Guest Post: The Fed Is Responsible for the Crash in the Money Multiplier … And the Failure of the Economy to Recover

Washington’s Blog.

Greg Mankiw noted in January 2009:

Econ prof Bill Seyfried of Rollins College emails me:

Here’s an interesting fact that you may not have seen yet. The M1 money multiplier just slipped below 1. So each $1 increase in reserves (monetary base) results in the money supply increasing by $0.95 (OK, so banks have substantially increased their holding of excess reserves while the M1 money supply hasn’t changed by much).

Since January 2009, the M1 Money Multiplier has crashed further, to .786 in the U.S. as of February 24, 2010:

(Click for full image; underlying data is here)

That means that – for every $1 increase in the monetary base – the money supply only increases by 79 cents.

Why is M1 crashing?

Because the banks continue to build up their excess reserves, instead of lending out money:

These excess reserves, of course, are deposited at the Fed:

Why are banks building up their excess reserves?

As the Fed notes:

The Federal Reserve Banks pay interest on required reserve balances–balances held at Reserve Banks to satisfy reserve requirements–and on excess balances–balances held in excess of required reserve balances and contractual clearing balances.

The New York Fed itself said in a July 2009 staff report that the excess reserves are almost entirely due to Fed policy:

Since September 2008, the quantity of reserves in the U.S. banking system has grown dramatically, as shown in Figure 1.1 Prior to the onset of the financial crisis, required reserves were about $40 billion and excess reserves were roughly $1.5 billion. Excess reserves spiked to around $9 billion in August 2007, but then quickly returned to pre-crisis levels and remained there until the middle of September 2008. Following the collapse of Lehman Brothers, however, total reserves began to grow rapidly, climbing above $900 billion by January 2009. As the figure shows, almost all of the increase was in excess reserves. While required reserves rose from $44 billion to $60 billion over this period, this change was dwarfed by the large and unprecedented rise in excess reserves.

[Figure 1 is here]

Why are banks holding so many excess reserves? What do the data in Figure 1 tell us about current economic conditions and about bank lending behavior? Some observers claim that the large increase in excess reserves implies that many of the policies introduced by the Federal Reserve in response to the financial crisis have been ineffective. Rather than promoting the flow of credit to firms and households, it is argued, the data shown in Figure 1 indicate that the money lent to banks and other intermediaries by the Federal Reserve since September 2008 is simply sitting idle in banks’ reserve accounts. Edlin and Jaffee (2009), for example, identify the high level of excess reserves as either the “problem” behind the continuing credit crunch or “if not the problem, one heckuva symptom” (p.2). Commentators have asked why banks are choosing to hold so many reserves instead of lending them out, and some claim that inducing banks to lend their excess reserves is crucial for resolving the credit crisis.

This view has lead to proposals aimed at discouraging banks from holding excess reserves, such as placing a tax on excess reserves (Sumner, 2009) or setting a cap on the amount of excess reserves each bank is allowed to hold (Dasgupta, 2009). Mankiw (2009) discusses historical concerns about people hoarding money during times of financial stress and mentions proposals that were made to tax money holdings in order to encourage lending. He relates these historical episodes to the current situation by noting that “[w]ith banks now holding substantial excess reserves, [this historical] concern about cash hoarding suddenly seems very modern.”

[In fact, however,] the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions.

The liquidity facilities introduced by the Federal Reserve in response to the crisis have created a large quantity of reserves. While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react. In other words, the quantity of excess reserves depicted in Figure 1 reflects the size of the Federal Reserve’s policy initiatives, but says little or nothing about their effects on bank lending or on the economy more broadly.

This conclusion may seem strange, at first glance, to readers familiar with textbook presentations of the money multiplier.

Why Is The Fed Locking Up Excess Reserves?

Why is the Fed locking up excess reserves?

As Fed Vice Chairman Donald Kohn said in a speech on April 18, 2009:

We are paying interest on excess reserves, which we can use to help provide a floor for the federal funds rate, as it does for other central banks, even if declines in lending or open market operations are not sufficient to bring reserves down to the desired level.

Kohn said in a speech on January 3, 2010:

Because we can now pay interest on excess reserves, we can raise short-term interest rates even with an extraordinarily large volume of reserves in the banking system. Increasing the rate we offer to banks on deposits at the Federal Reserve will put upward pressure on all short-term interest rates.

As the Minneapolis Fed’s research consultant, V. V. Chari, wrote this month:

Currently, U.S. banks hold more than $1.1 trillion of reserves with the Federal Reserve System. To restrict excessive flow of reserves back into the economy, the Fed could increase the interest rate it pays on these reserves. Doing so would not only discourage banks from draining their reserve holdings, but would also exert upward pressure on broader market interest rates, since only rates higher than the overnight reserve rate would attract bank funds. In addition, paying interest on reserves is supported by economic theory as a means of reducing monetary inefficiencies, a concept referred to as “the Friedman rule.”

And the conclusion to the above-linked New York Fed article states:

We also discussed the importance of paying interest on reserves when the level of excess reserves is unusually high, as the Federal Reserve began to do in October 2008. Paying interest on reserves allows a central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities. The central bank can then let the size of these facilities be determined by conditions in the financial sector, while setting its target for the short-term interest rate based on macroeconomic conditions. This ability to separate monetary policy from the quantity of bank reserves is particularly important during the recovery from a financial crisis. If inflationary pressures begin to appear while the liquidity facilities are still in use, the central bank can use its interest-on-reserves policy to raise interest rates without necessarily removing all of the reserves created by the facilities.

As the NY Fed explains in more detail:

The central bank paid interest on reserves to prevent the increase in reserves from driving market interest rates below the level it deemed appropriate given macroeconomic conditions. In such a situation, the absence of a money-multiplier effect should be neither surprising nor troubling.

Is the large quantity of reserves inflationary?

Some observers have expressed concern that the large quantity of reserves will lead to an increase in the inflation rate unless the Federal Reserve acts to remove them quickly once the economy begins to recover. Meltzer (2009), for example, worries that “the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain.” Feldstein (2009) expresses similar concern that “when the
economy begins to recover, these reserves can be converted into new loans and faster money growth” that will eventually prove inflationary. Under a traditional operational framework, where the central bank influences interest rates and the level of economic activity by changing the quantity of reserves, this concern would be well justified. Now that the Federal Reserve is paying interest on reserves, however, matters are different.

When the economy begins to recover, firms will have more profitable opportunities to invest, increasing their demands for bank loans. Consequently, banks will be presented with more lending opportunities that are profitable at the current level of interest rates. As banks lend more, new deposits will be created and the general level of economic activity will increase. Left unchecked, this growth in lending and economic activity may generate inflationary pressures.
Under a traditional operating framework, where no interest is paid on reserves, the central bank must remove nearly all of the excess reserves from the banking system in order to arrest this process. Only by removing these excess reserves can the central bank limit banks’ willingness to lend to firms and households and cause short-term interest rates to rise.

Paying interest on reserves breaks this link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By
choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves.

This logic applies equally well when financial conditions are normal. A central bank may choose to maintain a high level of reserve balances in normal times because doing so offers some important advantages, particularly regarding the operation of the payments system. For example, when banks hold more reserves they tend to rely less on daylight credit from the central bank for payments purposes. They also tend to send payments earlier in the day, on average, which
reduces the likelihood of a significant operational disruption or of gridlock in the payments system. To capture these benefits, a central bank may choose to create a high level of reserves as a part of its normal operations, again using the interest rate it pays on reserves to influence market interest rates.

Because financial conditions are not “normal”, it appears that preventing inflation seems to be the Fed’s overriding purpose in creating conditions ensuring high levels of excess reserves.

The Fed Has Failed Once Again

I believe that the Fed’s efforts to ensure excess reserves are completely wrong, as deflation is the greater short-term threat. See this, this, this, this, this, this, this and this.

However, regardless of whether or not the Fed has been right to worry about inflation since it started paying interest on excess reserves in October 2008, the real cost of this program to the American people and the American economy has been staggering.

In October 2009:

Otmar Issing, the ECB’s former chief economist, told an Open Europe forum in London that policymakers are entering treacherous waters. “Nobody can be sure that we have a self-sustaining recovery. The challenges facing the ECB are tremendous,” he said.

Money multipliers have collapsed everywhere. What M3 is telling us is that confidence is missing. I don’t see any way to stabilise M3 in such circumstances,” he said.

As Barron’s notes:

The multiplier’s decline “corresponds so exactly to the expansion of the Fed’s balance sheet,” says Constance Hunter, economist at hedge-fund firm Galtere. “It hits at the core of the problem in a credit crisis. Until [the multiplier] expands, we can’t get sustainable growth of credit, jobs, consumption, housing. When the multiplier starts to go back up toward 1.8, then we know the psychological logjam has begun to break.”

As I wrote last October:

Professor Tim Congdon from International Monetary Research says:

A key reason for credit contraction is pressure on banks to raise their capital ratios… “The current drive to make banks less leveraged and safer is having the perverse consequence of destroying money balances,” he said. “It strengthens the deflationary forces in the world economy. That increases the risks of a double-dip recession in 2010.”

But isn’t it good that governments are requiring banks to raise their capital ratios?

Sure, but unless they force the banks to write off their bad debts, they will remain giant black holes, and will never be adequately capitalized. If they are never adequately capitalized, they will never release money out into the economy through loans and other economic activity …

As just one example, remember that the nominative amount of outstanding derivatives dwarfs the size of the global economy. As another example, remember that several of the too big to fails have close to a trillion dollars each in toxic assets in off-book SIVs.

IMF chief Dominique Strauss-Kahn says that the history of financial crises shows that “speedy recovery” depends on “cleansing banks’ balance sheets of toxic assets”. “The message of all financial crises is that policy-makers’ priority must be to stop the quantity of money falling and, ideally, to get it rising again,” he said.

As many people have repeatedly written (including me), the world’s governments must restore sound economic fundamentals – which includes forcing banks to write down their bad assets – instead of cranking up the printing presses and trying to paper over all of the problems.

Moreover, as [we] have pointed out, governments can create all the credit they want, but if people do not have jobs, they will not borrow that money.

In addition, the amount of credit and wealth destroyed exceeds the amount of money pumped into the system.

When will the politicians listen? Will they wait until after the next huge market crash? When there are tent cities everywhere? After their governments default and they essentially lose sovereignty under “austerity measures” imposed by the IMF, World Bank or other agency?

Note 1: The NY Fed actually says that the M1 money multiplier is now moot as a metric. Specifically, the above-discussed paper states that the central bank’s policy of paying interest on excess reserves renders the M1 money multiplier – that all economists rely on – useless.

Note 2: It’s not just the Fed.  The NY Fed report notes:

Most central banks now pay interest on reserves.

Note 3: I understand that consumers’ balance sheets are so impaired that many are not looking for loans. However, many consumers and small businesses are looking for credit, and are being turned down.

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About George Washington

George Washington is the head writer at Washington’s Blog. A busy professional and former adjunct professor, George’s insatiable curiousity causes him to write on a wide variety of topics, including economics, finance, the environment and politics. For further details, ask Keith Alexander…


  1. NotTimothyGeithner

    Even if the banks didn’t have solvency issues, who would they lend to? Lets pretend the banks are solvent. Who would they lend to?

    -Housing. There are so many houses out there that the people motivated to buy probably already have. So its not in housing. You don’t need as much money to buy the house you want as one used to.

    -Small businesses. There are existing small businesses and new ones. If you were a younger or even an older person and wanted to start a business, whats available? Luxury/trendy stores don’t have a market anymore. You can’t compete with Wal-Mart. Alternative Energy is really hard to do because most states have restrictive laws to protect the existing power companies. Maybe some small outfits might expand, but I don’t see any markets out there. People are eating at home not out.

    Obviously, people can find examples of small businesses, but they aren’t indicative of a trend. There just isn’t the demand for it.

    1. Cathryn Mataga

      [quote]Even if the banks didn’t have solvency issues, who would they lend to? Lets pretend the banks are solvent. Who would they lend to?[/quote]

      Yeah, exactly. So obvious out here in
      the ‘real economy.’ I wonder if this kind
      of thinking is common inside of the
      administration/congress/financial system
      reality bubble.

      1. LeeAnne

        I’m sure your comment is knowledgeable and worth reading. I tried. Its very hard to read all caps.

    2. Jeff

      Just because You can’t think of any small business sector to lend to doesn’t mean that I can’t.

      I hear this circular argument all the time from Finance people. There aren’t any good loans/investment opportunities in small business The small business that need loans can’t get them because it’s a tough market.

      Bull. The incentives are set up wrong, as this article points out.

      1. NotTimothyGeithner

        So what sector are you lending to? The alternative energy sector? You might want to check the state laws. They are usually draconian to make sure the existing energy companies aren’t threatened.

        The point is you have to wipe out private debt. Individuals and any for-profit venture won’t materialize without some kind of major government interference, such as building a hospital. Those things rejuvenate neighborhoods.

        People won’t take on debt on en masse until its wiped out. They only took it on in the first place because they thought they were going to flip a house. That didn’t work out. People will be skittish.

    3. RagingDebate

      Well, only one thing to do: Blow our collective last wad into domestic energy while the capital remains. The big can give a lot of regional and small banks to lend to small business and create millions of jobs and spurt in consumer demand will numb some of the necessary deleveraging pain.

      I bet the American people would rather all roll the dice collectively than have one shooter. That would increase the odds of success wouldn’t you think?

  2. MacroStrategy Edge

    I am afraid this analysis is based on an antiquated, or at least irrelevant version of the banking system.

    Reserves do not and cannot constrain bank lending, especially in the monetary and banking systems prevailing these days, where central banks set a short term policy rate target, and have to provide ALL THE RESERVES DEMANDED at that interest rate level by banks.

    This is micro 101: the price setter must cannot simultaneously be the quantity setter.

    In addition, there are a number of banking systems, including the one to our immediate north, that have no reserve requirements.

    Banks may be restrained by capital ratios required by Basel I and II. They may be constrained by leverage ratios, as in the US. They may be constrained by their perceptions of the creditworthiness of their prospective clients. But they are rarely, if ever reserve constrained.

    This is unadulterated monetarist claptrap that needs to be discarded at once. If anything, the money multiplier brainwashing you have all been fed – and that appears both in Fed comic books explaining monetary policy to average people, as well as the prevailing economic textbooks used to indoctrinate students of economics – needs to be replaced with a credit divisor.

    The sooner we all get this clear in our heads, the sooner we can move forward out the current quagmire. Lose your illusions – you are being used!

    1. zanon

      You are 100% correct.

      The “money multiplier” that economists have “relied upon” is complete fiction.

      Good luck trying to get anyone to understand you though

      1. MacroStrategy Edge

        Zanon –

        It is very simple to understand and convey.

        Try this.

        Just ask the money multiplier advocates (and this is indeed the story in all the best selling economic textbooks) how the banking systems in the UK, Sweden, Canada, Australia and New Zealand are able to operate in this reserve multiplier paradigm…since they have no required reserves imposed on them whatsoever (source: “Monetary Policy in a World Without Money”, June 2000, Michael Woodford, Princeton University – you know, where Bernanke chaired the department).

        It is like pouring water on the Wicked Witch of the East…mainstream economics and finance is melting away, and everybody knows it except the tenured mainstream professors who are in denial that their life’s work was misdirected, and the mainstream media that keeps fawning over these poor misguided souls.

        As the lies, obscurations, and deliberate misconceptions dissolve before your very eyes, ask who’s interest did they serve for all those years, and what has actually been going on.

        Or if that doesn’t work, go read the public speeches of NY Fed President Bill Dudley in the second half of last year. On more than one occassion, he openly acknowledges the US banking system is not a reserve constrained system. I am told on good authority Chairman Bernanke concurs.

        Got proof? Yes we do. In the words of NYFRB President Dudley himself:

        “In terms of imagery, this concern seems compelling—the banks sitting on piles of money that could be used to extend credit on a moment’s notice. However, this reasoning ignores a very important point. Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not.”

        Full speech from July 29, 2009 linked here:

        Time to loose your illusions, folks.

        The reasons are staring you right in the face, hidden in plain sight as it were. Get up off your couches, come out from behind your computer screens. Go talk to your friends and neighbors and relatives about this, start exploring and crafting solutions with them and start taking your power back now. You’ve been duped.

        1. craazyman

          They just roll their eyes.

          I tried once to talk to a tax lawyer that I was dating about this. She’d listen silently, with sort of a stern set to her face, sort of staring vacantly at me in an evaluating way, and then she’d tell me that I complain too much about Wall Street and looting. She didn’t want to hear about it. She just wanted to talk about fun stuff and do fun stuff, and get doted over, and go shopping.

          I also tried to talk to my Dad about it. He’s an Ivy League PhD Economist (retired). He had a vague idea what I was talking about, but we got all snarled up in language when it came to deposit creation and money multipliers and whether banks or the Fed create money, and the relationship between credit extensions and money velocity. Frankly, I think he just didn’t want to remember. Eventually, we both got tired and changed the subject back to NFL football.

          This is a hard thing to talk about. It takes a certain kind of personality, somebody several standard deviations away from “average.”

          This is not the kind of thing that frends, neighbors and relatives will enjoy discussing. They’ll smile at you in a crazy way, like you’re some kind of lunatic. They’ll want an aspirin after 5 minutes, and then they’ll leave the room.

          I guess that’s why when the shit hits the fan, it will really stink. People will go from sitting around eating and drinking to rioting, in one shot, like a bond default.

          1. beesymph

            I have the same feeling that you do. I retired as a senior attorney from a large corporation and created a blog I deal with many of the same issues that Yves Smith does on Naked Capitalism, but more from the perspective of any outraged and concerned investor.

            I have written about Wall Street looting, the blatantly unconstitutional actions of Paulson, Bernanke, and Geithner and the fact that Obama has turned his back on his constituency the middle class working person. The middle class is being destroyed in this country to benefit Wall Street. So few see this ongoing destruction of our country.

            My friends will politely read my blog and comment that the posts make sense. The next comment is that the posts are too complicated or too depressing.

            Right now my friends pray that their pensions and 401ks are not destroyed. I try to tell them that the system is dangerously unstable and not to take risks in the current stock market which is being pumped up by the government.

            Unfortunately when the replay of 2008 occurs few will be prepared and rioting may indeed be the outcome.

          2. beesymph

            One last thought: you need to keep speaking to friends, family, co-workers etc. You can have an influence.

            We are immeasurably better off that Yves Smith, Karl Denninger, Michael Shedlock and others kept on posting their views despite the derision and indifference. I listened to their views and I was able to convince members of my family to sell stocks right after the HSBC revelation in 2007 of a $10b write off on sub prime mortgages. I received unmerciful second guessing until the market crashed in 2008. You will never get accolades or recognition but that is the price of being an adult.

          3. jerry denim

            This is a hard thing to talk about. It takes a certain kind of personality, somebody several standard deviations away from “average.”

            Very much agreed. That’s why its so nice all of us misfits have lovely online forums like this to find one another. I work in a sector about as far outside of finance as any professional working in contemporary corporate America can claim these days but yet last year as the stock market plummeted and people were in a panic lashing out at ACORN and irresponsible home buyers I found myself time and time again having to explain exactly how and what a CDS, a CDO is and how a MBS works to people like stock brokers. People who by vocation should have been in a far better position to lecture me on derivatives but they were completely ignorant and worse yet, uninterested in understanding what was happening.

            If you could shed any more light on Macro Strategy Edge’s comments please do so. I am interested and all ears.

          4. sam hamster

            My experience is that family politics will determine how your message is heard. Also, closed relationships will remain barren, while communicative relationships will enjoy dialogue on the economy. Overall, people’s moods are fragile and I would be very careful about “spreading the message” among family and friends.

            You may feel that you are trying to help, but your help may be perceived as an attack on their values.

        2. jerry denim

          Very interesting point. Please forgive my ignorance on this critical issue but I too have been laboring under the false impression of “reserve requirements” in the sense of which you speak. From the little that I do know about the Federal Reserve and our monetary system I realize that much is not what it seems; a great many things which are very simple are deliberately obfuscated by byzantine machinations, and many other things in truth are the exact opposite of how they are intended to appear to the public. So while your revelation is not shocking I am still a little confused and skeptical of your claims. Is all the talk of “Zombie’ banks a myth as well? How could gaping holes in bank balance sheets due to toxic assets not have any impact on lending behavior? Is capitalization an irrelevant concept? Are you saying if I were in possession of a bank charter I could make as many loans as I wanted without regard to reserve requirements?

          1. MacroStrategy Edge

            Jerry –

            No need to plead for forgiveness. Most people have been econned or kept in a state of financial illiteracy for a reason. They are much easier to manipulate and loot that way.

            The poster of the original note, George Washington, is not stupid. Read his work – you’ll see he is quite aware and astute. But this money multiplier stuff was probably taught to him from a textbook, or he bothered to go out and learn about himself, and he reads about it in the financial press. He took it to be valid, which would be the usual human approach to reading something in a textbook. He didn’t question it – why should he? And he’s unfortunately been econned on it, as have 90-5% of the people who have studied economics. Alternative or contesting views have been marginalized out of the picture. Although from time to time, even the NY Fed President let’s the cat out of the bag. You are of course free to chose not to believe me, but really, why would the NYFRB Pres. make something like this up? Read it – those are his own words, not mine.

            Regarding your specific questions:

            Is all the talk of “Zombie’ banks a myth as well?

            No. Accounting shenanigans have allowed banks to bury and hide losses, just as in Japan.

            How could gaping holes in bank balance sheets due to toxic assets not have any impact on lending behavior?

            These holes have nothing to do with reserves, which banks are holding in record proportions. These holes are in the bank’s capital position, its underlying equity. But accounting forbearance is allowing them to keep these from sight. Just look at the revelations in the last 48 hours about how the FRBNY, under Geithner, looked the other way after Lehman failed not one, but two of the NYFRB administered stress tests.

            Is capitalization an irrelevant concept?

            Where did I say capital was irrelevant? Please look again Jerry. I explicitly said banks can be capital constrained, right?

            Are you saying if I were in possession of a bank charter I could make as many loans as I wanted without regard to reserve requirements?

            Bank makes the loans. The loans create deposits. Deposits are convertible into currency at par – they are money.

            Banks do not first need reserves to make the loan – they can borrow them in the interbank market. The can borrow them from the Fed. And if the Fed is trying to target a short term policy rate, as NYFRB Pres. Dudley tells you point blank is the prevailing practice, the Fed has to provide all the reserves that banks demand at the target short rate, or else the Fed cannot hold the target.

            Banks do not even first need deposits to make loans. All they need is sufficient capital, and prospective customers they believe are creditworthy, or at least capable of paying huge fees up front for products that will blow up on them long after the loan officer is gone, or long after the bank has securitized the loan and sold off to some other hapless “professional” investor.

            Get this much, and you will be well on your to being d-econned about banks, the Fed, and current monetary arrangements.

      2. Matt Franko


        Yes good luck at a minimum, there are some “thick heads” out there, very entrenched…what will they spend their time worrying about if the US eliminates reserve requirements?

        They are apparently thinking about it. I’ll post this excerpt from Bernanke’s testimony of 10 Feb 2010 (Note 9): ” The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.”

        Link here. Resp,

  3. Jerry

    Hi..we should be on our way to tent cities soon. I work with unemployment benefits and the Fed has not extended benefits since Dec2009……they merely extended the time people can apply for the Dec 2009 extention… people are beginning to fall off the conveyor belt… is starting to quiet down in Unemployment Compensation offices across the USA…..Really sad!!!! Don’t hear on the news at all….next thing we will see is a drop in the unemployment rate which in reality is just that the Fed has provided no more extentions…

  4. Citizen38

    For those of you who need an explanation why awshingtons post is utter BS, below is a copy of Mish’s post today on this very topic.

    Tuesday, March 16, 2010
    Misconceptions about Money and Velocity
    Inquiring minds are interested in velocity and money. John Mauldin discusses both in The Implications of Velocity. Unfortunately, Mauldin perpetuates three widely believed myths in his article.

    Misconception #1: Money Supply Needs To Grow

    “Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, the population, and productivity, or deflation will appear. But if money supply grows too much then you have inflation.”

    Reality #1:

    Money supply most assuredly does not need to grow each year by the size of the economy, by increases in population, or anything else as is widely believed.

    An increase in money supply confers no overall economic benefit whatsoever. Over time, money simply buys less and less.

    Please consider a few re-ordered sentences of Rothbard’s classic text: What Has Government Done to Our Money?
    Money is a commodity used as a medium of exchange.

    Like all commodities, it has an existing stock, it faces demands by people to buy and hold it. Like all commodities, its “price” in terms of other goods is determined by the interaction of its total supply, or stock, and the total demand by people to buy and hold it. People “buy” money by selling their goods and services for it, just as they “sell” money when they buy goods and services.

    Money is not an abstract unit of account. It is not a useless token only good for exchanging. It is not a “claim on society”. It is not a guarantee of a fixed price level. It is simply a commodity.
    What Is The Proper Supply Of Money?

    Continuing from the book …
    Now we may ask: what is the supply of money in society and how is that supply used? In particular, we may raise the perennial question, how much money “do we need”?

    Must the money supply be regulated by some sort of “criterion,” or can it be left alone to the free market?

    All sorts of criteria have been put forward: that money should move in accordance with population, with the “volume of trade,” with the “amounts of goods produced,” so as to keep the “price level” constant, etc.

    But money differs from other commodities in one essential fact. And grasping this difference furnishes a key to understanding monetary matters.

    When the supply of any other good increases, this increase confers a social benefit; it is a matter for general rejoicing. More consumer goods mean a higher standard of living for the public; more capital goods mean sustained and increased living standards in the future.

    [Yet] an increase in money supply, unlike other goods, [does not] confer a social benefit. The public at large is not made richer. Whereas new consumer or capital goods add to standards of living, new money only raises prices—i.e., dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value.

    [Thus] we come to the startling truth that it doesn’t matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness of the [monetary-unit] gold-unit .
    The online book is a great read and I highly recommend reading it in entirety.

    Misconception #2: Falling Velocity Causes Economic Activity to Decrease, Requiring an Increase in Money Supply to Maintain the Status Quo

    “If velocity does slow by another 10%, then money supply (M) would have to rise by 10% just to maintain a static economy.”

    Reality #2:

    Falling velocity is a result of an increased demand to hold money as opposed to a desire to expand productive capacity or borrow to make purchases. In other words, banks do not want to lend and consumers and businesses do not want to borrow. The Fed can print, but it cannot determine where the money goes, or indeed if it goes anywhere at all.

    If the Fed increased money supply by 10%, the most likely consequence would be for money to sit or perhaps make its way into non-GDP producing financial speculation. Thus, GDP would not rise by 10%, instead velocity would plunge.

    Congress can get into the act by giving away money, as it does with various stimulus plans but that has encouraged little lasting economic activity. Unemployment checks maintain spending on food and essentials but those are low-velocity activities. And as boomers head into retirement, peak spending behind them, velocity is highly likely to continue its downward slide.

    By the way, when figuring velocity is it correct to use M1, M2, MZM, Base Money Supply, Austrian Money Supply, or True Money Supply? Obviously the measure of velocity differs widely depending on what definition of money one uses. In general, the broader the measure of money, the lower the resultant velocity.

    Misconception #3: In a normal scenario, banks take money and lend it out 9-10 times over.

    “And now we come to the policy conundrum for the Fed. They have pumped a great deal of money (liquidity) into the economy. Normally, banks would take that money and multiply it by lending it out (through fractional reserve banking at a potential 9-times factor), increasing velocity and the overall money supply.”

    Reality #3: Lending Comes First, Reserves Come Second

    Australian economist Steve Keen and I have emphasized reality number 3 on numerous occasions. Please consider Fictional Reserve Lending And The Myth Of Excess Reserves for a lengthy rebuttal to the idea that the Fed expands money supply then banks lend it 10 times over.

    Those are three widely believed misconceptions. Unfortunately they continually make the rounds. By the way, John Mauldin is a friend of mine and his columns are usually worth a look.

    1. MacroStrategy Edge

      Aside from misconception and reality 3, Mish looks like he has has done something of a hack job on this stuff.

      If he is quoting Rothbard, and Rothbard is detailing for you the rules of the game he believes obtain in a monetary system where money is a commodity, you need to think twice.

      The money in your wallet is not commodity money. It is not convertible upon demand into a specific number of units of a commodity. It is fiat money or credit money, not commodity money.

      The properties Rothbard is attributing to a commodity money system – which themselves are highly debatable, but that is another matter – do not hold true for the type of monetary arrangements most people are living under at present.

      Indeed, the gold standard is long since gone (if it ever existed) and commodity money is hard to find (if it exists anywhere on the globe at all at this time).

      So Mish, via Rothbard, has unfortunately taken you on a fairly irrelevant wild goose chase.

      Once again, you’ve been e-conned, as our host would put it.

      1. jerry denim

        Thanks for your detailed reply to my earlier post. That does help me out quite a bit although it is tough for me to get my head completely around the whole of it. While I do realize there is a difference between capital and reserves I’m still a little hazy as to just how much one differs from the other especially in light of the recent FASB changes.

    2. craazyman

      “””But money differs from other commodities in one essential fact. And grasping this difference furnishes a key to understanding monetary matters.

      When the supply of any other good increases, this increase confers a social benefit; it is a matter for general rejoicing. More consumer goods mean a higher standard of living for the public; more capital goods mean sustained and increased living standards in the future.”””

      This claim strains credulity, like so much written about economics.

      More cigarettes?
      More private prisons?
      More junk food?
      More get-rich quick work-at-home scams?
      More lotto tickets?
      More Hummers?
      More TVs?
      More vacuuous celebrity TV news?
      More useless niche kitchen appliances that you buy and use once?
      More atomic bombs?
      More bunker buster bombs?
      More high-tech jet fighter killing machines?
      More semi-automatic rifles?
      More = better?
      Most = best?
      A world choked with useless, soul-less crap = utopia?
      Human consciousness reduced the level of a bacteria colony = transcendence?

      1. Mickey Marzick in Akron, Ohio



        More is better repression is not necessary because the people believe they are free.

    3. RueTheDay

      Mish is a generally bright guy who needs to shed his Austrian economics indoctrination. In every case where his is just flat out wrong about something, it’s because he can’t get past the Austrian ideology that has been inculcated into his mind despite all of the facts and logic to the contrary.

  5. dd

    Family dinner discussion tonight: Well if Obama is going to super-tax the already over-taxed interest on the meager money market funds do we just liquidate into cash? There is absolutely no point in being in corporate bonds as the swaps market can replicate without cash principal payouts. Who in their right mind invests principal cash amounts so opaque derivatives can free ride? That leaves stocks or gold both overblown in the liquidity ride.
    The family consensus: wine cellar investment and housing improvement to at least enjoy the fruits of labor.
    Odd times.

  6. bakho

    Those are NOT excess reserves. That is money collected to pay off losses that are being kept off the books. This is what happens when the banks become zombies instead of defaulting and wiping out their shareholders.

  7. maniam

    “…The Federal Reserve Banks pay interest on required reserve balances–balances held at Reserve Banks…”

    Federal Reserve Bank print money(cost=paper cost&interest free)exchange for government bonds(interest paying).
    bonds deposited with treasury but they still owned the bonds and immediately got back the money/banknotes.
    so money created out of thin air earn interest from government(people).
    by paying interest on reserve balance,federal reserve bank share the spoils/loot with reserve banks(12).

    government never pay the principal so that bankster get interest payment in perpetuity through land sale,taxes,tariffs,etc.
    in economic down turn(created by banksters)interest on government debts must still be paid.but revenue from usual sources are not enough.therefore bankster get congressmen to look for scapegoat.this time it is china.
    i think the owners of federal reserve banks/reserve banks are own by jp morgan chase,morgan stanley(the grandson),goldman sachs,etc.but is there a head carrying the hydra snakes?

  8. Doc Holiday

    Obviously, banks need to justify bonuses for the crooks that are running the scams. Smaller reserves = smaller bonuses.

    Re: “Why are banks holding so many excess reserves?”

  9. scharfy

    Banks create credit ( money ) out of thin air. They don’t need our deposits and they don’t even loan our money. All they need is what they deem a creditworthy borrower given the interest rate structure, and they will fill in the regulatory blanks (Tier 1 , Leverage, etc) and get the necessary credit from the Fed.

    The mind repels it, but banks are not tightly constrained by how much money is deposited there. There are boundaries yes, but usually not decisive in lending decisions. They are just lending / check clearing arms of the Federal Reserve System. Kind of like an Army of mortgage brokers pushing product.

    So why are reserves climbing then? Banks are taking the cheap money from the FED and buying bonds. Its a nice intersection of monetary and fiscal policy. Why do a mortgage @ 5.5% when you can lend to UncleSam @ 3.7% -4.7% depending on your fancy. (don’t forget about the old borrow short lend long problem, the banks are up to that in spades again) (Its also why the FED can print and print without inflation – because the money’s not chasing goods yet, just parked on a ledger)

    It also gives one insight as to why the Fed gets annoyed when Team Obama gets fiscally footloose. Its a gamekiller for Ben. Inflationary readings in long dated treasuries (10’s and 30’s) due to GOVT spending, might force old Ben to tighten the reigns on Banks, take a more Hawkish stance, and raise short rates.

    That type of unwanted pressure would reduce the ability of our policy makers to extend and pretend. Ben needs those front rates low!, and Team Obama may force him to tighten against his will, because he keeps fighting wars and trying to expand entitlements and stuff…. :)

    But I would state that measuring the somewhat bunk Money Multiplier effect does give one a bird’s eye view of the lack of credit creation. However, this is not because they are “hoarding” our deposits. Theres just a dearth of creditworthy borrowers (even given the access to historically cheap money) in their view. No demand. What a difference a few years makes.

    Again, measuring the bunkish Money Multiplier, if you will is revealing, as it is a metric of credit creation, which IS perfectly relevant.

    Next stop, Government make-work programs to stimulate demand. Thats another can of worms though.

    That my amateurish take…

    And good comments above.

    1. Judas K. Foxglove

      “Banks create money out of thin air”?

      You should have notified Washington Mutual and the hundreds of other failed banks of this “fact”.

  10. ambrose evans-pritchard

    Question for MacroStrategy Edge

    Your points on reserves on most illuminating. I have been following this monetarist debate (as an amateur) with some interest.

    My hunch is that expected Basel capital requirements and new rules combined with a backlog of losses in the pipeline are the real culprits here, and that the Fed is still reluctant to grasp the nettle on Friedmanite QE because it has been side-tracked by the Bernanke doctrine of `creditism’ — which will prove to be an error.

    What do you think? Should we worry about the pace of M3 contraction (I regard the focus on M2 as odd since it cuts off time-deposits above $100,000) and the contraction of bank loans?

    1. MacroStratedge

      Ambrose –

      I do not subscribe to the mainstream economic (MSE) view that money is neutral. Not in the short run. Not in the long run.

      I work with a model where money and finance are intimately involved in the production of real output and the positioning of real durable assets, especially productive capacity.

      But I also do not subscribe to the monetarist cargo cult view that changes in the money stock have a mechanical influence on real side economic outcomes or inflation outcomes, and I find they often botch the transmission mechanisms that are actually at work in the world we inhabit.

      So to my eye, the collapse in money stock growth or money stock income velocity or both (“effective money supply”) is nothing other than the pale shadow of the private sector’s attempt to swing into a large net saving position post the financial panic of 2008 – a natural and to some extent reasonable reaction – along with what Kindleberger would describe as a creditor revulsion, as banks were forced to face how much they had corrupted their lending standards to keep up fee income, and have overadjusted accordingly.

      If you want to understand the framework I use to integrate money and finance with the real economy, and view an application of this financial balance approach, please see the two part piece posted on Naked Capitalism last week entitled “On Fiscal Correctness and Animal Sacrifices”…although perhaps you’ve already seen it, because it sounds a lot like your London Telegraph piece today…and the last two Martin Wolf pieces in the Financial Times, come to think of it.

      You guys seriously need to think about proper attribution of your sources if you expect them to keep feeding you ideas. So if you wish to pursue your question on velocity and money stock and the influence of money on the real world further, perhaps approach Yves for my e-mail address and we can take it from there…with the quid pro quo of attribution if you decide to use it for your publications. It is only fair.


      Rob Parenteau

  11. RueTheDay

    The Fed is in the process of moving towards a “corridor” system similar to the one in Canada. The interest rate they pay banks on reserves held at the Fed will set the floor for rates and the discount rate will set the ceiling. The reserve requirement will be dispensed with entirely. Trying to maintain rate targets via interventions in the fed funds market was proving too ineffective and inefficient.

    1. zanon

      RueTheDay you are incorrect.

      Canada does have reserve requirements. It just sets those reserve requirements at zero. But that is not the same as having no reserve requirements.

  12. Tim Coldwell

    Yves, Would a negative Fed rate encourage banks to get off the teat and start lending to productive real world enterprises? I think that the Swiss (and Japan) have had negative rates (for different reasons, perhaps) in the past. I seem to remember that Willem Buiter proposed such a policy not so long ago.

    1. zanon


      As RueTheDay points out, banks do not lend out reserves. Negative interest rates would just move savings to cash.

      Your other idea of US citizens being beneficiaries of higher interest rates is closer to being on right track. Easiest way to accomplish this is to simply tax them less.

  13. gordon

    Why is NO ONE concerned about SAVERS being paid interest? NOBODY represents the responsible Americans who planned and saved being pushed into risk assets for yield on these blogs! Banks should be allowed to pay more interest, thereby attracting deposits and we responsible Americans spend close to 50% of that interest into the economy. The conspiracy to push Grandma into risky assets is NEVER talked about, this and all the other blogs are a shame (SHAM) by neglecting this crush on the real middle class, those not liars on loans and addicted to greed.

    1. Tim Coldwell

      Indeed, I would go further and suggest US citizen/resident savers should be able to save direct with the treasury at attractive (aka high) rates so bypassing all banks. This could be the other side benefit of a negative Fed rate. In other words, the “profit” the Fed makes from a negative rate should be passed via Treasury to US savers (up to some reasonable $ limit per person). But, of course, Treasury is captured by the banks so don’t hold your breath.

  14. flow5











  15. ambrose evans-pritchard

    reply MacroStrategy,

    Thanks for your reply Rob. I keep an open mind on the monetarist side of this. I was influenced by the UK monetarists 20 years ago when they were (largely) proved right about the ERM crisis for Britain .. although many Keynesians saw through the absurdity off the situation too.

    On sourcing, I had not read that Animal Spirits piece, though I see now that we see things along the same lines. To be honest, I tend to read Naked Capitalism as a terrific way of keeping in touch with US affairs since I am already up to my ears in Europe.

    I have been banging on about these EMU themes for a very long time, dating back to my years as EU Correspondent covering the launch of monetary union and everything that has happened since. In fact, I wrote the leader for the Daily Telegraph on the Maastricht Summit in December 1991, so this is really half a life-time.

    I can’t speak for Martin Wolf, but I know he has been writing about the intra-EMU divergences for a long time too. What he wrote seems entirely consistent with a long string of articles over the years. Obviously this has become topical now, so we are cranking up the volume.


    1. MacroStrategy Edge


      Your passage, repeated below, reads so close to the central messages of the “On Fiscal Correctness and Animal Sacrifices” piece, and the “Let a Dozen Latvia’s Bloom?” piece that I issued in the past ten days that I could not believe me eyes.

      My apologies if I have falsely accused you of lifting it without attribution if these are conclusions you were able to derive on your own (Martin received the pieces directly from me, and acknowledged reading them before grafting them into his financial balances theme, so he has less ground to stand on). All I can say is our minds must have arrived at similar connections and conclusions, which given the fact yours has been stewing in the challenges of the region for decades longer than mine, makes me feel that much stronger about the results of my analysis.

      Regardless, I want to encourage you to keep cranking up the volume on this eurozone imbalances and adjustment issues, Ambrose, and if you can get to Martin, please keep the fire lit under him as well. You are an extremely skilled and powerfully persuasive writer. People like you and Martin can help others see things they may be missing. Believe it or not, that can make a huge difference from time to time. Now is one of those times

      In this case, it strikes me as critical that German policy makers come to see the twin contagion loops they have set into motion – one through the banking system as private debt distress spreads on the back of fiscal retrenchment efforts, and the other through tradable products markets as the domestic income deflations set off in fiscally retrenching nations lead to a collapse in their import demand and attempts to gain market sharer with their exports. These contagion loops are likely to come right back to haunt the Germans and their Dutch friends.

      This is a race to the bottom. No doubt the Germans do no realize what they have set into motion, and how it is about to boomerang on them. They are doing what they believe is right and sound, on political, economic, and ethical lines. But it may break more than a few nations, and it may trip their own recovery and banking systems up in a rather unpleasant fashion. Indeed, it may produce, paradoxically, precisely the opposite of the original intent behind EMU – to economically unify the region so that political extremism would once and for all be mitigated.

      There are no doubt adjustments that need to be made, not all of them pretty or painless. Greece, for example, has the lowest R&D in the region, so of course their productivity growth and product innovation is not going to keep pace unless they start putting money into R&D. Maybe some of the public pension fund investments need to be directed toward investments in companies willing to tack up that charge in Greece, for example.

      There are missing adjustment mechanisms that need to be put into place so that current account surplus countries are directed to play their part in the adjustment process in a pro-growth direction, so we see convergence upward, rather than convergence downward, as the defining or default dynamic set into play. And this holds just as true for Germany and the Netherlands in the eurozone as it does with regard to China and the West.

      Anyway, I appreciate your taking the time to clarify on sourcing. I think you are wise to keep an open mind regarding seeking out alternative points of view, although the old monetarist/Keynesian dichotomy you and I grew up in during the ideologically charged fights of the ’70s and ’80s is increasingly proving irrelevant as more people search for better ways to integrate the real and the financial sides of their economic analysis in a fashion that is true to the work of the macroeconomic innovators who were at each other’s throats in the 1920’s and 1930’s.

      If you get a chance, do describe what you mean by the Fed grasping the nettle on Friedmanite QE, and how you see it held back by Bernanke’s creditist orientation. My own sense is with housing double dipping, and a possible yield back up after the current QE lapses (especially since the GSE’s are about to lose their major counterparty, the Fed, who has been soaking up the liabilities the GSE’s issue, yet GSE spreads over Treasuries are razor thin, as if they were perfect substitutes now that the GSE’s have been effective nationalized), they may get dragged back into another round of QE, but they certainly are not setting the table for that, nor is it likely to be well received by the inflation fearing wing of the Treasury bond investor market.



      “As an aside, I happen to think that the German/EU policy of enforcing a ferocious fiscal squeeze on half Europe is demented and destructive. This Hooveresque strategy will tip these countries into a debt spiral, along the lines described by Irving Fisher in Debt Deflation Causes of Great Depressions (Economica, 1933). It will prove self-defeating, starting with Greece, which will see its public debt galloping up to 135pc of GDP this year. The policy will rebound against German exporters and Germany’s under-capitalized banks, ultimately dragging the entire eurozone into a deflationary swamp. Note that core inflation fell to a record low of 0.8pc in February. France’s Christine Lagarde is right to complain that Germany’s policy of perpetual wage-squeeze and export fetishism is untenable, and ultimately ruinous for monetary union.”

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