Steve Keen: "The Roving Cavaliers of Credit" (or Why Ben’s Helicopter Will Fail)

Readers responded with great enthusiasm the last time I hoisted a big chunk of material from Australian economist Steve Keen’s blog (see “Bernanke an Expert on the Great Depression?” )I was therefore quite gratified when he wrote asking me to cross post his latest piece.

Keen is a fiercely independent thinker, and has other qualities I like: he’s empirical, common-sensical, and cross disciplinary. His lack of deference for orthodoxy means he is seen among economists, as the British might say, as unsound.

Given how well conventional wisdom has served us, maybe it’s time we take the iconoclasts more seriously.

The post debunks several notions near and dear to the Fed, most economists, and pretty much all financial commentators. First, that the Fed’s current and expected money expansion moves are on a scale sufficient to create inflation. They aren’t because, second, we are working with the wrong paradigm. The assumption is that we operate within a “fiat money” or “fractional reserve banking system”. Keen argues these are incidental elements to what is more properly described as a “credit money system”.

This post is LONG and very much worth your attention, so you might want to get a cup of coffee first.

From Keen (see his site for the footnotes). Boldface his:

Talk about centralisation! The credit system, which has its focus in the so-called national banks and the big money-lenders and usurers surrounding them, constitutes enormous centralisation, and gives this class of parasites the fabulous power, not only to periodically despoil industrial capitalists, but also to interfere in actual production in a most dangerous manner— and this gang knows nothing about production and has nothing to do with it.” [1]

Ten years ago, a quote from Marx would have one deemed a socialist, and dismissed from polite debate. Today, such a quote can (and did, along with Charlie’s photo) appear in a feature in the Sydney Morning Herald—and not a few people would have been nodding their heads at how Marx got it right on bankers.

He got it wrong on some other issues,[2] but his analysis of money and credit, and how the credit system can bring an otherwise well-functioning market economy to its knees, was spot on. His observations on the financial crisis of 1857 still ring true today:

“A high rate of interest can also indicate, as it did in 1857, that the country is undermined by the roving cavaliers of credit who can afford to pay a high interest because they pay it out of other people’s pockets (whereby, however, they help to determine the rate of interest for all), and meanwhile they live in grand style on anticipated profits.

Simultaneously, precisely this can incidentally provide a very profitable business for manufacturers and others. Returns become wholly deceptive as a result of the loan system…”[1]

One and a half centuries after Marx falsely predicted the demise of capitalism, the people most likely to bring it about are not working class revolutionaries, but the “Roving Cavaliers of Credit”, against whom Marx quite justly railed.

This month’s Debtwatch is dedicated to analysing how these Cavaliers actually “make” money and debt—something they think they understand, but in reality, they don’t. A sound model of how money and debt are created makes it obvious that we should never have fallen for the insane notion that the financial system should be self-regulating. All that did was give the Cavaliers a licence to run amok, with the consequences we are now experiencing yet again—150 years after Marx described the crisis that led him to write Das Kapital.

The conventional model: the “Money Multiplier”

Every macroeconomics textbook has an explanation of how credit money is created by the system of fractional banking that goes something like this:

Banks are required to retain a certain percentage of any deposit as a reserve, known as the “reserve requirement”; for simplicity, let’s say this fraction is 10%.

When customer Sue deposits say 100 newly printed government $10 notes at her bank, it is then obliged to hang on to ten of them—or $100—but it is allowed to lend out the rest.

The bank then lends $900 to its customer Fred, who then deposits it in his bank—which is now required to hang on to 9 of the bills—or $90—and can lend out the rest. It then lends $810 to its customer Kim.

Kim then deposits this $810 in her bank. It keeps $81 of the deposit, and lends the remaining $729 to its customer Kevin.

And on this iterative process goes.

Over time, a total of $10,000 in money is created—consisting of the original $1,000 injection of government money plus $9,000 in credit money—as well as $9,000 in total debts. The following table illustrates this, on the assumption that the time lag between a bank receiving a new deposit, making a loan, and the recipient of the loan depositing them in other banks is a mere one week.

This model of how banks create credit is simple, easy to understand (this version omits the fact that the public holds some of the cash in its own pockets rather than depositing it all in the banks; this detail is easily catered for and is part of the standard model taught to economists),… and completely inadequate as an explanation of the actual data on money and debt.

The Data versus the Money Multiplier Model

Two hypotheses about the nature of money can be derived from the money multiplier model:

1. The creation of credit money should happen after the creation of government money. In the model, the banking system can’t create credit until it receives new deposits from the public (that in turn originate from the government) and therefore finds itself with excess reserves that it can lend out. Since the lending, depositing and relending process takes time, there should be a substantial time lag between an injection of new government-created money and the growth of credit money.

2. The amount of money in the economy should exceed the amount of debt, with the difference representing the government’s initial creation of money. In the example above, the total of all bank deposits tapers towards $10,000, the total of loans converges to $9,000, and the difference is $1,000, which is the amount of initial government money injected into the system. Therefore the ratio of Debt to Money should be less than one, and close to (1-Reserve Ratio): in the example above, D/M=0.9, which is 1 minus the reserve ratio of 10% or 0.1.

Both these hypotheses are strongly contradicted by the data.

Testing the first hypothesis takes some sophisticated data analysis, which was done by two leading neoclassical economists in 1990.[3] If the hypothesis were true, changes in M0 should precede changes in M2. The time pattern of the data should look like the graph below: an initial injection of government “fiat” money, followed by a gradual creation of a much larger amount of credit money:

Their empirical conclusion was just the opposite: rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later:

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly. (p. 11)

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered… The difference of M2 – M1 leads the cycle by even more than M2, with the lead being about three quarters.” (p. 12)

Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.

It doesn’t take sophisticated statistics to show that the second prediction is wrong—all you have to do is look at the ratio of private debt to money. The theoretical prediction has never been right—rather than the money stock exceeding debt, debt has always exceeded the money supply—and the degree of divergence has grown over time.(there are attenuating factors that might affect the prediction—the public hoarding cash should make the ratio less than shown here, while non-banks would make it larger—but the gap between prediction and reality is just too large for the theory to be taken seriously).

Academic economics responded to these empirical challenges to its accepted theory in the time-honoured way: it ignored them.

Well, the so-called “mainstream” did—the school of thought known as “Neoclassical economics”. A rival school of thought, known as Post Keynesian economics, took these problems seriously, and developed a different theory of how money is created that is more consistent with the data.

This first major paper on this approach, “The Endogenous Money Stock” by the non-orthodox economist Basil Moore, was published almost thirty years ago.[4] Basil’s essential point was quite simple. The standard money multiplier model’s assumption that banks wait passively for deposits before starting to lend is false. Rather than bankers sitting back passively, waiting for depositors to give them excess reserves that they can then on-lend,

“In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.[5]

Thus loans come first—simultaneously creating deposits—and at a later stage the reserves are found. The main mechanism behind this are the “lines of credit” that major corporations have arranged with banks that enable them to expand their loans from whatever they are now up to a specified limit.

If a firm accesses its line of credit to, for example, buy a new piece of machinery, then its debt to the bank rises by the price of the machine, and the deposit account of the machine’s manufacturer rises by the same amount. If the bank that issued the line of credit was already at its own limit in terms of its reserve requirements, then it will borrow that amount, either from the Federal Reserve or from other sources.

If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:

refuse to issue new reserves and cause a credit crunch;
create new reserves; or
relax the reserve ratio

Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.

Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve.

Central Banks around the world learnt this lesson the hard way in the 1970s and 1980s when they attempted to control the money supply, following neoclassical economist Milton Friedman’s theory of “monetarism” that blamed inflation on increases in the money supply. Friedman argued that Central Banks should keep the reserve requirement constant, and increase Base Money at about 5% per annum; this would, he asserted cause inflation to fall as people’s expectations adjusted, with only a minor (if any) impact on real economic activity.

Though inflation was ultimately suppressed by a severe recession, the monetarist experiment overall was an abject failure. Central Banks would set targets for the growth in the money supply and miss them completely—the money supply would grow two to three times faster than the targets they set.

Yves here. This strikes me as a bit of an oversimplification (at least as far as the US is concerned, but Keen is clearly casting his net broader than that). The Volcker-induced recession of 1980-1982 is depicted as a successful monetarist experiment. Volcker clamped down, hard, on money supply growth (then the various Ms were published weekly and everyone on Wall Street stopped to read the 4:00 PM release on Thursdays). However, that was the period in which banks were getting permission to offer new products, such as NOW accounts (checking accounts that paid interest) to compete with money market mutual funds. My understanding is that aroune 1982, money supply growth measures were becoming less reliable. However, I have wondered why the Fed never did research on how to look at money supply in the light of deregulation. I also wonder whether the “Ms were getting wacky” was an excuse for the fact that Volcker finally gave in to considerable pressure to ease up in July 1982. Back to Keen:

Ultimately, Central Banks abandoned monetary targetting, and moved on to the modern approach of targetting the overnight interest rate as a way to control inflation.[6] Several Central Banks—including Australia’s RBA—completely abandoned the setting of reserve requirements. Others—such as America’s Federal Reserve—maintained them, but had such loopholes in them that they became basically irrelevant. Thus the US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.[7]

However, neoclassical economic theory never caught up with either the data, or the actual practices of Central Banks—and Ben Bernanke, a leading neoclassical theoretician, and unabashed fan of Milton Friedman, is now in control of the Federal Reserve. He is therefore trying to resolve the financial crisis and prevent deflation in a neoclassical manner: by increasing the Base Money supply.

Give Bernanke credit for trying here: the rate at which he is increasing Base Money is unprecedented. Base Money doubled between 1994 and 2008; Bernanke has doubled it again in just the last 4 months.

If the money multiplier model of money creation were correct, then ultimately this would lead to a dramatic growth in the money supply as an additional US$7 trillion of credit money was gradually created.

If neoclassical theory was correct, this increase in the money supply would cause a bout of inflation, which would end bring the current deflationary period to a halt, and we could all go back to “business as usual”. That is clearly what Bernanke is banking on:

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days.

What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation…

If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. [8]

However, from the point of view of the empirical record, and the rival theory of endogenous money, this will fail on at least four fronts:

1. Banks won’t create more credit money as a result of the injections of Base Money. Instead, inactive reserves will rise;

2. Creating more credit money requires a matching increase in debt—even if the money multiplier model were correct, what would the odds be of the private sector taking on an additional US$7 trillion in debt in addition to the current US$42 trillion it already owes?;

3. Deflation will continue because the motive force behind it will still be there—distress selling by retailers and wholesalers who are desperately trying to avoid going bankrupt; and

4. The macroeconomic process of deleveraging will reduce real demand no matter what is done, as Microsoft CEO Steve Ballmer recently noted: “We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy”.[9]

The only way that Bernanke’s “printing press example” would work to cause inflation in our current debt-laden would be if simply Zimbabwean levels of money were printed—so that fiat money could substantially repay outstanding debt and effectively supplant credit-based money.

Measured on this scale, Bernanke’s increase in Base Money goes from being heroic to trivial. Not only does the scale of credit-created money greatly exceed government-created money, but debt in turn greatly exceeds even the broadest measure of the money stock—the M3 series that the Fed some years ago decided to discontinue.

Bernanke’s expansion of M0 in the last four months of 2008 has merely reduced the debt to M0 ratio from 47:1 to 36:1 (the debt data is quarterly whole money stock data is monthly, so the fall in the ratio is more than shown here given the lag in reporting of debt).

To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels. That US$20 trillion truckload of greenbacks might enable Americans to repay, say, one quarter of outstanding debt with one half—thus reducing the debt to GDP ratio about 200% (roughly what it was during the DotCom bubble and, coincidentally, 1931)—and get back to some serious inflationary spending with the other (of course, in the context of a seriously depreciating currency). But with anything less than that, his attempts to reflate the American economy will sink in the ocean of debt created by America’s modern-day “Roving Cavaliers of Credit”.

How to be a “Cavalier of Credit”

Note Bernanke’s assumption (highlighted above) in his argument that printing money would always ultimately cause inflation: “under a fiat money system“. The point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it.

We are therefore not in a “fractional reserve banking system”, but in a credit-money one, where the dynamics of money and debt are vastly different to those assumed by Bernanke and neoclassical economics in general.[10]

Calling our current financial system a “fiat money” or “fractional reserve banking system” is akin to the blind man who classified an elephant as a snake, because he felt its trunk. We live in a credit money system with a fiat money subsystem that has some independence, but certainly doesn’t rule the monetary roost—far from it.

The best place to start to analyse the monetary system is therefore to consider a model of a pure credit economy—a toy economy in which there is no government sector and no Central Bank whatsoever—and see how that model behaves.

The first issue in such a system is how does one become a bank?—or a “cavalier of credit” in Marx’s wonderfully evocative phrase? The answer was provided by the Italian non-orthodox economist Augusto Graziani: a bank is a third party to all transactions, whose account-keeping between buyer and seller is regarded as finally settling all claims between them.

Huh? What does that mean? To explain it, I’ll compare it with the manner in which we’ve been misled to thinking about the market economy by neoclassical economics.

It has deluded us into thinking of a market economy as being fundamentally a system of barter. Every transaction is seen as being two sided, and involving two commodities: Farmer Maria wants to sell pigs and buy copper pipe; Plumber Joe wants to sell copper pipe and buy pigs.

Money simply eliminates the problem that it’s very hard for Plumber Joe to find Farmer Maria. Instead, they each sell their commodity for money, and then exchange that money for the commodity they really want. The picture appears more complicated—there are two markets introduced as well, with Farmer Maria selling pigs to the pig market in return for money, Plumber Joe doing the same thing in the copper market, and then armed with money from their sales, they go across to the other market and buy what they want. But it is still a lot easier than a plumber going out to try to find a pig farmer who wants copper pipes.

In this model of the economy, money is useful in that it replaces a very difficult search process with a system of markets. But fundamentally the system is no different to the barter model above: money is just a convenient “numeraire”, and anything at all could be used—even copper pipe or pigs—so long as all markets agreed to accept it. Gold tends to be the numeraire of choice because it doesn’t degrade, and paper money merely replaces gold as a more convenient form of numeraire.

Importantly, in this model, money is an asset to its holder, but a liability to no-one. There is money, but no debt. The fractional banking model that is tacked onto this vision of bartering adds yet another market where depositors (savers) supply money at a price (the rate of interest), and lenders buy money for that price, and the interaction between supply and demand sets the price. Debt now exists, but in the model world total debt is less than the amount of money.

If this market produces too much money (which it can do in a fractional banking system because the government determines the supply of base money and the reserve requirement) then there can be inflation of the money prices of commodities. Equally if the money market suddenly contracts, then there can be deflation. It’s fairly easy to situate Bernanke’s dramatic increase in Base Money within this view of the world.

If only it were the world in which we live. Instead, we live in a credit economy, in which intrinsically useless pieces of paper—or even simple transfers of electronic records of numbers—are happily accepted in return for real, hard commodities. This in itself is not incompatible with a fractional banking model, but the empirical data tells us that credit money is created independently of fiat money: credit money rules the roost. So our fundamental understanding of a monetary economy should proceed from a model in which credit is intrinsic, and government money is tacked on later—and not the other way round.

Our starting point for analysing the economy should therefore be a “pure credit” economy, in which there are privately issued bank notes, but no government sector and no fiat money. Yet this has to be an economy in which intrinsically useless items are accepted as payment for intrinsically useful ones—you can’t eat a bank note, but you can eat a pig.

So how can that be done without corrupting the entire system. Someone has to have the right to produce the bank notes; how can this system be the basis of exchange, without the person who has that right abusing it?

Graziani (and others in the “Circuitist” tradition) reasoned that this would only be possible if the producer of bank notes—or the keeper of the electronic records of money—could not simply print them whenever he/she wanted a commodity, and go and buy that commodity with them. But at the same time, people involved in ordinary commerce had to accept the transfer of these intrinsically useless things in return for commodities.

“Therefore for a system of credit money to work, three conditions had to be fulfilled:

a) money has to be a token currency (otherwise it would give rise to barter and not to monetary exchanges);

b) money has to be accepted as a means of final settlement of the transaction (otherwise it would be credit and not money);

c) money must not grant privileges of seignorage to any agent making a payment.” [11]

In Graziani’s words, “The only way to satisfy those three conditions is …:

to have payments made by means of promises of a third agent, the typical third agent being nowadays a bank. When an agent makes a payment by means of a cheque, he satisfies his partner by the promise of the bank to pay the amount due.

Once the payment is made, no debt and credit relationships are left between the two agents. But one of them is now a creditor of the bank, while the second is a debtor of the same bank. This insures that, in spite of making final payments by means of paper money, agents are not granted any kind of privilege.

For this to be true, any monetary payment must therefore be a triangular transaction, involving at least three agents, the payer, the payee, and the bank.” ( p. 3).

Thus in a credit economy, all transactions are involve one commodity, and three parties: a seller, a buyer, and a bank whose transfer of money from the buyer’s account to the seller’s is accepted by them as finalising the sale of the commodity. So the actual pattern in any transaction in a credit money economy is as shown below:

This makes banks and money an essential feature of a credit economy, not something that can be initially ignored and incorporated later, as neoclassical economics has attempted to do (unsuccessfully; one of the hardest things for a neoclassical mathematical modeller is to explain why money exists, apart from the search advantages noted above. Generally therefore their models omit money—and debt—completely).

It also defines what a bank is: it is a third party whose record-keeping is trusted by all parties as recording the transfers of credit money that effect sales of commodities. The bank makes a legitimate living by lending money to other agents—thus simultaneously creating loans and deposits—and charging a higher rate of interest on loans than on deposits.

Thus in a fundamental way, a bank is a bank because it is trusted. Of course, as we know from our current bitter experience, banks can damage that trust; but it remains the wellspring from which their existence arises.

This model helped distinguish the realistic model of endogenous money from the unrealistic neoclassical vision of a barter economy. It also makes it possible to explain what a credit crunch is, and why it has such a devastating impact upon economic activity.

First, the basics: how does a pure credit economy work, and how is money created in one? (The rest of this post necessarily gets technical and is there for those who want detailed background. It reports new research into the dynamics of a credit economy. There’s nothing here anywhere near as poetic as Marx’s “Cavaliers of Credit”, but I hope it explains how a credit economy works, and how it can go badly wrong in a “credit crunch”)

How the Cavaliers “Make Money”

Several economists—notably Wicksell and Keynes—envisaged a “pure credit economy”. Keynes imagined a world in which “investment is proceeding at a steady rate”, in which case:

“the finance (or the commitments to finance) required can be supplied from a revolving fund of a more or less constant amount, one entrepreneur having his finance replenished for the purpose of a projected investment as another exhausts his on paying for his completed investment.” [12]

This is the starting point to understanding a pure credit economy—and therefore to understanding our current economy and why it’s in a bind. Consider an economy with three sectors: firms that produce goods, banks that charge and pay interest, and households that supply workers. Firms are the only entities that borrow, and the banking sector gave loans at some stage in the past to start production. Firms hired workers with this money (and bought inputs from each other), enabling production, and ultimately the economy settled down to a constant turnover of money and goods (as yet there is no technological change, population growth, or wage bargaining).

There are four types of accounts: Firms’ Loans, Firms’ Deposits, Banks’ Deposits, and Households Deposits. These financial flows are described by the following table. I’m eschewing mathematical symbols and just using letters here to avoid the “MEGO” effect (”My Eyes Glaze Over”)—if you want to check out the equations, see this paper:

1. Interest accrues on the outstanding loans.

2. Firms pay interest on the loans. This is how the banks make money, and it involves a transfer of money from the firms deposit accounts to the banks. The banks then have to acknowledge this payment of interest by recording it against the outstanding debt firms owe them.

3. Banks pay interest to firms on the balances in their deposit accounts. This involves a transfer from Bank Deposit accounts to Firms; this is a cost of business to banks, but they make money this way because (a) the rate of interest on loans is higher than that on deposits and (b) as is shown later, the volume of loans outstanding exceeds the deposits that banks have to pay interest on;

4. Firms pay wages to workers; this is a transfer from the firms deposits to the households.

5. Banks pay interest to households on the balances in their deposit accounts.

6. Banks and households pay money to firms in order to purchase some of the output from factories for consumption and intermediate goods.

This financial activity allows production to take place:

1. Workers are hired and paid a wage;

2. They produce output in factories at a constant level of productivity;

3. The output is then sold to other firms, banks and households;

4. The price level is set so that in equilibrium the flow of demand equals the flow of output

The graphs below show the outcome of a simulation of this system, which show that a pure credit economy can work: firms can borrow money, make a profit and pay it back, and a single “revolving fund of finance”, as Keynes put it, can maintain a set level of economic activity. [13]

These stable accounts support a flow of economic activity in time, giving firms, households and banks steady incomes:

Output and employment also tick over at a constant level:

That’s the absolutely basic picture; to get closer to our current reality, a lot more needs to be added. The next model includes, in addition to the basic system shown above:

1. Repayment of debt, which involves a transfer from the Firms’ deposit account to an account that wasn’t shown in the previous model that records Banks unlent reserves; this transfer of money has to be acknowledged by the banks by a matching reduction in the recorded level of debt;

2. Relending from unlent reserves. This involves a transfer of money, against which an equivalent increase in debt is recorded;

3. The extension of new loans to the firm sector by the banks. The firms sector’s deposits are increased, and simultaneously the recorded level of debt is increased by the same amount.

4. Investment of part of bank profits by a transfer from the banking sector’s deposit accounts to the unlent reserves.

5. Variable wages, growing labour productivity and a growing population.

The financial table for this system is:

As with the previous model, this toy economy “works”—it is possible for firms to borrow money, make a profit, and repay their debt.

With the additional elements of debt repayment and the creation of new money, this model also lets us see what happens to bank income when these parameters change.

Though in some ways the answers are obvious, it lets us see why banks are truly cavalier with credit. The conclusions are that bank income is bigger:

If the rate of money creation is higher (this is by far the most important factor);

If the rate of circulation of unlent reserves is higher; and

If the rate of debt repayment is lower—which is why, in “normal” financial circumstances, banks are quite happy not to have debt repaid.

In some ways these conclusions are unremarkable: banks make money by extending debt, and the more they create, the more they are likely to earn. But this is a revolutionary conclusion when compared to standard thinking about banks and debt, because the money multiplier model implies that, whatever banks might want to do, they are constrained from so doing by a money creation process that they do not control.

However, in the real world, they do control the creation of credit. Given their proclivity to lend as much as is possible, the only real constraint on bank lending is the public’s willingness to go into debt. In the model economy shown here, that willingness directly relates to the perceived possibilities for profitable investment—and since these are limited, so also is the uptake of debt.

But in the real world—and in my models of Minsky’s Financial Instability Hypothesis—there is an additional reason why the public will take on debt: the perception of possibilities for private gain from leveraged speculation on asset prices.

That clearly is what has happened in the world’s recent economic history, as it happened previously in the runup to the Great Depression and numerous financial crises beforehand. In its aftermath, we are now experiencing a “credit crunch”—a sudden reversal with the cavaliers going from being willing to lend to virtually anyone with a pulse, to refusing credit even to those with solid financial histories.

I introduce a “credit crunch” into this model by changing those same key key financial parameters at the 30 year mark, but decreasing them rather than increasing them. Firms go from having a 20 year horizon for debt repayment to a 6.4 year horizon, banks go from increasing the money supply at 10% per annum to 3.2% per annum, while the rate of circulation of unlent reserves drops by 68%.

There is much more to our current crisis than this—in particular, this model omits “Ponzi lending” that finances gambling on asset prices rather than productive investment, and the resulting accumulation of debt compared to GDP—but this level of change in financial parameters alone is sufficient to cause a simulated crisis equivalent to the Great Depression. Its behaviour reproduces much of what we’re witnessing now: there is a sudden blowout in unlent reserves, and a decline in the nominal level of debt and in the amount of money circulating in the economy.

This is the real world phenomenon that Bernanke is now railing against with his increases in Base Money, and already the widespread lament amongst policy makers is that banks are not lending out this additional money, but simply building up their reserves.

Tough: in a credit economy, that’s what banks do after a financial crisis—it’s what they did during the Great Depression. This credit-economy phenomenon is the real reason that the money supply dropped during the Depression: it wasn’t due to “bad Federal Reserve policy” as Bernanke himself has opined, but due to the fact that we live in a credit money world, and not the fiat money figment of neoclassical imagination.

The impact of the simulated credit crunch on my toy economy’s real variables is similar to that of the Great Depression: real output slumps severely, as does employment.

The nominal value of output also falls, because prices also fall along with real output.

This fall in prices is driven by a switch from a regime of growing demand to one of shrinking demand. Rather than there being a continuous slight imbalance in demand’s favour, the imbalance shifts in favour of supply—and prices continue falling even though output eventually starts to rise.

The unemployment rate explodes rapidly from full employment to 25 percent of the workforce being out of a job—and then begins a slow recovery.

Finally, wages behave in a perverse fashion, just as Keynes argued during the Great Depression: nominal wages fall, but real wages rise because the fall in prices outruns the fall in wages.

This combination of falling prices and falling output means that despite the fall in nominal debts, the ratio of debt to nominal output actually rises—again, as happened for the first few years of the Great Depression.

Though this model is still simple compared to the economy in which we live, it’s a lot closer to our actual economy than the models developed by conventional “neoclassical” economists, which ignore money and debt, and presume that the economy will always converge to a “NAIRU”[14] equilibrium after any shock.

It also shows the importance of the nominal money stock, something that neoclassical economists completely ignore. To quote Milton Friedman on this point:

“It is a commonplace of monetary theory that nothing is so unimportant as the quantity of money expressed in terms of the nominal monetary unit—dollars, or pounds, or pesos… Let the number of dollars in existence be multiplied by 100; that, too, will have no other essential effect, provided that all other nominal magnitudes (prices of goods and services, and quantities of other assets and liabilities that are expressed in nominal terms) are also multiplied by 100.” [15]

The madness in Friedman’s argument is the assumption that increasing the money supply by a factor of 100 will also cause “all other nominal magnitudes” including commodity prices and debts to be multiplied by the same factor.

Whatever might be the impact on prices of increasing the money supply by a factor of 100, the nominal value of debt would remain constant: debt contracts don’t give banks the right to increase your outstanding level of debt just because prices have changed. Movements in the nominal prices of goods and services aren’t perfectly mirrored by changes in the level of nominal debts, and this is why nominal magnitudes can’t be ignored.

In this model I have developed, money and its rate of circulation matter because they determine the level of nominal and real demand. It is a “New Monetarism” model, in which money is crucial.

Ironically, Milton Friedman argued that money was crucial in his interpretation of the Great Depression—that the failure of the Federal Reserve to sufficiently increase the money supply allowed deflation to occur. But he a trivial “helicopter” model of money creation that saw all money as originating from the operations of the Federal Reserve:

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated… [16]

When the helicopter starts dropping money in a steady stream— or, more generally, when the quantity of money starts unexpectedly to rise more rapidly— it takes time for people to catch on to what is happening. Initially, they let actual balances exceed long— run desired balances…” (p. 13)

and a trivial model of the real economy that argued that it always tended back to equilibrium:

“Let us start with a stationary society in which … (5) The society, though stationary, is not static. Aggregates are constant, but individuals are subject to uncertainty and change. Even the aggregates may change in a stochastic way, provided the mean values do not… Let us suppose that these conditions have been in existence long enough for the society to have reached a state of equilibrium…” (pp. 2-3)

One natural question to ask about this final situation is, “ What raises the price level, if at all points markets are cleared and real magnitudes are stable?” The answer is, “ Because everyone confidently anticipates that prices will rise.” (p. 10)

Using this simplistic analysis, Milton Friedman claimed that inflation was caused by “too many helicopters” and deflation by “too few”, and that the deflation that amplified the downturn in the 1930s could have been prevented if only the Fed had sent more helicopters into the fray:

“different and feasible actions by the monetary authorities could have prevented the decline in the money stock—indeed, produced almost any desired increase in the money stock. The same actions would also have eased the banking difficulties appreciably. Prevention or moderation of the decline in the stock of money, let alone the substitution of monetary expansion, would have reduced the contraction’s severity and almost as certainly its duration.” [17]

With a sensible model of how money is endogenously created by the financial system, it is possible to concur that a decline in money contributed to the severity of the Great Depression, but not to blame that on the Federal Reserve not properly exercising its effectively impotent powers of fiat money creation. Instead, the decline was due to the normal operations of a credit money system during a financial crisis that its own reckless lending has caused—the Cavaliers are cowards who rush into a battle they are winning, and retreat at haste in defeat.

However, with his belief in Friedman’s analysis, Bernanke did blame his 1930 predecessors for causing the Great Depression. In his paean to Milton Friedman on the occasion of his 90th birthday, Bernanke made the following remark:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” [18]

In fact, thanks to Milton Friedman and neoclassical economics in general, the Fed ignored the run up of debt that has caused this crisis, and every rescue engineered by the Fed simply increased the height of the precipice from which the eventual fall into Depression would occur.

Having failed to understand the mechanism of money creation in a credit money world, and failed to understand how that mechanism goes into reverse during a financial crisis, neoclassical economics may end up doing what by accident what Marx failed to achieve by deliberate action, and bring capitalism to its knees.

Neoclassical economics—and especially that derived from Milton Friedman’s pen—is mad, bad, and dangerous to know.

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  1. David

    My understanding of the Volcker monetarist experiment (gleaned from Greider’s “Secrets of the Temple”) is different. Whether you take the monetarist route of controlling the money supply or the standard route of controlling interest rates, you can be easy or tight with money. Monetarism is not inherently a tighter policy mechanism. I agree with Keen that Volcker’s monetarist experiment was deemed a failure because interest rates swung wildly and freaked out the business community. That was the reason Volcker gave it up and went back to controlling interest rates.

  2. IF

    I’ve read Steve Keens article before and I am still trying to digest it. But was it really necessary to copy the whole thing? At least I am usually diligent enough to follow most links.

  3. Yves Smith


    First, he asked me to cross post it.

    Second, it was actually a fair bit of work to import all the tables and put in the formatting.

    Third, I did not see any ready way to shorten it. This is an integrated argument, I could have truncated it and referred readers to Keen.

    Fourth, I though this post was important, and thought if i did truncate it, some readers would not click through, while they might read further on here.

  4. David

    Wow. What an interesting read! I don’t think neoclassical economists are blind to the way money is created through credit like Steve suggests. The simple toy models you read in Econ texts are just that: toy models meant to explain a complex topic to newcomers. They do talk about liquidity traps which is essentially what Steve is talking about.

    Still, perhaps he is right that they underestimate the degree to which the borrowers and lenders affect the money supply rather than the Fed. I think the Fed always thought that if they lowered rates enough, someone would borrow. I don’t think they thought the normally profligate American consumer would actually stop borrowing on their own volition. If so, that was dumb of them.

    It is pretty amazing that his model predicts all of those things just from a slow down in borrowing. That indicates that the model (and perhaps our real economy) is inherently unstable rather than stable as most economist insist.

  5. Yves Smith


    I haven’t read much of Keen (his Debunking Economics (looks very good, only got through the first wee bit) but my impression is that you have hit on one of his pet views. He seems to think that the notion that economic activity has a propensity to equilibrium is bunk.

    I suspect that it true, although there may be mechanisms by which certain things that get too far askew invite forces that push the other way (ie, high prices invite new entrants…..). But the existence of selective corrective mechanisms strikes me as falling far short of the equilibrium assumption.

  6. Tim Geithner's Mom

    A very interesting read. My main takeaway is the destinction between a pure fractional reserve system vs. a “credit money system”.

    In doing a simple thought experiment, it’s easy to come to the conclusion that in a pure FR system, the banks’ losses can never exceed the bondholder’s and depositors’ money. However, in a combination FR+CM system (or any CM system), the losses can be limitless, only bounded by the audacity of the bank in lending out phantom money.

    So, if what he says is true, then the banking system has the capapcity to be on the hook for much more money than it took in by borrowing or as deposits. Looking at the current losses in the banking system, does the loss data support this hypothesis? I’m truely interested, as the bank losses so far look to be, *ahem*, quite large (as are the government garantees helping to backstop them).

  7. Tim Geithner's Mom

    A very interesting read. My main takeaway is the destinction between a pure fractional reserve system vs. a “credit money system”.

    In doing a simple thought experiment, it’s easy to come to the conclusion that in a pure FR system, the banks’ losses can never exceed the bondholder’s and depositors’ money. However, in a combination FR+CM system (or any CM system), the losses can be limitless, only bounded by the audacity of the bank in lending out phantom money.

    So, if what he says is true, then the banking system has the capapcity to be on the hook for much more money than it took in by borrowing or as deposits. Looking at the current losses in the banking system, does the loss data support this hypothesis? I’m truely interested, as the bank losses so far look to be, *ahem*, quite large (as are the government garantees helping to backstop them).

  8. James B

    Thanks for posting this in its entirety. In the three or so years I’ve been reading financial blogs, this is one of the very best posts I’ve seen. It’s just nice to see someone taking an empirical approach to thee issues. Keen’s post is worth more than all the other inflation vs deflation jawboning I’ve seen combined.

  9. albrt

    Of course economies tend to equilibrium! Unfortunately, it is not a neoclassical equilibrium of maximum utility, it is a thermodynamic equilibrium in which we are all dead.

    Excellent post. At least we can be optimistic that bankers will not be able to siphon off wealth again on the same scale in our lifetimes.

    I just wonder if Mr. Keen really thinks that Helicopter Ben and Turbo Tax Timmy won’t eventually cause the printed money supply to catch up with private debt?

  10. bg

    Thank you for another Keen post. It helps the debate a lot. I have become completely convinced that the 100-or-so most influential macroeconomics types largely did not think a credit crisis was possible, and that same group believes in the helicopters. I light reading of minsky would say that the damage has already been done at the ponzi stage, and we simply have to work through the recovery. Instead there is a belief that the fire has just started, and time-is-of the essence.

    The inflationistas have not impressed me much more. It is possible for the government to stop collecting taxes, and pay for everything off its printing presses. This would create inflation, and would be a biblical jubilee. But it would halt lending, and destroy the assets of the current captains of industry.

    I am sure all this stimulus nonsense will not increase the GDP, and will simply shift debt from households to government, and possibly delay recovery by delaying asset price discovery.

    Where’s Keens toy model on stimulus?

  11. fuguez

    I read the article when he released and have to say that I agree with it. Not that he needs my validation.
    His approach appears to be a more network/systems approach, which allows for great variety of behaviours: approaching economics from the standpoint of differential equations rather than equilibrium. Micro-changes therefore have macro-effects and these effects are neither constant nor repeatable.

  12. Anonymous


    Great post, as usual. Credit money does what no one else can, explain what exactly is going on here.

    I would be interested to hear Mr. Keen’s reaction to Mr. Hempton’s post on how the banks in the US can keep going and recapitalize in two years (give or take) given the current spread on lending. I think this actually supports Mr. Hempton, but admittedly, my brain hurts.

    They are simply using the fiat money system to finance the credit money system. Fiat money is much cheaper.

    Neoclassical Economics is a joke. To even begin to call it anything close to science is an insult to real scientists. The ‘economists’ keep trying to make the model fit the problem. The model is completely broken, the econmomy may not be just yet. I hope this adds to the debate.

  13. Glen

    Keens ‘Oz Debt Watch’, Jesse’s Café Américain, Credit Writedowns and of course NC are the most informative and educational sites about. After reading ‘The Death of Economics’ by Paul Ormerod back in 1995, my opinion on economists and the study of economics changed dramatically. It’s refreshing to see more of those in the field growing louder in protest at the sorry state of objective analysis. Long may it last.

  14. Anonymous

    Copernicus vs the Church

    In high school earth science I went through a very interesting exercise.

    First, using simple protractors we plotted the visable planets (and the sun’s) orbits around the earth. This was the church’s assumption at the time. It looks like it probably should have, no rhyme or reason to it.

    Then we took those same measurments and assumed that the planets all revolved around the sun. Wow, it made sense, and more than that, it could predict what would happen in the future.

    The Church at the time apparently had all sorts of equations and arbritary adjustments that would correctly predict the movement, but it was all extremely complicated.

    This is just another one of those moments where the simple chage of frames makes everything clear.

    I am not a scholar of the church, or science at that time, may have my history wrong.

  15. IF

    Yves: my apologies. I saw the long article but missed that Steve Keen asked you for x-posting. It certainly was worthy and laborious.

  16. Michael S

    Thanks for this Yves. It is good to see Australians (who are disparaged here by the orthodoxy) get recognition from quality writers.

  17. folderholder

    I like the Credit-Money system theory; it explains much of what we can observe in the real world these days. Like every theory, though, it rests on certain foundations, or assumptions. One of these assumptions is that banks can be defined as trusted agents. Unfortunately, Credit-Money theory also demonstrates that banks can lose far more than their capital. So when do the banks stop being accepted as “trusted agents”? Clearly, when people are lined up around the block to claim their deposits then a bank, like Northern Rock last year, has lost its trusted status. This helps explain why so much of the TARP money went to banks that weren’t making new loans; the added capital was meant to preserve their trusted agent position and prevent bank runs.

    The Credit-Money explanation also suggests that the current scope of government bailouts is inadequate to stop the economy contraction. As this contraction progresses, the trusted agents will suffer further losses, putting pressure on government to undertake ever more heroic support measures. Undoubtedly, the government will respond to whatever degree is needed to support its patrons. The danger is that at some moment, clarity may set in and the population at large may realize that neither the banks or the government reman trustworthy. At that point, both financial and political events will tend to veer off established paths into unforeseeable directions. Yikes!

  18. Tim

    Keen makes a good (very good) case that base money follows rather than leads credit creation and a somewhat weaker one that it will be impossible to create inflation unless base money is increase another 20x. The accompanying graphs suggest that to get back to the debt/base money ratios of the 70s, when there was plenty of inflation thank you very much, would merely require a level 2-3x what it is now. Given it is growing at around 100% pa then maybe we should expect inflation in about 18 months time.

  19. Richard Kline

    What he said; insofar as his argument on credit money is concerned. I have thought this dimly and broadly for some years but in my dislike of economics (really, I can barely stand to read even good stuff like this on it) I didn’t bother to frame the thesis with the commendable level of clarity of Mr. Keen. For which, thankee, I printed it—and that’s praise.

    In essence, money is whatever a bank says it is. And so long as they speak at moderate multiples, they can say whatever they want; five, ten, fifteen to nominal deposits, not even getting into the issue of sweeps, fine. The government has its say, but in the US speaks only when spoken to, as we see rather nakedly now. Whenever bankers are allowed to say money into being by the boatload, it all comes apart.

    I am not fully convinced of Keen’s four-point deflation scenario in the middle of this essay. However, I am, regretably, simply too tired to sort out my divergences with it this evening, so I’ll let that dog lie. One other minor quibble I have from near the end is the parallel from the Great Depression in which price declines are mentioned. Now, back in the Thirties this really happened yes; in the model he makes here, price declines are essential to the kinds of deflections which he suggests, by analogy, are in the offing in our Awful Oughts. . . . But they really haven’t happened. Yet. Yes, we have significant asset price declines, and those have real shock effects just as shown. We have not had a general price decline in the US at the household level of the economy, which is the fundamental demand level of the economy. If seems inevitable, or at least highly probable, that a collapse in prices at the macro level—the down gap of shipping rates and the like—will find its way to the household consumer. The later part of 09 will be crucial to watch for this. But it hasn’t happened yet, and what kind of outcomes we have, and therefore what kinds of interventions to make, depend greatly on whether this happens a lot, happens a little, or doesn’t much happen.

    As a final note, my conclusion in reading Keen regarding What Is to Be Done? is much what it was a year plus ago: The government should simply set up a network of brand new government banks, which don’t really need any deposits at all (since it’s credit money) but could take certain kinds of deposits, and lend and very modest interest rates to the areas where lending is really required in the real economy and to consumers. We don’t have to have huge issuance by Congress to do this, just hire some staff, open the doors, do basic due diligence, and lend at ten to one against vapor in the vaults. And then seize the old, zombie banks and kill ’em stone dead.

  20. Richard Kline

    So Tim, yes the issue on the difficulty in creating inflation is where I held back in the argument also. I’m not sure of the multiples, but moreover the vector of deflation has a great deal to do with how much base issuance (or credit float) would be required to yield inflation. This is far higher and harder than Bernanke implies, to me; I’m with Keen in that regard. I’m not convinced that he has made as tight an argument regarding the depth and density of that deflationary vector, though. Like you, I do think we will manage to generate inflationary pressures, but the lag may be longer and more nonlinear than we anticipate—and that is the biggest part of my concern. That’s not to diminish Keen’s overall schema, I think it’s sound.

  21. Doly

    This is all very interesting, but the post doesn’t really explain what can cause a credit crunch in the first place, when presumably nobody wants it.

    I think a key point is in this paragraph: “The only real constraint on bank lending is the public’s willingness to go into debt. In the model economy shown here, that willingness directly relates to the perceived possibilities for profitable investment—and since these are limited, so also is the uptake of debt. But in the real world there is an additional reason why the public will take on debt: the perception of possibilities for private gain from leveraged speculation on asset prices.”

    Now, why would people start speculating at a given time? This explanation doesn’t really explain much. It’s fair to think leveraged speculation is what happens whenever banks offer cheap credit, and why would banks start offering cheap credit? The traditional answer to that is “central banks lowered the target rate”, but this post claims that central banks don’t really control the credit situation.

    Is it possible that the reason has to do with the profitability of investments becoming lower on average? Would that lead to banks lowering rates to encourage borrowing, which could create an asset bubble, ending in a credit crunch?

  22. patrick neid

    Another excellent postmortem, confirming again the historical record, that when bubbles burst all we are left with is deflationary splat.

    When the splat on the table can be seen to be picked up, put back in the bottle and re-inflated I’ll believe in “Plans”. To date there has never been a plan that worked in real time. What there has been is hindsight analysis that says would of, could of, should of. The idiot savant Krugman being the latest shrieking practitioner—They didn’t do enough in the 1930 and today’s “Plans” are too small. Yup Paul, keeping picking up the splat before it evaporates.

  23. joe


    Thank you for this most enlightening post. I’m no economist, but I do have a few bucks that have needed careful tending these past eighteen months or so. You, Calculated Risk and Mish have served me well, in a mix and match sort of fashion. This post gets to the heart of what we all need to know about money.

    Take good care. There are many who depend on you

  24. Anonymous

    Well the facts indicate that the price level is a lagging, and not a leading indicator. As Galbraith et al have maintained for years.
    keen’s analysis reminds me of the way Alexander Hamilton wrote about credit markets, but I haven’t looked at Hamilton for decades, so I may be off the mark.
    OTOH as economics appears to be yet an “infant science” (if science indeed be what the discipline of economics is), perhaps the analysis set out by the old-time economists – Marx, Hamilton – are worth considerably more today, than just historical interest. Which would make economics unlike most science of the 18th and 19th centuries.

  25. Anonymous

    “His lack of deference for orthodoxy means he is seen among economists, as the British might say, as unsound.”

    Sounds like the right kind of thinking when conventional thinking is what got us to this sorry state of affairs. The problem is no mater how many reasonable fixes are offered by parties outside the inner circle, all outside the loop a shunted. We can’t fix a debt problem by adding more debt when too much debt is the problem. This is also a generational event, Most the people who were born in the 20″s are dead, the lessons forgotten.

    Lies and fraud will be the path the leaders take.

  26. ruetheday

    “The most serious challenge that the existence of money poses to the theorist is this: the best developed model of the economy cannot find room for it.”

    This is the first sentence of Frank Hahn’s (Cambridge economist and ardent defender of neoclassical economics BTW) 1981 book, Money and Inflation. The “best developed model” to which he refers is the Arrow-Debreu model of General Equilibrium that is at the core of modern Microeconomics.

    Keen is not original in pointing out the logical inconsistencies and false assumptions that developed into neoclassical economics. However, he is quite correct in his statement that the mainstream response has been to simply ignore these problems.

    For a good overview of the basic problems with orthodox Microeconomics (without even considering the problem of money) see, “Dilemmas In Economic Theory: Persisting Foundational Problems of Microeconomics” by Michael Mandler.

    For a good overview of the problems caused by the introduction of money into economic models see, “Money, Interest, and Capital: A study in the foundations of monetary theory” by Colin Rogers.

    These are both fairly technical books that will require the equivalent of an undergraduate degree in economics and finance and proficiency in calculs to get the most out of, but the effort is well worth it.

  27. Anonymous

    I have thought most of this to be true on an intuitive basis, but it’s great to see someone be able to lay out a supporting theory and historic examples.

    Of course, it will get absolutely no traction in the USG–even in a new administration pursuing change and hope. It’s too “unsound” and doesn’t fit with the thinking of the Wall Street insiders even now running Treasury and the Fed.

    It will be an expensive lesson for us all.

  28. Anonymous

    Double Trouble – Coup Bubble

    Credit leads money by a country mile,
    Said the ruling elite with a knowing smile,
    And they set their puppets to flooding the land,
    Putting easy money in everyone’s hand …

    Shop till you drop said the commander in thief,
    As he instilled in the marks a false belief,
    That Scamerica the beautiful could never fail,
    That there was no end to the credit trail …

    And Greenspan and Ben allayed the public fears,
    With their soothing calmness they greased the gears,
    That made their ruling elite’s coup bubble grow,
    This was after all not their first rodeo …

    They knew easy credit is just counterfeit money,
    And so they opened the spigots and let it flow like honey,
    As derivatives spread throughout the world’s financial halls,
    They soon had the world by the credit balls …

    The ruling elite now broadened their grin,
    The marks were fooled and could not see their sin,
    To consolidate power and eliminate the middle class,
    Eliminate population and have all kiss their ass …

    Swing the ax …

    And release,
    Remove some fleece …

    And dump,
    Kill off a chump …

    Inflate the bubble,
    Exhaust it slow,
    Billions of people,
    Starve with no dough …

    Bumbling idiots,
    Or clever elite?
    The marks never question,
    The truth at their feet …

    If you want to find,
    The cause of the trouble,
    You have to pop,
    The deception bubble …

    Deception is the strongest political force on the planet.

    i on the ball patriot

  29. Allen C

    “sufficient injections of money will ultimately always reverse a deflation.”

    This is absolutely correct! If the Fed went into the open market with the intent of purchasing ALL outstanding govi debt, you WILL HAVE inflation and plenty of it. Devaluation in a fiat system is easily achieved.

  30. JKH

    This is an impressive piece, but it is far too long and complicated for the purpose of communicating a simple message.

    The message is that the “money multiplier” is a patently false description of money causality.

    “In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.

    This is absolutely correct.

    But it’s hardly the result of theory. It’s the way it is. And it’s nothing new. All of that data analysis isn’t required. One only need understand something about banking operations and the nature of money creation by credit extension. The system works as it is; not due to proof by data compilation. (And given some understanding of the banking system, the notion that bank money originates from government fiat is simply ludicrous.)


    “Given their proclivity to lend as much as is possible, the only real constraint on bank lending is the public’s willingness to go into debt.”

    This is absolutely wrong. Bank lending is constrained by capital; not by liquidity reserves. This “only real constraint” fallacy is just an extension of the core popular delusion associated with money multiplier causality.


    “With a sensible model of how money is endogenously created by the financial system, it is possible to concur that a decline in money contributed to the severity of the Great Depression, but not to blame that on the Federal Reserve not properly exercising its effectively impotent powers of fiat money creation. Instead, the decline was due to the normal operations of a credit money system during a financial crisis that its own reckless lending has caused—the Cavaliers are cowards who rush into a battle they are winning, and retreat at haste in defeat.”

    This is wrong as well. E.g. the power of the helicopter drop lies in the fact that it combines a fiscal and monetary operation in one blunt tool. The drop is at once an expansion of the rawest form of base money, and an immediate fiscal transfer. Commercial banks don’t do fiscal transfers.

    Volcker’s modus operandi is generally misunderstood, but another topic. He pulled the strings on the monetary base in response to developments in the broader money aggregates. That changed short term interest rates. It’s operationally no different than what the Fed does in normal (non liquidity trap) conditions today, except that today’s target variable is a broader mix of inflation predictive data than just the broad money supply. The Fed still adjusts the monetary base in order to set the short term rate. That said, the world has now changed with the zero bound in play, and with the Fed paying interest on reserves. Notwithstanding these changes, and the credit crisis per se, Keen’s basic thesis doesn’t change, which really only has to do with the fallacy of the money multiplier and the correct operational interpretation of money creation.

  31. donebenson

    Thanks Yves [and Steve Keen] for another truly excellent post.

    What I worry about is the definition of ‘inflation.’ Neither in the 1920’s in the US [leading up to the Great Depression], nor in the period after 2000 [or before, except for a brief spurt of commodity oriented inflation @2007], was traditional CPI inflation – an issue, despite the tremendous credit increases. But inflationary ‘bubbles’ in stocks, real estate, commodities, art, and bonds were evidenced instead.

    So, while Steve Keen may be absolutely correct to express that Bernanke’s ‘helicopter drops’ will not result in CPI measured inflation, will the huge increase in the ‘money supply’ show up in other areas, such as an increase in the price of gold, or other scarce assets?

  32. joebhed

    I read the whole article, and I am glad that you printed it.
    I haven’t read all the comments.
    I am also glad that you included the (s) in the opening on iconoclasts. License.
    I have been writing on this blog for quite a while that we really do NOT have a grip on the CAUSE of our monetary problems, and all other (credit, economic, housing, unemployment, etc) problems stem directly from a money system misunderstanding.
    To put things MUCH MORE SIMPLY than is necessary to get the point across than did Steve keen, for which I am eminently grateful, the basic problem in a so-called “credit” money system, which is, in fact a “debt-money” system, is this.
    We create ALL money in our economy as a debt. That is to say, BEFORE the banker issues a credit to your account, you provide the promissory note(PN) and the security contract, thus creating a DEBT, for which the bank creates money out of nothing and issues a credit to your account.
    That debt is repayable with interest.
    That interest is NEVER CREATED in any bank in the system.
    The sooner the myriad of financial experts, including Setser and Geithner, get their minds around this simple fact, the sooner we will all be backing Dennis Kucinich’s proposal to put the private federal reserve bankcorp out of business.
    Again, PLEASE read this on “HOW Debt Money Goes Broke”.

    We can actually solve our economic problem WITHOUT mortgaging the grandkids.
    Nuff said.

  33. DoctoRx

    1. Shame on you, anon 7:36.

    2. Nassim Taleb argues strongly that financial systems do not tend toward equilibrium.

    3. Re DOLY 7:38 AM and others: IMO: An intense effort by the Merchants of Debt over decades has helped convert the public over the years to take debt for granted; it didn’t “just happen” the way SARS just happened. This is similar to the way food marketing has helped cause the obesity epidemic.
    It’s human nature to be able to be persuaded. Pres. Obama and the MSM should be calling for gradual debt reduction and an equity-not-debt culture. Nouriel Roubini specifically calls for negotiated reduction of debt balances to save the system from collapsing.

  34. FairEconomist

    Keen has somehow fallen into attributing *inflation*, a monetary phenomenom, to debt levels. Increases and decreases in debt don’t have much to do with price levels – what did prices do in 1933-1945? Hint: they didn’t drop by 80%, as implied by Keen’s interpretations.

    I’m also shocked that Keen attributes the M0 jump to the Fed increasing reserves. When the Fed started paying interest on reserves, the banks all borrowed large sums from at lower interest rates to keep as reserves. Of course these increases weren’t really increases in reserves, but an attempt to game the messed-up system the Fed had created. Keen really should know better.

    Keen is correct in noting the demand-pull nature of debt expansion and I think he’s largely correct in expecting that inflation will not produce much *real* increase in nominal production in these circumstances (although it can prevent the truly horrendous additional of debt deflation, which isn’t in Keen’s model). But he’s very wrong predicting that printing money won’t increase prices.

  35. Mike Sankowski


    I disagree. This post is entirely necessary as the correct money creation process is completely ignored by most economists. They think the banks need reserves before they can lend – which is backwards from the way the world works. Because they think reserves precede lending, they think that providing reserves spurs lending, so therefore we have a huge program in place to give banks money.

    Clearly, it has not worked. Why? Because in the real world, banks make the loans first and then borrow the reserves from the fed as necessary.

    This is a great post by Steve Keen. Just a fantastic exposition and a great model.

    He does miss one important factor in this model, and makes a mistake about the demand for money.

    Basil Moore divides the world into horizontalists and verticalists. Horizontalists is Steve is describing here. It is important to distinguish between private money creation by banks, which by identity must net to zero (assets = liabilities), and government money creation.

    Government is the vertical component. The vertical component is net money growth created by government deficit spending. Money is created and destroyed by credit all the time, but net money can only be created by the government through deficit spending.

    Please – everyone here should be reading interfluidity and Warren Mosler. Understanding how money creation occurs and that taxes drive the demand for money is crucial.

    The sooner we understand the money creation process, the sooner we are going to exit this crisis.

  36. Anonymous

    Let me also add my thanks for a very interesting post. I think Keen’s model gets at what seems like an obvious observation of the real world that I’ve been waiting with frustration to hear someone address when talking about bank bailouts and stimulus plans: banks won’t lend if they don’t think the borrowers will make payments and prospective borrowers won’t borrow if they don’t think they are going to sustain it.

    Also, FWIW, I couldn’t help but read Keynes’ “animal spirits” explanation for investors’ fickleness into Keen’s change in expectations in his model that produced the credit crunch.

  37. Gloomy

    What happens if there is massive issuance of treasuries and printing of money by the government to buy such treasuries? Then all confidence is lost in the dollar and we move to a gold based system (or perhaps some other barter system). Abandonment of dollars will lead to massive infaltion. Welcome to our world!!

  38. FairEconomist

    Gloomy, in the 70’s we had inflation well into the teens, a loss of confidence in the dollar so bad Carter issued yen-denominated bonds, and legal gold. No shift to a gold standard. Actually, even hyperinflation doesn’t bring bank a gold standard – e.g Brazil, Italy, Weimar, etc. The gold standard is gone and it’s not coming back – even the worst outcomes of fiat money have repeatedly failed to bring it back.

  39. FairEconomist

    This post is entirely necessary as the correct money creation process is completely ignored by most economists.

    To some extent, but Keen’s conclusions are still a huge non sequitur. He’s saying debt levels drive price levels, even though the most casual glance at his long term debt graphs shows no connection – we didn’t have high inflation under Hoover, massive deflation during WWII, a surge in inflation in the late 80’s after mild and typical inflation under Carter, etc.

  40. Don

    For those interested in Marx’s analysis of money, one can listen to this one hour class room presentation by David Harvey, professor at NY University. Harvey has presented classes on Marx’s ‘Capital’ for many years and is the author of many books, including the ‘Limits of Capital’ in which he provides an analysis of ‘Capital.’

    In this presentation, Harvey presents Marx’s chapter 3 of ‘Capital’, describing what money is, the movement from C-C (commodity – commodity — the system of barter), to C-M-C (commodity produced in exchange for money to purchase another commodity), to M-C-M (the money credit system as described by Keen).

    Harvey discusses Marx’s insights on hoarding, how money becomes a commodity more valued than the physical commodity, the velocity of money, factors regarding the quantity and quality of capital and it circulation (or lack thereof), the role of money/credit creation that fuels speculative bubbles, etc.

  41. Gloomy

    @Fair Economist

    Whatever. The point is at some point loss of confidence in the dollar will lead to inflation, not deflation. This has been Buiter’s point.

  42. Anonymous

    “we should never have fallen for the insane notion that the financial system should be self-regulating. All that did was give the Cavaliers a licence to run amok”

    When I see a quote like the one above, what immediately springs to mind is that the author has some regulatory system in mind that should be given more power over individuals and markets, presumably a system guided by people who think like….the author. These altruistic regulators would have a high vantage point from their seats of power and thus could make better decisions than the rank and file dealing with life on street level. Such a system is always perceived (by its proponents) as an improvement over unruly capitalism because everyone knows that these all powerful regulators would be benevolent, no chance of them running amok, with even greater destruction due to their centralized base of power. And of course the general population would be closely watching how the regulators managed things and would reign them in at the first sign of excessive accumulation of central power. As Hayek explained, these are the central milemarkers on the road to serfdom.

    There are a few of us simpletons out here who just won’t accept the premise of “regulators” who can and will make better decisions than the market. We posit that the problems of late, and in previous historical examples, stem not from too little regulation, but too much. The level of interest rates, or the price of houses, etc., should be set by markets, not by the federal reserve board or the US government. Thus, all the recent wailing from the left that our economic condition proves that capitalism and free markets are doomed to fail, when our current problems are ,in fact, due to government, not market, distortions.

    But, if anyone does feel so inclined to doubt the market that they must advocate the continued advance of regulation (and no sentient person can deny that it has massively advanced in our economy over the last 100 years), then just understand that eventually a very powerful regulator will appear who does not agree with your vision of the world. Someone offering change and hope to the masses, who gains massive public popularity in a time of economic stress. Someone like Adolph Hitler.

  43. Advant Guard

    1. There are two requirements that restrict the growth of bank lending. The reserve requirement that Mr. Keen mentions and the capital requirement. A quick look at the Federal Reserve data shows that banks over 300 billion in excess reserves at the Federal Reserve. Clearly, the reserve requirement is not the limiting factor in bank lending.

    2. It is true that banks make loans and then get the reserves to back them (lending occurs every day the reserve requirement is enforced once a week.) However, Mr. Keen neglects the importance of the Federal Fund rate. Most banks that are short reserve get them from other banks, the price they pay for those reserves is key in deciding the price (interest rate) of the loans made to their customers. Since loan demand is price sensitive; by managing the cost of funds to bank the Federal Reserve tries to manage the rate of credit creation.

    3. Mr Keen talks about how the Roving Caviliers of Credit make large windfalls but when you look at the income statement of the major money center banks; you do not see any evidence of winfalls. They do make what seem to be large profits but when you compare profits against the even larger volume of loans that the make; it does not seem to be a business I would want to invest in even during the best of times.

  44. Anonymous

    I read Keen's paper at his web site when it was originally published last week. It does a great job of providing technical support to the points Mish & Denninger have been stating for quite some time: total credit is the primary driver, not monetary levels.

    Therefore, unless Bernanke wants to absolutely torch the $USD by creating 25x times the current money supply, his feeble attempts are no different than the tail trying to wag the dog.

    Total credit expanded based on a collective Madoff mentality fueled by housing (flip to the greater fool), and will decline proportionally to the point where debt is sustainable by income.

    But by claiming that bank assets are actually undervalued by short-term speculators, and using the strength of US Treasuries to back that position, our gov't has merely transferred total risk to the People as we go "all in".

    The problem is, even we don't have sufficient funds to play Martingale.

  45. Anarchus

    Yves, thanks for posting Keen’s essay here. I had a nice email exchange with him last week – he was extremely polite and knowledgeable.

    Perhaps like you and posters here, I’ve been extremely disenchanted with traditional economists for some time. Niall Ferguson, writing in the LA Times, gets it exactly right and funny too:

    “There is something desperate about the way economists are clinging to their dogeared copies of Keynes’ “General Theory.” Uneasily aware that their discipline almost entirely failed to anticipate the current crisis, they seem to be regressing to macroeconomic childhood, clutching the Keynesian “multiplier effect” — which holds that a dollar spent by the government begets more than a dollar’s worth of additional economic output — like an old teddy bear.

    They need to grow up and face the harsh reality: The Western world is suffering a crisis of excessive indebtedness. Governments, corporations and households are groaning under unprecedented debt burdens. Average household debt has reached 141% of disposable income in the United States and 177% in Britain. Worst of all are the banks. Some of the best-known names in American and European finance have liabilities 40, 60 or even 100 times the amount of their capital.

    The delusion that a crisis of excess debt can be solved by creating more debt is at the heart of the Great Repression. Yet that is precisely what most governments propose to do.”

    As they say, read the whole thing, here:,0,6972232.column

  46. step314

    I am skeptical of this. Whenever there is debt, there are two parties, a debtor and a creditor. The value of the debt to the creditor is the same as the liability of the debtor. Since he seems to be counting (non-financial) business debt and finance sector debt, wouldn’t it give a better impression if he included their assets as money as well? Looking at z1 data , household debt is “just” 13.9 trillion at the end of 2007 Q3. Under a fractional reserve system, one indeed would mostly not expect this to exceed the amount of money existent.

    He is on to something, namely that mortgage-backed securities are in some sense an end-run around the fractional reserve system, allowing debt to exceed money. True, you could consider the value of MBS, bundles of MBS, etc., as money, but this “money” is different from ordinary money. Assuming banks don’t sell the loans made to them, as long as reserve ratios are geared to deposits, the amount of money investors have deposited will always be a little more than peoples’ debt to the banks. I am inclined to think that this non-MBS-situation is better for poor people, because poor people don’t tend to invest (directly or indirectly) in mortgage-backed securities. That household debt can’t exceed the kind of money poor people have is probably better for the poor than that household debt can’t exceed a type of “money” that poor people don’t have.

    Personally, I think economics is about the only “social science” that is done very well. At least, the standard economics class I had in school more-or-less made total sense. But then I learned economics at a Public University (Chapel Hill, 1985), from an old professor who probably remembered the depression. His generation knew directly the usefulness of economics to the general welfare. Maybe lately people more tend to go into economics just as a possible entrance ticket to get some of that easy Wall Street money. It’s hard to figure why people seem to be behaving as though they don’t believe in standard economics anymore. It’s surprising to me how easily I can find abject stupidity about the subject in people who have supposedly thought about it more than I. One thing I did dislike about the standard Econ class is that it was very short on practical data about how things worked, as opposed to theory. I think there was some contempt for finance there (I can imagine economists would tend to look down on finance people as being money grubbers). The internet is great, because there is lots of information filling in the practical details of how things work. Maybe my having thought much about math and moral philosophy gives me an advantage.

  47. Anarchus

    Yves, a technical note on the money supply that struck in the 1970s:

    1. In 1970, Bruce Bent and Henry Brown “invented” the first Money Market Fund. Under Reg Q, banks couldn’t pay interest on demand (checking account) deposits, so it was an easy economic assumption to view M1 as a proxy for near-term demand. Money Market Mutual Funds began to change that, beginning in 1970.

    2. A big accelerator occurred in 1977, when Merrill Lynch launched the first Cash Management “sweep” Account, or CMA:

    3. Partly in response to the rapid disintermediation of cash money out of the traditional banking system, Reg Q was phased out over a six year period, beginning in 1980 and ending in 1986.

    Given these technical developments, accurate control over the money supply became much more difficult for the Fed.

    I recall but cannot find a nice quote about the issue from Paul Volcker saying something like, “it’s a terrible day for economics, because after this no one can say with any accuracy what the money stock is, anymore”.

  48. Anonymous

    Doly said: “Is it possible that the reason has to do with the profitability of investments becoming lower on average?”

    I am sure this is an old thought, but could this have something to do with the difference between cap gains tax rates and the comparatively high-friction drag of other kinds of tax, that do their magic every single time a dollar changes hands? I would way rather have a capital gain on a clever speculation than try to make money by patient investment that might lead (horrors!) to something that is taxable at the highest marginal rate. The “leverage” of 15% vs 38-54% is pretty powerful. Is it any wonder the mania started in great earnest in 2003?

  49. groucho

    Yves, thanks for continuing to post Steve’s work. As Jimmy JJ Walker use to say DY-NO-MITE!!!

    That being said, lets not be led too far astray from the roots of western civilization. private property and free enterprise with minimal state intervention, por favor!

    The lefty/marxist types such as Henry Lui, Michael Hudson, and Steve Keen should be heard for their EXCELLENT critiques of the current robber baron financial system.

    Let us be wise and use these wonderful insights to help us rework the current finance structure to help improve the private system NOT to replace it with a socialized inefficient govt controlled one.

    Again thanks for sharing these great insights.

  50. Mike Sankowski

    Thanks JHK.

    Richard and Tim,

    it is important to understand that credit is not the only process by which money can be created. It can also be created by government deficit spending. I think this is one of the few omissions by Steve in his post.

  51. David Pearson

    Fair Economist,

    Most Austrians define inflation as a rise in credit. Presto! Anything that makes credit go up is inflationary, anything that makes it go down is deflationary. One has only to prove that the Fed cannot make credit rise, and it follows the Fed cannot create inflation.

    Of course, you point out that if you define inflation as a rise in the price level, then the Fed certainly can create it as it did during the DEPTHS of the Great Depression (1933-1937). Further, there are countless examples of debt crises that have culminated in accelerating inflation.

    The better model of inflation creation during a debt crisis is the one William Buiter recently published in the FT: velocity accelerates with rising sovereign default risk.

  52. Anonymous

    “But he’s very wrong predicting that printing money won’t increase prices.”

    We shall see, but I think Keen is correct. In particular, the notion that Fed printed “money” can outstrip destruction of private debt is not believable; the notion that private debt fundamentally is the system is quite believable. From that it follows that there is an obvious limit to the amount of money, at which point it will collapse. At the most fundamental level: you cannot expect to be repaid by somebody when the repayment exceeds what that person will ever have or can ever produce.

    Thank you very much for reprinting this article.

  53. Andrew Bissell

    @Anon 11:23

    EXCELLENT post! It’s just amazing that people like Keen (or, in his day, even Marx) can perceive the roots of the current crisis so clearly, and yet turn around and recommend something like more vigorous regulation and a centralized “utility” lender (government as the Ultimate Cavalier of Credit) as the solution. It’s like they believe the government exists and is elected by people on a different planet or something.

  54. FairEconomist

    In particular, the notion that Fed printed “money” can outstrip destruction of private debt is not believable; the notion that private debt fundamentally is the system is quite believable.

    But this is all irrelevant to inflation, because, as is clearly shown in Keen’s own data, debt levels have nothing to do with inflation. You can have high inflation with plummeting debt levels (WWII) or strong deflation with soaring debt levels (Hoover). To make Keen right you have to define inflation, as David Pearson points out, to be changes in the total debt level, not even in the money supply. That’s a definition only a pedantic Austrian would care about, and not even many of those – Mises and Hayek would have used a money supply definition, and the Fed has demonstrably inflated those (M1 and M2) in the past 6 months.

    *I* want to see a moderate inflation to avoid debt deflation, and by that I just mean prices have to go up. Total debt levels can go to zero as far as I’m concerned.

  55. Greg

    Great post. I really liked the earlier one about Bernanke and the great depression.

    A couple thoughts.

    I risk sounding conspiracy minded but here goes. Is it really possible that Bernanke is as wrong as is suggested. I mean wrong and doesn’t know it. Seems to me by using his current response he is enriching those who do not need enriching, allowing them to accumulate more and when assets hit bottom (they’re not there yet by a longshot) they are cash rich and swoop in to collect them all. Maybe he wants that or at least thinks that is an acceptable outcome.

    About “equilibrium”. I find that to be one of the least descriptive terms being thrown around in these discussions. Being in Anesthesia I know a little bit about human physiology and pathophysiology. We have the term “homeostasis” which is analogous to equilibrium.

    A patient in congestive heart failure will compensate, homeostatic mechanisms will kick in and the patient will reach an equilibrium……. but they still have heart failure. Or at least they are forever changed and in a less healthy state than before the episode. When you suffer blood loss, you compensate and reach an equilibrium but you are not in an optimum state of health.

    Seems to me people can’t agree with an optimum state of health for the economy, but we know when its real sick. Even when its sick its in equilibrium though.

    Pretty much anything that isn’t spontaneously combusting or exploding is in equilibrium.

  56. Printfaster

    The economics of the current crisis are actually even simpler.

    Imagine a poker game where each of 10 participant buys $100 worth of chips. They then all pawn their watches into the game for $100 each of chips. They then take credit for $100 each of chips.

    Participant #1 gets tired and wants to go home to mommy, and cashes in his $300 of chips, getting $300 and leaving his watch.

    The next participant sees this and looks at the house/bank and sees $700 left in the bank and the bank has his watch and 8 others.

    #2 cashes out, leaving 10 watches and $400 in the bank.

    At this point a panic ensues and everyone wants their $300 before it is gone. The value of the watches is such that participants will take 2 watches for $100. The next 2 participants take 4 watches and $100, leaving $200 and 2 watches.

    This leave 6 participants with $200 and two watches to divide among themselves.

    Kind of reminds me of the CDOs and the bank mortgages.

    The problem comes in when there is more credit than is needed by debt flow, and where credit is used for speculation and not production for use.

  57. bb

    this theory perfectly explains why credit is collapsing: banks will not be able to reserve for it from the private sector and will have to rely the central bank to roll it over. putting the horse before the cart seemed to work for so long, but no more.

  58. Where's The Interest?

    Great info by Keen here. He briefly mentions nominal money supply at the end. Does he feel that due to credit being created well before fiat money that velocity of money will go dramatically down? According to what we’ve seen from the St. Louis Fed, it seems that’s what’s happened. If this is true, what are the effects then of defaults? Will there be even less nominal money out there to pay interest on debts?

  59. Where's The Interest?

    Great info by Keen here. He briefly mentions nominal money supply at the end. Does he feel that due to credit being created well before fiat money that velocity of money will go dramatically down? According to what we’ve seen from the St. Louis Fed, it seems that’s what’s happened. If this is true, what are the effects then of defaults? Will there be even less nominal money out there to pay interest on debts?

  60. Anonymous

    Dolly said: “I think a key point is in this paragraph: “The only real constraint on bank lending is the public’s willingness to go into debt. In the model economy shown here, that willingness directly relates to the perceived possibilities for profitable investment—and since these are limited, so also is the uptake of debt. But in the real world there is an additional reason why the public will take on debt: the perception of possibilities for private gain from leveraged speculation on asset prices.”

    Now, why would people start speculating at a given time? This explanation doesn’t really explain much. It’s fair to think leveraged speculation is what happens whenever banks offer cheap credit, and why would banks start offering cheap credit? The traditional answer to that is “central banks lowered the target rate”, but this post claims that central banks don’t really control the credit situation.”

    There is also another reason to go into debt and/or start speculating in financial assets using debt: to try to maintain your standard of living in the face of negative real earnings growth brought on by outsourcing, illegal immigration, and legal immigration. This is why the fed supports job and wage suppression policies: to keep wages low to keep price inflation low to keep interest rates low to allow for the production of MORE AND MORE DEBT. This enriches the bankers and the debt holders at the expense of everyone else. The fed is JUST TRYING TO TRICK PEOPLE INTO RETIRING LATER AND/OR WORKING LONGER HOURS IN THE PRESENT INSTEAD OF GETTING A WAGE INCREASE!!! They want all of the productivity gains to go to the shareholders and top management. That is their “REWARD’ for playing the way the fed wants.

  61. Anonymous

    FairEconomist, it depends on where the debt goes and aggregate supply. If the debt goes into aggregate demand and there is enough aggregate supply, very little price inflation. If the debt goes into financial assets, very little price inflation.

  62. Andrew Foland

    YS–thanks for posting (all of) this. I’ve read it once, and plan to do so several times again so I can absorb what’s going on. Sorry I can’t contribute more usefully to the discussion yet…

  63. Anonymous

    JKH said: ” “Given their proclivity to lend as much as is possible, the only real constraint on bank lending is the public’s willingness to go into debt.”

    This is absolutely wrong. Bank lending is constrained by capital; not by liquidity reserves. This “only real constraint” fallacy is just an extension of the core popular delusion associated with money multiplier causality.”

    I am going to disagree. I am going to postulate that the USA is in a pseudo zero reserve requirement state (no capital needed). The fed says the banks (their buddies) can produce as much debt as they can/want as long as wage inflation does NOT occur. Do NOT worry about reserves, capital, or reserve requirements. We the fed will help you out with that.

    Is it an accident that the fed now has the power to take the reserve requirement to zero?!?!?

  64. Anonymous

    Very informative, Yves. Thank you.

    My gold manufacturing formula is now compete. I’ll make an annoncement next weekend late at night, when everybody is sound asleep.

    Vinny GOLDgerg

  65. Anarchus

    Anon, regarding zero reserve requirements and capital needed to operate, you're confusing two very different issues. Reserve requirements a technical and unnecessary – my banking pals tell me there are no reserve requirements in Canada, for instance.

    Capital is entirely different. Common sense, S&P and Moody's ratings, BIS standards and most importantly the system's willingness to provide very short term funding to banks depends critically on their regulatory capital versus assets and loans outstanding. Why do you think the Treasury has to keep pumping billions of dollars of preferred stock into Citibank? It's because Citi's losses are so large that the bank's capital ratios are impaired and as a result the capital market is unwilling to give Citi the overnight funding it requires – and preferred injections count as equity capital from a regulatory standpoint.

  66. R.

    FairEconomist, Keen says that we have a combined system of fiat-fractional reserve banking and credit. We don’t have a pure credit based system. He does acknowledge that printing can create inflation, but only if it is significant relative to the total size of debt. If the money printing is less than debt destruction, we have deflation. This is happening now.

  67. walt

    Keen is not a reliable source of information on mainstream economics. For example, the idea that money is endogenous is not that unusual in macroeconomics, and is popular with the markets-are-always-perfect school. Bernanke is not a monetarist, and in fact believes that the key to Great Depression was not the decline in the money supply but the decline in credit because so many banks went out of business. That’s why saving the banks has been so central to his policies as Fed chair.

  68. Anonymous

    One important takeaway is that the real “currency” is trust. Once that trust is broken it takes years to rebuild. Basically a generation will have to pass before we trust the bankers again. Right now we discount their markers and the government is frantically trying to step in and pull the credit onto the books so that people will continue to trust the banks and the financial markets in general.

    Won’t work. Economics has nothing to do with science, contrary to one of the silly posts above. Economics is a kissing cousin of religion.

  69. Waldo

    I am a Chicago grad. Friedman still influences my thinking (currently reading "Free to Choose") greatly but my common sense says to analyze more deeply Keen's insight.

    I have to say Keen is correct about the real creation of money by banks. Has to be, this allows the free market to create money as opportunities dictate. Also explains the "herding" into bad mortgage debt by most all bank participants.

    I still strongly feel the "helicopter" measure by the Fed is of real value. First for taking a leadership position in a crisis (banks have to feel they are subordinate in nature to the big Fed bank) putting up cash and lowering interest rates.

    The long term solution is not more regulation but pain. I think in this crisis the pain may be fatal to the entire banking system (depends on how much of the mortgage debt each individual bank took on with bad debtors). Pain will modify these bank managers from doing such headlong deals into real estate.

    This also reinforces my view of what got the "herd" into bad debt in the first place. At the very top our finest banks went head long into real estate due to the pinching off of other avenues of robust earnings (M&A and IPO) and thus being more than willing to do their part in satiating the smaller bank players (competing for profits) into the mix.

    If we don't go back before the real uptick in real estate lending (2005) and determine oil's bulling of the financial markets by manipulating oil prices (and its affects on the financial market) we will not truly learn and understand this malaise we are currently in.

    You will find that all the borrowing by the hedge funds were on average paid back it is the damn real estate debt that got us into this mess.

    I am in the real estate biz. Real estate firm's do finance like America's entire finance system has done these past 4 years. One note about real estate developers, very sensitive to market down turns; most go belly up.

    i on the patriot – outstanding poem. Real creation.

    "Wisdom estimates, genius creates" – Ralph Waldo Emerson

  70. Anarchus

    R – we agree completely. The way that Keen looks at it, and myself, is that it’s going to be almost impossible for the Fed to reflate its way out of this responsibly, because too much liquidity is required and because if/when the Fed starts buying treasury notes and bonds at Treasury Auctions to augment demand, if the Fed doesn’t take action with reckless abandon I think the markets will just front-run them and sell from the stock of trading treasuries faster than the Fed can buy new issues and seasoned securities.

    So in this mental model, the Fed has a nuclear option only. The gradual, raising the thermostat approach won’t work; what they’ll have to do is launch an all out monetization blitzkreig.

  71. bb

    there are some generational differences as well that make the formulation of economics theories across time spans difficult as well.
    in the 1700s ‘helicoper money drops’ in france led to revolutions and decapitations. in the 1930 the same results would have occured due to the still vivid memories of the civil war and WWI. now helicoper drops seem quite possible and even advisible by many academics due to the widely held perception that no one will lose his life for failed economic policies. there is simply no sense of reprecussion for wrongdoing by officials.

  72. Yves Smith


    Per your question, why would speculation begin, experiments in behavioral finance have repeatedly found that when they set up a simple market, it does occur. I haven’t read how the experiments were constructed, but the finding appears well founded. It’s similarly well established in social psychology that people react to the perception of scarcity or the possibility of missing an opportunity; that may be the trigger for the speculative behavior (“gee, if I don’t get in soon, it will be too late”).


    Not sure I agree re your point on lending being constrained by bank capital. If you look at modern big banks, they have managed to circumvent capital constraints via SIVs and other games (ie, creatign AAA paper with derivatives or third party guarnatees that required lower levels of capital than the underlying pool of risks would demand).

    Keen’s model also does not allow for the fact that the vast majority of credit recently has shifted entirely outside the conventional banking system, via securitization. The main feature of securitization is that it requires NO bank equity, save when the assets to be securitized are warehoused. As of early 2007, only 15% of the non-farm lending in the US was done via banks.

  73. Anarchus

    Sir Waldo: I’ve attached two excerpts from a speech given by Dr. Michael Hudson below. I’m not arguing in favor of all of his ideas, but his observation that debt loads compounding at unrelenting geometric rates have the capability of overwhelming the productive growth in an economy is thought-provoking:

    “In the modern epoch, J. P. Morgan and John D. Rockefeller are reported to have called the principle of compound interest the Eighth Wonder of the World. The late 19th-century writer Michael Flürscheim described Napoleon as voicing a similar idea upon being shown an interest table and remarking: “The deadly facts herein lead me to wonder that this monster Interest has not devoured the whole human race.” Flürscheim commented: “It would have done so long ago if bankruptcy and revolution had not been counter-poisons.” And that is just the point, of course. Something must give when the mathematics of interest-bearing debt overwhelms the economy’s ability to pay.”

    ” . . . . The moral is that no matter how greatly technology might increase humanity’s productive powers, the revenue it produced would be absorbed and overtaken by the growth of debt multiplying at compound interest.”

    As a professional investor, I’ve often been surprised by how many large companies (like GE) have tried to maintain mathematically impossible growth rates (like 15%) when it’s just not possible to do so. Lots of people think that 10% or 15% growth rates aren’t hard to acheive and maintain when the empirical facts are very contrary. The real long-term growth of the U.S. GDP, for example, is predominantly a function of population growth and productivity gains, and when you put it together looking forward, real growth higher than 2%-3% is going to be very challenging to achieve.

  74. R.

    I am one of those who think that the Fed should be abolished completely and that the malinvestments of the past booms should be liquidated.
    Keen’s analysis of the financial world is correct, however, his support for Keynesian measures is not. Every bailout, no matter how scructured, only leads to another crisis, often worse than the last one. This is what worries me – both, the mainstream economists and the majority of “independent thinkers” support some sort of bailout of the current system with only cosmetic changes. No bailout will ever fix the problems we have, because the same players who have caused the current crisis will be allowed to lead us to the next one.

  75. rtah100

    Yves, posting this in full is marvellous! But I must second Mik Sankowski above: everybody needs to have Warren Mosler and Interfluidity drilled into them as well. Please help spread the word.

    If that sounds a bit religious, no excuse is needed: all shifts in axioms transcend reasoning, i.e. you cannot arrive at new axioms through logic from the old.

    All credit to you, I stumbled on Warren Mosler and the Interfluidity discussions from your blog. Credit money offers a unifying explanation of our problems.

    I’m not sure I agree with the Interfluidity discussion that government deficits are the solution. We all need to work harder at distilling why the neat macroeconomic identities (essentially a balance sheet) are really voodoo when applied to a dynamic economy (i.e. a cash/credit-flow).

  76. Anarchus

    David Pearson, regarding “The better model of inflation creation during a debt crisis is the one William Buiter recently published in the FT: velocity accelerates with rising sovereign default risk”, doesn’t that suggest that the crude model that Ray Dalio put forth in Barron’s over the weekend might be operative: that the first round of trouble will involve a large rise in gold and a large decline in the dollar. Supposedly using history as a guide, Treasury yields remain pretty muted due to rising demand for them as a safe haven, even in the face of potentially rapid increases in inflation. Either Dalio or someone else claimed that yields on German bonds held firm at 6% in the early stages of their hyperinflation back in the 1920s.

  77. Anonymous


    Thanks for cross posting this article. My only request would be to have more comments from you about what you think of his post. The dialog between other articles and your thoughts is what makes this blog the great blog that it is.


  78. john c. halasz


    “As a professional investor, I’ve often been surprised by how many large companies (like GE) have tried to maintain mathematically impossible growth rates (like 15%) when it’s just not possible to do so.”

    Really? Er, why not by swallowing up the little fish? You’ve never heard of monopoly rents? (Oligopolies are only a lesser degree of monopoly). Who was it that said, “competition breeds monopoly and monopoly breeds competition”?

  79. Waldo

    We all must understand that debt is not going away.

    Think about the capital pools that China will create in the next four decades or so (more than even the government has saved. I am talking about individual savings and corporate savings). This will still be the consequence of hard work.

    All the pooled capital has to be invested. And to think that bonds are not a good way to invest this capital is wrong.

    The globe will create more capital in the future (and will accelerate because of all of the economies coming online in terms of capitalism).

    There could be valid arguments how derivatives have created this. When the NYSE was created it could of easily been said how this aggregation of hard earned farmer’s capital would be the country’s demise. On average was not. (Though it did destroy some important people’s money such as Ulyssis S. Grant to name one).

    The real crap in the “honey” has been the use of Federal power to enrich the oil thugs.

    If I am a responsible businessman the opportunity of more debt will not adversely affect my business. But if I am a poor businessman then debt will bring pain and hopefully learning.

  80. Anarchus

    Halasz, yes, “really!”

    In colloquial terms, Warren Buffett said that geometric progressions forge their own anchors.

    In more practical terms, companies that grow through serial acquisitions in an industry to gain monopoly power run into many problems, including: after buying their way from low market share to moderate market share (20%) through the first 2-5 acquisitions, the market catches on and starts pricing future acquisitions at higher and higher prices. Beyond that, the Justice Department (even when sound asleep) takes a dim view of acquisitions that concentrate more than 50% market share with a single company; even without that you can’t buy your way over 100% market share.

    And not, I said for large companies. Nominal GDP has grown at +5.5% over the past 25 years (and given our slowing population growth is likely to grow slower in the future). If Wal*mart grows sales at 15% per year and GDP grows at 5.5% (both nominal $), then in 25 years Wal*mart sales will be 25% of GDP. It’s just not going to happen.

  81. JKH


    I certainly agree with your point on the role of off balance sheet entities and the shadow banking system in circumventing bank capital requirements.

    My comment related to the comparative functions of bank liquidity reserves and bank capital insofar as risk taking is concerned for a common balance sheet platform of liquidity and capital. Banks lend and assume other forms of risk (on balance sheet) as a function of their capital, not their reserve balances held at the Fed.

    This is not to deny that the bank capital constraint has been a ‘leaky’ one due to eruption of off-balance sheet vehicles and growth of the shadow banking system; or that risk has been terribly managed (e.g. Taleb); or that banks have generally been undercapitalized – just one reason being they did not allow properly for the contingency of having to repatriate off-balance sheet risk in the worst case liquidity scenario.

  82. rcthweatt

    The historical analogy I’d urge on everybody falls between Hamilton and Marx- the Jacksonian Democrats’ war on the “paper aristocracy” that controlled the banks. This didn’t end with the destruction of the Second Bank of the United States; the high-water mark was the outright prohibition of banking itself in the 1845 Constitutions of Michigan and Louisiana. For, without the restraining hand of a central bank, credit(paper) money creation had become even more unrestrained, with results similar to those we’re living through-the ‘taking’ as commodity prices are driven up, the crashes..absolutely no question Jacksonians accepted the credit money model.
    Reading above comments will supply analogs-note hostility to the Fed, questions about gold-the Jacksonians originated the doctrine of “Hard Money”(the title of a very influential book by one William Gouge,1832). It was a search for a ‘natural’, stable, self-regulating system not subject to manipulation or requiring constant Gov’t regulation. An enduring American myth, which hasn’t worked out in practice. The New Deal worked out pretty well, though, better than the alternatives.

  83. john c. halasz


    That there are limits to economic growth was not something I was disagreeing with. I was commenting on your expression of “surprise” at the ambitions of capitalist oligopolists, and suggesting you think a little deeper. In fact, the primary driver of corporate behavior is not really profit-maximalization, but rather rent-seeking, and, indeed, such rents are partially “justified” in that economies of/increasing returns to scale raise technical rates of productivity and such rents subsidize and help to manage the uncertainties and high costs of long-run fixed capital investment. Yes, oligopolies do hit their limits, inevitably, but then when they decline due to the erosion of their rents, they are replaced by the formation of new oligopolies. “Perfectly competitive markets” hardly describe the main realities of developed capitalism, and where they do approximately exist, they are scarcely profit-centers.

    It’s interesting that you mention Walmart, since it seems so contrary to traditional conceptions of oligopoly and rents, retail being generally a highly competitive and low margin sector. (I’m sure you’ve seen that video of the historical growth of Walmart outlets, depicted as dots on a map, spreading out exponentially like an algae bloom). But the answer, I think, is that Walmart amounts to a virtual industrial corporation, through its organization of its supply chains in depth. People complain of Walmart destroying local business networks and mistreating/underpaying their workers. But actually their largest effect is on their suppliers, since they manipulate their suppliers “competitively” to obtain cost-cuts by exploiting their monopsonistic position. Thus far they have boosted their profits through expanding relentlessly, while undercutting competition with lower prices, but, when they reach the limit of their expansion strategy, it will be interesting to see how they attempt to exploit the “platform” they will have built, by trying to accrue to it other sorts of rents. (I heard one of their executives suggest that they might try to develop their outlets as a national network for supplying alternative fuels, by-passing gas-stations, for example).

    So, you’re right that there are decided limits to growth in developed capitalist economies, but that does not eliminate the relentless drive of capital to expand itself at the basis of the system, since capital maintains its “value” through the reinvestment of profits and will relentlessly seek out new opportunities for investment, and will continue to accumulate, even though it outstrips available technical possibilities and available wage-based demand, (due to the asymmetry and inverse proportion in the distribution between wages and profits), to the point where capital begins to destroy itself. Schumpeter styled that in a more affirmative vein as “creative destruction, but that other fellow termed it the “tendential law of the falling rate of profit”. (Though nowadays, to simplify a bit, the excess accumulation and over-capacity is in China, and the declining wages and increasing load of debt and fictitious capital are in the U.S.) If you are, indeed, a professional investor, it might, indeed, pay to study such tendencies a bit more deeply, though, alas, timing these matters is difficult and “empirically” it will oft be “expressed” in inverted form, as when financial asset inflation, based on robust profit expectations, is actually a symptom of declining real profits taking hold.

  84. Anonymous

    Keen did get somethings right,like, only consumer demand controls credit/debt/money and interest rates.

    Contradicts himself esp. towards the end by equating debt/credit in dollar denomination. Kinda defeats the whole argument concerning debt/credit versus fiat. All credit/debit transactions aspire to be cash transactions.

    Also, you never borrow money, it is rented. Nothing is written in stone that interest is a prerequisite in banking. A fee based bank would only limit growth.

    Barter by nature is a break even transaction, no gain involved.

    Wondering how his charts conclude private debt amounts.

    Whole article is flawed since compounding interest was not even mentioned as inherent in this banking system and a controlling factor with inflation.

  85. Anonymous

    I read this article on Keen’s blog and I was glad you posted it on yours. Keen’s is adherent of Minsky’s Keynesian approach to the economy. This approach attacks many of the economic assumptions that the Fed and even Obama’s advisers are laboring under. I’m just getting familiar with Minsky and I hope you keep posting this viewpoint as part of your blog. Thanks

  86. winterspeak

    Very glad to see a Post-Keynesian post on Naked Capitalism. There are some differences between Keen and Mosler, but their similarities far outshone those.

    I'm a little disappointed that Keens did not focus on, and Yves did not pick up, the key identity pertaining to this crises: The Federal Deficit equals the net savings in the private sector. As demand for net private savings has gone up, the deficit must go up to fund it, otherwise it will be funded out of aggregate demand and unemployment.

    I see no great public outcry for a payroll tax holiday by Krugman, or Chicago.

    JKH & Yves: You both have good points about the constraint that capital places on banks. I think that private demand really does matter too though. We are all agreed (I think) that reserve requirements are a total non-issue.

  87. Jesse

    “Allen C said… “sufficient injections of money will ultimately always reverse a deflation. This is absolutely correct!”

    Allen C is absolutely right.

    Anyone who does not understand this does not understand economics.

    The value and quantity of the currency is always and everywere a policy decision in a purely fiat monetary regime.

    This is so outrageous a concept and the mind of the layman rebels against it, and they create marvelous webs of reasons and rules why ‘money’ is not arbitrary.

    But it is, and obviously so.

  88. Anonymous

    Well, I should keep quiet here because my knowledge of economics is inferior to all of you. But I can’t resist pointing out that debt is finite, goods and services are finite but the government’s ability to print money is infinite.

    Add to this the fact that there is obviously no discipline whatsoever in Washington and what you have is a recipe for inflation and all of the charts and graphs be damned.

  89. Minh

    I believe there were money made on top of the housing bubble that is still waiting under the matress to invest in new MBSs.

    Let’s wait and see. We now have a new administrations, new banks and the old framework, with old same people.

    From american banker 2/06
    Bailout 2.1: Unnamed sources told the Journal that the administration is shifting away from a plan to create a bad bank and guarantee troubled assets in favor of purchases of convertible preferred stock in weak banks and an expansion of the Talf, which is not yet in operation, to include outstanding mortgage bonds. In an opinion piece, economist Paul Romer argued that the rest of the Tarp money should be used to capitalize brand new banks which, with 9-to-1 leverage, could support $3.5 trillion of lending.
    Let’s Start Brand New Banks

  90. Anarchus


    Whether the reserve requirement was 10% or zero doesn’t really matter much at all – can we just set that aside as irrelevant?

    The relationship between bank lending and reserves up from 2003until about 4Q of 2007 was a very strange situation. Note that banks are the ultimate accrual accounting enterprises, so when Sarbanes Oxley was passed in the wake of the Enron/Worldcom/Tyco earnings manipulations scandals, banks, perhaps unintentionally, became a key target of auditors.

    As the economy performed well in 2003, 2004, 2005 and into 2006, responsible banks that wanted to boost provisions (reserves) for loan losses were told by their auditors that they could NOT. That would be earnings manipulation – because their recent loan loss experience had been almost non-existent (with the economy doing well), boosting reserves today would be akin to creating a rainy-day slush fund – ie, understating earnings in a boom period so that by drawing down reserves later you could boost earnings in a bust period. It was grossly irresponsible and asinine, but many small banks with skinny reserve-to-loan ratios told me they wanted to add to reserves but could not.

    There were also banks that had ridiculously optimistic expectations about the level of loan losses that would occur someday when the economy rolled over, but the issue I just described was significant as well.

    More importantly, as you suggest, the development of the “shadow banking system” and derivative plays worked to make capital constraints on lending less important than in the past. Two huge things I can think of quickly: (1) Where Sarbox clearly failed wretchedly was in reigning in abuses of SPEs – special purpose off balance sheet entities – that Enron in particular abused. Because banks made active use of off balance sheet entities called SIV’s and Conduits that allowed for stretching of capital and leverage abuses far beyond what BIS would have allowed, and (2) the whole mortgage originate-to-sell in structured form obviates the banking system to a point of irrelevance. When the securitization market was functioning, mortgage banks could crank their capital many times over by originating, then packaging and selling the mortgages as pooled securities. That takes a capital constraint away from the bank and passes the asset directly on to another lendor/investor. It also allows for almost unlimited leveraging of structured products out in hedge fund la-la land.

  91. Anarchus

    Jesse, if you think we have “a purely fiat monetary regime” you haven’t been paying attention.

    My position (not speaking for Dr. Keen or the post-Keynesians here) is that the wording of “sufficient injections of money will ultimately always reverse a deflation” is too imprecise to adequately describe the current situation. Over the past 6-9 months, we’ve had the largest expansion of the Fed balance sheet and most massive injections of liquidity into the capital markets in the past 30 years and . . . . we still have deflation.

    Clearly, if the Fed embarks on a nuclear monetary rampage and becomes the dominant purchaser at Treasury note and bond auctions and pursues similarly aggressive actions in the open market they can ultimately reverse a deflation. There’s no argument there. I also think that if Bernanke goes directly down that path he’ll be remembered as the worst Fed Chairman in the history of the country, and I think he knows that.

    The Fed has to try to appear responsible, crank very hard on monetary liquidity, not destroy the dollar, hope gold stays under control, maybe buy some treasury bonds and notes to keep treasury rates low and also reverse deflation. Some would call it a tightrope Bernanke needs to tiptoe across, but from my perspective it’s a complex multifactor differential equation with no solution set. Godspeed, Dr. B, and when done, I think G. William Miller will thank you . .. . . . .

  92. Anonymous

    Good thing you posted this here, Yves. Keen’s site says “bandwidth limit exceeded”. He’s been NakedCapitalized! (Sort of like being Drudged)

  93. tracy

    Waldo, I too am from a Chicago place, stepchild at best! When I was studying in the 80’s, I saw a story on a drug bust where they were unloading currency in PALLETS from a drug boat. I wondered, how much currency was disappearing from our system and funding blackmarkets and other country shadow economies and I wondered (as someone very into monetary theory) how that was impacting our economy. No one seemed interested in discussing, or even acknowledging any impact – it bothered me. A certain guy named Milken seemed to go around banks and ‘make money’ for corporations and I wondered, again, if all that ‘money creation’ would have an impact. Finally, securitization told me that 1) the Fed had no control, only the illusion of control, and 2) debt is a drug, you keep needing more for the same results. Like any other drug habit, either the organism dies from burnout, or crashes when the debt exceeds the ability to carry it.

    This post has killed my adherence to monetary theory – it should have died long ago.

  94. Anonymous

    Economics is a post historical evaluation of events, its use in predicting future events/trends is limited to factors which, in real time evolve due to synergy’s, which can not be predicted with any certainty.

    This observation bring us to the conclusion, anyone that prophesies out comes in human/economic activity’s in ever increasing time lines projections/outcomes, will suffer greater distortion in their projections/outcomes, due to unforeseen acts/reactions un-included in the original data input, hence the never ending need to update models.

    No wonder people try so hard to rig the game, its human nature to bring certainty into their actions vs out comes. Who would go to great effort and expense in their actions to loose it all or be reduced for it, this applies to the long horns in the game. Now try and model the day traders (casino slot machine players or the fickle herd), that in the last 10 years has exploded due to the PC and Internet, how do you model that traffic flow.

    Having said that we are still quantifying human activity’s in ideology’s of capitalists, socialists, communists, etc or mine, some of it is mine but we like to share and its ours. In the US alone all these ideology’s exist on some level in society, but the ruling class will have you believe its pure capitalism.

    I believe the images that can be seen in the media with regards to the fires in Victoria, Australia show us how tenuous life is, people living in a relatively stable country can have all that they have live for, removed and left with only their compassion for each other. I wish for a compassionate world, that is all, not riches or accolades of others. This seemingly is imposable due to those of the human race that require increasingly more than their fellow humans to fill some hurt or self perceived deficiency in their Psyche, to prove to them selves and to others their greatness.

    I find myself more and more concerned abut the mental health of the ruling class than any other issue before us today, economy, ecology or other, for if our rulers are suffering from mental illness (which historically happens allot) were screwed. The human race, due to its ever increasing activity’s suffering ever greater outcomes of calamity or as a good friend of mine used to say, to anyone crying in their beer “you brought that shit on your self mate” and Lady’s and Gents that is exactly what we have done. We have nothing but ourselves to blame for the state of the world, if you don’t like something get up and do something about it. Voting for a party is not good enough, you have to be pro active as in your face active, screw e-mails, phone calls, letters and all other passive means. Go down to your elected officials office and in their face make your case, over and over again until you can see the re-election fear in their faces.

    Option 2. Is bend over and pick up the soap.

    Skippy……has a diatribe moment out of compassion.

  95. Anonymous

    “A sound model of how money and debt are created makes it obvious that we should never have fallen for the insane notion that the financial system should be self-regulating.”

    Who’s the “we” who fell for it? Was it debated? Did somebody vote for it? Talk about obvious to the casual observer.

    No, it was grabbed behind the scenes -taken out and strangled -extorted in the halls of Congress -bribery paid and directed by lobbyists, the attorney shills of K Street paid by investment bankers, and PRd by Alan Greenspan, supported by starving regulators like the SEC of funds under Bush.

    These are crooks, thieves, liars, extortionists, hijackers, scum of the earth pigs stealing treasure created by generations of Americans and making money over the sick bodies of health care starved Americans who they seek to tax, strap with debt for life, and grovel for work with the masses of China and India.

    New York will be a lot better off without them: real estate affordable for the arts, privately owned cafes, stores of every kind, banks half a block long on every block shuttered along with Duane Reeds, Verizon et al. -a better world.

    Good riddance to the finance flunkie bubble.


  96. Jesse

    Dear Anarchus,

    I did not say that we have a purely fiat regmine. Nothing in this world is ‘pure.’

    But if what I said is true, and I think it is, then the onus would be to show how ‘not pure’ the regime might be; that is, what are the limiting factors on the Fed and the Treasury?

    So, if you throw out your first sentence, a weak attempt at wit, all you really do is agree with my premise, and expand on some potential limitations.

    And then we must assess those limitations rationally, and look at all the empirical data.

    So you were closer Anarchus. If you can relax the need to posture, then you might progress a little further.

    also, do you really think, seriously, that Bernanke and the people around him are going to be fastidious if the US sinks into an economic and civil abyss which you can barely imagine? Seriously?

  97. Anonymous

    Anarchus, we can set it aside. My point is that capital and reserve requirements limit the amount of debt that can be produced, and if the bankers can circumvent them (with greenspan looking the other way), those limits are removed.

    Yes, about the banks and provisions.

    Yes, about SIV’s, conduits, and securitization. The whole point of those is to produce more and more debt on the lower and middle class. If that does NOT work, get the gov’t to go further and further into DEBT!!!

    I would say that the economy APPEARED to perform well in 2003 to 200? ONLY because the fed (and greenspan in particular) was able to sucker some of the lower and middle class to go further and further into debt using housing for “leverage” and as an asset/collateral.

  98. Babe's Ghost

    This made a ton of sense to me. The upshot is kill the zombie banks and make new banks that operate like public utilities.

    The only cure for acute zombification is HVTLT
    (High Velocity Transcortical Lead Therapy)

  99. Babe's Ghost

    This made a ton of sense to me. The upshot is kill the zombie banks and make new banks that operate like public utilities.

    The only cure for acute zombification is HVTLT
    (High Velocity Transcortical Lead Therapy)

  100. dt

    I think the most interesting thing about keens article is it’s questioning. It doesn’t really matter if he is right or not, because if we start asking the right questions then we may start to get a handle on what to do – something which seems to be very much lacking at the moment.

  101. Anonymous

    Fellow Bloggers,

    I have been through Keen’s post several times, and scanned the comments here. But the detail is not the issue.

    The issue is, is there sufficient substance in Steve’s thesis to: (a) understand the causual factors of the current mess, and (b) determine a course of action which will result in the minimum damage to the majority of people on the planet from the Global Financial Crisis?

    I suspect that the answer to (a) is “possibly”. Then what seems to be needed is to nail this down, and nail it down fast! That means loads of data collection & analysis. I cannot do this, having been forcibly ejected from all forms of academia for being a consistent lazy pain in the ass, and being past my “use by” date. Does anyone have the resources to take that job on? Steve Keen? Nouriel Roubini?

    People, we really, really need an answer to (b). So far, our Masters have waffled and dribbled all over the place. If Steve Keen’s thesis can help, please let us grab it with both hands. Our Masters will soon be ready to grasp any straw. Please, lets’ do our best to give them one that works.

  102. sjc

    Says Keen: “Whatever might be the impact on prices of increasing the money supply by a factor of 100, the nominal value of debt would remain constant: debt contracts don’t give banks the right to increase your outstanding level of debt just because prices have changed.” As regards mortgage debt, that is not the case in Iceland. Mortgage payments fluctuate in response to the rate of inflation. Quite troublesome for many, at the moment.

  103. Flow5

    Absolutely God awful. Keen is a moron.

    He doesn't know the difference between the supply of money & the supply of loan funds. He uses the wrong money multiplier. He can't measure aggregate demand.

    And monetarism has never been tried. I.e., Volcker was retarded (thought you could target the money supply using non-borrowed reserves).

    Yves: yes the FED researched different measures of the money supply associated with deregulation:

    Divisia – aggregates” – Dr. William Barnett– &

    “debit-weighted-money-index” – Dr. Paul Spindt

    Neither one figured it out. You can't use absolutes, you must use rates-of-change. And Milton Friedman wasn't a monetarist.

    And it is mathematically impossible to miss economic forecasts. What a mess.

  104. Anonymous

    Well from reading this article and all the comments it has become apparent that nobody has any clue how money works in the long run. It seems that certain policies will work in specific time frames but not outside distinct range of time/condition points. Good luck defining those points and getting consensus!

    Your best option as a little person is to take your money, whatever that may be at the time, and go get as much valuable “stuff” as you can. Why save in money?

  105. tr

    This article represents REAL thought. I very much appreciate it and think it’s fundamentally sound. My one question is where the fiat money actually comes in. The federal Government creates various treasuries, “sells” them to the Fed in exchange for “money” (basically the Fed monetizes the debt). Then the government is on the hook to collect taxes from the economy in order to pay interest and principle on those treasuries.

    No money is created without debt and that debt is considered the security backing that money. The government presumes the right to borrow more than other players in the economy but the money its creates in the process is no different from money created anywhere else in the economy except that failure on the part of economic actors to repay that money is a crime.

    Turning a failure to pay from a civil issue to a criminal issue by transforming a bank’s bad assets into treasury debt and thus taxes should be FAR MORE DEFLATIONARY in the long run than anything short of a permanent bank holiday.

    A large injection of true fiat money would go a long way toward jump starting the economy since it would not be accompanied by an increase in government debt. It would have the potential of being quite aggressively inflationary as well.

    Another issue with the toy model that I think Keen alludes to but I’d like to see pursued full boar is the effect of increased efficiency on the relationship between output and job creation. Automation can create incredible economic good but one thing it doesn’t create is jobs. If you added output capacity vs employment and demand I think you might discover a huge latent capacity in our asset base with little relationship to additional labor. If money doesn’t circulate to those households somehow your demand “curve” goes down really quickly.

    The long term problem underlying this particular credit crunch is about the relative value and marketability of marginally trained human labor. The mortgage boom gave Joe Sixpack disposable income and a job framing houses. This economy will not fully recover on the back of labor that can be exported or replaced with a more efficient machine.

    The fundamental problem with the mortgage bubble is not abusive credit practices. It doesn’t matter that banks can loan money with little expectation of repayment. It’s that those houses were built for a workforce that has no capacity to earn money in the 21st century. When you include China, India, etc in “the economy” you see a giant capacity for the production of inventories that NO ONE CAN AFFORD UNLESS THEIR REAL PRICE IS ZERO.

    Remember Greenspan telling congress about the perplexing issue of growth without job creation during the internet bubble? The mortgage bubble was driven by a rather obvious short term strategy to maintain a lifestyle without an engine for job creation. The bubble has burst without leaving us at the threshold of a new engine. Alternative energy looked promising but reduced demand lowered the price of existing sources.

    Roads, buildings, education and medical care are all human labor intensive. If we pay for those in true fiat money along with taking serious short term pain in building an alternative energy infrastructure before prices support it…. I think you’ll actually see the economy move again. All of that is government spending…. The education should be focused on preparing a wide swath of this country for jobs that will actually exist in a world where automation takes up more and more of the bottom of the pyramid.

  106. jbpeebles

    Appreciate all the thought that’s gone into this article and the comments. I’d remind everyone that economics is an inexact science, despite the strength of everyone’s convictions. We don’t know precisely why the economy hurts, only that it does hurt. We only know we’re in a deflationary period when we’re in one. In the case of our most recent recession, it wasn’t discovered until after the Presidential election, up to a year later!

    Predictions aren’t so easily made. I don’t think we can declare this crisis solved simply by spending more. Additionally we’re seeing key changes to the system: the Fed is now debating the issuance of its own debt.

    Little attention is given to derivatives, but they are credit money at its worst. The sheer size of derivatives is incalculable. Uncertainty seems to have crept into the banking sector because of 1) the size and 2) the questionable methods available to measure them.

    Lastly, I’d remind readers that it was the relaxation of margin requirements that led investment banks to over-speculate/over-leverage themselves. The banks had combined with the Financial Modernization Act. Blame the de-regulatory shift, combined with a laissez faire approach to enforcement under Bush, which saw its deepest manifestation with sub-prime and mortgage-backed securities.

  107. Anonymous

    @flow5 said… and it is mathematically imposable to miss economic forecasts.

    The term “model” definition: copy of an object (historical)

    Something copied or used as the basis for a related idea, process, or system.

    Simplified version: a simplified version of something complex used in analyzing and solving problems or making predictions… a financial model.

    As you can see it is not a exact tool, but a general tool for forecasting in future possibility’s. When someone constructs a perfect model we can time travel, if you have one please share with us ok.


  108. sjc

    R. said… @2:37:
    “[Keen] does acknowledge that printing can create inflation, but only if it is significant relative to the total size of debt. If the money printing is less than debt destruction, we have deflation.”

    What metric are you using in determining to what extent “debt destruction” is occurring, if I may ask?

  109. Jono

    I much rather prefer the Austrian analysis of money and inflation. I’m sorry but Keen’s analysis should be thrown in the dustbin.

    He just doesn’t even understand the basic definition of fractional reserve banking.

    Two glaring problems are:

    1/ His definition as follows:
    “There is money, but no debt. The fractional banking model that is tacked onto this vision of bartering adds yet another market where depositors (savers) supply money at a price (the rate of interest), and lenders buy money for that price, and the interaction between supply and demand sets the price. Debt now exists, but in the model world total debt is less than the amount of money.”

    Any economist would disagree with this. Fractional reserve, by its very definition, occurs as banks engage in a form of fraud by creating new loans which are unbacked by reserves, thus lending out the same dollar in their reserves multiple times. This is a form of fraud, each person holding a deposit receipt believes they are entitled to withdraw cash reserves, yet the entire banking system does not have sufficient reserves to cover this.

    The simple existence of lending where an interest rate balances supply and demand for capital has nothing to do with fractional reserve. It occurs when banks literally engage in fraud and pyramid loans upon a small base of deposits.

    2/ He suggests that the Fed’s recent efforts to double the base money supply won’t matter because the amounts involved are too small compared to the debt outstanding. But what needs to be looked at is the effect it will have on other monetary aggregates – M3 or AMS – which include credit. Increasing the base money supply by $1 trillion can expand these monetary aggregates by many multiples – so long as banks are willing to create new loans. Right now they aren’t.

  110. Mike London

    Wow, a better model, Id say! Thanks for the post, and insights. I am not an economist, but have put a great deal of effort into attempting to understand the links between inflation, deflation, credit, and the “money supply”. I have been tortured for 4 or 5 years by the fact that the money supply (however abstractly measured) increased by double digits, but inflation lagged far behind.

    I’ve also been tortured by the obvious fact that banks continue to tighten (in my view, a natural rubber band ‘snap’ back from the grotesque lack of lending standards of the past 6 or 8 years), while the Fed continues to pump money into the banks, and most of that new money is simply sitting idle.

    I can’t see that any “stimulus” or bank “bailouts” will fix anything. It will take time for the banks to relax standards and start lending again. These models appear to be a heck of a lot closer to reality than what we read in the “papers”, then we’ve got a very long and nasty contraction ahead. Its bad to acknowledge, but good to understand what will happen over the next couple of years, so we can plan and act accordingly for the best interests of our families.

  111. Ralph

    Interesting article. But there is a series of paragraphs which had me tearing my hair out near the start. The series consists of five paras quoting Bernanke plus six paras thereafter. The quote from Bernanke starts. “The conclusion that deflation is always reversible under a fiat money system…”.

    First, at the beginning of the Bernanke quote he is sloppy in his use of the word “deflation”. Deflation can mean “falling prices” or “economic contraction”. PLEASE will everybody make it clear when using this word what they mean: first sense, second sense, or both.

    Second, Bernanke claims that if an alchemist finds a cheap way of producing gold, the price of gold will collapse (presumably to something near the new cost of production). True enough. He then points out that the Fed can print any amount of dollars it wants and that the effect would be the similar: a collapse in the value of the dollar.
    Well that’s a totally irresponsible thing for a central banker (or anyone likely to become a central banker) to say: “Hey I’m going to print billions of tons of dollar bills and make them near worthless”. He should be saying “I’m going to try and print just sufficient bills to raise demand a bit and get us out of the recession, but not so many as to cause excessive inflation”. Not only should he be saying that, but the latter is what would actually happen if exactly the right additional amount of money was printed. (This assumes that inflation derives only from excess demand and that inflationary expectations arising from the additional money have no influence, an over-simple assumption, I admit)

    Third, he then concludes (his fourth para) that “ under a paper-money system, a determined government can always generate higher spending….”. Well hang on. If dollar bills become near worthless as a result of printing more money, how are consumers going to increase their spending (in real terms)? By carting around wheel-barrow loads of dollar bills a la Weimar Republic, I suppose.

    Finally I think the six paras after the Bernanke quote are too pessimistic. Printing additional base money has two demand stimulating effects which I didn’t see mentioned in the article.

    First, printing and feeding additional base money into the economy increases household incomes (assuming the money is channelled towards households). And household spending increases with household income. This boosts demand.

    Second, printing base money improves household balance sheets (which have taken a severe battering, and partially explain the recession). This will also increase demand.

    But to repeat. Very good article.

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