Recently we were
“accused” by someone who was evidently a great adherent of the economics of
John Maynard Keynes of not understanding the Keynesian money multiplier. A few years back we had made the statement in
a posting that the Keynesian money multiplier is based on a fallacy and relies
on counting the same money multiple times — what in accounting is called “double
counting.”
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| "It doesn't have to work if the suckers buy it." |
The only way to
counter vague assertions such as this is first to demonstrate that you do
indeed understand what you’ve been accused of not understanding. For that reason, we are going to subject you
to the standard textbook explanation of the Keynesian money multiplier, and
then why we regard it as a load of hooey.
So, here is the standard explanation of its operation:
The money supply
expands to a maximum of the reciprocal of the reserve requirement. Thus, a 10% reserve requirement means that
the maximum possible expansion of the money supply is on the order of 10x, e.g., a $1 million infusion of new money
into the system means that the money supply can expand by $10 million ($1
million times 1 divided by .1).
As the
explanation goes, this is because $1 million is deposited in Bank A, of which
$900 thousand is lent out by the bank in new loans. These loans are deposited in Bank B, which
lends out $810 thousand. These loans are
in turn deposited in Bank C, which lends out 90% of what is deposited, and so
on, “cycling down” (so to speak) until no more loans are made. $1 million plus $900 thousand plus $810
thousand, and so on, eventually totals an expansion of the money supply in the
amount of $10 million.
There are two
reasons why this explanation is a complete fantasy, bordering on the
delusional, even though it is in all the textbooks.
One, the process
as described is completely illegal. The
bank cannot lend out the amounts it accepts for demand deposits for the simple
reason that it does not own the money, and every cent of that money must be
available on demand by the depositor, hence the name, “demand deposit.”
Examine your bank
statement. You will see that amounts
added to your account are “credited,” while amounts subtracted are
“debited.” If you are familiar with
basic accounting, however, you are aware that a “debit” is normally an addition
to the owner’s assets, while a credit is a subtraction from the owner’s
assets. Why is this reversed on your
bank statement?
Because your bank
statement is not really “your” statement.
It is a statement of what is on the bank’s books, not yours. All deposits in a bank constitute liabilities
to the bank, not assets, and cannot be loaned out. They must
be available for the owner “on demand,” that is, at a moment’s notice — and
that means no lending from demand deposit funds.
Now, these funds could be loaned out by the bank — for a
fee charged by the depositor — had they been deposited in a time deposit
(“savings account”). A time deposit is
not generally available on demand by the depositor but is often conditional on
the availability of liquid funds.
Thus, the first
reason a bank cannot function the way the Keynesian money multiplier requires
is that it is illegal for it to do so.
No doubt, you
say, however, banks are operating
illegally, and the multiplier does work that way because banks are illegal
institutions, and bankers are all criminals.
(The problem of collective guilt and making accusations without proof is
a problem for another day.)
The allegations
that banks are illegal institutions and all bankers are criminals, however,
falls apart as soon as we look at the real reason the Keynesian Money
Multiplier is a fallacy.
Let us assume for
the sake of the argument that a bank can, in fact, lend out the funds a
customer deposits in a checking account (i.e.,
demand deposit). As we have seen above, this
is illegal, but necessary if the multiplier is to work. We will now see that it does not, in fact,
work at all.
Let us assume the
same 10% reserve requirement, and the same $1 million deposited in Bank A. The bank lends out $900 thousand (again, it
cannot, but this is the assumption for the sake of the argument), and these
funds are deposited in the form of checks in Bank B.
According to multiplier
theory, Bank B then lends out $810 thousand of the $900 thousand it accepted
for deposit . . . but does it?
By no means. Bank B cannot lend out any part of the $900
thousand it accepted for the simple reason that it is not in the form of
additional reserves. It is in the form
of checks — which are not reserves, but claims on reserves . . . of Bank A.
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| Dr. Harold G. Moulton |
In order to
obtain the $900 thousand in reserves represented by the checks it accepted,
Bank B must present the $900 thousand worth of checks to Bank A. Bank A reduces its reserves by $900 thousand
(leaving $100 thousand), transfers the $900 thousand to Bank B, and cancels the
$900 thousand worth of checks.
Clearly there has
been no increase in the money supply, regardless how often loans are made, and
how many banks are involved. All that
has occurred is a transfer of funds, not money creation.
Thus, even if a
bank could legally lend out funds accepted for demand deposits, there would
never be any increase in the money supply.
The Keynesian money multiplier is a fantasy.
None of this is
new. This is, more or less, the
explanation of the Keynesian money multiplier theory given by Dr. Harold G.
Moulton, president of the Brookings Institution from 1928 to 1952, on pages 77
to 84 of his book The Formation of
Capital. This was published in 1935,
shortly after the Keynesian money multiplier theory was developed.
The only
misunderstanding about the Keynesian money multiplier here is the baffled
head-scratching that goes on among people who try to figure out its logic in
the harsh light of reality.
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