Scott Fullwiler: Krugman’s Flashing Neon Sign

By Scott Fullwiler, Associate Professor of Economics and James A. Leach Chair in Banking and Monetary Economics at Wartburg College. Cross posted from New Economic Perspectives

The debate between Paul Krugman and my friend Steve Keen regarding how banks work (see here, here, here, and here) has caused me to revisit an old quote. Back in the 1990s I would use Krugman’s book, Peddling Prosperity (1995), in my intermediate macroeconomics courses since it provides a good overview of what were then contemporary debates in macroeconomic theory as well as Krugman’s criticisms of various popular views on macroeconomic policy issues from that era. One passage near the very end of the book has always remained in the back of my mind; in it, Krugman critiques a popular view that was and still is highly influential regarding productivity and trade policy. He writes:

So, if you hear someone say something along the lines of ‘America needs higher productivity so that it can compete in today’s global economy,’ never mind who he is or how plausible he sounds. He might as well be wearing a flashing neon sign that reads: ‘I DON’T KNOW WHAT I’M TALKING ABOUT.’ (p. 280; emphasis in original)

In his latest post in this debate (which Keen replied to here), Krugman demonstrates that he has a very good grasp of banking as it is presented in a traditional money and banking textbook. Unfortunately for him, though, there’s virtually nothing in that description of banking that is actually correct. Instead of a persuasive defense of his own views on banking, his post is in essence his own flashing neon sign where he provides undisputable evidence that “I don’t know what I’m talking about.”

Moving right into Krugman’s post, he writes:

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

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

He continues:

First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand. I hope this isn’t controversial, although given what usually happens when we discuss banks, I assume that even this proposition will spur outrage.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Returning to Krugman, he then writes:

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

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

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

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

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

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

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

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

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

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

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

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

Krugman summarizes:

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

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

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

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

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

Concluding his post, Krugman writes,

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

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

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

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

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  1. JJ

    What we have here is prime evidence that a huge chunk of mainline economists do not understand how the banking system works. They do not understand *where money comes from*(!!). This is problematic in-itself, but exposes an even larger issue.

    Why are we saddled with this banking system? Who built it? For whom? Why do we have a privately created currency? Why does the United States government, the most powerful the earth has ever seen, borrow currency into existence from private banks (who are compensated outrageously for a non-productive bookkeeping entry)? It’s clear that economists (honestly, whatever that means) and our governments didn’t build this system.

    More to the point, wouldn’t a sensible society build a banking system that was easily understood (and managed) instead of lazily maintaining the one it inherited? We’re so far away from a meaningful overhaul of our banking system. We don’t even agree on how the one we’ve got works.

    This is absurd.

    1. jake chase

      Andrew Jackson told us that if the people understood banking there would be a revolution tomorrow. At least we don’t have to worry about Krugman becoming a revolutionary.

    2. F. Beard

      This is absurd. JJ

      What is especially absurd is that our so-called “free market economy” has a government enforced/backed money monopoly for private debts.

    3. digi_owl

      I suspect the modern banking system is a multi-generational mutation.

      It may first have started out with the Knights Templars, as a way for pilgrims to have some way to pay for their trip without carrying valuables. But the first real trace of what was to become modern banking is likely the merchant banks of Holland and such. In part because merchants could hand over a letter from the bank (check) rather than carry around chests of gold and silver, and in part because they could extend lines of credit to same and also the trading expeditions heading to far away places.

      Later on it becomes more and more common for people to keep their savings in a bank rather than carry it on their person. But this could then result in runs on said banks if people became worried that the banks could not cover the deposits in full, or was in the process of closing down.

      Out of that came the central banks, that provided a way for regional banks to cover any deficits on the ledger via short term loans.

      So it is not something that has been sprung on us fully formed, but rather something that has been shaped over time as new issues needed to be fixed (creating yet more issues down the road).

      1. Fíréan

        Letters of credit, or bills of exchange, were used in the banking systems in the Maurya Dynasty,in what we know of as India, some hundred years BC.( present day western calendar terms)

  2. libertas

    Many years ago, I spent some time as an assistant manager in a branch of a large bank. I remember specifically sitting at my desk every morning, going through the overdraft report from the previous night. I had in front of me a box filled with demand notes, pre-signed in blank by various customers with lines of credit. If there was an overdraft, I would fill in a note with date and amount to a round thousand, file it, update the customer’s loan balance and credit his checking account with the amount to cover his overdraft. Customers without lines of credit got their checks bounced.

    I created money “out of thin air” every day. It amazes me that there is any debate about how this works. How can people like Krugman not understand this simple process?

  3. Middle Seaman

    If Krugman is totally clueless about the banking system, why does it take such a long and convoluted post to demonstrate it?

    A Frech mathematican in the 19th century, was listening to the “great” work his student was explaining he did. The prof said: go down to the street and explain it to the first person you encounter. If the person understand, you did good. Otherwise, go and work some more.

    1. Metta

      @MiddleSeaman Long and convoluted? To the contrary, If your even remotely familiar with OTS and OCC regs and GAAP rules, then you’d appreciate the author’s efforts in juxtaposing banking theory with banking practices. If you seek clarification as to what the author is talking about, lookup the Collins Amendment in Dodd-Frank for a start.

      Moreover, @Libertas gives us a nice quick and dirty glimpse at life in the trenches.

      Unless your willing to proffer a shorter explanation within the confines of modern banking practices, your criticism is just empty nonsense. Given your distaste for actual details, You’d be expectedly happier in the Krugman (read simpleton) camp.

      Krugman is recklessly building his arguement for the govt to fill people’s pockets with cash, whether it be from hiring people to dig and fill the same hole or welfare checks.

      1. F. Beard

        Krugman is recklessly building his arguement for the govt to fill people’s pockets with cash, whether it be from hiring people to dig and fill the same hole or welfare checks. Metta

        Money just given to the population is exactly what is needed; forget the hole digging.

        1. digi_owl

          That, or mass defaulting on household debts. As long as the massive debt burden is upheld, it will act like a mill stone around the neck of the economy.

    2. jest

      Probably because Krugman wrote several cubic meters of bovine excrement to disprove. It took a lot of work to clean it all up.

      That was probably one of his most clueless articles, ever.

    3. Min

      “A Frech mathematican in the 19th century, was listening to the “great” work his student was explaining he did. The prof said: go down to the street and explain it to the first person you encounter. If the person understand, you did good. Otherwise, go and work some more.”

      Who was the student? Galois?

      (Galois thought that some of the profs were idiots. ;))

  4. bob

    Krguman analyzes the “banks” on a currency basis? Talk about the blind man and the elephant.

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

    This is the choice quote of the whole piece. Put a number on that Paul, even a percentage per day. 1 or 2 tops?

    I wish he were a bank, I’d be there tomorrow applying for a mortgage and walking out of the bank with 300k, CASH. He’d figure out why this was a bad idea pretty quickly after I forgot to buy a house and drove to the airport instead. Whatta you wanna bet paul?

    This could be the way to sum up his universe of banking and the size of the structure he is analyzing. His “banks” are payday lenders. What’s the largest cash loan that they will allow?

    Challenge for Paul himself- Call around, go ahead and name drop, get that celebrity cred out there for all it’s worth. How much will ANY bank loan you and let you walk out the door with, in cash?

    1. Dave of Maryland

      I tried that once. Asked a Chase branch in Brooklyn for $2500 in cash to buy a keyboard. It was virtually every cent they had in the shop. They grumbled, “why didn’t you give us notice?” Unless things have changed over the past 20 years (and they have, but not in this direction), banks don’t have cash money in them.

      You want cash, you go to your local post office. By 5 pm, even a branch PO has got thousands in actual cash on hand. If Willie Sutton was alive, he’d be robbing post offices. Judging by the visible security (none), POs are an overlooked target.

      1. Thanks Wang Ryan

        POs overlooked? No way – they are next in line for Bankster promoted austerity measures. Keep the faith!

      2. bob

        PO’s are “protected” by very severe federal penalties for trying to steal from them.

        The point I was trying to make was that no bank is going to allow a recent large “loan” to walk out the door as currency.

        Lines of credit may be different, but are also a lot smaller. Many different “products”, but most boil down to secured vs unsecured. “Loans” are usually secured by something.

        First, you are trusting the person to actually buy what is going to secure the loan. aka car loan

        Second, the risk of a car crash, or even robbery of the person, before the transaction for the collateral takes place, can put the bank at risk.

        Both cases end up as bad, unsecured loan. No collateral.

        Issuing a check drawn from the bank allows some measure of security to the bank that is lending the money. They could, in the end, decline to clear the check if it was endorsed over to my cousin vinny. Or if it were “cashed” out of the city/state/country.

      3. bob

        And honestly, thinking about that 2500 further…

        You probably showed up at the wrong time. Cash is a pain in the ass for banks, they try to keep just enough of it around.

        Ideally, they don’t have any cash left at the end of the day.

    2. I Like Nickels

      Kyle Bass Got $20 Million in nickels from his bank, but I seriously doubt whether Krugman or MMTers could explain how.

      1. bob

        If you have $20 million in the bank, and want it in nickels, call ahead, and bring a few trucks. 2,200 pounds per million.

        And also, the bank will need to get a few trucks full of nickels first. Not too many banks have 20 million in nickels.

        Call ahead, probably take at least a week. And they aren’t going to hold them long. Although, it would be very tough to steal. They might be heavier that the vault.

        1. bob

          Pardon, completely wrong on the weight. 1 million in $1 bills wieghts 2,200 pounds. It didn’t sound right when I wrote it. damn anon internet cititations.

          I redid the math from scratch and came up with about 110 tons (220,00O pounds) per million $ in nickels, at 5 grams per nickel.

          So, 20 million in nickels would be about 2,200 tons. Assuming fully loaded 25 ton (net) semi’s, that’s 88 trucks.

          That’s gonna weigh a whole lot more than the vault, and won’t fit in it either.

          I’d love to know the gritty details of that transaction. I’d heard it before, but never did the math on the weight of it.

          I did do the math on Sprott’s move. No way it’s over yet, despite (or beacuse of?) his announcement that the move is completed.

          1. I Like Nickels

            found this excerpt from the kyle bass interview. seems apologies due on both our parts. neuron missfire on my part and $20 million in nickels needs to be corrected to 20 million nickels. oops. but we all do that sometimes.

            no details on transportstion logistics, sorry.

            also, i do remember a nickel weighs 5 grams. honestly.


            He still owned stacks of gold and platinum bars that had roughly doubled in value, but he remained on the lookout for hard stores of wealth as a hedge against what he assumed was the coming debasement of fiat currency. Nickels, for instance.

            “The value of the metal in a nickel is worth six point eight cents,” he said. “Did you know that?”

            I didn’t.

            “I just bought a million dollars’ worth of them,” he said, and then, perhaps sensing I couldn’t do the math: “twenty million nickels.”

            “You bought twenty million nickels?”


            “How do you buy twenty million nickels?”

            “Actually, it’s very difficult,” he said, and then explained that he had to call his bank and talk them into ordering him twenty million nickels. The bank had finally done it, but the Federal Reserve had its own questions. “The Fed apparently called my guy at the bank,” he says. “They asked him, ‘Why do you want all these nickels?’ So he called me and asked, ‘Why do you want all these nickels?’ And I said, ‘I just like nickels.’”

            He pulled out a photograph of his nickels and handed it to me. There they were, piled up on giant wooden pallets in a Brink’s vault in downtown Dallas.

            “I’m telling you, in the next two years they’ll change the content of the nickel,” he said. “You really ought to call your bank and buy some now.”

  5. Gumbo

    PK’s “constrained by currency” did ring false, and I was with you up until “borrowed in the money markets”. Doesn’t that allow Paul to say “in the aggregate credit is constrained and my model works”?

    1. YankeeFrank

      No because the money markets are not the only place the banks can go to get the reserves, as the article makes clear. The Fed is the reserve provider of last resort, and is mandated to provide the reserves. The only constraint the Fed puts on the money a bank can request is the interest rate it charges.

      1. vlade

        Indeed, that’s where the money creation takes place.

        As you say, the willingness of Fed (or a CB in general) to provide the backstop is the only constraint on the system.

        The funny thing is, when you have too many deposits (more than loans), CB will take those off you as well – so CB is both the lender AND borrower of the last resort…

      2. Rodger Malcolm Mitchell

        My company used to lend our bank millions of dollars every evening. They would settle up the next morning. These loans are called “overnights,” and they provide the banks with the reserves they need for overnight balancing.

        Banks never are limited by reserves. They can get them, anywhere.

        1. digi_owl

          Was there not a issue with “pass the toxic CDOs” right before shit hit the fan? That one company/bank would pass their CDOs onto a different one right before their auditors stopped by, and then take it back once they were gone again?

          1. I Like Nickels

            I recall a comment from sheila blair (then FDIC head)stating the amount of CDOs held by the smaller 6800 some banks that the FDIC regulates was rather small.

            But if you can bounce ’em off the Big 19 at the speed of light, or go someplace “dark” with ’em, I guess that could make them hard to count.

  6. Mansoor H. Khan

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

    In my experience I have found that one of impediments to understanding modern money is NOT realizing that all bank deposits are part of the money supply and are functionally equivalent to physical paper cash (paper currency).


    Currency Supply = Money Supply = Bank Deposits + Physical Paper Cash + Coins

    Bankers love this confusion (that the public not think of bank deposits as currency).

    Here is how the bankers game really works (it is much simpler than most realize):

    Mansoor H. Khan

    1. David Williams

      J.B.S. Haldane said. “There are four stages of acceptance of a new theory”:

      1) this is worthless nonsense;
      2) this is an interesting, but perverse, point of view;
      3) this is true, but quite unimportant;
      4) I always said so.

      For a long time Professor Krugman refused to engage with this “worthless nonsense”; then he addressed its “perversity and errors” in his Blog.
      But, in his latest post, today (2 April 2012), he has reached stage three of the four stages of acceptance, where he accepts the truth of the counter argument, but only in the short term.

      He writes, with reference to Nick Rowe (who supports Prof. Krugman’s position):

      “Nick Rowe gets to the heart of it: when you push this argument, it always ends up with an appeal to the notion that the central bank will always supply as much monetary base as the markets demand, at a fixed interest rate.

      As Nick says, under current central-bank operating strategies this is true in the very short run. ..”

      This corresponds precisely to the “this is true, but quite unimportant” stage. He will soon be telling us that he always believed it!

      1. Scott Fullwiler

        Yes, excellent comment. Krugman just got to stage three in his teachable moment post–“ok, who cares how they set a target; what’s important is that they do it.” As if knowing why QE doesn’t work isn’t important, as just one example.

  7. financial matters

    “In short (!), the money multiplier model is wrong because it has the causation backward”

    Nice explanation here. Implies that productive loans are generated by credit worthy enterprises with productive ideas and these endeavors are actually hindered by our current system of private interest being siphoned off these loans. A more public system would charge more reasonable interest and feed this interest back for the common good.

    Sort of another refutation of the trickle down effect. Ie the false notion that bankers trickle these loans into the economy for our own good.

    1. I Like Nickels

      I remember the “public” wasn’t too happy to find out that their 1% money market account was funding Lehman Bros leverage.

  8. Peter T

    Money supply includes at least cash, cheques and credit card balances – usually more. And anyone can create money – you don’t have to be a bank. Form a company, sell shares, holders use shares as collateral with bank or broker, take money, spend money. Money has been created. Company crashes, shares are worthless, money has been destroyed. Cash is money as a metric – and as OP points out, there is as much as the public wants to measure. Other money is a transferable debt, and there is as much as the expectation of profit creates.

    1. RueTheDay

      “anyone can create money – you don’t have to be a bank”

      This is wrong. In the first example you gave, of a company selling shares, no money is created. Rather, money is simply being exchanged for something else, in this case, an ownership claim. In order to create money, you need to be able increase the amount of something that is part of the definition of money, like currency or bank deposits. Banks create money because they can increase the amount of bank deposits, as a result of making loans. The government can create money because they can print currency, in addition to other actions that affect the volume of bank deposits. The issuance of new shares or bonds by non-banks via the capital markets does not increase the amount of money. There are however, certain activities non-banks in the financial sector take that have the effect of increasing the money supply. These activities (like money market funds and repos) are referred to as “shadow banking” precisely because they mimic what banks do, just using different terminology and in an unregulated manner.

      1. F. Beard

        In the first example you gave, of a company selling shares, no money is created. Rather, money is simply being exchanged for something else, in this case, an ownership claim. In order to create money, you need to be able increase the amount of something that is part of the definition of money, like currency or bank deposits. RueTheDay

        Yet, common stock would be an ideal, usury-free, democratic (at least in the long run), ethical form of private money that “shares” wealth and power rather than concentrates them.

        Conventional money is a reaping mechanism and is thus suitable for governments. But as for the rest of society, the emphasis should be on “sharing”, not allowing one class of people – the “moneyed” and the banks – to control the rest of us.

    2. F. Beard

      And anyone can create money – you don’t have to be a bank. Form a company, sell shares, holders use shares as collateral with bank or broker , take money, spend money. Peter T [bold added]

      It appears to me that the bank or broker is creating the money above and in the case of the broker I doubt it is creating new money.

      However, common stock would be an ideal private money form if it were not disadvantaged wrt to the banks and FRNs for the payment of private debts.

    3. Lil'D

      No, this isn’t new money.

      IOU’s, checks etc spend like money but they are not money; there is both an asset and a liability created. New money doesn’t carry a liability – the sovereign doesn’t need to settle any debts.

      1. James Sterling

        Interesting. Am I right in thinking that frauds can “create new money” that is destroyed again when the fraud is detected? And that embezzlers create new, fake money in their employers’ accounts, and then spend the real money they embezzled?

        1. bob

          “destroyed again when the fraud is detected?”

          It not only has to be detected, but also “realized” as a loss for it to be “destroyed”.

          This is a central part of the “extend and pretend” regime, no one has to realize anything.

          Not only has no fraud been detected (no one in jail), but very few of the losses have been “realized”.

  9. Stoned Hick

    A couple of Krugman take downs in a week’s time. He gets paid well by the Times, plus he gets a boat load of cashso,etimes when he speaks publically. Not a bad gig. Rather then cryptic accusations:” This is how a Bank works you morans!”
    Why not detail how another financial writer, like all of them, has their own agenda or version of information they like to publically present? Many folks are in the camp that suggests Banks are lawless criminals that do whatever they please and get away with it, and TBTF should be smashed to piece. Citi, Ally, Capital One, BOA – every one of ’em.

  10. pebird

    Prof. Fullwiler:

    Great post. One minor suggestion on the title. Add “Wonkish” to the end.

    1. Scott Fullwiler

      Thanks. Wonkish sort of goes without saying whenever I post, doesn’t it? :)

    1. David Williams

      J.B.S. Haldane said. “There are four stages of acceptance of a new theory”:

      1) this is worthless nonsense;
      2) this is an interesting, but perverse, point of view;
      3) this is true, but quite unimportant;
      4) I always said so.

      For a long time Professor Krugman refused to engage with this “worthless nonsense”; then he addressed its “perversity and errors” in his Blog.
      But, in his latest post, today (2 April 2012), he has reached stage three of the four stages of acceptance, where he accepts the truth of the counter argument, but only in the short term.

      He writes, with reference to Nick Rowe (who supports Prof. Krugman’s position):

      “Nick Rowe gets to the heart of it: when you push this argument, it always ends up with an appeal to the notion that the central bank will always supply as much monetary base as the markets demand, at a fixed interest rate.

      As Nick says, under current central-bank operating strategies this is true in the very short run. ..”

      This corresponds precisely to the “this is true, but quite unimportant” stage. He will soon be telling us that he always believed it!

        1. Travis

          Actually this is the money quote in PK repost:

          “So the critics here are mistaking a management technique the Fed uses for convenience — a management technique that it hasn’t always used in the past, and might not use in the future — as representing some kind of fundamental law about how monetary policy does or doesn’t work.”

          He has almost completely conceeded the argument.

    2. lambert strether

      A blog war with Krugman is a blog war for the ages! Congrats to Scott for drawing fire. And — baby steps — at least Krugman is citing to a primary MMT source, as opposed to third parties quoting the stories. Perhaps at some point he’ll engage the scholarship. A man can dream….

      * * *

      I wouldn’t call Krugman’s post “arrogant”; the term of art is snarky, a term that comes from the political blogosphere, which heavily influenced Krugman’s style. Snark is well-suited to academic controversy — I’m thinking back to the letters column in the New York Review of Books, which I read with great pleasure as a child — and as in all matters of blogging, Krugman’s snarkery is impeccable. I suggest that Fullwiler respond by taking the high road, as befits the antagonist with the winning arguments.

      1. I Like Nickels

        I’m quite excited to watch this upcoming Debate of the Ages too between our exalted scholars.

        I hope whenever they finish, they will be required to hold up a flash card indicating one of the following:

        Flash Card A:

        I think unconstrained bank lending is a good thing.

        Flash Card B:

        I think unconstrained bank lending is a bad thing.

        My gut tells me we may need a Third Flash Card:

        I think unconstrained _________[fill in blank-anything real or imaginary is fair game] is a good thing.

        But we may need to consult the rules committee about whether we can add the third flash card or not.

        But the third flash card would make economics less dismal.

          1. I Like Nickels

            I suspect both of us would like to come back in our Second Lives as either a banker or a college professor.

          2. I Like Nickels

            I’d like to be the banker that delivered Kyle Bass his nickels. And that would take longer than some careers I’ve had.

    3. jest

      I just read it.

      He lost.

      He lost reeeeeeeeeeal bad.

      He should stop while he’s ahead, as he’s just embarrassing himself now.

  11. Benign

    As the author alleges, capital does matter. If the banking system were not as highly leveraged as it got to be (worse in Europe, and the investment banks’ “exception” led to their blowing themselves up in short order)–financial crises would not happen as often. And of course banking would not be as profitable as it is, and the banking lobby would have had to have been neutered in some way for capital requirements to be raised.

    Let’s amend the Constitution to undo Citizens United as a first step to turning the country around.

  12. Schofield

    There are clearly two Magic Money Trees (ability to create money from nothing) in operation in our supposedly democratic society. One Tree belongs to the Banksters and the other to a sovereign government. The motives in using the two Trees are what should concern us. As Michael Hudson has explained to us the “rational” motive of the Banksters is to get government and non-government sectors to take on as much interest bearing debt as possible and how they do that is not always that scrupulous (Subprime Mortgage Bonds fiasco). Clearly creating too much debt results in burst debt bubbles and accordingly more than necessary instability from investment cycles. With the other Magic Money Tree operated by government we have the motive of politicians seeking to inject re-election stimulus which may prove inflationary and generate yet further instability in seeking its containment.

    The issue, therefore, becomes one of how many Magic Money Trees do we actually need and how do we contain selfish motives. Clearly the answer must relate to how effective we can make the use of Magic Money Trees accountable to the general will of the citizens. I would argue the tools that citizens currently have at their disposal to achieve this accountability aren’t very effective and a big rethink is now urgently necessary.

    1. F. Beard

      The issue, therefore, becomes one of how many Magic Money Trees do we actually need and how do we contain selfish motives. Schofield

      We need at least one government money supply that is legal tender for government debts only. This should be inexpensive fiat. We also need any number of private money supplies that are only good for private debts.

      Clearly the answer must relate to how effective we can make the use of Magic Money Trees accountable to the general will of the citizens. Schofield

      The allowance of genuine private currencies for private debts would abolish the “stealth inflation tax”. That means that explicit tax increases would be needed if government was to increase its share of the real economy.

  13. F. Beard

    If we had only one huge bank, would it need any reserves except for net payments to the Federal Government and for withdrawals of currency? And if the Federal Government ran a constant deficit wouldn’t that mean that the bank would never need reserves except for cash withdrawals?

    And doesn’t interbank lending approximate that one huge bank so long as the economy is booming?

  14. Pro Fraudclosure

    Krugman said some good stuff too:

    “The failure to seek real mortgage relief early in the Obama administration is one reason we still have 9 percent unemployment. And right now, the arguments that officials are reportedly making for a quick, bank-friendly settlement of the mortgage-abuse scandal don’t make sense.

    The claim that removing the legal cloud over foreclosure would help the housing market — in particular, that it would help support housing prices — leaves me scratching my head. It would just accelerate foreclosures, and if more families were evicted from their homes, that would mean more homes offered for sale — an increase in supply. An increase in the supply of a good usually pushes that good’s price down, not up. Why should the effect on housing go the opposite way? “

    1. KnotRP

      The cloud over county title records is
      not cured by lawyer magical settlement
      dust. Good luck confirming that you
      really paid the right party on purchase
      or refinance.

      Also, is kruggles trying to assert that
      the central bank has total control over
      the actual issuance of money supply,
      and therefore total control over LEVERAGE
      in the economy? PK is arguing the CB is 100%
      responsible for the bubbles! Oops? Too bad, PK, but
      the bankers and motgage (and student debt barvesting machine)
      are to blame too. PK headlines the circus, anybody got a baguette?

  15. Kristjan

    Very good post Scott. Let’s see if Krugman is intellectually honest now. It is his duty as an economist to come out and say in public that he has been operating under wrong paradigm. What do we have economists for if they don’t serve the public?

      1. Detroit Dan

        Exactly. Every time Krugman gets cornered he obfuscates by citing IS-LM, or some other nonsense that sounds wonkish but is basically obfuscation…

  16. spooz

    As an accountant, I found it to be perfectly to the point. I like my explanations very basic so no assumptions have to be made. Some economists, it seems, like to leave things a little murky so they can continue to sell their theories as too wonkish for the woefully uninformed, who have no choice but to remain ignorant due to lack of superior intellect.

    1. digi_owl

      Reminds me of priests leading the prayer in latin, while the congregation, having no idea what the priest is saying, just repeats the words and hope for salvation.

  17. steelhead23

    I am not as concerned by the errors neoclassical economists make in the actual performance of banks, as I am by their misunderstanding the economic function of banking. Some say that lending pulls forward demand and thereby accelerates growth. That is true, but ignores the rather obvious feedback loop in asset values. The more money lent into the economy, the higher asset values rise and as the margin between the cost of production and price grows, the potential for financiers to extract rents grows. Hence, finance, which is parasitic not only on the current host, but on posterity, is being pressed to speculate on asset prices in order to make money at a time when balance sheets are very weak and are incentivized to facilitate transactions that their own risk analysis would deem too risky, simply to maintain the cash flows needed to remain solvent. That is, the Fed’s easy money policies are self-perpetuating if the goal is to prevent failure of a TBTF bank.

    The important aspect of Krugman’s misconceptions is that this view is incompatible with asset bubbles caused by easy money and how this bank-caused growth in asset prices destabilizes the economy. Loans, for the most part, are paid by wages. If credit grows faster than wages (as it has for over 30 years), a default event becomes increasingly likely. The Feds easy money policies are not merely hurting fixed-income investors, they are undermining the economy.

    Krugman is wrong, but what is truly annoying is that he appears to be unteachable, a crime of the first order for a Nobel laureate and a professor. I would encourage Dr. Krugman to ask himself this simple question: “What if I am wrong?”

    1. James Sterling

      It seems to me that if you pull demand from the future, the future eventually arrives, and you’ve pulled the demand from it, so you have to pull more demand from even further into the future. There must come a time when you can’t pull demand from far enough ahead any more, and then you hit a patch of demand drought.

      1. F. Beard

        The problem isn’t lack of “demand” (needs or desires) but lack of money or the ability to borrow more.

    2. Doug Terpstra

      This tends to discredit the Nobel prize in economics, just as it has been seriously eroded by the Peace Prize, given first to Kissinger and then to his greater war-crimes competitor, Obama. The Nobel Prize Committee looks increasingly like an obfuscatory Orwellian ministry of the oligarchy, whether it comes to promoting war or enabling criminal fraud.

  18. Anonymous Jones

    The choir is loud and accordant today, with nary a stray note.

    Preach on, brother!

    And ushers in the back, make sure those doors stay closed. Oh wait, what was that? No one’s trying to get in? Ok, well, let’s seal this place up anyway.

    1. diptherio

      Actually, I think there are plenty of people still coming in. The choir over on Krugman’s blog is quite discordant after his (non)response to this Scott.

    2. diptherio

      Actually, I think there are plenty of people still coming in. The choir over on Krugman’s blog is quite discordant after his (non)response to Scott’s piece.

  19. Doug Terpstra

    Even I’m beginning to understand MMT, so fifth-graders could easily get it too, if it were allowed into the classroom. Then even mainstream economists might not be too far behind in comprehension — and finally, one day, perhaps even Nobel Prize-winning economists might be enlightened. (Apologies to Jospeh Stiglitz)

    1. Detroit Dan

      in the same category as Nick Rowe and Scott Sumner, and anyone who claims we need NGDP targeting by the Fed…

  20. curlydan

    As someone who majored in economics, I think it’s almost a crime that economists aren’t required to take even a basic accounting class. I never did, and I regret it every year.

    1. Leverage

      Honestly? You do in mainland Europe. Didn’t know it wasn’t mandatory in USA (I suppose that’s where you are from). I see that as a complete disaster, not knowing about banking is already a disaster, but accounting? Jeez…

      Has not served us much though, looking at current disaster policies pushed around.

    2. ECON

      Get your accounting education through MBA or BComm or BBA or
      or professional accounting certification of your state auspices. Economics is not in the business of accounting save logic and accounting function standards.

  21. craazyman

    Professer Delerious Tremens Explains it All

    well well. Does the father make the baby or does the mother make the baby?

    The father/mother duality makes the baby.

    Which resembles the father/son/holy spirit trinity. It is always a “triad” and it’s always an ensemble.

    The ensemble itself is a singular agent of creation.

    Fed/Banking System/Society => Money

    Like Father/mother/baby => family => life creation process => money blood nourishing the body populace

    If the Fed didn’t exist, the male energy would be scattered and atomized but it would be the same emanation. The Fed arraigns it into a singularity to achieve a higher potency, for good or for bad.

      1. craazyman

        Oh man, you’re crackin me up. :)

        Just read Professor Keen’s post. Can’t believe anyone can imagine an economic model without money. Is he serious about the neoclassical economists? Holy Cow.

        That’s impossible because we know money = property like wave = particle. So the property/money duality is an embedded ontological construct. You can’t have an economy based on barter anymore than you can have an electron as a particle.

        You could have had an economy based on barter before money. but then the barter/spirit duality existed. This stuff is so self-evident when you drink 2 glasses of red wine and take alzaprolam. Who needs a textbook? I mean really.

        1. I Like Nickels

          Ya. Should be obvious to anyone you has ever said something like “My house is 200,000 Dollars.”


        2. MyLessThanPrimeBeef

          Wait till you hear from the really smart guys about the discovery called ‘money quantum entanglement’ whereby after two funds have interacted, when one fund is spent, for example, on hard liquor, the other fund will be appropriately spent in a correlated manner.

          1. I Like Nickels

            However, the theory is not fully understood yet. They are still trying to work out how pouring a Jim Beam at one end can cause a Johnny Walker Blue to pour at the other end.

  22. Hugh

    As I wrote here yesterday, Krugman simply does not understand fiat money. He knows the Fed can issue money. He knows the US went off the gold standard in 1971. But his whole intellectual framework for money remains the gold standard, just minus the gold. He can’t grasp or refuses to accept that when the government went off the gold standard and became a fiat creator of its currency, everything changed.

    He is rather like a guy who has heard of Einstein and relativity but continues to apply Newtonian solutions to all problems, even those where relativistic contributions dominate.

    I think it is at least as important to point out that, at least in one of the responses of Keen to Krugman, Keen made it clear that Krugman doesn’t understand debt either and continues, along with other neoclassicals, to ascribe little importance to it.

    1. I Like Nickels

      yeh. Krugman probably doesn’t even know you can’t buy a barrel of oil for $3 anymore. Even if you do try and get it some cheap place like Vietnam.

    2. psychohistorian

      Krugman is a border puppet. That is like a border router in a large network.

      He speaks the faith to the wannabe believers to keep them circling the temple.

      We have private faith based fiat money, who’s machinations supposedly is in the service of mankind but in reality only serves a few.

      Nationalize the Fed and neutralize the social control of the global inherited rich. It is sad to see how few comments cut to this chase……like Krugman is really someone other than a social obfuscation tool of the rich.

  23. Harry

    Yeah, I think you and Mosler and Keen are right. Taken me ages to get my head around MMT but I can see its right.

    The problem is the implications for legitimacy. Imagine what it means to the idea of fair wages? Wages = Marginal revenue product? Really? If some guys just print up their own money then why are the rest of us working for a living?

    Thats the problem with privatising the process of money creation. You hand out one incredible valuable franchise for nothing, and then the guardians of that franchise will inevitably get incredibly rich and powerful.

    1. Mark P.

      ‘If some guys just print up their own money then why are the rest of us working for a living?’

      Quite. To further belabor the obvious, a couple of quotes —

      “It is well enough that people of the nation do not understand our banking and money system, for if they did, I believe there would be a revolution before tomorrow morning.”
      – Henry Ford

      “The few who understand the system will either be so interested in its profits or be so dependent upon its favours that there will be no opposition from that class, while on the other hand, the great body of people, mentally incapable of comprehending the tremendous advantage that capital derives from the system, will bear its burdens without complaint, and perhaps without even suspecting that the system is inimical to their interests.”

      – The Rothschild brothers of London to associates in New York, 1863.

  24. FRauncher

    Actually Krugman as modified by Nick Rowe is right,at least in theory. It doesn’t matter which way the causation runs (and I agree with MMTon the usual direction). The overall creation of deposit money by loans is theoretically limited by reserve requirements, IF the Fed chooses not to create new reserves. There are no doubt many practical ways to get around this, but at the end of the day, the Fed can stop or at least dramatically slow bank creation of money.

    I don’t see how this conflicts with the basics of MMT.

    1. Matt

      Forget about reserve requirements, that is so 1960s. Starting in the 1980s the FRB reduced reserve requirements to the point that today only 1.2 percent of bank deposits are required reserves at the FRB. Just go to their web site.

      The banks were able to blow up the debt bubble because the FRB stepped aside and did not buy Treasuries to raise short term rates. The FRB had already handed over the “reserve” requirement money base limiter years earlier.

  25. SM

    Let me know where i’m wrong here, no yelling please.

    Is the prof saying that there is no reserve requirement at all, that at the end of the day, a bank doesn’t have to have, say 10% or whatever, in its accounts? Then what is required – just that the fed account is non-negative?

    And if its the case that there is no limit on the supply of money, that banks can just make whatever loan they want, including to each other, why would the interest rate ever increase, or be higher than slightly more than zero? I mean, if you could make a loan to a consumer at 1%, another bank could loan you the money to keep your fed account positive – and if the other bank can just create loans with no reserve requirements, why wouldn’t they just make any loan you asked for, just like you can do for your customers? Becuase making 0% on no loan seems like a worse deal than .01% on a loan to another bank. It would seem the only constraint on loans would be if you can find one from a customer that you think they can pay back. And why would the interest rate ever increase on loans between banks – you could always just borrow from one of the other banks out there that can also make infinite loans because there are no requirements, they don’t even have to look at their books, and definitely no reason to borrow from the fed – how is it that the infinite supply of money doesn’t mean that interest rates are always approaching 0% on lending between banks?

    I must be missing something so if someone could clear this all up i’d appreciate it.

  26. Bernd

    Let´s just juxtapose two quotes from Krugman, not even a week apart:
    “So, first of all, my basic reaction to discussions about What Minsky Really Meant — and, similarly, to discussions about What Keynes Really Meant — is, I Don’t Care. I mean, intellectual history is a fine endeavor. But for working economists the reason to read old books is for insight, not authority; if something Keynes or Minsky said helps crystallize an idea in your mind — and there’s a lot of that in both mens’ writing — that’s really good, but if where you take the idea is very different from what the great man said somewhere else in his book, so what? This is economics, not Talmudic scholarship.”(

    “I did have one thought, however: I realized that my own doomed-from-the-start attempt to bring in some clarity wasn’t original. It was, in fact, based on long-ago work by James Tobin and William Brainard, whose 1963 paper Financial intermediaries and the effectiveness of monetary controls addressed exactly the issue that has the MMT and related people so exercised today. And their bottom line?

    The main conclusions can be briefly stated. The presence of banks, even if they were uncontrolled, does not mean that monetary control through the supply of currency has no effect on the economy. Nor does the presence of nonbank intermediaries mean that monetary control through commercial banks is an empty gesture. Even if increases in the assets and liabilities of uncontrolled intermediaries wholly offset enforced reductions in the supplies of controlled monetary assets, even if monetary expansion means equivalent contraction by uncontrolled intermediaries, monetary controls can still be effective.

    As true now as ever.”

    Dismissing the value of prior insights and relying on them for authority, both within just a couple of days, seems like a fairly desperate attempt to avoid discussing the underlying questions.

  27. Steve Bertliner

    Krugman writes for the NYT, plus he’s been around for many years. This means he’s a team player, who doesn’t rock the boat. This is the Peter Principle, ergo bound to have his stuff “wrong”. That’s the purpose of an embed.

  28. John P

    I haven’t gotten through the whole post yet, but I’m confused about the first example. It seems to me that, although not done in exactly this order, that essentially the bank is borrowing from the money market and lending to the customer. It doesn’t seem like they are generating money in that case. What am I missing there?


  29. Chris

    thanks Scott – how did this guy get to where he is? He is hanging on to very old thinking, even the mainstream media are starting to smell a rat. When you start to do the accounting, as you have, you are so correct – banks do create loans independent of reserves based on

    Imagine if you went to your ATM and there was no cash. Of course there will always be cash to meet the demands of the community. My cash transactions are about 10 % of salary, rest are all electronic and settled between the banks.

    Go and get him. Krugman is naked, I think he knows it, but he has gone too far to back down now.

    I am so enjoying this as one of the economists who was taught all the wrong stuff in the 80s.

  30. Phil.R

    Hi Scott

    I started reading, but I couldn’t finish before the first fundamental assumption was clarified:

    You wrote “As is well known, and by the logic of double-entry accounting, the bank does make a loan out of thin air—no prior deposits or reserves necessary”.

    Can you explain why this is true as it is a bit lacking here, please. Could you do it in your own words (i.e. no links please) because I would like to discuss this with you and not an link, I hope you understand.

    At least in my experience, the double-entry accounting refers to that the bank maintains records on the originial deposit and the loan, but maybe I have understood it wrong.

    Wouldn’t this mean that I could be a bank? I just lend money to people and I can make myself rich as no prior deposits are needed?

    1. bob

      You can become a bank. You would be capital constrained, you couldn’t lend more money than you started with.

      But, the Fed isn’t going to backstop you, and lend you all the reserves you want, at a price below what you are charging for them.

      1. F. Beard

        …you couldn’t lend more money than you started with. bob

        Not necessarily. He might make deals with those who could redeem his liabilities to share the interest with them if they did not redeem them immediately.

      2. Phil.R

        Well, that could be true, but that is not what Scott F. wrote and which is his fundamental assumption:

        “no prior deposits or reserves necessary”

        so, if you don’t need deposits, you dont need own capital, because fundamentally these are the same thing, but different owner, right? If not how are deposits different from capital? Isn’t capital your “own deposits”?

        The same goes for lending, interbank or not. Lending are somebody elses deposits…

        So, why couldn’t I start a bank without capital, deposits, lending, reservers? Scott F. writes that banks create money out of thin air, why couldn’t I be a bank?

        Have any seen Scott F. ?

  31. OC

    I’m confused. Fullwiler writes:

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

    OK. This all sounds simple enough: no bank is ever deposit/reserve constrained because it can always find the reserves (to cover the loan) after the loan is made (at some price).

    But, if banks MUST EVENTUALLY find the funds/reserves in the money market to cover the overdraft produced via the loan’s migration to another bank, don’t the funds borrowed in the money market represent savings (savings that must have been derived from some income ALREADY EARNED by some agent)? Hence, that agent’s savings ARE being transferred (after the fact) to partially finance/back the loan.

    The point is that there is SOME constraint on bank lending that IS entirely independent of their willingness to lend (based on their perceptions of profit-making opportunities). That constraint is the quantity/supply of loanable funds-cum-savings. As the demand for those savings rises (c.p.), money market rates rise. BUT, why MUST we assume that SOME supply will always be forthcoming? Clearly, in late 2008, in many of these markets, THERE WAS EFFECTIVELY NO SUPPLY (of savings)–hence, bank lending effectively seized. Doesn’t such seizure suggest that (at certain moments) there is indeed a quantity constraint on bank lending.

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