Fractional Reserve Banking, Monetary Velocity, and “Pushing on a String”

By John Banks June 16, 2020

A fair number of people believe the Federal Reserve has control over the U.S. money supply. They also assume, by natural extension, that the Fed is responsible for the total amount of money in circulation.

Neither of those assumptions are true. It’s important to understand why, as we will shortly explain.

The Chairman of the Federal Reserve, in certain ways, is like a jockey riding an elephant.

The jockey appears to have control over the elephant. Through various actions and commands, the jockey can steer the elephant, or make it stop and go.

But in reality, the control is almost all psychological. If the elephant decides to freeze in terror, or to rear up and stampede, there is little the jockey can do.

A comparable situation exists with the U.S. banking system, and the amount of money and credit flowing through the system. The Federal Reserve has influence in this area — but not control.

The vast majority of money and credit in the system — more than 95% by reasonable estimates — comes from the lending activity of private banks and “shadow banks.”

(A shadow bank is a non-traditional entity that conducts lending activity outside the normal banking system, like a hedge fund lending to a small business.)

Lending expands the amount of money in the system through the principle of fractional reserve banking. A “money multiplier” effect occurs whenever money is lent out, and deposited, and then lent again. For example:

Alice deposits $100 with a lender.
The lender uses $90 of Alice’s deposit to make a loan to Bob.
Bob deposits $80 of his loan with a second lender.
The second lender uses $70 of Bob’s deposit to lend to Charlie.
Charlie deposits $60 of his loan with a third lender.
The third lender uses $50 of Charlie’s deposit to lend to Doug.

Through this process of lending and re-lending, Alice’s original deposit is multiplied.

If each bank holds back 10% and lends out the rest, and the process keeps on going, the money multiplier effect means Alice’s $100 deposit is magnified ten times, creating $1,000 worth of spending power in the system.

This is why, in any fractional-reserve-system, money and credit are the same thing. They are two sides of the same coin. If a lender is allowed to lend against deposits, new money is added to the system when they do so, because each new debit creates new spendable funds.

When Bob takes out a $90 loan, he simultaneously adds a $90 debt to his books and $90 in cash to spend; meanwhile Alice can rest assured that, if she checks the balance on her savings account, her $100 is still there.

The Federal Reserve holds sway over the banking system by setting the “reserve requirement.”

The reserve requirement determines the portion of funds that banks must hold in reserve for safekeeping. So, for example:

If the reserve requirement is 10%, banks hold 10 cents for each dollar of deposits.
If the requirement is 5%, banks hold 5 cents for each dollar of deposits.
If it is 1%, banks hold one cent for each dollar of deposits, and so on.

The “money multiplier” is the inverse of the reserve requirement. For example:

With a 10% reserve, the multiplier is 10X (the inverse of one-tenth).
With a 5% reserve, the multiplier is 20X (the inverse of one-twentieth).
With a 1% reserve, the multiplier is 100X (the inverse of one-one-hundredth).

The smaller the reserve requirement, the bigger the multiplier effect becomes. As we noted in our earlier example, at a 10% reserve requirement, Alice’s $100 could become $1,000 worth of spending power. This is because the inverse of 10%, or one divided by ten, is ten divided by one.

If the reserve requirement were 1%, as you can now hopefully see, Alice’s $100 could become $10,000 worth of spending power through the fractional reserve system. This is what would happen if new loans took place to the maximum limit, with 99 percent of each deposit lent out again each time.

And now for a pop quiz: What happens if the reserve requirement goes to zero?

At zero, the potential money multiplier effect is infinite. A fractional reserve banking system with no reserves can lend unlimited amounts of money.

This makes natural sense when you think about the math.

If the reserve requirement is zero, that would mean the bank can lend 100% of each deposit. That, in turn, means the bank could relend 100% of Alice’s deposit to Bob — and then 100% of Bob’s deposit to Charlie, and 100% of Charlie’s deposit to Doug — on and on forever.

So here is a weird thing, and it is important to get your head around it: In March 2020, in response to the pandemic, the Federal Reserve cut the reserve requirement for thousands of banks to zero.

At a zero-reserve requirement, U.S. banks have the technical capability to lend out infinite amounts of money (because they can relend 100% of deposits, and newly deposited deposits, ad infinitum).

What the Fed effectively did, in March 2020, was to say to the banks: “We give you permission to lend out infinite amounts of money!”

But of course, the banks did not lend to infinity. They didn’t even lend all the deposits they have on hand.

We know this because the Federal Reserve tracks the total amount of “excess reserves” held by depository institutions at reserve banks. Excess reserves are funds that could technically be lent out but aren’t being lent, for whatever reason.

As you can see from this data series via the St. Louis Fed, excess reserves skyrocketed during the pandemic. In effect this means that:

The Federal Reserve aggressively wanted to encourage private lending.
They did this, in part, by cutting the reserve requirement to zero.
The banks, in large part, declined the opportunity to lend aggressively.
We can see this because excess reserve totals shot higher.

The next logical question is: Why would banks refuse to lend when given the chance?

The banks are often greedy, but they aren’t stupid. If a bank makes a loan and the loan payments get delayed, or the loan goes into outright default, the bank will lose money on that loan.

As a result, banks will not necessarily rush in to expand their lending activity — even if the Federal Reserve wants them to.

Then, too, banks are often highly leveraged to their loan book, meaning a 5-10% loss on the loan portfolio could wipe out the bank’s equity. For example, imagine a bank with $100 million worth of equity and $2 billion worth of commercial mortgage loans. If just 6% of those loans go bad — creating $120 million in losses — the bank is insolvent.

This is all the more reason why, when the economy looks ugly, banks will turn conservative and cut back on their lending. If the outlook is truly ugly, and creditworthy customers are few and far between, the bank might hardly lend at all.

If the banks refuse to lend, or otherwise turn highly cautious and timid, there is little the Federal Reserve can do. In order for the “money multiplier” effect to take hold, the banks have to lend money, and the money has to circulate through the system.

The speed at which money circulates through the system — changing hands, getting lent and spent over and over — is known as “monetary velocity.”

When monetary velocity is high, the economy is humming. When velocity is low, the economy is stagnant, and extra liquidity from the Federal Reserve might not make a difference.

Imagine, for example, if the Federal Reserve tried to push a trillion dollars into the system, but the banks were too scared to lend it out (for fear of taking losses in a terrible economy).

In that instance, the Fed’s trillion-dollar liquidity injection would just sit in bank vaults as a form of excess reserves. As far as liquidity goes, it would be like a stagnant pool of water trapped underground. It would have no impact on monetary velocity, and it would not juice up the economy at all.

This is where the phrase “pushing on a string” comes from.

If you have ever laid out a long string across a table, and then tried pushing one end of the string, you know that nothing happens at the far end. There is no transmission effect from one end of the string to another.

This is what happens when the Federal Reserve, or any central bank, tries to pump new liquidity into a debt-laden, stagnant economy where the banks are too fearful to lend and corporations are too debt-laden to borrow more.

What matters a great deal more than the amount of liquidity in the system is the amount of monetary velocity in the economy. The more monetary velocity that is present, the more vigor and enthusiasm the economy has.

If dollars are moving through the economy quickly — because businesses and consumers are spending and borrowing and spending yet again, and banks are lending left and right — a modest amount of liquidity can then have a big impact, like lubricant circulating through an engine at a high rate of speed.

But the flipside also applies: The less monetary velocity an economy has, the less that liquidity has any form of impact. If the banks aren’t lending, and consumers aren’t spending, and businesses have already maxed out their debt levels, extra liquidity just pools in a stagnant way.

To briefly recap, the Federal Reserve cannot control the total U.S. money supply. The amount of money in the system will expand or contract based on the amount of lending and credit provided by the banks.

When an economy runs hot and animal spirits are strong, the Federal Reserve has ways to stop banks from lending, or at least to slow down the pace of lending. The Federal Reserve can raise interest rates, or raise the reserve requirement, which in effect reduces the money multiplier and reduces the total amount the banks can lend.

But it doesn’t really work in reverse.

When banks are fearful because the economy is sluggish, the Federal Reserve can try every trick in the book to make banks lend more — including cutting the reserve requirement to zero, which technically gives banks permission to lend to infinity — and still it’s possible that none of it works.

This also explains why efforts to “prop up” the economy, or otherwise artificially support the economy, can become so dangerous over the long term.

As debt levels build up, efforts to stimulate the economy further fall flat, because the weight of additional debt hurts more than the stimulus helps. Then, too, when private corporations find themselves loaded to the gills with debt, they find themselves lacking the stomach to borrow more.

Eventually, if the debt build-up goes on long enough, the debt jams up the whole system to the point where the central bank can provide as much liquidity as it wants, and yet all its efforts amount to “pushing on a string” with monetary velocity dead as a doornail.

This is the point where the weight of the debt starts feeling deflationary — and also the point at which aggressive MMT (Modern Monetary Theory) policies start to look increasingly attractive.

Unfortunately, this is exactly the path we’re on now. The more the Federal Reserve finds itself “pushing on a string” in its efforts to jumpstart a sluggish economy, with monetary velocity fading away due to the debt burden, the more it will start to eyeball ever-crazier experiments, with the ultimate risk of destroying faith in the currency.