Yves here. While the impetus for Steve Keen’s post is the ECB’s latest pretense that it can and is doing something to combat deflation, he provides an excellent and short debunking of two widespread misconceptions about money and banking. The first myth is the money multiplier and the second is that reserves are the basis for bank lending.
You’ve just made your morning coffee, and look up in horror as you realise that the gas burner has set your kitchen ablaze. So you take decisive action: you pour your coffee on the floor.
Such is the real impact of the European Central Bank’s latest attempt to revive the European economy, which cut rates a whopping 0.1 per cent (from 0.15 per cent to 0.05 per cent), and increased the negative interest rate imposed on bank reserve deposits from a huge -0.1 per cent to a gargantuan -0.2 per cent.
Forgive my sarcasm. But the mystery that should occur to everyone — and it probably does to most people who haven’t been given a £9000 lobotomy (as Aditya Chakrabortty recently described an economics degree) — is why an economist might think that such apparently trivial measures would have any impact on the disaster that is the eurozone economy.
Ah, but an economist can tell you why. It’s because of the ‘money multiplier’! This potent force will turn that allegorical puddle into a proverbial sea that will drown the flame of 25 per cent-plus unemployment in southern Europe.
The fable theory goes like this. Banks lend by taking money deposited by one customer (say €100), hanging on to a certain fraction of it (say 10 per cent, which is €10), which they add to their reserve assets. They then lend the rest (€90) out to another customer. That customer then spends that €90, and the people who get it put that in their own banks, who also hang on to 10 per cent (€9), and lend out the rest (€81). The process repeats indefinitely, at the end of which time the initial deposit of €100 has been turned into €1000 of new money and new spending along the way.
Seen from this viewpoint, the cause of the European crisis is obvious: banks aren’t doing their bit and lending on as much of their depositors’ funds as they could. Rather than hanging on to 10 per cent and lending out 90 per cent, they’re hanging on to say 25 per cent and lending out only 75 per cent. The consequences are less money, less spending, and more unemployment.
The evidence here is the amount of reserves that private banks are holding in excess of the amount they’re required to hold by law (see the third column in Figure 1).
Excess reserves were at trivial levels before the crisis (as small as €700 million), but shot up to more than €400 billion during the crisis. They’ve since fallen back, but are still more than 100 times as large as they were previously.
Figure 1: Private bank reserves in the eurozone
If only these excess reserves could be mobilised, just think of the economic activity they could generate! The required reserve ratio in the eurozone is just 1 per cent, which means private banks are required to hang on to just €1 in every €100 deposited. That means €110bn of excess reserves could generate as much as €10 trillion of new money — enough to blast the euro economy out of its doldrums.
But banks aren’t doing their bit. Instead, they’re just sitting on depositors’ funds and not lending them on, probably because they lack confidence to lend because they’re afraid their borrowers won’t be able to repay their debts.
So let’s prod these lazy banks to lend, by making it expensive to just sit on these funds. Let’s charge them to hang on to excess reserves. We tried a 0.1 per cent charge, and that wasn’t enough. Let’s double it!
There’s just one problem with this theory, in addition to the fact that a 0.2 per cent negative interest rate will cost the banks a mere €200m per year, which is chicken feed. It’s all bollocks, because banks can’t and don’t lend out reserves, and reserves don’t control how much they lend. To understand why, you’re going to have to suffer through some accounting.
When a bank customer deposits cash at a bank, the bank records the payment as both an asset and a liability. The cash itself is an asset, but because you as a depositor can demand that the bank give the money back to you at any time, it is also a liability of the bank to you. Figure 2 shows how Deutsche Bank would record the transaction if a random depositor — let’s call her Angela — deposits €100 with it:
Figure 2: Angela makes a deposit
Notice that Deutsche Bank’s assets and liabilities both rise by the same amount. This is a basic accounting rule: all transactions must be balanced, otherwise you haven’t recorded the transactions properly. I’m showing this here by making a positive on both sides of the ledger: assets go up and so do liabilities. (I use a different sign convention in my Minsky software, for technical reasons.)
What if Deutsche Bank then tries to use Angela’s cash deposit to make a cash loan of €90 to Mario, which is what the ‘money multiplier’ model says banks do? If I stick to that accounting rule, then the model implies that the next stage of the process looks like Figure 3: the bank has ‘hung on’ to €10 of Angela’s deposit and lent out €90 to Mario.
Figure 3: The ‘money multiplier’ model of a bank making a loan
But there’s are two problems. Firstly, no money has been created: it’s just been shifted from Angela to Mario. Secondly, no one’s told Angela that her account has gone down by €90. In fact, this isn’t supposed to happen, according to the ‘money multiplier’ model: her account is supposed to still have €100 in it.
So what if we write that down here? Then we get the picture shown in Figure 4, which to borrow a phrase from a sometime correspondent of mine, is “all wrong”, because the row doesn’t balance. There’s €100 in assets but €190 in liabilities.
Figure 4: The uncorrected second stage in the ‘money multiplier’ model
The correct story is shown in Figure 5. The bank just makes the loan to Mario by crediting his deposit account with €90 and showing the same amount as a loan in its assets. Its reserves don’t change, and they (and Angela’s deposit) are irrelevant to the operation.
Figure 5: The correct model of lending
I’ll say that again, this time quoting the Bank of England:
As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them … It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve …, which is then, in normal times, supplied on demand by the Bank of England.
To summarise the Bank of England — and to repeat myself — reserves are irrelevant to bank lending. They only exist so that one bank can settle its accounts with another, and banks keep these accounts as low as they can manage. So charging private banks a trivial interest rate on their trivial reserve accounts is about as effective at stimulating an economy as pouring your coffee on the floor is at stopping a kitchen fire. If this is the best that the ECB can manage, then Great Depression levels of unemployment in Europe will persist.