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Krugman versus Keen

from Edward Fullbrook

A few days ago Steve Keen’s paper “Instability in Financial Markets: Sources and Remedies” was posted on the Web, and, deservedly, it is attracting a great deal of attention.  Yesterday Paul Krugman entered the fray, with his New York Times column devoted to Keen’s latest. Followers of this blog are encouraged to enter the debate here.  Does the role of banks need to be included in the basic story that economists tell about how modern economies work?  Krugman says no.  Keen says yes.

Below is Keen’s long synopsis of his paper.

A Primer on Minsky

The paper starts with a synopsis on Minsky, since his “Financial Instability Hypothesis” is one of the key foundations of my approach to economics. He has come into vogue these days of course, but to people who’ve known his work for several decades rather than ever since the “Minsky Moment” of late 2007, a better expression would be that he’s “come into vague”. I read papers like Krugman’s “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach”, and for the life of me, I can’t see Minsky there. As I note in my paper:

Now, after the crisis that his theory anticipated, neoclassical economists are paying some attention to his hypothesis, and there has been at least one attempt to build a New Keynesian model of a key phenomenon in Minsky’s hypothesis, a debt-deflation (Krugman and Eggertsson 2010). However, to those of us who are not new to Minsky, it is hard to recognise any vestige of the Financial Instability Hypothesis in Krugman’s work.

My good friend and long term fellow rebel in economics Professor Rod O’Donnell once remarked that neoclassical economists are incapable of reading Keynes: they look at his words and then spout Walras instead. A similar phenomenon applies here: neoclassicals like Krugman read Minsky, and then proceed to build equilibrium models without banks, and think they’re modelling Minsky.

No they’re not: they’re creating an equilibrium-obsessed Walrasian hand puppet and calling it Minsky—just as they did to Keynes with DSGE modelling.


I used the word “equilibrium” twice above, because one clear methodological aspect of Minsky’s thinking is that macroeconomics is about disequilibrium. Neoclassical economists have the world precisely (to use an evocative piece of Australian slang) arse about tit. They believe that if it’s not an equilibrium model it’s not economics.

Nonsense! The precise opposite is the case: if it isn’t disequilbrium, then it isn’t economics.

There’s nothing “radical” about this, which is often the way that neoclassical economists react when I press this point: “assume disequilibrium? How dare you!?”. I dare because “disequilibrium” is so common in real sciences that they don’t even call it that: they call it dynamics. Any dynamic model of a process must start away from its equilibrium, because if you start it in its equilibrium, nothing happens. It’s about time that economists woke up to the need to model the economy dynamically—and to give Krugman his due here, he does admit at the end of his paper that his dynamics are dreadful, and need to be improved:

The major limitation of this analysis, as we see it, is its reliance on strategically crude dynamics. To simplify the analysis, we think of all the action as taking place within a single, aggregated short run, with debt paid down to sustainable levels and prices returned to full ex ante flexibility by the time the next period begins. This sidesteps the important question of just how fast debtors are required to deleverage; it also rules out any consideration of the effects of changes in inflation expectations during the period when the zero lower bound remains binding, a major theme of recent work by Eggertsson (2010a), Christiano et. al. (2009), and others. In future work we hope to get more realistic about the dynamics.

Hurry up Paul: you’re already eight decades behind Irving Fisher, who put the case for dynamics even for those who assume that equilibrium is stable:

‘We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium… But … New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium…

Theoretically there may be—in fact, at most times there must be—over-or under-production, over- or under-consumption, over- or under-spending, over- or under-saving, over- or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.’ (Fisher 1933, p. 339)

Endogenous Money

One key component of Minsky’s thought is the capacity for the banking sector to create spending power “out of nothing”—to quote Schumpeter. As well as explaining endogenous money, I show that Minsky’s analysis leads to the conclusion that aggregate demand is greater than aggregate supply arising from the sale of goods and services alone—and therefore that rising debt plays a crucial role in a capitalist economy:

If income is to grow, the financial markets, where the various plans to save and invest are reconciled, must generate an aggregate demand that, aside from brief intervals, is ever rising. For real aggregate demand to be increasing, . . . it is necessary that current spending plans, summed over all sectors, be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed. It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets. (Minsky 1963; Minsky 1982) (Minsky 1982, p. 6)

This aggregate demand is spent not just on goods and services, but also on buying financial assets—hence economics and finance are inextricably linked, in opposition to the failed neoclassical attempt to keep them separate in two hermetically sealed jars. This in turn transcends Walras’ Law to give us what I call the Walras-Schumpeter-Minsky Law:

Aggregate demand is income plus the change in debt, and this is expended on both goods and services and financial assets. Therefore in a credit-based economy, there are three sources of aggregate demand, and three ways in which this demand is expended:

1. Demand from income earned by selling goods and services, which primarily finances consumption of goods and services;

2. Demand from rising entrepreneurial debt, which primarily finances investment; and

3. Demand from rising Ponzi debt, which primarily finances the purchase of existing assets.

Neoclassical Misinterpretations of Fisher, Minsky & Banking

“How do you misinterpret me? Let me count the ways…”

There are so many ways in which neoclassical economists misinterpret non-neoclassical thinkers like Fisher and Minsky that I could write a book on the topic. This section focuses on just one facet of how they get it wrong: by ignoring banks, and treating loans as transfers from “savers” to “spenders” with no bank in between.

This is precisely how Krugman models debt in his recent paper:

In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents, but are subject to a debt limit. If this debt limit is, for some reason, suddenly reduced, the impatient agents are forced to cut spending… (Krugman and Eggertsson 2010, p. 3)

This is debt without banks—and without the endogenous creation of money—and it explains why neoclassical economists don’t think that the level of private debt matters.

With that vision of debt, a change in the level of debt isn’t important, because the borrower’s increase in spending power is counteracted by the lender’s fall in spending power. Here’s the lending process as neoclassicals like Krugman see it:

  Assets Deposits (Liabilities)  
Action/Actor   Patient Impatient
Make Loan   +Lend -Lend

Krugman therefore reassures his blog readers that there’s nothing to worry about when private debt levels rise or fall:

People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.

That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. (Krugman 2011)

That would be reassuring if true, since we could then ignore data like this:

Unfortunately, real lending is better described by the next table:

  Bank Assets Bank Deposits (Liabilities)  
Action/Actor   Patient Impatient
Make Loan +Lend   -Lend

In the real world, a bank loan increases “Impatient”‘s spending power without reducing “Patient”‘s, so that the level of private debt does matter.

Applying Minsky to Macroeconomic Data

In particular, the rate of change of debt matters because that tells us how much of demand is debt financed. When you add the change in debt to GDP, you get total aggregate demand, and that makes it exceedingly clear why the economic crisis occurred: the growth of debt collapsed, and took the economy with it:

Since change in debt is part of aggregate demand, the acceleration of debt—the rate of change of its rate of change—affects change in aggregate demand. This in turn has impacts on the change in employment.

It also impacts on change in asset prices. The relationship between accelerating debt and rising asset prices is clear even in the very volatile world of the stock market:

It is undeniable in the property market:


Since asset market volatility is driven by the acceleration of private debt, the Minskian solution to instability in finance markets is to somehow sever the link between debt and asset prices. I put forward two ideas.

Jubilee Shares

Currently, shares last for the life of the issuing company, and 99% of the trade on the stock market is in the secondary market. The Jubilee Shares proposal would allow shares to last forever as now when purchased on the primary issue market, but would have them switch to a defined life of (say) 50 years after a limited number of sales on the secondary market (say 7 sales). This would encourage primary share purchases, and also make it highly unlikely that anyone would use borrow money to buy Jubilee shares on the secondary market.

Property Income Limited Leverage

Currently lending to buy property is allegedly based on the income of the borrower—which gives borrowers an incentive to actually want higher leverage over time. “The PILL” would limit the amount that can be lent to some multiple (say 10 times) of the income generating capacity of the property itself.

  1. March 28, 2012 at 1:10 pm

    Krugman says that his basic reaction to discussions about “What Minsky Really Meant” or “What Keynes Really Meant” is that “Krugman Doesn’t Care.” The reason given for this rather debonair attitude is allegedly that history of economic thought may be OK, but what really counts is if reading Minsky or Keynes give birth to new and interesting insights and ideas. Economics is not religion, and to simply refer to authority is not an accepted way of arguing in science.

    Although I have a lot of sympathy for Krugman’s view on authority, there is a somewhat disturbing and unbecoming coquetting – and certainly not for the first time, as his rather controversial speech at Cambridge last year, commemorating the 75th anniversary of Keynes’ General Theory, bear evidence of – in his attitude towards the great forerunners he is discussing.

    Sometimes – and this goes not only for children – it is easier to see things if you can stand on the shoulders of elders and giants. If Krugman took his time and really studied Keynes and Minsky, I’m sure even he would learn a lot.

    Krugman is a great economist, but it smacks not so little of hubris to simply say “if where you take the idea is very different from what the great man said somewhere else in his book, so what?” Physicists arguing like that when discussing Newton, Einstein, Bohr or Feynman would not be taken seriously.

    Krugman’s comments on this issue is really interesting also because they shed light on a kind of inconsistency in his own art of argumentation. During a couple of years Krugman has in more than one article criticized mainstream economics for using to much (bad) mathematics and axiomatics in their model-building endeavours. But when it comes to defending his own position on various issues he usually himself ultimately falls back on the same kind of models. Models that actually, when it comes to methodology and assumptions, has a lot in common with the kind of model-building he otherwise criticizes.

    On most macroeconomic policy discussions I find myself in agreement with Krugman. To me that just shows that Krugman is right in spite of and not thanks to those models he ultimately refers to. And although Krugman repeatedly says that he is a strong believer in “simple models,” these models are far from simple (at least not in any interseting meaning).

    As all students of economics know, time is limited. Given that, there has to be better ways to optimize its utilization than spending hours and hours working through or constructing irrelevant economic models. And whether they are simple – something Krugman likes – or not, is not the nodal point.

    Instead of risking to just reinvent the wheel, I would rather recommend my students allocating their time also studying great forerunners like Keynes and Minsky, to help them constructing better, real and relevant economic models – models that really help us to explain and understand reality.


  2. March 28, 2012 at 1:12 pm

    Krugman’s “Banking Mysticism” post is scary; he does not know or understand endogenous money creation at all, something that even central bankers are realising is true (see the “We are all post Keynesians now” post here on RWER blog). The number of wrong assertions in Krugman’s short post is quite frankly staggering.

    Let’s take examples (the post is here: http://krugman.blogs.nytimes.com/2012/03/27/banking-mysticism/ )

    Krugman: “As I (and I think many other economists) see it, banks are a clever but somewhat dangerous form of financial intermediary…” No, Krugman; banks are not financial intermediaries! Banks create money every time they accept the debt of their borrowers. There is always going to be endogenous money creation in the banking system, that is simply how it works since bank-debt (deposits) are considered and accepted as money in the modern economy. Through double entry accounting, they create money whenever the bank-borrowers sign the dotted line on the mortgage/bank-loan.

    Krugman: “For in the end, banks don’t change the basic notion of interest rates as determined by liquidity preference and loanable funds — yes, both, because the message of IS-LM is that both views, properly understood, are correct. ” Seriously??!! First of all, the banks are not lending out loanable funds, they are creating money out of thin air. Second, the IS-LM has nothing to do with Keynes’s LP theory for the simple fact that there is not a shred of uncertainty in the IS-LM and Hicks himself admitted that after Davidson, repeatedly, pointed it out to him. Chick, Minsky and Kahn realised this as well to name just a few. Third, Keynes himself explicitly denied that his LP theory was the same thing as loanable funds, as Krugman is saying that “properly understood” is the case. And it’s not the same exactly because of endogenous money creation by the banking system.

    Krugman: “Banks don’t create demand out of thin air any more than anyone does by choosing to spend more; and banks are just one channel linking lenders to borrowers.” This is the part that shows best that Krugman does not understand Keen’s “Walras-Schumpeter-Minsky” law. The creation of bank-debt through endogenous money creation, no matter what kind of borrowing (Minskyian speculation/Ponzi borrowing), will always create spending power and demand in the economy. The sentence “banks are just one channel linking lenders to borrowers” is a sign of total ignorance of how the financial system works. If he would have written “pension funds” instead of “banks” the statement would be true. But it is painfully wrong as it stands.

    It is quite frankly painful to see Krugman being twisted between trying to understand endogenous money creation and at the same time trying to stick to his neoclassical guns. To me, he lost a lot of respect as a sensible economist with this post.

    • March 28, 2012 at 1:51 pm

      I totally agree with you, Olafur.
      It’s certainly amazing how an economist of Krugman’s stature can write such absolute nonsense on banking and money as “banks are a clever but somewhat dangerous form of financial intermediary” and “[f]or in the end, banks don’t change the basic notion of interest rates as determined by liquidity preference and loanable funds — yes, both, because the message of IS-LM is that both views, properly understood, are correct. ”
      And that is something you should have to read in the year 2012! Krugman obviously has learned nothing from Gesell, Fisher, Keynes and Minsky on these issues.

  3. peterradford
    March 28, 2012 at 4:54 pm

    I have just returned from depositing some cash in my local bank. An insignificant amount to be sure, but not the result of my being loaned to by that bank.


    Was that deposit a loanable funds sum? Is my bank an intermediary? Or is my deposit simply a recycled amount originating, way back, from a loan? If so, are the decisions of depositors like me completely irrelevant to an understanding of banking? Is that cash not really mine after all, and merely part of a giant flow from one bank to another? Did my decision have no macroeconomic effect?

    I agree Krugman ignores – apparently – endogenous money creation. But banks gather deposits as fast as they can? Why? If they can simply create money why would I, as a banker, ever waste my time building branches to attract deposits? Why would I raise or lower interest rates to “attract deposits” if I never needed to?

    Chick, in her book “Macroeconomics After Keynes”, pages 236-240, describes a difference between a “banking system” and an older, less sophisticated “bank”. She argues that the notion of being a ‘savings conduit’ (i.e. an intermediary) is outmoded once banking becomes so intertwined it can be called a system. She tries to make a great deal of this.

    The issue, it appears is causation: does savings drive investment; or does investment drive savings? Chick sits squarely in the latter camp because of her Keynesian view, while Krugman seems muddled and appears to tend towards the former.

    My life as a banker for 20 years would have been a whole lot more simple had I known that I was not running an intermediary. At least in part.

    It appears to me – naively obviously – that banking is more complicated than either side in the Keen – Krugman discussion implies. Banks clearly create money. They recycle it too. And that recycling is called intermediation. Which, in turn, can be called being a conduit for savings.

    Is this another case of two tribes not wanting to concede that there may be a middle ground?

    • davetaylor1
      June 28, 2012 at 2:35 pm

      So you were a banker and you don’t understand either the goldsmith’s fraud or reserve banking?

      “Why would I raise or lower interest rates to “attract deposits” if I never needed to?”

      The reserve banking system allows banks to create some multiple of the deposits on hand (c.f. lending out other people’s gold or entitlement to it), so long as the working fund created by the deposits is big enough to meet the likely peak demand for withdrawals as against loans. In the event it isn’t, the combination of reserve and commercial banks allows a defaulting bank to borrow liquid reserves (backed by assets like the market price of mortgaged property,stocks and shares and financial instruments) from other commercial banks, and in the event these are bankrupt too, from the reserve banks’ government bonded assets. Hence governments hurriedly issuing more bonds (at low yields) to stave off the recent risk of total system melt-down.

      So let’s suppose the reserve ratio is 10%. (It’s actually been much lower than that). Thus if someone deposits £100 the bank can not only issue further loans of £900 but get 7% interest on 9 times what you deposited while charging you for looking after your money, paying out (as of now) 3/4 % on 1 times your deposit. That looks like a pretty big incentive to me, Peter; and of course the secret of confidence trickery is to cover the truth of systemic fraud with innocent-looking appearances like intermediation. With morals like that, no wonder banks and bankers treat themselves to stately homes rather than their communities to decent schools and hospitals.

  4. rf
    March 28, 2012 at 11:14 pm

    When looking at an individual bank, it seems clear that their role is, in fact, intermediation. A bank borrows reserves (cash and settlement balances) from depositors, the repo market, issuing commercial paper, etc. and on-lends it to homebuyers, businesses, the government, and financial speculators, making profit from the spread. There may be a small amount of economic activity taking place without this kind of intermediation (intrabank transfers), but at the level of an individual bank this activity is negligible.

    However, this story doesn’t hold at the level of the entire banking system. ‘Money’ is created ex nihilo and interbank transactions are resolved essentially by transferring government bonds. There doesn’t seem to be any reason why lending would be constrained for the entire system, nor any reason why an increase in purchasing power from borrowing requires a corresponding decrease in purchasing power from saving.

    Loanable Funds starts with the first story. Investment requires saving and lending is supply constrained.

    Endogenous Money starts with the second story. Investment creates saving and lending is demand constrained.

    There certainly may be a middle ground, but it seems to me like Loanable Funds is yet another case of the fallacy of composition (which seems to grow quite happily from the well-fertilized soil of methodological individualism.)

  5. Rademaker
    March 29, 2012 at 8:52 pm

    I’m still very confused about the “loans create deposits” story and how I’m supposed to imagine this happens. Do I understand correctly that individual banks can not just create these deposits out of nothing without turning to another bank to borrow money from? Does the money creation consist in the fact that a bank borrows from another bank to create the deposit and the borrowing expands broad money while keeping base money the same? If so how does a bank profit from making the loan if the borrower could just as well go to the other bank directly?

    Any information appreciated.

    • merijnknibbe
      March 30, 2012 at 10:39 am

      Suppose you’re standing before an ATP machine. Your bank account has a zero balance, you do however the right to overdraw it to the extent of 1.000,–. You draw 100,– from the ATP machine, which means that you get a debt of 100,– while the amount of money in circulation (the money you just took from the machine) increases with 100,– (notes inside the machine are considered to be ‘base money’ and not ‘money in cirulation’ which is of course right: doubling (or quantupling) the amount of notes inside the machine does not alter spending power of people).

      In this case, a 100,– loan created a 100,– deposit (in your wallet). The point: the bank does not create the money – the bank and the lender together create the money.

      In the ATP case there still needs to be ‘base money’ in the machine. However – when you lend 10.000,– from a bank and it’s directly put on your electronic account, even that’s not necessary. The bank and you proclaim: “Let there be money”, somebody types “10.000,–” on your account – and then there is money. And debt, as the 10.000,– is also entered the “You Owe the Bank” account. And you will have to pay interest. And there is nobody who can stop the bank and you from doing this, the bank does at the moment of the transaction as a matter of fact not to have reserves to be able to do this.

      • Rademaker
        March 30, 2012 at 12:21 pm

        Thank you, that answers my question. It is mystifying to me that such a simple principle can fly under the radar of a whole establishment of economists. That’s why I’ve found it hard to swallow.

      • Rademaker
        March 31, 2012 at 12:00 am

        So you would say Krugman is plainly wrong about this: http://krugman.blogs.nytimes.com/2012/03/30/banking-mysticism-continued/

        “First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand. I hope this isn’t controversial, although given what usually happens when we discuss banks, I assume that even this proposition will spur outrage.”

        How do we break out of this your-word-against-his situation? Is it such a complicated thing to check what banks legally and pragmatically can and can not do?

      • pauljmey
        October 28, 2019 at 6:20 am

        I haven’t be in an econ class in year but, afaiu, Krugman doesn’t seem to understand fractional reserve banking. The bank makes as many loans (which is the source of their income) for as much as the banking reserve laws allow, so that the amount of cash on hand is never as much as their outstanding liabilities (and if the depositors decide to withdraw their money all of sudden, that’s a bank run and the bank fails, typically due to a “loss in confidence”). But in general, the bank creates a loan (by adding to the value of a checking account) out of thin air, and then gets paid via interest payments issued on the checking accounts of other banks as long as the loan doesn’t default. The deposits really only serve as a way to legitimate the credit worthiness of the bank, theorectically a country could simply lower the reser

      • pauljmey
        October 28, 2019 at 6:23 am

        reserve requirement and the amount of loans would instantly increase. Clearly this is a dynamic and stochastic process (where the likeliehood of default will vary with conditions), but there is nothing to suggest this involves “real” assets.
        Am I missing something and owe Krugman an apology?

      • pauljmey
        October 28, 2019 at 6:36 am

        PS To be more accurate, the bank is repaid by principal and interest payments on the loan, though the principal (minus its proportion of the reserves) is created out of thin air. Robin Hahnel (who is a very smart guy) was the prof who taught me this and would remark “banking is a very strange business” giving the impression (to me anyway) of experiencing some degree of being mystified.
        As I understand it, as long as the net outward flow of deposits remains less than the net inward flow of principal and interest the bank makes money and remains a going concern.

  6. Rademaker
    March 29, 2012 at 9:05 pm

    I get the impression that Keen’s table in the article does try to express that the bank creates the deposit out of nowhere on it’s own power without involvement of another bank. Is this consistent with rf’s views in the post above? I don’t see “intermediation” in Keen’s table. “Patient” is simply not involved in the transaction.

  7. Rademaker
    March 29, 2012 at 9:08 pm

    Here’s something that’s a mystery to me: in Keen’s model of banking as expressed by the table, why would a bank ever accept deposits? They clearly do seem to be doing this in the real world.

  8. JW Mason
    April 1, 2012 at 11:28 pm

    The thing is, it’s not just about whether we need to take into account the role of banks. It’s also whether Keen’s particular way of formalizing that role is helpful.

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