The problem with most (neo-classical) economists isn’t that they aren’t smart people (in fact some of them are ridiculously clever); it’s that they were taught wrong.
Like most others who study a subject, they sit down to read the textbooks assuming that they are correct – a reasonable assumption one might think. These textbooks teach them that the world works in a certain way. With regards to money and banking they teach the money multiplier model. This allows economists to assume that ‘money is neutral’, which in simple terms just means that:
- Banks are economically insignificant – they have no affect on the economy and are not special in any way
- Banks do not really create money, they merely intermediate between savers and borrowers
- Because they are simply intermediaries the level of debt in an economy does not matter – as one person’s debt is another person’s credit.
- Money simply exists to oil the wheels of barter.
- Money is just a token which we use to transact with each other
- The central bank has complete control of bank lending through control of the monetary base and the reserve ratio.
Of course, when you know how banks actually work you realise that all of these assumptions are completely wrong. However, if you don’t then you can go out and build models of the economy without money, banks or debt, which is exactly what economists have been doing. Of course, this is madness, and one of the principle reasons why most of them didn’t see the financial crisis coming.
However, some people who do get it are starting to take him to task – Scott Fullwiler states in his blog post 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.”
Krugman’s response, which one commenter called ‘snarky’ can be found here.
Its worth reading both these posts in full, if just for the entertainment value of the comments section.
The hope is of course that once economists finally understand what banks do they will ask the question:
“of all the ways we have of organising money and banking, is the best really the one we have today?”