bank's sovereign right to promulgate the creation of new money and credit: at once and ex-nihilo.

    I.e., "pushing on a string" only applied prior to the nominal legal adherence to the fallacious "Real Bills Doctrine" which was terminated in 1932 – due to a paucity of eligible (hopelessly impaired),
    commercial and agricultural paper for the 12 District Reserve bank’s discounting purposes. Gov'ts weren't made eligible until the 1933 Glass-Steagall Act, or U.S. Banking Act of 1933, with the (with further liberalization of the eligible collateral accepted provided in the Banking Act of 1935 – “secured to the satisfaction of the Federal Reserve Bank”).

    Historically, coming out of a recession, the commercial banks, today’s DFIs, bought highly liquid, short-term assets, pending a more profitable disposition of their legal and economic lending capacity, i.e., between 1942 and Oct 6, 2008, the CBs remained fully “lent up”, the CBs minimized their non-earning assets, their interbank demand deposits.

    Indeed, in direct contrast to the GR, excess reserves balances actually fell during some economic recessions, 12/69 – 11/70; 11/73 – 3/75; 1/80 – 7/80; 7/81 – 11/82 (i.e., until the S&L crisis). Excess reserve balances never exceeded > $2b, and only for 1 month, in 1/91 (and not over $4b until 8/07,
    and then not exceeding that threshold until 9/08 (just before the payment of interest on excess reserve balances turned non-earning assets into commercial bank’s earning assets on 10/6/08).

    The CBs always responded (by purchasing short-term securities), without delay – to any injection of excess reserve balances, i.e., to any excess lending capacity, by the Central bank. I.e., the CB’s response was always self-correcting, or counter-cyclically (without Gov’t intervention), by expanding the money stock (buying securities and zero risk weighted gov’t securities, not necessarily making loans). And today, in contrast to the Great Depression, there is a surfeit of eligible collateral (viz., considering our 19 + trillion dollar federal debt).

  • Spencer Hall

    The "monetary base" has never been a base (multiplier), for the expansion of new money and credit. Flawed as the AMBLR figure is (Adjusted Member Bank Legal Reserves), it was superior to the Domestic Adjusted Monetary Base (DAMB) figure, which is generally cited. The DAMB figure included AMBLR plus the volume of currency held by the nonblank public (Milton Friedman’s “high
    powered money”).

    Any expansion or contraction of DAMB is neither proof that the Fed intends to follow an expansive, nor a contractive monetary policy. Furthermore any expansion of the non-bank public’s holdings of currency merely changes the composition (but not the total volume) of the money supply. There is a shift out of demand deposits, NOW or ATS accounts, into currency. But this shift does reduce member bank legal reserves by an equal, or approximately equal, amount.

    An expansion of the public’s holdings of currency will cause a multiple contraction of bank credit and checking accounts (relative to the increase in currency outflows from the banks) ceteris paribus. To avoid such a contraction the Fed offsets currency withdrawals by open market operations of the buying type (e.g., purchases of governments for the portfolios of the 12 Reserve Banks). The reverse is true if there is a return flow of currency to the banks. Since the trend of the non-bank public’s holdings of currency is up (ever since 1930), return flows are purely seasonal & cannot therefore provide a permanent basis for bank credit and money expansion.

    And all currency gets into circulation, directly or indirectly, through the liquidation of time deposits, by the cashing of demand deposits. There is one exception in demand deposit creation; those historical instances when the U.S. Treasury borrowed from the Federal Reserve Banks. However, it cannot be said (as of time deposits), that increases in the public’s holdings of currency reflect prior commercial bank credit creation. It is more appropriate to say that expansions of currency are accompanied by concurrent expansions of Reserve Bank Credit.

    Although the DIDMCA of March 1980 made all depository institutions maintain uniform reserve requirements (but placed no restrictions on non-bank pass thru accounts), thereby expanding the “source base” from 65% of the commercial banks to 100% of the money creating depository institutions; Paul Volcker’s unconventional reserves-based-operating-procedure” was not unsuccessful. It was untried. This was because the BOG attempted to target only non-borrowed reserves (when at times, 10% of all legal reserves were borrowed). I.e., $1b of reserves in 1980 (borrowed or otherwise), supported $16b of M1. I say Volcker “attempted” because legal reserves grew at a 17% annual rate-of-change, from April 1980, until the end of that year. This presaged a 19.1% surge in nominal GNP in the 1st qtr 1981.

    Contrariwise, this so-called “operating procedure” (monetarism), was never “abandoned”, it was never tried. Monetarism involves more than watching the aggregates, it involves properly controlling them. Monetarism is not identical to smoothing percolating reserve position pressures (see factors affecting reserve balances, H.4.1 release), or what Paul Meek’s (FRB-NY assistant V.P. of OMOs and Treasury issues), stated objective in his 3rd edition of “Open Market Operations” published in 1974: of “gauging the general availability of non-borrowed (interbank) reserves in the commercial banking system (which vastly predates Paul Volcker’s experimental and rhetorically couched approach in Oct 1979).

    One dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days was
    immaterial. A new advance could be obtained, or the borrowing bank replaced by other borrowing banks. That's before the discount rate was made a penalty rate in January 2003 (see: Walter Bagehot in his book Lombard Street: "lend freely and at a penalty rate). And the Federal funds "bracket racket" was simply widened, not eliminated. Monetarism has never been tried.

    Between 1942 and September 2008, member commercial banks operated with no excess legal reserves of consequence. However legal reserves were actually only “binding” between c. 1942 until 1995. Since 1995, increasing levels of vault cash (larger ATM networks), retail and commercial deposit sweep programs, fewer applicable deposit classifications (including the "low-reserve tranche" & "exemption amounts"), & lower reserve ratios, have combined to remove most reserve, & reserve ratio, restrictions (including a 40 percent drop in overall reserve requirements during the early 1990’s).

    Subsequent to this period (in conjunction with the Emergency Economic Stabilization Act of 2008), Regulation D was amended, & the Board gave the District Reserve Banks the authority to pay the member banks quarterly interest on their (1) required and (2) excess reserves. As a result of the FED’s quantitative easing programs, unused excess reserves expanded dramatically (absent credit worthy borrowers and a paucity of competing assets). This new policy instrument (IOeRs), are contractionary & induce dis-intermediation within the non-banks (where the non-banks shrink in size & the commercial banking system’s size remains unaffected).

    The DIDMCA’s legislation also permitted the Federal Reserve Banks to offer the money creating depository institutions, monthly earning credits on their contractual clearing balances (prudential reserves). These clearing balances are not included in the “source base” (the base for the expansion of money and transmission of credit). The growth in these balances accelerated after the December 1990-92 cuts in, and removal of, specified reserve requirements. Since then, clearing balances initially moved inversely (as a replacement), with the diminishing volume of required reserves.

    Intra & inter-bank clearings, (debits and credits) are safeguarded from imbalances (overdrafts), using supplementary reserves (known as day-light-credit). Thus, at one time, the actual “source base” included 4 inter-bank balances held at their District bank, (owned by the member banks): (1) excess, (2) required, (3) contractual clearing, & (4) supplementary.

    Excess reserves are equal to total reserves (which since 1959 includes liquidity reserves, i.e., surplus and applied vault cash), minus the member bank’s (2) required reserves, minus an unknown volume
    of (3) Basel LCRs. The volume of excess reserves represents the banking system’s, unused, or its potential, incremental lending capacity. With this incremental lending capacity the banks have the legal capacity to “create credit”.

    The Reserve Requirements Simplification Rule (introduced on July 12, 2012), amended Regulation D (Reserve Requirements of Depository Institutions), by reducing the member bank’s administrative and operational costs by:

    (1) creating a common two-week maintenance period

    (2) creating a penalty-free band around reserve balance requirements in place of using
    carryover and routine penalty waivers

    (3) discontinuing as-of adjustments related to deposit report revisions and replacing all other as-of
    adjustments with direct compensation

    (4) eliminating the contractual clearing balance program

    Regulation D, by commingling legal reserves with required reserves, has made the job of monetary management more difficult.

    In our Federal Reserve System, 90 percent of “MO” (domestic adjusted monetary base) was currency prior to Oct. 6, 2008. There is no “expansion coefficient” assigned to the currency component. And the currency component of MO is so prominent, and the proportion of legal reserves so negligible (and declining); that to measure the rate-of-change in currency held by the non-bank public, to the rate-of-change in M1 (where 54% was currency), is, yes, to measure currency vs. currency (cum hoc ergo propter hoc); in probability theory and statistics, not a cause and effect relationship.

    Complicating the measurement of the monetary base is the fluctuation in the percentage of foreign currency circulation, to domestic currency circulation. The FED’s research staff estimates that foreigners hold one half to two thirds of all U.S. currency (this spread can result in a wide margin of error). Inflows and outflows of foreign-held U.S. currency (seldom repatriated) are attributed to political, and price, instability (as well as to seasonal flows), and all are immeasurable in the short run. I.e., the domestic monetary source base equals the monetary source base minus the estimated amount of foreign-held U.S. currency.

    The “shipments proxy” estimate of foreign-held U.S. currency uses data on the receipts and shipments of currency, by denomination, at the Federal Reserve’s 37 cash offices nationwide (note: > 80 percent of foreign-held U.S. currency are $100.00 bills). Because of its influence on the DAMB, quarterly estimates of foreign-held U.S. currency are reported in the Feds “Flow of Funds Accounts
    of the United States” & in the BEAs estimates of the net international investment position of the United States.

    The volatility of the (1) K-ratio, the public’s desired ratio of currency to transactions deposits (or currency-deposit-ratio), and the volatility in (2) the ratio of foreign-held, to domestic U.S. currency, both influence the trend rate for the cash drain factor (the movement of the domestic currency component of the DAMB). And the evidence points to sizable (& unpredictable), shifts
    in the money multiplier (MULT – St. Louis), for the constantly changing shifts in the composition of the “M’s”.

    The Federal Reserve Bank of Chicago uses legal reserves (“t”-accounts), exclusively, to explain the creation of new money and credit in the booklet “Modern Money Mechanics”. The booklet is a workbook on bank reserves and deposit expansion (changes in a bank’s deposits-loans resulting from open market operations). The stated purpose of the booklet is to “describe the basic process of money creation in a "fractional reserve" banking system” – the monetary base plays no role at all in this analysis.

    It is therefore both incorrect in theory, and thus inaccurate in practice, to refer the DAMB figure as a monetary base [sic]. The only base for an expansion of total bank credit and the money supply is the volume of legal reserves supplied to the member banks by the Fed, in excess of the volume necessary to (1) offset currency outflows from the banking system & (2) offset fluctuations in the level of member bank’s reserve balances (diverted & detained via the remuneration rate), in the 12 District Reserve Banks. The adjusted member bank legal reserve figure is that base.

  • Len Blake

    Well a good bank might want to place money in Operating companies via the Moskowitz Principle of Cross Collateralization. By converting to Debt to Equity in operating Company the effective return jumps considerably. K.K Moskowitz is buoyant about the stock symbol OPK, so Longacre Financial has
    converted debt to equity and when PFE buys OPK (per George Barnard of Porter Associates) at$44
    per share, the yield curve is extrapolated at rate of 9,9%!