Why the money multiplier remains so low

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.


7 responses to “Why the money multiplier remains so low”

  1. The General says :

    Great blog. A recent post by John Tamny, where he repeated a claim that the money multiplier doesn’t exist, led me down a rabbit hole that ended up here.

    I think I have a better understanding of how the multiplier works (or perhaps a renewed understanding, since I feel I am very much back, at least in spirit, where I started with Rothbard’s analogies in Mystery of Banking).

    My question is this: is there any way in which the Fed promotes inside money creation, outside of asset purchases? Would inter-bank transfers, for instance, differ in any substantial way without the Fed?

    Effectively, would there be any difference between a banking industry with a central bank that never bought assets, and a banking industry without a central bank?

    • Julien Noizet says :

      Apologies for the late reply.

      It’s an interesting and potentially tricky question.
      First, we shouldn’t forget reserve requirements, which represent a limit to the creation of inside money. We also shouldn’t forget that no economy is closed, and funding can potentially come from abroad. Let’s assume there is no reserve requirements in a closed economy.
      Then my view, as I wrote elsewhere, is that the market is the entity that defines a limit under the form of ‘liquid reserves’ they believe must be held by a given bank to be considered safe. This liquid reserves might be different for different banks, and comprises both cash and ‘secondary reserves’ under the form of highly liquid high quality assets.
      But this market-defined ‘limit’ isn’t permanently set and evolves over time with market sentiment. In a boom period, the market may well believe that fewer reserves are necessary, allowing banks to expand their inside money further. In bad times, the market wants banks to hold more reserves, forcing them to contract their lending.

      Now if we factor in reserve requirements and an open economy, it becomes quite a bit more complex…

      • mrkemail2 says :

        “First, we shouldn’t forget reserve requirements, which represent a limit to the creation of inside money.”

        No they don’t. Many nations do not use reserve requirements which are just devices to smooth out variations in overnight bank interest rates and do nothing to constrain lending.

        A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

        The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.

        So it is quite wrong for example to assume that the central bank can influence the capacity of banks to expand credit by adding more reserves into the system.

        Use the discount window Luke.

      • Julien Noizet says :

        No this is wrong mrkemail2.

        I suggest you real some of my posts on endogenous money (there is one link in this post). Banks thrive to AVOID borrowing from the central bank. Not because of the interest rate, but because of the stigma. This is well researched, and completely forgotten by endogenous money theorists.
        Second, plenty of countries use reserve requirements with significant effect on lending growth, as research has also shown.
        Third, the market would never let a bank expand its loan book without paying attention to its reserve holdings.

      • mrkemail2 says :

        Thanks for the response. I don’t agree entirely so I will try to flesh some things out.

        “because of the stigma”

        True, but here in the UK we have Funding for Lending, which is essentially a discount window the banks are not afraid to use. Banks get access to more funding if they increase their lending over time and even more cheap funding if they lend or cause certain others to lend to SMEs. That can reduces the backfill costs for a bank. Which is of course a form of central planning.

        My main point is reserve and capital ratios don’t *stop* the banks lending. They may slow them down, or they may put the current price of money up, but that’s about it. A hard constraint they are not.

        The textbook money multiplier story is completely wrong because banks do not lend reserves. The causality central to the money multiplier narrative is false. Sorry.

        To understand why you have to go back to the fundamentals. Loans create deposits. Deposits are used to buy capital in banks. Banks backfill any shortfalls in their ratios after the event.

        A loan doesn’t happen at an instant in time. It is a lengthy process (known as the ‘sales pipeline’). When you get prospects in the door with a loan application, you can use statistics to estimate how many of those will actually end up drawing down a loan. That, along with lots of other data, is used by the Funding and Treasury departments in a bank to make sure all the numbers add up – and to constantly update the current price of money and feed it back to the sales teams.

        So to get capital all a bank has to do is persuade enough depositors to swap some of their shiny new deposits for capital bonds and the regulator is a happy bunny again. The bank persuades people to buy capital bonds in the usual fashion – they pay a greater return on them.

        Similarly with the reserve ratio. The central bank has to make sure there are enough reserves in the system so that all the banks can hit their reserve ratios. If they don’t then they *lose control of their policy rate*. The banks all then borrow and lend the reserves to each other until everybody conforms with what are arbitrary ratios.

        The only constraint is if banks run out of creditworthy borrowers prepared to pay the current price of money.

        “We also shouldn’t forget that no economy is closed, and funding can potentially come from abroad.”

        I would like to go further into this point, as it seems quite complicated.

        For example the UK is effectively a closed economy in Sterling. Sterling doesn’t occur anywhere else and isn’t used anywhere else independently. All Sterling roads lead ultimately to the Bank of England.

        Even though the banks can raise potentially unlimited amounts of money offshore, isn’t their ability to lend it out here in the UK going to be ultimately limited by how much $ (or whatever) currency is available here to exchange the foreign money they’ve raised into? Surely someone has to exchange £s for $s in the opposite direction.

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