Chart of the Day: Monetary Transmission Mechanisms

Here’s a nice chart courtesy of Richard Koo via the folks at FT Alphaville. It shows how central banks ballooned the monetary base (reserves) after the Lehman bankruptcy.

Here’s the thing though, money supply flatlined as the money multiplier plummeted. See the lines at the bottom?

What gives?

Koo says that liquidity does not always translate to increased bank lending and suggests that this is because we are in a "liquidity trap". I like the first part of his analysis but not the second part. I mentioned this last May, writing:

Koo is pointing to the money multiplier fallacy that comes from the concept that banks are reserve constrained. Of course, none of this is true. Banks are never reserve constrained in our non-convertible floating exchange rate monetary system; They are capital constrained.

Theoretically, banks could lend out up to 10 times their reserves if the reserve ratio is 10% (money multiplier: loans = 1/reserve ratio). In reality, however, banks make the loans first and then look to the reserves afterward. That means some banks are short reserves and must borrow them in the interbank market.

When the entire banking system reaches the reserve limit, the central bank could theoretically create a credit crunch by refusing to increase reserves. But then the Fed would not be able to manipulate short-term interest rates.The Fed Funds rate is dependent on the central bank’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target.  So in practice, central banks always increase the level of reserves desired by the system in order to maintain the interest rate.

My point is that the money multiplier is a fallacy in a fiat currency credit system and we see that now that we are in a balance sheet recession in which credit growth is subdued due to private sector deleveraging.

Koo says QE2 drove speculation, but what about the real economy?

This balance sheet recession is not really about liquidity traps and and the zero bound for interest rates. It’s about overindebted private sectors that have limited increased demand for credit. If and when the demand for credit increases, so too will the money supply.

Source: Monetary blanks in the Eurozone, Izabella Kaminska, FT

P.S. – Also see John Carney on this – MMT and Austrian Economics Walk Into a Bar…

  1. Ralph Musgrave says

    Edward, You are quite right. As to liquidity traps, I regard the whole idea as nonsense.

  2. michael Phippen says

    Really Ed- Why don’t you do the math on your dismissal of liquidity traps and then please show it Krugman for a critique,

    1. michael Phippen says

      Maybe Ed -you are right and Krugman is wrong I don’t know I just want to know the back up for the differing positions.

    2. Edward Harrison says

      “Banks do not make loans on the basis of the reserves they hold. They respond to demands from credit-worthy customers and have in mind what it will cost them to make the loans under current conditions. When the transactions that follow the creation of a loan transpire it might be that the is short of reserves to ensure the payments clear. It has various options. It can seek funds from wholesale markets (other banks or other lenders), use deposits (not an overnight option really) or, ultimately, it can source the funds from the central bank.

      The very fact that the central bank sets a non-zero target policy rate means that it has to manage liquidity (reserves) to ensure that the rate sticks. This is an example where demand and supply rules. The centrral bank loses control of its interest rate target if there are excess funds in the system (and it doesn’t pay a return on those balances).

      The point is that the chain of causality is: Demand for loan from credit-worthy customer => bank loan creates deposit => any necessary reserves to maintain payments integrity added afterwards.

      So the increase in bank reserves (as in the current period) only really impacts on the central bank’s capacity to pursue a non-zero policy rate. It has to offer a return on the excess reserves to the bank equivalent to the policy rate to stop the competition in interbank market from driving the rate to zero as banks individually try to eliminate their holding of excess reserves. In aggregate, the bank transactions cannot eliminate a system-wide excess. That point thereby answers Greg Mankiw’s question – see the blog – It is a pity that he doesn’t know the answer himself – for more discussion.

      Liquidity trap or not, the size of the monetary base (currency plus bank reserves) is largely irrelevant. It does not increase the risk of inflation. It does not increase the funds available to banks to lend.”

  3. michael Phippen says

    Thank You very much!

  4. Dave Holden says

    fundamentally I lean toward Austrianism, I see to much in the way of the pretence of knowledge elsewhere.

    but I agree banks aren’t reserve constrained and there’s an argument that there not entirely capital constrained.

    For a nice discussion of constraints in banking (although it doesn’t elaborate on this particular point) check out this week’s always excellent econtalk.

  5. Benedict@Large says

    Isn’t it a bit more than just lack of demand for credit? Haven’t the banks with large pools of questionable capital raised the bar for what they consider credit worthy, thus choking off borrowers who would otherwise generally qualifiy? I keep hearing stories of this nature.

    This doesn’t of course change your point. It’s just seems that there’s both a demand and supply problem with credit that restraining the money supply.

    1. Dave Holden says

      Hi Benedict, Your right, credit isn’t purely demand driven, there is also a supply side aspect to it. Clearly the economy is a complex system with lots of feedbacks and side effects. The lack of humility in the face on such things is one of my bugbears with economists.

      I suspect one of the reasons for this rationing is to do with the risk weights that different types of loans are given under banks capital adequacy rules. Business loans for example are considered much more risky than mortgage loans. Under our current monetary system private sector banks are the main arbiters in both the amount of money created and how it is allocated both during a boom and bust.

    2. Edward Harrison says

      I agree that there are supply constraints when the business cycle is at its nadir. However, at this point in the business cycle i.e. in the third year after recession has supposedly ended and after FDIC-insured US banks have started earning tens of billions each quarter, supply side issues are not as relevant. Banks have long since started to loosen the purse strings and are only inhibited by the demand for credit amongst CREDITWORTHY borrowers. You can read the Fed’s survey of credit officers to see this is true.

      Now, that term creditworthy is key because the definition is flexible as the business cycle waxes and wanes. But, the bottom line is that this far into a business cycle, credit growth will increase as demand for credit amongst borrowers deemed creditworthy does.

      1. Dave Holden says

        But again it’s not just “demand” that matters, it’s the willingness to supply based on that judgment of “credit worthiness” and that judgment in of itself will depend on rules governing the risks of certain types of lending.

        Certainly in the UK there’s lots of anecdotal talk of a crunch in small business lending.

        1. Edward Harrison says

          Yes, it is demand by creditworthy borrowers that counts.

          But I think you’re parsing words here. I mean the demand for borrowing is ALWAYS there for uncreditworthy borrowers. Don’t people who are underwater want credit? Don’t the unemployed want credit? The reason I didn’t insert the term creditworthy to begin with is that it is a given that it is demand by creditworthy borrowers that counts since there is always an almost infinite demand for credit if it is given without regard to creditworthiness as we have just seen during the bubble.

          1. Dave Holden says

            The point is that you can be credit worthy but not get a loan. The supply side restriction is on the judgment by the bank on who is credit worthy.

          2. Edward Harrison says

            There is some of that. I agree and have written about that at length. But it’s not more severe than any other business cycle now. The defining character of this cycle is a lack of creditworthy borrowers with increased credit demand.

  6. Paul Baclace says

    Thanks for the succinct viewpoint. Now I see why Steve Keen uses change in public+private debt as a key economic measure: it captures the concept of effective money multiplier better than the money multiplier itself.

  7. Dave Holden says

    Well I can only go on anecdotal evidence. The point still stands that it’s not just demand that matters. In fact there’s an argument that the weighting given to different types of credit bias banks lending such that valid business demand for credit is less favoured than credit aimed at assets. Now that may be entirely valid or it may be one of the causes for a Ponzi based asset bubble.

    1. Edward Harrison says

      Its no different on the supply side than in 1976, 1984, 1994, or 2004. The point is that’s a business cycle phenomenon that goes without saying and this cycle is now no more severe than any other on the supply side.

      Read what credit officers are saying and don’t go on anecdote.

      PS. Credit is INcreasing.

      1. Dave Holden says

        I’m not is a position to argue whether its *different* I’m just making the point that supply side matters and type of credit matters.

        1. Edward Harrison says

          I think everyone agrees with that statement about supply side credit. But when you talk about balance sheet recessions as secular events, the supply side is less relevant. The supply side is a cyclical phenomenon. That’s my point and that’s an important point to make.

          1. Dave Holden says

            On the issue of supply

            “Read what credit officers”

            Where would I find this information?

  8. Dave Holden says

    Thanks Edward.

  9. Edward Harrison says

    Dave Holden, also read this whole piece by PIMCO.

    This part applies to what I have said about credit supply having loosened in the US (and elsewhere):

    Another positive for the U.S. economy in 2012 is the nascent revival of availability of consumer credit. In recent months, this has become most clearly evident in the areas of student loans and also automobile financing. The latter was a critical component in the recovery of automobile sales to a 15 million annualized sales rate in February 2012 (a level of activity not seen in the sector since March of 2008) according to the U.S. Department of Commerce.

    An important question, however, is whether this recovery in consumer credit availability will filter deep enough and wide enough in the household sector to allow for a sustained and continued drop in the U.S. household savings rate, which will be needed to sustain cyclical U.S. economic growth in the face of a weakening outlook for fiscal stimulus and exports. The potential certainly exists and will be strengthened significantly if current improvements in employment and income can be sustained into 2013.

  10. Dave Holden says


    OK, so it looks like I was aware to a certain degree about credit supply in the US from following Denninger who charts it. I think the point about the uptick in Student loans confirms my point on supply side constraints and risk weightings. From a creditors point of view I would have though student loans were one of the safest type to make for example. I think my point is, this risk weighted supply constraint or bias will affect how any recovery proceeds.

    Coincidentally, Golem has a post out today talking about lending and risk weights.

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