WHY DOESN’T THE BANK-LOAN MULTIPLIER EFFECT
CREATE AN INFINITE AMOUNT OF MONEY?
Analysis by G. Edward Griffin, 2008 June 26
It has been argued that, if banks can create money out of nothing at a ratio of nine new dollars to one dollar in reserve, then the multiplier effect can go to infinity. This is based on the theory that, starting with $1000, Bank A can create $9000 loaned to Customer A, who deposits it into Bank B, which uses it as a reserve to create an additional $81,000 loaned to Customer B, who deposits it into Bank C, which uses it as a reserve to create an additional $729,000, and so on. Fortunately, it does not work that way. It’s bad enough as it is, but at least we are spared the horror of this hypothesis. Here is how it works.
1. We begin with a starting “reserve” of $1000 resulting from the bank’s stockholders or, for our example, a deposit from John Gullible. If Gullible withdraws his money and it is not replaced by new deposits, the bank will be out of business because it will have no “reserves” upon which to create money for loans. In fact, it will have to call in the loans that were based on that $1000 in order to allow it to be withdrawn. So it is essential for the bank to maintain at least $1000 in deposits by replacing withdrawals with new deposits. We assume here that the bank is able to do that and has $1000 in “reserve.” At this point, the bank’s books are evenly balanced with $1000 in assets (Gullible’s money on deposit) offset by $1000 in liability. The deposit also is viewed as a liability, because the bank does not own it and is obligated to give it back to Gullible at some time in the future. So far, the money supply has not increased.
2. The bank creates $9000 based on $1000 reserve and loans it to Trendy Wendy, who takes it as a deposit in her checking account. At this point, the bank has an additional $9000 in assets (money on deposit in Trendy’s checking account), but that is offset by $9000 in liability because, once again, the bank does not own this money. Trendy is entitled to take it out of her account and spend it at any time. Thus, the books remain balanced with assets equaling liabilities, but the money supply has expanded by $9000.
3. The next day, Trendy uses her loan to purchase a used car from Honest Abe. She writes a check to Abe who deposits it into his checking account at the same bank. The money has moved from one account to another within the bank; but total assets and liabilities do not change, and the money supply does not further expand.
4. Abe decides to use his new money as security for a loan. He understands that the bank is able to multiply deposits by nine to one so he goes to the bank and says he wants a loan for $81,000 based on his new deposit of $9000. The bank, however, will not be able to issue the loan because, although it has a new asset of $9000 from Abe, it no longer has the old asset of $9000 from Trendy. Thus, based solely on Gullible’s $1000 deposit, the bank is incapable of creating more than $9000.
Let’s complicate the example by considering that there are two banks in the system. Actually, the result will be the same even if there are thousands, but let’s start with only two for the sake of clarity.
5. Let us assume that Abe takes his $9000 to a second bank and makes the same proposition for a loan of $81,000. It would appear that there is nothing to prevent the second bank from creating the requested loan through the multiplier effect. That would be true if the banks were not obligated to honor each others checks, which might be the case if one were dealing with banks in separate countries using separate currencies. However, banks within the same banking system do have such obligations, which means they have to be careful not to create more money than they realistically can pay out when other banks demand it in settlement.
For example, if the second bank does create a loan of $81,000 to Abe, and he uses it to purchase a sail boat, and if the seller of the boat deposits Abe’s check into the seller’s account at the FIRST bank, the first bank will immediately present Abe’s check to the second bank and demand a transfer of $81,000 to the first bank. Based on the transactions in this example, we can see that the second bank would be foolish to create $81,000, because, once it is loaned to Abe, it no longer has it, and the chances of having to deliver that money to another bank is 50%. If there were three banks in the system, the chances would be 66% and so on. The more banks there are in a system, the more certain it is that the creating bank will be called upon to “settle” its customers’ checks with other banks. If they can’t do that, they must borrow the money from other banks or the Fed or go out of business.
Of course, each bank can rely on checks from other banks clearing through its books in the same way, which, if everything else is equal, will offset its own obligations. But everything else is seldom equal, so banks must maintain a safety margin, making sure they don’t create more loans than are being created by other banks, on average. The main point, however, is that, even if all the banks were able to synchronize their loan ratios perfectly so that no safety margin would be required, that would represent a state of affairs comparable to there being only one bank in the system, in which case we are back to a single multiplier ratio of nine-to-one.
In practice, such efficiency is never possible, and the actual multiplier ratio within the entire banking system is always slightly less than the theoretical maximum.
Printed on 07 September 10 at 17:51
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