The Fed Is Responsible for the Crash in the Money Multiplier ... And the Failure of the Economy to Recover

Greg Mankiw noted in January 2009:

Econ prof Bill Seyfried of Rollins College emails me:

Here's
an interesting fact that you may not have seen yet. The M1 money
multiplier just slipped below 1. So each $1 increase in reserves
(monetary base) results in the money supply increasing by $0.95 (OK, so
banks have substantially increased their holding of excess reserves
while the M1 money supply hasn't changed by much).

Since January 2009, the M1 Money Multiplier has crashed further, to .786 in the U.S. as of February 24, 2010:

(Click for full image; underlying data is here)

That means that - for every $1 increase in the monetary base - the money supply only increases by 79 cents.

Why is M1 crashing?

Because the banks continue to build up their excess reserves, instead of lending out money:

These excess reserves, of course, are deposited at the Fed:

Why are banks building up their excess reserves?

As the Fed notes:

The
Federal Reserve Banks pay interest on required reserve
balances--balances held at Reserve Banks to satisfy reserve
requirements--and on excess balances--balances held in excess of required reserve balances and contractual clearing balances.

The New York Fed itself said in a July 2009 staff report that the excess reserves are almost entirely due to Fed policy:

Since
September 2008, the quantity of reserves in the U.S. banking system has
grown dramatically, as shown in Figure 1.1 Prior to the onset of the
financial crisis, required reserves were about $40 billion and excess
reserves were roughly $1.5 billion. Excess reserves spiked to around $9
billion in August 2007, but then quickly returned to pre-crisis levels
and remained there until the middle of September 2008. Following the
collapse of Lehman Brothers, however, total reserves began to grow
rapidly, climbing above $900 billion by January 2009. As the figure
shows, almost all of the increase was in excess reserves. While
required reserves rose from $44 billion to $60 billion over this
period, this change was dwarfed by the large and unprecedented rise in
excess reserves.

[Figure 1 is here]

Why
are banks holding so many excess reserves? What do the data in Figure 1
tell us about current economic conditions and about bank lending
behavior? Some observers claim that the large increase in excess
reserves implies that many of the policies introduced by the Federal
Reserve in response to the financial crisis have been ineffective.
Rather than promoting the flow of credit to firms and households, it is
argued, the data shown in Figure 1 indicate that the money lent to
banks and other intermediaries by the Federal Reserve since September
2008 is simply sitting idle in banks’ reserve accounts. Edlin and
Jaffee (2009), for example, identify the high level of excess reserves
as either the “problem” behind the continuing credit crunch or “if not
the problem, one heckuva symptom” (p.2). Commentators have asked why
banks are choosing to hold so many reserves instead of lending them
out, and some claim that inducing banks to lend their excess reserves
is crucial for resolving the credit crisis.

This view has lead
to proposals aimed at discouraging banks from holding excess reserves,
such as placing a tax on excess reserves (Sumner, 2009) or setting a
cap on the amount of excess reserves each bank is allowed to hold
(Dasgupta, 2009). Mankiw (2009) discusses historical concerns about
people hoarding money during times of financial stress and mentions
proposals that were made to tax money holdings in order to encourage
lending. He relates these historical episodes to the current situation
by noting that “[w]ith banks now holding substantial excess reserves,
[this historical] concern about cash hoarding suddenly seems very
modern.”

[In fact, however,] the total level of reserves in the
banking system is determined almost entirely by the actions of the
central bank and is not affected by private banks’ lending decisions.

The
liquidity facilities introduced by the Federal Reserve in response to
the crisis have created a large quantity of reserves. While changes in
bank lending behavior may lead to small changes in the level of
required reserves, the vast majority of the newly-created reserves will
end up being held as excess reserves almost no matter how banks react.
In other words, the quantity of excess reserves depicted in Figure 1
reflects the size of the Federal Reserve’s policy initiatives, but says
little or nothing about their effects on bank lending or on the economy
more broadly.

This conclusion may seem strange, at first glance, to readers familiar with textbook presentations of the money multiplier.

Why Is The Fed Locking Up Excess Reserves?

Why is the Fed locking up excess reserves?

As Fed Vice Chairman Donald Kohn said in a speech on April 18, 2009:

We
are paying interest on excess reserves, which we can use to help
provide a floor for the federal funds rate, as it does for other
central banks, even if declines in lending or open market operations
are not sufficient to bring reserves down to the desired level.

Kohn said in a speech on January 3, 2010:

Because
we can now pay interest on excess reserves, we can raise short-term
interest rates even with an extraordinarily large volume of reserves in
the banking system. Increasing the rate we offer to banks on deposits
at the Federal Reserve will put upward pressure on all short-term
interest rates.

As the Minneapolis Fed's research consultant, V. V. Chari, wrote this month:

Currently,
U.S. banks hold more than $1.1 trillion of reserves with the Federal
Reserve System. To restrict excessive flow of reserves back into the
economy, the Fed could increase the interest rate it pays on these
reserves. Doing so would not only discourage banks from draining their
reserve holdings, but would also exert upward pressure on broader
market interest rates, since only rates higher than the overnight
reserve rate would attract bank funds. In addition, paying interest on
reserves is supported by economic theory as a means of reducing
monetary inefficiencies, a concept referred to as “the Friedman rule.”

And the conclusion to the above-linked New York Fed article states:

We
also discussed the importance of paying interest on reserves when the
level of excess reserves is unusually high, as the Federal Reserve
began to do in October 2008. Paying interest on reserves allows a
central bank to maintain its influence over market interest rates
independent of the quantity of reserves created by its liquidity
facilities. The central bank can then let the size of these facilities
be determined by conditions in the financial sector, while setting its
target for the short-term interest rate based on macroeconomic
conditions. This ability to separate monetary policy from the quantity
of bank reserves is particularly important during the recovery from a
financial crisis. If inflationary pressures begin to appear while the
liquidity facilities are still in use, the central bank can use its
interest-on-reserves policy to raise interest rates without necessarily
removing all of the reserves created by the facilities.

As the NY Fed explains in more detail:

The
central bank paid interest on reserves to prevent the increase in
reserves from driving market interest rates below the level it deemed
appropriate given macroeconomic conditions. In such a situation, the
absence of a money-multiplier effect should be neither surprising nor
troubling.

Is the large quantity of reserves inflationary?

Some
observers have expressed concern that the large quantity of reserves
will lead to an increase in the inflation rate unless the Federal
Reserve acts to remove them quickly once the economy begins to recover.
Meltzer (2009), for example, worries that “the enormous increase in
bank reserves — caused by the Fed’s purchases of bonds and mortgages —
will surely bring on severe inflation if allowed to remain.” Feldstein
(2009) expresses similar concern that “when the economy begins to
recover, these reserves can be converted into new loans and faster
money growth” that will eventually prove inflationary. Under a
traditional operational framework, where the central bank influences
interest rates and the level of economic activity by changing the
quantity of reserves, this concern would be well justified. Now that
the Federal Reserve is paying interest on reserves, however, matters
are different.

When the economy begins to recover, firms will
have more profitable opportunities to invest, increasing their demands
for bank loans. Consequently, banks will be presented with more lending
opportunities that are profitable at the current level of interest
rates. As banks lend more, new deposits will be created and the general
level of economic activity will increase. Left unchecked, this growth
in lending and economic activity may generate inflationary pressures.

Under
a traditional operating framework, where no interest is paid on
reserves, the central bank must remove nearly all of the excess
reserves from the banking system in order to arrest this process. Only
by removing these excess reserves can the central bank limit banks’
willingness to lend to firms and households and cause short-term
interest rates to rise.

Paying interest on reserves breaks this
link between the quantity of reserves and banks’ willingness to lend.
By raising the interest rate paid on reserves, the central bank can
increase market interest rates and slow the growth of bank lending and
economic activity without changing the quantity of reserves. In other
words, paying interest on reserves allows the central bank to follow a
path for short-term interest rates that is independent of the level of
reserves. By choosing this path appropriately, the central bank can
guard against inflationary pressures even if financial conditions lead
it to maintain a high level of excess reserves.

This logic
applies equally well when financial conditions are normal. A central
bank may choose to maintain a high level of reserve balances in normal
times because doing so offers some important advantages, particularly
regarding the operation of the payments system. For example, when banks
hold more reserves they tend to rely less on daylight credit from the
central bank for payments purposes. They also tend to send payments
earlier in the day, on average, which reduces the likelihood of a
significant operational disruption or of gridlock in the payments
system. To capture these benefits, a central bank may choose to create
a high level of reserves as a part of its normal operations, again
using the interest rate it pays on reserves to influence market
interest rates.

Because financial conditions are not
"normal", it appears that preventing inflation seems to be the Fed's
overriding purpose in creating conditions ensuring high levels of
excess reserves.

The Fed Has Failed Once Again

I believe that the Fed's efforts to ensure excess reserves are
completely wrong, as deflation is the greater short-term threat. See this, this, this, this, this, this, this, this and this.

However,
regardless of whether or not the Fed has been right to worry about
inflation since it started paying interest on excess reserves in
October 2008, the real cost of it's program to the American people and the American
economy has been staggering.

In October 2009:

Otmar Issing, the ECB's former chief economist, told an Open Europe forum in
London that policymakers are entering treacherous waters. "Nobody can
be sure that we have a self-sustaining recovery. The challenges facing the
ECB are tremendous," he said.

"Money multipliers have collapsed everywhere. What M3 is telling us is
that confidence is missing. I don't see any way to stabilise M3 in such
circumstances," he said.

Barron's notes:

The
multiplier's decline "corresponds so exactly to the expansion of the
Fed's balance sheet," says Constance Hunter, economist at hedge-fund
firm Galtere. "It hits at the core of the problem in a credit crisis.
Until [the multiplier] expands, we can't get sustainable growth of
credit, jobs, consumption, housing. When the multiplier starts to go
back up toward 1.8, then we know the psychological logjam has begun to
break."

As I wrote last October:

Professor Tim Congdon from International Monetary Research says:

A
key reason for credit contraction is pressure on banks to raise their
capital ratios... "The current drive to make banks less leveraged and
safer is having the perverse consequence of destroying money balances,"
he said. "It strengthens the deflationary forces in the world economy.
That increases the risks of a double-dip recession in 2010."

But isn't it good that governments are requiring banks to raise their capital rations?

Sure,
but unless they force the banks to write off their bad debts, they will
remain giant black holes, and will never be adequately capitalized. If
they are never adequately capitalized, they will never release money
out into the economy through loans and other economic activity ...

As just one example, remember that the nominative amount of outsanding derivatives dwarfs
the size of the global economy. As another example, remember that
several of the too big to fails have close to a trillion dollars each in toxic assets in off-book SIVs.

IMF chief Dominique Strauss-Kahn says
that the history of financial crises shows that "speedy recovery"
depends on "cleansing banks' balance sheets of toxic assets". "The
message of all financial crises is that policy-makers' priority must be
to stop the quantity of money falling and, ideally, to get it rising
again," he said.

As many people have repeatedly written (including me),
the world's governments must restore sound economic fundamentals -
which includes forcing banks to write down their bad assets - instead
of cranking up the printing presses and trying to paper over all of the
problems.

Moreover, as [we]
have pointed out, governments can create all the credit they want, but
if people do not have jobs, they will not borrow that money.

In addition, the amount of credit and wealth destroyed exceeds the amount of money pumped into the system.

When
will the politicians listen? Will they wait until after the next huge
market crash? When there are tent cities everywhere? After their
governments default and they essentially lose sovereignty under
"austerity measures" imposed by the IMF, World Bank or other agency?

Note 1: The NY Fed actually says that
the M1 money multiplier is now moot as a metric. Specifically, the
above-discussed paper states that the central bank's policy of paying
interest on excess reserves renders the M1 money multiplier - that all
economists rely on - useless.

Note 2: It's not just the Fed.  The NY Fed report notes:

Most central banks now pay interest on reserves.

Note 3: I understand that consumers' balance sheets are so impaired that many are not looking for loans. However, many consumers and small businesses are looking for credit, and are being turned down.

Comments

[wake the roach]

"It hits the core of the problem in a credit crisis. Until (the multiplier) expands, we can't get sustainable growth of credit, jobs, consumption, housing."

Well that is the most honest statement one can make...

Growth in credit = economic growth. They are two sides of the same coin.

Somewhere in their pea brain must be this notion that servicing debt just means borrowing even more to service the existing debt with.

Ahhh, yes... Thats how it worked in 1913 and thats how it works today...

If you want to see economic growth, then you want to see credit expansion...

If this concept of expanding credit forever actually worked for people other than those who have the connections to benefit from this scam, then nobody would need to work. All we have to do is borrow more and more, spend and travel and enjoy the fruits of debt, then when we get old, we borrow some more and leave it to our children and their children to spend.

Bravo A+++... So why does it not work, what grounds money to reality, what is this invisible wall that we hit, what is the common denominator?

Its only fiat imaginary money backed by nothing correct, so why can we not just print money at a rate that keeps inflation at say 3% forever. Who cares if we have to keep adding zero's, we will just lop some off every 100 years or so?

Here in lies the hard reality and the crux of the worlds economic problem that 1 in 1000 actually get... 

There is no such thing is a fiat currency. Money since its very conception is and always will be a claim on energy.

The original currency was the only energy source humans could consume, food. The birth of agriculture created surplus which now reguired a unit of account to allocate this surplus and money was born. Food which in all its different currencies (fish or apples) is a claim on, and is given its value by its energy content.

The difference today is that we now determine a currencies value by the portion of coal, gas or oil energy that currency allocates you to consume.

Money and credit are a claim on energy, economic growth is using that energy.

Problem is of course, that the M1 money was also created from debt. This debts interest can only be serviced through the credit money multiplier so thus we need to consume more energy in a way  that provides greater net energy gains to service this debt but that cannot happen. Our primary energy sources are finite and we have no technology available that can change that.

I'll finish up this long and I'm sure ignored lesson with a couple of questions everyone should ask and understand if you want to know why there will never be a sustained recovery.

Why is it that whenever the price of oil reaches 4% of GDP we go into recession?

When oil prices increase and drive the price of goods and services higher, why do central banks lower interest rates instead of raise them? Because higher prices across all goods and services must automatically mean monetary inflation right?

And finally, given that we are now in a recession (soon to be depression), why has the price of oil not fallen below 4% of GDP with such reduced US demand?

[B9K9]

I'm rapidly becoming a fanboy - you wouldn't happen to know Mako would you?

Yes, you are absolutely correct. The only way to beat the exponential math of compounding principle+interest is to generate sufficient wealth by achieving output levels (productivity) in excess of capital costs.

See my comment to CD below - the normal cycle before reset has historically been around 50 years. (It takes about that amount of time for the original debt to double, thereby exceeding the carrying capacity/value of the underlying asset.)

However, and this is a mighty big however, the eon's long cycle has been interrupted (postponed actually) a few times since 1694: the exploitation of the new found Americas, including massive emigration; the discovery of coal, followed by oil & gas; two massive capital destroying world-wars; and finally, the incorporation of billions of slaves (globalization) into core production.

Now it appears we really have reached the end of the line. Unless we come up with some miracle in either food production, resource extraction/utilization, or some incredible production optimization scenario, we are going to experience the largest default in both recorded & unrecorded history.

[wake the roach]

The only way to beat the exponential math of compounding principle+interest is to generate sufficient wealth by achieving output levels (productivity) in excess of capital costs.

Abso f**king lutely, + 1 to infinty....

And to rephrase into terms relative to energy.

The only way to beat the mathematics of exponential growth in the consumption of a finite energy resource is to generate sufficient wealth (replace each energy unit consumed + interest) by achieving output levels (net energy gains) in excess of capital costs (finite energy consumed).

Money and energy? Two sides of the same coin.

We have only escaped the inevitable results of exponentially consuming finite energy resources (most critical today is oil) for this long because we could always substitute productivity by just increasing the rate of extraction or what could be thought of as energy inflation. 

Three billion new and thirsty oil consumers guarantee that the infinite growth economic model is now on life support, never to regain consciousness again...

Whether one believes we have reached or are close to reaching peak oil does not really matter as it misses the point completely.

Price as a function of supply and demand is all that matters and once the ability to increase the rate of supply has been reached, the system begins to feed on itself.

Not even the most religious economist can trump the mathematical and physical laws of our universe and unless uncle Ben can conjure up 10 new ghawar's and thus one buck gas, well... You know...

To take one glimpse of a graph charting the increase in debt since 1913 is to understand that we have climbed this roller coaster ride to the top, but unlike a roller coaster ride, going down the other side won't be much fun...

And yeah, read your comment to CD, given me a lot of reading to catch up on haha ;-)

[ThreeTrees]

Nice dialogue Roach and B9K9.  I look forward to reading more of your exchanges.  Thought-provoking shit, to say the least.

[ThreeTrees]

A ponzi scheme only works if people are buying into it.  So yes, in this case it does come down to a psychological logjam.  Ignoring, of course, the limits with which we're saddled in a deterministic, thermodynamically bound universe...

[Ripped Chunk]

+!  Rave out!

"What an idiot! This concept would make a person think that there are no boundaries to credit creation"  Ben!,   Ben!  Hello!  That is after all the ultimate wet dream of the arrogant hedonistic idiots now, isn't it?

[Cyan Lite]

Why are folks here clamoring for an increase in inflation, would would require tigheting of the Fed Funds rate (and thus the interest paid on reserves)?  This would further exacerbate the problem of reserves growing, and less lending from the big banks.

[Ned Zeppelin]

Who clamored for inflation?

[Gordon_Gekko]

the psychological logjam

Is that what they call the effects of long term looting, a**-raping and pillaging the public?

[Failure to Comm...]

The logjam is affecting my colon negatively.

[WaterWings]

That and all the Fedspeak like "Overseas Contingency Operations", which means, bombing weddings of people that don't speak English.

[35Pete]

But they hate our freedoms. 

[knukles]

Not True

A decrease in the multiplier does not automatically translate into deflation , nor an increase, inflation.  The multiplier measures exclusively the ratio of reserves (base) to a monetary aggregate. 
Further, the public effectively controls exogenous shifts in the multiplier for any given level of reserves in the system through a change in their aggregate demand for funds.  Thus, should the public's demand for funds increase substantially without any offsetting decrease in the availability of reserves which in turn would force the multiplier even higher, then indeed, the capacity for higher inflation is assured.

What is happening now is that the public's demand for funds has remained relatively constant whilst the availability of reserves has simply skyrocketed.  Thus, the decline in the multiplier.
A pure manifestation of Benny the Red's fixation with the contraction of monetary policy prior to and in part a cause of the Great Depression.  Not wishing to be tagged a party pooper along with Andrew Mellon, he's flooded the system with high powered money, thus buy definition, driving the multiplier lower as a result.

Deflation can exist, but is not a result of the aforementioned relationship; may be a cause, but not a result.

[bingaling]

"What is happening now is that the public's demand for funds has remained relatively constant whilst the availability of reserves has simply skyrocketed."

I disagree public demand is decreasing . So what happens when the public refuses to go into debt?

Answer: prices get lower to entice the consumer (or 70% of the US economy) to come back to the debt "table" . and the Fed isn't allowing it .It is a simple matter of supply and demand -

You add in unemployment and U6 (20-25% depending who you ask) and it is apparent that prices must deflate in order to increase demand becasue 1/4 of the population is making less -prices should reflect that.

The more prices go up the more demand will decrease and add increased pressure on employment numbers . The Fed is boxed in. It has a choice "let the banks fail or let the economy fail (70% of the US economy is the consumer) .For now it has chosen to let the banks live at the expense of the consumer .The money it has spent went to the wrong party it should have gone to debt relief for the consumer who support the banks . The banks DO NOT support the consumer . Money "floats" up not down .

I believe deflation is a sure thing because it is the consumer or 70% of the economy who will demand it anything other than this scenario is unnatural and catastrophic.

I will leave it with "if you take away the flies from a pond the bullfrogs will die of starvation . If you increase the amount of flies, bullfrogs will get fat and multiply." The Fed is artificially feeding the Bullfrogs when they should be helping to create flies .This ain't rocket science it's common sense .

[Ned Zeppelin]

You understand, of course, that this "money floats up not down" concept of yours, while correct, is not the policy that is pursued, but rather its opposite. In fact, extend your analogy by noting that when the Fed stops feeding the bullfrogs, the small minnows and lesser amphibians and micro-invertebrates become the next food source for the bullfrogs.  We are those imcro-invertebrates.

[bingaling]

Good point. I understand it and because of it the pond will just become a lifeless puddle of water when this is all said and done if it is not already .

[swamp]

Inflation is a monetary event, not an economic event.

Public demand be damn if the banks won't lend, people won't have money and prices will adjust downward in deflation.

[Sancho Ponzi]

Here's a great post from Market Oracle:

'The implications of Velocity of Money on the Economy'

http://www.marketoracle.co.uk/Article17866.html

[ThreeTrees]

+1 Well put.  Post more like this.

[Alexandra Hamilton]

This looks interesting, especially in view of the re-financing need corporations, financial sector and otherwise, will have in the near future. It seems they are preparing for the Wall of Maturity of 2012 already.

http://wp.me/px1MN-fF

[Rainman]

......and Uncle Sugar will muscle right to the front of the debt rollover line each and every year. That's gonna be real interesting.

[Justin Credible]

but wait!  the second derivative is improving!

[dcb]

deflation is great for everyone not in debt. i.e. the people who didn't get us into this mess and are paying for the bailout. Why should the system be rigged in favor of those who cause the problems

[Failure to Comm...]

It's not a bug, it's a feature.

[SteveNYC]

Even Shalom Bernanke can only deny nature's laws for so long. Soon, he will be crushed by her in a most savage display of deflationary power.

[Ripped Chunk]

They designed it that way???

[anarkst]

"Why should the system be rigged in favor of those who cause the problems."

When has it ever been different?

[doublethink]

How do YOU spell deflation?

W-E-A-R-E-S-C-R-E-W-E-D

[Buck Johnson]

You hit it right on the head, it will be Stagflation on steriods.

[Al Gorerhythm]

In Chinese or Cap Hill speak....

We-a-rescrewed!!!

[Mad Max]

In the words of FDR, "We have nothing to fear but a decades long, deflationary hyperinflationary depression, culminating in the most horrendous war the world has ever seen."

Or something like that.  I'm paraphrasing.

[Miss Expectations]

In the words of Winston Churchill, "You've done so much, for so long, with so little, that soon you'll be able to do everything, with nothing, forever."

Or something like that.  I'm paraphrasing.

[Mad Max]

Severely reduced pay for everyone!  Yay!

[DoChenRollingBearing]

Close enough for government work.

[George Washington]

Thanks: first laugh of the day ...