Banking Buffoonery, Modeling Mysticism and Why Paul Krugman Should Be Sweatin’ Bullets

old lady and krugman

We have a few things to say about the recent debunking of established monetary theories.

In case you missed it, the Bank of England issued a report in March explaining that standard textbooks get money and banking all wrong.

The authors point out that banks don’t wait for deposits before making loans, as often claimed by academics. It’s the other way around. Banks create new deposits when loans are made, for this is how loan proceeds are delivered to the ultimate recipients. The fact that deposits then slosh around from bank to bank has no bearing on future loan issuance, which is always matched with newly-created, not old, deposits.

Moreover, the role of bank reserves is badly botched by academics. Central banks don’t use the monetary base (currency plus reserves) as a tool to constrain lending, contrary to textbook descriptions of the so-called money multiplier. Rather, bank reserves are supplied by central banks “on demand”. The authors explain that policymakers normally don’t “fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”

The media conveyed these points with unusual excitement for such a bland topic. But the bigger story goes beyond banking fallacies to a between-the-lines message about economic modeling.

Effectively, the BoE joined forces with the rebels in economics who’ve long argued that standard models are bunk. To see the connection, you only need to recognize that bank lending isn’t pure financial intermediation as assumed by modelers (leading them to ignore banks entirely), but a direct stimulant to spending because it creates purchasing power without prior savings.

Moreover, the BoE’s report discredits many well-known pundits, some more so than others. We’ll pick on one from the “more so” category: Paul Krugman.

Krugman is an obvious choice, for two reasons. First, we don’t expect his favorite methods to survive the BoE’s truthiness, as we’ll argue in a moment. Second, he’s surely one of the nameless “commentators and bloggers” referenced in the report, and whom the authors would like to set straight.

A fight that Krugman wishes he’d never picked

Consider the brouhaha that followed Krugman’s claim, in a 2010 paper co-written with Gauti Eggertsson, that he had built a model channeling the late Hyman Minsky. Apparently, Krugman had never read Minsky, or maybe he did but didn’t quite comprehend what he was reading. Minsky rejected the fallacies that Krugman embraces.

Here are a few telling pieces of the long exchange triggered by Krugman’s paper, beginning with the prominent Minskyite, Australian economist Steve Keen:

Keen:  [N]eoclassicals like Krugman read Minsky, and then proceed to build equilibrium models without banks, and think they’re modelling Minsky. … No they’re not: they’re creating an equilibrium-obsessed Walrasian hand puppet and calling it Minsky. … One key component of Minsky’s thought is the capacity for the banking sector to create spending power “out of nothing”—to quote Schumpeter.

KRUGMAN:  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 … 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.

Keen:  [T]he empirical evidence overwhelmingly supports the case Krugman is trying to dismiss out of hand, that banks can and do “create credit out of thin air”, with the supposed regulatory controls over their capacity to do so being largely ineffective.

KRUGMAN:  I often see the view that banks can create credit out of thin air. There are vehement denials of the proposition that banks’ lending is limited by their deposits, or that the monetary base plays any important role; … This is all wrong … any individual bank does, in fact, have to lend out the money it receives in deposits.

Commenter Dan Nile:  I have worked in bank lending. Bank loan investors can in fact write checks out of thin air … they are different from other financial intermediaries in having the privilege of issuing credit (fungible with currency) at will.

Commenter Ron T:  Ms Kaminska from FT Alphaville laughs at one chap who “just discovered” that banks create money ex nihilo. She says this could have been “news” in 1913. Apparently, it is still news to Swedish Bank prize laureates 100 years later… Bankers know this full well, the street knows this, time for the ivory tower to catch up.

Commenter Neil Wilson:  I strongly suggest you spend some time at a bank and understand how they actually conduct operations … There is no reserve limit … Failure to understand the buffering nature of banks *will* lead you to the wrong economic model. This is why you missed the great crash.

Commenter hangemhi:  Paul – no shouting, and you’ve been rebutted, quite convincingly, about 20 times in 29 comments. What’s your reply?

KRUGMAN (replying to commenters):  It’s obvious that many commenters don’t get the distinction between the proposition that banks create money — which every economics textbook, mine included, says they do (that’s what the money multiplier is all about) — and the proposition that their ability to create money is not constrained by the monetary base. Sigh.

Scott Fullwiler:  Krugman demonstrates that he has a very good grasp of banking as it is presented in a traditional money and banking textbook. Unfortunately for him, though, there’s virtually nothing in that description of banking that is actually correct.

We doubt that Krugman recognized how silly he looked when he called his adversaries “banking mystics” – the title of his second post excerpted above. Maybe he does now, though, considering that the mystics are backed by the authority of none other than the Old Lady of Threadneedle Street.

Modeling mystics

Once again, though, the bigger issue has to do with the way that banking feeds into models. Krugman’s challenge is that he hitched himself to the model that defined macroeconomics for three decades after World War 2 – the IS-LM model.

His more mathematical peers can hide behind the jumbles of equations known as DSGE models, which rule academia today. DSGE modelers can tweak assumptions and equations at will to deflect criticisms, even as none of their formulations actually work.

But Krugman swears by a framework that looks just as it did when introduced by Sir John Hicks in 1936, and one that’s easily explained to a layperson.

In Hicks’s IS-LM model, central banks are assumed to control the money supply, private banks are treated as mere intermediaries in the credit markets, and these two sides of the economy are thought to be separate and distinct. With these assumptions, IS-LMers can claim to find a happy equilibrium that brings together the presumably independent markets for money and credit.

If you believe in the model, you also have to believe textbook concepts such as:

  1. “Banks are just one channel linking lenders to borrowers.”
  2. “Banks don’t create demand out of thin air any more than anyone does by choosing to spend more”
  3. “Banks’ lending is limited by their deposits.”
  4. “Money is constrained by the monetary base.”

Conversely, if you understand that textbooks aren’t valid and money and credit markets are anything but independent, it’s ridiculous to put any faith in IS-LM. And while the model isn’t mentioned anywhere in the BoE’s report, it’s easy to make the connection.

The Old Lady will get her way

Make no mistake, the report got Krugman’s attention, notwithstanding his cool-as-a-cat response (which skirts the issues at hand and ignores the contradictions between his well-documented positions and the BoE’s reality check).

As possibly the profession’s loudest IS-LM advocate, he knows the stakes.

Even without the BoE, he was fighting a losing battle, considering the increasing attention on banks after the Global Financial Crisis. This was one takeaway from the early 2012 debate excerpted above. While most people interested in the economy are busy searching for the reality that lurks behind failed theories, Krugman defends the same old, same old, based on the inaccurate claim that bank lending is no different than other forms of credit creation.

With the BoE’s report, we expect economists to leave Krugman’s side more rapidly than they otherwise would. It’s uncomfortable to take a position on monetary matters that contradicts the world’s second oldest central bank and the first with a monopoly on currency issuance. Old-time Keynesians and Monetarists using IS-LM can easily ignore private bankers who point out that their assumptions aren’t valid, but the BoE is a different story.

What’s more, misconceptions about banking aren’t the only problems with the way that economists use IS-LM. The model was unhelpful from the start, as more or less agreed by Hicks when he called it nothing more than a classroom gadget. In time, we expect the rest of the profession to join Hicks in condemning the notion that IS-LM has any practical value. It may take awhile to weed out the stubborn holdouts, but if we’re right in expecting the demise of Krugman’s economics, it’ll be well worth the wait.

(Click here for an appendix with more discussion of the IS-LM model. Also, for empirical analysis of the differences between bank lending and other types of credit, see our earlier post, “3 Underappreciated Indicators to Guide You Through a Debt-Saturated Economy,” and the accompanying “technical notes.”)

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2 Responses to Banking Buffoonery, Modeling Mysticism and Why Paul Krugman Should Be Sweatin’ Bullets

  1. Dave says:

    Shockingly, Charles Plosser, president of the Philly Fed, doesn’t know how banking works. He is afraid that banks will start lending out their reserves not knowing that they do not and cannot lend out their reserves. Our country is in the best of hands.

  2. flow5 says:

    Krugman: “banks are just one channel linking lenders to borrowers”

    CBs create new money when they lend/invest (CBs, from a system’s standpoint, never loan out existing deposits, saved or otherwise). And all time/savings deposits originate from other bank deposits. Thus, never are the CBs intermediaries (conduits between savers & borrowers), in the savings-investment process. In other words, investment never equals savings because voluntary savings are impounded within the CB system. I.e., monetary savings are a leakage in Keynesian National Income Accounting. Likewise, Hicks’ IS=LM formula is also bad math.

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