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 capitalisation 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 post was re-published on Alt-M.

Following my latest post on the regulatory regime uncertainty caused by Brexit, evidence of the damages has started to emerge.

Unsurprisingly, and in line with the studies mentioned in my previous post, uncertainty is affecting both the demand and supply sides of credit.

On the demand side, the FT reports that

like other small British companies … longer term prospects have been altered by the EU referendum. Last month’s vote has dramatically increased uncertainty on issues ranging from regulatory standards to supply chains. […]

Other local companies have reported laying off staff, raising prices, or scaling back on investment plans, among a range of responses that also include seeking to take advantage of the weaker pound, in a survey compiled by Business West, a lobby group in the south-west of England.

This is evidently not conducive to borrowing and investments, and City AM reports that the number of M&A deals in Britain indeed significantly dropped in the first half of the year. Furthermore, the FT also reports that large British banks “expect demand for credit from businesses and households to fall as a result of post-Brexit economic uncertainty, according to a Bank of England review.”

The same article seems to show that, on the supply side, banks are for the time being only tightening commercial real estate lending given their pessimistic view of the sector (which also was a major contributor to UK banks’ losses during the financial crisis).

Finally, another FT article shows that

An index tracking sentiment in the European banking sector has reached an all-time low, even surpassing levels seen in 2012 when Mario Draghi promised the European Central Bank was prepared to do “whatever it takes” to stabilise the bloc and protect the euro.

This is likely to affect the supply of credit in medium-term across the whole of Europe as Brexit uncertainty exacerbates already-existing European banking issues. The shorter this lasts the better.

Sadly, this situation could take up to six years, according to the UK foreign minister…

The British voted in favour of leaving the European Union at the end of last week. Whether the UK effectively leaves the EU and what sort of arrangement emerges is yet to be determined. What is certain is that the business world now finds itself in the most uncertain of political environments: no one knows what kind of ruleset is actually going to be put in place and how long this state of limbo will last.

The whole situation is likely to prove damaging for the UK economy as businesses freeze hiring and investments until they have a better understanding about the rules they’re going to have to comply with. Brexit is in effect a typical case of what Robert Higgs named ‘regime uncertainty’.

Higgs described how regulatory regime uncertainty considerably hampered private investments in the US in the 1930s, which in turn affected economic recovery. This period saw Hoover and then FDR’s New Deal make considerable changes to the US legal and regulatory frameworks. According to Higgs:

given the unparalleled outpouring of business-threatening laws, regulations, and court decisions, the oft-stated hostility of President Roosevelt and his lieutenants toward investors as a class, and the character of the antibusiness zealots who composed the strategists and administrators of the New Deal from 1935 to 1941, the political climate could hardly have failed to discourage some investors from making fresh long-term commitments … there exists a great deal of direct evidence that investors did feel extraordinarily uncertain about the future of the property-rights regime between 1935 and 1941. Historians have recorded countless statements by contemporaries to that effect; and the poll data presented earlier confirm that in the years just before the war most business executives expected substantial attenuations of private property rights ranging up to “complete economic dictatorship.

Seen in light of modern expectations framework, Higgs’ theory does make sense: businesses are unlikely to engage into activities whose legal treatment is uncertain. In one of my first ever posts I wrote that, given the uncertainty inherent to a productive process that takes time, a stable ruleset and predictable property rights treatments were fundamental features of intertemporal coordination between savers/investors and borrowers/entrepreneurs.

Stable rules provide a clear guide to entrepreneurs: constraints are known in advance allowing them to anticipate future demand and plan accordingly with the understanding that their investments are protected as long as they remain within legal boundaries. The Rule of Law – what Hayek described as a ‘meta-legal’ framework that spontaneously and progressively emerged, and which is mostly incarnated today by the Common Law – represents the most effective instance of stable rules. But even the less stable Civil Law – which is mainly comprised of what Hayek called ‘legislation’ – can represent a relatively effective legal framework as long as rules aren’t changed on a regular basis. Surprisingly however, the academic litterature on regime uncertainty remains rather thin.

Coincidentally, a paper published earlier this year by Bordo, Duca and Koch (Economic Policy Uncertainty and the Credit Channel: Aggregate and Bank Level U.S. Evidence Over Severa Decades, also available on NBER here) adds extra empirical evidence to Higgs’ original findings. Basing their research on a recently published ‘economic policy uncertainty index’ (EPU thereafter), and controlling for other macroeconomic indicators, they look at how regime uncertainty affects bank lending in the US between 1961 and 2014. Overall, they find that

policy uncertainty significantly slows U.S. bank credit growth, consistent with it having an effect on broad loan supply and demand. We find that lagged changes in the EPU index are negatively and significantly linked to the growth rate of bank lending both at the aggregate and cross-sectional levels.

They also find that this effect is more pronounced for larger, less well-capitalised banks, as well as banks holding smaller amounts of cash reserves, and that the effect is likely amplified in Europe*:

The results have several important implications. First, statistical evidence suggests that economic policy uncertainty has affected bank lending in the U.S., which other studies have found to have important effects on economic activity and which we also find. This could have implications for Europe, where the Baker-Bloom-Davis (BBD) index of economic policy uncertainty rose more than in the U.S. during the post-crisis slump and the economies are more bank dependent. More recently, the EPU index in Europe has not recovered as quickly as in the U.S., where the subsequent recovery in bank-lending growth has been stronger as has been the overall recovery in GDP growth.

Given that London represents a substantial share of Europe’s financial activity and is the main Euro clearing centre (a situation that the ECB has fought for years), the implications for a post-Brexit Europe are clear. Domestically, the demand and supply of loans in the UK are likely to remain subdued as long as the legal framework that will apply to British banks and corporations in the future is unknown. The uncertainty is also going to hurt foreign banks, which have large operations in London thanks to the UK’s ‘passporting’ rights (which allow financial firms based in the UK to offer services throughout the EU under single market rules). Many of those institutions are unsure whether to move operations to other EU jurisdictions as nobody knows if the UK will be able to retain single market access and Euro clearing. This paralyses business-making in a period of already heightened regulatory uncertainty.

Legal uncertainty affecting the financial sector is of the worst kind given its repercussions on economic activity. It is therefore unsurprising that, following the Brexit vote, stockmarkets in the EU have fallen more than those in the UK. The announcement even triggered the worst fall in EU banks’ share price in history.

Brexit will have repercussions on lending and investments both in the UK and in the EU as long as this state of uncertainty lasts. And it can even end up being more damaging for other EU countries, already suffering from low economic growth and constantly-changing banking regulation. Of course, politicians seem unaware of this issue: some of the top ‘Leave’ campaign leaders mentioned triggering the article 50 of the Lisbon Treaty (which brings about the departure of a member of the EU) only in… 2020.

Given that it takes two years of negotiation following the trigger for a country to be formally out of the union, and that undoing EU laws while negotiating new trade deals can last many more years, it is clear that those politicians are at best – some would say unsurprisingly –  completely ignorant of the damages they are making. It took Greenland, which withdrew from the pre-EU in 1985, three years to negotiate the terms of its exit with the union at a time when EU laws were not as invasive as they are now. Good luck to Europeans.

*They also question the timing of the implementation of new harsh banking regulations (i.e. Basel 3) which may have delayed the post-crisis economic recovery in their view (a point I have made in a number of posts over the years).

PS: Bordo, Duca and Koch also provide further evidence of the 1990s deregulation myth: