Krugman’s Flashing Neon Sign

By Scott Fullwiler

Update: Paul Krugman has posted a reply to this post that is a straw man.  He and Nick Rowe are viewing this all through the lens of the old Monetarist/Keynesian debates in which there was a choice b/n interest rate targets and monetary aggregate targets; the Monetarist critique assumed the Keynesians were going to keep interest rates at the same level forever and not change them.  Once John Taylor came up with his “rule,” everyone agreed an interest rate target could work. 

What we are talking about here is operational tactics–the CB can only target an interest rate.  It cannot target a reserve balances or the monetary base directly.  But that is different from strategy–that is, WHERE the CB puts its target and WHEN it chooses to change the target.  There is NOTHING in anything I’ve ever said or anything any PK’er, MMT’er, etc., has ever said that suggests the CB can’t set the target wherever it wants whenever it wants.  The point is that whatever the target is, THAT is what its daily operations defend directly, not a monetary aggregate, not the monetary base, not reserve balances.  There is nothing in anything I’ve said that would preclude the CB from running a Taylor’s Rule type strategy, for instance, that responds at any point in time endogenously to the state of the economy.  That is, the target rate is an exogenous control variable (i.e., it is necessarily set by the CB) that it sets endogenously in response to economic events.

The debate between Paul Krugman and my friend Steve Keen regarding how banks work (see here, here, here, and here) has caused me to revisit an old quote.  Back in the 1990s I would use Krugman’s book, Peddling Prosperity (1995), in my intermediate macroeconomics courses since it provides a good overview of what were then contemporary debates in macroeconomic theory as well as Krugman’s criticisms of various popular views on macroeconomic policy issues from that era.  One passage near the very end of the book has always remained in the back of my mind; in it, Krugman critiques a popular view that was and still is highly influential regarding productivity and trade policy.  He writes: “So, if you hear someone say something along the lines of ‘America needs higher productivity so that it can compete in today’s global economy,’ never mind who he is or how plausible he sounds.  He might as well be wearing a flashing neon sign that reads:  ‘I DON’T KNOW WHAT I’M TALKING ABOUT.’” (p. 280; emphasis in original)

In his latest post in this debate (which Keen replied to here), 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.  Instead of a persuasive defense of his own views on banking, his post is in essence his own flashing neon sign where he provides undisputable evidence that “I don’t know what I’m talking about.”

Moving right into Krugman’s post, he writes: “There are vehement denials of the proposition that banks’ lending is limited by their deposits, or that the monetary base plays any important role; banks, we’re told, hold hardly any reserves (which is true), so the Fed’s creation or destruction of reserves has no effect.  This is all wrong, and if you think about how the people in your story are assumed to behave — as opposed to getting bogged down in abstract algebra — it should be obvious that it’s all wrong.”

Yes, I will argue here that banks either individually or in the aggregate are not limited by their deposits and the monetary base doesn’t constrain bank lending, but my argument as well as that of the endogenous money crowd in general (MMT, horizontalists, circuitistes, etc.) has nothing to do with whether or not banks “hold hardly any reserves.”

He continues: “First of all, 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; like employees of any financial intermediary, they must buy assets with funds they have on hand. I hope this isn’t controversial, although given what usually happens when we discuss banks, I assume that even this proposition will spur outrage.”

In fact it is wrong, and in fact that is not controversial.  Let’s start with a basic bank and its customer and do T-accounts for both.  The bank creates a loan and a deposit “out of thin air,” and the customer has now a new liability (the loan) and an asset (the deposit) as shown in Figure 1. 

As is well known, and by the logic of double-entry accounting, the bank does make a loan out of thin air—no prior deposits or reserves necessary.  But this isn’t really the point Krugman wants to make, so let’s just move on.  Krugman continues:

“But the usual claim runs like this: sure, this is true of any individual bank, but the money banks lend just ends up being deposited in other banks, so there is no actual balance-sheet constraint on bank lending, and no reserve constraint worth mentioning either. That sounds more like it — but it’s also all wrong.”

Actually, that’s not the argument I would make whatsoever.  Neither would any person who understands endogenous money, horizontalism, the circuit, etc.  The number of banks involved has nothing to do at all with the argument.  Our argument is valid if we consider only 1 or 1 million banks.  So, again, let’s keep going.

Krugman:  “Yes, a loan normally gets deposited in another bank”

Actually, a loan doesn’t get deposited in another bank—a deposit gets deposited in another bank.  The loan is a bank’s asset, and a deposit is a bank’s liability.  Here we see the very beginnings of the importance of remaining clear on accounting if one wants to truly understand what “loans create deposits” means.  If we assume, as per Krugman’s example, that Customer 1 takes the proceeds of the loan and deposits them in, say, Bank B, then we have Figure 2 below:

This is a bit more complicated than Krugman made it sound, isn’t it?  Let’s walk through this slowly.

Customer 1 withdraws the deposit from Bank A, which is the “-Deposit” on Bank A’s liability/equity side, and the “-Deposit @ Bank A” on Customer 1’s asset side.  Customer 1 then makes a deposit in Bank B, which is the “+Deposit @ Bank B” on Customer 1’s asset side and the “+Deposit” on Bank B’s liability.

But how does the deposit get from Bank A to Bank B?  Let’s assume it’s done by electronic transfer here (that is, Customer 1 instructs Bank A to transfer the funds from the account at Bank A to the account at Bank B) since Krugman wants to discuss currency withdrawals below.  Note that as far as the banks are concerned, this is the equivalent to Customer 1 spending the proceeds of the loan and the recipient of the spending being another customer that banks at Bank B—that is, in either case the deposit simply moves from Bank A to Bank B.

Now, let’s also assume that Bank A had no reserve balances on hand when it made the loan.  How does it transfer reserve balances to Bank B?  As it turns out, the Fed provides an overdraft for any payment sent in which a bank’s account goes below zero—that is, the payment is never rejected when it occurs on the Fed’s books.  The Fed does this as part of its legal obligation to promote stability in the payments system (more on this in a minute).  The rub is that the Fed requires Bank A to clear this overdraft by the end of the day, which Bank A will most likely do in the money markets (such as the federal funds market, often via pre-established lines of credit).  So, on the liability/equity side for Bank A, we end with “+Borrowings” in the money market to clear the overdraft.

Note underneath Bank A’s balance sheet I’ve shown the totals or net changes to its balance sheet overall, which is simply a loan created offset by borrowings in the money markets on the liability/equity side.  So, the loan was made without Bank A ever needing to meet reserve requirements, without needing reserve balances before making the loan, and without needing any deposits.  Can Bank A just continue to make loans forever this way without ever needing any of these?  The key here is to understand the business model of banking—which is to earn more on assets than is paid on liabilities, and to hold as little capital (equity) as possible (since that’s generally more expensive than assets).  The most profitable way to do this is to make loans (that are paid back, obviously, so credit analysis is an important part of this) that are offset by deposits, since deposits are the cheapest liability; borrowings in money markets would be more expensive, generally.  So, Bank A, if it is not able to acquire deposits is not operationally constrained in making the loan, but it will find that this loan is less profitable than if it could acquire deposits to replace the borrowings.

If Bank A wants a more profitable loan but is not able to acquire deposits, it can raise the rate charged to Customer 1 and thereby preserve its spread, which can result in Customer 1 taking his/her business elsewhere.  But it can still make the loan.  In other words, it is not deposits or reserve balances that constrain lending, but rather a bank’s own choice to lend given the perceived profitability of a loan—which can be affected by the ability to obtain deposits after the loan is made—and also given a perceived creditworthy borrower (someone has to want to borrow, after all, if a loan is going to be made) and sufficient capital (since regulators will want the bank to hold equity against the loan).

A digression is in order here on the central bank and the payments system.  According to the Fed’s data in 2011 payments settled using Fedwire (the Fed’s main settlement system) averaged $2.6 trillion per business day, or about 17% of annual GDP each day.  A significant percentage of these payments themselves settled a still larger dollar volume of transactions on private netting payments systems.  And the US is not unique in this regard, as I explained here (see Table 1), in other countries payments settled on the central bank’s books each business day routinely average between a low of about 10% and a high of over 30% of annual nominal GDP.  As the monopoly supplier of reserve balances (since the aggregate quantity can only change via changes to its balance sheet), it is the central bank’s obligation to ensure the stability of the national payments system.  All central bank’s therefore provide reserve balances to their banking systems on demand at a price of the central bank’s central bank’s choosing.

Note that it cannot be any other way.  If the central bank attempted to constrain directly the quantity of reserve balances, this would cause banks to bid up interbank market rates above the central bank’s target until the central bank intervened.  That is, central banks accommodate banks’ demand for reserve balances at the given target rate because that’s what it means to set an interest rate target.  More fundamentally, given the obligation to the payments system, it can do no other but set an interest rate target, at least in terms of a direct operating target.

What does this mean for our present context?  It means simply that there is no quantity constraint on the quantity of reserve balances the central bank will supply, and thus there is no reserve constraint on a bank or on the banking system’s ability to create loans.  Central banks stand ready to provide reserve balances at some price always.  They can adjust this price up or down if they are concerned about the expansion of credit or monetary aggregates, and this increase in price can be passed onto borrowers who may then not want to borrow.  But this means that the manner in which a central bank can exert control over credit expansion is indirectly through its interest rate target, not through direct control over the quantity of reserve balances.

Returning to Krugman, he then writes:

 “— but the recipient of the loan can and sometimes does quickly withdraw the funds, not as a check, but in currency.”

Actually, withdrawing funds—spending them, in other words—via check or electronic transfer is far and away more common than withdrawing via currency.  When I took out a mortgage to buy a house, I didn’t withdraw the funds in cash (duh!), and neither does anyone else.  When I buy a plane ticket with my credit card (which is a loan, by the way, that creates a deposit—do you think Citibank has to look to see if it has sufficient reserve balances before approving your loan to buy those clothes at Nordstrom?), the funds are disbursed via reserve balances, not currency.  Again, these absolutely dwarf any currency withdrawals of funds created by a loan—it’s not even close.

And currency is in limited supply — with the limit set by Fed decisions.

This statement is simply mindboggling.  It’s so wrong I don’t know where to begin.  The Fed NEVER limits the supply of currency.  Never.  Ever.  To do otherwise would be to violate its mandate in the Federal Reserve Act to provide for an elastic currency and maintain stability of the payments system.

To play along, withdrawing the funds created by the loan as currency would look like this:

Here, instead of the transfer to Bank B, Customer 1 withdraws in the form of currency, which depletes Bank A’s vault cash.  Let’s assume that this leaves Bank A holding less vault cash than it desires to hold.  In that case, Bank A purchases more vault cash from the Fed.  If we further assume that Bank A did not have the reserve balances to settle this transaction with the Fed, as in the previous example, it receives an overdraft from the Fed that it clears in the money markets.  The net change to Bank A’s balance sheet is then the same as in Figure 2—a loan offset by borrowings.  Again, no prior reserve balances required, whereas the Fed also supplied currency to replenish vault cash on demand.  (Yes, a bank does need to have sufficient vault cash on hand to meet the withdrawal in the first place, but it is common for them to place restrictions on withdrawals to avoid running out—such as when your ATM only allows you to withdraw $200/day.)  As in Figure 2, the bank’s decision to make this loan would be based on the profitability of the loan, not any quantity constraints related to the monetary base.

And the same goes for the aggregate—there is no constraint on banks’ abilities to obtain currency from the Fed.  For instance, consider what a director of the Fed’s payments system operations said about currency in Congressional Testimony in 2006:

One of our key responsibilities is to ensure that enough currency and coin is available to meet the public’s needs. In that role, the twelve regional Federal Reserve Banks provide wholesale currency and coin services to more than 9,500 of the nearly 18,000 banks, savings and loans, and credit unions in the United States. The depository institutions that choose not to receive cash services directly from the Reserve Banks obtain them through correspondent banks. The depository institutions, in turn, provide cash services to the general public.  Each year, the Federal Reserve Board determines the need for new currency, which it purchases from the Department of the Treasury’s Bureau of Engraving and Printing (BEP) at approximately the cost of production.

Note that she did not say anything about limiting the supply, or the Fed setting the supply.  Two times she specifically said—as I emphasized via italics—that currency in circulation is based on the public’s needs, not any target set by the Fed.  Consider also what the New York Fed says about how the quantity of currency in circulation is determined:

Depository institutions buy currency from Federal Reserve Banks when they need it to meet customer demand, and they deposit cash at the Fed when they have more than they need to meet customer demand.

As with reserve balances, the Fed could attempt to target the quantity of currency in circulation indirectly—that is, changes in the federal funds rate target might be able to influence how much currency the public wants to hold.  But (a) there is strong evidence that currency demand is almost completely unrelated to the Fed’s target rate, and (b) this would mean that it was the fed funds rate target constraining bank lending, not currency or any sort of quantity constraint.

(As an aside, not also the the New York Fed made clear that because the quantity of currency in circulation is based on the public’s demand, the Fed also does not have the ability to oversupply currency.  In that case, banks just sell the currency back to the Fed in exchange for reserve balances—which as above don’t enable more/less lending than otherwise.  Similarly, if the public were somehow holding more currency than it desired, it could simply deposit these in a bank as a deposit, savings account, CD, money market fund, etc—which banks would then return to the Fed.  In other words, because there are (in fact, numerous) opportunities to convert currency into highly liquid (in some cases just as liquid as currency) stores of value that also take the currency out of circulation, there is no such thing as a “hot potato effect” for currency (or deposits either, since they too can be converted into savings, money market funds, CDs, etc.)  The Fed can’t supply any more or any less currency than the public wants to hold.  Helicopter drops are fiscal operations, not monetary operations.)

Krugman summarizes: “So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

As above, the quantity of reserve balances the bank is holding has nothing to do with it.  Krugman is correct that there is no automatic process that will enable a bank or the banking system overall to keep deposits equal to the amounts of their loans created, but as I’ve explained that represents a potential reduction in the profitability of the loan, not a quantity constraint on a bank’s or the banking system’s abilities to create loans out of thin air.  The only relevant quantity constraint on creating a loan is capital—assuming capital requirements are strictly enforced—not reserve balances, not reserve requirements, not deposits, not the monetary base, etc.  The latter can only affect the loan decision by influencing the profitability of the loan—a price effect of monetary policy, at best—and similarly the borrower’s decision can be affected by the fed funds rate set by the Fed (and the rate the bank charges as a markup over this), which is another price effect.  The reason for this is that a central bank defends the payments system every day, every hour, every minute, at some price.  This is the essence or fundamental truth of central banking, and anyone who fails to grasp it doesn’t understand central bank operations.

So how much currency does the public choose to hold, as opposed to stashing funds in bank deposits? Well, that’s an economic decision, which responds to things like income, prices, interest rates, etc.. In other words, we’re firmly back in the domain of ordinary economics, in which decisions get made at the margin and all that. Banks are important, but they don’t take us into an alternative economic universe.

Strange that he would say “stashing funds in deposits” since deposits settle a greater dollar volume of spending than currency does.  At any rate, Krugman wants to argue that banks aren’t important since they can’t “do” anything more than occurs in a model without banks.  Again, that’s not even close to true.  As above, banks create loans without regard to the quantity of reserve balances they are holding; they obtain any reserve balances needed at the federal funds rate or roughly equal to it.  Their ability to replace withdrawals with other deposits merely affects the profitability of lending, not the ability to do so.  Consider, for instance Canada, which has no reserve requirements and where the central bank is so good at forecasting banks’ demand for reserve balances (due to how the interbank market functions there) that banks actually desire to hold no reserve balances overnight—reserve balances only exist on an intraday basis.  What if the Canadian public decided also to stop using currency?  (There was in fact a good deal of research on this possibility related to the so-called e-money revolution back in the late 1990s and early 2000s.)  This would mean the monetary base was zero.  Would this stop banks from lending?  No.  Now, add reserve requirements to this—which we’ve already shown above do not constrain banks—and a desire to hold currency by the public—which we’ve explained is met on demand by the central bank.  Nothing’s changed.  The size of the monetary base is a result or an outcome, not a cause.

Instead, Krugman argues that these at least in the aggregate do constrain banks’ abilities to lend, as in the traditional money multiplier model or the loanable funds view.  But in fact a world with banks is quite different if the size of the monetary base doesn’t matter, ever.  On the way up, this is particularly so in a world in which the largest banks can exist on ever smaller margins between their lending rates and rates paid on liabilities (given scale and also increasing revenues from non-interest sources), while also providing the revolving fund of financing for institutions investing in the money markets.  As such, banks can provide the financing for an asset price bubble while the monetary base responds in kind, rather than vice versa; on the way down, as the desire for bank credit relative to income slows, increasing reserve balances or currency don’t necessitate spending.  And those paying back debt simply destroy bank deposits (since the repayment results in a debit to the payor’s deposits and a debit to the bank’s loan); there is no transfer from those repaying debt to lenders (and it wouldn’t work that way anyway—debt repayment is out of income for the debtor, but the transfer is a portfolio shift for the owner of the debt, not income aside from the interest payment).

Concluding his post, Krugman writes, “Now, under current conditions — that is, in a liquidity trap — the monetary base is indeed irrelevant at the margin, because people are indifferent between zero interest public liabilities of all kinds. That’s why there are no immediate policy differences between some of the monetary heterodoxies and what IS-LMists like me are saying. But that’s not the way things normally are.”

Krugman wants to reiterate that the size of the monetary base matters, unless we are in a so-called liquidity trap, as he thinks we are in now.  His own definition of the liquidity trap is when reserve balances earn the same as t-bills, as they generally do now (within a few basis points).  Under those conditions he wants to argue that the monetary base can be as large as the Fed wants it to be and it won’t be inflationary and it won’t encourage more lending.  What he fails to understand is that it is only when the Fed sets its target rate equal to the rate paid on reserve balances (which will mean t-bills earn roughly the same as reserve balances—Krugman’s liquidity trap) that the Fed can actually target the quantity of reserve balances and by extension the monetary base.  And even then, it must be sure to provide at least as many reserve balances as banks desire at the target rate to achieve its target rate in the first place.  The key point here is that “under normal circumstances” the monetary base’s size would be determined endogenously based on the public’s demand for currency and banks’ demand for reserve balances at the Fed’s target rate; the Fed or any other central bank can only control the size of the monetary base directly by creating “liquidity trap” conditions that set interest on reserve balances equal to interest on t-bills.

In short (!), the money multiplier model is wrong because it has the causation backwards—banks create loans based on the demand by borrowers, perceived profitability, and capital they are holding.  The quantity of currency held or in circulation and quantity of reserve balances held or in circulation at the time of the decision to create the loan have nothing to do with it.  If there are reserve requirements, then the quantity of reserve balances may increase as lending may increase reserve requirements and the central bank will have to raise the quantity of reserve balances circulating to achieve its target.  Similarly, if credit creation raises the public’s demand for currency, then the central bank will have to increase currency in circulation, as well.  It also means that the loanable funds model is wrong.  Banks are not constrained by deposits whatsoever, but the quantity of deposits they can raise after making a loan to replace a withdrawal will affect the profitability of the loan.  Again, the constraint is a price constraint, not a quantity constraint.

And, for Krugman and others like him that want to defend the money multiplier, loanable funds, or any other perspective that suggests banks individually or in the aggregate are constrained by currency, deposits, or reserves in lending, well . . . . here’s your (flashing neon) sign.

223 responses to “Krugman’s Flashing Neon Sign

  1. WOW!!!! Another grand slam from Fullwiler! Someone get this in Krugman’s hands!

  2. Excellent article. I think Krugman will read this. He must know about this website by now.

    “Sonny Corleone had strength, he had courage…. Yet he did not have his father’s humility but instead a quick, hot temper that led him into errors of judgment.” – Mario Puzo, The Godfather

  3. Scott, this may be your most important analysis yet. The fact that I’ve never read anything else you’ve ever written is irrelevant to my conclusion.

    For me though, this clears up some confusion. Not on how banks actually operate but how Krugman thinks they operate. Never understood what he was talking about. Working in the banking industry will do that to you. Perhaps Krugman should try it out sometime since this is all verifiable fact.

  4. Great Stuff!! Another arrow in the quiver… 😉

  5. Scott

    1. To set an interest rate target and to try to control the reserve balances at the same time is obviously impossible. But all of your logic is used to demonstrate the case of monetary tightening – in which case the central bank should indeed be willing to tolerate high and volatile fed funds rate if they were targeting reserve balances. Witness here :

    I know you might say they were following ‘dirty interest rate targeting’ but that seems to be the case beginning ’82, not from ’79 to ’82.

    2. This logic holds symmetrically for monetary expansion only if you presuppose that the ‘demand for reserves’ is infinitely elastic at a given interest rate – which is identical to saying that bank credit creation is perfectly exogenous to central bank action at a certain interest rate. That is, you are presupposing your result. I understand that the excess reserves held today give credence to your claim, but they don’t prove it. If today, the Fed were to reverse some part of QE and the excess reserves were to come down by the same amount without changing credit, your argument would be proved. If credit and reserves would both come down, it would be some evidence of a banking multiplier (albeit one that is not constant, of course).

    3. To set an interest rate on reserves equal to the target rate is not the liquidity trap. The liquidity trap – whether it is a relevant analytical tool or not – means that both of these rates are very close to the zero interest rate on currency. The money/bonds definition of liquidity trap only holds if all money is axiomatically assumed to be non interest bearing. Interest rate on reserves equal to the target rate simply means that the convenience yield of excess reserves is 0. This is called, ironically, the Friedman rule. See Kashyap & Stein,, 2012. (Page 3 of 17)

    4. None of 1 to 3 above is necessarily a defence of Krugman.

    • Dan Kervick

      The point is that Fed’s impact is via price, not quantity. The MMT prediction as I understand it is that if the Fed drains excess reserves but maintains the same overnight rate, there should be no change in in lending activity.

      • Yes, exactly. Maintaining the same IoR and draining excess reserves is precisely reverse-QE. If the quasi-monetarist viewpoint is ‘correct’, such an action should reduce lending (by an unknown, but not insubstantial). If the post-Keynesian/MMT viewpoint is ‘correct’, it should not reduce lending.

        • Dan Kervick

          OK, but saying the impact is by an unknown amount is very different from the usual money multiplier account and does little to support the incredible faith in monetary policy tools the market monetarists possess. It also seems a little crazy to me as a tool for macroeconomic stabilization, when obviously more effective fiscal alternatives are available. Why focus on pumping the banking system full of reserves to lower an already very low target rate even lower, in the hopes that this will squeeze some additional trickle of lending out of the banks, when one could use those keyboard strokes to send and spend money in the real economy and boost demand and the flow of lending.

          The problem is a world of real economy participants without enough income to turn desires into effective demand; it’s not banks with inadequate resources to make loans.

          • “when one could use those keyboard strokes to send and spend money in the real economy and boost demand and the flow of lending”

            Yes, a helicopter drop would also be my preferred policy. You can call it fiscal/ monetary/ whatever – I wouldn’t bother much with that.

            That, and/or negative IoR.

            Both have benefits over and above the reduction of real interest rates. Perhaps neither is politically feasible given the institutional and practical constraints of the American political process – which I admittedly don’t know much about. Hence the debate reduces to nominal rates vs government purchases, liquidity traps, etc. circa the 60s.

            Only QE is new. QE is firmly rooted in a vision of central banking – ‘the lending channel’ – that has come to dominate the ‘include credit into monetary policy’ literature of the mainstream. Witness Kashyap, Stein, Bernanke, Gertler. Trouble is, deposit-taking institutions aren’t necessarily important anymore. Those that are might be capital constrained as well, which reduces the effectiveness of the lending channel in the work of all the dudes mentioned above.

            Regardless of any of this, if what I read online is accurate, the US government should still be investing billions in infrastructure. And not just because it increases G.

  6. Robert Searle

    What is far more important than any of the above “chit-chat” is the evolution of a financial system akin to Transfinancial Economics

  7. Pingback: The theory and reality of modern money and banking (chart) « Real-World Economics Review Blog

  8. Merijn Knibbe

    The VLTRO operations of the ECB can be understood as resulting from the need (!) to increase reserves of Euro-banks. See this graph by Erwan Mahe:

  9. “Banks are not constrained by deposits whatsoever, but the quantity of deposits they can raise after making a loan to replace a withdrawal will affect the profitability of the loan.”

    Scott, I understand the whole article but I have some problems with the use of the term “deposit”. In a “loans create deposits” framework, at the beginning ot the process there is an identity Loans = Deposits, a simple bookkeeping entry (this is the typical circuitist argument, no?), but what do you mean when you say “but the quantity of deposits they can raise after making a loan”? Deposit in what sense?


    • Julius: for this you have to look at a two-bank model.

      If there’s only one bank in the universe, then loans create deposits, and those deposits can’t go anywhere; if someone writes a check and gives it to someone else, that other person has to deposit it back in the same bank. With two banks, the two banks are fighting over *who has* the deposits, and the one with more deposits is more profitable.

      (Currency has a small impact on this, but not much. If you assume that the single bank in the universe is ALSO the currency issuer, it has no impact at all. If not, you can treat currency holdings as matching up with deposits at the Central Bank, and this is basically right — why do you think they’re “Federal Reserve Notes”?)

      • Nathaniel,
        In the Flow of Funds Accounts (FOFA) statistics, prior to year end 2007, each year the Fed held Treasuries B in its System Open Market Account B[SOMA] equal to the currency in circulation CC. So if the annual currency drain is cc/year, which would deplete reserves and deposits from banks, the Fed would buy Treasuries from nonbanks to reverse the accounting entries and “service the currency drain” b[SOMA] = cc each year such that the sum of changes results in B[SOMA] = CC and bank balance sheets are isolated from the currency drain.

        I am not sure it is true that a bank with more deposits is more profitable since wholesale borrowings may be used to expand loans in a profitable manner at least for the short term, while in the long term I would look for a decrease in securities/loans ratio in the aggregate bank balance sheet and an increase in the borrowings/deposit ratio as a sign of increasing financial fragility during, say, and asset price bubble caused by bank interaction with other banks and nonbanks. In other words when banks increase loans and rely more aggressively on rolling over short term liabilities in the interbank money markets, the banking system is more prone to cause a bubble and to consume the liquidity in short term bank liabilities which will become sufficiently illiquid to end the expansion of bank assets and trigger asset price deflation in a bank liquidity crisis.

  10. This is the ideal place to build a computer model to simulate the system so described. Time delays have a real impact here as does the activity the physical activity the loan was made for. Since loans are meant to be paid back and the borrower has to eat the borrower must make more money to pay back the loan, an important macro effect that balances except if the food comes from an entirely different banking system say as an import. This results as a sort of system leak.

  11. Scott, this comes from Nick, if you have the time or interest to answer:

    “Scott fullwiler definitely more clear. One question for Scott; what happens when the 6 weeks are up, and the interest rate becomes an endogenous variable?”

    • Dan Kervick

      It seems to me that if bank lending is somehow inhibited by bank uncertainty about the overnight rate that the Fed will following their next major policy decision, that only underscore the MMT claim that the issue for the banks is price, not quantity.

      • Louis-Philippe Rochon

        Banks are never constrained by central bank actions. They are only constrained by thier own pessimism, 1) regarding the creditworthiness of potential bank borrowers, or by 2) the uncertainty regarding expectations of future level of effective demand (the creditworthiness of the economy, so to speak).

        • I think they also care about the spread between the cost of reserves and the commercial lending rate.

    • bravura performance over on worthwhile, wh10 🙂

    • If the commercial banks think the interest rates to borrow from the Central Bank are rising, they see lending as less profitable. So they lend less. (Because fewer loans appear “profitable”.) So the money supply contracts.

      If they think the interest rates to borrow from the Central Bank are dropping, they see lending as more profitable. So they *MAY* lend more. And then the money supply will increase.

      But there are many other things which affect banks’ view of whether lending is profitable, including perceptions of creditworthiness, ability to charge confiscatory fees and interest rates (usually due to monopolistic and oligopolistic practices) and various regulatory matters. In particular, a bank which is engaging in accounting frauds to conceal insolvency from the regulators will not expand general lending — because the bank wants to use any money it gets to get itself out of its insolvent position and allow it to stop the accounting frauds.

      If you assume that those other factors move slower than the Fed, you can construct an LM curve with interest rate as the INDEPDENDENT variable and the other numbers as DEPENDENT variables. Bizarrely, this is NOT the standard LM model, which is why the standard LM model is wrong.

      If the Fed is offering a substantially higher rate on reserves than the discount window rate, banks will rarely lend any money at all to anyone else (borrowing money from the Fed and dropping it in reserves sounds perfect if it’s profitable). Similarly if T-bills pay substantially more than the discount window rate….

      This is all pretty simple, isn’t it?

  12. Louis-Philippe Rochon

    To Scott and Nick,

    I thought I would my hat into this ring. First, good pieces by both of you. I think this goes a long way in clarifying some ambiguities. To answer Nick’s question, in 6 weeks 3 things can happen: 1) the rate can increase, 2) it can decrease or 3) it can stay the same. This is entirely at the discretion of the central bank. There are no market forces acting on the rate. Currently the CB follows an inflation target. Assuming some inflation pressure, the CB would raise the rate. But this is not the result of market forces: it is an exogenous or administered decision by the CB. In this case it would raise the rate to, say, 2%. Markets would adjust and the market rate would move to 2%. Markets know that the CB can enforce this rate ay any time, so they will comply.
    Now, the proof, so to speak, that the rate is full under the control of the central bank is that assume for a moment that the CB had an unemployment target, in which case, the rate would need to fall further, and the CB would lower the rate to, say, 1%. Or the CB may decide to leave the rate where it is.
    In the first scenario, the horizontal supply curve would move upward at a higher rate: a vertical shift of the horizontal curve. In the second scenario, the curve drifts downward io the new lower rate, whereas it would stay where it is if the CB did not change the rate.

    I hope this helps. Thank you to both.

    • Scott Fullwiler

      Thanks, LP! Yes, agree completely. The overnight rate is never endogenous since the CB is the monopoly supplier of reserve balances.

    • To preempt, because I believe I have been down a similar road with Nick Rowe before, my sense is that he is saying the interest rate becomes endogenous because the CB will need to react to endogenous market forces in a very specific way to maintain price stability / full employment / or whatever the CB’s goal are etc. In other words, it will be ‘forced’ to alter the interest rate to specific levels to achieve those goals. In my mind, though, even if we assume Nick is right about the influence and necessary path of the CB’s policy, the interest rate is still exogenous because the CB can still adjust it to wherever it likes, regardless of the impact on the economy. But now we’ve entered into a debate about the influence of CB policy and what constitutes good CB policy and have exited a discussion about the ‘exogeneity’ of the interest rate on reserves.

      Would you agree?

      • Scott Fullwiler

        Yes. There’s nothing that I’ve said anywhere that precludes the CB from running a Taylor’s Rule-type strategy. This is about tactics, not strategy. Tactically, the interest rate is the control variable, not reserve balances, etc. Strategically, the CB sets the target where it wants, responding to events as in a Taylor’s Rule if it chooses. Nick would say it has no choice but to do that–I would just say nothing I’ve said says it can’t do that.

      • My only beef with this is that, despite the fact that the US Congress in its infinite wisdom has assigned to the Fed the “mandate” to achieve full employment, there is no evidence that the Fed actually has any effective control over aggregate demand and employment. That’s why it’s so important to refute these Krugman errors. We need to get people to stop looking to the Fed to do a demand support job that can only be accomplished effectively by fiscal policy. There is no quantitative fix for inadequate aggregate demand and unemployment.

        Right now we have an administration that doesn’t want to get into the business of renewing the call for fiscal activism, because the political environment makes it much easier for them to focus on long-term debt reduction and fiscal restraint. Krugman (along with Delong and Romer and Yglesias) is effectively running interference for them by siding with monetarists in holding out the potential of central bank policy as the key to the solution.

        But it can’t work. I understand the political constraints and environment as well as anybody else. But if we want the government to do something serious about unemployment and stagnation, it has to come from fiscal policy. So we need Krugman and Delong and Romer and Yglesias and others to stop filling people’s minds with monetary policy pipe dreams and start pouring their considerable prestige and abilities into a renewed fiscalism.

        • Well, personally I’ve come to see that there is massive evidence for the theory that the unemployment rate is driven over the 10-to-50-year period by *distributional* issues; basically, if there’s a large middle class and a fairly well-to-do lower middle-class, there is enough aggregate demand to keep labor occupied; if all the money is in the hands of the rich, there isn’t, unless the government steps in with direct employment, something like the Civilian Conservation Corps.

          Central bank policy is incapable of fixing these distributional problems; simply incapable. It does not have the power to selectively remove money from the rich or creditors, and give it to the poor or debtors.

          Fiscal policy is capable of fixing these problems, but does not necessarily do so; it is a matter of *where the money is spent*.

          This means that over the long run, only progressive tax policy can prevent recessions.

  13. Scott Fullwiler

    Thanks for comments thus far.

    Ritwik–I will reply later. No time now, but wanted to know I wasn’t ignoring you.


  14. Louis-Philippe Rochon

    Yes I think you are correct. Markets force CB to change rates. This is why I was never a fan of reaction functions, preferring what I called with Mark Setterfield, parking-it rules of interest. But the problem I have with these reaction functions is that the rate could go up, down and stay there depending on the function you have. So what are markets ‘forcing’ CBs to do exactly? It is wholly subjective.

    • Thank you for the reply. Are you saying you would like the CB to avoid reacting to the market and just ‘park’ the rate? The thing is, in Nick Rowe’s mind and probably Krugman’s, they think if you don’t respond to the market appropriately, things will spiral out of control. So they struggle with your position. I guess this is a broader issue about their macro theories and Post-Keynesians’?

  15. Pingback: Things I Should Not Be Wasting Time On -

    • It’s funny how Krugman appeals to the weak exogeneity of the Fed Funds rate … something critiques had been doing in early 90s.

    • Dan Kervick

      Krugman is effectively conceding all the points that he was manifestly wrong about, while pretending that it’s his critics who were wrong and are wasting his time.

      The money multiplier is dead.

      • “Krugman is effectively conceding all the points that he was manifestly wrong about, while pretending that it’s his critics who were wrong and are wasting his time.”

        Yes, that was embarassing, wasn’t it?

        “The money multiplier is dead.”
        Only until currency revulsion and distrust strikes worldwide and we all go back to demanding “hard money” based on piles of gold (or whatever). The money multiplier is an artifact of a gold-standard system where banks were deeply distrusted by the population; we may return to such days in the future.

        It’s like DeLong having separate chapters on Depression Economics and Growth Economics. There are separate theories of Modern Money economics, and of Gold Standard economics when nobody trusts most issuers of currency. The transition between the two states is dramatic.

        • I believe MMTers do have theories regarding what causes the collapse of currency systems and the creation of “Distrust” economies where people demand “cold hard cash”.

  16. “The first element is made up of the “autonomous factors” (the sum of “banknotes in circulation” plus “government deposits” minus “net foreign assets” plus “other factors (net)”, which is the net effect of the remaining balance sheet items affecting money market liquidity). These factors influence the liquidity of the banking system and are labelled “autonomous” in central bank jargon because they are not normally the result of the use of monetary policy instruments. Some of the autonomous factors are not under the control of the monetary authorities (“banknotes in circulation” and “government deposits”).”

    The idea that there is a limited supply of currency is wrong also in the european case. Why Krugman doesn’t read official documents?

  17. Scott,
    I am also confused what it means that “but the quantity of deposits they can raise after making a loan” – but where would those additional deposits come from? From someone depositing cash into the banking system? The amount of deposits can only grow after another loan is made, which would also require a new deposit later… Seems like ad ifinitum.

    • I’m suppose to be cramming for an exam, but I can’t resist answering for Scott.

      I think the confusion likes in the difference between an individual bank’s balance sheet, and the banking system as a whole. When bank A makes a loan to a credit worthy customers, deposits are created out of thin air, BUT there’s no reason why the customer should hold those deposits in bank A. They may prefer to hold them in Bank B, C, …Z.

      So, individual banks within the financial system have to vie for deposits, but the deposits in the system as a whole are not injected from without. Does that make sense?

      • Mitch,
        Thank you for the response, but no, it doesn’t make sense to me. Let’s say we are talking about the banking system as a whole (or that there is just one bank). Banks loan 1000, make deposits of 1000. Do they need to attract even more deposits? Where would they come from?

        Or, maybe it works like this: Say there are 2 banks. Bank A makes a loan, loses the deposit and reserves to bank B, but attracts another deposit to replace reserves, also from bank B, which can spare a deposit now, since it attracted the one coming from the loan the bank A made? So the banking system as a whole shifts the deposits from banks who have more deposits than loans to those that made loans and lost the deposits in transfers?

        • Scott Fullwiler

          Banks don’t “need” to attract more deposits. They would like to because that enhances the profitability of the loan. In your example, without knowing more I can’t say if they need more–but the point is the direction of causation. The deposits don’t constrain the loan, but the expectation of the ability to attract deposits can cause a bank to raise the rate it charges. In the aggregate, if banks view borrowers as creditworthy, loans will be made, period.

          “Where do they come from?” Deposits are created by previous bank loans, government spending, exports. But they can also “come from” a conversion of, say, a CD to a deposits, or a savings account to a deposit.

          • Scott Fullwiler

            should have said “if banks view borrowers as creditworthy AT A LENDING RATE THAT IS PROFITABLE, loans will be made.” It’s about the price of credit, not how many deposits there are.

        • OhMy, if there is just one bank, it does NOT need to attract deposits. There is no “outside”. (This is also largely true of central banks. Notice that the Federal Reserve Bank, a central bank, doesn’t give a damn whether it has any deposits.)

          If there are TWO banks, they fight each other for deposits because the one with more deposits is more profitable.

          Does that make sense? Banks with “more deposits” than average make money at the expense of banks with “less deposits” than average. The interbank lending market and the Federal Reserve make of the difference; the bank with “less deposits” borrows from the bank with “more deposits”.

          • Ohhh, I get it. The reason people are confused is that they don’t know about the interbank lending market!

            A bank which is “short on deposits” just borrows from a bank which has “excess deposits”. It’s called the “interbank lending market”. The only effect of this is that the bank which is short on deposits *pays interest* to the bank with excess deposits.

            If there is a shortage over the whole system, they borrow from the Fed, which promises to print whatever money is needed to do so. The Fed does not have to borrow the money; it declares that it exists.

    • The mystery of missing deposits with the loan/deposit ratio different from 1, is easily resolved with recourse to (1) the basic accounting identity; (2) simplified balance sheet for a bank; and (3) sum of balance sheets for aggregate BANKS. Here is the simplified balance sheet:

      Required Reserves (RR)
      Excess Reserves (ER)
      Securities (S)
      Loans (L)

      Liabilities and Net Worth:
      transaction accounts (TA) = lowest cost deposits
      savings accounts (SA) = high cost deposits
      time deposits (TD) = higher? cost deposits
      borrowing from Nonbank corporations (BRP) = Repo liabilities
      borrowing from domestic banks (BFB) = Fed funds
      borrowing from Eurodollar banks (BED) = eurodollar funds
      borrowing from Federal Reserve (BFF) = discount window
      Net worth

      Although it is true that new loans create new transaction accounts, so do new purchases of securities from Nonbanks, when BANKS in aggregate create new transaction accounts by expanding securities plus loans, in the process of liquidity management to free up excess reserves, BANKS redistribute the TA liabilities into a mix of the ones shown above in the simplified balance sheet shown above for purposes of illustration. Steve Keen follows Minsky who says strains in the interbank borrowing or liabilitity constraints on BANK asset expansion occur in the money markets (borrowings) which is consistent with the crisis where spreads on Repo borrowings and Eurodollar borrowings caused counter-parties to lose the ability to roll over positions in short term interbank markets, this would cause a rise in deposits which have nowhere else to go in the aggregate BANK balance sheet mix, assuming no converstion to currency, since there is no external source of BANK liabilities in the aggregate balance sheet.

  18. It’s great to have one of the founding assumptions of mainstream economics being debunked by Scott and Steve.

    But there is a fair way to go yet, I think.

    Firstly, while the interest rate selected by the Central Bank is arbitrary, that charged by private banks to their counter-party term (dated) borrowers is not. The cost of private bank credit consists of the cost of the interest paid on term deposits; operating costs; and the cost of defaults.

    So – irrespective of the arbitrary rate the Central Bank is using – private banks cannot (over time) reduce lending rates below the level necessary to cover these costs and make a return to shareholders at a level (and that greedy level is much higher now than was the case (say) 30 years ago).

    Note here that in addition to creating the virtual promissory notes (central bank look-alike ‘virtual cash’) which are then the object of interest-bearing loans, private banks also create and credit virtual cash – as demand deposits – to the accounts of suppliers, staff, management, asset sellers and shareholders (as dividends).

    ie private banks spend AND lend money into circulation.

    The other point to make is that there is a vast amount of ‘shadow’ money/credit (not dissimilar to OTC derivatives compared to on-exchange) which is created, settled and cleared outside the banking system not in exchange for fiat currency, but essentially by reference to it as an accounting unit.

    The best example here is a credit creation and clearing system like the Swiss WIR or VISA, where there are no deposits, and obligations are settled and cleared by reference to fiat currency.

    These systems are the platypi of the financial system: merely by existing they demonstrate the inadequacy of existing assumptions and classifications.

    • “So – irrespective of the arbitrary rate the Central Bank is using – private banks cannot (over time) reduce lending rates below the level necessary to cover these costs and make a return to shareholders at a level…”

      Ah ah ah. Usually correct, but there’s one more important insight to make here. The banks COULD reduce rates below that level as long as they were truly unregulated (but still backstopped by the Fed). It is the *solvency regulations* — where if the bank has greater liabilities than assets it is shut down by the FDIC or the Fed — which causes the banks to have these restrictions. These are also called “capitalization rules”.

      Without the solvency regulations, a bank could simply borrow money from the Fed, and hand it to their executives and shareholders. What’s to stop them?

      There is some evidence that the Fed is allowing insolvent megabanks to continue operating indefinitely. However, because they expect to be shut down if they get too brazen about their insolvency, they still need to have high interest rates on loans and high profitability because they want to get out of insolvency before the regulators decide to actually enforce the solvency rules.

      The Federal Reserve, in contrast, is guaranteed that it will never be shut down for insolvency; it’s given a license to print government-backed money (quite literally). This privilege is also held by other central banks; the Bank of England, for a certain period during its history, was a commercial bank with central bank privileges, a deeply profitable situation to be in.

    • Thank you also for clarifying the distinct roles of money:
      – unit of account;
      – store of value;
      – medium of exchange;…

      …it is very common to use the same unit of account with a different medium of exchange, and these are often NOT stores of value. See VISA for reference.

  19. Louis-Philippe Rochon

    Banks don’t lend deposits. when a loan is made, the bank has both an asset (the loan) and a liability (the deposit). SO when a loan is made, a deposit is created. So if I borrow $5000 from the bank, the bank deposits it into my account (or creates a line of credit).

    • Banks don’t lend deposits.

      Exactly. Krugman seemed to be muddling assets and liabilities in an earlier post. If a walk-in customer brings in $1000 in cash to create a demand deposit, the cash that goes into the vault becomes the bank’s asset, while the $1000 credited to your account balance is the bank’s liability. However, I suppose in defense of Krugman we could just say that he was using a kind of sloppy common-sense, non-accounting concept of “deposit” where one would say that if some portion of the bank’s total reserves resulted from a customer depositing them, then we can call them “deposits”. That’s very unclear talk, though. We should stick to the established terminology where deposits are liabilities, not assets.

      The bank’s vault cash plus the reserve account balance at the central bank comprise the banks total reserves, which are an asset of the bank. And the point that Scott and other are making is that the bank’s lending is not constrained by its total existing reserves, neither at the level of individual banks nor for the system as a whole.

      Krugman seems to be using the old “fractional-reserve” textbook picture where the deposit liabilities of the banks and the system as a whole that have been created via loans must be limited to some maximum fraction of their total reserves. If that were the case, then since the Fed is the monopoly supplier of reserves, the quantity of reserves supplied to the system sets a bound of the quantity of deposits established via loans.

      But there is no such bound. The lending and deposit balances come first, and the reserves increase as a consequence. And the CB will always supply the reserves needed so that banks can make the payments that are transacted as a result of all those deposit balances.

  20. Pingback: Une analyse limpide

  21. Samuel Conner

    Is it fair to say that the reason that banks accept deposits in the first place is that they are a cheaper source of reserves (which they need to clear payments) than the alternatives? Prof Krugman seems to think that banks need to receive deposits before they can lend, as though there were limits on their ability to “access” horizontal money. But (it appears to me) banks’ interest in horizontal money from depositors is simply that accepting reserves (that accompany a deposit from another bank or that are purchased with currency returned to a reserve system bank) via deposits is the cheapest way to acquire them.

    I hope that you and your colleagues are able to pursue this conversation with Prof Krugman. If he were to become more open-minded toward MMT, it might be very helpful.

    • “Is it fair to say that the reason that banks accept deposits in the first place is that they are a cheaper source of reserves (which they need to clear payments) than the alternatives?”

      Yes. You could pretty much run a bank with no deposits. Lend money out, borrow from the Federal Reserve.

      If the *solvency regulations* are not enforced, it’s even simpler. Lend money out. Who says you have to have anything backing it? As long as you are capable of getting your accounting entries accepted within the check-clearing system, you can keep lending forever. Some TBTF banks seem to be in this position.

  22. Louis-Philippe Rochon

    Exactly. The CB can runa Taylor rule if it chooses to. It does not change anything. It could target growth or unemployment, and that would change nothing to the mechanics of monetary policy. Good post Scott.

  23. Pingback: More on why Minsky Matters | Credit Writedowns

  24. If deposits are only necessary to make loan profits go up, it stands to reason that those profits can go down, all the way to zero and below, in the absence of deposits. After all, if the rate banks borrow at to cover loans goes up, their loan rates have to go up as well. So people go elsewhere, to banks with deposits that can cover loans given out at a lower rate.

    Banks that don’t take deposits cannot lend money, because they would go out of business. Banking without deposits is an unstable strategy that simply will not emerge.

    • “If deposits are only necessary to make loan profits go up, it stands to reason that those profits can go down, all the way to zero and below, in the absence of deposits. ”

      This is correct provided the Federal Reserve or other central bank is lending money at an interest rate greater than zero.

      However, it is important to note that the requirement to have profits above zero is driven by the *solvency requirements*. If those are not enforced, banks can pretty much create money and hand it to their executives, and who’s to stop them?

      Yes, it’s an unstable strategy to have no deposits. And unstable strategies happen ALL THE TIME when you have short-term thinkers running the banks. We have short-term thinkers running the banks.

  25. Interesting food fight between the economists. One is right, the other wrong. I’m siding with Scott.

    Was PK wrong? A gap in knowledge? Or was he just talking his book?

  26. Fascinating.

    This kind of thing is why actual scientists have so little respect for economists. You’re an associate professor at a school no one knows and you talk about a Nobel winning professor at Princeton as though he’s a complete idiot. I first wrote the last sentence to say “talk about the work of a” but cut that back because you’re actually arguing about blog posts, not academic work.

    There are a dozen ways to say anything. You choose to write things like, “This statement is simply mindboggling. It’s so wrong I don’t know where to begin.” Really? You could have written a post saying you have problems with what he said and if he meant this then you disagree with him. You could have chosen any number of ways to do this but instead your first move and the one you put in print is, in essence, to say Krugman is an idiot.

    Again, this is why real scientists think so poorly of economists. Immaturity. Inability to listen and react with understanding. Picking fights in which you read a statement one way and assume that is what it must mean. Arguing over terminology. Pathetic.

    • You mean like mature physicists and mathematicians who write books called “Not Even Wrong”, and name a theorem the “Hairy Ball Theorem” so they can snicker about it in their boy’s club tree house?

    • First, the fact that PK is a Nobel prize winner is irrelevant in evaluating his views. They have ti be evaluated based on what they assert not on who Krugman is or what recognition he has received in the past.

      Second, Krugman blogged his views and Scott’s reply was also in the blog form. That form has different norms than professional journals have. the writing is more informal and the emotional content is stronger. That may be too bad, but that’s how you need to write if you want people to read your content.

      Third, Krugman is no more moderate in the tone of his writing than are his critics. In fact, in many of his posts he has been insulting, dismissive, discourteous, and intellectually dishonest in relation to those who disagree with him and their views. This piece makes that clear:

      Fourth, I won’t hold any briefs for economics as a real science, but will simply note instead that all of them, including Physics, involve exchanges where people can be insulting to one another when there are paradigm differences involved in their disputes or disagreements. You see it now in Physics in arguments over string theory, or the many worlds view of Quantum Theory. Disputes that become less than civil are common in science and they are not enough to mark a claimed science as “unscientific.”

      On the other hand, forms of reasoning and exchange that are closed-minded, involve ad hoc rationalizations of positions, cite empirical evidence selectively and practice theoretical justificationism in preference to attempted testing and refutations of ones own views and the views of others are “unscientific” whether practiced by a Nobel prize winner or not.

    • I can’t remember who said this, but when I first heard it I didn’t really understand it: “Economics is the art of rhetoric.” I understand a bit more now that there’s a reason for that statement– economics is an incredibly difficult field because it has to deal with human cognitive abilities, social interactions, culture, banking, political and elite power, etc, etc, etc. And appreciating that philosophers and “economists” have been struggling for the last several centuries to understand how in the hell all of this works. It’s always been a “work in progress” and understanding has come very gradually because the problems are so daunting. As any “science” has done in history advancements come in spurts, a revolution if you will, and we are currently at one of the inflection points for economics. Just look at the history of Physics, mathematics, engineering and materials science — they’re all still evolving. Economics seems to be lagging — but that’s only due to the complexities of the subject.

      I’m retired from a career in one of the applied sciences — engineering — and I have a lot of respect for economists who are trying to make sense of how our economies work. Structural-engineering understanding (modeling) has had a number of revolutions in the last century (fracture mechanics and dynamic instability just to name two areas) . Keep in mind that it was only about 60 years ago that the new large jet airplanes began to fall out of the sky — The Comet. These disasters prompted the beginning of a hard-earned, more fundamental understanding of structural behavior in a new environment — and it took an immense amount of engineering talent and effort to achieve this. It also took a lot of re-examining of the assumptions that held sway until those planes started to fall from the sky. Dynamic instabilities were the problem, and the old static structural analyses were found insufficient.

      Now that the financial system has “fallen from the sky” there is a new urgency to find solutions and thus assumptions about the old models are being questioned. Irving Fisher had the beginnings of a “modern” understanding of economics and the need to appreciate the “dynamic” nature of much of how the system operated. However, he didn’t have the tools at that time to do the complicated modeling of dynamic systems.

      That’s where, I think, the new breed of economists — Scott, Steve Keen and numerous others — are dragging the field of economics into the modern age (at least the next step in its evolution). I particularly am impressed with Steve Keen’s dedication to actually applying dynamic systems modeling (which come at least partially from engineering) in analyzing aspects of the financial economy. Of course, fundamental to all of this is understanding how the banking system REALLY works. That is the reason that this blog, and Scott’s discussion of comments are so valuable to those of us “scientists” who respect the work of these “radical”, revolutionary economists. Thanks to you all!

      And, jonathon, your use of the pejorative “pathetic” at the very end emphatically negated all of the godlike rhetoric that preceded it.

  27. Pingback: Krugman vs Minsky: Who Should You Bank On When It Comes to Banking? « Multiplier Effect

  28. Figure 2 is wrong (and the rest of the post I guess since I have not read it yet).
    Figure 2 should be following (the picture without reserves):

    Bank A:
    (1) A: Loan to Customer1 | L: Deposit to Customer1
    (2) A: Deposit to Customer1 | L: Transfer to Bank B

    (1) A: Deposit in Bank A | L: Loan from Bank A
    (2) A: Deposit in Bank B | L: Deposit in Bank A

    Bank B:
    (1) A: Transfer from Bank A | L: Deposit to Customer1

    • Not sure what the point of this is. The customer is described as withdrawing the deposit (in cash) from Bank A, and then depositing it in Bank B. In that case, there is no transfer. When the customer withdraws the cash from Bank A, Bank A’s total reserves are lessened, along with its deposit liabilities. When the cash is deposited at Bank B, Bank B’s total reserves are increased, along with its deposit liabilities.

      However, if you like, we can imagine that the customer makes the deposit in Bank B by writing a check on her Bank A account. In that case, when the check clears, the lessening of Bank A’s reserves and corresponding increase in Bank B’s reserves is accomplished via a transfer from A’s reserve account to B’s reserve account.

      They are just two different mechanisms for accomplishing the same thing with the same accounting result. In the first place the changes in total reserves are accomplished via the physical movement of vault case. In the second case, the result is produced by a debiting and crediting of reserve account balances at the central bank.

    • Scott Fullwiler

      It’s not wrong, I just wrote the transfer as a subtraction of deposits and reserves, since that’s what actually happens.

      • Yes, you are wrong. Bank B doesn’t need reserves. See below alternative Figure 2.

        • Scott Fullwiler

          Bank B receives reserves from the transfer.

          • Bank B doesn’t need reserves. It doesn’t make a Loan. Reserves are needed to support a Loan.

          • “Bank B doesn’t need reserves. It doesn’t make a Loan. Reserves are needed to support a Loan.”

            Bank B would never accept to take over bank A’s liabilities (“deposit” it now owes) if it wasn’t compensated by a transfer of reserves.

          • OhMy,

            Bank B didn’t take over Bank A’s Liabilities. It got transfer of money from Bank A and allocated it to Customer 1′s account.

        • Whether or not Bank B “needs” reserves, it gets additional reserves as a result of the transfer.

          What do you think the “transfer” amounts to? If the customer moves a deposit from Bank A to Bank B, Bank B isn’t just going to add a liability in the form of a deposit balance for the customer without getting paid by Bank A. The transfer from A to B takes place via the banks’ central bank reserve accounts.

          Bank B could simply create a new deposit balance for B without getting either a transfer from another bank or a walk-in cash deposited by the customer. That would be a loan to the customer. But that is not what happens when a customer moves a deposit from one bank to another.

          • I repeat specially for you:

            “Bank B doesn’t need reserves. It doesn’t make a Loan. Reserves are needed to support a Loan.”

          • Julius,

            We are talking about “conceptual banking” here. Reserves are supporting the probability of default by a borrower. Bank B doesn’t have a borrower. Bank B got “risk-free transfer of money” from Bank A.

          • Alex, bank B gets reserves during the transfer…
            …and then it LENDS the money to bank A in the interbank market, thus explaining what loan the reserves are “for”.

            Understanding the interbank market resolves most of these confusions.

          • Notice that the INTERBANK MARKET is the *only* situation where deposits create loans!!!

            In the Interbank Market, deposits actually do create loans….

          • (Mind you, the interbank market has relatively little macroeconomic effect. It is equivalent for most purposes to each of the banks running a deficit or surplus in its account at the central bank.)

      • OhMy,

        Bank B didn’t take over Bank A’s Liabilities. It got transfer of money from Bank A and allocated it to Customer 1’s account.

        • Dan Kervick

          A transfer is a transfer of reserves. That’s how the payment system works.

          • I have touched the concept of reserves in my reply to you below.

            Reserves are associated with the possible defaults on loans. Bank B has made no loans. Reserves is purely accounting concept.

          • Dan,

            Reserves on loans are conceptually identical to the reserves on accounts receivable (from an accounting point of view).

          • Scott Fullwiler


            You have got to be kidding me. All this back and forth and you were confusing bank capital and reserve accounts held at the Fed all along. Give me a break. You have wasted everyone’s time.

          • Scott,

            I don’t think that time was wasted here. At least, it brought a nice expert (Bart) to the discussion.

          • Alex, do you have any idea how rude, arrogant, and ignorant you come off telling Scott he is wrong and passive aggressively suggesting he is not an expert? And all along you were basing this off of a superficial understanding you gained from the Khan Academy (which btw is very questionable in the way it presents banking)? Are you kidding me? Bart clarified what you were being told all along, RE: reserves vs capital, with more specific accounting terms. But to suggest Scott is not an expert in banking only reveals your ignorance regarding who he is and your knowledge of banking.

          • Uh Wow,

            I wouldn’t do it if Scott had not made a mess with his accounting, which I pointed out. I have just ignored all his accounting mistakes and continued talking conceptually.

            • You are quite thick, sir. Scott didn’t make any mistakes, as Bart verifies. YOU are the one that doesn’t no how to do proper, real-world accounting and are trying wiggle out of this by hiding behind your “conceptualizations,” which STILL confuse capital with reserves held at the central bank. It’s a joke, man. Give it up. There is no grey area here. The accounting is done how Scott does it. It’s okay.

          • It’s no point for me arguing here with you. You have added nothing to the discussion. I will wait if Bart answers to my post below to him.

  29. Non-economist here, so I apologise if this is a stupid comment.

    But it looks to me as though you and Krugman are describing operations at different levels. You’re talking about the day-to-day operational reality, and he’s talking about the practical constraints over the longer term.

    I mean, I don’t get how this: “there is no quantity constraint on the quantity of reserve balances the central bank will supply,”

    Can be understood to be true, given this: “The rub is that the Fed requires Bank A to clear this overdraft by the end of the day, which Bank A will most likely do in the money markets”

    I’m a freelancer, and I do work before I get paid. That doesn’t mean I place no constraint on my clients to pay me. This timing issue that you seem to be making a big thing of seems rather irrelevant to me. It would be as correct, and more true, it seems to me, to say: “the quantity of reserve balances the central bank will supply is constrained by its requirement that banks clear their overdrafts; it grants banks just eight hours to do so” (assuming you mean working day here).

    Seeing as you MMT guys are so keen on talking about how banks “really” work, I’m also a bit surprised by all this talk of creating loans and deposits in a single stroke. Because most of the time, that’s not how it works, is it? I’ve been working on an industrial development project, and the condition for most of the loan drawdowns is that the money will be paid directly to contractors and suppliers. So the bank doesn’t create any deposits (or if it does, they disappear instantly), but it has to pay these suppliers with real money (real fiat money – the bank’s credit has to be good enough to be accepted). As you note, this money is given automatically by the central bank, but the bank then has just eight hours to find that money from another source. To me, this sounds very much like what Krugman says: “they must buy assets with funds they have on hand”. On hand right now – no. On hand within eight hours.

    The consequences of failing to pay back the central bank overdraft are presumably quite severe, so this seems like a fairly effective constraint. It’s not a direct numerical constraint imposed by the Fed, but the fact that the Fed works (to the extent it does) through the capital markets rather than by imposing absolute limitations surely isn’t news?

    Again, sorry if I’m just being dumb. I came via Krugman, who addresses non-economists. I was initially very interested in this MMT stuff, because I completely accept that a lot of the way people talk about money is a hangover from the days of gold coins, and updating the language and concepts would be cool. But a lot of the credit system does ultimately depend on someone’s judgment of another person’s ability to pay, in ways that are still very much similar to gold coin payments.

    • Dan Kervick

      Phil, I replied to this comment below but mistakenly started it off with the salutation “Alex”.

      It’s the comment about beans. You can’t miss it 🙂

    • Phil, it’s not a stupid comment…

      …but timing is CRUCIAL. As Keynes said, “in the long run we are all dead”. All of economics is about timing. If you don’t understand the timing of the effects, you will not understand bubbles, busts, or basically any other economic effect whatsoever.

      The fact that loans precede deposits explains how private banks can create a bubble. If it worked the other way around, the central bank would be able to prevent bubbles from starting (by restricting availability of money to be used as deposits). But it doesn’t work that way, and the central bank therefore *can’t* prevent bubbles from starting, it can only pop them after they start.

      This is a very, very important conclusion.

      Does that help?

    • “The consequences of failing to pay back the central bank overdraft are presumably quite severe,”

      Only if you’re a “little bank”. If you’re “too big to fail”, the consequences are nonexistent and the central bank will keep lending to you.

      Ask the insolvent Japanese banks.

  30. Alternative Figure 2 (the picture with reserves):

    Bank A:
    (1) A: Loan to Customer1 | L: Deposit to Customer1
    (2) A: Reserves for Loan to Customer1 | L: Borrowings
    (3) A: Deposit to Customer1 | L: Transfer to Bank B

    (1) A: Deposit in Bank A | L: Loan from Bank A
    (2) A: Deposit in Bank B | L: Deposit in Bank A

    Bank B:
    (1) A: Transfer from Bank A | L: Deposit to Customer1


    Guys, have you studied accounting?

    • Scott Fullwiler

      Bank A has transferred resrves to Bank B. That is what is going on on the asset side of both banks. This simultaneously debits the deposit account of the customer at Bank A and credits it at Bank B.

    • Alex, I think the point is to focus on Scott’s use of the term “quantity constraint”.

      Suppose you are a grocer who sells dried beans. You also sell transferable IOU’s for beans. You have a back-room storehouse filled with beans. To sell beans and redeem IOU’s for beans that tendered to you, you have to make withdrawals of beans from the storehouse. If you don’t have enough beans in the storehouse, you can still sell the IOU for beans, and then order additional beans from your supplier.

      But here’s the thing: Your supplier sells magic beans. The very moment you place an order for more beans, the supplier makes more beans appear in your storehouse. Poof, and they’re there. So whenever people present IOUs for redemption at the storehouse, there is never any chance of the storehouse being caught short.

      Of course the supplier charges a price for this service. What matters to you as a vendor of beans and IOUs for beans is the spread between the price your supplier charges for your supply and the price you need to charge to make your sale of an IOU profitable. If that latter price is acceptable to your customer, you can make the sale.

      But you never face any constraint based on the quantity of beans you have in your storehouse or the quantity of beans your supplier has in his possession, because the beans are conjured up out of thin air. All that matters is the price your supplier charges for the conjuring.

      The only difference between the IOUs for beans and the IOUs for the money supplied by a government is that IOU’s for the government’s money are themselves accepted almost everywhere as a medium of exchange, so they might rarely be redeemed by bank customers, but are only transferred. But the market for IOUs for beans probably exists because people want lots of beans and don’t use the IOUs that often as media of exchange, and so the IOU’s are frequently redeemed for beans.

      • Dan,

        Truly speaking, I have not read the whole post (after I discovered that Scott didn’t comprehend the very accounting concept of reserve as an offset to the possibilities of default for a banking loan).

        If there are some other concepts here, which are worth reading in your opinion, I will take a look.

        • Dan Kervick

          Sorry Alex. The above was actually supposed to be a reply to Phil.

          • Dan Kervick

            But “reserves” in this context refers simply to the balance in a bank’s reserve account at the central bank. Those balances are used for settling and clearing payments between banks. They are not juts some kind of payment risk hedge or buffer. They are the monetary assets banks use routinely, every minute, to pay other banks.

          • I answered to you above. I repeat it here, so we can continue at one place:
            “Reserves on loans are conceptually identical to the reserves on accounts receivable (from an accounting point of view).”

            These are reserves that are held in central bank. Banks need reserves when they are making loans. Then they can borrow money from each other (they can’t create reserves “out of nothing” as loans).

        • You are confusing loans, which are dated obligations, with demand deposits, which are undated obligations.

          Capital is needed to support dated interest-bearing loans made by banks in the event of defaults. Reserves are not capital, and have nothing to do with defaults by borrowers in respect of dated interest-bearing bank loans.

          A demand deposit is an undated obligation, and banks hold reserves because a demand depositor may require cash to be transferred, or to be available for withdrawal in paper form, at any time.

          Capital consists of the ownership claim by shareholders and other permitted forms of capital (eg subordinated loans) over reserve assets (ie virtual cash/promissory notes held on demand deposit) and other less liquid assets.

          • Chris,

            I see it differently.

            1. Loans are assets not obligations. Reserves are needed to offset assets and not obligations.

            2. Deposits are obligations. To offset obligations there is equity (a.k.a. capital) and not reserves as you said.

            3. Equity is also used to offset the non-performing loans but not the other way around, i.e., reserves are not used to offset deposits.

            4. Reserves are used to “offset” loans as an additional cushion besides equity where the former is held with the Fed. The main point is that reserves can’t be discretionary created by the banks and have to be bought either from other banks or the Fed.

            4a. The main contradictory point with other commentators here is whether reserves do go with assets (loans) or with liabilities (deposits). I believe that reserves offset the loans and Dan and Scott and you believe that reserves provide an access to the Fed account. On the other hand, Steve Keen asserts that reserves are not required at all by the Fed.

        • Alex,
          Sorry to jump in as I have never posted here before but thought I might be able to help out a bit. I think you and Scott are simply talking about two different things. The word “reserves” has two different meanings in the banking world. First, as Scott has said, reserves consist of vault cash and a bank’s balance at the Federal Reserve. Vault cash satisfies public demand for actual currency, and reserves at the central bank enable payments among banks to be cleared , probably in the trillions, on a daily basis. And yes, banks are required to hold a certain ratio of consumer demand deposits as reserves at the Fed, but those reserves have nothing to do with their loan book on the asset side of their balance sheet. Second, the “reserves” that you refer to as supporting loan activity or mitigating against loan default, are among bankers more commonly referred to as “loan loss reserves” or “allowance for loan losses”. Loan loss reserves are an accounting term….they are a contra-asset account which every bank maintains on an on-going basis and do correspond very much to an offset to accounts receivable for any firm. So overall gross loans will be adjusted down by the amount in the loan loss reserve account and thus it does constitute a recognition of the potential for default. Loan loss reserves are usually adjusted on a I believe quarterly basis by a “loan loss provision” which is an expense item which adds to the loan loss reserve account. There are other adjustments which banks make to reflect their view of the quality of their loan portfolio and banks vary widely in their methodologies, but ultimately you will see it on the balance sheet through changes to the loan loss reserve account. Loan loss reserves have nothing to do with reserves that the bank may have on deposit at the Fed. And loan loss reserves are not a setting aside of cash, they are an accounting recognition of the fact that a loan portfolio will undoubtedly experience some loss. When bankers talk about “reserves” more often than not they are talking about loan loss reserves, particularly if they are on the lending side of the bank’s activity. The discussion here is about reserves which a bank has at the central bank.

          • Thanks Bart. I guess you are right. It’s always a pleasure to listen to an expert.

          • Bart,

            Btw, I admitted below that I was wrong when I had associated reserves with possible losses. But I still believe that both historically and conceptually reserves are linked with the loans.

            “Let’s talk conceptually. Historically, bankers got deposits and lent out money to other clients using the law of large numbers, i.e., deposits would never be withdrawn simultaneously. But they kept some money in reserves to make sure that depositors could have always got their money when needed.

            Therefore, reserves are conceptually associated with loans. The only difference is that now these reserves have to be put with the Fed.

            Perhaps, I was not right when I linked reserves with the probability of defaults as Chris has pointed out but the main point still holds — reserves are associated with the loans and not with the deposits. Thus, Bank B doesn’t need to transfer reserves from Bank A.”

          • Bart,

            I think I understand it clear now (after some contemplating) the function of reserves both from historical and from conceptual perspective. If you are interested in my view, I will share it with you – just let me know.


            P.S. Btw, I have just finished reading the whole article. I think that the following statement — “The quantity of currency held or in circulation and quantity of reserve balances held or in circulation at the time of the decision to create the loan have nothing to do with it” — is wrong. The author oversimplifies the picture.

    • Dan Kervick

      Alex, you’re mixing banking accounting apples and business accounting oranges. Bank reserves are not some kind of buffer stock taken out of profits and set aside as a cash flow hedge against potential defaults on accounts receivable. A bank’s total reserves consist of (1) its vault cash, plus (2) its total reserve account balance at the central bank. These are the funds from which the bank makes payments to other banks. When a payment order on a bank deposit account is conveyed to another bank, the payment is settled and cleared through the Fed via a debit from the first bank’s reserve account to the second bank’s reserve account. There is no separate fund of “operating cash” from which the payment could be made instead.

      So as Scott says, when the depositor transfers a balance from one bank to another, that necessitates a payment from the first bank to the second bank. That payment will take place via the two banks’s reserve accounts at the Fed.

      • Dan,

        Chris Cook posted a good comment about the same matter. I replied to him above.

      • Dan Kervick,

        Pag. 25. Bank of Japan and Eurosystem don’t allow banks to use cash to satisfy reserve requirement. I don’t want to correct you, it’s just another example of the fallacy of “Krugman’s currency” argument!

      • Dan and Chris,

        Let’s talk conceptually. Historically, bankers got deposits and lent out money to other clients using the law of large numbers, i.e., deposits would never be withdrawn simultaneously. But they kept some money in reserves to make sure that depositors could have always got their money when needed.

        Therefore, reserves are conceptually associated with loans. The only difference is that now these reserves have to be put with the Fed.

        Perhaps, I was not right when I linked reserves with the probability of defaults as Chris has pointed out but the main point still holds — reserves are associated with the loans and not with the deposits. Thus, Bank B doesn’t need to transfer reserves from Bank A.

        • The only function is reserves is to meet any reserve requirements (dependent on institutional arrangements in a specific country) and as a means of settlement between banks. Scott’s figure 2 is correct. When the customer from bank A withdraws his deposit and places it into bank B, then Bank A is required to clear with Bank B, it does this with reserves. Reserves operate on the liability side, capital operates on the asset side (loans) because it is used to offset risk and absorb losses.

          This is basic stuff and covered in nearly every central bank paper which details the day-to-day activities of its payment system.

          What is your historical source?

        • Dear Alex,
          Thanks for referring to me as an “expert”. I don’t feel like an expert anymore, , but I did do quite a few years as a commercial banker in a large money center bank in New York. One thing I can tell you for certain, is that when looking at a potential loan never, ever did we look at reserves, in the sense of “required reserves” , which are deposits that a bank has to maintain at the Federal Reserve or the central bank of its jurisdiction. Those reserves are computed according to DEPOSITS, not loans. Yes it does go back to the origins of banking, but it has been put in place by the relevant authorities to protect depositors and has NOTHING to do with the loan book or to “support loans”. I have to say that I see that you are still mixing the two different ways in which the term “reserves” is used in banking. The other way in which the term “reserves” is used, as I said previously has to do with “loan loss reserves” or “allowance for loan losses”, which is a contra account on the asset side of the balance sheet and is an estimate of what the loan losses of a loan portfolio might be and is computed in a variety of ways by banks. Periodically, probably quarterly as I said, that contra account will be increased by “loan loss provisions” which is really just keeping the loan loss reserve account up to date to reflect the evolving portfolio. And there is a lot more that happens to the loan loss reserve account depending on the actual performance of the loan portfolio. BUT as I said earlier, the loan loss reserve account is NOT cash that is set aside to cushion the loan portfolio and it is definitely not cash that the bank has to send to its account at the central bank. The reserves that banks have on deposit at the central bank PRIMARILY support the payments clearing system among banks. Yes in many countries a certain amount of reserves are known as “required reserves” because the regulator requires them to be maintained at the central bank and are based on customer DEPOSITS that a bank has on its balance sheet…in the US the ratio, which varies according to the type of customer deposit and the amount is set by the Federal Reserve Board and is known as Regulation D. I would suggest you look on the website to see how it works…but THAT type of reserves has absolutely nothing to do with loans. Then you can easily google “bank accounting loan loss reserve” and come up with some good accounting explanation about how that works. The two are different, and sorry to have to break it to you but Scott is totally correct in his post. He is only talking about reserves that a bank holds with the central bank. And believe me, banks do not need reserves to make loans. Reserves in that sense can always be obtained from the market or the central bank, after the fact.

          • Bart,

            Thanks for your message. Here is my current view as promised. Feel free to criticize it if you disagree.

            (1) Conventional reserves in the Fed. I have already examined them from a historical perspective. So, what is their current functionality? Currently, those reserves are conceptually associated with POTENTIAL loans and not with deposits. Perhaps, the Fed doesn’t want to keep track of the loans provided from the deposits in question. Therefore, the Fed makes reserve requirements for the potential loans. This is why I still think that reserves are associated with the loans (though for simplicity the Fed associates them with the potential loans). Thus, it looks for you like reserves are associated with deposits while they indeed are associated with (potential) loans as it has been always historically.

            (1a) Scott is still conceptually wrong. It’s because reserves associated with the potential loans (or quasi-deposits in the above sense) are not transferred from Bank A to Bank B. Conceptually, Bank A can decrease its corresponding reserve account (after the deposit is withdrawn by Customer 1) and Bank B has to increase its (but it has nothing to do with the transfer of reserves between the banks).

            (2) Reserves as a loss provision. You have covered them extensively and I have no objections. You were not right when you said that I was still mixing them with reserves per (1). Yes, I was not right originally when I said about “positive” cushion. It’s a “negative” amount but it is not significant conceptually here (since conceptually it’s an offset). And yes, obviously banks don’t keep these reserves with the Fed (since they are “negative”). I was originally wrong here and I have admitted it.

            (3) Reserves as an instrument for the clearing system. Ideally, it is best to have them as little as possible (since they are an “obstacle” in normal situations when the Fed doesn’t pay interest on them). Therefore, banks use reserves from (1) for this purpose.

            P.S. It was a pleasure talking with you.

          • Bart,

            Re (2): There are “Direct write off method” (Non-GAAP) and “Allowance method” (GAAP) for the reserves on accounts receivable.

            I guess banks use an “allowance method” for the bad loans. Am I right?

        • Alex, once again…Scott is absolutely correct, conceptually and otherwise. The funds which a bank has on deposit at the Fed are reserves, and they have absolutely nothing to do with loans and have only to do with deposits a bank has on its balance sheet. Second, when a customer withdraws funds fom his account from bank A and transfers them to bank B, bank A loses reserves and bank B gains reserves on the books of the Fed, WHERE THE TRANSACTION CLEARS. Interbank payments clear through the Fed by means of debiting and crediting reserve accounts which banks maintain at the Fed. It has nothing to do with loans. It has absolutely nothing to do with whether bank B needs the reserves or not….bank B GETS them. What they do or do not do with them is entirely up to them. Please consult the federal reserve website for a correct definition for reserves, and their purpose and then rejoin the discussion.

          • Bart,

            Thanks for your message. You have not convinced me so far. But I will read the Fed’s documents later as you suggested. Here is my current beliefs w.r.t. the matter you have just outlined.

            1. Reserves are associated with deposits in their capacity to produce loans and not with deposits themselves (as Kant’s “thing-in-itself”). If banks didn’t lend they would not need reserves since money would always be available. It is the process of lending that creates the need in reserves. This is why reserves are associated with the (potential) loans.

            2. The fact that the Fed uses reserves to transfer funds from one bank to another is irrelevant here. First, reserves are embodying an instrument of the clearing system here, i.e., reserves per (3) from classification above. Second, I actually was talking about the required change in reserves as the result of transaction but it looks like a controversial issue to discuss (since banks have 30 days to adjust reserves after transactions according to Steve Keen’s post linked in the original article).

  31. My brain is fried at this point.

    Thoughts? Why does this miss the point about B being the indirect target and r the direct? I think I had this figured out but now I am confused.

  32. Hi Scott!

    Though I’m inclined to side with you, I think at least in one aspect of your argument you are actually wrong or at least partly wrong. You write “As it turns out, the Fed provides an overdraft for any payment sent in which a bank’s account goes below zero—that is, the payment is never rejected when it occurs on the Fed’s books”. I’m a european myself, so I’m not intimate with the workings of Fedwire, which is the electronic payment system provided by the Fed for commercial banks, but I have recently read about TARGET2, which is the analog of Fedwire in the European monetary union. In TARGET2 the payments proceed instaneously and can indeed be rejected, if the sender doesn’t have enough liquidity (central bank money) on his TARGET2 account. In fact statistically around 2% of payments are rejected. That doesn’t mean of course, that the sender can not try again, after having got liquidity somewhere (for example at the discount window). The system with ovedraft, which you describe was, I think, in place bis until the eighties, but now wie have so called real time gross settlement systems (RTGS), of which Fedwire and TARGET2 are examples.
    Another thing: your line of argument is, that banks are completely unconstrained in there lending decisions by the amount of central bank reserves they own. But if so, why do the have sophisticated liquidity management systems in order to avoid the situation, where the don’t have enough liquidity to make necessary payments. Or am I confusing here something ?

    • You have a point.

      There are limits to how much banks can incur daylight overdrafts. Banks may have to keep collateral with the Fed in general.

      Some banks cannot even use the facility.

      I think the right way to say this is that the Fed usually accommodates but will warn institutions and put fines if they regularly violate limits. I guess that’s what happens in Europe. Having said that it is possible that the Fed rejects payments.

      • Scott Fullwiler

        “I think the right way to say this is that the Fed usually accommodates but will warn institutions and put fines if they regularly violate limits. ”

        Yes, exactly. And the Fed thought about rejecting some payments several years ago and then decided against it. Note that the CB could reject payments if it chose to as long as this didn’t threaten the payments system, so it would have to be something rather isolated and not widespread, and the system overall would still be supplied with desired balances at the target rate as always.

        • Nice points.

          In fact central banks have themselves taken the initiative for payments to happen real fast and it couldn’t have happened unless they were highly accommodating.

  33. Richard Rosso

    Scott took Krugman to school!!!! Love the “boom” at the end ties it all up nicely. Wonderful, wonderful work..And it’s only Monday! Let’s see what the response to this is. If Krugman was smart he’d end it now but since his ego is so huge I expect additional great commentary from SF!

  34. Scott

    Sorry, but your update is a complete cop-out. You’ve reduced a debate about monetary theory to the job description of a junior trader at the open market operations desk.

    I want loan, bank creates loan, loan creates deposit, deposit creates reserve shortage, bank comes to central bank to meet shortage, junior trader repoes the bank’s treasury holding and credits its reserve account. Tomorrow morning junior trader’s boss comes, runs his Taylor rule spreadsheet again, sheet suggests to hike fed funds rate, fed funds rate is hiked. Bank becomes less profitable and hikes its credit rates across the board. Day after tomorrow, my neighbour who was planning to renew his floating rate mortgage goes ahead and makes the principal payment instead. Bank now has excess reserves, goes to central bank again. Central bank reverses the repo. All rules of the game are met. ‘Money’ is endogenously created and destroyed.

    If that is your story, then there is nothing in this story that any monetarist/ neo-classical would disagree with. The 6 week horizon, the Taylor rule etc. are all institutional details that we can fill in depending on what particular subset we’re studying. The basic, overarching theme of the story is – the central bank controls the price level, and the central bank controls credit creation (to the extent that it is controlled by anything apart from the independent ideas in my head and my neighbour’s heads).

    • Dan Kervick

      Seems to me the upshot of your story, Ritwik, is that the CB influences credit creation through its control of the price of reserves, but does not control credit creation. The quantity of reserves turns out to be largely a by-product of the interest rate spread between the policy rate and the commercial lending rate, and the demand for credit at the latter rate, rather than the cause driving bank lending.

      There is no plausible ghost of the “money multiplier” here; no predictable ratio between the ex ante provision of reserves and the ex post increase in loans.

      • Yes, true. There is no ‘predictable multiplier’ (By the way, I have never quite understood why predictable has been assumed to mean constant – finance types has vol. as a parameter in their models and model it as a stochastic, time varying quantity. But it is still a parameter, not an epiphenomenon. One can presumably model the money multiplier similarly. But I digress, that’s not my point here.)

        The multiplier, interest rates, reserve balances, everything are epiphenomena. There are only three parameters – tastes (real), technology (real) and the central bank’s response function.

        In the PK/MMT story, tastes, technology and ‘the nature of the banking system’ are parameters. Everything else is epiphenomena.

        Both stories have money. But only the first story is ‘monetarist’ , the way I understand the term.

        The Taylor rule story is a monetarist story. Agreeing with it is to concede the monetarist pov. To move to a truly non-monetarist aggregate demand story, you would have to invoke Woodford, not Taylor. The rest of the debate is simply about how intermediate macro textbooks should be written.

        And I would not stress much over ‘control’ vs ‘influence’, as long as the influence is ‘primary’. First order logic can only take binary truth values. The real world is fuzzy. We all know that. Even neo-classical economists.

        I do want to clarify that ‘my story’ – to the extent that I can claim to have one – is not a monetarist story. But that doesn’t matter for this debate.

        • The key difference as I see it is that Krugman is using a model with an LM curve where interest rates are a function of quantity of money.

          This is just wrong. Redraw it with an LM curve where quantity of money is a function of interest rates and you might have something….

    • Scott Fullwiler

      It’s the distinction between strategy and tactics. The tactical operating target is the target rate and can’t be anything but. The strategy is where to put the target rate and how to adjust it. No cop out. that’s always been the view. Central bank operations are about price, not quantity, as we always say. It has huge implications for understanding that QE, IOR, saving/investment, government deficits, and so forth work differently than the mainstream view. And our predictions on each of those have been spot on whereas the mainstream understanding of tactics has been wrong on each.

  35. In your update, modify your last sentence by saying “That is, the target rate is an exogenous control variable (i.e., it is necessarily set by the CB) that it sets endogenously in response to economic events, given its exogenous, technocratic response function”

    And we’re in Nick Rowe’s world.

    • I’m genuinely curious, what is the substantial difference by arguing that the target rate is endogenous? i.e. that there are a set of economic variables current theory suggests interest rates can influence, and which the central bank targets (e.g. inflation in a specified zone, 2-3%).

      It doesn’t alter the Post Keynesian story that the banking system is not constrained by the quantity of reserves, rather it is constrained by capital, demand by credit worthy borrowers, and profitability of potential loans. That the central bank accommodates demand for reserves at its target rate.

    • “And we’re in Nick Rowe’s world.”

      Not sure where you are getting at – looking at your comments.

      Take the Bank of England for example. Inflation was high sometime back but the bank did not raise rates because the “reaction functions” are just rules of thumb.

      The Nick Rowe world is a fundamentally different world. In that world interest rates tend to the natural rate – so they always get away by saying those things. Around here you see a different viewpoint – that the long run is a series of short runs and there is no natural rate that the short term rate is tending toward.

      There is simply a huge difference of philosophy.

      • I guess the key point here is that the central bank’s reaction function, its method for setting interest rates, is very, VERY political — it’s not an automatic phenomenon or a market phenomenon. Commercial bank interest rates are dependent almost automatically on the central bank interest rate, but they are NOT dependent in a clear way on monetary base or quantity of money or anything like that. So to set up a proper model, you have to treat central bank interest rates as the independent variable. Which classical LM fails to do.

  36. I will defer to krugman just because he has never steered me wrong. But in the grand scheme of things why is there a big fight over this? You guys have taken wonkery above a level I can keep up with with this one.
    Your wonky post in plain English…say 100 words or less would probably be digested better by me. Krugman doesn’t write a book in his response because he assumes the reader knows this stuff.
    After reading some more I think you all are talking past each other. To Krugman bank lending doesn’t matter but to the other side it does. Krugman seems to see the money supply as one number, while the other side seems to want to separate money supply(in terms of the FED) from bank created money by the process of lending. I remember seeing a video explaining how banks can “create money” last year. Say someone took out a loan and bought a car for 20k, the dealer, manufacturer, employees all get aid…some money ends up deposited in a bank where it is put to work, lent again, buys products…. meanwhile the car buyer has a car he is still making payments on but the 20k has at this point turned into more “goods” than 20k…
    I hope you guys get in a room and sort this out or agree to disagree.

    • Dan Kervick

      Fausto, I think this is why this dispute is not merely unimportant wonkery and actually matters

      New Keynesian and monetarist misunderstandings about the banking and monetary system are responsible for the belief in the money multiplier model of the relationship between central bank reserve quantity adjustments and the volume of bank lending. The result has been a parade of prominent economists telling us that we can address the problems of a stagnating economy and persistent unemployment with monetary policy alone. The central bank boosts reserves and “loosens” money, and the banks cooperatively follow suit by lending more. The focus is all on the supply side of the equation.

      The mainstream Keynesians like Krugman tell us that we don’t need fiscal policy to support flagging aggregate demand and boost unemployment, unless we are in the special circumstances of a liquidity trap. The liquidity trap means that the effectiveness of monetary policy is temporarily switched off, and we have to temporarily switch to fiscal to handle the liquidity trap emergency.

      But if the story Scott is telling is correct. Then this picture – both the hard-line monetarist version and the soft-line mainstream Keynesian liquidity trap version – are just wrong. There is never a money multiplier transmission mechanism that allows the central bank to control the quantity of bank lending to firms and households – and thus investment, consumption and employment – via quantitative operations of monetary “tightening” or “loosening”.

      We need ongoing fiscal policy action for macroeconomic stabilization.

      Bill Mitchell had a post on this last summer:

      • Thanks, that reply helped quite a bit.

        Although I only got into reading economic blogs in 2008(thanks to Krugman) this discussion has gone a little deeper than I usually go. I lot of citations and numbers.

        I can see both sides of it…I’m not ideological…more about “what works in this world we live in?”

      • Dan, thank you. I agree, but here’s a question:

        So-called “automatic fiscal stabilizers” qualify as fiscal action, right?

        This includes things like unemployment insurance, of course.

        But I think this would also include progressive income tax (pull cash out of the *top* of the economy during bubbles, strictly automatically).

        This means that “ongoing fiscal action” could be set up with a stable set of laws. Congress doesn’t need to intervene repeatedly; it just needs to set up automatic stabilizers which print money and hand it to the poor during recessions, while extracting money from the rich during booms.

  37. Thomas Bergbusch

    Contrary to some posters here, I’m getting the feeling that, far from dismissing MMT out of hand, Krugman is actually engaging in this conversation, albeit grumpily, and that, as Stephen Hawking has done several times in his field, he will eventually own up to being wrong. Things have reached the stage where his own self-respect, not to mention the tides of economic evidence AND opinion (and thus his own influence over politics and public policy) can only be sustained if he changes his stance. And that will be both an act of courage on his part and economically rational.

    • The smooth way to handle it is to come to an “understanding,” like when firms agree to pay a fine and cease certain operations without admitting guilt. Let’s see if this results in Prof. Krugman’s changing the way he speaks about this in the future. He got off the insolvency limb when he found it being sawed off and shifted to talking about inflation being the constraint. Let’s see what happens here now that he knows people are watching and are ready to call him out.

  38. I don’t ever remember Paul Krugman saying that there should not be large fiscal stimulus in the current era. Or that monetary action was the sole effective tool – in fact he has long argued the contrary.

    • Dan Kervick

      Fair enough. Krugman has indeed called for additional fiscal stimulus. But he continues to defend theoretical models that undermine the public case for that stimulus. Krugman has joined a chorus of other pundits who have been banging on Ben Bernanke now for a year or two, claiming that the Fed could be doing much, much more to boost aggregate demand and employment. To my mind, the case for this claim isn’t there. And Krugman’s recent posts about of banking only make it more plain that he has been operating with defective models of the banking system that leads to an overestimation of the capacities of the central bank. If someone really believes that the Fed could flood the economy with more commercial bank lending – and the jobs that would be financed by that lending – if only they stopped running a “tight money” policy, then obviously they will find the Fed blameworthy for their failure to take this course and pursue their full employment mandate. But I believe that the model of the banking system that Scott has outlined shows that these kinds of estimates of the Fed’s latent powers are vastly overblown.

      To me, people like Krugman, Delong and Yglesias, by joining forces with fiscally ultraconservative economists like Scott Sumner in focusing attention on the Fed, are acting as enablers and interference-runners for the politicians, helping them pass the buck for their own failure to pursue more aggressive fiscal action. The administration doesn’t want to run the political risks that come from renewing the charge on behalf of activists government and fiscal expansion. They would like to take the politically safe but economically misguided approach of running on long-term deficit reduction and fiscal restraint instead. So they are trying to set up the Fed as the fall guy, whose “tight money” policies are responsible for our economy’s failure to grow more rapidly and slash unemployment more quickly. Krugman, Delong and Co. shouldn’t let them get away with this. Let’s put more pressure on the politicians to do what is needed, rather than creating a scapegoat out of the Fed.

      And it’s especially damaging to the long-term goal of public understanding about macroeconomics and the role of the public treasury in the nation’s economic health to be lending so much intellectual prestige and capital to stubbornly reactionary and theoretically backward monetarists.

      • Krugman recognizes that while fiscal policy would be ideal, we will not get it due to political issues. So that’s where th focus on the FED comes from.

        The FED can’t solve it but it sure can do more than it is doing.

      • Please don’t put Yglesias in the the same sentence with DeLong and Krugman.

      • Well, honestly, the Fed probably has enough leeway, legally, to establish its own commercial bank (say, a Fair Housing Bank or a Clean Energy Bank or something) and capitalize that bank with printed money — and use it to employ a whole bunch of people, and have it specifically buy preferred stock from industries which we wish to invest in, so as to capitalize those industries….

        So I think the Federal Reserve actually does have power to do more stuff. But the “more stuff” it has the power to do is pretty much fiscal policy, and would be considered WAY out there. And Krugman is not actually suggesting that the Fed start freelancing in fiscal policy (though I am suggesting it!)

        • Notice that by establishing its own commercial bank it could create a corporate culture which would prioritize supplying money to people over, you know, solvency. This already exists at a lot of large banks, but those banks insist on supplying money to their executives, not to the people who would actually boost the economy…

          • Heck, take the extreme version: the Fed could capitalize a new bank every day, have each of them lend out money to targeted, unable-to-pay-the-money-back poor people, and have each one declare bankruptcy.

            The legal abilities of the Fed are pretty broad. I mean, the political blowback would be severe, but basically I’m saying the Fed CAN engage in fiscal policy if it really wants to.

  39. BTW, the link for “old Monetarist/Keynesian” requires a login to Outlook Live.

  40. Krugman updates:

    “Update: OK, I’m done with this conversation. I’ve had enough back and forth, including off-the-record stuff, to confirm for myself that there’s no there there. And there are more important battles to fight.”

    • Dan Kervick

      I have to say that kind of remark by Krugman is extremely inappropriate and selfish. Even if he’s not convinced by anything, why not just say something like, “I’ll leave it to my readers to read the many papers that have been cited and make their own judgments.”

    • Amusing how Krugman tweaks the arguments. Keen clearly says that New Keynesians take the underlying 3 assumptions of neoclassicals and tweak it with some sticky prices and rigidities.

    • He may be done with this conversation, but it’s far from done with him. This all won’t soon be forgotten. All he did today was show that he is a doctor of economics, not finance. He also earned some red penalty flags, but that’s par for the course on the internet. At the end of the day, I’m still really glad that he goes on the Sunday talk shows to tussle with right-wingers who otherwise would dominate the economic debate with their Friedman nonsense.

  41. Pingback: Markets … | Economic Undertow

  42. Scott, could you talk more about bank captial and leverage requirements and how these do or do not constrain lending?

    Even if deposits and reserves don’t constrain lending by a multiplier could you still get a multiplier like story with capital and leverage ratios?

    • These do constrain lending and are extremely important.

      This is where the shadow banking system comes in. “Shadow banking” operations, such as issuing mortgage-backed securities and then putting them in money market funds, were designed to evade the capital requirements and the leverage requirements, and did so successfully.

      • Note that the demonetization of MBS-backed money market instruments, due to people’s fear that they wouldn’t be able to convert them into Fed-backed dollars, was the immediate trigger of the economic collapse. This was caused by the *solvency requirements* which are still being enforced, even against shadow banks…. requiring that capitalization be greater than zero.

        If you don’t enforce the solvency requirements, you kick the can further down the road, and the Fed did this with the megabanks. Eventually, however, you have the problem that money is based on trust, and pretty much anything can be demonetized if trust goes away.

        How that trust is lost is an interesting question, but I think basically any shady or dishonest behavior erodes it, whether it is apparently banking-related or not. So, for instance, George W. Bush’s lying the US into the war in Iraq is the worst thing which has been done to trust in the US Dollar in decades.

        • Nathaniel,
          I agree when banks originate loans for distribution to nonbank finance companies in exchange for fee income, the loans create deposits during origination, and the sale of loans cancels bank deposits during distibution, so what would otherwise be illiquid bank loans with matching bank liabilties, become illiquid portfolios of the nonbank “Shadow banks” backed by nonbank money market liabilities representing a strain on the small M1 money supply. However during the crisis one reason banks became insolvent is being forced to take back a substantial portion of the previously distributed loans which had put-back guarantees, the banks could not easily raise new capital against the rapid loan increase in the put-backs because of the market conditions, so Fed is “in a box” when it is being lenient about bank solvency since to do otherwise would not be in the interest of stabilizing the financial system, the only other resolution of many banks being illiquid is resolution via bankruptcy and the trial balloon, letting Lehman Bros fail, sent the banking and financial systems into a panic in the interbank money markets. Again, too big to fail may be the diagnosis although network banking in the modern era might result in a panic even with many banks holding capital as liabilities of other banks and nonbanks. The solution to all these bad private liabilities is increasing the Treasury float and letting banks earn income to boost the ratio of Treasury securities to loans to become solvent again over time which is a result that is described by Hyman Minsky (banks in aggregate need to hold more good public debt to become more solvent in a private debt crisis).

  43. Excellent description of monetary operations, as is your standard.
    But you labor under two huge disadvantages in the debate.
    What you say is understandable.
    And it is factual.
    And the following was beyond the pale, as you noted also,
    “And currency is in limited supply — with the limit set by Fed decisions.”
    I must have missed that part in the Fed minutes.
    Or maybe thats where they go off the record, and bring in the ouija board for currency targeting, the part that disabuses them of any notion that they`re actually setting the funds rate.

  44. If currency really were limited in supply, then the zero bound wouldn’t exist!

    That’s how you get rid of the zero bound – by not allowing banks to convert reserves into currency. Currency then takes the properties of a bearer bond, i.e. can trade above face value.

    • & it did trade this way in the 19th century. Banknotes from different banks, silver certificates, gold certificates, US Notes, Federal Reserve Notes, and actual coinage, all had slightly different values (and the values varied from city to city!)

  45. What’s up Scott? This is Mike Sax over at Diary of a Republican Hater-we’ve spoken before, think you remember me. I’ve been following the debate between you/Keen vs. Krugman. Actually, what I found most interesting here was that link you supplied where you explain that a helicopter drop is actually a fiscal operation. This is important because the more you read the Market Monetarists for example-but probably this is true of all Monetarists the less clear it becomes on what the difference between fiscal and monetary policy even is.

    Lars Christensen went as far as claiming there’s no such thing as fiscal policy. Even an helicopter drop according to him is monetary policy-he claims that fiscal policy is just monetary policy done in an inefficient way.

    I then wrote a post where I referred to his argument as a “postmodernist mind fuck”. He was actually tickled by the phrase and wrote a piece on my piece. Then I wrote one more piece on him writing on my piece-that was about his first piece.

    The point is though that you certainly are helping me out, to discuss this as the Monetarists more and more obscure the diffrence between the two. Scott Sumner never stops claiming that fiscal stimulus is not needed if you do monetary stimulus right. You do a good job of boiling down the old Monetarist-Keynesian debate as between an interest rate target and a monetary aggregates target.

    If you have written more about what fiscal vs. monetary policy is and consitst of please give me a link. Any clarification would help me-reading these guys just leaves me perplexed.

    • Scott Fullwiler

      Hi Mike,

      I responded below before I saw this. If you can get a copy of Randy Wray’s book, Understanding Modern Money, the approach is explained there. Keep reminding me via Twitter or something if you can’t find what you’re looking for and I’ll keep looking for something that answers your questions.

    • The key point as I see it is that fiscal policy can have deliberate redistributional effects (which is IMPORTANT as I have explained elsewhere), and monetary policy can only redistribute upwards.

      I think that is the difference. This is also why right-wingers hate fiscal policy but like monetary policy — it’s all about making sure the money only flows upwards.

  46. Dan Kervick:

    Sterling work! Fighting fires across the blogosphere! I salute you!

  47. Dan Kevick, to hear you tell it the Fed is pretty much impotent. I’m not saying you’re wrong-in reality I don’t know what to believe. Sumner and company argue every day that it’s all powerful, you feel it’s near powerless.

    If the Fed were to raise it’s inlfatioin rate to 3 or 4% that would do no good? How about a negative example-Volcker in the early 80s. It certainly seems he whipped inflation-and forced us into 11.3% unemployment, the highest since the Depression-even during this downturn it never got that high. I remember Galbraith too has always been very critical of the Volcker Fed.

    Does the Fed in your fulfill any important role at all? Do we need it?

    • Mike Sax, I probably sometimes express my position in an extreme way because I am focusing on the role of the Fed in the recent recessionary times. In a more normal economy with higher interest rates, I believe the Fed can help stimulate lending by lowering rates, and help cool down lending in an overheated economy by raising rates.

      But since I think interest rates are really the only significant channel through which the Fed influences economic performance, I don’t think there is much that can be expected of them when we are pressed up against the zero bound and aggregate demand is still flagging. The problem, it seems to me, is a lack of spendable income for people who don’t want more credit, not a lack of credit availability. Sumner still thinks the Fed has some kind of mysterious power to reach out beyond the banking system and start plopping money here and there all around the economy, and to target the total level of aggregate nominal spending. He also has a profoundly top-down vision of the economy and thinks the Fed can move mountains by its ability to diddle the expectations of the relatively small class of people who trade in asset markets, and pay close attention to everything Ben Bernanke says. But Sumner dances around constantly when asked to fix on an the details of actual transmission mechanisms for this incredible power.

      Now lately, in their zeal to defend to powers of the central bank, we have been getting some truly radical, and frankly dangerous, calls from the monetarists to allow the Fed to appropriate to itself all sorts of broad spending powers that every American schoolchild has learned are the prerogative of the United States Congress and the people who elect them. And sure, if we allow the central bank to become a second, unelected Congress that can conduct a second channel of fiscal policy by crediting bank accounts without any direct democratic accountability and debate over its spending decisions, then it can no doubt have the same kind of macroeconomic impact that an unleashed Treasury could have. But if we cross that Rubicon and go down that authoritarian road, turning the Fed into some kind of neo-Soviet Stroibank empowered to spend and command real national resources outside the normal democratic process at the behest of a technocratic elite, we will probably never get our democracy back.

      There is a political dimension to all this. For forty years in the neoliberal era, we have had an organized conservative and reactionary effort to shrink the role of the public treasury, to castrate and disempower popular progressive government, and get the political and democratic branches of the government out of our economic lives. And this isn’t mainly about “macroeconomics”. It’s about political power, control and the command and distribution of wealth. So there are people who have a strong vested interest in wanting it to be true that the Fed can handle macroeconomic stabilization and the full employment mandate all by itself. They need this to be true, because if it isn’t, they undermine one of the main arguments for their ideological agenda.

      • As for “why do we need the Fed”, the Fed exists to prevent solvent banks from shutting down due to liquidity problems; look up the history.

        This is a pretty important function as it increases general trust in the banking system MASSIVELY and therefore increases general economic activity. If this function went away, most people would keep a small safe in their house filled with cash.

  48. I of course agree with you on the neoliberal era, and agenda. It does seem when you elaborate a bit more you do kind of agree with Krugman-that monetary tinkering can help during normal times, but this is not a normal time-he calls it “the liquidity trap.”

    Sumner of course never stops heaping scorn on the idea that the interest rate mechanicsm is the only tool in the Fed’s tool box. He likes QE though he also concedes it may not do much, he argues that the “expectations” channel would be that powerful.

    As to your concern about the Fed usurping the democratic process I must admit that my reaction is to point out that Congress is broken anyway. It’s power hardly needs to be usurped-they’ve abdicated it. So if the Fed while an unelected body will do what’s necessary to help the economy I for one say go for it.

  49. What I’m trying to get Dan, is really the distinction between fiscal and monetary policy. I know that people like Sumner just don’t want there to be fiscal stimulus. But the more the debate goes on the less clear I get about what the difference atually is.

    I can relate it to myself, at the super “microo” level. If the government gives me a choice between sending me a $50,000 check-as if!-or doing some complicated operation with the banks that they say will improve the economy at some time, in some way that at some point may finally indirectly benefit me by brining the economy back, I would choose the $50,0000 and it wouldnt be a hard choice. So to me that’s the truoble in the debate between monetary and fiscal-fiscal operations may more directly help the average joe right away. And sometimes that’s what’s needed.

    • Scott Fullwiler

      Hi Mike,

      For us, the distinction b/n Monetary and Fiscal Policy is the following:

      Monetary policy is about setting interest rates, mostly
      Fiscal policy is about adjusting the qty of net financial assets of the non-government sector

      Some discussion here: (starting on p. 13, part III–brief, so I’ll look for a better summary; Wray explains it in his 1998 book more thoroughly)

      • This is the same as saying that fiscal policy can change the distribution of wealth, and monetary policy can’t.

        Think about it for a moment if you don’t realize this. 🙂

        The distribution of wealth is of course key; an economy with all the wealth at the top always has a lack of aggregate demand and therefore stagnates and shrinks.

    • Dan Kervick

      For me, the critical distinction is a political and institutional one: the distinction between central bank policy and legislative policy.

      If Congress were to increase its spending by $500 billion dollars without either raising taxes or authorizing the treasury to issue new debt, and passed a new law directing the Fed to clear any checks issued by the Treasury, without regard to the Treasury account balance and without creating some kind of overdraft debt from the Treasury to the Fed, then one could reasonably say that Congress is conducting both fiscal policy and monetary policy at the same time.

      Of course, some people would like the central bank to start spending money in all sorts of highly unconventional ways. If Scott Sumner wants the Fed to level NGDP target, but wants it to hit that target by buying bridges, highways and building – or by sending money to random Americans – then the first thing to say is that he is advocating a dangerous form of anti-democratic tyranny, since every American schoolchild knows that only the elected, democratically accountable political branches of the government are supposed to possess the power of the purse in this country. The second thing to say is that he is advocating that the Fed assume operational control over a significant portion of fiscal policy.

      • You seem to agree with me. 🙂

        Honestly, I wouldn’t have as much of a problem with money-printing entities building bridges. Take away the federal guarantee that only Fed-backed money counts for paying taxes — let me pay my taxes in Ithaca Hours — and I’d be fine with the Federal Reserve executing fiscal policy. It can’t do worse than a Republican-dominated US government.

  50. On Sumner of course his big panacea if NGDP targeting that’s supposed to be like you said, a miracle worker. But it does if nothing else sound too good to be true-no description of the tramsmission mechanism, etc.

  51. I’vw just posted my own attempt at an intevention-Dan I do mention our conversation here among other things

  52. Scott,
    Please correct me if I am wrong, but it seems like Krugman can claim victory. He can say that the CB can target the money supply thru a series of interest rate targets and he “won”. You are reduced to arguing that the demand for credit is pretty interest insensitive, something he won’t buy and that is that.

    • Scott Fullwiler

      Note that I say in this post that the only possible way to target monetary aggregates is through an interest rate target. How can he “win” if he says later something I already said several times? And that’s moving the goal posts, more importantly–this debate was about whether banks “matter” and if they are constrained by reserves and deposits–if we’re right and they’re not, then that changes all sorts of things and all their models are wrong. If he claims victory as you suggest, that’s just obfuscating what this debate was all about.

    • Scott Fullwiler

      See this summary–Krugman declaring victory as you say moves the goalposts, as I said:

    • The debate was over:
      (1) Do you need to include the commercial banking system in your model?
      MMTers won, by saying yes. Krugman lost, by saying no, and is now pretty much saying yes.
      (2) Do the loanable funds / monetary base / money multiplier / etc. have any use as independent variables controllable by the Fed?
      MMTers won, by saying no. Krugman lost, by saying yes, and is now pretty much saying no.
      (3) Do loans come before deposits at commerical banks?
      MMTers won, by saying yes. Krugman lost, by saying no, and is now saying he always said yes, which is intellectually dishonest.
      (4) Is the interest rate as set by the Fed an essentially independent variable, with the Fed reaction not subject to mathematical modelling due to unpredictability, while the quantity numbers are functions OF the interest rate, modellable as automatic/market reactions?
      MMTers won, by saying yes. Krugman is still saying no, but that view is inconsistent with what he’s admitted above.

      By the way, when I say “won”, I mean “marshalled empirical and historical evidence to back the position”.

      Krugman is being slightly intellectually dishonest by refusing to admit that he’s reversed his position, but that’s just typical defensiveness, which everyone does. It’s still unfortunate to see him doing it.

  53. Ok Scott. I’ll talk to you on Twitter then. Is Wray’s book online?

  54. Jonathan Dean

    Professor Fullwiler, perhaps you could consider apologising to Professor Krugman for the somewhat impolite tone struck in the original post? It seems clear you are correct in your analysis and taking steps towards a reduction in hostilities might advance your view and benefit many. Sayre’s Law should be in effect here, with the stakes being too high not to take the behavioral high road. I would certainly applaud the reserve you showed in your post update.

    If this is too much of a stretch, engaging with Nick Rowe, in depth, over on his blog might be a nice gesture (apologies if you have already done this; I know many of your MMT compadres have). He seems a very nice guy.

  55. Pingback: Krugman and loans without parents « Economy View

  56. Bill Thompson

    I’ve been following and reading about Dr Krugman’s and Steve Keen’s arguments with some interest. I have also posting my own disagreement with Krugman’s not-out-of-thin-air arguments on his blog. He seems to have little clue on the use of the digital fractional multiple at the commercial bank level and never ever mentions the paper buying paper(the Fed printing money to buy Treasuries — QE) capabilities of the Fed as a Central Bank.

    In the last huffy blog rebuttal by Krugman against Keen, I think Krugman was having great problems with Keen’s logically incisive top down engineering-style criticisms of Krugman’s arguments. In the end, it appeared that Krugman just ran from Keen’s logical arguments. First time I’ve every seen Krugman do that. He just huffed a bit and gave up — probably because Keen wasn’t being Wonkish enough. To be honest, I don’t think Krugman likes real world engineers all that much.

  57. Pingback: Bring Back Fiscal Policy | | New Economic PerspectivesNew Economic Perspectives

  58. Pingback: Deus Ex Macchiato » Fair value gains as monetary base – even better than the real thing

  59. I think it would be useful if someone could write about what exactly “captital constrained” means (or is composed of). There are a lot of explanations from all the Modern Money people about how banks are not reserve constrained, but rather capital constrained. And further, there are a lot of explanations about what reserves “are,” but it seems there are very few explanations about what capital “is” …does that make sense?

    What are the opereational realities of capital constaint?

  60. Pingback: Dan Kervick: Beware of Rule by Central Banks « naked capitalism

  61. Geez, if this creates so much controversy, just imagine the debate of my related question (!), which is about banks vs. other entities in creating horizontal money …
    I’ve previously read Mosler and others say, as examples, that the following can create horizontal money:
    (a) credit card companies; anyone that issues commercial paper in USD
    (b) foreign entities issuing in USD (e.g. an Indian steel company issues USD bonds)
    (c) anyone that extends”credit”/IOU
    I can understand how banks are special in that (most of the time) banks trust each other in lending, and can borrow fed funds or at the discount window (i.e. banks have a special credibility in creating money that is recognized by other banks and the Fed).
    I’m having a tough time understanding the other examples, unless the banking system works in parallel (e.g. a bank must always make the initial loan or purchase the asset). I can see (d) creates a balance sheet item (accounts receivable), but that doesn’t create deposits anywhere, unless the entity that receives the IOU can actually monetize it (borrow against it).

    • First thing you have to understand is what money is. Any time someone will take something from you and give you goods and services, it’s “money” (medium of exchange). It’s the “oil” of economic transactions. Large numbers of people — we call them “poor people” — fail to perform economic transactions which would be mutually beneficial — such as starting businesses in vacant buildings — due to lack of money.

      The medium-of-exchange role of money is the key one for macroeconomic purposes.

      Credibility — trust that someone else will accept the money — is the core of “money-ness”. If people are money-constrained and unemployed, and you can talk a whole group of them into accepting money which you just printed at home, then you will be able to create an economic boom out of nothing. (Good trick if you can do it.)

      • It is useful to recognize two kinds of financial instruments: money and investments. In the United States at present I would define money as a zero maturity financial instrument used as a customary means of payment in trade or settlement of debts, this is best identified as M1, the sum of currency in circulation and transaction accounts at depository instutions not held by banks, central bank, or treasury (M1 money as a nonbank asset). Investments are not zero maturity financial instruments and are not generally used as a means of final payment, admittedly, there are financial instruments with money-like properties but I would use M1 as the pure money and other monetary aggregates as investments that require M1 to unwind, if society fails to roll over the other investments, bank liabilities all want to pile up as M1 and society is in the liquidity trap!

        Then my question for Mr. Mosler would be how investmens created by nonbank firms can be forced to become money M1 and then perhaps converted to other monetary-aggregates or money-like investments as the non-transaction liabilities of banks? If he has a credible answer I would like to hear it … I think credit card liabilities are much like off-balance sheet obligations of banks (lines of credit) in that when the customer demands a loan it appears on the books of the bank at the time the line of credit is converted to an actual loan of funds, as for the other examples, I am curious on the subject.

  62. Wow, reading through this thread I see a major conceptual confusion (at least on my part). Back in Econ 101 I was taught the tradition idea that banks take deposits and can loan out a fraction of the deposit. If they are required to keep %10 of the deposit “in reserve” as I remember this was referred to as the reserve requirement. As I am understanding it now, there is no such thing in practice. In addition, the “reserve deposits” banks hold at the fed have nothing to do with this concept?
    In the popular press it seems people are confusing this textbook idea of “reserves” with bank capital, over which there are some requirements (Basel).
    This seems like a huge mix up in terminology and concepts. If it is true that there is no such thing as a “reserve requirement” that constrains bank lending, and that this is a thing that Paul Krugman’s believes in, is he simply mistaken about the existence of something that is objectively untrue? I.e. there really are no regulations that require banks to hold a certain amount of reserves in proportion to there loans. The only practical requirement is that they have enough deposits in there reserve account at the fed by end of day to avoid overdraft.
    On the other hand, if there still are requirements that banks hold a certain amount on reserve (I guess the only place they can hold this is in their fed account) but since they are able to borrow them, Keen et al are saying this amounts to no practical constraint on lending? If so, then it seems a bit semantic to say that banks ability (or desire) to make loans is indendent of the amount of reserves made available by the Fed. The fed targets interest rates, which affect lending amounts (I think). Doesn’t the fed essentially affect the amount of money available to support loans by changing the interest rate on its loans to the banking system?
    The idea being that the amount of underlying reserves available ( for lack of a better term) is conceptually almost the same as the Feds primary interest rate? Isn’t this Krugman’s main point? That in a “normal” economy the Fed can at least influence the amount of loans banks make by raising or lowering interest rates? The higher the Feds rate, the fewer loans that will be profitable for banks to make. This holds except when we have a situation like now when the Feds primary rates are near zero?
    It would be helpful if a knowledgeable party without a dog in the fight could present each sides arguments in there strongest form.

    • “If they are required to keep %10 of the deposit “in reserve” as I remember this was referred to as the reserve requirement. As I am understanding it now, there is no such thing in practice. ”

      Correct, there is no such thing in practice; it went out with the gold standard. There are still some “reserve requirement” regulations, but they have no practical effect; they can be consistently met by accounting shenanigans, and they are.

    • My reading of Hyman Minsky is that banks are inclined to expand assets in a growth economy with participation from nonbank borrowers, that is, until the financial collateral available for hypothecation in the interbank lending markets reaches some saturation or breaking point. Even though banks are self-funding, that is, they create the transaction account funds which are the source for the whole liability mix in the aggregate bank balance sheet, it is the mix of assets (loan to securities ratio up on the asset side) and liabilities (money market secured and unsecured borrowings to deposits ratio up on the liabilities side) that will end a bubble and reverse the system from a phase of bank balance sheet expansion to a phase of bank balance sheet contraction. See my post above for a summary of the aggregate bank balance sheet mix (April 7).

  63. Everyone knows Krugman’s wrong. But there is no evidence to prove that “Once John Taylor came up with his “rule,” everyone agreed an interest rate target could work” . In fact that’s some joke.

  64. Pingback: The Political Path to Full Employment | | New Economic PerspectivesNew Economic Perspectives

  65. That’s called the conventional (after-the-fact), wisdom? The current level of interest rates (policy rate), is not necessarily one that coincides with the proper rate of growth of bank credit (& there is no model to prove this). And that doesn’t even account for the fact that Taylor’s formula is ex-post (inflation measures are ex-post, gDp measures are ex-post, targets are ex-post, revisions to the data are ex-post, etc.).

    Richard Fisher, November 2, 2006: – Fed

    “In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data.”

    Unfortunately, the effect of FOMC operations on the federal funds rate is unknown for an indefinite length of time. The effect of Fed operations on interest rates is INDIRECT, and varies WIDELY over time, and in MAGNITUDE.

    The money supply could never be managed by any attempt to control the cost of credit (i.e., thru interest rates pegging governments, or thru “floors”, “ceilings”, “corridors”, “brackets”, etc).

  66. Pingback: TheMoneyIllusion » More reasons to stop talking about inflation

  67. Pingback: Krugman contra Minsky: ¿a quién deberíamos creer en cuestiones bancarias? | Vamos a Cambiar el Mundo

  68. Pingback: Krugman | Pearltrees

  69. Pingback: The ultimate vindication of Republican supply-side economics - Page 40 - US Message Board - Political Discussion Forum

  70. Going off the Gold standard was a Giant Mistake. There is no value in pretty much anything we own its all just perception over paper that keep getting printed at a rate nobody really knows.

  71. Russell O'Connor

    Here in Canada, we’ve had no reserve requirements for some time. One thing still puzzles me though. The Bank of Canada’s overnight target interest rate is 1% and has been for quite some time and the Bank rate is 1.25%. This means than institutions can borrow from the Bank of Canada at 1.25%. What I don’t understand is why there are many savings accounts (see ) that provide interest rates above 1.25%. The rates on that list vary from 1.35% to 3%. Why would banks give such high interest rates to consumer savings accounts when they could borrow from the Bank of Canada at 1.25% instead?

  72. Pingback: Debunking another cornerstone of the Austrian-Keynesian dialectic: do Central Banks really control the Money Supply? « Real Currencies

  73. Pingback: Debunking another cornerstone of the Austrian-Keynesian dialectic: do central banks really control the money supply? « The Daily Knell

  74. Pingback: Eurokrise und kein Ende – Spanien im freien Fall | NachDenkSeiten – Die kritische Website

  75. Pingback: Understanding the Permanent Floor—An Important Inconsistency in Neoclassical Monetary Economics - New Economic Perspectives

  76. How To Make Money Quickly

    Hmm is anyone else encountering problems with the pictures on this blog loading?
    I’m trying to figure out if its a problem on my end or if it’s the blog.
    Any suggestions would be greatly appreciated.