The money multiplier is dead
The Bank of England’s Quarterly Review contains a detailed description of how money creation works in the UK’s fiat money economy. Partnered with a useful primer on money and a couple of explanatory videos entertainingly hosted in the gold vaults (where is the pallet labelled “Deutschland”, I want to know?), it is a comprehensive and clearly-written guide.
And it is controversial. It rejects conventional theories of bank lending and money creation (my emphasis):
“The reality of how money is created today differs from the description found in some economics textbooks:
• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”
To be sure, numerous papers from many eminent researchers and august institutions (including the Fed, the IMF, the ECB and the Bank for International Settlements) have cast doubt upon conventional theory as an adequate explanation of money creation in a modern fiat money system. But to my knowledge this is the first time that a central bank has presented an explanation of money creation that so comprehensively departs from conventional orthodoxy.
Predictably, heterodox economists such as Steve Keen and Cullen Roche, who have written extensively about endogenous money creation and the inadequacy of conventional theory, are rejoicing. Equally predictably, perhaps, others argue that the Bank of England’s paper is confused, contradictory or simply wrong. It is of course difficult for mainstream economists to accept that the theory they have believed and taught for so many years – and upon which many models of the economy depend – is simply inadequate. But there are some genuine concerns that need addressing.
It is hard to argue that the Bank’s simple explanation of how lending works is wrong:
“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.”
Anyone who has ever bought a house of course knows that their bank account is credited with the amount of the loan, and they then pay that money to the seller. But many people think the money is somehow “transferred” from other people’s deposit accounts. As the Bank shows in this neat chart, this is not what actually happens:
Note that the balance sheets of both banks and consumers
increase as a result of lending activity. In other words, banks do not “lend
out” deposits. No-one’s deposit account is reduced in value because someone
else has borrowed the money. New deposits are created when banks lend.
The reason for the controversy around this appears to arise from the practice of banks pre-funding large lending commitments. As the ECB explains (p.38),
“business unit gives all of its deposits to the ALM desk to be invested at market rates…..'and goes to the ALM desk for all of its funding requirements if it wishes to grant loans”
This appears to suggest that asset & liability management (ALM) functions in banks act as internal clearing houses, taking pooled deposits from deposit-taking business units and allocating them to lending units. On this basis, some argue that banks do in fact “lend out” deposits.
To a degree, ALM units do indeed do exactly that. But the funding they provide is not for lending as such, it is for deposit drawdown. Loans still create deposits, but when the loan is drawn, it is the new DEPOSIT that is paid out. If that payment goes to a different bank, that leaves an asset-liability imbalance on the bank’s books, which must be funded. It is the job of ALM units to ensure that such mismatches are covered: if there is insufficient existing liquidity to fund the mismatch, it is their job to obtain funding from markets or (as a last resort) from the central bank to close the gap. Pre-positioning funding is a prudent operational practice designed to prevent sudden liquidity shortfalls.
The Bank of England also notes that when loans are paid off, bank credit money (so-called “broad money”) is destroyed. Under normal circumstances, repayment of one loan would be replaced by creation of another, either to the same borrower (refinancing) or to another borrower, so the net effect on the money supply is zero. But when more loans are being paid off than are being created, money in circulation diminishes. Not surprisingly, the Bank commends QE as a replacement for inadequate bank credit creation in a deleveraging cycle. Personally, I remain unconvinced of its effectiveness, because of its unfortunate distributional effects: I can’t help thinking that direct reflation would be more effective.
The other controversial part of the Bank of England’s analysis concerns the role of the central bank in managing the money supply. Basically, they argue, the central bank cannot and does not fix the quantity of money in circulation. Most people would accept that the central bank cannot directly control the amount of money created by commercial banks when they lend (so-called “broad money”. But the Bank of England also argues that the central bank cannot fix the quantity of base money either. This is in direct contradiction of most economic textbooks, which explain monetary policy thus:
“central banks determine the quantity of broad money via a ‘money multiplier’ by actively varying the quantity of reserves….central banks implement monetary policy by choosing the quantity of reserves. And,because there is assumed to be a stable ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank deposits as banks increase lending and deposits.”
But the Bank is uncompromising:
“Neither step in that story represents an accurate description of the relationship between money and monetary policy in the modern economy. Central banks do not typically choose a quantity of reserves to bring about the desired short-term interest rate. Rather, they focus on prices — setting interest rates. The Bank of England controls interest rates by supplying and remunerating reserves at its chosen policy rate. The supply of both reserves and currency (which together make up base money) is determined by banks’ demand for reserves both for the settlement of payments and to meet demand for currency from their customers — demand that the central bank typically accommodates.”
So reserve creation responds to demand for bank loans, rather than driving it:
“This demand for base money is therefore more likely to be a consequence rather than a cause of banks making loans and creating broad money. This is because banks’ decisions to extend credit are based on the availability of profitable lending opportunities at any given point in time.”
I have been saying this ad nauseam for as long as I can remember. Banks lend when the risk/return profile is in their favour. When it is not, no amount of extra reserve creation will make them lend. Monetary policy therefore focuses on the PRICE of money, not its quantity, since changes in the price of money will influence the returns available to banks for lending and therefore their willingness to lend.
Though as the Bank explains, other factors are important too- such as macroprudential policy, consumer demand for loans and general economic circumstances. I therefore question their assertion that the quantity of money “ultimately” depends on the monetary policy stance. Did the price of money ultimately cause the credit bubble that burst spectacularly in 2007/8? If so, it is a massive indictment of central banks. Personally I think a rather less grandiose view of monetary policy is appropriate: monetary policy influences lending, but in the end the decisions are made by commercial banks and their customers, who are as prone to irrational behaviour as anyone else. Malfunctioning credit markets are the result of bad decisions by all players, not just central banks.
There is much, much more in this document. I strongly recommend reading the whole piece. But if there is one lesson that should be drawn from this, it is that fiat money systems simply do not operate in the way that classical economic textbooks describe. The money multiplier explanation of money creation can at last be consigned to the dust of history.