The “Money Multiplier”

The “Money Multiplier”

October 21, 2007


Money doesn’t multiply. If you take $1m of $20 bills, and put it in a briefcase, and you opened it ten years later, there would still be $1m of $20 bills. Excepting counterfeiters, only the Fed can create base money. “Base money” is our word for money — other forms of so-called “money” are really forms of credit.

Money is pretty simple. It has a value, which represents the balance of supply and demand for the currency. The Fed (or whatever entity is managing the currency, if you don’t like the Fed) can adjust supply at will to properly balance it with demand. That’s about it. As long as the value is stable, there really isn’t much more to worry about, with the possible caveat of liquidity-shortage type events, which represent a short-term increase in demand for money.

Historically, there has been an idea of the “money multiplier,” which is the notion that banks “multiply” money through various forms of credit. This remains a common idea among economists today, although they are not as fixated on the idea as they were twenty years ago, I think. In my copy of the textbook Economics: private and public choice (2003) the “money multiplier” is described on pages 299-301. John Hussman, the economics professor turned asset manager, has written extensively about the idea of the “money multiplier,” and how it doesn’t exist in real life.

The gist of the “money multiplier” is that an increase of base money leads to “multiplication” of this base money by the banking system, which leads to credit growth, and thus a flush and healthy economy. When (as is so often the case), this process doesn’t work, we start to hear about the “broken transmission mechanism.” This was a popular phrase regarding Japan in the 1990s. I suppose this “money multiplier” idea has roots as one of those concepts that was repopularized in the 1930s. The notion that the world economy could be saved from itself via central bank manipulation seized the minds of generations of economists, including our current Fed chairman Ben Bernanke, who based his career on the notion that a bit of Fed nonsense would have averted the Great Depression.

The reason that the “transmission mechanism” so often seems “broken” is that it doesn’t exist in the first place. Think about it. Why does a bank lend money? Why does an entity borrow money from a bank? It takes two to tango. If you put a hundred bankers in a room, and asked them, “why did you make your last loan?” not one of them would say, “I was multiplying money in response to the Fed’s increase in base money.” Indeed, in practice it most often works the other way around: two parties decide to enter a credit contract, and if, for whatever reason, the creation of this credit contract results in a greater need for base money to undertake the transaction, then this greater demand would, if things are working properly, be met with greater supply by the central bank. So the transmission mechanism is really the other way around — the supply of a properly managed currency will adjust in response to changes in demand for currency, which arise through all the transactions of the economy including credit transactions.

This is not to say, as Hussman sometimes argues, that a central bank has no effect on credit conditions. It most certainly does. However, those effects are primarily a) regulatory/moral suasion, b) changes in the value of money, and c) changes in interest rates as a result of central bank policy. Here’s a concept:

Credit is just people making deals.

People enter into credit contracts, both borrowers and lenders, voluntarily. It is a “free market.” It’s just people making deals. Nothing unusual there. However, their decision to enter into a contract, and the terms of the contract, can certainly be affected by the three avenues of central bank influence listed above.

The central bank manipulators are much enamored of the “money multiplier” concept, as it lies at the root of their theories of government manipulation of the economy. However, the more libertarian types are also equally confused about the “money multiplier,” leading to the excessive fascination with credit today. To take one example, former Fed chairman Greenspan is often blamed today for the US housing bubble and associated lending silliness. Although people rarely mention a “money multiplier” explicitly in this case, the basic concept it the same — namely the idea that hundreds of independent financial institutions, and millions of freely-acting borrowers, entered into certain transactions due to some sort of centralized control. Actually, the Fed’s influence was limited to a) regulatory/moral suasion (they didn’t say don’t do it), b) changes in the value of money (generally reflationary in 2002-2005), and c) changes in interest rates (low, in response to the deflation of 1997-2002). This was certainly influential, but not really in the way that many people imply.

Another place the libertarian types stumble is regarding the “money multiplier’s” effect on monetary value. After all, if banks “multiply” money, and “too much money” leads to inflation, then banks and the “money multiplier” must cause inflation, right? This “too much money” that causes inflation is not credit, but base money, and the only entity that creates base money today is the central bank. Commercial banks did create base money in the past, in other words they printed their own currencies. However, since the currencies were redeemable for gold, and the banks adjusted their supply of currencies appropriately, this was generally not a problem. If the central bank today creates too much base money, then the value of the currency (as noted in the exchange rate with gold and other currencies) will decline. This is inflation. If banks create credit, in any amount, but the central bank manages base money supply and currency value appropriately so that the value of the currency is stable (against gold), then there will be no inflation. It is possible that you could have entirely too much credit, possibly accompanied by a certain unsustainable economic frenzy or an asset bubble. But you won’t have inflation.

The concern among libertarian types about banks’ supposedly inflationary “money multiplier” leads to their somewhat hysteric denunciation of “fractional reserve banking,” supposedly a great horror. When banks’ real role is understood, this “fractional reserve banking” fascination dissipates. I think this is somewhat irrational emotional residue that remains over many bad experiences with banks over the years. Before the advent of deposit insurance in the 1930s, in very many instances small-scale savers who thought they had “money in the bank” were shocked to find out that the money wasn’t really there. In fact they were making loans to the bank, and the bank, going bankrupt, was unable to pay them back. Also, on a more sophisticated note, the presence of so many levered lenders (as opposed to direct, asset-based lending) does create pressure on currency managers to “do something” in the event of widespread default, and that “something” often amounts to some sort of money printing/currency devaluation.

So, I think we can see that there is no “money multiplier,” and banks/credit creation is really no inherent threat to the stability of currencies. Currencies are managed by adjusting supply in response to demand, to maintain a stable value. Banks are just another form of business — they do what they do. The whole process is a lot simpler than most people think.

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Martin Feldstein popped up in the FT last week, espousing on the wonderful advantages of a declining dollar.

Feldstein, a professor at Harvard who was chairman of the Council of Economic Advisors under Reagan (and who was also short-listed as Alan Greenspan’s replacement), leads with the idea that a lower dollar would help reduce the U.S.’s current account deficit, now running about 6% of GDP. This is a disastrously bad idea, and the fact that Feldstein is out in public flogging it at this time suggests that perhaps some Administration types are thinking the same way. Well, they might get the results they expect — a smaller “current account deficit” — but not in the way they think.

A “current account deficit” is really a measure of imported capital. It is matched with net importation of goods and services because capital is, actually, goods and services. The paper part is just a contract saying who gets paid what in return for the capital (goods and services) imported.

In an economy, there are generators of capital (“savers”) and recipients of capital. On a cashflow basis, the “savers” are cashflow-positive and the recipients are cashflow-negative. These recipients of capital could be making sound investments. On average, the corporate sphere, which is normally a capital-user, makes productive investments. Other potential recipients of capital include the government and the consumers. The corporate sector normally generates positive cashflow from operations, but invests an amount greater than that in capex, leading to a net demand for additional capital. You could say that the corporation is running a “current account deficit.” Consumers are normally capital generators (“savers”) in aggregate, although that is not the case today. The government is normally a cashflow-generator when it is running a surplus, and a cashflow-user when it is running a deficit.

The world is basically an open market, so when the cashflow-generators in an economy (normally the citizens) look for places to invest their capital, they can potentially look worldwide. When the cashflow-users in an economy (normally the corporations and often the government) look for sources of capital for their needs, they also look worldwide. Today, with a low savings rate (often negative) and large government deficits, on balance there is much more demand for capital than there is creation of capital in the U.S. The result, of course, is that the demand for capital is satisfied in some part by foreign capital, producing a “current account deficit.”

This is all fairly mundane, conventional economics. You’ll notice, however, that there is NO mention of currency value in the above description. Thus, we can also see that WHATEVER THE CURRENCY DOES, the “current account balance” will reflect the relative balance of the supply and demand of domestic capital.

Rather, the currency value affects this system in other ways. For example, if the U.S. dollar tanks (as it is doing now), then foreign investors may be unwilling to export capital to the U.S. and accept U.S. dollar debt in return. What would happen if all foreign investment stopped, as appears to be indicated in the most recent TIC data? Then, of course, U.S. capital creation and capital use must balance. The U.S. consumer savings rate would most likely go up, corporate capital use might go down, and the government budget deficit might go down too (in this case forced by higher interest rates). We are likely to see the consumer savings rate go up soon, as the primary use of capital among consumers (home equity loans) is shutting down rapidly. This is likely to lead to a falloff in consumption, which doesn’t inspire corporations to invest much. The government will do what it does. In the end, markets clear via price, and price in this instance is primarily interest rates. Higher interest rates tend to encourage savers and discourage borrowers. With higher rates, foreigners might become interested again.

Thus, if there is a correlation between a sinking currency and a shrinking current account deficit, it is not necessarily because of “trade” but rather because of the deteriorating investment environment in a country experiencing devaluation and inflation. At some point nobody would want to invest there (foreign or domestic), in which case all capital would be exported to more promising locales, and the country would run a current account surplus! Likewise, countries that have exceptionally good conditions for growth (typically among emerging markets) will often run very large current account deficits as capital is imported. This hasn’t been the case so much recently, because emerging markets (particularly China) have also had very high savings rates recently, so the great demand for capital has been satisfied by domestic sources, on balance.

However, whenever foreign capital is employed, there are currency issues involved. The U.S. doesn’t have this so much because entities typically issue debt in dollars. We’ll talk more about that some other day.

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Thanks to Jim Puplava for offering to interview me for his wonderful Financial Sense radio program and website. Jim and his guests are very sophisticated, and it was an honor to be on the show. Here’s the recording of the interview. I’m afraid I was a bit of a rambler for the show — Jim was asking questions of a sort I haven’t been asked before, so I didn’t have my answers worked out. (Also, we had some technical problems which impaired our ability to chit-chat.) Jim read my book (not necessarily so common among interviewers) and I can tell he was really able to appreciate what I was getting at. Thanks again Jim!