Friday, July 15, 2016

The Money Multiplier…

John Tamny has written a book, Who Needs the Fed?  It was reviewed by Jonathan Newman at the Mises site.  Tamny is offering a rebuttal to a few of Newman’s comments.  I have decided to stick my nose in the middle of this.  I will not go point by point, as there is much more in Tamny’s post than I care to deal with.  In fact, I am only going to comment on one item.

It was regarding a Tamny post some years ago that I wrote something on the money multiplier.  It was quickly pointed out how I stepped into it; I then backed off, but did not feel completely settled.  I believe I know better today (or not, let’s see what response I get to this post).

Explicit in the Austrian view of banking is that $100 deposited in Bank A is loaned to another individual who deposits (assuming a 10% reserve requirement) $90 in Bank B, and then Bank B lends $81 to an individual who deposits the funds in Bank C. To Austrians $100 deposited with a bank quickly becomes $271; presumably on the way to infinity.

Missed by Austrians focused on the lending of money among many is that with the previously mentioned scenario, there's still only $100. To save is to give up use of money to someone else.

Tamny argues that there is no money multiplier – in my previous post I agreed.  In this post I will agree…and disagree.

My mistake in my first post was that I was thinking of an all-cash economy – no checks, no debit cards, no credit cards.  In this case, Customer A deposits $100 with (in reality loans $100 to) Bank B.  It is physical cash that Customer A deposits (for this example to be meaningful, the physical cash must be backed by something – even if it is backed only by the risk that the bank defaults due to issuing too much of it).  Customer C borrows $90 cash from Bank B.  The bank is now holding $10 cash and has a note from C for the $90 owed to B.

There is no multiplier.  And for this, I don’t care about the balances held in each individual’s account (or the sum of the two balances: $190).  What matters only is the cash drawn from the accounts.  There is only $100 ($10 with the bank and $90 with C) and some notes – a note from Bank B to customer A for $100, and a note from customer C to the bank for $90.  There is no multiplier if all deposits and withdrawals – meaning also all payments – were made in cash. 

But we do not live in an all cash world, and this is where I believe I went off the rails the first time.  In today’s world, A has a bank balance of $100; C has a bank balance of $90; and, to complete Tamny’s example, D has a bank balance of $81.

To keep it simple, I will focus on debit cards – not credit cards, not checks, not Apple Pay, not PayPal.  With the debit card, each use results in a simultaneous transfer of funds from my account to someone else’s account.  (This unlike cash, where I go to the bank, withdraw $10 and walk around with it for a while, and always keep a balance of cash in my wallet.)

At the same moment, all three of us (A, C, and D) could spend our entire $271.  To keep it simple, let’s say we spent it with each other, thus draining and replenishing our bank balances simultaneously.  To keep it simpler, we all bank with the same bank.

We were able to spend $271, not $100 (technically, not $90 – as the bank is keeping $10 for no one to spend).  No one “[gave] up use of money to someone else,” yet both the depositor and someone else received balances to use.

The balances never leave the system.  Every withdrawal is a simultaneous deposit, and all $271 can be withdrawn simultaneously because it is also deposited simultaneously.  This is impossible in a cash economy, but possible with debit cards (and, with slight twists, all other electronic forms of deposits / withdrawals).

Now, back to my simplifying assumption – all three of A, C, and D trade only with each other and they all bank at Bank B.  It turns out this is not a simplifying assumption; it is reality.

…while I'm all for ending the Fed simply because it doesn't and never has served any useful purpose…

But it did and does serve a “useful purpose.”  Among many other “useful purpose[s]” overlooked by Tamny, the Fed offers a completely closed-loop system – no chance that funds leave the system (other than the almost trivial physical cash balances held).  Everyone who uses US Dollars trades with each other; everyone who uses US Dollars banks at the Fed.

The Fed has eliminated competition; the Fed (along with government deposit insurance, which technically is not necessary given the powers held by the Fed) ensures no risk of damaging bank runs.


So, in my previous post I was right – there is no multiplier – but I should have added: in an economy where all withdrawals and deposits are made in cash.  Individual bank balances might say one thing, but balances available to spend are strictly based on cash held.

I was also wrong – there is a multiplier in an economy where virtually all (or even some meaningful portion of) deposits and withdrawals are electronic and the system is closed-loop.  It is this world in which we live.

I am willing to be right…or wrong about any and all of this; let me know.


  1. Why should cash make a difference? Let's say that the deposit is made in cash, the loan is made in cash, which is withdrawn in cash and deposited in another bank, which after which a fraction of that is loaned in cash again and so on.

    1. Cash is limited, either by being backed by a commodity or the possible bankruptcy of the issuing institution. I noted this above.

      If I loan you $100 cash and you decide to loan $90 of this to a friend, have you multiplied money?

    2. What is multiplied is the credit or accounts on bank ledgers. The physical cash or digital cash element is irrelevant. There is a base amount of currency in existence, and on top of that (and much larger) is credit or accounts on bank ledgers (in the current system).

    3. Matt

      Read this reply carefully and think about it. Then read the above post again and think on it some more:

      There is nothing on a ledger if I take cash out from the bank. It is in my wallet, not on a bank's ledger.

      You asked why should cash make a difference. The answer is right in front of you.

    4. I understand that. There is only a certain amount of cash floating around. Where we are differing is the importance of it. You are basically describing the system described by Rothbard in the Mystery of Banking. The credit issued by banks will have an effect on prices in the sector it is issued, for example the housing sector. That is probably the main factor behind bubbles and why there isn't general high price inflation.

    5. Matt: "Why should cash make a difference?"

      Matt: "The credit issued by banks..."

      I give up.

    6. LOL. I see what you are saying but the cash in your pocket isn't the credit that I am talking about.

      Are you saying that there is no multiplier effect when there is no central bank? That doesn't make sense. Say someone deposits $100. Another person borrows $90 to purchase something from you. Then you take this money as cash and deposit it in another bank, and then that bank will lend it out on a fractional basis. There is your multiplier.

      The first bank has $10 cash in its vaults or somewhere, and a loan that it issued for $90. The second bank will have $9, and a loan issued for $81 and so on. Anyone can withdraw the cash, such as it is, and if it is a depositor (rather than a loan recipient) then it shuts down the multiplier right away. Mainly this is because of the demand to hold cash ("drainage").

      Because the cash is there physically there is no reason that a bank would refuse to do business with another bank or individual if they are willing to provide cash (or equivalent digital currency).

  2. BM said : "I am willing to be right…or wrong about any and all of this".

    Fact: It makes no difference whether you are right or wrong. :-)

    Fact: the Fed is a scam .[ But you already knew that].

    Fact: the Fed is a bastard child of an even bigger scam, the US government and its sycophants. [ But you already knew that].

    Fact: the Fed is a very necessary "enabler" of the modern US empire state. The two need each other like a whore needs a "john", like criminal needs a place to rob. [ Do you already know that?]

    As far as I can see, any attempt to "end the Fed" via legislation must fail. It could only happen superficially.

    That is, any such "end the Fed" legislation that passed would most likely be preceded or accompanied by other legislation to set up a "new" Fed-like institution immediately upon the demise of the original. So nothing would be gained by "ending the Fed". It's a "libertarian" chimera, a mirage that by itself would accomplish nothing beyond perhaps, the very very short term.

    This is because the Fed _is_absolutely_essential_ to the essential , [i.e. superficially successful] functioning of the state that created it out of necessity, [because no government can ever operate within its original fiscal limits, but must inevitably overspend way beyond its taxable revenue limits, for wars, welfare, etc. etc. , in order to maintain its illusory power over the individual and "society". ]

    As far as I can see, it is waste of time for the freedom-seeking individual to pursue that goal or contribute money/support to an organization with the sole stated goal of "ending the Fed"].

    Fact: ending the Fed by itself is just "pissing in the wind".

    In order to be effective it would have to be accompanied by the simultaneous ending of multitudinous welfare scams in all government- run forms ,[e.g. medicare, social security healthcare subsidies, housing mortgages, student loans, public "education" etc. etc. ad infinitum, plus corporate welfare and associated, plus the military welfare system. The military is essentially just welfare for people with uniforms and guns].

    And of course , that ain't all. There are many, many other forms of government welfare aided/abetted/enabled by the Fed that I have not even mentioned.

    Obviously, none of that [ending all welfare etc. etc.] is ever going to happen, at least not via purposeful legislative intent.

    Forget "End The Fed":

    It seems to me that it is more important and productive for the freedom-loving individual to just accept the existing giant scam system known as "the Federal Reserve System", and to then find ways to fully protect both themselves and their savings from it , whether or not the Fed "ends" within the span of their own lifetime.

    Good News?

    The good news is that this can be fairly easily done, without any so-called Fed-free "libertopia" that many envision as necessary ever having to happen in the real world - provided ones' attention and energies are not needlessly diverted into futile attempts to end a government operated institution that is absolutely essential to _all_ of its scam operations, as is the Fed :-) .

    Regards, onebornfree.

  3. I have been thinking of about this site that you linked, and I am increasingly uneasy about it. There seems to be a number of assertions there that are unsupported by the evidence. And taken to its logical conclusion stuff like quantitative easing doesn't even exist.

    Compare with Bank of England -

  4. I recall distinctly when Tamny first made the claim that the money multiplier doesn't exist in Forbes.

    I spent entirely too much time arguing in the comments of that article, but I learned a great deal.

    Here's a good reference from Standard & Poors on the subject:

    TL;DR, banks create loans from thin air, they don't borrow and lend from reserves, and the reserve is not 5% or 10% or any other fixed amount. In one sense, the money multiplier doesn't exist, in another sense: the reality is far worse.

    IIRC, Rothbard uses an example in "Mystery" of a bank that prints and loans gold receipts in excess of gold reserves. The illustration is cast aside and replaced with the money multiplier, but the reality of modern banking is much closer to receipt-printing than the deposit-lend cycle.

    Banks effectively create as many loans as the market will bear, with little to no regard for "reserves" (within certain logical parameters, such as, they wouldn't make a single loan for 10x their cash holdings).

    Why don't customers run the bank? FDIC. Why don't competing banks run each other out of business? As BM stated, the Fed makes the system a closed-loop cartel so that competing banks can't run each other out of business. Without the Fed, bank competition would severely restrict credit creation.

    I'm glad Tamny thinks we should abolish the Fed, but he's dead wrong to say it isn't an integral part of our current system.

    IMO, a post-Fed banking system would replace demand deposits with highly liquid mutual funds and a team of managers using cash holdings to keep the fund value at a fixed rate. Bad management would result in the fund losing value (which spreads losses proportionally), as opposed to a bank run.

  5. I'm a bit hung up on Tamny's comments about banks rarely if ever going to the Fed for loans.

    What about interbank transfers?

    It's not like the old days when banks would find themselves with competitors notes. Today, the Fed homogenizes and pasteurizes those transfers so that banks can't demand specie like they used to. One banks deposit creation is as good as the next.

    I don't doubt that banks are generally good at what they do, and the absence of the Fed might not be immediately felt precisely because banks are shrewd and credit creation is balanced. However, that remains to be seen because the Fed exists precisely to prevent banks from having to balance inflows and outflows, or use their cash holdings to peg a fund value at a certain dollar value.

    As I read Tamny, he seems to make good points, but he so fundamentally misunderstands how credit is created, and the lengths the Fed goes to ensure that this credit is synonymous with money. For example, when you get a paycheck, do you think, "My employer has paid me in US$", or do you think, "My employer has paid me in bank credit which the Fed goes to great length to ensure is accepted the same as US$"?