Chapter 39 - The Multiplier Effect

I start this chapter sitting in Cologne Cathedral. To warm the topic up on this winter’s night, I start by blowing this concept out of the water. I give you some excerpts from a 2014 Bulletin by the Bank of England [1]

The Bank of England 2014: “Money creation in practice differs from some popular misconceptions - banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.” [1]

The standard economics texts are wrong and misleadingly so. There were times when banks were restricted in their lending by being required to keep to keep a fixed fraction in reserve. The location, size, and form of the reserve might also be regulated. This is now very much a myth. The banks can borrow the reserves. What is of interest is the nature of the reserve. The reserve might be gold, silver, cash currency, just more Bank Credit or some invented virtual money at the Central Bank. In the future, it might be the virtual SDR created out of thin air by a private corporation. This corporation might say to us: “Look at me! I’ve just created money and you have to buy it off me with real assets!”

The volume of lending tends to be controlled by the citizen’s appetite for borrowed money and the bank’s willingness to create the requested credit. This has some advantages in that credit has the potential to expand without restriction to meet demand. As around 93% of the Money Supply is pure Bank Credit, this effectively means that the Money Supply is completely elastic. It expands when money is needed and contracts, when not needed. When people need money, they can earn it, steal it, extort it, beg for it or borrow it. The last is the common option. The borrower is prepared to pay a small regular fee for its rental. The rental fee is included in the borrower’s calculations when deciding on the viability of a project. If a lid is put on the volume of credit, many projects may be stifled. My point is that restriction of credit creation is not helpful to the economy. The argument against me involves concerns that vast volumes of credit will be created. This is extremely valid. The volume of credit is important but we need to be more concerned as to who and what is using this credit. If the fresh credit is being used for purchasing Rhino tusks, the share prices for Rhino tusk companies will rise, as will the price of Rhino tusks. Rhinos will be hunted to extinction for more Rhino tusks. Soon, the banks will stop lending to those who call themselves Rhino tusk collectors, but are better called Rhino tusk speculators. The price of Rhino tusk will fall dramatically as everyone sells out of Rhino tusks because the Rhino tusks are worth less than they borrowed. The bubble and bust added nothing but a nasty distortion to the economy. How fresh money is allocated is more significant than how much fresh money is created. Money for first-time homebuyers is important. Money for new long-lasting homes is important. Money for business operation, start-up and expansion is crucial. Money for speculation is pure evil . Anything that is carried out for the purpose of ‘making money from money’ is in the very bad basket . Anything that enables or improves civilized life is in the good basket. Humans live by trading with each other. To take advantage of the means of trade is bad for society .

How fresh money is allocated is more significant than how much fresh money is created.

Money should not be lent for speculation including speculation in land and housing. (Usually disguised as ‘Investment Property’.)

There is an assumption that there is a need to prevent banks from creating too much credit. This is wrong. There is a need to stop banks creating inappropriate credit. This is fresh Bank Credit that may damage or distort the economy. This is generally fresh loans for speculation which includes speculation in any financial instrument including: shares, stock, foreign currency, gold, commodities, land, housing, industrial, commercial property, and any number of other items. Where fresh credit is provided for new houses or business expansion, the economy will expand. Where fresh credit is supplied to speculators, great gains will be made in the financial sector without adding one dollar to the real economy. The fresh credit to the speculators will impact the real economy, but in a negative manner. Rents and real-estate prices will rise destroying business viability. Able graduates will be suckered into the finance industry to the detriment of the real economy that feeds, clothes, and houses us.

The type of reserve also influences the situation. In the ‘old’ days, gold was sometimes used at the reserve. If the reserve was to be a full reserve with no multiplier, one dollar of gold had to be held for each dollar note issued. The result is a rigid money supply and a constant recession style economy. However, it was worse than this. Those with excess money might hoard some gold or hoard the notes so there was a constant downward slide on the volume of money that was actually circulating. There was also an international payments issue. If gold was exported for international trade or interest or war, the volume of base metal fell causing a contraction of the Money Supply. As usual, those hoarding money retained their hoards with the result that the volume of money actually circulating fell by an even greater proportion. Full reserve banking does not work. The misguided idea that money must be backed is false. The value of money does not come from gold, it comes from its ability to purchase part of the GDP. Money is backed by goods. If money is linked to gold, it is not gold that gives money its value but money that gives gold its value. The GDP gives value to the money and that value is passed to the value of gold. Thus gold obtains its valued from money and money gets its value from its ability to by goods. The false value of gold, that some commentators talk about, is derived from its link to the value of money. Useless gold becomes a fake commodity because of its link to money. Not the other way around. Gold is entirely unnecessary for the operation of a money system.

Gold obtains its value from money by decree. Money gets its value from goods. The false value of gold, that some commentators talk about, is derived from its link to the value of money.

Billions for the Bankers, Debts for the People (1984), Sheldon Emry: “The German government financed its entire operations from 1935 to 1945 without gold, and without debt.”

Money for business operation, startup and expansion is crucial. Money for business operation, start-up and expansion is crucial.

New Messiah says: “Money for speculation is pure evil.”

The Bank of England 2014: “...In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality.”

The Bank of England 2014: “Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money - the so-called ‘money multiplier’ approach. ...”

The Australian, D. J. Amos in a pamphlet from 1943: “the Government was compelled to hold a reserve in gold equal to one-fourth of its note issue.” [2]

The Australian, D. J. Amos in a pamphlet from 1943 “Between the years 1914 and 1920, the Commonwealth Government increased the note issue from, in round figures, £9½ million to £59½ million, but all these notes did not go into permanent circulation. Sooner or later they fell into the hands of the associated banks, who imprisoned in their vaults all of the notes that were not absolutely necessary for the nation‘s “small change.” Upon this imprisoned national currency, they based an enormous increase in bank credits ― a currency which comes into existence as a debt due to the banks ― for the use of which they charged a heavy rate of interest. By 1920 the banks held nearly £32 million in Australian notes, and the following table shows clearly what had happened:” [2]

Currency In Circulation In Millions Of Pounds. [2]
(Copland’s “Currency and Prices in Australia.” Commonwealth Year Books).
Year.Australian Notes.Bank’ Credit.
Maximum Increase1162

D. J. Amos 1943: “They keep them to meet any demands for cash made upon the banks, and give credit for from nine to twelve times the amount of these cash deposits.” [2]

In some cases, they did not hold the notes, they just held the ‘rights’ to notes from the government and issued Bank Credit against the ‘rights’ without physically having the notes in their vaults. Although it seems ‘naughty’, it does have the effect of creating a flexible supply of money in the predominant form of Bank Credit. More at issue is for what purpose the money is lent. If it is lent to purchase existing assets, asset prices rise with no new wealth generated for the nation. If it is lent for new houses on freshly divided land, the housing stock increases. If businesses receive excessive knockbacks, the economy will be sluggish. Credit allocation is critical to the efficient functioning of the economy.

In our example, we have a double multiplier. The government issues notes at four times the volume of gold. The private banks issue credit from the Cash Currency notes with a multiplier of possibly around eight. So for each £1 value of gold, there is the potential for up to £32 of Bank Credit. This is 3% to 97%. This was when the pound note in Australia was technically redeemable in Gold. It was technically equal to a specific weight of gold. In practice, the value of money is dependent on what it will buy at the next transaction. Money does not need to be ‘backed’ by anything. The backing of the money is the goods that it will purchase. If money will purchase goods, it has value. If it will not purchase goods, it has no value. If it buys a lot of apples, it has high value. If it buys but one apple, it has low value. The backing for money is the GDP of the nation. Provided it will buy part of the GDP, it has value. Money does not need any other backing than its freedom to buy items and services.

The problem with a fixed multiplier is that there is a ceiling on the total volume of credit available in the Money Supply which means that productive effort is going to be stifled somewhere in the economy. The concept of the reserve is protective. If all customers have a bad dream and run to the bank to convert their bank credit to Cash Currency or gold or whatever supposedly ‘backs’ the money, there are sufficient ‘reserves’ to prevent damage to the bank. However, if the backing is paper Cash Currency, more can be printed in any quantity within a reasonable time. Gold is notoriously difficult to replicate. Gold makes a poor backing for money because it is so inflexible. However, gold is more commonly used as a backing for paper notes which are used as a backing for Bank Credit. However, the gold is not redeemable, and paper notes will only be replaced with paper notes. In reality, this is much more flexible.

Part of the concept for a ‘reserve’ is to ensure that there is enough backing in the event of a demand for the backing (A run on the bank. People queuing at the door to get convert Bank Credit into Cash Currency) and part of the concept is to ensure that banks do not create excessive credit. The use of reserves fails to ensure that Bank Credit is used appropriately (Not for speculation and bubble creation) and it also fails to ensure that adequate Bank Credit is available in downturns. The reserve is an ineffectual ‘credit control’.

When I started a business, the bank gave me a fully flexible overdraft facility whilst they held the title to my house. I needed that overdraft as it allowed expansion in the business. When I took on a big event, I paid out a lot of money before the event and the payment might lag by weeks or months. The business had a cash-flow problem. The worthwhile event was profitable but drained the bank account. The flexible overdraft was essential to the success of my business. I could buy and sell and organize events without worry about the timings of payments. Some government departments were shockingly slow to pay. The reason I mention this is that Bank Credit is essential for a successful business sector in the economy. The government is close to incapable of providing the same credit allocation as the private banking sector. Like most private enterprises, they are more efficient than government enterprises and carefully monitor and analyze their performance. Banks are similar. They monitor and analyze risk when making loans in a way that government banks are incapable of doing. This is not to suggest that private banks should have it all their own way. Private banks tend to concentrate on profitability without considering the effects on the economy. They lend for profit, not for national betterment. Government banks also have an important role. They can’t match the risk-averse private bank in the high street lending portfolios but they have a massive role to play in other ways. One of these is to keep the excesses of private banks in check. Another is to ensure adequate money is available at all levels of business. Yet another is to provide money (credit) when private banks go on their cyclical destruction of money through the cessation of credit creation.

D. J. Amos 1943: “Since the establishment of the Bank of International Settlements at Basle, early in 1930, central reserve banks (more or less independent of the Governments of the countries in which they were situated) had been springing up like mushrooms all over the world, amid a chorus of approval from deluded Governments and people whom these banks were intended to reduce into servitude. Why not, reasoned the Scullin Administration, under cover of establishing one of them in Australia, get back into the hands of the Government the powers given away in 1920?”[2]

D. J. Amos 1943: “On April 2, 1930, Theodore brought forward his Central Reserve Bank Bill. The new bank was to control the note issue and the gold reserve. All other banks, including the Commonwealth Bank, were to keep 10% of their current accounts and 3% of their fixed deposits with it.” [2]

It is essential that credit is controlled. Reserves are not a good method. Reserves can restrict excessive expansion, but they do not alter the destiny of fresh credit. Credit for business is essential. Credit for speculation is evil. The volume of credit should be steady with a mild, steady and constant rise. The rise should match the increase in population and the increase in productive capacity. No falls should be tolerated. Interest rates have a mild effect but are ineffective in controlling the magnitude of the money supply. Private banks are notoriously inconsistent in the provision of credit. It is possible that a 5% annual increase in the Money Supply is suitable. I shall call this the "Ideal Annual Money Supply Increase". It is a purely theoretical figure open to discussion. A 0% increase causes a recession. A negative increase causes a depression. An annual increase of say 20% causes a boom. This all assumes that the velocity stays idle. Static velocity cannot be assumed. There is a downward trend to velocity as hoarders are extremely adept at grabbing fresh money.

UK Fluctuation in Bank Lending

Fluctuation fo bank lending in UK. Creative Commons Attribute - Andy Chalkley.

Greece Fluctuation in Bank Lending (Private Loans)

Fluctuation of private bank lending for private loans in Greece. Creative Commons Attribute - Andy Chalkley.
Ideal Annual Money Supply Increase. Creative Commons Attribute - Andy Chalkley.
Recession Annual Money Supply Increase. Creative Commons Attribute - Andy Chalkley.
Depression Annual Money Supply Increase. Creative Commons Attribute - Andy Chalkley.
Boom Annual Money Supply Increase. Creative Commons Attribute - Andy Chalkley.
Fluctuating Annual Money Supply Increase. Creative Commons Attribute - Andy Chalkley.