The Myth of the 'Money Multiplier'

I'm reading an article in which The Wall Street Journal's Martin Feldstein says the Federal Reserve is holding back the economy by paying interest on reserves. He says that reserves are just sitting in the banking system, all fat and happy, earning a risk-free 15 basis points instead of being "lent out." If the Fed were to simply stop paying interest on reserves, then the banks would have no choice but to start lending again.

Like many people, Feldstein subscribes to the false notion that reserves are "lent out." It's a Jimmy Stewart "It's a Wonderful Life, Bailey Building and Loan" sort of belief wherein the banks take in money, hold a certain amount as reserves and then lend the rest out. Or it's the notion that the Fed controls the supply of credit money by manipulating the level of reserves.

The former is inapplicable, because the Bailey Building and Loan was not a commercial bank. It was a savings-and-loan, which cannot create demand deposits, but does take in money from people and lend it back out in the form of mortgages.

The latter involves the concept of the "money multiplier," meaning total credit money outstanding is the reciprocal of the mandated reserve requirement. In other words, if the mandated reserve requirement is 10% -- which it is here in the U.S. -- then the size of the credit money stock should be roughly about 10 times that. Since roughly $3 trillion in reserves are sitting in the banking system, the money supply should be $30 trillion.

Clearly it's not, and the reason is that this has nothing to do with the Fed paying interest on reserves.

As an aside, it makes me curious as to what Feldstein thinks about Canada. That country doesn't have a reserve requirement, yet the size of the money supply is not infinite. Or what about Japan? There, interest on reserves was zero for many years and practically no lending occurred.

Reserves are not lent out. They sit in the banking system and function mostly for clearing purposes. Moreover, the causal relationship between reserves and loans is the opposite of what most people think: Loans create deposits and reserves, and not the other way around.

If a bank has adequate capital, it will make a loan if it sees a profitable opportunity, regardless of whether it has a sufficient amount of reserves. That's because reserves can be borrowed, and ultimately the Fed supplies the banking system with reserves in order to keep the fed funds target rate where it wants it.

Bank lending, therefore, is only constrained by capital and the amount of profitable lending opportunities. We can also add regulatory oversight. The first two factors are determined by general economic conditions. If those conditions are poor -- with people out of work, asset prices falling, business sales down and so on -- then it's likely that lending will be sluggish, if there is any at all.

As for regulatory oversight, that is more politically determined. Either way, all these conditions have conspired to limit bank lending since the crisis, and not the fact that the Fed pays interest on reserves. Feldstein is another example of how mainstream academic economics has completely lost its relevancy. Our "experts" don't even know what they're talking about.