Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
Yesterday, I was walking over to the library and I ran into an old colleague who has been dragooned back into teaching macroeconomics on a casual basis. The person was telling me that they were dreading taking the class next week because the topic was banking and the relationship between reserves and the money supply. Accordingly, the person said the chapter in the textbook specified by the lecturer-in-charge was about the money multiplier. The person I met is familiar and sympathetic to Modern Monetary Theory (MMT) and posed the question “how can I do it?”. My answer was that students deserved better and that the lecture should develop the multiplier from a critical perspective so that students know about it but realise how far-fetched it is as a depiction of how the banking system actually operates.
As background, I should add that I am no longer associated with the teaching faculty at the University and hold a research chair outside of the teaching and faculty structure. The research centre I direct is within the Research Division of the University. Soon after I left what was then the Economics Department, the neo-liberal managerial onslaught that is rife within Australian universities collapsed the economics discipline into a business school and wiped out a lot of the “social science” component of the program. The strongly Modern Monetary Theory (MMT) and Post Keynesian teaching emphasis of the past has been largely lost and those in charge of teaching macroeconomics here are mostly mainstream (using Dornbusch of all things as the textbook – its about as bad as Mankiw!). It is a very sad outcome for students.
Anyway, I also mentioned to the person that I had just that morning been reading a rarely cited 1963 paper Commercial Banks as Creators of “Money” – by Nobel Prize winning economist (the late) James Tobin. I had read it a long-time ago while I was doing my PhD and was alerted to it again by one of the regular billy blog readers (thanks Jeff).
The article considers the money multiplier by juxtaposing the “Old View” and the “New View” of banking. I went back into my database to see the notes I took when I read the article originally (in 1983!). It is quite amazing that articles like this get lost in the mainstream literature. Despite obvious flaws they categorically demonstrate that the material that is presented in macroeconomics textbooks and which students subsequently take away from their studies as “truth” is typically misleading and often totally wrong.
Perhaps the greatest moment of triumph for the elementary economics teacher is his exposition of the multiple creation of bank and credit deposits. Before the admiring eyes of freshmen he puts to rout the practical banker who is so sure he “lends only the money depositors entrust to him.” … [in fact] … depositors entrust to bankers whatever amounts the bankers lend … [for] … the banking system as a whole …. a long line of financial heretics have been right in speaking of “fountain pen money” – money created by the stroke of the bank president’s pen when he approves a loan and credits the proceeds to the borrower’s checking account.
In the blog – Money multiplier and other myths – I provide an elementary account of the money multiplier that is taught to students. This is a central mainstream concept which underpins its view that inflation results from budget deficits and that the central bank can control the money supply.
The mainstream macroeconomics textbooks tell students that monetary policy describes the processes by which the central bank determines the money supply. In Mankiw’s Principles of Economics (Chapter 27 First Edition) he says that the central bank has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system” and the second “and more important job”:
… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).
They link this alleged capacity to control the money supply to inflation via the belief in the now-discredited but still prominent Quantity Theory of Money.
Textbooks like that of Mankiw mislead their students into thinking that there is a direct relationship between the monetary base and the money supply. They claim that the central bank “controls the money supply by buying and selling government bonds in open-market operations” and that the private banks then create multiples of the base via credit-creation.
Students are familiar with the pages of textbook space wasted on explaining the erroneous concept of the money multiplier where a banks are alleged (according to Mankiw) to “loan out some of its reserves and create money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations.
Allegedly, the money multiplier m transmits changes in the so-called monetary base (MB) (the sum of bank reserves and currency at issue) into changes in the money supply (M).
Students then labour through algebra of varying complexity depending on their level of study (they get bombarded with this nonsense several times throughout a typical economics degree) to derive the m, which is most simply expressed as the inverse of the required reserve ratio.
So if the central bank told private banks that they had to keep 10 per cent of total deposits as reserves then the required reserve ratio (RRR) would be 0.10 and m would equal 1/0.10 = 10. More complicated formulae are derived when you consider that people also will want to hold some of their deposits as cash. But these complications do not add anything to the story.
The formula for the determination of the money supply is: M = m x MB. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the RRR = 0.10). The way this multiplier is alleged to work is explained as follows (assuming the bank is required to hold 10 per cent of all deposits as reserves):
- A person deposits say $100 in a bank.
- To make money, the bank then loans the remaining $90 to a customer.
- They spend the money and the recipient of the funds deposits it with their bank.
- That bank then lends 0.9 times $90 = $81 (keeping 0.10 in reserve as required).
- And so on until the loans become so small that they dissolve to zero
The following table shows you what the pattern involved is. The results are self-explanatory. In this particular case, I have shown only 20 sequences. In fact, this example would resolve at around 94 iterations where the successive loans, then fractional deposits get smaller and smaller and eventually become zero.
The conception of the money multiplier is really as simple as that. But while simple it is also wrong to the core! What it implies is that banks first of all take deposits to get funds which they can then on-lend. But prudential regulations require they keep a little in reserve. So we get this credit creation process ballooning out due to the fractional reserve requirements.
That is nothing like the way the banking system operates in the real world. The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.
The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government”.
This leads to claims that if the government runs a budget deficit then it has to issue bonds to avoid causing hyperinflation. Nothing could be further from the truth.
Further, the central bank does not have the capacity to control the money supply in a modern monetary system. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank. The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.
Tobin clearly knew this in 1963. After presenting the mainstream view of the money multiplier he said:
The foregoing is admittedly a caricature, but I believe it is not a great exaggeration of the impressions conveyed by economics teaching concerning the role of commercial banks … in the monetary system. In conveying this melange of propositions, economics has replace the naive fallacy of composition of the banker with other half-truths perhaps equally misleading.
Tobin then argues that this old way of thinking – which links the behaviour of the financial and monetary institutions with the real economy – ultimately via the Quantity Theory of Money – is inferior to a “new view” which is more ground in the world of the “practical banker”. The new view:
tends to blur the sharp traditional distinctions between money and other assets and between commercial banks and other financial intermediaries; to focus on demands for and supplies of the whole spectrum of assets rather than on the quantity and velocity of “money”; and to regard the structure of interest rates, asset yields, and credit availabilities rather than the quantity of money as the linkage between monetary and financial institutions and the policies on the one hand and the real economy on the other.
So financial intermediaries including banks aim to bring together borrowers “who wish to expand their holdings of real assets … beyond the limits of their own net worth” and lenders “who wish to hold part or all of their net worth in assets of stable monetary value with negligible risk of default”. The assets of the banks are the obligations of the borrowers (loans etc) while the liabilities are the assets of the lenders (deposits etc).
Interestingly – and gold bugs take note – Tobin says that:
Neither individually nor collectively do commercial banks possess a widow’s cruse. Quite apart from legal reserve requirements, commercial banks are limited in scale by the same kinds of economic processes that determine the size of other intermediaries.
The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share.
So there is a limit on bank lending imposed by the opportunities to profit and the availability of credit-worthy customers.
His Section V entitled – Fountain Pens and Printing Presses is especially interesting although I would use different terminology (especially with respect to the “printing press” characterisation).
Evidently the fountain pens of commercial bankers are essentially different from the printing presses of governments. Confusion results from concluding that because bank deposits are like currency in one respect – both serve as media of exchange – they are like currency in every respect. Unlike governments, bankers cannot create means of payment to finance their own purchases of goods and services. Bank-created “money” is a liability, which must be matched on the other side of the balance sheet.
This goes to the heart of the difference between vertical and horizontal transactions which define the relationship, in the first instance (vertical), between the government and non-government sector and, in the second instance (horizontal) between transactors within the non-government sector.
The following diagram is taken from Deficit spending 101 – Part 3 and allows you to understand the difference between vertical and horizontal transactions within a modern monetary system.
In terms of the vertical transactions between the government and non-government sector, the tax liability is characterised as being at the bottom of the vertical, exogenous, component of the currency. The consolidated government sector (the Treasury and RBA) is at the top of the vertical chain because it is the sole issuer of currency.
The middle section of the graph is occupied by the private (non-government) sector. It exchanges goods and services for the currency units of the state, pays taxes, and accumulates the residual (which is in an accounting sense the federal deficit spending) in the form of cash in circulation, reserves (bank balances held by the commercial banks at the central bank) or government (Treasury) bonds or securities (deposits; offered by the central bank).
The currency units used for the payment of taxes are consumed (destroyed) in the process of payment. Given the national government can issue paper currency units or accounting information at the central bank at will, tax payments do not provide the state with any additional capacity (reflux) to spend.
The two arms of government (treasury and central bank) have an impact on the stock of accumulated financial assets in the non-government sector and the composition of the assets. The government deficit (treasury operation) determines the cumulative stock of financial assets in the private sector. Central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds.
Tobin says in this regard:
Once created, printing press money cannot be extinguished, except by reversal of the budget policies which led to its birth. The community cannot get rid of its currency supply; the economy must adjust until it is willingly absorbed. The “hot potato” analogy truly applies.
To further understand what happens at the macro level he observes that the “preferences of the public normally play no role in determining the total volume of deposits or the total quantity of money. For it is the beginning of wisdom in monetary economics to observe that money is like the “hot potato” of a children’s game: one individual may pass it to another, but the group as a whole cannot get rid of it. This is as true, evidently, of money created by banker’s fountain pens as of money created by public printing presses.
But the important point is that portfolio preferences may be disturbed when, for example, a budget deficit adds bank reserves (high powered money) to the non-government sector. Economic adjustments then occur to resolve the desires of the private sector to hold different financial assets according to their yields and risks.
The diagram shows how the cumulative stock is held in what we term the Non-government Tin Shed which stores fiat currency stocks, bank reserves and government bonds. I invented this Tin Shed analogy to disabuse the public of the notion that somewhere within a nation there is a store where the national government puts its surpluses away for later use. There is actually no storage (that is, saving) because when a surplus is run, the purchasing power is destroyed forever. However, the non-government sector certainly does have a Tin Shed within the banking system and elsewhere.
Any payment flows from the Government sector to the Non-government sector that do not finance the taxation liabilities remain in the Non-government sector as cash, reserves or bonds. So we can understand any storage of financial assets in the Tin Shed as being the reflection of the cumulative budget deficits.
Taxes are at the bottom of the exogenous vertical chain and go to rubbish, which emphasises that they do not finance anything. While taxes reduce balances in private sector bank accounts, the Government doesn’t actually get anything – the reductions are accounted for but go nowhere. Thus the concept of a fiat-issuing Government saving in its own currency is of no relevance.
Finally, payments for bond sales are also accounted for as a drain on liquidity but then also scrapped.
The US government regularly trashes US currency notes that it collects as taxes which suggests that the “revenue” goes into the trash bin rather than is used to underpin spending!
As an aside, in the following news story you learn that the revenue also might go into recycled paper and cardboard products. The US Government was looking green in 1912!
My friend and some-time co-author Randy Wray sent me a link to a photo the other day. I did some further research and determined that the photo was part of the famous Harris and Ewing Inc. collection which was donated to the US Library of Congress in 1955.
The photo appeared in an article published by the Washington Post on June 2, 1912 and it shows officials from the “US Treasury Department, Bureau of Printing and Engraving. Destruction Committee” destroying old US currency notes. The woman is one Mrs. Louise Lester who was apparently “in charge of mutilation” and the only woman to have served in this role up to that point in history.
Here is the image from the original Washington Post story from 1912. If you want to see a clearer image of the original photo used in the story then click the photo.
Anyway, back to the story.
The private credit markets represent relationships (depicted by horizontal arrows) and house the leveraging of credit activity by commercial banks, business firms, and households (including foreigners), which many economists in the Post Keynesian tradition consider to be endogenous circuits of money. The crucial distinction is that the horizontal transactions do not create net financial assets – all assets created are matched by a liability of equivalent magnitude so all transactions net to zero.
This is the sense that Tobin says that every banking asset is matched by an offsetting liability. While the non-government sector cannot create or destroy net financial assets denominated in the currency of issue, Tobin says of “bank-created money” that:
… there is an economic mechanism of extinction as well as creation, contraction as well as expansion. If bank deposits are excessive relative to public preferences, they will tend to decline; otherwise banks will lose income. The burden of adaption is not placed entirely on the rest of the economy.
So when a loan is paid off the liability and asset is extinguished and the broad measure of the “money supply” shrinks. However, transactions within the non-government cannot reduce the level of bank reserves. They can redistribute them but not alter the net cash position of the economy. Only vertical transactions can change the net cash position.
Tobin then considers the textbook treatment of monetary expansion. He says that according to this mainstream view, “additional reserves make it possible and profitable for banks to acquire additional earning assets. The expansion process lowers interest rates generally – enough to induce the public to hold additional deposits but … not enough to wipe out the banks’ margin between the value and cost of additional deposits.”
But the textbook description of multiple expansion of credit and deposits on a given reserve base is misleading even for a regime of reserve requirements. There is more to the determination of the volume of bank deposits than the arithmetic of reserve supplies and reserve ratios. The redundant reserves of the thirties are a dramatic reminder that economic opportunities sometimes prevail over reserve calculations.
Again, the terminology is mainstream. But the importance of this point is that it undermines the notion that reserves are loaned on a fractional basis and are thus “multiplied” into the money supply.
What determines banks’ willingness to extend loans is not the volume of reserves in the system but rather the demand by credit-worthy borrowers (“economic opportunities”) who the banks’ estimate will deliver a risk-tolerant return on their capital.
In relation to the diagram above, private leveraging activity, which nets to zero, is not an operative part of the “Tin Shed” stores of currency, reserves or government bonds. The commercial banks do not need reserves to generate credit, contrary to the popular representation in standard textbooks.
Tobin continued to argue that the mainstream textbook approach dismissed the 1930s build-up of “redundant reserves” (while the broader money aggregates collapsed) “simply as an aberration from the normal state of affairs in which banks are fully ‘loaned up’ and total deposits are linked to the volume of reserves”.
The same point is being made in the current period after the rather dramatic balance sheet expansions of the central banks via quantitative easing. The broad money aggregates are static or shrinking yet the major central banks are holding massive increases in bank reserves.
Tobin correctly says:
The thirties exemplify in extreme form a phenomenon which is always in some degree present … An individual bank is not constrained by any fixed quantum of reserves. It can obtain additional reserves to meet requirements by borrowing from the Federal Reserve, by buying “Federal Funds” from other banks, by selling or ‘running off’ short-term securities. In short, reserves are available at the discount window and in the money market, at a price. This cost the bank must compare with available yields on loans and investments. If those yields are low relative to the cost of reserves, the bank will seek to avoid borrowing reserves and perhaps hold excess reserves instead. If those yields are high relative to the cost of borrowing reserves, the banks will shun excess reserves and borrow reserves occasionally or even regularly.
Thus, the extent to which the central bank supply of reserves is used “depends on the economic circumstances confronting the banks – on available lending opportunities and on the whole structure of interest rates from the Fed’s discount rate through the rates on mortgages and long-term securities.”
The upshot of these insights is that there is a “much looser linkage between reserves and deposits than is suggested by the textbook exposition of multiple expansion for a system which is always precisely and fully ‘loaned up'”.
So Tobin clearly understood that a growth in the supply of reserves will not necessarily be related in any particular way to the growth in broader monetary aggregates, as is assumed by the mainstream and taught day-in-day-out to students studying macroeconomics.
He also notes that “loans and deposits will expand by less than their textbook multiples” because the “open-market operations which bring about the increased supply of reserves tend to lower interest rates” which “diminish the incentives of banks to keep fully loaned up or to borrow reserves”.
So the way the monetary system actually works is that bank reserves are not required to make loans and there is no monetary multiplier mechanism at work as described in the text books.
Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. The loan desk of commercial banks has no interaction with the reserve management desk as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit.
The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans.
It is also possible that the price that the central bank sets at the discount window may influence the profitability of certain loan opportunities for banks and curtail lending.
I hope my former colleague, who I bumped into yesterday, doesn’t follow the textbook and force the monetary multiplier as presented onto the students. I hope that instead, the students are exposed to the concept as a classic example of the way the mainstream profession misleads the students.
I also hope that by the end of the lecture they are thoroughly dis-abused of the concept.
I also hope that my former colleague then traces out how the mainstream uses these erroneous concepts to mount ideological attacks on governments and force them to introduce macroeconomic policy settings that are not consistent with the pursuit of public purpose. Specifically, I hope the students realise after the lecture that the claims that budget deficits will lead to hyperinflation if the government stopped placing debt into the private markets when they net spend are totally without theoretical foundation.
The Saturday Quiz will be back sometime tomorrow – even harder than last week!
That is enough for today!