“Don’t let monetary realism slide into monetary mysticism!” – Paul Krugman
I feel like I am beating a dead horse at this point, but I think it’s worth noting a few things with regard to Paul Krugman’s blanket dismissal of the importance of the Bank of England’s paper on endogenous money. Dr. Krugman says heterodox thinkers are frustrated. And yes, many of us probably are frustrated because the sands of “Mainstream” macro appear to keep shifting without really acknowledging that there are much bigger underlying problems in many of their views.
So let’s review a few of the facts and frustrations here:
- In the latest edition of this ongoing discussion Paul Krugman is clearly saying something different than he said just a year ago. Today, he says banks don’t “have unlimited ability to create money”. This is obviously true as banks are capital constrained, but this is also quite different from saying “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” as Paul Krugman did just last year. The latter view is obviously wrong to anyone who understands endogenous money because it’s clear that a bank doesn’t “lend out the money it receives”.
- Over the course of the financial crisis many mainstream economists expressed a clear rejection of endogenous money views on modern banking in favor of the money multiplier view and the idea that banks “lend out” reserves or deposits. These were all varying versions of some exogenous monetary model or versions of what is essentially a barter monetary system where banks are nothing more than intermediaries as opposed to being entities that can actually increase aggregate demand through their very own money creation. This view is obviously wrong to anyone who understands endogenous money because banks don’t exist in a barter system and are indeed endogenous creators of money.
- The bigger issue here goes deeper though and it strikes a serious blow to the models that many mainstream macroeconomists utilize. Many mainstream economists said we were in a liquidity trap. This meant that the Central Bank could create money and it would just sit there idly and banks wouldn’t “lend it out”. But these economists also thought that real interest rates were simply too high and since nominal rates were already zero then the policy response needed to increase inflation expectations to reduce real rates. That is, if you could boost inflation expectations sufficiently then we could establish an interest rate at which markets would clear (you can see Krugman endorse this view here). These economists often justify this view by using a IS/LM model in which the money supply is fixed. It’s obviously wrong if you understand endogenous money because the money supply is not fixed.
- The even worse view, promoted by many mainstreamers, is the flawed concept that if you actually set negative nominal interest rates then maybe that money would flow out of the banking system by enticing banks to lend it out. These views are obviously wrong if you understand endogenous money because bank lending isn’t a function of supply side mechanics primarily.
So, all this time people who claim to have understood the financial crisis have been utilizing an incomplete model of the way the monetary system actually works and endogenous money is central to all of these misunderstandings. And in promoting this erroneous set of understandings, they’ve been promoting their views about negative interest rates, inflation expectations and other flawed policies that would have never been promoted by people with a sound understanding of endogenous money. In other words, their flawed understandings led directly to flawed prescriptions and in my view have contributed to the currently sluggish economic recovery. This is pretty important stuff in my opinion and remains a substantial puzzle for many mainstream macroeconomists. Unfortunately, it doesn’t look like many of them have any real desire to solve it for themselves.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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