Chart of the Day: Monetary Transmission Mechanisms

Here’s a nice chart courtesy of Richard Koo via the folks at FT Alphaville. It shows how central banks ballooned the monetary base (reserves) after the Lehman bankruptcy.

Here’s the thing though, money supply flatlined as the money multiplier plummeted. See the lines at the bottom?

What gives?

Koo says that liquidity does not always translate to increased bank lending and suggests that this is because we are in a "liquidity trap". I like the first part of his analysis but not the second part. I mentioned this last May, writing:

Koo is pointing to the money multiplier fallacy that comes from the concept that banks are reserve constrained. Of course, none of this is true. Banks are never reserve constrained in our non-convertible floating exchange rate monetary system; They are capital constrained.

Theoretically, banks could lend out up to 10 times their reserves if the reserve ratio is 10% (money multiplier: loans = 1/reserve ratio). In reality, however, banks make the loans first and then look to the reserves afterward. That means some banks are short reserves and must borrow them in the interbank market.

When the entire banking system reaches the reserve limit, the central bank could theoretically create a credit crunch by refusing to increase reserves. But then the Fed would not be able to manipulate short-term interest rates.The Fed Funds rate is dependent on the central bank’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target.  So in practice, central banks always increase the level of reserves desired by the system in order to maintain the interest rate.

My point is that the money multiplier is a fallacy in a fiat currency credit system and we see that now that we are in a balance sheet recession in which credit growth is subdued due to private sector deleveraging.

Koo says QE2 drove speculation, but what about the real economy?

This balance sheet recession is not really about liquidity traps and and the zero bound for interest rates. It’s about overindebted private sectors that have limited increased demand for credit. If and when the demand for credit increases, so too will the money supply.

Source: Monetary blanks in the Eurozone, Izabella Kaminska, FT

P.S. – Also see John Carney on this – MMT and Austrian Economics Walk Into a Bar…


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.