Paul Krugman vs. MMT: The Great Debate


There’s a tremendously important debate being waged across a bunch of different websites, including Paul Krugman’s at The New York Times, about how banking really works.

Unfortunately, it’s probably a bit tough to wade into the debate at this point. So I’ll do my best to summarize what’s going on.

ACT I: Krugman Answers Keen

Last week, a maverick Australian economist named Steve Keen linked to a paper he had written for a conference to be held in Berlin later this month. The paper, entitled “Instability in Financial Markets: Sources and Uses,” starts with a synopsis of the work on the financial sources of economic instability by the late economist Hyman Minsky. In particular, Keen argues for the Minskyite point that an understanding of banking is central to understanding the economy.

Paul Krugman weighed in the very next day with a post arguing that Keen’s insistence that banking is crucial was misplaced. Krugman argues that bank lending doesn’t necessarily increase demand in the economy—it just shifts money around.

“If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and I’m not sure what,” Krugman writes.

A few hours and scores of blog comments later, Krugman returned to the debate to accuse Keen and the “Minskyites” of engaging in “banking mysticism.” (The Minskyites he most likely had in mind were Modern Monetary Theorists like economist Randall Wray, a former student of Minsky.) Krugman compared Keen and the Minskyites of being similar to Austrian economists in that both assign “unique powers” to modern banks.

Of course, one of the best ways to pick a fight with a Minskyite is to compare him to an Austrian. The typically left-wing Minskyites typically despise what they regard as the right-wing quackery of Austrian economics. (Austrians, as far as I can tell, don’t spend much time thinking about Minsky or MMT at all.) Krugman no doubt knows this, which is why he decided to make the comment in the first place. He wanted to poke the bear.

The bear might not have noticed the poke, however, if not for Krugman attempting to also take the honey.
(Editor's note: enough with this metaphor!
JC: Okay, fine. Grrr

Krugman really provoked the MMTers by claiming that the idea of a loanable funds market is basically correct. Banks, he argued, make loans from deposits. That is, deposits create “loanable funds” that banks can lend out. Interest rates, he argued, are determined by loanable funds and liquidity preference.

“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,” Krugman wrote.

This idea of loanable funds runs directly contrary to what MMT claims about banking. Instead of bank deposits creating the opportunity for loans, loans create bank deposits. The funds needed to create the loan are manufactured out of thin air when the bank credits a borrowers account with the amount lent.

Banking regulations require that banks have reserves equal to a fraction of their deposits. Banks can meet these reserve requirements by having sufficient deposits in place. But they can also meet these requirements by borrowing reserves from other banks in what’s called the Fed Funds market.

The Federal Reserve targets the interest rate of this kind of borrowing in an effort to meet its monetary policy goals of low inflation and full employment. The idea is that a higher the interest rate a bank must pay to borrow reserves, the higher the interest rate customers will pay for loans.

Act II: Let Loose the Dogs of Blog War

Two days later, Keen responded by arguing that banks do not need deposits to create loans. To support this claim, Keen points to a 1969 paper by Alan Holmes, then senior vice-president for the New York Federal Reserve.

“In the real world, banks extend credit, creating deposits in the process, and look for the reserves later,” Holmes wrote.

Keen went on to summon the ghost of long-dead economist Joseph Schumpeter to back up the notion that banks introduce additional demand into the economy, not by transferring purchasing power between depositors and borrowers, but by creating new funds “out of nothing.”

Canadian economistNick Rowe entered the fray on the side of Krugman with a post arguing that, while commercial banks can create money out of thin air, they are contrained by their reserves.

“Commercial banks promise to redeem their money at a fixed exchange rate (at par) for central bank money,” Rowe explains.

Which means the central bank controls the size of the money supply, because it is the source of bank reserves. If it doesn’t want the money supply to expand, it should refuse to allow banks to lend beyond their reserves, Rowe argues.

He concedes, however, that if the central bank targets an interest rate, it has to “let individual commercial banks set monetary policy.”

This is a pretty crucial point so let’s pause for a moment and examine it. As I mentioned at the end of Act I, banks that don’t have reserves sufficient for regulatory requirements can borrow from other banks in the Fed Funds market. If demand for reserves climbs, the price for those reserves climbs—unless someone intervenes.

That someone, of course, is the Federal Reserve. The Fed targets the Fed Funds rate. If demand increases, the rate will exceed the target unless the Fed increases the supply of reserves. If the demand falls, the rate will drop below target unless the Fed drains reserves. So in order to hit its target, the Fed must increase or decrease the amount of reserves to match the demand for reserves.

Krugman returned to the fight with his most explicit rejection of “monetary mysticism” yet.

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.

This brought forth Scott Fullwiler, an MMT economics professor. Fullwiler says that Krugman’s posts on banking amount to a flashing sign announcing “I DON’T KNOW WHAT I’M TALKING ABOUT.” It’s really just a matter of double entry book-keeping, Fullwiler argues. When a bank makes a loan it creates a liability for itself—a customer deposit—and an asset for itself—the loan. The customer, of course, has the mirror opposite: an asset called a bank deposit and a liability in the form of an amount owed to the bank.

But what happens when the bank customer who borrowed from JPMorgan Chase spends the money he borrowed and the guy on the other end of the deal deposits the money in Citibank?

The deposit gets transferred from JPMorgan Chase to Citigroup. This typically happens by having the Federal Reserve debit reserves from JPMorgan Chase and credit reserves to Citigroup. If JPMorgan’s reserves were to run short of the requirements, it would borrow the reserves on the interbank market. If the reserves were unavailable on the interbank market for some reason, the Fed would automatically credit JPMorgan with a loan of the reserves. In short, the amount of reserves would grow.

Note that it cannot be any other way. If the central bank attempted to constrain directly the quantity of reserve balances, this would cause banks to bid up interbank market rates above the central bank’s target until the central bank intervened. That is, central banks accommodate banks’ demand for reserve balances at the given target rate because that’s what it means to set an interest rate target. More fundamentally, given the obligation to the payments system, it can do no other but set an interest rate target, at least in terms of a direct operating target.

Act III: Krugman Declares Victory

On April 1, Krugman returned with a post warning Rowe against any attempt to “engage the monetary mystics in a rational discussion.” He cites a 1963 paper by economist James Tobin arguing that monetary controls can be effective even with banks existing.

Krugman’s critics think this was an odd thing to do because no one was arguing that banks mean monetary controls are ineffective. And it was even odder, because Tobin also wrote a paper called “Commercial Banks as Creators of Money,” which supports the views that Krugman is arguing against.

The next day Krugman returned with a post that claiming his opponent maintains that banks can “create unlimited amounts of inside money, never mind the size of the monetary base.”

The Unlearning Economics blog thinks this is a “sleight of hand,” because that really wasn’t what anyone was claiming at all. The claim, rather, was that lending isn’t reserve constrained.

By noon yesterday (Monday), Krugman was beginning to declare victory in the debate.

“That’s the bottom line: the Fed controls credit conditions, except when we’re in a liquidity trap and it’s pushing on a string. Everything else — all the talk about banks creating money, and yes, all the gotchas my critics think they’ve found in what I’m saying — is irrelevant to the actual economic discussion,” Krugman writes.

A few minutes later he returned with a post declaring “OK, I’m done with this conversation.”

Later, he updated it with this: “I’m all for listening to heretics when they offer insights I can use, but I’m not finding that at all in this conversation, just word games and continual insistence that the members of the sect have insights denied to us lesser mortals. Time to move on.”

That’s probably wishful thinking on Krugman’s point. He may move on, but this debate will no doubt be picked over on blogs until kingdom come. Or, you know, until another Eurozone country goes kerplunk and everyone gets distracted.

By the way, I apologize for having so many economists in this post. Somedays, that’s just the way the world is.

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