Money, the financial system and the Federal Reserve

Edward Harrison here.

We seem to be moving forward with this discussion on monetary policy, banking, and reserves. Things seemed to be veering wildly off track but I have seen a huge number of good comments in the last 24 hours. Now, John Carney does a good job of summarising some of the initial forays in this back and forth that started between Steve Keen and Paul Krugman but that has since branched out. I am going to try my hand at framing the discussion here in order to weed out a lot of the extraneous stuff. Where there are mistakes, I will fix them accordingly as they are pointed out. I think this is pretty important, so please pay attention to this one.

The comments from the last post I wrote and from a follow on post by Tom Hickey at Mike Norman’s blog got at the heart of the debate and so I will try to characterise what was said.


We have been living in a world predominated by floating exchange rates and currency non-convertibility for forty years now. Nevertheless, most of economics world seems to take a fixed exchange rate, Bretton Woods, or gold standard view of money and banking. In that world, as Warren Mosler quipped, bank lending is reserve constrained with the interest rate an endogenous variable via bank competition for reserves.

I put it this way in December [emphasis added]:

In the old gold convertible system, the central bank had to jack up rates to prevent an outflow of gold. Interest rates were the release valve. But in those old days, only by adjusting the gold peg i.e. depreciating the currency, could countries under attack get away with low rates once the vigilantes were on to them. That’s what happened during the Great Depression. Once the conversion was broken, the currency depreciated and depression lessened immediately.

Today the release valve is always the currency because there is no gold tether. So the currency gives way, not interest rates.

Bond vigilantes and the currency relief valve

What this in effect means for the domestic banking system is that in a nonconvertible floating exchange rate system, lending is not reserve constrained as banks can create reserves by making a loan that creates a deposit. Any one institution can always borrow reserves from other banks or from the Fed itself if it finds itself short of reserves (See this BIS paper from 2010 for further discussion).

The US government, as monopoly issuer of its own sovereign currency, has given the Fed monopoly power in the market for base money. The Fed then exercises this monopoly power by targeting the overnight rate for money, the fed funds rate. That is to say, the Fed targets a rate or a price, not a quantity. Almost all modern central banks of today operate with explicit interest rate targets, allowing the overnight rate to fluctuate within a range. Any monopolist can only control either price or quantity, not both. Now, central banks could target something else like reserves to transmit monetary policy into the economy; and they have done in the past. The Fed targeted reserves from 1979-1982. What the Fed found was that it had only a controlling influence on base money because targeting the monetary base meant volatility in interest rates (see this 2004 ECB paper for further discussion). But, more importantly, because bank loans create deposits that actually need reserves to maintain the integrity of the payments system, the Fed is forced to supply them according to its legal mandate.

In short, reserves are about helping set interest rates, not about pyramiding money on a reserve base.

Under present institutional arrangements, the Fed Funds rate is dependent on the Fed’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target or within its target band.  The Fed can’t target a rate unless it supplies banks with all the reserves that the banks need to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target. So in practice, if a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate. Not doing so means at once that the Fed cannot hit its target or that transactions fail as the payments system breaks down.

In sum: In a nonconvertible. floating exchange rate system, the amount of credit in the system is determined by the risk-reward calculations of banks in granting loans and the demand for those loans. Banks are not reserve constrained. They are capital constrained. Financial institutions grant credit based on the capital they have to deal with losses associated with that activity.

I don’t think anything I wrote is particularly controversial for those with banking and money as their primary economic discipline or area of study. But if you read textbooks like the one I got in business school by Glenn Hubbard, you find sentences like "The monetary base sometimes is called high-powered money because a given amount of base allows creation of a multiple amount of money" (p. 420, Money, the Financial System and the Economy, Hubbard, 1995). This suggests that the banks in fact are pyramiding credit/money creation on the back of reserves when this is not the case. I checked my intro college economics textbook by Baumol and Blinder from 1985 and it’s exactly the same kind of stuff. The reality is that banks are not reserve-constrained because the Fed must supply reserves to back loans already granted. Only if and when the Fed decides to raise the fed funds rate to curtail credit growth will reserves be constrained. And they will be demand-constrained, not supply-constrained.

Central Bank Flexibility – tactics, strategy, and policy

Given that framing above, the question everyone is asking is whether any of that matters over the long-term. Here’s how I explained Nick Rowe’s objection to the concept of endogenous money:

I think the real difference between what Nick Rowe is saying and what people like Scott Fullwiler and Steve Keen are saying is that Nick believes over the medium-term, central bank interest rate policy is endogenous. What I think Nick means is that Scott Fullwiler’s view is reasonably clear and straightforward in his view that central monetary policy is exogenous but that it only matters over a short-term time horizon because central bank interest rate policy adjusts endogenously over the medium-term to commercial bank and other economic variables such that it is really endogenous rather than exogenous.

Further, I think Nick Rowe is saying that it creates an expectation of central bank interest rate policy merely by announcing its target rate and the market moves to accommodate that target, knowing the central bank is the monopoly supplier of reserves. In that sense the central bank has control. But what he seems to suggest is that the central bank policy rate cannot be determined independent of macroeconomic variables (like inflation specifically) and that central bank may be forced to change policy based on these, making it possible to treat the central bank policy rate as medium-term endogenous.

Nick Rowe says my view of his previous commentary is fairly accurate. Scott Fullwiler doesn’t like the terms short- and medium-term. He would rather see us talk about Fed tactics, strategy and policy.

Scott frames it this way (with minor edits for readability):

  1. Tactics – can the central bank directly target reserve balances, monetary base, etc?
  2. Strategy – what sort of rules/discretion balance does the central bank follow in adjusting the target it has set tactically. How often? How big of an adjustment each time? By what criteria?
  3. Policy – How does the macro economy work and what role can or should the central bank play in stabilizing it?

Scott goes on to say that:

The debate between Krugman/Keen once it got to issues related to the money multiplier and loanable funds was about tactics–can banks individually or collectively create loans without regard to deposits or reserve balances? This is closely linked to an understanding of what banks are/do and hence Krugman’s view that they didn’t need to be included since inserting them didn’t change how one should view the money multiplier or loanable funds models. This is where I jumped in, because Krugman in my view was completely wrong on these points.

But Krugman’s reply to me, and Rowe’s post, brought in strategy and policy–”the central bank must change the interest rate target by adjusting to events and expectations” which is about how the central bank should adjust its target (strategy) within the context of how the macroeconomy works and interacts with monetary policy (policy)…

The MMT view is that we need to understand how the tactics work to inform our strategy and even our understanding of how the economy works. Krugman tried to suggest understanding the tactics is irrelevant to these two. This is a very significant distinction between the approaches.

Further, in MMT, we keep these three (tactics, strategy, policy) separate when we discuss them. Neoclassicals generally don’t–so, when I say the central bank must set an interest rate target (tactics) but can move that target wherever it wants (the possibilities for strategy), Nick says no the cb must set a target that responds to the economy and thus must be endogenous (strategy in the context of view of macroeconomy). We end up talking past each other as I have not invoked yet at all how central banks “should” set strategy with regard to how the macroeconomy works. While we will disagree on the latter, in our view jumping to that without clarifying and setting a common language for tactics and strategy complicates the discussion unnecessarily.

This is progress.

Translation: we agree on the basics here but semantically there are differences. 

  • MMT’ers believe the central bank, as monopoly supplier of reserves has monopoly power and therefore full discretion to act as an exogenous actor.
  • Nick Rowe says a central bank must set a target that responds iteratively to the economic variables like inflation and thus must be endogenous as a overarching strategy in the context of a macroeconomy).

I think that’s where we stand.

My Conclusions

  • We have been living in a world of floating exchange rates and currency non-convertibility but the economics world very often – and wrongly – takes a Bretton Woods view of money and banking.
  • The Bretton Woods world is one in which bank lending is reserve constrained with the interest rate an endogenous variable via bank competition for reserves.
  • In a nonconvertible floating exchange rate system, lending is not reserve constrained (over the short-term) as banks can create reserves by making a loan that creates a deposit. Any one institution can always borrow reserves from other banks or from the Fed itself if it finds itself short of reserves. If a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate.
  • But questions remain about what a central bank can target and to what effect and as to the discretion a central bank has in adjusting any target it has set "tactically". Some say that over the long-term a central bank must respond iteratively to macro economic variables. Others believe the central bank has full discretion to set policy as an exogenous actor.
  • My question is whether the above suggests banks MUST be including in any realistic economic model for it to have predictive power even in more extreme economic circumstances like the ones that existed during the great credit bubble. The Great Financial Crisis would suggest yes. yet, many in the economics field resist this notion. Hopefully, we can get more answers on this question as a result of this post.
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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. Mansoor H. Khan

    Edward Harrison said:

    “Banks are not reserve constrained. They are capital constrained.”

    In reality banks are “lender of last resort” constrained as proven during the financial crises of 2008.

    TBTF banks know ultimately the FED can create as much capital as needed by them by the stroke of a mouse click.

    more at:

    mansoor h. khan

  2. Paul

    I think the confusion here for people like me who have been attempting to follow this debate is the use of the word constrained. You are correct that in order to target an interest rate that the Fed must be willing to supply reserves on command at the target price (so in this sense banks are not constrained by a “lack of reserves”). However there is a cost associated with acquiring said reserves (the interest rate which you have alluded to) which one can argue is a constraint if it makes potential loans unprofitable or requires interest rates that are too high to make a profit and attract borrowers. So to me the phrase “banks are not reserve constrained” that is often thrown around is inaccurate. Does this make sense?

    1. Edward Harrison Post author

      I understand what you’re saying but in terms of precision, a constraint in math (and in economic modelling as a result) is always a hard constraint i.e. there’s no way around it. What you are talking about is not a hard constraint.

      The reality is that banks will make loans they think will be profitable as you say. They can’t know which loans will actually be profitable since a borrower can always default. That’s what credit analysis is all about. Moreover, sometimes banks do lend even when they can’t make a profit. My own experience in Europe for example is that a company which gives a bank profitable business in something like equity underwriting or mergers and acquisition is the perfect candidate for a cheap loan because the fee income dwarfs the bank loan income.

      Bottom line: banks have a portfolio of assets to look after amongst different lines of business. The profitability of an individual loan is both hard to calculate against the cost of funds and unknowable at issuance. So while banks are thinking about the risk and rewards of doing business, you can’t look at this as a constraint.

      1. 4D

        Ed, good summary of a great debate, but I would question whether in reailty the banks are, or should I say were, even “capital constrained” given the amount of off-balance sheet debt they have created.

        1. Nathanael

          Exactly. The banks are fundamentally regulation-constrained. Most capital requirements have been enforced only against smaller banks, not against the big six money center banks. Even the requirement of solvency has not really been enforced against the big six money center banks, who are allowed to use fraudulent accounting to maintain the fiction of solvency.

          Mansoor Khan is right; banks are fundamentally limited by the willingness of the Fed to backstop them. Eventually they will hit the currency revulsion limit, but I’d rather that didn’t happen…

  3. jstuart902

    We need to keep in mind why this discussion is important: If base money, created, expanded or contracted by the Fed does not drive bank lending, then big jumps in base money (2008-2009) will not impact M1 money supply (which it didn’t), thus breaking one of the supposed links from Fed policy to inflation. Inflation fear is where it is at. This is the core, underlying fear that runs the warnings and lectures from the neo-liberals. Obviously, the inflation discussion is a big one, and breaking this one link does not cover the entire ground. But it’s a very good start.

  4. wh10

    Ed- nice job.

    BUT – even in Nick’s world, isn’t still ultimately about price and not quantity, as per Mosler?

    “I believe you are all missing the point.

    First, there is a distinction between fixed fx policy and floating fx policy.

    With fixed fx lending is continuously reserve constrained and the interest rate is endogenous via competition for reserves.

    With floating lending is never reserve constrained, as this particular institutional structure allows banks to create their own reserves.

    that is, with floating fx/non convertible currency,
    loans create deposits and reserves as a matter of accounting

    any ‘needed’ reserves are, functionally, overdrafts in fed reserve accounts, and overdrafts are loans. so when the ‘need’ arises the deed is done. CB choice never enters into it. For the CB, it’s necessarily about price, and never quantity. I call it hard endogeneity and have been pointing this out for going on 20 years. “

  5. Whitaker Lim

    I’ve been following the MMT debate with a great deal of interest. Over at Global Economic Intersection, guest author Stephanie Kelton writes about the Fed here:

    What I’m wondering–and I’m hoping that Mr Harrison will respond–is whether Bernanke is in effect practising a version of MMT (regardless of the theory or name being applied to what he is doing).

    1. Hugh

      Of course. I have written about this before. When our elites want trillion dollar tax cuts for themselves or trillion dollar wars or a trillion dollar defense establishment or multi-trillion dollar bailouts, the money is always there, as MMT predicts. But when it comes to the 99% and our needs of jobs, healthcare, housing, education, and retirement, then our elites revert to gold standard thinking and tell us that the money is not there and that we must do without.

      1. ggm

        I think Lambert coined the expression “MMT for me but not for thee” to describe this phenomenon.

          1. MacLaren

            Since he hasn’t replied, I’ll venture a guess as to his thinking and reasoning.

            The elites (the banks/banking system) run the monetary system for themselves and their benefit, via the extraction of income and wealth from the productive members of the economy.

            So whatever the system, ask youself, Cui bono?

  6. tiebie66

    This debate is really interesting, I admit. My thanks to all for interesting posts and comments. Personally, I do wonder if the reserve constraint/non-constraint matters because, IMO, in the final analysis the availability of credit relative to the ability of the economy to service debt is the ultimate issue. Because the productivity of an economy determines the amount of debt it could carry, as well as determine the way the economy responds to debt growth, banks must be included in economic models.
    Regarding the autonomy of CBs, I think that the FED’s mandate(s) makes it an endogenous actor – hence it must respond to economic activity with interest rates in ways that allow it to meet its mandate(s). Even if not mandated, it cannot be completely exogenous unless it doesn’t care about the economy (e.g. about killing the goose that lays the golden eggs).

    1. Hugh

      I think MMT doesn’t deal very well with debt. Of course, neoclassicals don’t really deal with it at all. But essentially interest on debt tranfers wealth from the 99% to the 1% and it does so in a way that ultimately must completely destabilize the system. You see while banks can create money because they know they can depend on the Fed backing their action. The rest of the private sector, i.e. the 99%, has no counterbalancing ability to create money. At this level, it is essentially a zero sum game with wealth flowing from the 99% to the 1%.

      Now the government can do this by its tax and fiscal policies by taxing wealth away from the rich and spending which goes into the pockets of the 99%. But in point of fact, the kleptocracy I keep talking about, this rebalancing does not occur so wealth inequality grows as well as indebtedness among the 99%.

      1. Chris Cook

        It’s the toxic combination of compounding interest and private property – particularly in land – which is, and has been for thousands of years, the problem.

        We have once again reached an unsustainable concentration both of real wealth – ie ownership of productive assets – and of monetary wealth ie debt claims over productive assets.

        Monetary solutions on their own cannot cure the problem of imbalanced real wealth distribution: so systemic fiscal reform is also necessary.

        As I have pointed out, this means we really need to park the central insight of MMT – which in my view is what I think of as the polarity of currency.

        ie the fact that currency is a credit/equity instrument and not a debt instrument.

        We should consider separately the equally vexed question of what is the proper BASIS of currency. This in my view requires a Modern or perhaps a post-Modern Fiscal Theory.

        1. Curtis

          Hugh and Chris Cook understand what the problem is. Interest is not natural in the sense that it grows forever. Nothing in the natural world does that. “Debt” by David Graeber and “Payback” by Margaret Atwood understand. The other aspect is the 80 year cycle and institutional memory. I am 77 and grew up with the stories of the depression and it feels a lot like those stories. In addition the elephants in the room are resource depletion, population growth, and world wide pollution. The interesting part is that all of the problems were laid out in courses called Environmental Science that have been taught in colleges since the 70’s. The answer now seems to be what the hippies tried to do back in the day. My mental image is the little monkey who is caught with his hand in the coconut filled with rice that is tied to tether and wont let go. even as he is captured. How much is that like our society. How much are we like Moses? He saw the promised land and knew what it would be like, but God did’t let him go there. Ironic or tragic, or both?

          1. Nathanael

            You are correct. I learned of the 20s and the Depression from my grandmother, and we’re repeating the same damned mistakes.

            And yes, the hippies were right in the 70s on environmental matters, but we haven’t managed to implement it because of a bunch of old oil-and-coal fossils (pun intended) who are still running the government.

        2. Nathanael

          The traditional way to retain a system with compound interest was to take the money from the wealthiest and redistribute it to the debtors periodically.

          The bluntest instrument is confiscation (a.k.a. land reform) and if things get really bad it’s the only option. Debt forgiveness and bankruptcy are the next bluntest instruments.

          More subtle is progressive taxation, whereby the rich simply have their money taken by taxes (92% top rate under Eisenhower — and then there’s the estate tax) and it is redistributed to the poor (or to everyone on a per capita basis) in cash and services.

          This is fairly peaceful as a redistributive method, and has a whole lot of other benefits. The reduction in top-bracket taxes consistently preceded the rise in private debt and it is NOT a coincidence; it’s the cause.

  7. Hugh

    I don’t think the differences between Krugman and Keen are semantic. MMT and economists like Keen reject the money multiplier and loanable funds hypotheses.

    Also I don’t know what endogenous money creation means in the context of kleptocracy (you know, the actual political-economic system we have) since money is not created as required by the real economy but rather in response to and for the furtherance of various looting strategies.

    1. Lil'D

      Um, the very definition of “semantic” is that it’s about meaning

      Much of MMT is merely descriptive. MMT’ers often go babbling on prescriptively, but that can and should be a separate discussion. The primary importance of MMT is that it (in my opinion) correctly describes the workings of (i) private and (ii) central banking in a system of sovereign nonconvertible currency

  8. Economic Maverick

    Thanks Ed,

    Since I was a kid, I’ve literally been asking the question “where do banks get their money”, and for whatever reason, I still can seem to figure this answer out! Am I just dense and dumb?

    Now this Krugman vs Keen debate has left me more confused than ever!

    For many years, I went around asking the question “where do banks get their money” to everyone including loan brokers, retail bank managers, I-bankers, my grad school professors, credit analysts and commercial banks, and the answers I got were either nonsensical, or the textbook econ 101 answers about “loanable funds”

    Than over the last year(s) i discovered MMT and Post-Keynesian community, largely as a result of you and Yves, and slowly dabbled with forayed into horizontalists land and other endogenous money folks. A few weeks ago I put up a post on this topic on my own personal blog:

    I did this after doing some serious reading from people like you, Yves, Team Wray/UMKC, Carney, Keen, MMR, Ramanan, Team Mike Norman (Tom Hickey gave me some great feedback, as did Team MMR and Ramaman), so I finally thought I figured it all out, and now this Krugman vs Keen thing has confused me more than ever. I’ll say this, the one thing about the “loanable funds” model is that atleat it’s easier to understand. The MMT/Endogenous money folks might be more accurate, but, like reading Noam Chomsky, it’s too painful for the brain (and soul!) to handle, too hard to understand for mere mortals like me (who are perhaps a bit dense!), that my head starts to hurt, so therefor and I just prefer to go back to the comfort of mom, apple pie, saluting the flag, and “loanable funds”

    1. davegerlitz


      What is confusing about: “Banks create credit out of nothing”? That’s it. There’s nothing more to it than that. Qualified borrower shows up, bank grants loan; end of story. If and when the borrower transfers or spends the proceeds of the loan elsewhere, & depending on its current reserve position, the bank will either borrow from other banks or from the Fed; or not at all. All that, however, is secondary to the decision to grant the loan. That’s where banks get their “money”: from the minds of their underwriters.

      1. Nathanael

        Yep. Banks create money.

        YOU TOO CAN CREATE MONEY! Write a check. Convince the person you give it to not to *deposit* it but merely to endorse it to the next person, and to convince them to do the same thing. Woo-hoo, it’s money!

        Now, the government has certain regulations regarding the creation of money by banks, and they will do what it takes to satisfy the regulations — this is what all the messing about with deposits and reserves and interbank lending and the discount window is. Furthermore, when you want to turn your “bank money” into Federal Reserve Notes, the bank has to get them from the Fed, and there’s a whole system for this.

        But to a first approximation, banks create money.

    2. F. Beard

      …it’s too painful for the brain (and soul!) to handle, too hard to understand for mere mortals like me (who are perhaps a bit dense!), that my head starts to hurt, so therefor and I just prefer to go back to the comfort of mom, apple pie, saluting the flag, and “loanable funds” Economic Maverick

      “The process by which money is created is so simple that the mind is repelled.” John Kenneth Galbraith

    3. H. Alexander Ivey

      Let me add a bit to what davegerlitz says, which is quite correct and is the heart of how banking works.

      First, there is confusion over the terms “money” and “credit”. At the end of the day, they are the same thing. But “money” is often used to mean the paper or coin directly issued by a government. Credit is usually meant the promise of payment by a bank – a loan. At this point people don’t see that the two are really the same, and they don’t see that they both really come from the same source. The government. Most modern countries, UK, US, etc., license the banks to issue “money” or credit, so in a sense, a very strong sense, the government backs up the ability of the bank to issue “money” or credit.

      Now most mainstream economists ignore money, or mostly ignore it, and totally mis-understand what is credit and ignore it too. That is like a so-called doctor understanding human anatomy – bones and stuff, but not understanding (and ignoring and saying it is not important) blood flow! Mainstream economists decree that their models must be static or in equilibrium. The only time a body is “static” or in equilibrium is when it is dead!

      Long story short: money is a promise, and credit is a form of money. A government backs up the value of the money or credit and it uses the banks as an ESSENTIAL part of the THREE part system of capitalism (producer, consumer, and banker – the party that guarantees the medium of exchange (called money or credit). Banks are not constrained by reserves or capital or money supply or anything BUT the question of “Will I make a profit from this loan?” (And yes, Virginia, “profit” can mean money to the bank, money to the loan officer, money to the bank CEO, money to his friend, etc. And yes, Virginia, the bail outs can guarantee that the banks make a profit. And for those keeping score, the Fed reserve rate is really a bar that the bank must be above to make a profit – high Fed rate, the bank, in theory, needs to charge more on a loan to make a profit, the Fed rate is certainly NOT a limit of any kind or even, really, a “strategy” or “tactic” to influence the amount of money (dollar bills and credit) in circulation.

      1. Lil'D

        Money and credit are NOT the same thing.
        Money doesn’t need to be settled, credit does. Creation of credit results in offsetting asset & liability.

        Credit spends like money

        but it’s fundamentally different in nature

        1. Mel

          Until the point where government levies some taxes to reduce the money supply. Then money pays back just like credit, no?

          I can see that the “credit spends like money but …” can be a very useful distinction in many discussions, but I think we have to remain precise about the kind of discussion we’re having.

      2. Calgacus

        Long story short: money is a promise, and credit is a form of money. That has it backwards. Credit = debt is just another word for, just a type of promise, a relationship between two economic agents. Money is a form of credit/ debt. The fundamental concept in MMT, non-insane economics, is not money, which is derived, but debt.

        Maverick: Where does money come from? One of the best answers is Minsky’s: Everybody can create money. [make a promise, say I owe ya one] The problem is getting it accepted. [for something else you value].

        A monetary system is just a system regulating, recording how people say “I owe ya one” to one another. That’s all. Everything else is just boring details, usually presented with painful mind-boggling verbiage and scary big words, and which rarely gets to the point, which is usually hidden in some footnote somewhere. Par for the course in modern scientific exposition. :-)

  9. Anonymous Jones

    Thank you, Ed.

    This was a great post (and truly a relief to finally see something on this site that appreciates the complexity in the topic as well as the intertemporal nature of the policies, the actors, and the incentives in the system).

    I fear you are going to get a lot of the “this is not semantic” from the growing chorus of inflexible know-it-alls around here, but after perusing Rowe’s blog for quite a while yesterday, I slowly came to the same conclusion you did in this post.

    It is a difficult topic, and that is why so many quick formulations like “banks can create money out of thin air” (while correct) do not tell the entire story that there are ultimately constraints on this behavior just like comments such PK’s “bank loan officers can’t just create checks out of thin air” (while incorrect) do have meaning in the longer term because obviously there are ultimately constraints on this type of behavior.

    Anyway, I get a kick out of all the hand-wringing over the precise definition (and application) of endogenous and exogenous, as if this massive, shifting intertemporal political-economic system around us can be solved if we just figure out the right variables and the precise terms.

    So while I’m saddened that we’ve fallen so far down the rabbit hole that I only seem to see great posts or terrible posts, this was a great post! And I really appreciate you taking the time, care and effort to produce it.

  10. Paul Tioxon

    Ed, I admire your analysis. It seems that a simple description of what banks do, what central banks do and how it effects national and the global economy, without being constrained by theory or ideology to distort the simple picture of how the financial system operates and the role it has in the larger economy, is now a politicized academic debate. If I am to understand your operational definition of endogenous when the banks act to control interest rates, they are acting in and of itself and not the result of “The Market”, which would then be a exogenous cause of the central banks, The Fed, changing interests rates.

    If this is correctly understood, all of the reserves, all of the money created by the Fed would result in banks making all of the loans needed to get the economy up and running and unemployment reduced to tolerable levels, certainly lower than where they are now. But the banks are not constrained by not enough reserves, not enough liquidity, since the Fed allows more than enough,instead, there is not enough capital to cover all of the bad loans they would make in an economy as bad as this one. There are not enough loans out there, not enough credit worthy businesses to lend to. So, if more loans were to be made, they would have to reduce their underwriting standards to a “subprime” market. And this market would mostly result in more defaults and non performing loans than credit worthy. Of course, they tried to work around this dilemma by lying about the AAA rated quality of tranches of pools of loans. But non performing is non performing and that is not what the investors paid for. The banks can not lend because there is not enough business to lend to that will be able to pay the loan back resulting in a need for increases the capital to cover the losses. So, instead of throwing good money after bad, they just don’t lend. They do not risk their capital and we contract the economy. Would that sum up the practical description of how we got to where we are and why we are stuck such as it is?

    1. Rcoutme

      Please, please, please answer this one. It seems like this is the crux of the situation. I have been following the MMT debate and wondering where so many things have gone wrong. Thus: it seems not, as Mosler suggests, that we do not have enough money in the system to employ everyone, but rather that we do not have the money in the right hands. If we simply created the demand (and money) then that would lead to inflation (or hyperinflation), which would likely further impoverish the 99% (as it did in Zimbabwe).

      1. Nathanael

        You are sort of correct. Here’s a clarification.

        The money is not in the right hands. It is “potential money” (a phrase I got from a very smart commenter who I have lost the name of), tied up in the hands of the 0.1%, who never do anything with it except financial manipulations. Because it never gets *spent* it never acts like “kinetic money” (to coin a phrase) which is what keeps real economic activity going.

        The amount of *kinetic money* — money actually being used to buy actual things, not just financial stuff — is the variable related to actual economic activity.

        We have plenty of kinetic money + potential money. However, so much of the money is in the hands of the 0.1% that it’s mostly potential money. We don’t have enough kinetic money.

        This is the distinction; so this is why it is arguably both true that “we don’t have enough money circulating” (kinetic money) and “we have plenty of money but it’s in the wrong hands” (kinetic + potential money).

    2. gyges

      Yes, that’s a reasonable view of what got us here.

      But it’s not just that banks don’t see too many credit-worthy parties to lend to (in performing their own profit analysis diligence), it is also that a great many potential borrowers aren’t seeking loans (as seen in the FED Senior Loan Report fluctuations over the last 5 years), because they are more interested in paddling cautiously through uncertain waters and/or deleveraging. [If you’re a company looking at slack demand for your goods–goods you might mark down soon just to move them–you are disinclined from accumulating more debt to restock those shelves, so to speak.] The banks, as you describe, are faced with the reality of higher rates of nonperforming loans now and the prospect of future nonperforming loans if they lower standards as you describe. In that light, it makes sense for banks and potential borrowers to focus on balance sheet repair, and there is no quick fix for that. If anything, various ill-conceived policy responses have served to entrench some of these poor investments that otherwise might have unwound more quickly (even if more brutally and less orderly). Add to this picture the legal shortcomings of poor policy design and lack of any meaningful enforcement, and you have all the ingredients needed for crises of confidence and law; all of it inhibits the virtuous cycle of enterprise.

      You also have technical monetary policy tools like IOER. It plays several roles in the system, from putting a floor under rates, encouraging foreign banks to maintain reserves at FED, and other effects on the repo markets …but in our conversation today it serves to mitigate banks’ cost of servicing reserves. Currently IOER=25bps, FDIC fees are I think ~15bps, and from what I understand servicing those reserves costs more than 10bps so FED’s IOER encourages banks to keep that money parked there in FED (see Fred: EXCRESNS) which in turn enables the FED to have the reserve pool it needs to meet its constant Fed Funds targets that Ed Harrison talks about in the post.

      It’s a complex system and there are many factors, all of which have a temporal component–something modern money theorists are analyzing and minds like Steve Keen are exploring with dynamical circuit models.

  11. Anon

    Ed, re: your discussion of your old econ textbooks, Stephanie Kelton had a great comment in Krugmans blog about requiring students to tear out two chapters of the textbook and burn it.

  12. Wyntunnel

    Does anyone dare bring energy into the picture? I’m barely keeping up with the discussion but it seems to me that credit creation, being an advance on future productivity, is constrained by the potential of that future to occur. Unless I am mistaken, are profit margins not declining steadily across most industries as the energy portion of production cost goes up? Is this not why there a so few short term “profitable” businesses to invest in? We’ve reached peak innovation because there is nothing left to do that does not involve cheap energy inputs. The real economy’s health depends good old fashion people power, but even THAT depends on the cheap energy used to explode the population to 7 going on 9 billion people. We have 10s of millions of unemployed worldwide who just want a decent paycheque for a decent day’s work. There is graffiti to remove, bridges to rebuild, healthcare workers to instruct, diseases to fight, art to be created,…It would be great if we could substitute something in the place of oil but that’s not looking very likely any time soon and that is the rub. We’ll soon have too many mouths to feed and Malthus will laugh in his grave as we fall into ours by the billions. WHATEVER the underlying mechanism, it seems clear enough that the global banking system has created way to much debt. God knows how many generations it would take to repay if not a penny more were created.

    1. Rcoutme

      I think you have missed the point of MMT. Future generations do not have to repay the debts. The goods and services that they produce will be consumed by them. It is not possible for us to consume the goods and services of 10 years from now today. Thus the dichotomy of wanting to ‘pay down the federal debt’ but having high unemployment. If we undertake the ‘austerity’ programs that Greece, UK, etc. are doing then we will exacerbate unemployment. That would make absolutely no sense in a macroeconomic scale. You don’t reduce your quantity of goods and services in order to pay someone back!

      Thus, the real question becomes where and when will inflation hit–and how do we make sure it comes in manageable chunks.

      1. Mansoor H. Khan


        “Thus, the real question becomes where and when will inflation hit–and how do we make sure it comes in manageable chunks.”

        This is the main question now that we have peak oil. The past 100 growth years bestowed on to us by cheap and plentiful fossil fuels is now ending.

        The constraint to economic growth was time and peak credit.

        We got around peak credit by doing Keynesian government spending (war spending, defense spending, space program spending, cold war spending, GI bill spending, and other government deficit spending).

        Keynesian government spending acted like a debt jubilee. It replaced currency removed from the economy due to lack of lending whenever we reached peak credit.

        Peak oil will have to be resolved by doing the reverse. High spenders will have to be taxed to control inflation. In a sense the available energy supplies will be have to be allocated indirectly (by taxing consumption and rebating money to those with lower incomes).

        For our world economy money (and demand created by spending money) is a social relationship which combines:

        1) raw materials

        2) labor (entrepreneurs, managers, engineers and other workers)

        3) knowledge (management and engineering knowledge)

        4) and time

        in order to produce real goods and services.

        The constraint to real production today is probably lack of cheap and plentiful fossil fuels (and peak credit).

        mansoor h. khan

        1. Nathanael

          Actually the result of peak oil and global warming is that we will need to tax *high greenhouse gas producers*. This is of course connected to high consumers, but is not *exactly* the same; people who manage to have high consumption and low fossil fuel use need to be encouraged.

  13. Edward Harrison Post author

    Thanks for all the comments so far. Just a general comment from me here. I tried to stop short of saying anything controversial in this post because I wanted to see if I could cobble something together that was agreeable to all the parties involved in this debate.

    Personally, I think it’s bad for the economics profession for people to see economists arguing over very fundamental concepts of economics the way we have seen these past few days. I am sure that it gives off the impression to some that economics is so imprecise as to be meaningless. My hope was to see if we could stop bickering and get something up on this subject that was by and large agreed to.

    One thing I thought was interesting in the comments was Paul Tioxin’s quip: “But the banks are not constrained by not enough reserves, not enough liquidity, since the Fed allows more than enough,instead, there is not enough capital to cover all of the bad loans they would make in an economy as bad as this one. There are not enough loans out there, not enough credit worthy businesses to lend to. So, if more loans were to be made, they would have to reduce their underwriting standards to a “subprime” market. And this market would mostly result in more defaults and non performing loans than credit worthy.”

    Of course I agree with the thrust of this. That’s why my site is called Credit Writedowns. The reality we are living in is one in which private debt is so high that the only way to spur the kinds of credit growth that would feed through and a robust enough economy to close the so-called output gap without serious fiscal deficits is for banks to start making bad loans. In fact, that IS what the housing bubble was all about and I would argue we were in this same place, but with lower debt levels in 2001-2003 before that bubble.

  14. RueTheDay

    I think Krugman has been highly unfair to Keen, et al in these discussions.

    That having been said, Krugman raises an objection to MMT that I have personally raised on this blog and elsewhere in the past:

    A central argument in MMT is that in order for the Fed to target a short term interest rate, it must supply banks with all of the reserves they need to make loans. This is strictly true. However, the target Fed Funds rate is not a constant in anything other than the short term between FOMC meetings (and even not necessarily for that length of time, as the Fed has made rate changes between scheduled meetings). Thus, the statement really needs to be modified to “the Fed must supply all of the reserves banks require to make loans FOR AS LONG AS THE FED DESIRES TO MAINTAIN ITS CURRENT INTEREST RATE TARGET”. That is a profoundly different statement with different implications.

    1. Scott Fullwiler

      Exactly. And I said precisely that in my original post, so it was a complete straw man for Krugman/Rowe to respond as they did, not to mention that it moved the goalposts regarding what we were discussing in the first place.

      Here’s what I wrote:

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

  15. Boston Scrod

    Ed, I think you lost me on this one:

    “The reality we are living in is one in which private debt is so high that the only way to spur the kinds of credit growth that would feed through and a robust enough economy to close the so-called output gap without serious fiscal deficits is for banks to start making bad loans. In fact, that IS what the housing bubble was all about and I would argue we were in this same place, but with lower debt levels in 2001-2003 before that bubble.”

    Since I normally am able to understand most of what you have to say, the problem may well be on my end here.

    Are you saying that profusion of bad loans made during the mortgage bubble was a good thing (and that we should repeat the process once again in order to stimulate the economy)? If so, how is the ongoing use of government policy to prevent the transparent writedown of these outstanding high risk loans that are currently underwater defensible?

    Or was your basic point that broader fiscal deficits and the associated Keynsian stimulus are the only currently viable course for reviving the current moribund economy?

    What does seem clear to me is that if you are recommending high risk loans versus direct increased fiscal expenditure, any decision to backstop these loans with public monies when they fail is likely to get you to a similar (or worse) result than you would have had with direct fiscal expenditure in the first place.

    Maybe what you’re really saying is that there is no easy way out of the hole we’ve dug for ourselves. If so, then, I completely agree.

    1. F. Beard

      Maybe what you’re really saying is that there is no easy way out of the hole we’ve dug for ourselves. If so, then, I completely agree. Boston Scrod

      I disagree. Short term all we need is a universal bailout ala Steve Keen with leverage restrictions on the banks to prevent the problem from reoccurring.

      Longer term we need to allow non-usury forms of private money such as common stock to replace the role of credit in our economy.

  16. jsmith

    Yeah, well, I’m with Hugh on this one.

    This debate is akin to watching Doris Kearns Goodwin or Chuck Todd describe politics in our day and age of inverted totalitarianism aka neofascism: it bears no resemblance to reality and attempts to make it appear that the system we are living under can somehow be explained outside of ideas of theft, fraud and criminality.

    I mean, how is any of this really different from what Mishkin stands as a symbol of?

    To recap, he put out blatantly false descriptions of reality concerning Iceland to hide the fact that the elite were basically running a fraudulent ponzi scheme.

    Now, we have people debating whether this school or that theory best describes our situation when then entirety of the system is based on criminality and theft.

    Unless we are commenting on how criminal the entire enterprise is, how can debates on which philosophical school best describes the situation be considered worthwhile and NOT aiding/abetting the criminal class that loves nothing more than keeping the more intelligent of the masses busy with “debates” that draw fire from examinations of said criminality?

    Bravo, Mr. Keen, for more accurately depicting how we are being stolen from. Huzzah!

    Again, are Chuck Todd/Goodwin/Maddow really doing the country a service when they attempt to paint the presidential elections as time-honored American traditions filled with wonky historical nuance instead of neofascist theater designed to lull the masses into a false sense of control over their subjugators?

    Sure, many posters here will pooh-pooh this idea as their very livelihood is linked to said criminal system – yes, yes, it’s criminal but we’re all making (smaller amounts of) money off of it, too, so let’s not protest TOO loudly – but as the matter stands any commentary/debate that attempts to treat said system as anything other than the institutionalized criminality it truly is does nothing to further a real solution.

    1. SR6719

      jsmith: “Unless we are commenting on how criminal the entire enterprise is, how can debates on which philosophical school best describes the situation be considered worthwhile and NOT aiding/abetting the criminal class…”


    2. Scott Fullwiler

      Understanding those issues and understanding the operational details of the monetary system aren’t mutually exclusive. If you ever get rid of all the problems you mention, you still have to know how to make good policy, and for that you need to know how the system works. But you won’t get that if you’ve got the professional economists not understanding the system and then giving advice. Note also that we have Bill Black, Yves, and Jamie Galbraith (Predator State author) in the MMT camp, so those with expertise are addressing those issues, as well.

      1. Scott Fullwiler

        To clarify, I wasn’t suggesting Bill, Yves, and Jamie were full-fledged MMT’ers, since I don’t know if that’s how they’d label themselves. They’re certainly sympathetic, though. And some MMT economists like Wray integrate their work.

        1. jsmith

          I would disagree.

          Inherent in this monetary system is that criminality is institutionalized from the get-go – i.e., the people who have institutionalized the system have the money and power to change the rules (read: buy governments, think tanks, universities) by which people understand the system thereby ALWAYS retaining an advantage over the common person.

          As we have seen, reality in the world of finance has taken a back seat to fantastical criminality – the only seeming limits to the methods by which the elite will continue to steal is how much they have to finance their pawns (read: governments, think tanks, universities) in promulgating said chimerical devices of theft.

          Instead of looking at the problem from a humanistic level we are thus forced to diagnosis the problem from a systemic level – just as the masters of the system would like.

          Instead of “Workers of the world unite, throw off your chains!”, we are left with “No exogenous/endogenous money creation!!”

          Rousing indeed.

          It is my belief that you can’t create good policy until the objectives you strive for are first made perfectly clear.

          Is MMT really a humanistic theory?

          Do its proponents really believe that in MMT humanity has arrived at an entirely new understanding of how to better serve the masses? How to better life on earth?

          If so, it would seem that they should be able to explain said benefits to everyone in a way that the beneficiaries could conceivably comprehend.

          The fact that every debate on the merits of MMT remains in the stratosphere way above the comprehension of the common person should make any person a bit leery about debated technocratic solutions.

          Again, my point is this: any real progress in the Western world has been cleverly stymied by the “serious” people through a concerted campaign to paint any discussion of human betterment and progress as hopelessly idealistic and thus unworthy of “serious” consideration.

          We have all seen how well this has worked out for everyone.

          Isn’t it time to question our commitments of time and effort to debates and discussions that only further solidify the hold the elite have over the system?

          IOW, shouldn’t we be debating the purpose and points of our systems instead of the finer academic points of policy?

          Sure, it’s fun but so is fantasy baseball or filling out a March Madness bracket.

          1. davegerlitz


            “Is MMT really a humanistic theory?

            Do its proponents really believe that in MMT humanity has arrived at an entirely new understanding of how to better serve the masses? How to better life on earth?”

            Yes, I believe that the proponents of MMT, through the job guarantee (prescriptive) and its description of the monetary system (descriptive) believe they have solved the conundrums of modern economics: how to achieve price stability and full employment, through which we can “better life on earth.”

            Furthermore, there are many, many attempts at explaining this in layman’s terms throughout the blogosphere: Mitchell’s debriefings, Wray’s “one-pagers” at the Levy Institute, some of Kelton’s stuff at NEP. Tcherneva has some very accessible stuff as well (the female wing of MMT is very underrated, imo).

            The problem is not so much MMT as 1) the many varying schools of economics and their linguistic differences and 2) the deliberate creation of cognitive dissonance by the media and politicians, as you mention, which makes MMT just another voice crying out to be heard over the ensuing chaos.

            What Harrison (& Fulwiller & Rowe) are doing here is having that debate amongst the academics and trying to bring it around to agreement of language so that the 2nd barrier can be tackled. That doesn’t mean there aren’t accessible pieces of literature out there. There are. Whether or not that 2nd barrier ever actually gets tackled is up to us.

          2. Scott Fullwiler

            “IOW, shouldn’t we be debating the purpose and points of our systems instead of the finer academic points of policy? ”

            You need to know how it works first to know what to do about it.

    3. Carla

      “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” Upton Sinclair

    4. Hugh

      Yes, I do not identify as an MMTer because it fails to ask the right question. What kind of a society do we wish to have? I would ask everyone, Do you think we have the resources as a country and a people to provide all of us with the building blocks for a good and fulfilled life, a good job at a living wage, good housing, good infrastructure, good education, good healthcare, and a good retirement? If the answer is yes, and I think it is, then we really should be asking about how we can deploy our society’s resources to achieve these ends.

      This is where the real discussion should be, where we should be going as a society and what is keeping us from getting there. Note that all of this precedes any mention of money or monetary systems. It is about resources and recognizing that our greatest resource is ourselves and what we can accomplish together.

      MMT because it focuses on the monetary system is an afterthought, a secondary consideration. It doesn’t really see the kleptocracy we are in or where we could be going. Indeed as we see, it is perfectly amenable to exploitation by our kleptocratic elites. MMT will not save us. So this debate between it and the neoclassicals is really beside the point. It is rather like two philosophical schools onboard the Titanic debating the true nature of its propulsive system, ignoring that the ship has hit and iceberg and is sinking.

      1. Derek R

        MMT is general and only really describes the monetary aspect of society so it can apply to many different types of society.

        Right-wing MMT: inflation control via a sales tax on all purchases, including food, energy and other essentials; implement the Job Guarantee via service in the Armed Forces; reduce all other taxes and government programs.

        Left-wing MMT: inflation control via a progressive income tax/corporation tax plus any other taxes deemed necessary or appropriate; implement the Job Guarantee via employment in infrastructure projects such as road maintenance/construction, dam-building, railway electrification, and so on; spend on programs to tackle social problems as required.

        Theocratic MMT: inflation control via tithing; Job Guarantee via monasteries/religious orders; spending via church construction, social programs and large-scale religious events.

        Green MMT: inflation control via carbon/resources taxes; Job Guarantee via recycling/waste disposal work; spending on programs to enhance urban density and otherwise reduce environmental impact.

        Georgist MMT: inflation control via Land Value Tax only; Job Guarantee implemented as an educational/work experience program; spending mainly as core government functions plus a citizen’s dividend.

        So yes, the real discussion should be about where we should be going as a society and what is keeping us from getting there but note that the MMT gives us a template to use if we decide that our society needs to include credit and money.

        1. F. Beard

          How about:

          Social Dividend MMT: Inflation control by reducing the Social Dividend.


          1. Derek R

            Sure. Also…

            Corporate MMT: inflation control via poll tax; Job guarantee via apprenticeship; spending via production subsidies and privatisation of government functions.

            My point is that there’s a million of these MMT compliant societies. Some of them would display more growth than others; some of them would be more just; some would be more equalitarian. But from a monetary point of view they should all “work”.

          2. F. Beard

            The Social Dividend MMT would not require taxation – just a reduction in the dividend till the economy caught up to the money supply.

          3. Nathanael

            That particular version of corporate MMT fails because
            (1) the poll tax fails when the people being taxed don’t have any money
            (2) the job guarantee fails when the apprenticeship programs are paying so little that they don’t provide enough money for food

            There is a version of “corporate MMT” which works, but it has to make sure that poor people are *just rich enough* — Henry Ford’s “I pay my workers enough to buy a Ford” is proper corporatist MMT in action.

        2. Hugh

          None of your examples is congruent with what I outlined as fundamental social goals. Your examples merely illustrate my point that there is nothing inherent in MMT which will take us where we need to go. While MMT may provide a critique of neoclassical economics, it is not a critique of kleptocratic ones. That’s a fairly damning failure. Neither neoclassical economics nor MMT even touch on the dominant economic model of our times: kleptocracy. Something I have said before, this is like a group of military historians getting together to discuss the period 1939-1945 without any mention of or reference to World War II. Does it really matter if some of them get a few of the subsidiary issues right when all totally miss the big picture?

          Is it really supposed to mean something to us that Krugman is wrong and Keen, right when both miss the obvious?

          1. Nathanael

            Kleptocracy is a totally political problem. It’s not surprising that economists are amateurs at solving it.

            Almost nobody understands political history any more. The 0.1% surely don’t. Anyway, my study of history says that kleptocracy generally ends with the bloody execution of the kleptocrats, after which would-be kleptocrats — rulers who refuse to give the average plebians a “fair deal” — are more cautious for 100 years or so. French Revolution, Russian Revolution, collapse of the Roman Republic, etc.

            I’d like a better political “way out”, but history only shows one alternative, best exemplified by FDR. The “class traitor” who saved his own class by stopping the kleptocrats among his class. An enlightened 0.1%er might be able to take power and crush the kleptocrats. Emperor Augustus kind of fits this pattern too, and Earl Grey in the UK certainly does.

        3. Nathanael

          Note that the right-wing version of MMT and probably several of the others fail at inflation control when there isn’t any money in the hands of the average person, because you can’t get taxes from people with no money. Of course inflation is rarely a problem in those circumstances, but that means you’ve settled into a “bad equilibrium” where everyone’s bankrupt. This causes the money economy to become irrelevant….

          Taxation has to fall on someone who has money.

          1. Derek R

            Fair enough, Nathanael. I think the lesson to take home from these different MMT thought experiments is that there is more to creating a successful economy than just making it conform to MMT principles. The production/consumption side of the economy has to have the correct incentives in place too.

            As you say there is no point in taxing people who don’t have any money. It’s also not a good idea to tax people who are adding to society’s wealth. You really want to tax people who are impoverishing society.

            That is why I personally think that Georgism and MMT would be a good combination on which to base the economics of a society.

    1. F. Beard

      The money is redeemable; one can redeem his tax liabilities and private debts with it.

      Or if you wish you can buy your favorite shiny metals with money on the open market and thereby “redeem” it.

      1. indio007


        I mean redeemable with issuer. Ya know , the party that is initially transferring it for value.

        Ya know US Code 12 411….

        They shall be redeemed in lawful money on demand at the Treasury Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank.

  17. Bernd

    Hi Ed,

    whilst this whole debate on whether banks are reserve constrained and how the finer details of the process works is very interesting, all sides of the debate seem to be in agreement, that the “loanable funds” model is debunked and that banks make loans, thereby creating deposits and finding reserves subsequently.

    The whole debate however started( ) with Krugman dismissing Keens paper and his assertion of lending adding to AD, out of hand based on his “loanable funds” model.
    (“[…] Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. I guess I don’t get that at all. If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and I’m not sure what. I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand.[…]” ).
    Given the current agreement isn´t it fair to say, that Keen actually does seem to have a point, with his assertion, that lending adds to AD?

    1. H. Alexander Ivey

      First, make no mistake, there is no agreement here. Klugman and Keen are on two different tracks, two different “approaches” to reality, and these tracks are incompatible. And no, the debate here is not whether Roman Catholics or Protestants are “right” or whether they can live together (a question of religion), but what is “real” or true and what is make-believe and false. Keen is correct, Klugman is wrong.

      What Keen,, are saying is that debt is a major component of an economy. Ignore debt, ignore the debt velocity (debt to GNP), ignore the debt acceleration (debt to GNP2), and you will be like a physicist ignoring distance, velocity, and acceleration. You will not be able to explain much of anything.

      1. Bernd

        Not sure, from what I gathered, nobody, at the current stage of the debate has persited in claiming, that the “lonable funds” model is accurate. But Krugman used precisely that model to question one of the underlying assumptions of Keens paper.
        Krugman and Rowe subsequently, less or more directly conceded the point, that the “lonable funds” model is bs, however managed to sidetrack the debate to the role of reserves in banking and the influence of central banks.

        Not that that discussion isn´t important or interesting, it definetely is!

        My point was just, that Krugman objected to one of the underlying assumptions (lending adds to AD), tried to make his point by advancing his “loanable funds” theory, and dismissed the rest of Keen´s paper on grounds of being based on faulty assumptions. Subsequently it turns out Krugmans “lonable funds” model is less than accurate, which both Krugman and Rowe concede.
        Keen seems to be right in terms of lending adding to AD, even if you follow Rowe´s line of argument.
        Hence, there´s two debates here:

        – Is lending by banks a purely a form of transfer in spending power?


        – What´s the precise relationship between reserves, bank loans, the CBs,…?

        Whilst the whole debate here seems to be about the second question, the first one seems to have been settled in Keens favour.
        Hence even if Rowe/Krugman where to be right about the second question, it would be irrelevant to the validity of Keens paper and there seems to be mutual agreement, that Keen is correct what the first one is concerned.

  18. Ted P.

    Capital may be the constraint, but the quantity at which banks are constrained is not set by free market principles. It is manipulated via gaming capital rules, the very existance of accrual accounting, and “financial innovations” like CDS hedges that transfer the cost of funds subsidy to speculators while magically erasing large chunks of credit risk from the banking system (something the Fed is currently trying to fix with new proposed rules, but will certainly be lobbied away). But, most importantly the quantity is impacted by the artificial reduction in liquidity risk that is created by the central banks, which leads to an overallocation of capital to banks and artificially enhanced profits via direct reduction to banks’ cost of funds.

    So, yes they are capital constrained and not reserve constrained … but, that is precisely the problem.

  19. Schofield

    Try trawling through the MMT literature and it doesn’t have a lot to say on the merits and demerits of alternative strategies (adjusting the price or quantity of money or temporarily side-lining it) for defeating inflation. This makes it vulnerable to attack from the Neo-Conservatives/Neo-Liberals.

    1. FRauncher

      I was under the impression that the MMT ideal was to control inflation/deflation fiscally, thus short circuiting money creation. The only problem being how to get there politically.

  20. Schofield


    “I was under the impression that the MMT ideal was to control inflation/deflation fiscally, thus short circuiting money creation. The only problem being how to get there politically.”

    Yep it does but there it seems to stop without much discussion of any problems in this approach versus the merits and demerits of the other two approaches I mentioned above price and side-lining. The issue of how best to deal with inflation is crucial to the use of money and consequently where power should lie in controlling the creation of money.

    1. F. Beard

      The issue of how best to deal with inflation is crucial to the use of money and consequently where power should lie in controlling the creation of money. Schofield

      The solution is coexisting government and private money supplies with government money being de jure and de facto legal tender for government debts only. That would effectively abolish the “stealth inflation tax”. Thus government overspending would not harm the private sector. In fact, government overspending would make the payment of taxes EASIER in real terms since government money would be cheaper.

      Jesus implied this solution in Matthew 22:16-22, btw.

  21. Travis

    Ed, or anybody who can help

    I missed something. Nick says the CB is endogenous because it must change interest rate in response to changes in the inflation rate. But it is the CB that choses the rate of change in the price level that they are targeting. The Fed could target a 2,3,4,5,6… inflation rate. What am I missing?

  22. EmilianoZ

    Does it really matter whether the money is created out of thin air by the banks themselves or by the Fed? The Fed is a creature of the banks. It’s like a ventriloquist pointing to his puppet and saying: “It aint me, it’s him”.

    It’s a testament to the obfuscation powers of the 1% that something as fundamental as money creation is shrouded in such nebulous mystery.

    1. lambert strether

      More than a puppet and a ventroloquist; an entire class. Here’s the famous cartoon by Thomas Nast; question: “Who stole the people’s money”? Answer: “‘Twas him!”


      Though a layperson, I’m with the commenters who point out that 1% criminality needs to be part of the, er, model. I have yet to see Krugman mention either accounting control fraud or Bill Black’s work; and MMT is at least institutionally close to Black if not (yet) analytically.

      I mean, surely from the three perspectives of tactics, strategy, and policy, it matters whether the players are criminals or not?

      1. Scott Fullwiler

        I think many are missing the point here. We have a mainstream in the field that doesn’t know how banking actually works, and as a result they think we should deregulate, etc. etc. and do all the things that helped create the problems we have now (and which played no small part in the criminality). If they never understand banking and the monetary system, we will never have a profession that can adequately even assess the problems Hugh and others are talking about here–they will never even think to consider those things in the first place and they will continue to design/recommend policies to policymakers that allow current conditions to continue and even get worse.

  23. George

    I just finished Charles C. Mann’s ‘1491’ and ‘1493’.

    A major point, which he doesn’t remark upon, is how resilient systems are that have evolved, and how fragile are systems that are designed by humans.

    Throughout both of those books, economic systems, ecosystems and farming systems developed by the native Indians had persisted for at least 1000 years.

    Throughout both of those books, systems imposed by Europeans, and by the Indians when they were trying to adjust to societies where 95 – 98% of their peoples had died, failed miserably.

    If you look around the world today, modern systems of government and the regulatory regimes they have imposed are failing nearly universally.

    From a mathematical and systems POV, it couldn’t be any different. If you can’t predict any future, you certainly can’t, and shouldn’t try to, prescribe/regulate a path to a desired future.

    From the POV of a developer of complex control systems, I see none of the requirements for a control system for the economy. And, in fact, there is zero evidence from any country that nations can improve their economies over 50-year periods. The evidence is all the other way : the higher the total government burden, the lower the economic growth rate.

    No serious person in the world of technology thinks any of these approaches can work. We observe that in fact, they do not work.

    Yet the world of lawyers, economists and literary intellectuals continues in the same group-think that has produced these disasters.

    1. Nathanael

      This is just not true. See my comment below. There are numerous examples of governmental interventions with clear benefits in the 50-year timeframe. Lots and lots of them.

      You just have to not be stupid about the intervention. (Sigh.)

  24. Schofield

    MMT says inflation is most effectively tackled by fiscal policy tax drains and not CB interest rate hikes but does nothing to argue the effectiveness in modern times with control of money increasingly in the hands of an elite using sophisticated tax evasion techniques. Here is an example of the historical argument supporting the MMT fiscal policy tax drain solution:-

    However, if the majority’s (the wage earners) real incomes are increasingly failing to keep up with inflation the question becomes whether their failure balances out against the elites ability to resist the taxation drain. Indeed whether the bursting of the debt bubble now presages an attempt by the majority to seek to overturn the power of the elites in order to combat the long running deflationary effect on their incomes.

    1. Rcoutme

      Even if I grant your suppositions (implied and stated), it does not refute any argument by the MMT people that taxes should be used to control inflation. It simply means that, when all the ‘real’ increase in income goes to only a few (think the recent talk about the 1%), the taxes should fall almost exclusively on those who have more money than is good for the economy. Thus: for those who have more money than God, maybe we should kinda, sorta (get ready for all the hate from the conservative lunatic fringe (not all conservatives))…
      …raise the tax rates on the very wealthy? [Writer has barricaded himself in a snow fort in Siberia, awaiting the onslaught of the rabid reactionaries who are going to burn him as an evil socialist]

  25. Schofield

    George says:

    “From the POV of a developer of complex control systems, I see none of the requirements for a control system for the economy. And, in fact, there is zero evidence from any country that nations can improve their economies over 50-year periods. The evidence is all the other way : the higher the total government burden, the lower the economic growth rate.”

    Disallowing for the 50 year factor and the Great Recession China’s rapid growth through the use of MMT by the state to cancel non-performing bank loans or roll them over the last thirty years would appear to disprove your point.

    1. Nathanael

      It seems clear that national governments can improve their economies over a 50-year period by any of several techniques:
      (1) establishing government-supplied health care
      (2) building transportation infrastructure
      (3) establishing progressive taxation: taxing the very rich massively and transferring money to the poor.

      There are lots of historical examples.

      The case for the third is clear economically, and is due to the fact that the poor are constrained in spending on real goods and services by lack of money, while the rich aren’t.

      The case for the first two is actually more difficult to make theoretically, but the empirical examples are definitive.

  26. Travis

    George says:

    “From the POV of a developer of complex control systems, I see none of the requirements for a control system for the economy. And, in fact, there is zero evidence from any country that nations can improve their economies over 50-year periods. The evidence is all the other way : the higher the total government burden, the lower the economic growth rate.”

    Actually the empirical literature finds no correlation between state as a % GDP and growth.

  27. Matt

    Thanks for this very readable post… I understood Nick Rowe’s posts but this is the first time I think I’ve understood what Keen/Fullwiler are saying.

    “Some say that over the long-term a central bank must respond iteratively to macro economic variables. Others believe the central bank has full discretion to set policy as an exogenous actor.”

    Would it be fair to say that the second view is correct theoretically but the first view is correct pragmatically?

  28. bc

    In physics, time is a variable just as in economic theory, but there is an important fundamental distinction between how time is treated in the two disciplines. In physics, time for the model system is always the same as time for us, as observers. Indeed, physics assumes that time is the same value for everyone sharing a given reference frame in space-time. So do economists. The problem arrises when economists start creating dimensionless parameters the same way physicists do. When physicists say something is growing exponentially in time, they invariably mean something is growing exponentially with respect to a dimensionless parameter formed by multiplying time by another scale factor made up of other physical constants which are themselves assumed to be preordained universal constants of the universe, the same everywhere and for all values of time. This is a great simplifying assumption for physicists. This assumption is also made by economists, including econophysicists like Keen, with potentially error inducing consequences. In economic modelling, the ubiquitous scale factor for time is interest rate. Interest rate is not a primordial universal constant, Indeed, it is often a function of physics time i.e. calander time, and also varies from place to place (reference frame to reference frame-e.g. Japan, etc.). Time derivatives in economic models need to acknowledge this by using the chain rule and explicitly writing out the terms involving derivatives of interest rates with time. If Keen would add this to his model, I think it would be helpful in showing how CB policy setting interest rates can be incorporated into these models. I predict that such a model will “back test” more succesfully than the current version, and could one day help guide CB policy.
    The tautological, reflexive (per Soros), recursive, self referential,fractal, and semantic complexity that is muddying the current debate is largely traceable to this one concept IMO. For you laymen, I’m saying the Fed is stretching (and dilating) economic time relative to real time through interest rate policy. This causes growing distortion in economic behavior if persisted in one direction too long which might be powerfully predictive and explanatory, and this would be better revealed if economic models incorporated this time dilation effect.

  29. Schofield

    I think if Alan Greenspan had had a house price bubble growing in his gut he’d have been looking for treatment in “double-quick time!”

  30. Schofield

    Matt says:

    “Some say that over the long-term a central bank must respond iteratively to macro economic variables. Others believe the central bank has full discretion to set policy as an exogenous actor.

    Would it be fair to say that the second view is correct theoretically but the first view is correct pragmatically?”

    As in when Baby Bankster had crapped all over the floor Primary Central Bankster Carer had to clean the mess up?

    1. Nathanael

      The behavior of the European Central Bank, raising rates during a massive recession, proves that central banks do *not* have to respond sanely or appropriately to conditions, and that they often don’t. So no, Rowe’s view isn’t really correct.

      It is true that not responding correctly may bring down the entire governmental system, but the ECB went on its merry way ANYWAY….

  31. financial matters

    Nice discussion.

    I think the issues being discussed are complementary but I prefer the directness of Michael Hudson’s previous post. Has more to do with the degree of power inherent in the differences of MMT from neo-classical theories…

    “”It’s a war of finance against the economy.””

    “”Nowhere in the textbooks do you find a relation between the credit supply and asset prices, real estate, stocks and bonds.””

    “”What you are seeing is a financial grab of infrastructure that is taking place by the ability of commercial bankers to prevent the central bank from creating credit.””

    “”“So, what you are seeing today is a new kind of warfare. It is a financial warfare against the entire society, not only against labour, but against industry and, most of all, against government.””

    “”And, yet, modern economics treats all of the theft, the capital transfer, the transfer payments that are occurring today, as if it were all productive, as if all income is earned.””

    “” Only the debts of the 99% to the rich have to be paid””

    “”“And in the United States the corporate raiders and the leveraged buyout companies make a capital gain by cutting wages, by downsizing the labour force, by outsourcing it to other countries, and, especially, by seizing the pension funds and using the pension funds to pay off the bankers and write down the debt, so they have more equity.””

  32. Schofield

    How often do we hear from right-wingers how much more efficient and better private enterprise is at delivering goods and services than government and yet using a Baby Bankster (Private Banks) and Carer Bankster (Central Bank) analogy we can see that looking after Baby Bankster is hard work. Baby B’s worse prank is financing things that are disconnected from the underlying productive capacity of the economy like the housing bubble that burst and gave us the current Great Recession. Sorting out this mess has involved Carer B becoming Lender of Last Resort and using trillions of dollars that could have gone to other uses. The really big problem though is how Baby B seems to suffer from several hundred years of retarded development since this latest recession is one in a long string of recessions stretching way back and caused by socially dysfunctional lending. When you look back cleaning up Baby B’s mess has become so much of habit that Carer B has had to resort to creating a Deposit Insurance Scheme and even when it comes to par clearing Baby B can’t be trusted to organize it Carer B has to keep checking up on Baby B and make reserves available at a moment’s notice. Time don’t you think after all this time to realize the futility of expecting a Baby to create money and lend sensibly? Maybe after taking the money creation away from Baby B and introducing some new rules Baby B might be allowed to carry on par clearing and even decide on loan viable customers after they agree to risk some of their own piggy bank money with the loan. Certainly society literally can’t afford to carry on baby-sitting this brat!

  33. Brandon

    Really stupid question: I understand that the Fed is legally required to make of the reserve shortfall of a bank, but isn’t this done via the discount window? And if so, the discount window is not “normally” used to a significant extent.

    1. Nathanael

      The existence of the discount window is what allows the interbank market to clear. It is used routinely. Even though only a tiny tiny fraction of the banks in the country go to it in any given month, and only for a tiny quantity of money, if it didn’t exist, the interbank market would behave *totally differently*.

  34. Rob Denehy

    All of these concerns and implications are very interesting. I would contend that future paths of the global economy will develop naturally and any human internention made to “solve” the crisis has at best a 50-50 chance of success – in other words, we’re shooting in the dark.

    What is money? Debt? These questions may be important from a systemic viewpoint, and the answers we settle on may be important in terms of the interventions we choose, and the outcomes that flow from them. But these conversations are taking place at a rather ethereal level of thought. The number of people even aware of MMT is probably on the order of 0.1%. Their “revolutionary approach” to money and debt can only have an impact if it becomes a mainstream idea, and that will take time, if it occurs at all. In the meantime, the perception of the other 99.1% of the people about what money and debt “are” is quite simple and obvious in the extreme. The operational advantages of having money and avoiding debt are clear, consume a large part of the lives of the lower classes, and the interactions in the world of higher finance would seem like so much professorial BS [no insult intended to anyone, just saying].

    One disadvantage the academic classes have is that they know, even if they’re not economics majors, that there is something strange about money. It requires a level of abstraction that only humans can reach to understand the symbolic value of litte slips of fancy paper. We are raised with this abstraction from birth in modern society, and it has become second nature to us, but many humans have only a limited understanding of cash flows. That’s why some people are so impoverished – lack of education, information, or intelligence. How does a reinvented notion of money and debt change their behavior? Does it? Is there a channel for describing the system to non-analytical minds?

    The crux of the matter is confidence. Confidence was shattered pretty thoroughly in 2008, when the Treasury declared an emergency that would collapse everything if we didn’t act within days to save the banks.

    At one level, confidence in: continued income, stable prices, a job, long-term stability of money as a medium of exchange and a store of value

    At another level, confidence in: soundness of counter-parties in financial transactions, asset valuations, future revenue streams, financial market perception of deficit spending, global reserve currencies, sovereign debt valuation.

    Obviously, I am describing two different worlds here, the world of the everyday, “working” economy, and the “capital workers” economy. The motivations, perceived savvy and hubris of the latter have gotten us where we are. I know, it was all for the benefit of the little people.

  35. Rob Denehy

    Are the behavioral changes that are likely to change our situation going to come from the top – the elites in government, political, and academic circles? Or will changes in the behavior of consumers, “the masses”, change how our economy runs? What benefit is it for the elites to control the money in such a way that impoverishes the many? When you have all of the wealth you could possibly need, why would you deprive others of a small share?

    The motivation is power. Whether from the perceived wish of the right-wing to run our lives along Puritan lines, or the wish of the left, of asset-sharing through communal living and the abolition of the corporation.

    When the question is framed this way, does it not lend more credibility to the social justice, or at least pragmatism, of highly progressive income taxes?

    I am suspicious of the MMT “Job Guarantee”. As has become a popular point lately, in some circles re” the unemployment situation: a job is not a job is not a job. They’re not like roses. The jobs being lost seem to be much more “valuable” jobs to the economy and to the job-filler. Keeping cleaner toilets in public building will not spur the economy or innovation.

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