Banking #1 – The Money Multiplier: Myth or Reality?

  By Richard from Canada | July 23, 2012 - 04:17 |

 

The following quotes are from the referenced article, by Frank Shostak an adjunct scholar of the Mises Institute, tries to explain that the money multiplier is at work because that is the essence of a central bank’s management responsibility!! 

“Whilst in a free market economy the practice of fractional reserve banking would tend to be minimal, this is not so in the case of the existence of a central bank. By means of monetary policy, which is also regarded as the reserve management of the banking system, the central bank permits the existence of fractional reserve banking and thus the creation of money out of “thin air.”

“In this respect the modern banking system can be seen as one huge monopoly bank which is guided and coordinated by the central bank. Banks in this framework can be regarded as branches of the central bank. In other words, for all intents and purposes the banking system can be seen as being comprised of one bank.”

“Furthermore, it must be realised that in a free market the tendency of being “caught” practicing fractional reserve banking, so to speak, rises, as there are many competitive banks.”

Note that caught means not having the money on hand when demanded by the depositors.  This liquidity crisis can potentially become a solvency crisis.

“In short, as the number of banks rises and the number of clients per bank declines, the chances that clients will spend money on goods of individuals that are banking with other banks will increase. This in turn increases the risk of the bank not being able to honour its checks once it practices fractional reserve banking.”

“We can conclude then that in a free banking environment if a particular bank tries to expand credit by practicing fractional reserve banking it runs the risk of being “caught”. Hence in a true free market economy the threat of bankruptcy will bring to a minimum the practice of fractional reserve banking.”

“Conversely, as the number of competitive banks diminishes, that is, as the number of clients per bank rises, the likelihood of being “caught” practicing fractional reserve banking diminishes. In the extreme case of there being only one bank, it can practice fractional reserve banking without any fear of being “caught” so to speak.”

“Whether legal reserve requirements are applied on the average of the last four weeks deposits or on same day deposits is beside the point, so far as the money multiplier is concerned. The existence of the money multiplier is the outcome of fractional reserve banking, which the current banking system makes possible. In short, it is the existence of the central bank that enables banks to practice fractional reserve banking, thereby creating inflationary credit.”

http://mises.org/daily/1118/

So it appears that there will be this tendency for TBTF banks to emerge and attempt to dominate the lending landscape in effect aided by the central bank who will perceive big banks as a less complex banking system than alot of smaller banks??

 

Written by: Richard from Canada on July 23, 2012.
Tagged , , , . Bookmark the permalink.
  • Lyle

    “In short, as the number of banks rises and the number of clients per bank declines, the chances that clients will spend money on goods of individuals that are banking with other banks will increase. …”

    I understand this – but don’t understand this. If there’s the central bank reserves essentially behind them all… what difference?  Help!  ? 

    • CSArichardo

      That is the point.  No incentive not to leverage the fractional reserve system to the max.

      • windslice

        We do not have a fractional reserve system.

        Banks will always lend out if there is a demand and they can make a profit. The limit on how much they can lend out is set by the capital reserve ratio NOT the amount of cash they hold against depositors’ money.

    • windslice

      I don’t understand it.

      The number of banks is decreasing, both small piddly little banks in the States. 

      http://www.fdic.gov/bank/individual/failed/banklist.html 

      Around 50 this year and many hundreds over the last five years.

      And the big banks are being merged and taken over.

      If there is a net outflow of depositors’ funds leaving a bank which reduce its reserves to the minimum, it must either find more funds from other places such as the money market or central bank, or sell off its assets, such as bonds, and then its loan book.

  • windslice

    Not much more time to spend here today, so just a few points

    We do not have a fractional reserve system in the US, UK or Europe. There is no requirement to hold liquid cash-like instruments to back depositors’ accounts. I do wish that we could stop having references to it.

    In a “free banking” environment I the depositors would expect to set our own level of interest. The cost of borrowing is the fundamental cost of banks’ operations. They have to fund the loans from our money. I am fed up with the actions of central banks to artificially suppress the level of interest to zero by using the massive levers they have.

    No savers are happy with the current situation of getting paid next to nothing for their money, losing out to inflation year on year.

    • snedmeister1

      Unfortunately Windy, they don’t care about the savers….
      ( Whether you are fed up with it or not )

      It’s a shit situation if you have money saved, isn’t it…???

      ( Hello )

      • windslice

        The shit would be a lot deeper if I hadn’t saved.

    • CSArichardo

      That is his point, it is all central bank backed like they are one big monopoly bank !! 

  • joebhed

    Not sure if Shostak was addressing the ‘money-multiplier-myth’ as it is discussed today so much as to show that fractionally-reserved banking would NEVER work today without the public backstop of deposit insurance.
    Which is obviously true.

    But he and other Austrians ultimately fault what they claim is the GUV’MINT in the form of the central bank, which is really private.

    Every modern monetary economy should have a central bank to provide order to the payment system and account for the international trading balances so as to maintain order in the system. Of course, it MUST be public and only as such have the role of lender-of-last-resort, NOT so save the banks but to maintain the economy at its potential output.

    Most importantly, it MUST oversee a system of banking akin to, but not exactly the same as, full-reserve bank lending.

    In sum, it is NOT the central bank that enables the creation of inflationary credit – it is the pro-cyclical nature of fractional reserve banking, with or without the CB.

    • CSArichardo

      Agreed but who decides whether you are a failed bank or not.  TBTF banks even if they should fail will always get to eat up another failed bank first and look like they are the savior ! ?

      • joebhed

        If the banking system is doing banking – and that’s a big IF, and doing it on a ‘full-reserve’ basis, there would never be a TBTF situation.
        TBTF means too big to fail the economy.
        Any very large banks that does unsound lending using its own money, its depositors money and other borrowed money can never be TBTF.the economy
        All of the other banks would be as sound as their loans.
        Any bank could fail, and unsound lending should lead to bank failure.
        Worrying about who decides IF a bank is TBTF is a lot of coming late to the barn door closing.
        What we need are reform measures that prevent any aspect of finance from crashing the real economy.
        Lending REAL, rather than conjured up, money is a foundation issue for future economic stability.

        • CSArichardo

          That is why bank size needs to to capped.

          • joebhed

            There are three ways to limit the risk to the real economy from the shadow/investment banking super-domino.

            The first is to limit the size to a certain leverage ratio; from no-limits to say 15 times equity.
            The second is to separate completely the risk-prone investment banking sector from the more sedate commercial banking sector where we all live and work (Glass-Steagall).
            The third is to disallow leverage using ANY vehicle. All investment by all banks must be done with real money, using either full-reserve or real-money(non-reserve) basis for lending (The Chicago Plan, the 1939 Program for Monetary Reform, the Kucinich Bill -HR 2990 )
            Perhaps in that order.
            Or, from a crash, directly to HR 2990.

        • Jetser

          “Lending REAL, rather than conjured up, money is a foundation issue for future economic stability”
          But both types of money are real!

          How could the “lending real money” policy be enforced whilst maintaining economic freedom?
          For example, if I have some “real” money, lend it to someone, and get a loan document in exchange then should I be able to exchange the loan document with a willing 3rd party in another transaction? Or should I have to find someone with “real” money, sell the loan to them and then use the “real” money in my other transaction?

          What about if 2 people wanted to complete a transaction over a period of time? For example, if someone has goods with a value of $100 should they be free to transact with someone who has no money but can promise to pay $110 next year? Or should the buyer go off to find someone with money, organise a loan and then return to complete the transaction?In each case my answer would be “allow them to use credit as a medium of exchange.” If you allow people the freedom to do as they see fit then what you end up with is essentially what you would have if you allowed banks to extend credit instead of lending currency. I suspect you wouldn’t stop them doing this but you would object if there was a bank acting as a 3rd party in a transaction keeping account of the credits and debits.

          • joebhed

            Good questions.

            I especially CAP the term REAL money to distinguish between
            what is called here “full-reserve” bank money lending, and today’s “conjured”
            money of banker privilege, created through fractional-reserve lending..

            Yes, REAL money is akin to full-reserve or 100 Percent Money.

            If REAL money is in existence, then conjured money could not
            be.

            See the Kucinich proposal for reform on how the transition
            to REAL money is done.

             

            http://kucinich.house.gov/uploadedfiles/need_act_final_112th.pdf

             

            It is a monetary transformation on a day certain.

            Nobody loses anything REAL, and the same amount of money is in existence.

             

            To be clear , LENDING would take place as needed for
            commerce in a REAL money world.

            Anybody who has anything to lend can do so on their own
            terms.

            There is ZERO restriction on lending.

            The restriction is on the money system and the currency in
            circulation – it is Constitutionally called “to regulate the Value thereof”….

             

            As for enforcement – if you read the penalty clause 10 years
            in jail should suffice.

            And what restriction do you see on ‘economic freedom’?

            Having full employment and a stable currency is what
            economic freedom is all about.

             

            Again, this is not about ANY restriction on the use of
            credit.

            I can lend you $5 Bucks, or $5 Billion – if I have it.

             

            I can’t CREATE the $5 Billion to lend.  Nor the $5 Bucks.

            Neither of those are extending credit.

            Both are money creation.

            There is no restriction on banking, only on money creation.

            Thanks.

            • Jetser

              It seems my suspicion was correct. The examples I used were intended to show how everyday transactions are similar to what banks do when they create money. If 2 people are allowed to use debt as money then it makes no sense to ban a bank from doing the same. In either case, money is created. If 2 people agree that one without cash can purchase from the other then it makes no sense to ban a bank from keeping a record of the credit and debit on each person’s accounts. Banks (supposedly) have expertise in credit checking and are more trusted, so they add value to the credit creation process and make the credit more acceptable as money.

              Currency would be a better term than REAL Money, because there is no such thing as unreal money. It’s either money or it’s not. Currency is a subset of money.
              http://en.wikipedia.org/wiki/Currency 
              http://en.wikipedia.org/wiki/Money 

              While Mystic is trying to understand balance sheet accounting as the basis for banking, it’s imperative to understand the balance sheet accounting which is the basis of money. In the history of money, credit pre-dates currency! As I see it, “FRB” is a perfect fit for what money is.

              I don’t have time to read the bill but similar ideas I’ve seen appear to be a boon for reckless banks, at least in the short term. If a bank has extended credit to people who can’t fulfil their end of the deal then it needs to raise capital to cover that loss. Unless, of course, the government comes along, asks the banks how much they owe depositors and hands them that much in cash! Moreover, that type of solution is a reformatting of the system to match people’s desire for how it should work. I’m sure a better solution could be arrived at if how it works is better understood.

              If I sell you a house and get a dollar IOU in return but the house value falls and you lose your job then all I can get from you is the reduced value of the house. That’s fine because it only directly affects the people involved in that transaction. Looking at the balance sheet model, if a bank extends credit to enable you to buy my house then you owe the bank and the bank owes me. But if you lose your job etc then all I can get from the bank is the reduced value of the house (except where they are able to raise capital to cover the loss, and they should also have other debtors and creditors to lessen the effects). If this should happen then one resolution would be to reduce the $number in my account (and punish the bank executives appropriately). This would rebalance the assets and liabilities and only the people involved in the transaction would be directly affected. Instead of the government making me whole, I would have to take my loss and get over it. If this was in place you can imagine how bankers and savers would change their behaviour.

  • Jetser

    One free market money system is LETS, which in Mises’ context could be described as a zero-reserve system. 
    Everybody in the system starts with nothing, and when one member does an hour’s work for another member their accounts are marked up as +1 and -1 respectively.
    http://www.letslinkuk.net/home/theory.htm

    If you look at the blocks below the zero line and think of them as hours of labour then you might be tempted to call this a full reserve system where hours of labour are the reserve. But those hours have only been promised and may not ever be worked. Our “fractional reserve” system could be described in a similar manner since all credit money is a promise to provide something of value, which may never be provided. Banks are “caught” not when they extend credit beyond the level of their deposits but when the people they extend credit to are unable to provide what they promised (unless the bank is unable to raise capital to cover the difference).

    • Jester

      I meant ”unless the bank is ABLE to raise capital to cover the difference”

  • Jasp

    Hi Richard,

    I am understanding this post as an additional source of opinion of how the basic accounting function feeds into creating a system that leads to “too big to fail”. Is this your intention? I was searching around for some basic explanations following on from Mystic’s posts about the debits and credits and think I may have found some links that do a pretty good job of going some way to explaining it in an understandable way:

    First, a link to a video that explains what is meant by fractional reserve banking – the title refers to “how banks create credit” and initially I thought, ahah, the money from nothing cycle, but no such luck. Still, useful to bear in mind as this is often what people mean and quite a neat summary:

    http://www.moneyweek.com/investment-advice/how-to-invest/video-tutorials/video-tutorial-how-banks-create-credit-14200

    Next, 2 videos from Paul Grignon. Together they are quite long, but easy to follow and also have little jokes as light relief. He does have an agenda, but I do think there is some interesting stuff here and he explains it very well. What I liked, was that he mentions both fractional reserve banking and what has been spoken about here, the creation of money from nothing. He also goes into the consequences as he sees them.

    Part One:

    http://www.youtube.com/watch?v=PlxKtDOkEj4

    Part Two:

    http://www.youtube.com/watch?v=lsmbWBpnCNk

    I was going to be brave and do this as a post, but couldn’t find the instructions (I’m sure there were some once) and anyway, they fitted in well with what you have posted.

    I’d be interested to hear others’ views and where you think there are flaws in the logic.

    Apologies if this all old hat to old OTP participants and it has been demolished to bits.

    Happy watching!

    • lgrinaker

      Thanks, Jasp. 

      In wanting to better understand what Keen is asserting and how that breaks from convention, I’m also trying to get a better feel for the “convention” he’s working to break from, along with, perhaps, some other competing ideas that take up the same subject.

      So I’ll check out some of these resources you point to, Jasp, along with taking my time with Richard’s post…

      Linda

      • Jasp

        Thx Linda, will have to take some time over what you wrote and the other stuff being posted to try and reach an understanding. Hope to be able to think of something, but time is running away. Tsktsk….

    • lgrinaker

      Okay, I’ve had a chance to watch the 2nd of the two attachments (the one with the 2 dollar bills showing onscreen).

      I’ll scribble a few things that come to mind before having to head out:

      1)  It didn’t help me with the nitty gritty of a bank’s balance sheet, which is why I’m still working with what Mystic has made the recent videos about (for which I’m really grateful, by the way – I really do want to “get” this well, and I think I’ll need to dig around some more to help me to ultimately nail it; I’m beginning to look at something by Randall Wray now that might help me to get a bit further with it, ;-)).

      As Mystic mentioned, the loan agreement becomes the bank’s asset (the left side of the ledger).

      And the new deposit account becomes the bank’s liability (the right side of the ledger).

      The question is: 

      When the deposit funds are drawn (causing a “-” on the liability side), from what, exactly, does the the bank draw on to cover that draw from the deposit (which would cause a “-” from the asset side) in order to balance the bank’s books… if they can’t draw from the long-term paper loan? (damn, why did Mystic have to bring that fly in the ointmint up?!?)

      If it draws from existing reserves, whether from its own bank or the overall collection of banks within a nation (even after the loan is drawn up and the deposit account is set up), then it isn’t “creating” new money, and the money supply would not change, even temporarily, via loans. 

      It would do what Keen said… money would simply move from “patient people” that are content to leave aside some of their funds (for a small bit of interest for doing so) for a time to “inpatient people” who need money in the present for whatever reason, and the money would eventually come back again to the “patient people” as the loan is paid back.  The only difference would be that the money wouldn’t be “sitting around,” it would be out in circulation, which still doesn’t actually change the money supply, even temporarily.

      Now, of course, we know (as the video also points to) that the money supply has gone ballistic because of lent money, far more than would happen by simply lending out existing reserves (even though it is technically a *temporary* huge boost in the money supply, it’s clearly still a huge boost in the money supply).

      But I don’t yet know exactly how that happens, while also keeping the bank balance sheet working as it should.  And that’s something that the video didn’t go into.

      I know there’s a way (and maybe more viewings of Nick’s 2nd scratch video will still help me, ;-)), but I don’t yet get a good sense of that.  Or maybe it’s like Sned said, that due to my interests in MMT, I’m looking for something at this point with the banks and loans and balance sheets that is not what I really need to be looking for (or something like that, ;-)).

      ~~~~

      2.  I know Keen also works on showing that the interest needed to pay back a loan is not the problem this video says it is (having to do with an unclear understanding of stocks and flows, something that is a little further down the road for me to try to better understand; that comes up in the following video at about the 1:20 marker):  This video shows about banking what he’s talking about (although he, too, doesn’t, even later in the video about the time I wish he would, get into how exactly a bank manages its balance sheet in the present system of making loans):

      http://www.youtube.com/watch?v=s-Qg-2d50Eo

      Further, MMT works on showing that the Govt. paying interest isn’t the problem the video (with the 2 dollar bills showing in the screen shot) says it is either.

      3.  However, I do really appreciate the video’s bringing up the fact that we’ve got a real world of limited resources, and the way we’re currently dealing with money (from govt. sources and/or lending sources) is not accounting for that at all well. (MMT seeks to do so, as do others, such as Joe, and the folks making this video… They seek to make such things the constraints we *actually* pay attention to, rather than paying attention to whether or not a nation issuing its own free-floating fiat currency will “run out of money,” which isn’t an *actual* constraint.)

      4.  Finally, it may be that some of the solutions the video proposes might indeed be helpful, but, as Nick mentioned recently, that’s further down the road for me as well (since I’m currently working on trying to better understand the system we currently have).

      And this brings up Joe’s contributions again, which really goes for changing the current system (and not simply the way we see it, which apparently has many of its own problems, ;-)).  What Joe’s folks propose differs a lot from MMT in that sense. MMTstrives to better describe the system we actually have and to better work within that.

      ~~~~

      What Joe works with (which I looked at a lot more earlier on) is so appealing in many ways because it (the fix) just makes it all so much more straight forward (or so, that’s how I remember my earlier introduction to it). 

      I know that I veered away from that early on because I thought MMT stood a better chance, since it doesn’t try to change the current system so much, but to change our understanding of the current system. It then makes policy proposals that makes use of that better understanding.

      ~~~~

      These days, I don’t know… MMT’s work *may* make more inroads more quickly for the reasons mentioned above.  But because it is *so* hard to change even the way folks look at our current system, and *so* hard to work within its various convolutions, ;-)…  that may be no less difficult than convincing folks to just scrap the system we have and go for the much clearer system that Joe (and all those involved in what he describes) proposes, ;-).

      ~~~~

      But again, right now, I’m just trying to get a better grasp of what we’ve got and how it may differ from what the prevailing economic “view” says we’ve got (as well as how it may be the same and/or different than what the video above has to say, still more tries to better describe the current system). And at this time, I find MMT to be the most helpful for me along those lines.

      Okay, time to head out and work on other things, ;-).

      Linda

      • Jasp

        Linda – was getting myself in a pickle, but have found something that may help:

         http://www.3spoken.co.uk/2011/12/double-entry-view-on-keen-circuit-model.html

        Haven’t had a chance to digest it – must get on with the other life, you know!

        Hope to look at it later. Gee, the pile of “look at later” is getting out of hand.

        • lgrinaker

          What a great find, Jasp – thank you!

          It’s really neat to learn about some of the evolution for Keen (and some of his collaborators) on creating the model for his ideas regarding “endogenous money” and how important bank lending is to the overall economic system.

          What you found goes back to January of this year, I believe.  And what I posted yesterday is dated at the beginning of July.

          In your find, the comment section got into questions of vertical integration.  And it looks like that’s occurred within “The Mechanism” section of July blog entry that I posted here, and is apparently a result of his collaboration with some of the MMT folks (as we witnessed a bit of from the gathering between Keen and some MMT folks and their presentations that Mystic posted not too long ago).

          I’m feeling much better in seeing what a struggle Keen also went through to get a good handle on the double entry bookkeeping system from accounting.  He needed a lot of help as well! ;-)  And it looks like he got it.  And that, in turn, is going to help his modeling project, “The Minsky Project” tremendously.

          http://www.youtube.com/watch?v=qepFaJW0-9Y

          I think I’ll post your find within the thread to the post I put up yesterday.  Thanks, again, Jasp!

          • joebhed

            linda and jasp,
            please excuse my interruption.
            Keen and the MMTers(Levy) have made major advances on their work-in-progress under the Minsky Project.
            But Keen never had or saw a model that integrated debt, central banks and finance into a systems-dynamic monetary system model until Keen witnessed the presentation of Dr. Kaoru Yamaguchi’s Debt-Free Money Model at the American Monetary institute’s conference a couple of years ago.
            Keen remarked unabashedly that Dr. Kaoru’s model was the most sophisticated he had ever seen, and Dr. Kaoru told him it was his(Keen’s) for the using, and publicly available.
            Don’t get me wrong, Keen had done yeoman’s work in bringing the dynamic-economy model to its highest level of sophistication.
            On the day of Dr. Kaoru’s presentation, Steve had only a lot of “how does this..” questions.
            But after taking it home and studying overnight, he cam back the next day and made the above comment.
            I like it when Keen occasionally makes the comment that we are ‘learning’ (making it up) as we go along.
            Here’s a link to Dr. Kaoru’s later presentation.
            http://www.old.monetary.org/yamaguchipaper.pdf

            Thanks.

            • lgrinaker

              I remember seeing that via a report from you, Joe.  That was a while ago when I saw that, but as you bring it up, I do remember that…

              And, of course, I’m just sticking my head in to a few places as I begin to look into this.  I mainly was just noticing the particular accounting model he was working on up until January, that it needed a lot of work, ;-) (it was just plain wrong, apparently, in accounting terms).  And folks were also saying that as it was, it still needed vertical integration.  Then, in this post from early July, hand in hand with his work over this past while with some MMT folks, that model seems to have made that “vertical integration” step. (Of course, I may be all wrong in my beginning take on it.)

              It may be that it had all clicked conceptually for him at an earlier time, along with much about some of the fundamental aspects of modeling (and perhaps that’s the time you are referring to), whereas maybe it took him a while to piece it all together via the added dimension of the double entry book keeping, which seems to have evolved for him fairly recently.

              But I’m looking around now for further explanations to see if there’s anything to what I’m beginning to think about this, and there is all sorts of discussion out there with some really talented and experienced folks, who are having all sorts of disagreements along these lines – including among several MMTers, ;-).

              If this is an evolving model (as well as an evolving “school of thought” as these various folks work to come together on some things), it may be that I’ll have to wait to learn more from those working together at this time in order to see further discussion about what this model is helping them to “see.”

              Linda

    • CSArichardo

      Absolutely where I am going with it.  In fact I would argue that the role of a central bank is in fact made easier with TBTF banks !!