Economic Myths - The Money Multiplier

Please note, this myth is quite different to the government spending multiplier myth, which I debunked here.

Wiki's take on the money multiplier is here. The article includes a clue (itself flawed) as to why it is flawed here:

In the ["Loans first"] model of money creation, loans are first extended by commercial banks – say, $1,000 of loans (following the example above), which may then require that the bank borrow $100 of reserves either from depositors (or other private sources of financing), or from the central bank. This view is advanced in endogenous money theories, such as the Post-Keynesian school of monetary circuit theory, as advanced by such economists as Basil Moore and Steve Keen.

This myth is based on a misunderstanding of how banks work. The traditional somehow static model makes the following basic mistakes:

a) There is a limited amount of "money" in circulation.

b) Banks can only raise a limited amount of "share capital".

c) Banks take deposits first, and then they lend them out.

d) The amount of "money" which people would like to borrow is unlimited.

Therefore, they conclude, if the Basel Ratio, the total amount of share capital is set at 20% of total assets, banks will lend out five times as much as their total capital. If the Basel Ratio is reduced to 10% (i.e. leverage increased from five to ten), banks will be able to lend out ten times as much as their total capital.
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If you remember The Golden Rules, clearly this is nonsense as the assumptions are contradictory. The Golden Rules are...

e) As far as banking is concerned, "money" is not a thing in itself. It is a unit of measurement, and what it measures it indebtedness between 'borrowers" and "depositors" with the bank acting as middleman. So total financial assets always equal total financial liabilities, down to the last penny. It all nets off to nothing.

f) A bank's capital structure is not particularly important, i.e. how the "financed by" or "liabilities" side is split up between share capital, bonds and deposits. Building societies traditionally were 100% funded by deposits, for example. The old textbook example of the goldsmith who lends out customers' gold at interest also assumes that the entire operation is funded by deposits. A bank could easily be 100% share capital financed, the bank would simply have to have a rolling operation whereby shares are constantly being issued and redeemed at very close to net asset value per share, which would be close to par value.

f) Loans create deposits, not the other way round. When you take out a £10,000 personal loan, a bank "splits the zero" by creating a deposit account for you with £10,000 in it which you can withdraw and spend, and a personal loan account which means you owe the bank £10,000.

g) Clearly, there is an upper limit to the amount of money which people, collectively, want to borrow at prevailing interest rates and conditions, because a bank, however reckless and well or badly funded will adjust the interest rate and conditions depending on people's ability to repay.
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So even if (b) were correct (it is not entirely incorrect, to be honest, but this is market psychology at work) the conclusion above is clearly nonsense.

If a bank has a fixed amount of share capital £100 and the Basel Ratio is 20%, they can lend out £500. If the Basel Ratio is reduced from 20% to 10% (i.e. permitted leverage increases from five to ten), then they can lend out £1,000.

But where does the extra £500 come from? It comes from "deposits" of course. The model does not dispute that for one second, but that makes a mockery of the notion that the amount of "money" sloshing around is limited (a) and also makes a mockery of the notion that banks take deposits first and then lend them out (c).

This is where Wiki's brief description of the "loans first" model is incorrect. If a bank lends out $1,000 (i.e. creates it out of thin air), then it has to increase its share capital by $100 and take new deposits of $900.

Assumption (d) is clearly nonsense. There is an upper limit, even in the worst credit bubble of all time. Yes, some people will take out 100% mortgages if they can, a few people took out 125% mortgages, presumably there are a very few people would have taken out 150% mortgages if they'd been on offer. And when the credit bubble goes too far, it usually pops very quickly.

Despite the best efforts of the UK government to reflate the housing bubble (and they are doing disappointingly well), the total amount of mortgage loans outstanding has remained stubbornly close to the £1,200 billion mark for the past six or seven years.
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The other fatal flaw in the traditional model is that if the Basel Ratio were set to zero (which is perfectly plausible) then the amount of "money" sloshing around would tend to infinity, which is clearly not true.

In fact, you could easily argue that if the Basel Ratio were set to zero, this is tantamount to saying that banks are not allowed to issue shares at all and they have to be funded entirely by deposits (like the traditional building society model).

How would such a bank behave - more cautiously, or more recklessly? You can easily argue that it would be more "cautious", i.e. it would make fewer loans. the reason for this is psychological/behavioural as much as anything.

If you take over a bank with $1,000 loans, $1,000 deposits and no reserves or share capital whatsoever and know that if the bank goes bust your name will be mud and you'll never work in banking again (again, not realistic assumptions - nowadays, you might be stripped of your knighthood but you'd get a massive great pension payoff), then any hint or rumour that the bank has problems collecting in all the mortgage repayments would trigger a bank run and it would be all over within hours.

Therefore, you would be as cautious as anything with lending, you'd only grant 60% mortgages to people who'd been in the same steady job for years and had a good record of regular savings towards the 40% deposit (like the traditional German Bausparkasse).

You'd charge the highest interest rates and pay the lowest interest rates you could get away with to try and build up a bit of a cushion if things get sticky, and so naturally, your bank would not find as many willing borrowers and willing depositors as other more "reckless" banks - in fact, the only people who'd deposit with you would be people trying to save up that 40% deposit.

At any one time, you would have (say) 1,500 savers with an average deposit of 20% of the price of a house each and 1,000 borrowers with an average mortgage of 30% of the price of a house each.

(Of course, this is still a bit of a Ponzi scheme, because the borrowers would have to be repaying their mortgages quicker than they build up the original deposit (which is just about plausible, as the borrowers have more spare cash as they no longer pay rent as well), which is why, as soon as a government lifts the restrictions on what a building societies or a Bausparkasse can do, they pelt headlong into disaster. But let's gloss over that.)