Tuesday, October 28, 2008

Is There A Credit Crunch? Evidence from the Money Multiplier

There has been a debate raging in the blogosphere as to whether there really is a credit crunch. On one side of the debate is Alex Tabarrok and these authors who argue that while there is some stress in credit markets there is no systemic credit crisis such as the one in 1990-1991. Taking the opposive view is Mark Thoma, Tyler Cowen, John Kwak, Free Exchange and, well, almost everybody else.

When thinking about the credit crisis question, I think it is useful to look at the money multiplier for the monetary base. The monetary base is a measure of money that includes currency in circulation and bank reserves. It is also a measure of money that the Fed controls and uses to alter liquidity in the banking system. In normal times, the Fed can increase the monetary base by injecting reserves into the banking system. Banks, in turn, lend out a portion of these reserves to borrowers who then spend the funds. The parties that sold the goods or services to the borrower then takes the funds earned and deposits them in their banks. These new deposits becomes reserves of which a portion are lent out again. This cycle continues until there are no more excess reserves to lend out. The banking system, then, can turn small amount of monetary base into a much larger amount of money. How big the total amount of money becomes relative to the initial injection of monetary base is called the money multiplier.

These, however, are not normal times. Banks' balance sheets are hemorrhaging and the economy is in a recession. Banks are not eager to make loans in this environment and are more likely to sit on the new reserves coming from the Fed. This development means less credit and if pronounced enough a credit crunch. One implication is that if, in fact, there is a credit crunch then the money multiplier should be sharply falling. Thus, it makes sense to look at the money multiplier. The figure below provides the money multiplier using MZM as the broad measure of money and the St. Louis Fed's monetary base measure. (See here for why MZM is used over M1 or M2) The data are on a bi-weekly basis and go through the week of 10/8/08. (Click on the figure to enlarge.)

This figure shows the money multiplier peaked the week of 6/4/08 and begin a sharp descent in late August. Compared to the credit crisis of 1990-1991, Y2K, and 911, this drop is huge. This striking drop is mirrored in the figure below which shows total reserves in the banking system:

These figures indicate banks are sitting on their reserves, and lately there has been a lot of reserve creation by the Fed. These figures may not settle the debate, but they do suggest that we are closer to a systemic credit crunch than to a minor credit market hiccup.


  1. Very interesting and disturbingly similar to the collapse of M1 in
    1931-33 even as the base increased by 20%.
    James Hamilton has a related post on the Fed's current balance sheet at
    where he states the Fed is deliberately encouraging banks to sit on excess reserves (hence the paying of interest on reserves)

  2. David,
    I am curious as to what economists think will happen to our money supply once hedge funds / other financial institutions stop delevering? Will all this freshly "printed" money suddenly come out of the woodwork to give us price preasure? (I dont say inflation, because I believe adding to the money supply is inflation) Are we simply countering delevering deflation with our monetary policy or will there be an "inflationary day of reckoning?"
    LCDR Neil Colston
    (SW) Texas State 1997

  3. Neil:

    A look at the bond market--yield curve or TIPS--indicates the market expects disinflation to be more likely in the near future. What you are asking, though, is what happens beyond the near future, when the U.S. economy gets out of this current recession. The good news here is that all of Fed's recent money creation has been "sterlized" or is easily reversable (See the link above from commentator ECB for more on this development.) However, should conditions get dramatically worse and the Fed's indepednce get further compromised, one could forsee an "inflationary day of reckoning." Right now, though, that seems unlikely to me.

    Great to hear from a Texas State Alumnus.

  4. Fantastic evidence Prof. David. I am a regular reader of your blog.

    Indeed Banks will sit on the aid and accumulate reserves. Thats why another round of stimulus is required.

    Yet, all the stimuli may be wasted! I guess going back to Keynes dig-a-hole-and-fill-it up mechanism is required to jump-start the economy!

    Just one suggestion - it will be great if you allow entire feed to go to readers - or if you can write a synopsis as first para will do. This helps me parse the post for further read. Currently part of your post that is visible in my reader is not indicator of entire post - hence usually I am lagging on your posts.

  5. Nice post. Your insights helped me with this post on the latest "socialism" from President Bush:

  6. David,

    I think paying interest on reserves is causing cash hoarding by banks, making the marginal velocity on each new reserve dollar effectively zero.

    Velocity is a psychological phenomena. The only way to turn it is to change psychology. How do you reverse the psychology of hoarding? Two ways: 1) you can try to create optimism about the real economy; or 2) you can publicly commit to creating inflation through quantitative easing.

    Which of the above choices are most plausible? Well, the Fed has tried for months to create optimism about the real economy, and it simply has not worked. That leaves option 2). Bernanke knows how to do this, and in fact his speeches have dealt extensively with the subject of "flying the helocopters".

  7. David Pearson:

    Yes, I realized after I wrote the post--thanks to the James Hamilton post cited above by ECB--that paying interest rates on reserves was probably a big factor. Still, I am puzzled by the action. If, as you mention, psychology boosting is not working and the only other option is quantitative easing, then paying interest on reserves seems counterproductive. If you want more spendinng and inflationary pressure then create incentives for banks to loan. Instead the Fed has created incentives for banks to hold excess reserves. Am I missing something here?

  8. While it doesnt wholly clear up the question David raised in his second comment, here is David Altig:
    It is to facilitate management of
    the fed funds rate, he says .

  9. Re: David Beckworth

    If you want to increase the incentives for banks to loan, then how about increasing the returns on those loans - by raising interest rates?