The title of this post is a bit misleading since it’s not just Mankiw that lied to you. Austrian economists lied (or are just as ignorant), as are prominent Keynesian's.
I pick on Mankiw because his textbook “Principles of Economics” is used by the vast majority of Econ 101 professors so it’s an easy target. His example of credit creation and how deposits are multiplied throughout the private sector is still used today both online and in classrooms to erroneously describe how the monetary system of a sovereign nation such as the US operates. The point of this post is to explain how the neo-liberal concept of the money multiplier is false and consequently the central bank does not control the money supply.
Money Multiplier Explained
Mathematically the money multiplier goes a little something like this:
M= m X MB, where
M = money supply
m = money multiplier
MB = monetary base
So if the reserve requirement is 10%, then for every $1 of deposits the money supply will rise by 10 times this amount. The theory is alleged to work in this fashion:
· Bank collects $100 in deposits
· Since they are profit seeking, banks then loan out $90, then $81, and so on
· This process continues until the loans are essentially zero.
According to Mankiw, if the Fed wants to increase the money supply, they simply buy bonds in the open market, creating additional reserves in the banking system that is then lent out. And if the Fed wants to reduce the money supply, then bonds are sold into the banking system. Or, in his words:
“If the FOMC decides to increase the money supply, the Fed creates dollars and uses them to buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply.”
According to this (erroneous) theory, the bank must FIRST acquire deposits/reserves BEFORE making loans.
Thus, the money multiplier theory that all Econ 101 students were indoctrinated with leads mainstream and arm chair economists to believe the central bank can control the monetary base (by adding and draining reserves) and ultimately control the money supply.
While this looks good on paper and on some website devoted to promoting neo liberal myths, it’s simply not how the banking system works.
Loans Create Deposits
Notice in the above discussion of the money multiplier the first step in credit creation was accumulating deposits/reserves. This is simply false, and not how the banking system operates.
Please find me one bank executive or one loan officer in the US that checks his reserve requirements before making a loan. The next time you have the opportunity to interact with a loan officer, please ask them the name of the person in charge of making sure he or she does not loan out required reserves.
Banks make loans to credit worthy borrowers. Loans to credit worthy borrowers create deposits in the banking system. To meet their reserve requirements, banks borrow in the inter-bank market. Please note at no point were reserves considered nor required before a loan was made.
The simple reality is bank lending is demand driven, and banks will always meet the demands of borrowers they deem credit worthy and profitable up to their capital positions. Bank lending is never supply driven. Reserve requirements are irrelevant to bank lending decisions and can always be met in a fully functional inter-bank market
Mainstream and arm chair economists that do not recognize this process like to point out that the Fed is creating a lot of ‘high powered money’ by replacing banks government bond holdings with reserves and ultimately that ‘high powered money’ must find its way into the private sector, creating inflation.
Of course, if you pay attention to how the banking system operates in reality and not on pen and paper, then it is obvious loans create deposits and banks have access to reserves that meet requirements by borrowing from other banks in the inter-bank market. The excess reserves currently sitting at the Fed play no role in a bank’s lending decision, giving the Fed zero control over the money supply.
So to all you Austrian and other neo-liberal economists influenced by Greg Mankiw please explain why excess reserves will cause a lending tidal wave when, in reality, banksalready have access to all the necessary required reserves in the inter-bank market.
The idea that central banks control the money supply is leftover from the gold standard days, when the central bank could control the money supply by adjusting gold stocks. FYI – the US is no longer on the gold standard. Modern day text books need to be updated.
Simply put, the Fed creating additional reserves does not increase a bank’s lending capacity. Loans create additional deposits which generate reserves. Capacity to lend does not explain the lack of bank lending today. Banks are not lending today because there is a lower supply of credit worthy, profitable borrowers and bank capital positions have eroded.
The Fed creating additional reserves changes the composition of bank balance sheets but does not allow the bank to grow its balance sheet any quicker than otherwise.
Even Fed researchers are waking up the erroneous belief of the money multiplier.
AP
