The two greatest crises in US economic history are the Great Depression and the recession that began in 2008. And though the particulars are quite different, these events share at least one aspect in common: the collapse of the money multiplier, a ratio that compares the amount of money created by the Federal Reserve to the amount of money created by banks.
The Fed creates money by adding money, known as fed funds, to the reserve accounts that commercial banks are required keep at the nation’s federal reserve banks; banks create money, or funnel these funds into the economy, by issuing loans. In the recent crisis, the Fed created vast amounts of money by buying mortgage-backed securities and other bad assets from banks, and paying for these purchases with fed funds. However, despite the increases in their reserve accounts, commercial banks held back on lending — keeping this additional money out of the wider economy.
Say the money multiplier has a stable value of 1.6. That means that for every dollar the Fed creates, the private sector creates $1.60. Fed funds are essential for clearing transactions among banks, and when banks have more money to clear transactions, they are willing to lend more. Under normal conditions, this results in the multiplier effect.
Though the money multiplier was an important area of interest in the 1970s and ’80s, it has been largely ignored since. In a recent paper, Saki Bigio, working with Javier Bianchi of the University of Wisconsin and NBER, took a new look at the money multiplier to determine why it became unstable during the recent crisis and why banks were not lending.
Using a mathematical model, they investigated five possible reasons that would explain why banks held onto their money. “Often these are stories you’ll read about in the press,” Bigio says. “Some stories are logically inconsistent, and some don’t have a quantitative impact.” One reason, often cited in the news reports, is that tighter post-crisis regulations discouraged banks from lending. However, the researchers’ model showed that while regulations may have had some impact, they were not a key factor for the collapse of the multiplier.
Another theory that has received a lot of attention relates to the banks’ loss of equity during the recession. “When banks lose a lot of equity, they suddenly hold much more debt relative to equity than what they would want,” Bigio explains. “So they try to de-leverage; in the press, this is known as the ‘Big Leveraging’ story.” As with tighter regulations, the researchers found that de-leveraging was not a primary cause in the multiplier’s collapse.
In the end, they found that one factor — the disruption in the interbank market in 2007 and 2008 — had a particularly strong effect on lending. “When some money market funds were failing, and AIG and Lehman Brothers fell apart, there were substantial disruptions in the interbank market,” Bigio says. The total value of transactions that must be cleared each day among backs is about $7.5 trillion — close to half of the country’s GDP. With this market rattled, banks cut back on borrowing with each other. “They became very cautious about what to do with their new funds,” Bigio says. “They didn’t want to extend new lending, because they were afraid they wouldn’t have a way to settle transactions.”
After the fall of Lehman, Bigio notes, the Fed made it clear that it would lend money to banks at very low rates if additional reserves were needed to settle interbank transactions. Yet banks were still reluctant to lend. “The initial contraction in lending in the interbank market translated into the destruction of investment opportunities,” Bigio says. “A lot of firms stopped purchasing and instead put their funds into savings, because they were afraid that banks would cut their credit lines and make it difficult to get new loans.” This lack of spending hurt many companies and cost many jobs, Bigio says. “The financial disruption eventually caused a disruption in physical production.”
Incorporating the money multiplier into modern macroeconomics has generated interest among policymakers. The researchers have presented their findings to the central banks of France, Sweden, and Japan, and many of the U.S. Federal Reserve Banks. “Back when modern macroeconomics developed, the concern was, ‘Let’s do something about inflation,’ ” Bigio says. “The concern now has turned to, "Let's avoid disruptions in international markets.’ And you can’t do that without talking about banks. Because that’s where problems start.”