Ashwin Parameswaran makes an incredibly important point here:
“Krugman completely misses the fact that the supply of “dead presidents” is endogenous.”
Dr. Krugman has once again delved into the abyss of endogenous money. Throughout the crisis many economists have argued that the relationship between base money and the broader money supply is temporarily broken. As if all those reserves are being held by banks or other agents because they’re near cash equivalents in a “liquidity trap”. Dr. Krugman says that this is even more true due to the fact that the monetary base has historically been composed of cash.
But Ashwin makes the crucial point here. Cash levels are endogenous. Ie, their amounts in circulation are determined by the demand of the users of private bank money. As I’ve explained before, cash comes from outside the private sector when the US Treasury gets an order from the Fed for cash notes. But the Fed only issues these orders when the demand from their members banks increases. Why is this? It is because cash is merely a facilitating feature of private bank money. In other words, you can’t even obtain cash unless have an account at a bank whose vaults are stuffed with Federal Reserve Notes in the case that you might need some for the purposes of conveniently transacting in these notes.
These ideas of “high powered money” and the “monetary base” are unfortunate terms that muddy the waters in understanding how money is created and how the monetary system works. In a world of endogenous money where almost all money is created by banks these concepts get large facets of the workings of the monetary system wrong. Now, I don’t doubt that monetary policy will become more effective outside of the balance sheet recession. But the end of the balance sheet recession won’t magically bring the money multiplier back to life. It’s dead. It’s always been dead and we should make sure this myth remains very dead.
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.