Posted by: Dirk | October 27, 2014

Paul Krugman and monetary theory

Paul Krugman has voiced his view on monetary theory again in today’s column in the NY Times:

Some background: More than seven years have passed since the housing bubble burst, and ever since, America has been awash in savings — or more accurately, desired savings — with nowhere to go. Borrowing to buy homes has recovered a bit, but remains low. Corporations are earning huge profits, but are reluctant to invest in the face of weak consumer demand, so they’re accumulating cash or buying back their own stock. Banks are holding almost $2.7 trillion in excess reserves — funds they could lend out, but choose instead to leave idle.

And the mismatch between desired saving and the willingness to invest has kept the economy depressed. Remember, your spending is my income and my spending is your income, so if everyone tries to spend less at the same time, everyone’s income falls.

While I agree with the policy conclusions, I still cannot agree with the monetary economics, namely that:

  1. Savings finance investment (credit does!)
  2. banks can lend out reserves to the private sector (they cannot)

These points have been discussed before (here and here), and Krugman has not changed his opinion. Fair enough, apparently he was not persuaded to change his mind. So here we are, in 2014, with no public figure understanding how money and credit work in the real world. At least the British central bank, the Bank of England, understands it (there is a companion article which is good as well). Here is an excerpt:

Far more important for the creation of bank deposits is the act of making new loans by banks. When a bank makes a loan to one of its customers it simply credits the customer’s account with a higher deposit balance. At that instant, new money is created.

That means that you do not need savings to create a loan. Since the loan is enough to finance investment, there is no need to wait for savings to roll in order to be able to make loans. The workings of the actual monetary system are a bit more complicated – but not too much. (After all, both articles together are below 50 pages combined.) And then it says this:

So banks are allowed to hold a different type of IOU from the Bank of England, known as central bank reserves and shown in green in Figure 2. Bank of England reserves are just an electronic record of the amount owed by the central bank to each individual bank.

Note that it says ‘banks are allowed to hold a different type of IOU from the Bank of England, known as central bank reserves’, not ‘the private sector’ or ‘businesses’ or ‘everybody’. Since monetary theory is complicated stuff, I would like to see the debate on endogenous renewed. It is a, perhaps the, decisive issue for the Western world in the 21st century.

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