RIP Money Multiplier Model
Louis-Philippe Rochon
Full Professor, Laurentian University
Editor-in-Chief, Review of Political Economy
Founding Editor, Review of Keynesian Economics
David Fields
Economist, State of Utah
Fellow, The Monetary Policy Institute
Monetary Policy Institute Blog #151
Mainstream thinking about monetary policy is rooted in a faulty understanding of how the banking system operates and in particular how monetary policy is implemented.
In turn, this can only lead to egregious policy proposals. This approach is at the root of many policies that we saw adopted during the financial crisis, for instance, that undoubtedly made things worse. In 2024, we should at a minimum expect economists to understand the banking system: it should be a self-evident truth. Yet, as surprising and perhaps shocking as it may sound, even Nobel Laureate economists such as Paul Krugman lack an understanding of such a crucial concept, as was revealed to all to see when he debated Steve Keen on the topic.
The mainstream view of banking rests on something called the ‘money multiplier’ model, which permeates every undergraduate economic textbook. According to this view, banks are considered financial intermediaries, that is they connect savers (who deposit their savings at the bank) and borrowers (who seek to borrow funds from the bank). The causality is clear: higher savings (deposits) translate into higher lending: deposits create loans.
If this view is correct, then banks can easily be constrained in their lending activities by a lack of deposits. In other words, if banks do not have sufficient savings in the form of bank deposits, they won’t be able to lend as much and meet the demand for bank loans. If this happens, then firms cannot borrow, investment will fall and the economy can suffer and risk falling into a recession. This is where the concept of credit rationing comes in: as a result of a lack of loanable funds, credit must be rationed given the limited supply of funds, which, in turn, it is perceived , gives way to an investment crowding out effect. This is what is called the ‘credit-led and supply determined’ approach.
Accordingly, in the neoclassical model, banks are not necessary: savers can always find willing borrowers on their own. Banks simply make the whole process easier, hence why they are called intermediaries.
During a banking crisis, for instance, it is thought that banks can not lend, and central banks must somehow intervene, through Open Market Operations or unconventional policies, and inject liquidity into the banking system, at which point, with increased deposits, banks can now lend more. The assumption is as follows, the Fed increases the monetary base, which causes the money supply to increase by a multiplied amount. For example, suppose that the Federal Reserve carries out an open-market operation by creating $100 to buy $100 of Treasury securities from a bank. The monetary base then rises by $100, which if performed too aggressively is thought to trigger future inflation. This is the so-called ‘helicopter money” phenomenon, which is theoretically flawed and empirically untenable.
Nevertheless, this was precisely the interpretation of the position of banks during the Great Financial Crisis in 2007–8, for instance: mainstream economists (and central banks) believed banks were unable to lend. Hence, central banks, via Quantitative Easing, flooded banks with reserves with which they could now lend. In this sense, central banks are seen as powerful institutions that can directly impact banks’ ability to lend.
In addition, central banks are believed able to influence bank lending by changing the reserve requirements, that is the amount of reserves banks must deposit with the central bank. By increasing these requirements, banks have less money to lend.
But the problem with this approach of course, as post-Keynesians well know, is that it is an “obsolete explanation of how the Fed [a central bank] operates and influences banks.” In other words, “banks do not collect gravel from savers in order to lend it to cement companies”: banks are not financial intermediaries. Money is fully endogenous, as it has been through history.
Yet, the belief in financial intermediaries is quite strong among mainstream economists, despite the fact that a recent article by Federal Reserve researchers, published in the Review of Political Economy, is unambiguously clear:
“While some textbooks are sound in their descriptions of these topics, many miss some key aspects of how banks make decisions, inaccurately explain how the Fed implements monetary policy, and contain outdated descriptions of the linkage between banks and the Fed.”
Ouch.
The rejection of the money multiplier model is spreading. Of course, this rejection has been at the heart of post-Keynesian economics since at least the 1950s, if not before. Kaldor called it a ‘scourge’.
In a celebrated Bank of England article by bank researchers, Michael McLeay, Amar Radia and Ryland Thomas, for instance, it was claimed that:
“another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach.”
How can Nobel laureates not be aware of this?
There is much on which to comment. First, with respect to what happened during the financial crisis, banks were always able to lend, such is the theory of endogenous money, but were reluctant to lend, given the uncertain economic climate. It was about the unwillingness of banks to lend, not about their inability to lend. If this view is correct, then there was no need for central banks to inject more liquidity, except perhaps to help banks settle their debt with other banks.
But one thing is clear: when it comes to lending, banks are never constrained by a lack of reserves or deposits. When someone goes to the bank to borrow, the bank advisor does not call a central office to inquire whether the bank had those funds to lend. Rather, in lending, banks simply lend what they want. In doing so, they create bank deposits. So, banks create deposits, they are never constrained by deposits, but they can be constrained by a lack of good borrowers.
Indeed, banks don’t lend to everyone who wants to borrow. They will indeed refuse to lend to many borrowers, if these borrowers don’t meet the bank’s basic criteria. In other words, banks are constrained by a lack of good customers — what post-Keynesian call ‘creditworthy’ customers, defined as borrowers capable of reimbursing their initial loans with the banks. In this sense, they have a rather special role to play: by lending they allow production to go ahead and create money in the process.
John Maynard Keynes once wrote, in the Treatise of Money, that:
“Credit is the pavement along which production travels and the bankers if they knew their duty, would provide the transport facilities to just the extent it is required in order that the productive powers of the community can be employed at full employment.”
In this sense, banks are deemed ‘special’. The role of banks is to grant entrepreneurs’ absolute command over property, allowing firms to pay out money for capital goods and the wage bill to keep production and distribution going in advance of receiving profits from expected sales of consumer goods.
Whether we like it or not, banks are at the heart of our economic systems, and as such understanding what they do and indeed how they do it is crucial.
