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.)

Building Societies Now More Liable to Failure

From the Daily Mail

The Treasury is considering allowing mutuals – such as Chelsea, Nationwide and Yorkshire - to raise more funding from so-called non-members. Members include customers with mortgage borrowing and shareholding investors.

Building societies presently can currently only source 50 per cent of their funding from non-members. The ability for societies to source increased funding from non-members would be an advantage if wholesale money markets became cheaper in the future.

Sounds like yet another desperate throw of the dice in trying to inflate house prices.

I'm not sure when the 50% rule was introduced, but its effect in the last boom was that it moderated risk-taking. Nationwide couldn't do the crazy things that Northern Rock did with the money markets because their growth was limited by savers. For government-guaranteed organisations, this is a good thing. But rather than retaining that rather sensible measure, the government are going to scrap it.

Ideas for blog posts

Here are a few things which I've scribbled down on bits of paper over the past few days which I vaguely intended to 'blog about at the time but never really got round to it. So as an aide memoire for the future:

1. The normally prudish Sun newspaper showed a Page Three girl who was wearing invisible underwear as advertised by Bar Refaeli.

2. Porn shops in Westminster won a refund/reduction of hefty licensing fees from the council, because they contravened EU Directive 2006/123/EC, which seems like quite a sensible directive on the face of it. All of this raises a lot of interesting questions (economic, legal, sovereignty etc). How do we square Article 12 with licensing of taxi drivers, for example?

3. Supposed right-wing Tory John Redwood musing about how nice it would be if we could go back to the lower tax rates we had when the Chancellor was... Gordon Brown (top rate income tax 10% lower, National Insurance 2% lower, VAT was 2.5% lower etc).

4. The UK is not absolutely useless at everything: shock Britain exports more vehicles than it imports for first time since 1976

5. It appears that they are going to make people criminally liable for death and injuries caused by their dogs, something which I have long advocated.

6. Tory government is close to achieving its pre-election pledge of getting construction of new housing in England down to less than 100,000 a year for the second year running. With the rain stopping play during April and all the Olympic and Jubilee ructions, I'm sure they'll get it down to five figures for the next year. Hoorah! The Hallowed Green Belt is Preserved For Future Generations! But not to build homes on, obviously - just think, instead of having a house with a rental value of £10,000 a year, we could be growing £100's worth of potatoes or something.

7. Queues at Heathrow. FFS. When you think how much human effort and ingenuity it takes to run global air travel: the aeroplanes, the technology, the staffing rotas, coping with the weather, air traffic control, difficult passengers, getting people's luggage on the right aeroplane, killing as few passengers as possible, guarding against terrorist attacks etc, it is amazing how well it works, really. And the UK government can't even organise a few dozen people to sit in booths, open passports, check the face, hold it face down on a scanner and mutter "Enjoy your stay" while chewing gum.

8. I explained recently why the building society funding model, where a company's assets are matched £ for £ with customer/owner deposits instead of shares is a vastly superior way of running a business than having share capital. So instead of a shareholder being paid dividends at the whim of directors; investing in a company by buying shares from an existing shareholder and realising his investment by selling his shares to a third party; a depositor invests directly in the business and withdraws money from the business.

It occurred to me today that this model is also used by Unit Trusts: a UT's net assets are always funded £ for £ by unit holders' funds: you invest in a UT by paying in money, which is invested on your behalf (in shares in other companies, but that is not important), all the income and gains of the UT are credited pro rata to unit holders as they go along, and if you want your money back, you withdraw it from the UT itself, and to the extent that withdrawals are not matched with new subscriptions, the UT just sells some of the underlying assets. So the model does work in real life, it's nothing new or unusual.

9. While looking for something else, I stumbled across a couple of instances of Austin Mitchell MP saying sensible things about Council Tax, e.g. here and here. And about London.

10. UK banks not completely dishonourable: shock RBS repays £163bn emergency loans

11. BobE emailed me this fine piece of Home-Owner-Ist drivel from guess which paper:

Regardless of where you are on the income scale, nobody could ever call your decision to buy a house irresponsible – whatever happens, you need somewhere to live, and swingeing rents usually represent far worse value. For low-earning households to have avoided mortgage debts, they would have had to actively decide to stick with renting; that is, to pay the same, for a worse property that they'd never have any equity in, just on the off-chance that, as a result of a possible downturn, they might be dragged down by the debt. What a bizarre thing to expect of people, when you're preaching a can-do, pull-yourself-up-by-your-bootstraps, aspirational Tory attitude.

12. Jorge emailed to ask whether I thought Iceland should adopt the Candian dollar, I can't say I have a view on that one way or another.

13. Finally, is it just me or do Natalia Vodianova's legs look completely out of scale (in a bad way) in this photo from today's Evening Standard?

Why the Building Society funding model is the best kind of corporate structure.

1. I have mused on this topic before, see e.g. Inefficient Markets Hypothesis, The multi-billion Chinese investment in Thames Water was no such thing and Beyond The Corporation, part 1, part 2.

2. Please note, I am not talking about the respective merits of banks or building societies, this is about having a system which has the benefits of public limited companies without the drawbacks and applies to all types of businesses (not just banks/building societies).

3. It is claimed that the big benefit of being able to switch your investments between different types of business, by selling shares in one and buying shares in another is that this leads to an efficient allocation of capital. If you do it properly and you are lucky, then yes, this leads to an efficient allocation of your own money, but there is a complete disconnect between what you are investing in (the shares) and the real underlying investment in productive capital (which is carried out by the companies whose shares are bought and sold). So whatever signals the secondary market in shares is sending, there is little or no link between that and what businesses are actually doing.

4. People are unfamiliar with Limited Liability Partnerships (which are a far better corporate structure than a limited company for small and medium sized businesses), so let's talk about how things would work on the scale of large plc's if their share capital/reserves side were structured in the same way as building societies. In other words, instead of a company having assets of (say) £1 million and share/capital reserves with a balance sheet value of £1 million, but whose shares might be worth a multiple of that, the company would just have 'members' deposits' with a balance sheet value of £1 million.

5. The gimmick being, that you cannot 'sell your shares' in a building society to a third party on the secondary market, if you want your money, you just withdraw it and somebody else invests in your place. Unlike with companies limited by shares, there is no distinction between the 'primary market', i.e. shares being issued (where an investor gives the company cash for shares) and the 'secondary market' where the first investor sells those shares to a third party, who can sell them on to a fourth etc.

6. If quoted plc's were like building societies, then at the end of every profit period (a year, a month, a quarter, it does not matter), the company would draw up a new balance sheet and allocate the increase in value (the profit) pro rata to all members' deposits, instead of paying out part of the profits as dividends on shares.

7. At any time, some members will want to withdraw some of their profits or their deposits and others will want to invest in that business, so the company will end up running simplified deposit accounts for all members (which is perfectly do-able - banks and building societies manage). The company might have to limit the amount which members can withdraw or limit the amount of new deposits which it can accept, so there might have to be some sort of waiting list approach or a cap on withdrawals/new investments. Withdrawals and new investments are to a large extent equal and opposite, so if a company accepts cash deposits it doesn't really need it will have spare cash to repay those who want to cash in immediately - which is how it works with banks and building societies.

8. So this would save investors the bother of doing two quite separate analyses: the first being an analysis of the health of the underlying business and the second being an analysis of how the share price is doing and what future dividend payouts are likely to be. Instead, you would just look at the list of public traded companies in the financial pages, and for each one it would say:
- what the profit share in the last profit period was as a percentage of deposits (the higher the better as far as investors are concerned;
- how long the waiting list is to invest in that company (if there is one), and
- whether there is a restriction on withdrawals, i.e. because the company is making losses, because it plans to expand in future and/or because not enough new investors want to put their money in.

9. To make a comparison between the two:

- Let's say that a quoted plc started the year with total assets £1 million, made profits of £200,000 (so now has £1.2 million total assets) and intends to pay out £120,000 as dividends (keeping £80,000 for future expansion). Dividend yields are currently 4%, so all things being equal, the shares in that company are worth £3 million. £1.2 million of that £3 million is real wealth (the real net assets of the business) and £1.8 million is pure speculative value; it's a nice capital gain for the original investors but a potential capital loss for future investors.

- Using the building society funding model, the total assets are also £1.2 million, and 20% is added to members deposits b/f of £1 million, and the directors announce that members may withdraw up to a tenth of the face value of their deposits (i.e. up to £120,000). If the directors know that there is a long waiting list of potential new investors, then the one-tenth figure will be increased of course, that's just details.

10. The two big advantages of the building society funding model are:

- There is no speculative capital gain to be made - either you are happy leaving your money with this business and earning 20% a year in profit share (or interest) or you want to withdraw your money, either to spend it or because you want to invest it in a different company which pays 25%, or which pays less than that but which has a safer business. Now, some people will bemoan this, but one man's capital gain is just another man's capital loss. If you are lucky to get into a successful company right from the word go, then you can sit back and be paid your 20% return each year, withdrawing or reinvesting it as you please, which is a better way of doing things that sitting there waiting for the right moment to sell your shares (i.e. just before the share price collapses).

- Instead of focusing on things not directly related to the actual business (like the share price or the dividend yield), investors will just look at how profitable businesses actually are, i.e. how much interest they pay on deposits. So profitable businesses will find it easy to attract new investment and the directors of not-so-profitable businesses will have to up their game to prevent members wanting to withdraw everything (like a 'bank run', only this would be a 'company run'). In extremis of course, the members would sack the management and either install a new one or just sell off all the assets, shut the company down and take their cash elsewhere. For the investors, this will be a lot less risky than with a plc, because they won't have paid £3 million for their shares, they will not have paid more than £1.2 million (using the same figures as above).