What’s wrong with the money multiplier? – Banking 101 (Part 2 of 6)

What’s wrong with the money multiplier? – Banking 101 (Part 2 of 6)

MODEL? We’ve seen the two main ideas that the general
public have about the way banks work. Both of them are wrong. That’s not too surprising,
after all, unlike the Positive Money team most people don’t spend their time obsessing
about how banks work. And banking is complex, which means that most people give up trying
to understand it. But what about economics or finance students?
Most of these students and graduates have a slightly better understanding of banking.
They get taught about something called the ‘money multiplier’. The money multiplier story says that banks
actually create much of the money in the economy. Here’s how the story goes: A man walks into a bank and deposits his salary
of £1000 in cash. Now the bank knows that, on average, the customer
won’t need the whole of his £1000 returned all at once. He’s probably going to spend
a little bit of his salary each day over the course of the month. So the bank assumes that
much of the money deposited is ‘idle’ or spare and won’t be needed on any particular
day. It keeps back a small ‘reserve’ of say
10% of the money deposited with it (in this case £100), and lends out the other £900
to somebody who needs a loan. So the borrower takes this £900 and spends
it at a local car dealer. The car dealer doesn’t want to keep that
much cash in its office, so it takes the money back to another bank. Now the bank again realises that it can use
the bulk of the money to make another loan. It keeps back 10% – £90 — and lend out
the other £810 to make another loan. Whoever borrows the £810 spends it, and it
comes back to one of the banks again. Whichever bank receives it then keeps back 10% i.e.
£81, and makes a new loan of £729. This process of relending continues, with
the same money being lent over and over again, but with 10% of the money being put in the
reserve every time. Note that every one of the customers who paid
money into the bank still thinks that their money is there, in the bank. The numbers on
their bank statement confirm that the money is still there.
Even though there is still only £1000 in cash flowing around, the sum total of everyone’s
bank account balances has been increasing, and so has the total amount of debt. Supposedly this process continues, until after
around 200 cycles, almost all of the original money is now in reserves, and only a fraction
of a penny is being relent. By now, the sum total of all bank accounts adds up to about
£10,000. So the multiplier model that is still taught
in many universities implies that this repeated process of a bank taking money from a customer,
putting a little bit into a reserve, and then lending out the rest can create money out
of nothing, because the same money is double-counted every time is it relent.
The model says that if the reserve ratio — that’s the percentage of customers’ money that
the banks have to keep in a reserve — is 10%, then the total amount of money will grow
to roughly 10 times the amount of cash in the economy. You can imagine this model as a pyramid. The
cash is the base of the pyramid ,and then, depending on the reserve ratio, the banks
multiply up the total amount of money by relending it over and over again. The fact is that what we’ve just shown you
is completely wrong. It’s an inaccurate and outdated way of describing how the banking
system works. In fact, banks in the UK haven’t worked like this for years. But despite that, this model is still used
most of the time whenever people talk about how money is created, whether in universities
or on videos on the internet. Before we spent 5 months researching exactly how the system
worked, we used to think it worked like this too. The fact that this pyramid model is still
used is a problem for three reasons: Firstly, this model implies that banks have
to wait until someone puts money into a bank before they can start making loans. This implies
that banks just react passively to what customers do, and that they wait for people with savings
to come along before they start lending. This is not how it really works, as we’ll see
later. 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 — that’s the percentage
of customers’ money that banks have to keep in reserve – or the amount of ‘base money’
— cash — at the bottom of the pyramid. For example, if the Bank of England sets a
legal reserve ratio —- and this reserve ratio is 10%, then the total money supply
can grow to 10 times the amount of cash in the economy. If the Bank of England then increases
the reserve ratio to 20%, then the money supply can only grow to 5 times the amount of cash
in the economy. If the reserve ratio was dropped to 5%, then the money supply would grow to
20 times the amount of cash in the economy. Alternatively, the Bank of England could change
how much cash there was in the economy in the first place. If it printed another £1000
and put that into the economy, and the reserve ratio is still 10%, then the theory says that
the money supply will increase by a total of £10,000, after the banks have gone through
the process of repeatedly re-lending that money. This process is described as altering
the amount of ‘base money’ in the economy. But the most significant implication of this
model is that the Bank of England, or the Federal Reserve or European Central Bank,
has complete control over how much money there really is in the economy. If they change the
size of the base — by pumping more ‘base money’ into the system — then the total
amount of money should increase. If they change the reserve ratio, then the steepness of the
sides of the pyramid will change. But eventually, the reserve ratio stops the money supply growing
any further. At some point we reach the top of the pyramid and the money supply stops
growing. So there’s absolutely no possibility that the money supply can get out of control. There’s just one small problem. Almost everything
about this description of banking is wrong. In fact, 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.” It might be forgivable for textbooks to be
out of date if the rules had changed in the last couple of years — after all, a lot
of rules and regulations changed during the financial crisis. But Professor Goodhart actually
said this in 1984. 27 years, later university students are still learning a description
of banking that is completely inaccurate. This is a big problem. If these students then
go on to become economists and advisors to the government, and they don’t even really
understand how money works, then our economy could end up in a real mess. Oh wait…it already is! Now, I have to point out that these videos
do apply to the UK, and we haven’t had time to confirm exactly how things work in the
USA and Europe. But for those of you in the US, a paper published in 1992 refers to a
textbook still used in universities today — and states that “the multiplier model…is
at best a misleading and incomplete model, and at worst a completely mis-specified model’. Here’s the bottom line when it comes to
the ‘money multiplier’: 1. There’s no reserve ratio in the UK anymore,
and there hasn’t been for a long time. 2. The Bank of England doesn’t have any
real control over the amount of cash, or even electronic ‘base money’ (which we’ll
talk about later). 3. And the Bank of England certainly doesn’t
have control over how much money there is in the economy in total. It’s not just economics graduates who have
the wrong information. Even people working in the Treasury still believe it works according
to the textbook. We’ve had letters from the Treasury saying things like this: In relation to the point about the control
of money, it is the Bank of England alone which has control over the monetary base.
This consists of currency (banknotes and coins) and reserves held by commercial banks at the
Bank of England. Commercial banks are responsible for extending credit to individuals and businesses
and have no authority to create or print money, digital or otherwise. Allowing people with an incomplete understanding
of how money works to manage our economy is very dangerous. It’s like allowing engineering
students who don’t understand gravity to build skyscrapers.

45 thoughts on “What’s wrong with the money multiplier? – Banking 101 (Part 2 of 6)

  • If all this teaching is wrong then all economic models will be wrong, all predictions will be wrong. So no wonder they did not see the crash coming and ven more to the point they won't see the next one coming either.

    We have just had a fiasco over GCSE results in the summer so why does this government allow totally out dated teaching to degree/masters level in economics when it is not even accurate. This must be the biggest unrealized scandal in education.

  • That is why quantitative easing hardly works: banks do not lend because of lack of base money but because they are afraid of not getting paid back. While in the previous decades they created unlimited loans for the housing bubble without needing the Bank of England raising the base money. The collapse of bubbles is the main reason for banks to stop lending. Hence the economic downturn.

  • funny enough the money created with the loan is coming out of thin air and is only allowed because they have a banking license from the central bank. Banks book a loan that is not being paid back as a loss. But how can you loose something that you created out of thin air? Thanks to the banking license they can even continue to create loans out of thin air!

  • So far, so good. Thank you.

    I'd like to see an exploration of derived value, .i.e, gold/silver-backed currency. Also, clarification between money and currency, especially in the context of fiat would be appropriate.

    Monetary multipliers could also be expounded upon to include the derivatives market. Is there options trading in the UK like in the US? There isn't in Germany, I've learned.

  • "If all this teaching is wrong then all economic models will be wrong, all predictions will be wrong."

    -Not necessarily. Much of what I've heard out of the Mises Institute preaches that fractional reserve banking is fraudulent. It's the Keynesian and Keynesian-derivative philosophies that presume to have predictive modelling. The only thing the Austrians predfict is that there is a business cycle and that Keynesian intervention will ultimately end in disaster.

  • Caveat: I'm not claiming to be a classical liberal/Austrian/Misean. I've haven't yet gleaned from my readings if they are for anti-trust policies or not but so far, it seems as if they are completely anti-regulation. Which seems naively too far in the other direction.

  • University teaching is not a scandal in education. First everyone has to understand that you learn the money multiplier model in your most basic economic courses and so it is only meant to give you a gist of how money is created, economic students such as myself learn about exceptions to this model and other theories as well so to say we are restricted and derive everything from this one model is wrong.

  • Most university's teach DSGE model of economics which does not even take money or debt into consideration according to Steve Keen. Any system of teaching that say's borrowing is just someone else s savings is sheer lunacy. I have no problems with them teaching a historical view so long as they teach an accurate current view as well.

  • Many other countires do have a reserve ratio. Eurozone has 1%, Russia and India 4%, China 20.5%. According to Wikipedia..

  • AND when that (Digital) bank loan 'money' is repaid – It DISAPPEARS ! So repayment of loans in THIS man-made SYSTEM causes Recessions/Depressions/Busts/Bankruptcies – after the BOOM – of lots of loans. What a wank/dick SYSTEM.

  • what they teach in universities is ALL bullocks
    not only about money and economics but also about the history of WW1 and WW2 
    and about healthcare…
    and so on

  • In europe the banks work in the same way. You know why? Because a private banks are owned by the same group of very rich people. So if a scam works in the UK, they will use the same scam all over the world.

  • I thought there was a reserve ratio in the UK, but to have none is terrifying. I'm pretty sure Obama allowed American banks to have zero reserve requirement not to long ago as well. Regardless, banks always ignore the rules. When Goldman Sachs books were looked into during 2008. They were found to be leveraged 333 to 1. A 0.03% reserve ratio.

  • at 3:44 the video talks about 3 reasons why the multiplier model is wrong.
    Reason 1: Banks do not react passively and wait for savings
    Reason 2: The Bank of England has absolutely no control over the amount of cash/electronic money because there is no reserve ratio

    but whats the third reason???


  • Part 3: Absolutely correct. "Double counting" an accounting with the money is a serious error.
    If you lend  6 cats to the bank, and write down "I loaned 6 cats" does not create 12 cats.

  • The Bank of England is absolutely correct.
    I see you fall into the same error you actually presented, pretending deposits (IOU) are the same as the money described in an IOU – that writing down "I have loaned you 6 cats" somehow made 12 cats appear.

    It is a FACT that the only money created in the system in England is created by the Bank of England.

    Test your theory by using another economic good as if it was money and see if makes sense. If it does not, your theory is wrong.

  • Your premise is that money shouldn't make money. But, the reason we charge interest is to compensate the person for A) Opportunity Cost of those funds being redistributed and B) The risks associated with lending. This is the same reason your deposits are given interest (although miniscule) to compensate you on your investment/ lending of those funds.  

  • it's interesting to see what consistency actually does. I've been drawing consistently, which enables me to see into another dimension; now, I am able to listen into another dimension, based on practice, as well as applied  knowledge. this information is life changing…count me in!

  • The legal implication of the lack of fractional reserve lending means that commercial banks are outlaws and are in fact counterfeiting money. The actual asset/liability model using promissory notes as negotiable instruments is illegal because the bank brings nothing to the table. They do not offer consideration thus it is an illegal contract and their actions are illegal

  • 7:47–8:05 : This statement of the treasury is strictly speaking correct and not in contradiction to this series of videos either: It only says that the monetary BASE (= cash + central bank deposits of private banjs at the central bank) is under exclusive control of the central bank. That's true.

    The fact that this is of limited practical economical relevance because what is much more relevant to the real economy is the amount of credit money (which is created by the private banks) is another story.

  • The truth is relatively simple.
    Money has a value for working people.
    Money has little value for countries or multinational banks.

    The reason why this is not openly discussed is simply to keep the working people working. It would frustrate them to know that their country or their bank can legally create money out of thin air.

  • In a nut shell what Banks do is to lend you an umbrella when the sun is shining, and then fore close on the loan when it starts raining. It is the world's biggest ponzi scheme.

  • So your argument is that banks don't need any deposits to lend, then why do they get deposits and put interest on them?

  • you don't have a clue what you are talking about ! you don't understand anything about this system of CENTRAL BANKING ! of course there is reserve ratio ….and of course Centrak banks do influnece the money in the economy ……the money multiplier is real as well ….

  • wow the german Bundesbank even writes that what you said in their website


  • Bank should be governent own not private because its money bank 1st and most purpose was to save ppl money and transfer from 1city to other so they dont need to carry it why not goverment own all the banks and no one whould be allowed to create bank this way money will be control money belong to govermenr and people who ear it not to private banks banks should only be govermently have u ever seen private police no or private army no one is allowed to have private tank.f16 or private nuclear bomb it bong to goverment so does money saving belong to govrment courts should realiz these and get banking sector under goverment control.control mean people working in bank should be goverment employees not private

  • Biggest problem is with word deposite 99 people think there money is save but actualy its loan to bank and 2nd mistake it that u have given loanto bank put u dont know so u can buy things when u have loan it to bank so mow loaner and borrower both can to shopping and i see in ur computer 100$ and other guu also see 50$ these 50$ are ur whicj are goven to orher guy but u dont have problem if u can buy things with computer numbers problem happen when system collapas bank default

  • It’s deliberately misleading to trick people into becoming debt slaves, while the likes of The Rothchilds, George Soros and Sheldon Adelson make of with fat profits that were ill gotten.

  • If Britain changes its banking system it will need to re build its military to deter global finance from declaring war on the United Kingdom. The big banks also have a lot of influence within our democracy so it’ll be difficult to get this pushed through. None the less we must get it pushed through.

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