Posted by: Dirk | March 31, 2012

Krugman vs. Keen debate on endogenous money

I was recently reading the Steve Keen paper prepared for the INET conference in two weeks here in Berlin and was half-way through when Paul Krugman commented on it on his blog. I want to comment on what I think is the main discussion and will not say anything about the way economic research has to be conducted, although I have just published a paper with Hans-Michael Trautwein in which we describe the way Paul Krugman ‘does models’. Anyway, here is the most relevant extract:

Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. I guess I don’t get that at all. 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. I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand.

This is the main issue. Krugman takes a neo-classical perspective and accepts the identity that savings is equal to investment. Only if somebody saves, another can invest. Therefore, if I save instead of consuming and somebody else lends and spends, aggregate demand should not change. That is correct, given the assumptions above.

However, the assumptions above describe an economy which is not like ours. Banks lend out of thin air, creating so-called endogenous money by keystroke. The MMT primer by Randall Wray describes this process. At the end of the day, money is just numbers in spread sheets. Money flows are cleared by banks, which use exogenous (=government) money for clearing. The important thing is: first they lend, and then they care about financing that lending. This means that lending creates deposits, not the other way around, as Krugman argues.

So, banks give loans if demand is high enough and effective, meaning that the lending party has enough reputation/collateral/etc. to be entrusted with a loan. With reserve ratios at record lows in most of the developed world – one percent in the eurozone – banks can create a €1,000,000 loan by just hitting some keys on a computer keyboard and then afterwards coming up with €10,000 in cash to deposit in the reserve facility. They can do this by repoing some sovereign debt, which European banks held in huge amounts. Until the crisis hit, this was very cheap and banks were able to increase lending by increasing leverage at very low costs.

Therefore, where real estate bubbles were in the making, like in Ireland and Spain, domestic banks (and domestic subsidiaries of foreign banks) increased lending without increasing savings and without capital inflows to compensate for the increase in lending. This is what Paul Krugman does not (yet?) accept as reality and what Steve Keen and others have been pushing as an explanation for the current malaise for some time. Oh, and by the way: Knut Wicksell in 1898 already thought about a credit-only economy and how banks would fill the gap between savings supplied by households and loans demanded by investors.

Personally, I think that only when policy-makers and politicians have understood this can we see effective policies that deal with the crisis. The crisis cannot be undone. Capital was mis-allocated by free-lending banks, with the ECB not being aware of the consequences of money supply growth that increased much faster in the periphery than in the core, and now there is some serious strain in balance sheets of households, private sector firms, banks, and governments in large parts of the European periphery. The investment have been inefficient, and they will never return what was thought they would. The sovereign debt crisis then is clearly a symptom, not a cause of the euro zone problems. The real causes lie in the way the euro is designed.

Macroeconomic imbalances will always exist, and finding conditions under which these do not lead to depressions is a simple task: regulate the financial sector through one European regulator, add a fiscal component that acts as an automatic stabilizer on the demand side, reform the stability and growth pact in a way that it does not produce instability and stagnation, and redraft the ECB’s goal from inflation-targeting to (sustainable) growth-maximizing while making it a lender of last resort. This would change the profile for economists working in the ECB from believers in low inflation back to the often hated economists that know their trade-offs (“one the one hand …, on the other hand …). You would get a whole new group of economists and a whole new discipline of economics, I promise.


  1. What is infinitely more important that all this is the development of a new global paradigm. It can benefit both the poor, and the rich…and yet, lead to a high degree of global justice than presently exists. Here, I refer to my “work in progress” project of Transfinancial Economics…

    The above ofcourse would also require at the end of the day a whole host of experts to “hammer out” the details.

  2. […] flipped through my files and found something which might be interesting for those following the Keen-Krugman debate. In his paper, Steve Keen draws two simple balance sheets in order to explain the fact that lending […]

  3. […] points have been discussed before (here and here), and Krugman has not changed his opinion. Fair enough, apparently he was not persuaded to […]

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