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Krugman vs. Keen

from John Balder and the current issue of the RWER

To explore the origins of the global financial crisis, the first step is to specify the relationship between banking, money and credit. According to the mainstream view, a bank serves as an intermediary between a borrower and a lender. As a pure intermediary, a bank has no impact on real economic activity. This view – taught in most Economics 101 textbooks – implicitly assumes that money is available in finite quantities that are regulated by the central bank.

Several years ago, Paul Krugman and Steve Keen engaged in an enlightening back-and-forth about banking, money and credit. The discussion examined whether banks lend existing money (implying money is neutral) or newly create the money they lend (money is not neutral).

 Economist Category Result
Krugman (2012) Money is neutral Banks lend already existing money
Keen (2011, 2017) Money is not neutral Banks newly create the money they lend

In support of neutral money (mainstream view), Krugman (2012) casually asserts:

“Think of it this way: when debt is rising, it’s not the economy, as a whole borrowing more money. It is rather, a case of less patient people – people who, for whatever reason want to spend sooner rather than later – borrowing from more patient people.”  

Krugman notes that banks lend existing money as intermediaries between borrowers and savers. In other words, a bank must have $100 in deposits before it can make a loan for $100. Deposits create credit (or a bank liability is needed for a bank to create an asset). This view asserts that money is neutral and can be ignored, as it has no relevance for real economic activity. This view seems to be intuitive, in fact almost obvious; after all, if I do not have $10, I cannot lend it to you.

Conversely, Keen (2011) argued that banks newly create the money they lend. If true, this suggests that money creation impacts real economic activity and is not neutral. But how does a bank “create” money? When a bank makes a loan, it simultaneously creates a deposit (which is money) for the borrower in an identical amount.[1] For example, if I borrow $10,000 from my bank, the bank creates a deposit account in my name with $10,000 in it. In creating credit, a bank necessarily creates a deposit and thus, money. This is how double-entry bookkeeping works. Loans create deposits.

According to Richard Werner (2012), more than 95% of all money created in the US and UK is a direct result of credit creation by banks.  When a bank creates credit, it also creates money.  Post-Keynesians have been making this argument for more than three decades, though few have listened (e.g., Basil Moore was an early proponent) and this view was recently affirmed by the Bank of England (McLeay 2014a and 2014b): “Whenever a bank makes a loan it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” Yet, despite the factual basis of this claim, it has been ignored by neoclassical economists, given their attachment to equilibrium analysis.

Banks are authorized to create credit, ex nihilo (“out of nothing”) so credit (money) cannot be neutral. In creating credit, a bank creates money that a borrower uses to purchase goods and services that add to aggregate demand and economic growth. Banks are not limited to acting only as intermediaries that move money from savers to borrowers.[2] Importantly, banks also determine how credit and money are allocated. In the real-world, money creation distinguishes banks from other financial intermediaries (e.g., shadow banks) that can extend credit but do not possess the authority to create money. Within the financial sector, only banks are granted this authority. Money is a form of credit, an obligation to pay. In Werner’s (2012) words, “banks are the creators of the money supply” and “this is the missing link that causes credit rationing to have macroeconomic consequences.” In short, finance (banking, money and credit) matter!

[1] Keen (2011 and 2017) and Werner (1995, 1997 and 2012).

[2] Mainstream economics continues to assert that credit and money are neutral and do not impact real economic activity. Neoclassical economists have good reason to be defensive. Given the structure of their models, dropping the neutral money assumption will result in an indeterminate outcome.

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  1. October 5, 2018 at 2:13 am

    Richard Wernes points out that Japan used ‘credit guidance’ to direct the nature of the central bank’s and hence also the private banking sector’s money-creation, directing it towards chosen economic goals. There seems to be zero understanding of this in the West, and the possibility gets hidden beneath the blanket assumption that central banks must have independence.

    The QE for People arguments are in effect arguments for central banks to use the same credit guidance tools to direct QE towards affordable housing, debt write-offs or climate solutions. Could a public service central bank also extend credit guidance to the private banks that it shelters under its broad financial wings?

  2. October 5, 2018 at 3:48 am

    This ties into discussion of payment systems. Originally, banks operated the payment system by issuing their own printed bank notes. The private banks would print the notes and then they would lend those notes against collateral into the payment system they operated. This payment system required trust by both buyer and seller in the bank to not abuse the power to print bank notes other than for lending against hard assets. A common hard asset was gold. Why would people post gold as collateral for a loan funded with paper? Because only paper was fully accepted by the bank in its running of the payment system. To promote confidence banks would often offer to redeem paper for gold especially if the paper loan was collateralized by gold. A run on the bank we are told was caused by banks becoming unable to produce gold on demand but more typically it was triggered by loss of trust in the payment system run by a particular bank. Just as it happened in 2008 sister banks would refuse to honor each other’s paper and the payment system would freeze up. This would cause fear of a bank failure and people would panic. This led to the central bank idea so there could never be a payment system failure due to interbank refusal to honor each other’s paper.

  3. October 5, 2018 at 3:24 pm

    Thank you very much for making this comparison between Krugman and Keen. Keen is a really intelligent guy and is creating a program called Minsky which will eventually show how the money system really works. See here: https://www.nakedcapitalism.com/2018/09/steve-keen-how-economics-became-a-cult.html

  4. Prof Dr James Beckman, Germany
    October 5, 2018 at 4:21 pm

    As a business economist, I am most concerned with the QUALITY of the loans, although the volume ultimately does indeed affect quality. Since much of the enormous quantity of US housing loans was sold as securities overseas, the global system absorbed some of the risk of loans which all but certainly were to become unpayable as soon as variable rates were greatly increased. Indeed, many of the variable rates were teaser, meaning they were below the actual market rates at time of issuance. An enormous train wreck waiting to happen.

  5. Roy Langston
    October 6, 2018 at 4:41 pm

    An empirical examination of banks’ ledgers establishes that Krugman and neoclassical economics are just objectively incorrect. The money that is placed in a borrower’s demand deposit account does not come out of any other account. It is simply a liability of the bank that balances the creation of the loan asset in the bank’s loans account. The key point is that just as creation of that money boosts prices in the market where it is spent (usually real estate) by increasing effective demand, when the money is erased on repayment of the principal, it reduces prices generally by reducing effective demand. That is why the debt money system is inherently economically destabilizing: it creates positive feedback both on the way up and on the way down.

    • Prof Dr James Beckman, Germany
      October 7, 2018 at 7:33 pm

      Roy, let’s say the borrower puts in $300 K of her own money & that $100 K of the bank’s. The house sells some years later for $450 K. Forgetting all the expense & tax issues, does not the borrower have $50 K profit after repaying the bank & considering her own original contribution? And isn’t that a sign of economic activity?

      • October 9, 2018 at 9:04 am

        So you are a business economist, James, concerned with the QUALITY of loans! Being myself a human, I see QUALITY in a loan which enables a man to house himself and his family so he is in a position to profit them and us by his work, and NEGATIVE QUALITY in a loan which merely enables “legal” owners to raise prices and thus “rip off” buyers. (If someone has done $50K’s work improving the house that is another matter: a real profit is being passed on to enhance the value of the buyer’s work).

        Being specifically a sometime control engineer, I would rather agree with James Langston that the debt money system is inherently unstable, and hope that economists get their heads round the effects (chaos and error control) of positive and negative feedbacks, so they can give politicians the courage to interpret debt money as personal credit, socially repayable only by doing the work which needs to be done.

        With only about ten years left before it will be too late to prevent climate disaster, monetary aims need to be undone by negative feedback and positive feedback needs to drive a rapid switch to environmental aims controlled by Nature’s negative feedback and pre-Capitalist common sense. When the work has been done, then will be the time for rest and recreation.

      • Prof Dr James Beckman, Germany
        October 9, 2018 at 6:01 pm

        Dave, I agree with you totally. The super-wealthy have/will buy islands. Apparently someone is promoting New Zealand for the multi-billionaires. Most people don’t care to know much about the future, past or present except when they feel affected. “Gosh, look at that different person moving in down the street or, my god, next door.” That kind of stuff.
        Unless one mobilizes massive political/social support, each family must fend for itself in most places, at least in the West with its frequently moving populations, or so it seems to me.

      • Roy Langston
        January 18, 2020 at 4:11 pm

        By that “logic,” the profit obtained by a protection racket is also a sign of economic activity.

  6. October 8, 2018 at 5:43 pm

    It is also true and perhaps important to point out that the government-central bank sector also produces money from nothing (ex nihilo), rendering talk of “financing” government spending misleading or incorrect. Like commercial banks, this sector can take actions that create deposits–by sending direct deposits or paper checks. As commercial banks do not wait for deposits to lend, the public sector does not borrow or wait for tax revenues in order to spend.

    Great post, though I’m skeptical that Krugman would say that money is neutral without the qualification that it can change things in the short run.

  7. October 9, 2018 at 12:23 am

    No mention of “credit cards here,” or the range of institutions, not all banks that issue them; is that because both parties consider them just a form of the “loans” which Krugman starts out with?

    Also, don’t we need to talk about leverage? Where does it come from if in Krugman’s illustration, it would always be one to one, a loan creates a deposit. But a deposit is not a reserve, is it? And credit cards don’t have a repossessable asset behind them, like a house in a mortgage, or an auto in an auto loan…I suppose in the case of student loans, we can indenture the student to work in the fields, like sharecroppers…

  8. October 12, 2018 at 2:42 pm

    Governments invented money about 7000 years ago. Mostly to ensure an efficient and easily administered way for ordinary people and others not so ordinary to pay their taxes. Why would governments give up, voluntarily or otherwise exclusive control of the manufacture and uses of money to any other part of society? Especially banks, which have not always been helpful or sympathetic toward governments. There are only two reasons I can see. First, governments are filled with very stupid people. Second, governments get more out of giving up money than they get by keeping that control. Neither seems plausible to me.

  9. Toby Fulton
    April 18, 2020 at 9:01 am

    I work for a bank and I think Keen and Krugman are both correct but too focused on their own theories. I don’t know if they’ve resolved their differences or not.

    The concept that most people miss is the difference between ‘money’ and ‘financial assets’.
    Money is what is in people’s transactional accounts (or folding cash if they’re old school) and can influence demand by being spent over and over again. Financial assets are not able to be spent – they are by definition iliquid.

    When a bank makes a loan (a financial asset) it creates new money in the customers transactional account. So a financial asset (the 3yr or 30yr loan) has been used to create new money. In this respect Keen is correct. At this point both money and credit has been created in the banking system.

    This new money gets spent by the borrower (on a car, house, whatever) and is now circulating in the banking system. It ends up in another persons transactional account (at the same bank, or a different bank).

    But bank’s can’t operate with a balance sheet of illiquid assets (loans and mortgages) and liquid liabilities (customer transactional accounts). This is a very risky liquidity mismatch – think Northern Rock and a ‘run on the bank’.

    So banks need to convince people to convert their liquid money (sitting in transactional accounts) into illiquid bank financial assets (term deposits, bank issued bonds, etc) by offering a competitive interest rate.

    When a customer ‘buys’ a term deposit or a bank bond the money from their transactional account is ‘destroyed’. It has been converted into a bank issued financial asset. It is now an illiquid bank financial asset / investment for the customer and an illiquid customer financial liability for the bank.

    So the new money that was previously circulating from one person’s account to another (and influencing demand) is no longer money. The person that decided to ‘save’ and invest in a bank term deposit destroyed the money. There has to be enough ‘savers’ (buyers of bank financial assets) to allow banks to match their lending. So in this respect Krugman is correct.

    Banks can operate fine with a certain proportion of their liabilities as customer transactional accounts. So only a portion of newly created money needs to be converted into term deposits and bank issued bonds. The rest keeps circulating by people buying and selling stuff from each other and therefore influencing demand.

    I’m probably missing something but I just stumbled across this post and thought I’d throw in my 2 cents.

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