The "game" of banking has been turned upon its head.

First, let's look at the Adjusted Monetary Base (or M0). This is the one monetary aggregate that the Federal Reserve actually controls. Notice that it exploded in the middle of 2008, as the Fed started quantitative easing and pushed rates to zero. They were desperate to try and thaw out the credit markets that had frozen.

That in turn caused M1 to increase.

But the broader measure on money that is M2 rose into 2009 and has then gone sideways. Normally the stimulus of such raw money growth in M0 would have M2 exploding upward, as you get a money multiplier effect.

We all know that a US bank can lend out about nine times the deposits it has on hand. When the Fed puts money into the system, it can be multiplied rather quickly if banks choose to lend. This is called the money multiplier.

"Restated, increases in central bank money may not result in commercial bank money because the money is not required to be lent out – it may instead result in a growth of unlent reserves (excess reserves). This situation is referred to as 'pushing on a string': withdrawal of central bank money compels commercial banks to curtail lending (one can pull money via this mechanism), but input of central bank money does not compel commercial banks to lend (one cannot push via this mechanism)." (Wikipedia)

This described growth in excess reserves has indeed occurred in the financial crisis of 2007–2010, with US bank excess reserves growing over 500-fold, from under $2 billion in August 2008 to over $1,000 billion recently. Look at the chart below. This is what has all the gold bugs salivating. Where else has this happened without hyperinflation?

Now let's turn to our old friend Paul Samuelson and his textbook that we all read in Econ 101 to learn about the money multiplier:

"By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, 'no nothing,' simply a substitution on the bank's balance sheet of idle cash for old government bonds."

–(Samuelson 1948, pp. 353–354)

And that is what has happened. And all those mortgage bonds and other assets the Federal Reserve has purchased? They have been put right back into the Fed by the banks. There has been no money multiplier. In fact, the money multiplier, as measured by the ratio of MO to M1 growth is at its lowest level ever. Look at the graph below:

What this graph shows, astonishingly, is that a dollar added to the monetary base now has a NEGATIVE multiplier effect. Without showing yet another chart, bank lending has fallen percentagewise the most in 67 years. The actual amount of bank loans is falling each and every quarter, with no signs of a bottom. Consumers are reducing their debt and leverage. Bank loans are being written off at staggering rates. Over 700 banks (I think that is the figure I saw) are officially on watch by the FDIC, with more banks being closed each week.

There is at least $300-400 billion in losses on commercial real estate waiting to be written down. Housing foreclosures are rising and hundreds of billions have yet to be written off. As more families fall into unemployment or underemployment, there will be more writedowns. Is it any wonder that banks are having to shore up their balance sheets and make fewer loans?

With capacity utilization just off all-time lows, why should we expect businesses to borrow to increase capacity? Inventory levels are much lower than two years ago. Businesses no longer need to finance as much inventory. They simply need less.

Dennis Gartman writes:

"Effectively the Fed had become a cash machine rather than a monetary expansion machine. At the end of last year, the multiplier had actually fallen to less than 1.0 and the trend remains downward. If anyone had told us five years ago that the money multiplier would be down to 1.0 we would have laughed. The laugh, however, would have been upon us, for it is there and it is still falling. Hard it shall be to sponsor strong economic growth when no one really wants to take a loan or when few banks want to make a loan. The "game" of banking has been turned upon its head, and the strength of the economy suffers while inflationary pressures (at least for now) remain virtually non-existent."

Next week (or within a few weeks) we will review the velocity of money, as the normal, accustomed relationships about money supply and inflation are proving to be wrong. We live in extraordinary times. We are coming to the End Game of the debt supercycle that has lasted for 70 years. Everything is changing in front of our eyes. It compels us to understand the basics of how economies function, and what is both different and not different about the times we are in.

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John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore

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Myth "We all know that a US bank can lend out about nine times the deposits it has on hand." I don't know who started this myth, or where the broken telephone kicked in, but surely financial sites should be more informed. Have you ever tried to lend out . .more the same book 9 times? It doesnt work, its physically impossible. Banks have to accurately account for their assets and liabilities. If you lend out the same deposit to more than one person, your debits and credits will not add up, or you will have to create dodgy "money creation" accounts in your ledger. I am not sure what the bank's auditors would say about that, but I can guess. It would be illegal for any institution other than the central bank to create money. . .less by What? on February 28 2010, 06:42 Find this comment inappropriate? Report it

Re:Myth Its called fractional resrve banking... The way all banks work. Look it up. by Matt on February 28 2010, 09:11 Find this comment inappropriate? Report it

Matt's the one who should do some thinkiing The article should have stated that a bank can lend out about nine times the SHAREHOLDERS' EQUITY it has on hand. And that nine time's lending must logically be funded by deposits from customers (liabilities) on hand plus shareholders' capital. Or . .more put otherwise: ASSETS (Loans to Customers) = SHAREHOLDER'S EQUITY (incl retained profits) LIABILITIES (Deposits from customers). It is thus obvious that a bank's cannot create assets (loans) out of thin air; it must be funded by a combination of capital deposits. . .less by Bill on February 28 2010, 09:24 Find this comment inappropriate? Report it

@ What Called fractional reserve banking, that's what banks do. They receive a deposit of 10.000 Rand from grandma and can immediately lend out 9 times as much to you and me AND START EARNING INTEREST ON IT. In the US some banks can lend out 20 times, some . .more banks have no limits, and can lend out UNLIMITED amounts. Can you imagine the commissions? And banks can cook the books; the FASB (Financial Accountancy Standard Board), under pressure from politicians and bankers, just changed the "mark to market" rules. Banks can now put their own imaginary value to worthless assets in their financials. Don't believe them if they say they are making profit; it is the world of make-believe. Read, read, read: http://is.gd/9nZYS http://is.gd/9nVDJ http://is.gd/9nWQ4 . .less by Troy Ounce on February 28 2010, 09:34 Find this comment inappropriate? Report it

How Banks work Banking 101. Comercial banks have authority to create money. When they make a loan they write money into existence. Old fractional reserve rules were traditionaly a 10:1 ratio. ie new money can be created up to the limit of 10x what a bank has on . .more deposit. At the height of the crisis some big name UK banks were geared at 60:1. ie their loan limit ratio was 60x what they had on deposit. What happens when the loan is paid off. The debt money is then extinguished. The bank loaned you not one cent to start with. They gave you an unbacked UOI. Yes UOI not IOU. The money on deposit comes from second hand beneficiaries of other internal or external loans. Like the builder or a previous owner, in the case of a home loan. Inflation targeting is a way of controling the flow of fresh debt money comming out of commercial banks. If i am wrong please let me know. . .less by Bob on February 28 2010, 14:38 Find this comment inappropriate? Report it

Where is the real economy? I believe that over time some Banks have unwittingly detached themselves from main street economies. Large banks no longer require main street as they can derive profit from propriety Trading. Therefore there is no incentive to engage with main . .more street anyway. Smaller banks are caught in a deflationary housing market with indebted customers. Other mid tier banks are so obsessed with new fee structures and alternative means of skimming a profit, that they have forgotten what they are and what they are supposed to do. Banks balance sheets can be patched up forever, but if they are not making loans or people don't want loans then their role is mute. The real economy exists externally of banks. Until full attention is paid to that issue not much will change. . .less by Bob on February 28 2010, 14:56 Find this comment inappropriate? Report it

Confusion = 10 x amusement Judging from the expert comments, it appears that not even experts understand banking! But at least they get a bonus? by Simple on February 28 2010, 19:15 Find this comment inappropriate? Report it

Inflation alive and well and soaring in a country near you. What with the world awash with fiat currency no matter where you live in the world today iflation is rampant. Do you that live in South Africa believe your government when they put out their lying numbers on inflation. If you . .more do then just dream on.As for the crooked banking system throughout the world it just a matter of time before the bankers get strung up. . .less by Rota Roota on February 28 2010, 23:56 Find this comment inappropriate? Report it

Fractional Reserve - not quite immediate, but 10 times nevertheless It works like this: 1. person A deposits R100 000 in bank 2. at a required reserve of 10%, bank can lend R90 000 of the R100 000 to person B ........Total in circulation R100 000 R90 000 = R190 000 3. person B uses R90 000 . .more loan to pay person C 4. person C deposits R90 000 in bank 5. bank can loan R81 000 of the R90 000 to person D ........Total in circulation R100 000 R90 000 R81 000 = R271 000 ... etc The result is that at a 10% reserve ratio, the multiplier is 10 times the sum initially deposited. . .less by M on March 01 2010, 02:41 Find this comment inappropriate? Report it

Inflation / Deflation It seems as if many countries in the world is in deflation mode. Home values tumbling, unemployment rising, little or no salary raises. Are consumers reducing loans or are bad loans written off. Without US government financial assistance the USA is . .more in a full blown depression. And to such a state that the printing of money has no affect. . .less by ea on March 01 2010, 03:13 Find this comment inappropriate? Report it

@M: So $100 of REAL MONEY created $1000 of DEPOSITS, (assets in the hands of the real economy) MINUS $900 loans (liabilities in the hands of the real economy) which equals the $100 we started with? Not everyone would consider that money creation. M0 and . .more MB do not reflect this as money supply. It is however credit extension, and creates potential purchasing power. . .less by Jack on March 01 2010, 03:14 Find this comment inappropriate? Report it

Fractional*reserve banking .. par.1 The alternative .. full*reserve banking .. died out more than two centuries ago, so we should perhaps deal with this mystery (NOT) for once and for all. @Bill is right: The article should have stated that a bank can lend out about nine . .more times the SHAREHOLDERS EQUITY it has on hand. And that nine times lending MUST LOGICALLY BE FUNDED by deposits from customers (liabilities) on hand plus shareholders capital. Commercial banks do not really create money from thin air. The system of fractional*reserve banking merely allows them to lend out most of the deposits and capital that they are able to secure. It is called fractional*reserve merely because these banks are required to keep only a fraction of their deposits in reserve. If the reserve requirement is 10%, it means they must cover their lending liabilities by only 10% in the form of highly liquid assets, (the quality of these assets effectively regulated by Basil conventions). . .less by Jack on March 01 2010, 04:07 Find this comment inappropriate? Report it

Fractional*reserve banking .. par.2 So if Bank A gets in 100USD in deposits it is typically able to on*lend 90USD. (i.e. if the reserve requirement is 10%, only 90% of deposited money is actually saved). So, in theory, 90USD is now (theoretically) available to be deposited at Bank B, . .more and this bank needs to actually save only 9USD before on*lending 81USD. And so it (can theoretically) carry on until the entire 100USD is actually saved all over the banking sector. (We all know this kind of logic is stretched, as we do not borrow from banks to lend back to them?) There is however a potential wealth*effect involved. The total amount of DEPOSITS (claims against the banking sector) is now 100 90 81 and eventually approaches the inverse of the 10% reserve rate times the monetary base, therefore 1/10% x 100USD = 1000USD. (this kind of logic however confuses DEPOSITS and LIABILITIES) . .less by Jack on March 01 2010, 04:09 Find this comment inappropriate? Report it

Fractional*reserve banking .. par.3 But do note that according to this (extremely theoretical) logic, that for the banking sector to CREATE the last 900USD from the original 100USD of REAL MONEY, all of this CREATED MONEY ended up as SAVINGS in the accounts of banks all over. . .more (different forms of deposits form part of the calculation of various measures of money supply). These saving are also tied up by loan commitments, so this theoretical demonstration is actually sterile in explaining how more money lands up in the hands of spenders, and how it drives demand*led inflation. There is of course a LOANS LEAD RESERVES THEORY which contends that activity in the real economy demands from banks to lend the 1000USD, which then requires of the commercial banks to secure the reserve requirements in cash and secure liquid capital, through capital*raising, or from the central bank directly. More realistically, bank lending, and credit extension, facilitates economic activity which demands further lending from banks, to the extent that interest rates make monetary expansion (or contraction) viable. . .less by Jack on March 01 2010, 04:11 Find this comment inappropriate? Report it

Fractional*reserve banking .. par.4 As Maudlin promises to discuss in his next article, money is effectively created by every transaction. The speed of money through the economy determines effective money supply. Example: to buy a 1000USD worth of goods may require that potential . .more buyers hold 1000USD worth of cash. However, if there is only 10USD worth of cash on the economy, if A uses the 10USD to buy from B, and B then uses it to buy from C, and so on, a 1000USD worth of money is soon spent. Because of the velocity of the money through the economy, the effective amount of money will therefore appear to be 1000USD, and the faster it moves through the economy, the higher money supply will effectively be. It is this kind of accelerated economic activity that eventually creates inflationary pressures, if money becomes too loose and demand starts outpacing the real capacity in the economy. The whole thing is like gas in a balloon which is being produced by catalytic process. If the gas heats up, the pressure rises because the molecules move faster. To regulate you have to cool the gas down, or reduce the supply of gas by reducing catalyst and/or withdrawing gas. . .less by Jack on March 01 2010, 04:13 Find this comment inappropriate? Report it

Fractional*reserve banking .. par.5 Inflationary fears at this stage stem from a misunderstanding of economics, or a mistrust of central banks, or both. Almost the entire argument that Mauldin presents points to the risk of a collapse in money supply and the threat of deflation.. the . .more reason central banks are responding with extraordinary measures. Yet he fears HYPERINFLATION??? As Mauldin quotes a description of the PUSHING ON A STRING principle: withdrawal of central bank money compels commercial banks to curtail lending (one can pull money via this mechanism), but input of central bank money does not compel commercial banks to lend (one cannot push via this mechanism). We should not be suspicious of excess reserves nor should we be overly wary of inflation. In theory, at least, the central banks have the tools ready to withdraw stimulus in time to prevent hyperinflation, although the process cannot be expected to be smooth sailing. The pain is in the adjustment to the real economy that is now required. If we trust the Fed, as I do, there is a basis for our faith in sound economic theory, if not in historic experience. . .less by Jack on March 01 2010, 04:16 Find this comment inappropriate? Report it

Mind the gap between disinflation and hyperinflation Having noted a clear conservatism of banks (considering their hesitancy to lend), since the start of the credit crunch, Mauldin suggests the illogical conclusions: This is what has all the gold bugs salivating. Where else has this happened without . .more hyperinflation? I find this quite irrational. Under normal conditions, excess reserves are negligible. During periods of crisis only a small rise in excess reserves will cause a remarkable increase in the ratio he presents. That this should be shocking, or lead to the conclusion of inflationary pressures, is quite extravagant reasoning. Under normal conditions, banks will lend as much as they are allowed to, and excess reserves will approach zero. But during a crisis, the interests of self-preservation and a lack of confidence about the stability of the financial system, including doubts about the continued value and liquidity of assets held, and the potential stress that withdrawals may place on (fractional) reserves, and the risk that normal channels to access capital or meet liquidity requirements may not remain open, will cause banks to hold excess amounts of liquid reserves. This does not necessarily presage inflation, or hyperinflation, but merely suggests an ability of these banks to increase credit extension once confidence returns to the financial markets. . .less by Jack on March 01 2010, 04:21 Find this comment inappropriate? Report it

Conclusion Even given the extraordinary monetary stimulus underway, the modern central bank should be able to arrest inflationary pressures before inflation is allowed to be entrenched structurally and spiral out of control. by Jack on March 01 2010, 04:23 Find this comment inappropriate? Report it

@Jack Yup, thanks for clarifying... just showing how the theoretical multiplier works - many people think that it's an automatic ability for a bank to lend out 10 times what it gets in. by M on March 02 2010, 01:49 Find this comment inappropriate? Report it

@Jack RE Minding the Gap I don't disagree with anything you have said, but in defence of Mauldin, he has been highlighting and warning on deflationary pressures and countering inflation arguments since the beginning of the crisis, so I am inclined to believe (especially . .more since he continues to highlight deflationary pressure here) that in this article he is quoting the hyperinflationary fears of the gold bugs rather than his own analysis. I would think this article is just a case of unclear writing. . .less by M on March 02 2010, 02:02 Find this comment inappropriate? Report it

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