"This looked like a lot more fun on BET"
There is nothing like a good online beef. Throw in a couple of economists and you have some must-see TV (or Must-see Twitter Feeds). Based on a recent research note (and two accompanying videos) from the Bank of England titled "Money Creation in the Modern Economy", economist Steve Keen takes to task economists in general (and Paul Krugman in particular) for peddling what he believes is a false picture of money creation and the role of banks in the economy.
The BOE paper addresses two popular notions of banking and money creation most of us are taught in school:
1) Banks function primarily as intermediaries to lend out money to borrowers from savers' deposits.
2) Banks create money by "multiplying up" Central Bank money to create new loans and deposits (aka Fractional Reserve Banking).
According to the BOE, the process actually works in reverse. Deposits aren't necesarrily created by savers but, rather, from bank loans itself.
- "In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's account, thereby creating new money.
The reality of how money is created differed from the description found in some economic textbooks....Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits....In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money "multiplied up" into more loans or deposits."
The paper explains that people and businesses can also affect the stock of money. As an example, we are able to "destroy money by using it to repay...existing debt". The BOE continues that "monetary policy acts as the ultimate limit on money creation".
Now, how does this figure into Keens Vs. Krugman. It has to be with how economic models are used in policy recommendations and decisions as per Keen:
- "...if you admit the reality that banks create money by lending, and that money is destroyed by debt repayment (a point I have to admit that I took some time to appreciate), all the simple equilibrium parables of conventional economics fly out the window. In particular, the level of economic activity now depends on the lending decisions of banks (and the repayment decisions of borrowers). If banks lend more rapidly, or if borrowers repay more slowly, there will be a boom; if the reverse, there will be a slump. As the Bank of England puts it, if new loans simply make up for old ones being repaid, then there is no effect, but if new loans exceed repayment then aggregate demand will increase.
And here comes the right hook:
- "...Krugman has been the most visible and aggressive defender of the proposition that banks don’t matter...[he continues] to press the belief that banks are “mere intermediaries” in lending, that they can be ignored in macroeconomics...Now...he has been directly contradicted on these points [by the BOE]...I expect Krugman’s riposte will be the KISS [Keep It Simple Stupid] principle: that while the “loans create deposits” argument is technically true, it doesn’t make any real difference to macroeconomics."
Krugman is an extremely influential economist but I have yet to see his take on the BOE paper. Hopefully, he has something to say as money creation and its affect on the economy seems to be a slightly important topic for policymakers to get right.
