The Money Multiplier – a dead end of economic theory

Regarding the extent of credit, supposedly “created” by the commercial banking system, the most fantastic ideas present themselves to the public. I’m not talking about mere verbal inaccuracies, based on vague definitions. If I call commercial credits (or the corresponding savings deposits) by the name of “money” so as to make them undistinguishable from the coins or notes of a central bank, then commercial banks must in fact be considered the creators of vast sums of money, as they are the places were deposits and corresponding credits are to be found. Money properly speaking – the money created by central banks – will then represent nor more than an infinitesimal fraction of the total amount of „money“ to be found in the economy.

Here, I am not concerned with this type of semantic imprecision, but with theories proclaiming a real creation of money from nothing. Such theories have been upheld and are still taught to students of economics by an overwhelming majority of economists, including among many others, so illustrious names as Ludwig von Mises, Joseph Schumpeter, the early Keynes, Hajo Riese, Jörg Huffschmid, Bernd Senf, Joseph Huber, Otmar Issing, Paul Samuelson etc. The late Keynes, Silvio Gesell, Helmut Creutz as well as Gunnar Heinsohn and Otto Steiger have rejected this idea. (1)

I want to emphasize at the outset that I am only speaking of loans granted by commercial banks. Central banks always had the option to create fiat-money out of nothing though its money supply does by no means represent nothingness as long as its volume strictly reflects overall economic output. Only if this condition does no longer prevail central banks create “arbitrary money” (in other words, money not backed by values of the real economy) – a fact abundantly demonstrated in our time by the hazardous policies of the American Fed and its European counterpart (the ECB). (2)

The Money Multiplier

At first glance the so-called “Money Multiplier” taught by some of the best-known economists and textbooks as an undisputable scientific truth, seems to be quite plausible.

To demonstrate what this theory of money creation implies, let’s consider as our starting point a single commercial bank instead of the really existing multitude. Though in theory perfectly possible, such a merger of all existing commercial banks into one single institution would in practice be quite inefficient, as a large amount of expert knowledge would necessarily get lost. (3) I resort to this simplification for the sake of argument. If a saver (creditor) entrusts € 100,000 to this bank for a total of ten years, the bank uses its contacts with potential investors in order to immediately pass the money on to a trustworthy debtor. In its own interest the bank acts with utmost speed as it has to pay interest to the creditor which it only gets from the borrower (deducting for its own efforts the so-called bank margin). As long as it can not find a borrower, the bank makes a loss.

Now, let the debtor use the borrowed money to buy a product such as, for instance, a printing press. The manufacturer in his turn has no actual use for € 100,000, so he transfers the money to his saving account where it will be bound for ten years. The bank again finds an investor who just made an invention which requires him to purchase plastic material worth 100,000 €. Let us again assume that the plastics manufacturer has no actual use for this sum and therefore lends it out to the bank for ten years. And so on and so forth in the same manner. The bank will find another investor, who in turn buys from a manufacturer who again lends the 100,000 he received for his product to the bank for the coming ten years. It is important that all these transactions happen almost simultaneously in the interest of the bank. We assume, furthermore, that the borrowers make their purchases in the shortest possible lapse of time, and that all the sellers of the respective products immediately put the received money on their savings accounts. Since all processes are confined to a single commercial bank, the original € 100,000 will not leave the bank for a moment (they will be merely transferred from one account to another). For this reason the whole process may indeed happen almost at the same time – in theory in a single moment. (4)

Let us now consider the logical structure of this chronologically compressed sequence which may be stretched to infinite length. After a first deposit of mere € 100.000 has been made, it is theoretically possible for a commercial bank to hand out credits without quantitative limits – and that is exactly what the theory of the Money Multiplier implies:

Savings:……………….. Loans:                                        Purchase from company:

100 000                           debtor A buys printing press      from company 1

100 000                           debtor B buys plastics                from company 2

100 000                           debtor C buys x                          from company 3

etc.                                  etc.                                              etc.

Sum total of savings=∞  sum total of loans=∞                  sum total of purchases=∞

Up to the present day this example of a so-called “money multiplier” (5) is to be found in the most serious economic textbooks, (6) except that it normally assumes a slightly different shape. The miraculous money creation is usually illustrated with reference to several commercial banks and it explicitly includes the requirement of reserves within a system of fractional-reserve banking, in other words it deducts a certain proportion of savings to be deposited at the Central Bank. (7)


Suppose the bank has to subtract 10% from any deposit, in our example from those 100.000 € it just received from a saver. That means it will only pass 90.000 € to borrowers. At the subsequent stage the same 10% will again be deducted from the remaining 90,000 so that now only 81.000€ are at the bank’s disposal. In the final analysis, the total amount of all deposits following each other in the above described chain will be equal to one million while the sum total sum of all possible loans amounts to 900,000 € (which corresponds to a reduction of exactly 10%). If, however, the reserve ratio would be one percent, the sum total of all possible deposits would be inflated to ten million €, while the Bank may only grant loans amounting to nine million nine hundred thousand € (which corresponds to a reduction of exactly one percent).

An endless flood of possible credits?

The higher the reserve ratio the less credit is “created” by the Money Multiplier. Conversely, the multiplier seemingly “creates” limitless money as soon as the reserve requirement is down to zero. A simple trick would be sufficient – the mere reduction of reserve requirements to zero – in order to flood economies all over the world now and for all times to come with an inexhaustible cornucopia of freely created money. A credit crunch or any related obstacles to investments in the real economy would be impossible.

The money multiplier presupposes an identical volume of savings and loans

Probably it is the obvious absurdity of this conclusion, which compels the proponents of this curious theory to consider the above mentioned example only in connection with reserves in a factional-reserve banking system. This, howerver, is a logically superfluous addition to the multiplier which in no way changes its logical structure. Adding reserves is nothing more than a subterfuge so that the adherents of this theory need not explain an infinite credit creation which has never been observed in the real world. (8)

But it is one thing to emphasize the obvious absurdity of infinite credit creation, and another to reveal the hidden flaw still to be found in the most renowned economic textbooks. Where is the error?

It can’t be refuted by statistical facts, in other words, by the unmistakable numbers of the German Bundesbank, which clearly indicate that the sum total of all outstanding credits never exceeds the volume of savings and demand deposits. Helmut Creutz, when using this argument against the Money Multiplier, has chosen the wrong argument. (9). Look again at the above example and you will realize that banks have multiplied credits to exactly the same degree as the amounts of savings. That is what the logical structure of the Money Multiplier presupposes. If all savings are instantaneously passed to borrowers as loans, then commercial banks are indeed capable of increasing these indefinitely – provided they can make use of infinite deposits as well. The factual argument of Helmut Creutz is therefore quite useless as a proof against the Money Multiplier. It may be properly used only against the assertion that commercial banks usually lend more than they take in from savers.

A series of elementary fallacies

Fallacy one of the Money Multiplier theory is the assumption that loans exceed deposits. This assumption is evidently wrong. (10)

Fallacy two is the error of thinking, mistakenly, that the Money Multiplier has anything to do with or is logically dependent on fractional-reserve banking. There is no logical connection between the two.

Fallacy three relates to the first link of the above described chain, which in current textbooks is invariably represented by a cash deposit. Now, if we look more closely at the chain, we notice that absolutely nothing changes, whether we start with 100,000 € paid in bills or whether we start somewhere in the middle with a mere transfer of book money. Bernard Lietaer is therefore mistaken if he ascribes a particular role to the initially deposited banknotes, raising them to the status of “hot money” without which the whole process of money creation would not come into being. (11) This is a mistake. The chain may start at any point, no matter whether cash or non-cash be used in the transaction.

And this brings us to fallacy four based on the mistake to ascribe any particular meaning to the chain as such. In fact it makes no difference at all whether – with or without reserves – 1000 savers successively bring each 100,000 € to our bank or whether they do so outside a chain simultaneously and independently of each other.

The crucial flaw in Money Multiplying

But that’s not all. As yet we have still omitted the most serious and foolish fallacy. Be sure that nobody actually believes – least of all the bankers themselves – such a process of infinite money creation to ever have happened or likely to occur in the future. Practice and theory are indeed diametrically opposed to each other. The fallacy is difficult to discern because it is not found in the logic of the process itself but in its preconditions. Theorists of money have always been so obsessed with their object that they keep falling into the trap of considering money and credit as substances detached from the things which they represent.

As soon as we consider loans for what they really are, namely surplus money due to the presence of surplus assets (that is surplus labor or surplus means of production), the mirage of multiple credit creation instantly dissolves into nothing. New deposits can occur only if they represent surplus money in the hands of their owner. But as surplus money is nothing else than a monetized surplus of real assets, it can be mobilized only in so far as the latter really exist – never beyond. A saver can not place a surplus on his banking account which he doesn’t own in the first place.

Fallacy five. In the above described chain of the Money Multiplier we presupposed that each firm or individual would immediately transfer the 100.000 € received for its products to its respective savings account, so that the bank may in turn hand it out as a new loan. But this is a totally unrealistic assumption, as it would imply that all money received in commercial transactions represents surpluses for their respective owners. As a matter of fact, the sum total of all surpluses to be used for investments is quite limited. It corresponds to each country’s savings rate. If the latter amounts to ten percent, this means that on average citizens only take one in ten Euros to their savings account. Hence, there can be no question of an infinite creation of deposits and loans, as suggested by the Money Multiplier (no matter whether or not mitigated by reserve requirements). It remains a secret of esoterically misled economists – including some great minds in their midst – how to reconcile the existence of a national savings rate with their theory of boundless money creation.

A useless construct built on wrong preconditions and incorrect conclusions

The best that can be said about the construct of the Money Multiplier is that the chain described above is not logically impossible, though in practice its probability is hardly higher than throwing a dice six times with a six. It is bereft of any relevance, given the crucial fact of available surplus, as represented by the savings rate of a country. Commercial banks can not create money arbitrarily. This opportunity is open to central banks only. (12)

The ludicrous theory of the Money Multiplier is a prime example of the disastrous effects of misleading mathematical precision (13) on the common sense even of most distinguished economists. In view of such theories it must be admitted that frequently expressed doubts about the scientific nature of academic economics are perhaps not really unjustified. Let me add that I leave aside other heterodox ideas on the subject of money creation by commercial banks. On closer inspection these too dissolve like futile soap bubbles. (14)

1 On this question see my book Wohlstand und Armut. Marburg 2010, pp. 151.

2 The concept of “arbitrary money” is explained in detail in the aforementioned work.

3 In a centralized socialist bureaucracy a single commercial bank would be the (inefficient) counterpart to the tens of thousands of commercial banks which characterize market economies. It is obvious that a large number of individual decision makers are much better qualified to assess the creditworthiness of a correspondingly large number of private borrowers.

4 The reason why I have grouped all commercial banks in a single one (thus departing from the usual examples of multiple credit creation), is based precisely on the possible simultaneity of all events.

5 When the Money Multiplier is meant to demonstrate the creation of book money, the argument remains the same.

6 So in: Otmar Issing, Einführung in die Geldtheorie. WiSo Kurzlehrbücher; 10th rev. edition, Munich 1995. Or Paul A. Samuelson and William D. Nordhaus, Volkswirtschaftslehre. Mi-Verlag, Landsberg 2005, p. 725. Or Harvard professor Niall Ferguson in: The Ascent of Money. New York 2008, p. 50.

7 The Money Multiplier is usually exemplified in connection with several commercial banks. This is meant to explain the otherwise troublesome fact that the directors of individual banks have no idea of such a miraculous multiplication. Logically, nothing changes in our argument, except that the demonstration of a single bank has the aforementioned advantage to allow for an almost simultaneous chain expansion.

8 For instance Bernard Lietaer, Das Geld der Zukunft. Munich 1999, p 68; but also Samuelson, Volkswirtschaftslehre, pp. 725.

9 Helmut Creutz, Die 29 Irrtümer rund ums Geld. Munich 2004, pp. 172.

10 This statement only applies to the Money Multiplier, but is not true in a general way as commercial banks not merely serve as agencies which transfer the money of savers to reliable borrowers. They fulfill the further function of providing the economy with cash from the central bank in exchange for first class securities. See my article Die drei Funktionen einer Geschäftsbank ( and in more detail Wohlstand und Armut, pp. 95. This function is, of course, far removed from any money creation out of nothing, since these securities represent economic output! In this way commercial banks get that additional amount of money which they did not receive from savers. But they have to pay a borrowing fee (wrongly called interest) to the central bank. The amount of this fee the central bank determines according to economic performance. If the latter stagnates or is going through a decline, the money supply to via commercial banks to the economy will be reduced in order to avoid inflation. The central bank therefore raises the borrowing fee (central rate), thus forcing commercial banks to increase the interest on lend money to such a height as to discourage further borrowing. If, on the other hand, the economy is growing, the central bank allows the money supply to increase in order to counter deflationary trends. For this purpose, the prime rate will be lowered – money becomes cheap and the business pays off for banks and borrowers alike.

11 See Bernard Lietaer, op. cit., p 68. Lietaer only repeats accepted textbook wisdom with regard to “fractional reserve banking” and the “money multiplier”. See and

12 Since base money is transferred to the economy via commercial banks (see note 10), the latter act in fact as transmission belts for “arbitrary money” issued by centrals banks as soon as the latter accept junk bonds for securities.

13 A remarkable example is the following article in Wikipedia:

14 This remark applies to the special variant of the Money Multiplier invented by Prof. Bernd Senf. Mr. Senf first apologizes to all those generations of students whom he had led astray by teaching MM in its conventional shape for years as an indisputable truth. He now holds it to be thoroughly wrong. However, instead of justifying his changed position by scientific argument he only speaks of “meaningless questions” to which one cannot expect to get more than “meaningless answers” (Bernd Senf, Der Nebel um das Geld. Munich 2001, pp. 159). Unfortunately, Mr. Senf was unable to bear the loss of his childhood faith for a long time, for he hastily puts another in its place. He now offers his own quite ingenious version of credit creation to the public. I regret to say that this innovation of his is both practically irrelevant and logically untenable. For details see my book Wohlstand und Armut, p. 168.