The myth of the money multiplier - by Steve Keen

Three Business Spectator readers contacted me directly about one topic last week – bank money creation, and how bank reserves work. Following an old journalism adage that three direct enquiries about a topic from the public means that everybody’s interested in it, I’m diving into wonkdom to answer their queries in detail here. Ignore this post if the adage isn’t true for you, but if it is and you haven’t yet had your morning Java, now’s the time for that stroll to the barista.

OK, caffeinated? Here we go.

The standard story about how banks create money, and how reserves work, is the “Money Multiplier Model”. Money creation starts with the government injecting “fiat money” into the economy – say by giving a welfare recipient $100 in cash. That recipient then deposits the cash in a bank, which hangs on to a government-mandated fraction of it (the “Reserve Requirement”) – say 10 per cent or $10 – and lends out the rest to a borrower. The borrower then deposits that $90 in another bank, which does the same thing – hangs onto 10 per cent of the $90 or $9, and lends out another $81 to another borrower.

The process repeats ad infinitum, and in the end a total of $1,000 is brought into existence: the original $100 in cash, plus $900 in credit money created by the private banking sector (matched, of course, by $900 in debt).

This alleged system, known as Fractional Reserve Banking, is seen as “fraud” by Austrian economists, and by many in the public. To inflationists, because Bernanke has hit the printing presses, dramatically increasing Base Money, and therefore money in circulation will soon explode, leading to hyperinflation.

To Neoclassical economists, it’s just the way banking works: bank lending is controlled by the Fed because, “even if banks hold no reserves”, Fed control over the currency means that private banks must do what the Fed wants.

And to anyone who’s done empirical research, it’s a myth.