Home > Minsky, neoclassical economics, Real World Economics Movement > Who is right? Krugman or Keen or / and 9 Central Bank economists?

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).

  1. Claude Hillinger
    April 3, 2012 at 3:30 pm

    Please explain why central banks “have” to supply reserves to any bank that creates the need for them through its lending activities.

    “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.”

    • April 3, 2012 at 5:05 pm

      If they don’t then the system is short of reserves and very quickly the payment system collapses. The indicator of this is that the overnight Libor rate diverges quickly from the policy rate – banks are bidding up trying to clear their accounts – and the normal interbank lending system quickly dries up.

      To keep control of the policy rate and prevent mass panic the central bank has to accommodate the private banks desire the clear the payment system.

      • John
        April 4, 2012 at 10:58 am

        Hi Neil,

        My understanding of banking and finance is rudimentary. Would be great if you could help clarify a few things.

        1. As the Libor rate diverges from the policy rate… is the implication that there is pressure for the policy rate to be adjusted upwards?

        In which case, why not adjust the policy rate so that it traces the Libor rate?

        2. Is such bank behaviour fostered by the implicit guarantee that the central bank will supply reserves to any bank? And without this implicit guarantee, banks will not “create money at will, even without reserves, though they will have to find or borrow these reserves afterwards”?

      • March 26, 2013 at 8:27 am

        Why would the payment system collapse?
        Wouldn’t a bank short of reserves simply be in violation of reserve requirements?
        If the RR was 10% and a bank had only 5% reserves, ignoring any penalties imposed, wouldn’t the bank be operating as if the RR was 5%?
        Banks operating in nations with 0% RR are able to calculate their own RR based on their need to make settlement, etc..
        Couldn’t a bank operating under a 10% RR, do the same and calculate the % of reserves based on its needs. Say it calculates that it only actually requires 1% RR to operate could it then not continue to function normally if RR are 10% but it only has 1% (ignoring any penalties incurred)?

        The only problem I can see is if the level of reserves was so low that they were unable to make the demand for cash.

    • Nixda
      April 4, 2012 at 7:54 am

      @Claude: As far as the ECB is concerned, it is in their legal responibilities to provide the necessary liquidity to the banking system. I guess the Fed has similiar responsibilities.

      • Nathanael
        April 8, 2012 at 12:51 am

        The Fed was specificially ESTABLISHED to prevent liquidity crises (i.e. banks running out of money — bank runs — which break banks which are solvent.)

        It is its primary purpose.

        Look at what happened before the Fed, or to institutions without Fed banking. There are bank runs, the payment system collapses, people’s checks written on bust banks don’t clear,… after a while most people start keeping their money under their mattress.

  2. April 3, 2012 at 3:40 pm

    Why is our money system unstable?


    In this article, I set out in words the argument that I present in Money as Debt II – Promises Unleashed.



    I claim that the design of the banking system itself necessarily creates an ongoing shortage of Principal that results in INSTABILITY and potential COLLAPSE of the system in the absence of PERPETUAL DEBT GROWTH. I claim that this occurs, even in the theoretical case of a COMPLETE ABSENCE of INTEREST and with ALL PAYMENTS BEING MADE in full and on time.

  3. Marko
    April 3, 2012 at 5:57 pm

    Keen’s analysis would be relevant even in the absence of banking intermediaries. Imagine the following hypothetical scenario : A small fraction of the population owns nearly all the wealth , and receives a large share of the income. The rest of the population work at low-wage jobs , consuming nearly all of their incomes , and accumulating few assets. There is a large group of chronically unemployed or underemployed – a reserve army of labor – who consume on a subsistence basis , with or without gov’t support.

    The wealthy see that they can boost the demand for the goods and services produced by the companies they own if they lend money to the masses. It’s a win-win for the wealthy. They sell more product , and even if it means hiring more workers , there will be increased profits , given the low wages guaranteed by the reserve army. They make money on the interest on the loan. And there is no crimp on their lifestyle , since they consume only a tiny fraction of what they earn or own.

    This works , raising demand and thus profits , and continues to work as long as they keep lending to the workers. The workers , sensing the willingness of the lenders to keep lending , realize that they can borrow enough to not only consume more , or acquire some assets , but also to make their loan payments. What a great country !

    Oops , wait a sec. One of the wealthy lenders sees that he’s lending at such a high rate that he’s depleting his stash , which makes him nervous. He raises his interest rates and restricts his lending. Soon , others follow suit. The workers , who’ve been making their payments using newly-borrowed money., now have to cut consumption drastically. Output falls , layoffs ensue , assets lose value , and the workers are bankrupted. The economy is toast.

    This requires no banking , and no creation of money out of thin air. Savings , which the wealthy had in abundance , is simply consumption deferred. Borrowing of those savings , by the workers , simply advanced that consumption into the present. On paper , it all balances out. In practice , it wrecks lives and the economy.

    ( BTW , any resemblance of the above hypothetical scenario to current reality is purely coincidental. )

    • merijnknibbe
      April 4, 2012 at 8:09 am

      This is not too different from the Krugman/Eggertson scenario – which shows that even in a New Keynesian world private debts can become toxic! What’s not in this model as I recall (but I read it some time ago) is that debts can even increase when people do not borrow to consume in the sense of ‘final demand consumption’ (total final demand being the old school but better phrase for ‘aggregate demand’) but to finance/fuel increases in, for instance, house prices or ovepriced other assets or overpriced life insurances. There has to be no ‘monetary saving’ from the part of the ‘patient’ consumers to finance this kind of borrowing. Banks will finance this with ‘money created out of thin air’. This money does not directly create ‘final demand’. But it does create ‘debt’.

      • D R
        April 4, 2012 at 6:21 pm

        Whether or not you agree with his philosophy about model-building, Krugman believes in keeping his models as simple as possible while still demonstrating his point. So it’s not that Krugman doesn’t understand certain things– it’s that he considers them unnecessary for the purposes of demonstration.

    • March 26, 2013 at 8:48 am

      Where does money come from in your example?

      You just seem to assume the previous existance of money both as a unit of account and as a debt, but where did it come from?

      What is the unit of account? Who sets it?

      Money is the non-interest bearing debt of a sovereign issuer who possesses the power of taxation.
      It is the debt in which all other debts (& accounts) are denominated.

      For money to exists it must first be spent into the economy.

  4. Claude Hillinger
    April 3, 2012 at 9:15 pm

    Reply to Neil Wilson

    In your view the central bank is hostage to the financial sector and must supply banks with any amount of reserves that they may need, regardless of how reckless their behavior may have been. The reality is that a bank that is unable to honor withdrawals from demand deposits could and should be taken over by the state. That’s what the Swedes did in the 1990s and Iceland more recently. That this was not done during the recent and current financial crisis has a simple reason: The banks finance the politicians and the politicians bail them out in return, with our money of course!

    The above applies to banks considered to be too big to fail, a category that in my view was invented in order to justify the bailouts. In the US more than 300 banks collapsed in the period 2007-2011 (http://www.davemanuel.com/history-of-bank-failures-in-the-united-states.php). Depositors were paid out by the FDIC to the extent that they were insured. There was no panic as far as the general payments system was concerned.

    • Nathanael
      April 8, 2012 at 12:53 am

      The central bank exists for the purpose of *loaning* money at penalty rates to banks which are *solvent* but are suffering bank runs — which don’t have enough money to honor withdrawals today, but do have enough *assets* to do so (if the depositors were willing to accept less liquid assets).

      The FDIC and similar operations exist for the purpose of liquidating banks which are *insolvent*.

      You are correct that currently *insolvent* TBTF banks are being propped up by the Fed, which is what it was never supposed to do.

  5. April 4, 2012 at 3:45 am

    All the quotes by Franklin are quite to the point. For even more on what central bank economist’s knew on endogenous money, see my recent Levy WP 718 on “shadow banking and he limits of central bank liquidity support “.


  6. Claude Hillinger
    April 4, 2012 at 3:22 pm

    Reply to NIXDA

    ‘Necessary liquidity’ is a completely vague term that the central bank can interpret as it wishes. A bank as a responsible enterprise should keep adequate reserves, or what is the same thing, it should not over extend its lending. If the bank fails this responsibility, the central bank is under no obligation to bail it out.

  7. macroambiente
    April 4, 2012 at 6:18 pm

    This is really an interesting debate and I would be gratified if I could help with some observations. I will not take into consideration the disastrous Krugman’s retreat reported by Fulbrook today.
    First, Krugman misses completely the point. In a few words, IS-LM is just a one more monetarist fallacy. At the LM side the fact is that 1) money stock is not entirely exogenous and 2) the central bank cannot control the stock of money not only because it has an endogenous component, but mainly because the central bank prints money to pay interests on bonds autonomously issued by the Treasury. At the IS side, the fact is that investment, consumption and hence GDP are almost independent of the interest rate – in the real world what matters to consumers and companies is the income. The LM is, theoretically and practically, a straight horizontal line and the IS “curve” is statistically a vertical line. In passing, lenders are banks and financial capitalists and not consumers postponing spending; Krugman should dispense with naïve notions like a “lender’s fall in spending power”.
    Second, Keen is right about banks creating money “at will”, but it is at the will of the borrowers. That is by the way why there is endogenous money. When someone, by fortune or disgrace, ask for a loan in fact banks create money out of thin air and at will, in the sense that they do not need to have previous reserves. Krugman’s monetarist notion of loanable funds is useless for they are indefinite. Like any other seller, banks can use arguments to convince clients to borrow more, but all the same banks cannot create demand for credit because banks cannot create income for the borrowers to pay interests. The only one whose loan capacity is not bounded by the income is the government, and by the simple reason that “its” central bank prints money out of thin air to redeem T-bonds, then paying interests on the public debt.
    Third, in the sample of central banks experts quoted by Frederick everybody is right. Moreover, those experts also know that central banks are printing money out of thin air to pay interest upon T-bills. They just do not intend to talk about that. However, this may be the main technical point to be considered in this debate because money printed to pay interests is unbacked money, thus leading to harmful consequences.
    Illustrating the point, as shown in Economic Reasons Why Monetary Policy Is Fraud, in the United States the main source of M2 formation in the 50 years between 1959 and 2009 was the accumulated interest rent derived from the public debt. This money thus issued averaged 46.2%, almost half of the money supply. This tsunami of oligarchic unbacked money probably deserves more attention here because it seems that the subject behind the debate are the financial and economic crises. In fact, given that any public debt follows an explosive trend, the financial capitalists collect more and more capital to lend. So, in the financial market the competition increases, new instruments are created and more risks are assumed, especially by those with bailout insurance from insiders.
    The economic necessary and sufficient condition for the capitalist economy to be socially harmonious is that the decision about printing new money be democratic. There is no economic reason why the government should not create new money. What happens today is that people has been convinced that “government should not print money” and worse, believe that economists are preventing governments to do so. However, anyone who prints T-bills which are redeemed by somebody else – the central bank in this case – is in fact printing money. All the world around governments are printing money through the open market operations of “their” central banks. EU was born out of this rule and now European countries discuss how will them get back.

    • Nathanael
      April 8, 2012 at 12:57 am

      Good points. However, there is empirical evidence that the IS curve really exists; high real interest rates *discourage* investment in real businesses which have lower rates of return, which chokes off economic activity in those sectors. Look at railroads in the 1970s. Meanwhile, the LM curve has it backwards, but interest rates *do* cause changes in the amount of loans made, so… there’s some way to do something with that.

  8. April 9, 2012 at 7:26 am

    I was so concerned about this issue of whether banks needs reserves to make loans, or not, that I wrote an article around it a year ago. Here is the opening:

    Last March, Ben Bernanke wrote:

    “The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.”

    So, the Fed is on record as saying we ought to move to a banking system toward a system in which there are no reserves at all, making all the discussion about reserve requirements, including that found on this site, moot.

    Let’s be careful not to fight the last war.


    Perhaps this is not as bizarre and alarming as it first appears, or at least, it is not such a radical change from what is actually being practiced right now. After all, the Federal Reserve essentially back-stopped the 19 biggest TBTF banks when their reserve ratios proved insufficient. Perhaps they (that is, Bernanke) are thinking, “Well, we managed to cover the worst banking bust in history. How much worse can it get?” Perhaps Bernanke is just acknowledging in fact what has already been practiced in the last crash.
    For the rest of the article, see here:
    Zero Reserve Banking? http://www.huffingtonpost.com/scott-baker/post_1754_b_825640.html

    In any case, the most powerful Central Banker in the world thinks reserves are an anachronism and are indeed, costly and distorting (of what?). Ellen Brown, author of Web of Debt, says much the same thing, that banks lend first, and then find the money for the loan. Right now, that often means going through the Fed, which is the most accommodating it has ever been, with near zero % interest rates.
    I think the amount of liquidity is no longer the problem, it is what that money is being used FOR – namely to gamble in derivatives or buy back company shares (boosting pay for the C-Suite, but incurring debt, albeit at very favorable rates) instead of investing in the business through R&D or other true growth strategies. This is self-cannibalism, not capitalism.

    • Stuart Birks
      April 9, 2012 at 9:29 am

      Scott Baker :
      Last March, Ben Bernanke wrote:
      “The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.”
      So, the Fed is on record as saying we ought to move to a banking system toward a system in which there are no reserves at all

      There is a difference between there being no requirement and banks choosing to have no reserves. Banks may still see it in their interest to hold reserves even if this is not a statutory requirement. Surely Benanke is just saying that it could be enough, untimately, to allow banks to set their own level of reserves.

      • March 26, 2013 at 9:02 am

        Canada has a zero reserve requirement but banks still need, and hold reserves for other purposes; settlement, etc.

        As long as banks are given a legal privelege to create credit, the CB can only set the price not the quantity of credit.

        What needs discussing is the entire idea of what banks should lend for, the distinction between productive & unproductive credit.

      • March 26, 2013 at 4:02 pm

        “As long as banks are given a legal privelege to create credit, the CB can only set the price not the quantity of credit.”, Vilhelmo De Okcidento.
        WELL SAID.
        Justaluckyfool would like to add: IF the CB can not set the quantity of the “temporary money printed” they should be considered as no longer a CB of a Monetary Sovereignty. A true Monetary Sovereignty CB must be able to control the quality and QUANTITY of its currency.

      • March 26, 2013 at 4:16 pm

        “Scott Baker :
        Last March, Ben Bernanke wrote:
        “The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.”
        So, the Fed is on record as saying we ought to move to a banking system toward a system in which there are no reserves at all ”
        That would eliminate one of the symptoms; however with a mandate of 100% capitalization it would cure the disease.
        Because such “an unprecedented amount of credit expansion” to make the banks solvent an “incomprehensible” amount of ‘new currency ‘ would be required to prevent “systemic failure”. How does one solve this dilemma?
        Bernanke (He will win the Noble ) has shown the way. A proven method : “QE”. He needs only to change the goal of the Fed: Start as a Central Bank Working For The People (CBWFTP) while at the same time stop working for the benefit of the Private For Profit Banks (PFPB).
        GOOGLE OR BING: “Switch Game- PFPB, CBWFTP”
        Why would you remain silent, if in fact this is correct?
        Or why even if it needs to be corrected?

  9. April 8, 2013 at 5:36 pm

    justaluckyfool :. A true Monetary Sovereignty CB must be able to control the quality and QUANTITY of its currency.

    I would disagree.

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