We all know that deflation — understood as declining consumer prices — is enemy number one of ECB-chairman Mario Draghi. As long as inflation stays near zero, or at least below the official inflation target of 2%, Draghi can do what he loves doing most: turn the ECB into the biggest (publicly managed) hedge fund in the world.

Draghi is like a teenager at a high school prom, who longs for an impossible love. As long as the night does not end, he can at least have the illusion that he might succeed in doing the impossible. But that he will never reach his goal, is also now at the ECB clear. Draghi may think that he can stimulate credit growth, but as readers will know by the end of this article, he aims for the impossible. Draghi will fail again.

But as long as the music keeps playing, and inflation does not exceed 2%, Draghi will think he will reach the unreachable.

To understand why Draghi wants something impossible, we first have to understand what limits bank credit expansion in normal circumstances, and what limits such credit growth in today's, extraordinary (and artificial) circumstances. Draghi ignores the "new" circumstances. He might lower interest rates a thousand times more, without having any effect whatsoever on bank credit growth.

What we will also do, although it is not our goal in this analysis, is to show why the "money multiplier" is a myth. This theory says that (commercial) banks can exponentially expand bank credit on top of each other's bank deposits.

You can guess by now: banking is surrounded by misconceptions.

A bank does not "create" money, a bank creates credit.  That we call this credit "deposit money", makes no difference.

And because a bank creates credit, and not money, it is limited in the amount of credit it can create, without losing its money reserves to other banks. That we — ordinary citizens — use that bank credit in turn as a medium of exchange is irrelevant for our analysis.

Let's assume a banking system with two banks, and without any central bank. What happens when Bank A — all other things equal — extends credit?

Because Bank A is not the only bank, at a certain point of time account holders of Bank A will exchange payments with account holders of Bank B. Since Bank A now has more deposits outstanding (bank credit), Bank A experiences an “adverse clearing.” Ergo, Bank A now owes money to Bank B: Bank B has a claim on (a part of) the bank reserves of Bank A.

Those bank reserves historically consisted of gold, the ultimate money. Nowadays they consist of central bank liabilities (deposits at the central bank).

On a competitive market, Bank B will choose not to hold a mere claim on Bank A’s reserves, but will request payment from Bank A (do you now see the difference between money and credit?). Bank A will lose reserves and is forced to reduce its balance sheet.

Bank A has two options:

• sell loans and/or stop re-lending maturing loans;
• go to the interbank market to borrow reserves.

In our example, Bank B holds excess reserves and can choose to lend them out. In our simplification, Bank B is thus the supply side of the (interbank) market for bank reserves, and Bank A the demand side.

Whatever Bank A decides to do, the sum of outstanding credit will once again conform to the sum of total bank reserves. The system is in balance.

The bank reserves of both banks are thus of great importance, especially due to the consequences of bank lending for reserve balances.

What If Banks Expand Credit Simultaneously?

A smart reader will by now think: but what if our assumptions are incorrect and both banks expand credit at the same time? No adverse clearing would occur, and banks are now able to expand credit without a similar increase in savings elsewhere in the economy.

When both Bank A and Bank B begin lending, on top of all the already outstanding credit, then the volatility of those “clearings” (net claims between banks) increases. This was the brilliant insight of economist George Selgin.

Because more bank deposits (commercial bank liabilities) are exchanged, the size of the adverse clearings increase. While Bank A and B would owe millions a day before, they now (figuratively) owe billions.

This volatility forces banks to limit its operations and its lending because of the increased risks that this volatility entails.

We know that historically this volatility is reflected in increasing (short term) interest rate volatility on the interbank market.

One problem: The Federal Reserve, and the ECB, and in fact every other central bank, view volatility as something inherently evil. Volatility is bad, period.

Why volatility would be always bad, has never been explained. More importantly, that this volatility limits bank’s ability to expand credit, has never been understood. Volatility must die, according to modern central banks. And that is why central banks “stabilize” these short-term interest rates on bank reserves (the rate that banks charge each other) by intervening and enforcing their “target rate” at all times.

How do they stabilize this interbank rate?

By creating bank reserves out of thin air, and lending them to banks that experience adverse clearings, against a non-market interest rate (better yet, an almost always too low interest rate!).

Under normal circumstances a commercial bank is limited in expanding its balance sheet by the sum of reserves it holds. But when the Bank of England, the Federal Reserve, or the European Central Bank create all the reserves they want in a blink of an eye, the expansion of bank credit is no longer restrained.

In reaction to a citizens’ initiative on 100% reserve banking, Dutch minister of Finance Dijsselbloem explained in a letter to parliament the above as follows:

“An individual bank must attract financing when it lends to balance its books when deposits flow to other banks”

This is correct, although the problem is that a central bank can disrupt this process, because it can create reserves out of nothing to help banks with the above mentioned “adverse clearings!”

In addition, Dijsselbloem confuses bank reserves with bank equity. On the one hand he mentions “balancing books,” which, I assert, refers to the equity or capital of a bank (wrong!), while on the other hand he talks about bank deposits flowing to rival banks, which would bring a bank into trouble, because it now has too few reserves to settle with other banks (in case bank deposits are transferred to other banks) or with its own clients (in case of cash withdrawals).

I previously mentioned “new” circumstances. What do I mean?

The fact that bank credit barely grows, is not because of a lack of reserves, but because of something else. Better said: excess reserves have never been so high as right now. The one thing that normally restrains banks in expanding credit, is now completely irrelevant.

Then what is the real reason credit growth does not pick up? Why are banks not lending, despite their excess reserves?

Today, a bank faces the following situation:

• Under Basel III, banks must hold a certain percentage of capital (equity) against its “risk weighted” assets

As such, banks have various options:

• A government bond is seen as “risk free” and therefore do not form part of a bank’s “risk weighted” assets
• Deposits at the central bank (excess reserves!) are seen as “risk free” and therefore do not form part of a bank’s “risk weighted” assets
• Any other loan forms partially or entirely part of a bank’s “risk weighted” assets

The problem?

As soon as interest rate of all (European) government bonds are arbitraged to the ECB rate, a bank runs out of options.

Banks do not have any choice: they can extend credit as for instance home mortgages, but then their “risk weighted” assets increase! And when the sum of “risk weighted” assets increase, a bank’s equity no longer complies with Basel III’s capital requirements. Bank equity is, after all, calculated as a percentage of the bank’s “risk weighted” assets. When the sum of “risk weighted” assets increases, all other things equal, bank equity declines.

In sum, banks are not limited by reserves, but by their “risk weighted” capital and Basel III’s capital requirements. Banks are not constrained by reserves, but by capital.

If Draghi wants to succeed in his attempt to increase bank lending by lowering the interest rates on excess reserves, then Basel III must be revised and the idea of “risk weighted” assets must be thrown out of the window!

In other words, Draghi is trying to accomplish something that is completely outside of his sphere of influence.

As long as Basel III is not revised, Draghi is pulling a dead horse. The only thing that he achieves by lowering interest rates, is to lower yields on government bonds to the same extent. But no bank will even slightly consider lending money out to anyone else than governments or the ECB, because it otherwise would fail to comply with Basel III.

They do not have any other option.

Draghi can lower interest rates further, but banks will simply not extend credit to anyone else than the central bank or governments, because of the nature of Basel III’s capital requirements.

At the same time, the reckless monetary policy of Draghi leads to a whole set of new problems. Not only do low (negative!) interest rates have negative consequences for pensions and savers. No, Mario Draghi also unleashed an immense credit cycle, which will inevitably turn into a recession and crisis, even bigger than the one we had in 2008.

And that is all because Mario Draghi has the illusion he can conquer that impossible love at his high school prom.