Almost every single mainstream economic textbook teaches some version of the money multiplier theory of banking. In short, this is the view that $1 of central bank reserves allows a bank to make $10 of loans or something like that. The basic premise works from the causation that Central Banks control the money supply. Of course, as I’ve explained many times before, this is completely backwards. Banks make loans by creating deposits and Central Banks supply reserves as needed. The Central Bank has only an indirect control on the supply of net financial assets in the financial system at any time.
This myth has caused a good deal of confusion over the last 7 years as many of the most prominent economists in the world have expressed concerns about reserves “getting out” into the economy as banks “lend them out”. You can see this list of prominent economists expressing this concern over the last 7 years. The latest example of this can be seen in a recent piece by the Minneapolis Fed talking about how the danger of inflation is lurking thanks to the excess liquidity in the form of reserves. The author writes:
“What potentially matters about high excess reserves is that they provide a means by which decisions made by banks—not those made by the monetary authority, the Federal Reserve System—could increase inflation-inducing liquidity dramatically and quickly.
for every dollar in excess reserves, a bank can lend 10 dollars to businesses or households and still meet its required reserve ratio. And since a bank’s loan simply increases the dollar amount in the borrower’s account at that bank, these new loans are part of the economy’s total stock of liquidity. Thus, if every dollar of excess reserves were converted into new loans at a ratio of 10 to one, the $2.4 trillion in excess reserves would become $24 trillion in new loans, and M2 liquidity would rise from $12 trillion to $36 trillion, a tripling of M2.”
That sounds scary. Thankfully, it’s totally unwarranted. As I’ve explained before, bank lending is primarily demand driven. Banks can’t just force people to take on new loans. And since balance sheets have been recovering from the debt crisis and the housing bust there has been abnormally low demand for new debt. But the more important point is that the author’s operational understandings are simply wrong. Banks can’t liquefy the economy by choosing to turn their reserves into loans because having more reserves doesn’t give banks the ability to make more loans in the first place. This gets the causation backwards.
The reason QE didn’t cause sky high inflation has nothing to do with interest on reserves or banks failing to convert their reserves into new loans. This thinking is like the apple salesman who thinks that stocking the shelves with more apples will lead to more demand. This gets the causation wrong though. The reason QE didn’t cause inflation was because the demand for new debt was low and adding more reserves to the banking system wasn’t going to give banks the ability to make more loans in the first place. Instead, the low inflation has been largely the result of low demand for new debt (among other factors). Economists have had the causation wrong here for decades. All QE did was expose the operational reality of banking. Unfortunately, old lessons don’t die fast. And so the myth of the money multiplier continues to haunt us to this day….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.