The Magic of Money Multiplication (and Its Risks) - 2021-03-23

Ever wonder how banks seem to create money out of thin air? It's not magic, but it's pretty close. It's called the money multiplier effect, and it's a fundamental part of how our financial system works.

Let's say you deposit $100 in your bank. That money doesn't just sit in a vault. The bank is allowed to lend out a portion of it, keeping a small percentage in reserve (let's say 10%). So, they lend out $90 to someone who wants to buy a car. The car dealer then deposits that $90 in their bank. That bank, in turn, lends out 90% of that amount ($81), and the cycle continues.

This process repeats itself, with each loan creating a new deposit. Theoretically, that initial $100 can multiply into $900! It's like a chain reaction of lending and depositing. The catch? There's only $100 of actual physical cash. The rest is essentially electronic entries in bank accounts. If reduce reserve percentage from 10% to 5%, the loan amount will increase to $1900!

This is why banks often ask for an appointment if you want to withdraw a large sum of cash. They don't actually have all that money readily available. They're relying on the multiplier effect and the flow of deposits and loans.

So, what's the benefit of this money multiplication? It fuels economic activity. Businesses borrow money to expand, people take out loans to buy homes or start businesses, and the economy grows. As Charlie Munger pointed out, this is one reason why places like Singapore attract foreign companies – the deposited money can then be used to stimulate the local economy.

The money multiplier effect can be significantly weakened by economic downturns. While a $100 deposit can theoretically support $900 in loans, this relies on consistent repayment. During a downturn, increased defaults disrupt this process. For example, if a shop tenant fails to pay rent, the property owner may be unable to repay their own loan to the bank, and may also be unable to pay their suppliers. This, in turn, can prevent the supplier from repaying their loans, especially if they have limited cash flow. These cascading defaults diminish the multiplier effect, potentially leading to a broader economic slowdown.

The money created through loans is often referred to as M2 (a broader measure of money supply than just physical cash, which is called M0). Understanding how the money multiplier works and the risks associated with excessive borrowing is crucial. It explains why economies go through cycles, and why we need to be prepared for the inevitable downturns. It's not magic, but it's definitely a powerful force.

I once heard a fascinating story from a banker about a tense moment in Hong Kong. Their branch suddenly faced a severe cash shortage, and interbank lending rates shot through the roof. Faced with this liquidity crunch, the banker made a crucial, and seemingly expensive decision. Instead of borrowing cheaper US dollars and converting them to Hong Kong dollars, he chose to borrow directly from the interbank market, even though it cost an extra one to two million Hong Kong dollars. He later received a congratulatory call from US headquarters, praising his foresight. Their conversation centered on the critical issue of currency risk. Borrowing US dollars would have created a dangerous exposure. This decision echoes the Asian Financial Crisis of 1997, where many banks took on massive amounts of cheap US dollar debt. This influx of US dollars increased the money supply within the banking system, which, thanks to loan multiply effect, multiplied tenfold through loans, fueling rapid economic growth. However, when the downturn arrived, the sharp drop in local currency value against the US dollar made it incredibly difficult for these banks to repay their US dollar loans. This mismatch between currency liabilities and assets can cripple a bank and, when widespread, trigger a systemic financial crisis.

The boom-and-bust cycle, seemingly an inevitable part of market dynamics, likely explains Warren Buffett's famously cautious approach to liquidity. While he rarely elaborates on this specific move, his substantial holdings of highly liquid assets like bonds position him to act as a lender of last resort during a financial crisis. By keeping significant capital in bond, Buffett maintains a strategic reserve. This reserve can be deployed to stabilize the system when a sudden shortage of funds arises, providing crucial support when conventional lending channels freeze up. Importantly, this strategy isn't purely altruistic; it also allows Buffett to capitalize on distressed situations, earning substantial profits by invest during times of crisis. In essence, Buffett's liquidity acts as a private sector backstop, mitigating systemic risk during times of extreme stress, while simultaneously presenting lucrative investment opportunities.