Expert Commentary

Collapse in Money Multiplier Points to Deflation

The Fed can print as much money as it wants, but it might not go anywhere.

OK, stay with me here for just a minute while I lay some groundwork: In monetary economics, a money multiplier is a measurement calculated as the ratio of commercial bank money to central bank money. In a fractional-reserve banking system, commercial banks can extend credit (loans) based on the amount of reserves held at the central bank. In simple terms, this is why the amount of “money” in the economy in the form of credit far exceeds the amount of money at the central bank. If one new dollar of reserve money is created by printing it, that new dollar should be multiplied into many more dollars via the commercial bank system. The money multiplier is a controversial concept, with institutions such as the Bank of England vocal critics of it as not capturing the true dynamic between central bank money and money in the economy. Nevertheless, it offers a general insight into what might be happening.

The chart below shows the money multiplier for the United States of America, calculated by dividing the M2 Money Stock (which includes deposit accounts at commercial banks etc.) by the Monetary Base (reserves at the Fed). M2 was nearly 8 times larger than the Monetary Base at the end of the 1950s and the ratio grew during the 1960s and 1970s, reaching 12 in the mid-1980s. During that time of growth in the money multiplier, price inflation was historically high, especially in the 1970s. Since the mid-1980s, though, the multiplier has been declining. Some of this was purely mechanical, due to financial deregulation in the 1980s and 1990s whereby conventional bank accounts were being closed in favor of institutions such as mutual funds offering daily redemptions. This became known as the shadow banking system.

However, at its core, the money multiplier is essentially a measurement of both the willingness of private banks to extend credit and of the private economy to demand credit. Having been relatively flat for a decade from the mid-1990s, the money multiplier suddenly raced higher in 2006 and 2007 as the real estate and credit bubbles went into their peaks. But look what happened after the crash in 2008. Despite the Fed printing trillions of fresh dollars, the money multiplier collapsed, indicating that the fresh dollars were not being transformed into credit via the commercial bank system. Banks wanted to hoard cash, taking years to get back into a lending groove. From around 2015, the ratio moved higher as the credit-fueled economy started bubbling again.

Which brings us to the present day. The Fed has expanded the monetary base by 50% since September 2019 yet the money multiplier is, once again, collapsing. Are banks hoarding cash? Are businesses and individuals not wanting new loans? It’s probably a combination of both, indicative of a deflationary mindset. The relentless fall in the money multiplier over the past three decades has coincided with an era of subdued and falling price inflation, so-called disinflation. If our Elliott Wave analysis is correct, the economy’s current tailspin and fall in the multiplier will accompany a deflationary collapse.