Who is right? Krugman or Keen or / and 9 Central Bank economists?
from Edward Fullbrook
The monetary theory debate starring Krugman and Keen currently raging on the Web desperately needs real-world grounding in the context of the guest post by Jesse Frederik that appeared on this blog on 26 January. The debate is centered on how banks work.
Keen holds that:
neoclassical economists . . . 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.
Instead Keen holds to the hypothesis that in the real world banks today can create money at will, even without the required reserves at the time they make a loan, and that by so doing they may create demand for goods, services and existing assets.
Krugman labels people who favor this hypothesis as “mystics”. His hypothesis is:
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. 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. (emphasis added) (“Banking Mysticism“)
But on this question, where do economists with direct experience in central banking stand? Is their message the same as “the message of IS-LM”? Frederik’s post offers the views of nine such economists. Debate followers with real-world inclinations will find them interesting. Here is most of Frederik’s post.
Does the ‘money multiplier’, this core concept of monetary theory, exist? Do banks need reserves before they create money? Not according to central bankers. Banks can create money at will, even without reserves, though they will have to find or borrow these reserves afterwards. But as the central bank has to provide these, this is not any kind of constraint, even when the central bank increases the rate of interest. Some quotes which imply that central banks can not control the amount of money by influencing reserves:
Alan R. Holmes, Federal Reserve Bank of New York (1969):
‘In the real world, banks extend credit, creating deposits in the process , and look for the reserves later.’
Nobel prize winners Finn Kydland en Ed Prescott , Federal Reserve bank of Minneapolis (1990):
‘There is no evidence that either the monetary base or M1 leads the [credit cycle], although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit cycle] slightly.’
Charles Goodhart, member of the Monetary Policy Committee of the Bank of England (2007):
‘The money stock is a dependent, endogenous variable. This is exactly what the heterodox, Post-Keynesians, from Kaldor, through Vicky Chick, and on through Basil Moore and Randy Wray, have been correctly claiming for decades, and I have been in their party on this.’
Piti Distayat en Claudio Bori, Bank for International Settlements (2009):
‘This paper contends that the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is ﬂawed and uninformative in terms of analyzing the dynamics of bank lending. Under a ﬁat money standard and liberalized ﬁnancial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulﬁll the demand for loans if it wishes to.’
Seth B. Carpenter, Federal Reserve (2010):
‘Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. Specifically, our results indicate that bank loan supply does not respond to changes in monetary policy through a bank lending channel.’
Vitor Constancio, vice president of the ECB (2011):
‘It is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.’
Update (31-3-2012): see also THE OPERATIONAL TARGET OF MONETARY POLICY AND THE RISE AND FALL OF RESERVE POSITION DOCTRINE by Ulrich Bindseil (2004), at the time head of liquidity management of the ECB:
“From today’s perspective, one could feel that academic economists unconsciously colluded in their distaste for re-questioning the applicability of macro-economic models on day-to-day implementation of monetary policy, and their lack of willingness to study the actual features of money markets and monetary policy operations. As Goodhart (2001) puts it: “large parts of macro-economics are insufficiently empirical; assumptions are not tested against facts. Otherwise, how could economists have gone on believing that central banks set H [the monetary base] and not i? In so far as the relevant empirical underpinnings of macro-economics are ignored, undervalued or relatively costly to study, it leaves theory too much at the grasp of fashion, with mathematical elegance and intellectual cleverness being prized above practical relevance.” Unfortunately, it needs to be admitted that the list of RPD (Reserve Position Doctrine, MK) inspired papers that contain empirical (econometric) analysis is long.”
It seems also noteworthy that both groups, academic economists and central bankers, showed little interest in studying well-documented historical experience (e.g. Bagehot, 1873, King, 1936, Sayers, 1976). Overall, the 20th century thus seemed to have witnessed in the domain of monetary policy implementation a strange symbiosis between academic economists stuck in
reality-detached concepts, and central bankers who were open to such concepts, partially since they allowed to avoid explicit responsibility. Masking responsibility seemed to be of particular interest whenever the central bank’s policies were strongly dis-inflationary and thus causing recession and unemployment (in the US in 1919-21 and in 1979-82).