or why Paul Krugman doesn’t understand Modern Banking. Some readers may have noticed the brouhaha in the blogosphere about a blog post from Paul Krugman criticizing the paper from Steve Keen, which will be presented at the upcoming INET conference in Berlin. Paul Krugman then doubled down with another post and again with another post. First a personal advice: Folks, all these screaming and yelling “Dear Paul, but …” is only a waste of time. Paul Krugman will never ever concede that he’s wrong on anything concerning economics. The only appropriate response in my humble opinion is to state the obvious and then move on. These people take a perverse pleasure being yelled at from laymen, because … Well, they’re thinking like a “Nobel” economist and you are not!
That said I will not comment in this post on Krugmans take on Minsky (poor old Hyman rotating in his grave), his obsession with highly stylized ISLM models (not applicable to the real word) and him bringing up the money multiplier argument (which isn’t dead because it was never alive). I will confine myself to the mechanics and accounting of modern day banking. So what is the problem with Krugmans mythical banking theory? In his original post he states:
Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. 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. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and I’m not sure what. I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand.
This is the “Loanable Fund Theory”. No mystery here. I’m wondering why some people are shocked? You can find this sort of reasoning in almost any Econ 101 Textbook students are brainwashed with. Econ Profs all over the world teach this myth and write about it in their blogs. They simply ignore the fact that the whole world dropped the Goldstandard long time ago and thus some concepts applying solely to a convertible money regime must also be abandoned. So what is actually going on?
John walks through the door of his bank to apply for a loan of $700 to purchase an iPad from the local Apple Store. The loan desk in the bank checks whether John is a creditworthy customer and if not so either asks John for some collateral or denies his loan application. If the loan desk approves Johns loan application the balance sheet of the bank changes. The deposit of $700 in Johns account is a liability for the bank. The corresponding asset is the loan. Voila. New nominal demand for an iPad was created out of thin air.
Note that the loan desk of the bank hasn’t called the back office whether enough deposits or reserves are available to approve the loan to John. The only thing that happened is, the bank determined whether John is creditworthy and the price (interest) of the loan. The price of the loan reflects Johns creditworthiness and costs which (maybe) incurred by the bank once John withdraws his deposit to purchase the iPad. Once John withdraws his monies the balance sheet of the bank changes again. On the asset side there’s still the loan. But instead of the deposit liability there’s a liability to the Central Bank, which must be settled.
So what are these mysterious Central Bank reserves? Every bank has an account at his national Central Bank. These are accounts for reserves or high-powered money or base money which can only be issued by the Central Bank. The purpose of base money is to facilitate the myriad of transactions happening daily in the banking system. Reserves are basically a unit of account. Once John withdraws his monies to purchase his iPad the following happens to banks balance sheets. The deposit liability at Johns bank is gone. Instead the bank must transfer reserves to the bank of Apple. These reserves are deducted from the banks CB reserve account. Thus its assets with the Central Bank (reserves) shrink accordingly.
The bank of Apple has a new liability which is the deposit of Johns money in the Apple account for the iPad. Plus a new asset which are the reserves transferred from Johns bank CB reserve account to Apples bank CB reserve account. Now what happens if Johns bank doesn’t have enough reserves for the transfer? In normal times banks minimize their reserve holdings because of opportunity costs. Johns bank can get the required reserves from the Interbanking market or from the discount window of the Central Bank with a penalty interest rate. Anyway the Central Bank will always provide the reserves necessary to preserve the integrity of the payment system.
Conclusion: Loans create deposits. Not the other way round. And a loose banking system can create artificial extra nominal demand which can cause a problem once it is gone. And YES Paul: Banks can’t create loans just how funny they are. Loans are constrained by the number of creditworthy customers who walk through the banks door and the capital requirement posed on the bank. But this is a subject for another post.
PS: To answer the ad hoc assumption of Krugmans last post. If every John thinks he must withdraw his loan in cash to purchase something the Central Bank will simply accommodate this new stone age desire by printing more notes. Once John has his $700 iPad the Central Bank will destroy the notes.