Thesis Addendum

Problems with the money multiplier model of fractional reserve banking

In my thesis I felt like I had to provide some context for the way Bitcoin operates, in part because Nakamoto criticizes the way banking works (“lending money in waves of credit bubbles”). In doing so I shortly reviewed fractional reserve banking. However, this money multiplier model of banking has several implications, is suggestive and should not lead to the wrong conclusions. Firstly, this multiplier model implies that banks have to wait until a person puts money into a bank before the bank can make a loan. This implies that banks react passively to what customers do, and that they wait for people with savings to come along before they start lending.

Secondly, it implies that the central bank has ultimate control over the total amount of money in the economy. They can control the amount of money by changing either the reserve ratio or the amount of ‘base money’.

Thirdly, it implies the money supply can never get larger than the central bank intends. This is an assumption in itself, as the task of the central bank is not to put a quantitative cap on money – it rather is to provide financial stability.

The money multiplier model of banking is incomplete. Already in 1984, professor Charles Goodhart of the London School of Economics, and an advisor to the Bank of England for over 30 years, described this model as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.” Mis-instruction of not just some bankers, but of all who have had some education in high school concerning economics – i.e. everybody.

Firstly, the underlying concept of the money multiplier is that in order to make loans banks first require people to deposit money. However, this is not true – when banks lend they create deposits.

Nor do banks need reserves in order to make loans. Alan Holmes, former senior Vice President of the Federal Reserve Bank of New York, said the following about this matter: “In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” This theory is commonly referred to as ‘endogenous money theory’.

While reserve ratios might be useful for other reasons, it is almost impossible for the central bank to use reserve ratios, or limit reserves held by banks in other ways, to restrict credit creation by banks. There are several reasons for this, not least because “banks extend credit, creating deposits in the process, and look for the reserves later”.

Of course, the central bank could choose not to provide a bank with extra reserves when requested. However, if the bank in question had extended credit and requested reserves in order to make a payment on behalf of a borrower, by not providing the reserves the central bank could create a problem for the bank in question.

Therefore if the Central bank wants to restrict the money supply by using reserve ratios or by restricting the amount of reserves availability to private banks, it must be willing to either allow large fluctuations in the interest rate or alternatively intermittent liquidity crises. Due to the potential for liquidity crises to turn into solvency crises, and because a solvency issue at one bank can cause a cascade of bankruptcies throughout the entire banking system, the central bank are unlikely to pursue the second option.

Doing so goes against one of the central bank’s core functions – its mandate to protect financial stability.