Krugman vs. People Who Understand How Banks Work

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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.

Paul Krugman is a highly influential economist who seems to have learnt everything he knows about banks from an economics textbook.

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?”



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Andrew Jackson

Andrew Jackson holds a BSc in Economics and a MSc in Development Economics from the University of Sussex, and is currently studying for a PhD at the University of Surrey. He is a co-author of the book “Where Does Money Come From? A guide to the UK monetary and banking system” with Josh Ryan-Collins and Tony Greenham from the New Economics Foundation, and Professor Richard Werner from the University of Southampton.
  • João Granchinho

    Fullwiler’s article is long and targets specific points. He took the time to analyze and engage Krugman’s claims and form a clear rebuttal where he disagreed. Krugman’s response is short and vague, typical of someone who doesn’t want to risk his “status” engaging arguments that go against his own, whatever truth they may hold. If Mr. Krugman doesn’t want to “waste his time” making sure his claims are solid, his “status” will suffer in the end.

  • Luis Celhay

    Maybe you want to dig into an actual economic textbook to try to actually write something that is at least half true, because your six points on the neutrality of money are not even a quarter. By the way, if you actually want to criticize the neutrality of money I suggest you pick up an austrian economics article on the subject, there are plenty.

  • GWHodgson

    Just one of Krugman’s arguments reveals his confusion:

    “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.”

    Fullwiler doesn’t really address this properly.

    The point is that there are two kinds of bank assets, and Krugman doesn’t see the significance of this. Banks, as he says, must buy assets with funds they have on hand, but only those which are already in someone else’s hands. They acquire loan assets, newly created out of thin air by the signature of a borrower, with deposit liabilities, newly created out of thin air by the keystrokes of the loan officer.

    When the borrower spends the money and the bank loses the deposit liability to another bank, then it must also transfer a balancing asset to that bank and this must come from funds they have on hand, but only to the extent that it is not at the same time acquiring deposit liabilities from that other bank, which is the issue that Fullwiler focuses on.

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