In an interesting talk last week, San Francisco Fed president John Williams spoke about the need to modernize economics education. His remarks on the death of the “money multiplier” caught my eye:
The breakdown of the standard money multiplier has been especially pronounced during the crisis and recession. Banks typically have a very large incentive to put excess reserves to work by lending them out… If a bank were suddenly to find itself with a million dollars in excess reserves in its account, it would quickly try to find a creditworthy borrower and earn a return on that one million dollars…
But, this hasn’t happened—not at all. The Federal Reserve has added $1.5 trillion to the quantity of reserves in the banking system since December 2007. Despite a 200% increase in the monetary base—that is, reserves plus currency—measures of the money supply have grown only moderately….
Why has the money multiplier broken down? Well, one reason is that banks would rather hold reserves safely at the Fed instead of lending them out in the still struggling and risky economy. But, once the economy improves sufficiently, won’t banks start lending more actively in order to earn greater profits on their funds? And won’t that get the money multiplier going again? And can’t the resulting huge increase in the money supply overheat the economy, leading to higher inflation? The answer is no, and the reason for this is a profound, but largely unappreciated change in the inner workings of monetary policy….
I’m referring to the 2008 legislation that allowed the Fed to pay interest on bank reserves…
John Williams is an outstanding macroeconomist, far more knowledgeable that I am—and when he attributes the death of the money multiplier to interest on reserves, I’m hesitant to disagree with him. But as far as I can tell, this dramatically overstates the impact of interest on reserves. In reality, the “money multiplier” broke down because it never really existed in the first place.
Here’s the textbook story: as the Fed pumps reserves into the system, banks suddenly have the ability to increase their lending and create new money. Since the reserve requirement on checking accounts is 10%, any increase in bank reserves will lead to money creation ten times the size of the initial injection.
Casual observation suggests some problems with this story. After all, money market funds share many of the characteristics of checking accounts, and yet they have a reserve requirement of zero. Shouldn’t that make the money multiplier infinity? Since the money supply clearly isn’t infinity, there must be something other than reserve requirements limiting money creation.
And that’s the key point: even in normal times, the cost of meeting the reserve requirement accounts for only a small portion of the cost of creating money. If you’re accepting checking deposits and lending them out when the riskless nominal interest rate is 4%, you’re losing 10%*4% = 0.4% each year because the reserve requirement forces you to hold base money rather than T-bills. That’s not trivial, but it’s hardly overwhelming: the much more challenging part of a bank’s job is finding a decent borrower. If the reserve requirement falls from 10% to 5%, and the cost of holding reserves declines from 0.4% to 0.2% (if the riskless rate stays the same), you’re not going to suddenly find twice as many places to lend the money.
I’ve been over this before, but let’s try another analogy. Suppose you live on an isolated island filled with peanut farms, where peanuts are turned into peanut butter with tiny, handheld machines. There are lots of peanuts, but not many machines; since each machine can only produce a certain amount of peanut butter each month, local economists observe a extraordinarily close relationship between the supply of machines and the supply of peanut butter. They call this relationship the “peanut butter multiplier”.
Suddenly, unexpected visitors descend on the island with a boatload of peanut butter machines. There are now so many machines that the supply of peanuts can’t keep up. Many machines sit idle, and economists are shocked to see the “peanut butter multiplier” disappear. The ratio of peanut butter production to peanut butter machines plummets.
Obvious enough, right? Now that peanuts are the scarce input rather than machines, the direct relationship between machines and peanut butter production no longer holds. But the mechanics of the “money multiplier” are really no different: like the machines in my story, bank reserves are one input for money creation. They’re not the only input, however, or even the most important one; you can’t have peanut butter without peanuts, and you can’t have money creation without creditworthy borrowers.
It’s true that historically, there has been a direct relationship between reserves and deposit creation. Excess reserves have stayed at roughly zero, as banks hold precisely the amount necessary to satisfy their reserve requirements. But that’s just an artifact of how monetary policy is conducted: at the margin, the only reason banks hold reserves is that they need to meet reserve requirements, and as long as the federal funds rate is greater than zero (so that reserves are costly), they will limit their holdings to the bare minimum that’s acceptable under the rules. Since the federal funds rate was always significantly greater than zero until the last few years, there were no excess reserves. And now there are:
Technically, the federal funds rate is still a little higher than zero. With interest on reserves, however, there is now zero cost to holding reserves—in fact, the cost is slightly negative, as mysterious technical issues prevent banks from arbitraging away the (small) gap between the rate paid on reserves and the federal funds rate. Now that reserves are costless to hold, textbook microeconomics tells us that the relationship between reserves and money creation will break down: the reserve requirement is no longer a binding constraint, and the other costs of taking and lending deposits will determine banks’ activity.
Is there any reason to think this would be different if there was no interest on reserves, and the federal funds rate fell to zero? Not at all. We’d see the same pattern: with the rate at zero, reserves would no longer be a costly input, and other costs would dominate instead.
Lest you think this is all overconfident theorizing on my part, let’s consider the obvious empirical example: Japan. In 2001, Japan began its policy of quantitative easing, which resulted in an enormous increase in the supply of base money. Interest on reserves, however, wasn’t paid until 2008. What happened in the meantime? A 2003 paper asking “Who Killed the Japanese Money Multiplier?” makes the outcome clear enough.
I often see articles attributing the breakdown of the money multiplier to some special feature of the current economic climate: interest on reserves, or banks’ reluctance to lend during a recession. In truth, the reason is much simpler. The money multiplier has never been a deep structural relationship. The apparent “multiplier” in the data is no more profound than the relationship between peanut butter machines and peanut butter. When an input is scarce, output will move with it. When the input is no longer scarce, output will not.
No surprises here.