Reserve substitution and the money multiplier May 10, 2012 at 7:40 am

In an important and interesting article on VoxEU, Singh and Stella discuss a new and to my mind convincing analysis of the money multiplier (or the lack thereof). It is well known that, despite a massive increase in central bank money, there has not been anything like the concommitant increase in credit that the multiplier would predict. Singh and Stella have two explanations:

The first relies on a correct interpretation of the liquidity needs and management of a modern financial system which comprises not only conventional banks but also financial institutions operating in their shadows. Such non-bank financial institutions do not have access to monetary base as they hold no reserves at the central bank. Instead they rely on their access to the repo market predicated on their ownership of what is perceived to be highly liquid collateral.

Due to this shift, the liquidity fulcrum of the pre-crisis US financial market was composed only partly of central bank liabilities—and it was a very small part. More importantly, the magnitude of the liquidity fulcrum was determined not by the monetary policy authorities but instead by market practice. The nature and volume of assets determined by the market to be acceptable collateral is the key.

I absolutely agree with this, which is why in the past I have suggested that the central bank consider not one but three policy tools; the rate at which it provides money (as usual), but also the amount and the collateral against which it will lend. Central banks should explicitly the implications of their definition of eligible collateral and, if necessary, change it. That is because collateral is in competition between being used at the central bank and being used in repo. As S&S explain:

The enormous increase in bank reserves reflects a substitution of monetary base largely for highly liquid government securities in private-sector portfolios. But as government securities serve as collateral in the private-credit market, the effective size of the market liquidity fulcrum is unchanged by such operations. Little wonder then that market liquidity conditions remain tight despite the increase in bank reserves. That is, although quantitative easing which merely swaps bank reserves for US Treasury bills increases the textbook monetary base and “should” lead to an increase in market credit, in our view this accomplishes virtually nothing in terms of easing liquidity pressures. It merely changes the composition of assets within a given sized liquidity fulcrum.

Central bank operations only create new liquidity if they take as collateral assets that are no longer accepted at full value as collateral in the market.

The part of the story that S&S are missing is the impact of capital. Banks don’t just need funds to lend, they also need capital to support the risk of lending. Add in that dynamic (and understand the impact of rehypothecation), and I think you have a much more convincing account of the money (de-) multiplier than the textbook one.

(HT FT Alphaville.)

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