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Simply Wrong? The Money Multiplier (part II) Jericho, "Many dollar bills", wikimedia commons

Simply Wrong? The Money Multiplier (part II)

In this sequel, Marat Markert advances three arguments why misunderstanding money, banking and the monetary system might have repercussions beyond the pages of a textbook, and what to do about it.

In part 1 I pointed out how economics 101 textbooks misrepresent money and the monetary system by teaching undergraduates the money multiplier theory. In this part I advance three arguments why misunderstanding money, banking and the monetary system might have repercussions beyond the pages of a textbook, and what to do about it. Ultimately, teaching financial literacy – how our system works today – would go a long way in enabling students to follow policy- and reform discussions, and actually also empower them to participate in shaping the monetary system we have today.

Discover the World …of the 1950s-1970s

Money is difficult, so it’s not surprising that debates around money and the monetary system are constant (and have been going on for quite some time). I hear you: “Different theories and diverse view-points—that’s what I want from a university education.” Strangely enough, for our econ 101 course we use a textbook that teaches undergraduates the money multiplier and no other monetary/banking theory. Hence, we somehow decided to focus exclusively on stuff that is empirically inaccurate. This is not a sign of intellectual diversity, but actually contrary to the ethos of any educational institution.

One of the slogans of Leiden University is “Discover the world at Leiden.” Sure, the money multiplier is a way to discover the world of money and banking, but that is the world from 1950s-1970s (at best). It was during this period when central banks tried to control the money supply by targeting monetary aggregates (M1, M2 etc). That’s the period when the money multiplier theory had some intellectual purchase. But from the ’80s onwards central banks in advanced economies shifted to interest rate targeting, indirectly admitting that reserve requirements—the crucial ingredient in the money multiplier story—do not actually constrain bank lending as the money multiplier theory would have it. But the bigger picture is this: the ethos of a research institution that is dedicated to the pursuit of truth via scientific methods seems to me at odds with the way our textbooks introduce money, banking and the monetary system to undergraduate students today in 2021.

Some would argue, “But it is an introductory textbook. You have to start somewhere.” Of course, easy and intuitive theories can help students navigate this complex world. And undoubtedly it is psychologically gratifying when you finally understand something that seemed so difficult initially. The money multiplier is one of those easy and intuitive theories. But are “easy” and “intuitive” the main goals of education? I’m not an astrophysicist (nor a flat-earther), but I imagine it would be hell of a lot easier for B.Sc. students in astrophysics to learn flat-earth theories than theories about gravitational forces and relativity. And while this seems like a silly analogy, it also seems to me that this is exactly what econ 101 textbooks are doing when teaching the money multiplier, the flat-earth version of our monetary system. But here is the difference as to the effect of what is taught in intro to astrophysics and econ 101: The universe doesn’t care if we teach flat-earth theories, but the functioning of our monetary system pretty much depends on the conceptual priors of its users. How people think about money can have an impact on how the system works, in particular its legitimacy.

Economic theories: an engine, not a camera

But let’s take a step back and think again about the realism of assumptions in theories. In my previous post, I asked whether it matters if theories might have no correspondence with reality. Should the underlying assumptions of theories be realistic? Surprisingly some economists think that the answer to this question is: no. For example, Milton Friedman wrote in his Essays In Positive Economics:

Truly important and significant hypotheses will be found to have ‘assumptions’ that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions (in this sense). (1953, 14)

So far so good, but Friedman went on:

To put this point less paradoxically, the relevant question to ask about the ‘assumptions’ of a theory is not whether they are descriptively ‘realistic,’ for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions. (15)

In plain English: if the theory predicts reality well, then who cares if it is based on assumptions that are pulled out of thin air. Fortunately, when it comes to the money multiplier no one even remotely involved in studying or managing the monetary system for a living thinks that the this theory is accurate, let alone yields any useful prediction (see the numerous links I provided in part 1).

But here is the thing: economic theories are not just neutral observations detached from the reality they seek to describe; they might be wrong or inaccurate, but their proliferation can actually shape reality, too. They can turn out to be an engine, not a camera. Historical analysis has shown that monetary reforms are preceded by specific theories and concepts about the nature and functions of money. As Christine Desan noted: “Conceptual commitments had material impact in the project of making money” (Desan 2014, 331). This was true during 17th century debates in England on money, as it is today. I hazard a guess that part of the appeal of cryptocurrencies like bitcoin is rooted in 19th century notions of commodity money–so, conceptual priors matter.

In short, economic theories can shape reality, and that is the case for monetary theories, too. By choosing what to teach students about money and the monetary system, educational institutions can have an impact: we can either teach how the system works, or nurture myths and folk theories about one of the most important institutions in modern societies.

Folk Theories of Money, Crisis and Reforms

“So what?” one might interject. “As long as money works and people use it in daily life, why not live with a mix of practical knowledge and ignorance?” Yet, nurturing “folk theories” of money might turn out counter-productive during times of crisis. Over the last decade, for instance, central banks in Europe, who for their part have relied on folk theories of money when communicating to the wider public their monetary policy stance, suddenly saw their policies contested by the public when they had to rescue banks during the Great Financial Crisis. Obviously, if you’ve been telling people for decades that you control the money supply and then suddenly find yourself pouring eye-watering sums of money into financial markets to avoid a complete meltdown, people might start asking questions (if not right away jumping to making up their own answers about central banks printing money and stoking Weimar-like inflation). You might think that such an episode would lead to monetary reforms. Indeed, since the Great Financial Crisis we aren’t short on reform proposals for our current monetary system, either from civil society organization or academics. But rather than reform, we are stuck with a system that muddles through with small micro-level technocratic fixes. Meanwhile, the wider public debate seems increasingly relegated to libertarian internet memes a la “money printer goes brrrrr”.

To reform a system that is essentially based on people’s beliefs, trust and expectations, one would actually first need to understand how that system works. This is particularly relevant for a complex system like our monetary system. Perry Mehrling summarizes this succinctly:

It is hard to build a better society if you don’t know how the system you are trying to reform works. Indeed, I would submit, ignorance of how the system works allows those few who do know, i.e. the bankers, to build more or less as they like, for their own convenience and profit […] If we want change, we need to anchor our ideas in reality, which is to say in the logic that is expressed, in practice, in the system as it operates today. (2017, 3)

So, no, practical knowledge and ignorance are not enough. But in the name of academic diversity: let’s keep reading the chapters on the money multiplier in our textbooks, but let’s also put this theory into its historical context, let’s explain why the theory does not have much purchase anymore and, most importantly, let’s also teach how the system actually works today. This way an educational institution would teach actual financial literacy, and not the financial industry, whose educational focus “consists essentially of giving people quizzes about compound interest as a substitute for a decent social safety net”, and the effect of which is at best dubious. I think that would form a good basis for societal impact universities crave so much.