Dan Kervick: Krugman’s Flawed Model of Open Market Operations

By Dan Kervick, who does research in decision theory and analytic metaphysics. Cross posted from New Economic Perspectives

In my recent post Escaping from the Friedman Paradigm, I noted the following remark by Paul Krugman on the way monetary policy ordinarily functions when interest rates have not fallen to the zero bound:

… people are making a tradeoff between yield and liquidity – they hold money, which offers no interest, for the liquidity but limit their holdings because they pay a price in lost earnings. So if the central bank puts more money out there, people are holding more than they want, try to offload it, and drive rates down in the process.

And I was very critical of this model of central bank open market operations.  As I put it then:

… what in the world can it mean to say the central bank “puts money out there” that people then try to “offload”?   How can that happen? The central bank doesn’t stuff money into people’s pockets, and it doesn’t force them to hand over their financial securities in exchange for money.  It offers money in the open market in exchange for securities.   So if people preferred the securities to the money, they would’t have traded the securities for the money in the first place.  It makes little sense to say that  financial institutions first seek money for their securities on the open market, and then having too much unwanted money hanging around seek to dump it by obtaining securities for their money.

Interestingly, Krugman offers up the very same flawed model in a piece in yesterday’s New York Times:

Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserve — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits.

Again, this model of Fed securities purchases makes no sense to me. The central bank doesn’t buy securities by exercising some kind of eminent domain.  It doesn’t force banks to sell their securities.   Rather, the Fed Open Market Desk announces it’s intention to buy securities and the primary dealers then submit offers.  In other words, the Fed offers to pay money for securities in the open market, and banks only sell those securities if they accept the price determined by an offer they themselves have made.  So it makes little sense to say that at the end of this process the banks find their portfolios in an undesired condition and therefore need to “rebalance” them.

When Krugman says that the banks then “induce” the public to hold more currency and deposits, I take it he means that the banks then lower their lending rates so that more people are willing to borrow at the new, lowered rate.  This they do, according to Krugman, in order to carry out the portfolio rebalancing he has described.  But I believe the process here works quite differently.  The Fed has no ability to push dollars and deposit balances out into the economy by forcing undesired money on banks which will then force the money onto the public, but achieves its aims by targeting interest rates.

Banks generally make their money on the spread between the rate they must pay for additional funds and the rates they are able to charge for the loans they make to the public, and the key rate in the market for funds is the rate paid in the interbank lending market (the “Fed Funds” rate.)   The Fed has shown that it has the ability to target this rate with very little volatility.  Thus it simply announces the new rate it wants to set, and participants in the market move automatically to that new rate.  If the rate is lower than it was previously, this will increase the banks’ willingness to loan at lower rates than previously and will thus build up aggregate bank deposit balances.  This will increase the banks’ aggregate demand for reserve account clearing balances to handle the larger volume of payment obligations that are the natural consequence of the expansion of deposits.  The primary dealers, who possess reserve accounts at the Fed and are themselves the key supplying participants in the interbank market, will attempt to satisfy that demand by selling more securities to the Fed in exchange for dollar reserve balances.  And the Fed then buys those securities via open market auctions.

So Fed open market purchases are not aimed to force money through the system and out into the hands of the public.  They are designed to support and accommodate the higher demand for reserves that the Fed itself has influenced by announcing a new target Fed Funds rate.  The Fed influences lending and expands bank balance sheets by targeting prices, not quantity.  And of course, none of this works any longer once the Fed Funds rate has fallen close to the zero bound, and the Fed cannot set the rate any lower.

Also, Krugman is still attempting in this new piece to defend the loanable funds model of credit markets.  He often seems to suggests that when banks want to increase their loans, they satisfy their increased demand for funds by attracting more deposits from the public, presumably by offering better rates for CDs and term deposits, better services etc.  But while that might make sense from the standpoint of some individual banks, it makes little sense from the standpoint of the banking system as whole, and cannot explain the function of bank credit markets in response to an increased demand for consumer loans. For the most part, when a bank customer deposits funds in a bank, those funds come from transfers from another bank account.  For example, your employer’s paycheck to you is a payment order issued against your employer’s own deposit account at some bank.  if you deposit your employer’s paycheck in your bank account, your bank will ultimately collect the funds by receiving a transfer into its reserve account from the reserve account of your employer’s bank.  The same sort of transfer occurs if you move your deposit account from one bank to another to take advantage of better terms. An individual bank can absorb deposits from its competitors and use those funds to expand its lending; but the banking system as a whole cannot in any significant way increase its lending by sucking up deposits.  Instead, banks extend their lending and deposit account liabilities first, which increases its subsequent demand for larger clearing balances in its reserve accounts, which the banking system as a whole then meets by absorbing injections of funds from the Fed as part of the open market operations described above.

Paul Krugman seems determined to be the last dinosaur standing in defense of some outdated models of central bank operations.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.


  1. Alex Hanin

    You cannot agree with D. Kervick (and many others) if you’re not willing to abandon the IS/LM framework. Krugman reminds his readers each week (more or less) how well IS/IM has worked over the last 5 years.

  2. from Mexico

    Dan Kervick said:

    Instead, banks extend their lending and deposit account liabilities first, which increases its subsequent demand for larger clearing balances in its reserve accounts, which the banking system as a whole then meets by absorbing injections of funds from the Fed as part of the open market operations described above.

    Isn’t that somewhat of a departure from the endogenous theory of money as articulated by Steve Keene and Michael Hudson?

    In theory, the Fed can limit the amount of money the commercial banks create through the cash reserve ratio, thus limiting the money multiplier, and upping the reserve requirement. It can cut back on the amount of government-created money in the system. In practice, however, don’t Keene and Hudson argue that this seldom, if ever, happens?

    The bottom line is that money creation is driven by loan demand, instead of loan demand being driven by money creation. Loan demand is the cause, and money creation the effect, and not the other way around.

    1. from Mexico

      And what are open market operations? Don’t they merely boil down to the Fed offering to exchange government-created money for commercial bank-created money? It’s kind of like being able to exchange a goat’s ass for a diamond, with the expectation that goat’s ass contains a diamond.

      1. craazyman

        that’s true, but nobody can eat diamonds. Yet if they’re hungry enough, a goats ass might have some meat.

        that’s money for you. It’s the goats asses that make the meal and the diamonds are only the decoration.

      2. Ben Johannson

        In open market operations the Fed extends an offer to buy securities with reserves, usually via repurchase agreements which guarantee the seller a profit.

        1. Dan Kervick

          Right, there is no exchange of anything for commercial bank-created money. Open market operations are exchanges of Fed-issued money for securities, or securities for Fed-issued money.

          1. from Mexico

            But what are “securities,” at least the ones the Fed is acquiring from the commercial banks in its open market operations, other than commercial bank-created money that was created not in the conventional banking system, but in the shadow banking system?

            Investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), but most are not generally classed as SBS institutions themselves.[1][2] At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks.[3]

            The core activities of investment banks are subject to regulation and monitoring by central banks and other government institutions – but it has been common practice for investment banks to conduct many of their transactions in ways that don’t show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors.[4] For example, prior to the financial crisis, investment banks financed mortgages through off-balance sheet securitizations (e.g. asset-backed commercial paper programs) and hedged risk through off-balance sheet credit default swaps.[4]


            1. Dan Kervick

              The securities the Fed purchases are mainly US Treasury debt, along with mortgage backed securities and agency debt issued by government sponsored entities.

              1. Jsn

                So, as I understand it, the MBS dreck the Fed is soaking up is in fact bank created money, probably worth a good deal less than a goats ass.

                1. skippy

                  One little observation that keeps on hiding in said goats ass is… the multiplier effect that all that virtual time dependent expectations (Securitization) had on other asset classes, forecasting, demand creation…. across the entire economic strata…. globally.

                  skippy… its like losing more that half your CPU and RAM whilst in the middle of a game…. Oops… just crank up the GPU with HFT… that will fix things.

                2. Yves Smith

                  No, this is an oft-repeated urban legend. The Fed does not have dreck on its balance sheet.

                  The MBS the Fed is buying for QE are all government guaranteed, either explicitly (Ginnie Mae) or Freddie/Fannie.

                  The Fed did support dreck, but only during the crisis, and not by buying it. It had all those alphabet-soup lending programs. Some allowed dealers to pledge dreck as collateral for loans.

                  Now the Fed will still lose money, but not for reasons of credit quality, aka “dreckiness”. It will lose money because that’s inevitable. QE is a “buy high, sell low” strategy, explicitly. But they will finesse this by holding the MBS to maturity (they amortize pretty quickly, average life is around 5 years). And then that’s only MTM losses. The Fed will still earn money on an income basis.

                  1. from Mexico

                    Yes, but is it not also true that the government guarantee of agency debt was not made explicit until after the GFC? This of course wasn’t as outrageous as the government’s decision to pay off the banks 100% for all AIG’s worthless CDS which they owned. AIG, after all, wasn’t a semi-public agency. But it was nevertheless one of several extraordinary actions the government took to bail out the banks.

                    Extending the explicit government guarantee to agency debt was of course not something the Fed did, but it was part and parcel of the federal government’s package of policy actions to bailout the banks.

                3. Dan Kervick

                  No it’s not. If you look at the Fed’s balance sheet you will see that it is earning a great deal of money from its SOMA portfolio, and as a result has been remitting tens of billions to the US Treasury each year.

    2. Ben Johannson

      All Dan is saying is that the Fed must accomodate an increase in reserve supply when banks make loans. Hell’s Cargo extends a loan to a customer: if the quantity of reserves in the banking system is insufficient to meet the additional reserve ratio requirements then the Fed must add reserves or lose control of the interest rate.

      1. from Mexico

        What I’m saying is that reserve requirements have been reduced to such a point as to be all but meaningless.

        Here’s the argument:

        Banks typically have 3% of their assets in cash in order to meet customer needs. Since 1960, banks have been allowed to use this “vault cash” to satisfy their reserve requirements. Today, bank reserve requirements have fallen to the point where they are now exceeded by vault cash, which means lowering reserve requirements to zero would have virtually no impact on the banking system. US banks are already operating free of any reserve constraints. The graph below shows reserve requirements falling to zero over the last fifty years.

        Although, under current regulations, all depository institutions are required to maintain reserves against transaction (checking) deposits, the reality is they don’t. The purpose of bank reserves is to absorb losses and add stability/liquidity to the financial system in times of crisis. The “vault cash” banks use to satisfy reserve requirements is useless in absorbing losses because they are indispensable for banking operations (think ATM cash).

        In summary, today most depository institutions are satisfying their entire reserve requirement with this vault cash, which they hold to meet the liquidity needs of their customers and would hold even in the absence of reserve requirements. For these institutions, reserve requirements are effectively non-existent.


        Maybe you or Kervick can punch holes in this argument. I’m all ears.

        1. Dan Kervick

          Well this part is completely false:

          The purpose of bank reserves is to absorb losses and add stability/liquidity to the financial system in times of crisis.

          The author seems to be confusing reserve requirements with capital requirements throughout the piece.

          The purpose of reserves is simply to process payments to and from the bank. There are other ways of organizing the payments system that don’t require a positive reserve balance – Canada has such a system, and it is quite stable.

          1. Ben Johannson

            Yeah, confusing capital and reserves is a major sign the author does not grasp the fundamentals. Insofar as reserves being meaningless well, yeah from a certain point of view. Unless the public radically changes its preference for holding physical currency reserves are useful for the payment clearing system and satisfying accounting requirements, but little more.

            1. Nathanael

              “Unless the public radically changes its preference for holding physical currency ”

              This will happen. The preference has already gone up a great deal since 2008. That’s just a leading indicator.

          2. F. Beard

            Canada has such a system, and it is quite stable. Dan Kervick

            Canada is less hypocritical about its money system while we must pretend that ours is free market.

            1. Bapoy

              Canada is an exporter of oil and commodities which were in very high demand through the last crisis (China). Australia is the same. Their luck won’t be as good this time around, China has no appetite for energy and commodities this time.

              In a free markets, the market dictates the amount of currency and the price, banks are allowed to fail, prices are allowed to drop, and purchasing power is not extorted from the population for “the good of humanity”.

              Canada and the US have a centrally controlled fiat money systems. The root of inflation, high executive pay, union thuggery, wars, high unemployment and imbalances in general, etc, are all due to the attempt to control by the Fed. The article is simply looking for a way to push currency onto the population and it is accurate in my opinion. The only way for the Fed to push currency onto the markets is via lowering of interest rates, all else is a failure and will continue to be a failure. My guess is that the author thinks what we need is inflation, I disagree. Basically, one push for an UP equals one push for a DOWN. And by the way, the DOWNs seem to pile and pile on until a collapse. What we need is lower prices and re-balancing (settlement) between nations.

              Given that home prices are somewhat more depressed in the US, anyone wants to bet that Canada/Australia will collapse in a greater crash than the US?

              1. skippy

                Smaller populations are more agile and require less input to function.

                Skippy… who’s needs are the greatest in regards to resources, who imports the most to maintain its self… eh… if the financial lights were to go out… what would some have to trade.

            2. zygmuntFRAUDbernier

              I was looking at OSFI’s “Guide to Intervention” to see if there was anything about TBTF. Instead, I found out about the FIRP: (OSFI is the Canadian Banking Regulator)
              “FIRP means the institution restructuring provisions of the CDIC Act whereby an order may be made by the Governor in Council, on the recommendation of the Minister, to vest the shares and subordinated debt of a federal member institution in CDIC and/or appoint CDIC as receiver of the member for purposes of carrying out a transaction […]”. OSFI Superintendent –> Finance Minister —> Cabinet & Governor General. [no TBTF, on paper.]

          3. from Mexico

            Dan Kervick says:

            Well this part is completely false:

            The purpose of bank reserves is to absorb losses and add stability/liquidity to the financial system in times of crisis.

            The author seems to be confusing reserve requirements with capital requirements throughout the piece.

            The purpose of reserves is simply to process payments to and from the bank.

            Whoa! Not so fast!

            The purpose of bank reserves that you are parroting here is the new one, which is of recent Fed vintage (circa 1975). But, even according to the Fed itself, it hasn’t always been this way:

            Laws requiring banks and other depository institutions to hold a certain fraction of their deposits in reserve, in very safe, secure assets, have been a part of our nation’s banking history for many years. The rationale for these requirements has changed over time, however, as the country’s financial system has evolved and as knowledge about how reserve requirements affect this system has grown. Before the establishment of the Federal Reserve System, reserve requirements were thought to help ensure the liquidity of bank notes and deposits, particularly during times of financial strains. As bank runs and financial panics continued periodically to plague the banking system despite the presence of reserve requirements, it became apparent that these requirements really had limited usefulness as a guarantor of liquidity. Since the creation of the Federal Reserve System as a lender of last resort, capable of meeting the liquidity needs of the entire banking system, the notion of and need for reserve requirements as a source of liquidity has all but vanished. Instead, reserve requirements have evolved into a supplemental tool of monetary policy, a tool that reinforces the effects of open market operations and discount policy on overall monetary and credit conditions and thereby helps the Federal Reserve to achieve its objectives.


            Notice the spin the professional liars at the Fed put on the reserve requirement. If one looks at the historical chart of reserve requirements mandated by the Fed, it wasn’t until 1975 that the free-fall in reserve requirements began:


            So the Fed apparently operated for 62 years under the belief that ample reserve requirements were necessary as a liquidity cushion.

            The fiction now being peddled by bank regulators is that the liquidity cushion can be met by capital requirements instead of reserve requirements. However, in an environment of regulatory forbearance, such as we have been living in since 2007, capital requirements are easily gamed with obscure rule changes and become all but meaningless. A perfect example of this can be seen in what happened during the S&L crisis of the 1980s:

            Most political, legislative, and regulatory decisions in the early 1980s were imbued with a spirit of deregulation. The prevailing view was that S&Ls should be granted regulatory forbearance…. To forestall actual insolvency, therefore, the FHLBB lowered net worth requirements for federally insured savings and loan associations from 5 percent of insured accounts to 4 percent in November 1980 and to 3 percent in January 1982.16 At the same time, the existing 20-year phase-in rule for meeting the net worth requirement, and the 5-year-averaging rule for computing the deposit base, were retained. The phase-in rule meant that S&Ls less than 20 years old had capital requirements even lower than 3 percent. This made chartering de novo federal stock institutions very attractive because the required $2.0 million initial capital investment could be leveraged into $1.3 billion in assets by the end of the first year in operation….

            The FHLBB also made other rule changes which lessened capital requirements:

            Reported capital was further augmented by the use of regulatory accounting principles (RAP) that were considerably more lax than generally accepted accounting principles (GAAP). However, where GAAP was more lenient than RAP, the Bank Board adopted the former….

            Perhaps the most far-reaching regulatory change affecting net worth was the liberalization of the accounting rules for supervisory goodwill.19


            And to top it all off, the FHLBB changed the rules so that capital requirements could be met with “in-kind-capital” (stock, land, or other real estate).

            BOTTOM LINE: Capital requirements were all but meaningless.

            1. Ben Johannson

              Providing sufficient liquidity to ensure payments between banks is a necessary aspect of the system, because if people think they might not be able to cash a check you’ll have a bank run on your hands. The real role of reserves in establishment of the Fed system was to create confidence the banking system would not freeze as the private system had so often in the past. The author’s problem lay in thinking that reserves are used to absorb losses, which is what capital is for.

              1. Nathanael

                As far as I can tell, none of the megabanks had sufficient capital to absorb their losses in 2008.

                It seems that capital has nothing to do with anything. The megabanks survived because the government announced that they would be given free cash and kept operating even if they were actually insolvent.

                They were already filing fraudulent accounts, and they have continued to do so. (The various accounting frauds were all documented in various FT articles.)

                It seems that the way it actually works is that banks survive losses until they (1) run out of cash for withdrawal (which reserve requirements are intended to prevent), or (2) the government decides to stop bailing them out. Full stop end of story. What does capital have to do with anything?

    3. Dan Kervick

      Current Fed policy is to target the Fed Funds rate. As a result, if the demand for reserve balances grows, the Fed usually must accommodate that demand by supplying more reserves. If it doesn’t do this, the Fed Funds rate will be bid up by banks seeking to increase their reserves via interbank borrowing.

      Currently, the banks are carrying a large volume of excess reserves, so it would be possible for banks to expand their deposits without that increase resulting in an increased aggregate demand for reserves.

  3. profoundlogic

    “So Fed open market purchases are not aimed to force money through the system and out into the hands of the public. They are designed to support and accommodate the higher demand for reserves that the Fed itself has influenced”


    It’s just a circle-jerk, a Ponzi scheme perpetrated on an unsuspecting public. The Fed doesn’t give a “#@!* if the money makes it into the real economy, because the general public isn’t their primary constituent; the banks are.

    The whole Yellen vs Summers debate is comically preposterous. The only candidate we should be concerned with is the one who will put an end to this crony capitalist, profit-skimming disaster, and that person certainly isn’t being considered for the position.

    1. Dan Kervick

      That wan’t the point.

      The Fed actually does “care” whether money makes it into the real economy. But it doesn’t have many tools for doing this. The Fed is the central bank, not some all-powerful monetary authority. By institutional design, the operations it conducts are between it and the banks that are part of the Federal Reserve system.

      If Congress took steps to increase aggregate demand and move toward full employment by undertaking a large program of expansion of government gross investment and consumption, then bank lending would expand as a result, and the Fed would accommodate that expansion.

      But our incompetent and malevolent Congress refuses to act.

      1. F. Beard

        then bank lending would expand as a result, and the Fed would accommodate that expansion. Dan K

        Yeah. And then we might get a “nice” positive feedback loop (George Soros’ “Reflexivity”) of rising asset prices justify more lending which in turn drive up asset prices which justify more lending, etc. I believe the expression for that is “bubble.”

        Why not instead just ban further credit creation (at least temporarily) and pass out new fiat to the population ala Steve Keen? And Keen, to my knowledge, is not a “religious nutter” (your words) so you need not reject his suggestion out of hand.

        1. from Mexico

          Steve Keen and Michael Hudson are my kind of guys too.

          If your discussion doesn’t include private debt, then you’re part of the problem and not part of the solution.

          1. F. Beard

            I talk about BOTH, in case you haven’t noticed, though private debt is much more serious. Public debt is welfare for the rich since deficits should be financed with pure money creation without borrowing but that fascist holdover from the gold standard can wait.

      2. Susan the other

        Thank you Dan for your repeated patient explanations of how this all works. I was getting capital and reserve requirements mixed up too. Everytime I read one of your essays I feel like impeaching the entire congress. I don’t think they are going to lift a finger until half the cities in America declare bankruptcy.

        1. pebird

          I like to think of central bank reserves as public reserves, functioning to keep the payments system going and set the risk free interest rate. Capital reserves are private reserves, used to keep the individual bank going and target the the bank’s rate of return.

          Kind of analogous purposes, but different contexts. Since here in the US we have no concept of the public, they are easily conflated.

          1. F. Beard

            Reserves + physical cash are the real money. So why are only banks allowed to deal in reserves and not the entire population? Why doesn’t every citizen have a risk-free fiat account at the Fed (or US Treasury when the Fed is abolished) and if the banks need reserves then they can borrow them from the population and not have them freshly created by the Fed?

            Why? Because our money system is fascist.

              1. F. Beard

                Fascism should more appropriately be called Corporatism because it is a merger of state and corporate power. Benito Mussolini from http://www.brainyquote.com/quotes/quotes/b/benitomuss388775.html

                But I have nothing against corporations in principle because they are a means to democratically (per share at least) consolidate capital for economies of scale. But, of course, when corporations are privileged by government, as the banks are, then they cease to be good.

                Here’s a broader view of fascism, also by Mussolini: See any parallels to the current direction of the US? Especially the unending warfare?


              2. F. Beard

                But my own personal definition is “welfare for the rich” and that deserves all the invective one can summon – so long as one remains accurate.

              1. Nathanael

                “Why doesn’t every citizen have a risk-free fiat account at the Fed (or US Treasury when the Fed is abolished) and if the banks need reserves then they can borrow them from the population and not have them freshly created by the Fed?”

                Yep. You know what? We USED TO have risk-free bank accounts. It was called the “Post Office Bank” and it was abolished in the 1960s.

        2. Dan Kervick

          Thanks the other Susan. That was a theme of the very first post over at NEP. For some reason the dominant tendency of contemporary critical and dissident blogs and alternative press is to ignore Congress, and beat up on everyone else besides the chief malefactors in the US Capitol

          The biggest customer in the known universe is the US government, whose purse is controlled by Congress. Congress has the power to put a whole generation of unemployed and underemployed Americans to work. It has the power to formulate, pass and launch a program to radically transform our society and economy, creating many millions of new jobs and new forms of wealth in the process. It has the power to legislate changes in the labor and income system to drive a greater share of the return from industry into the hands of ordinary people, so that we can get an income-driven recovery, instead of a credit-driven recovery. It even has the power to modify monetary policies if need be.

          And yet for some reason Congress – that insipid, malevolent, incompetent and corrupt band of plutocratic toadies and hard-right ideological buffoons and monsters – is barely discussed.

          Whenever I read NC its all about the evil banksters, the evil President, the evil corporations, the evil Fed. It’s almost all Bernanke, Obama, Dimon and those folks all the Yes, yes, yes, yes. Fine. They deserve it. But why aren’t their daily calls for Mitche McConnell and John Boehner to be drawn and quartered? Where is the hatred of the evil Congress? For some reason the simple and obvious failure of elected legislators to not be idiots and take productive action to shape the future of their country is routinely ignored here, perhaps because it doesn’t fit into the category of the usual conspiracy theories, which tend to focus on remote individual titans, and not the more hum-drum monsters right in front of us.

          A lot of it comes from Tea Partiers (and the quasi-tea partiers and closet tea partiers and zero hedgers and Ron Paulers who hang out on sites like this one) Their attitude is resolutely anti-government, and so they don’t really want the government to do anything dramatic and constructive. So they hang out here, sometimes pretend to be progressives, and stoke knee-jerk sympathies for their libertarian stupidities. (Some are worse, and seem to come here to provoke some more “jump on the black guy” follies.)

          I have been strongly recommending the work of Mariana Mazzucato to people as an antidote to obtuse and tragic American obsession with libertarian solutions, and kneejerk resistance to activist government.

          And on the money thing: I write a lot about monetary operations to try to remove the stupid and toxic air of mystery and conspiracy that surrounds the whole business. If people want to reform the monetary system, fine. But they need first to understand how the existing system actually works, and drop all of the crackpot populist mythologies and legends. Everywhere I turn these days, it seems there is some new species of monetary crank hawking some silly new monetary ware – bitcoins, local scrip etc. – that completely avoids confrontation with the problems.

          If you don’t have enough money, that doesn’t mean the “money system” is broken.

          1. F. Beard

            Yes, Congress is at fault BUT SO ARE for proposing lame make-work for the victims of theft instead of RESTITUTION.

            Like a trampled spring and a polluted well is a righteous man who gives way before the wicked. Proverbs 25:26

            At best that makes you a trampled spring and a polluted well, no? Since you won’t call theft theft?

            1. from Mexico


              It’s pretty rich to lash out at the commentariat when it doesn’t zero in on the role of congress in its response to a post titled “Krugman’s Flawed Model of Open Market Operations.”

              Since when is congress involved in open market operations? That’s a new one on me.

              And I suppose I spend about as much time hanging around these parts as anyone, and I surely haven’t noticed any surfeit of get-out-of-jail-free cards being lavished on our congress critters. Not in these parts I haven’t.

          2. craazyman

            who elects these people? faaaaak this stuff is complicated. most people aren’t going to spend years researching monetary theory. that’s not an activity for everybody to take up as a hobby. the only reason I did is to try and score a 5 or 10 bagger. then I distracted myself after I realize I understood it better than anybody on the planet and that I did this just riding on a bus. that kind of freaked me out. but I got lucky. I’m not saying I’m particulary insightful, I just luckd out with a brain wave fluctuation. Most people are unlucky, like my search for the 10-bagger. It’s like that for almost everybody. the search ad search but never find. and then they get exasperated, and then desperate, and then they elect some bozo to congress, and then it’s over. As Ezekiel himself says “Destruction cometh.’

            1. craazyman

              also there are certain personalities, and I’m not saying who they are, who think folks will be rioting in the streets.

              that won’t happen, now that football season is almost here. just now, just to see the Giants driving on 4th and inches, and get the first down on the Big Screen TV. It’s that comforting sense of being almost home. Whatever was causing the disturbance in the force is over. It may have simply been a temporary vacuum produced by a slackness in early pre-season football anticipation It may have been a Tuesday or a Wednesday thing. those are usually the days when mental shit happens.

              Nobody will riot until at least next summer.

              for sure, nobody will riot during football season. and what would they be rioting about anyway? congress? they elected congress. they’d have to be rioting against themselves. that’s usually what drives people to various forms of yoga or meditation.

              It may be that people get so spaced out by yoga, various drugs and navel gazing they just lay around when football isn’t on. that’s frankly what I think is happening already. that’s more or less my situation.

              1. Nathanael

                Rioting will not happen. The mood is different.

                Remember how everyone kept talking about how *orderly* and *well-behaved* “millenials” were? These same millenials are the ones who are extremely disillusioned with the existing institutions.

                That’s a dynamic which doesn’t create riots of any sort. It creates revolutions.

          3. Nathanael

            Some of us have been paying a lot of attention to how Congress operates. I don’t think you were one of them.

            If you followed things closely, you would be blaming Harry Reid, Joe Biden, and yes, Barack Obama, for encouraging the phony 60-vote nonsense in the US Senate, which sabotaged all attempts to get anything sane out of Congress, and guaranteed that Republicans would win the 2010 legislative elections.

            Reid, Biden, and Obama *handed* the 2010 election to Republicans, and I warned them that they were doing it at the time. The public does not understand claims that “We had only 59 of 100 votes, we couldn’t do anything” — becuase such claims are ASININE.

            I’ve called for the outright abolition of the US Senate. So I think I have more credibility in blaming Congress than you do. And a lot of the fault in Congress points right back at Ex-Senator Barack Obama, who should have effing known better than to let the Republicans run the Senate with a minority of 40.

      3. profoundlogic

        They really do care? Have any concrete evidence? Let me know when they open up the discount window so we can all apply for some interest-free loans.

        A few questions to ponder…

        Did the Fed not facilitate the recapitalization of some the biggest control frauds (i.e. America’s largest banks) in history?

        Did the Fed not approve banks to own/trade commodities, allowing some of the most egregious price-fixing, profit-skimming operations in recent memory?

        If the Fed really “cares” why is so much of that reserve cash they’ve printed (Oh right, it’s not printing, just an account marker) sitting as reserves in foreign banks?


      4. Nathanael

        “The Fed is the central bank, not some all-powerful monetary authority. By institutional design, the operations it conducts are between it and the banks that are part of the Federal Reserve system.”

        This institutional design was the “devil’s bargain” of 1913, which guaranteed banks the seignorage from money-printing, in exchange for giving the government control over certain interest rates.

        This was not a good bargain and it is coming back to haunt us. We actually need an all-powerful monetary authority, one which could, for instance, issue “Greenbacks”….

  4. Dale

    To Krugman, MMT-orbit people are “… people who believe that they have discovered the hidden secrets of the monetary universe, somehow missed by generations of economists.” (The quote is from the same NYT post.)

    P.K. declares, in his sum-up, that the mainstream “got it all straight half a century ago”, and that anyone who disagrees is “almost surely just getting caught up in his own word games”.

    Even these oblique references are welcome indicators of the intellectual disquiet that suffuses Economics these days. There’s a lot of generalized anxiety about its growing incoherence, and even irrelevance, as the crisis drags on. But P.K. made his bones and won his pseudo-Nobel prize in this world. He doesn’t dare examine its flaws too closely. Yet.

    1. Yves Smith

      Half a century ago, the US was still on the gold standard. Krugman saying this was all settled a half a century ago means he’s admitting he’s applying the wrong model to our current fiat money system.

      Well, glad he’s made it official.

  5. denim

    “When Krugman says that the banks then “induce” the public to hold more currency and deposits, I take it he means that the banks then lower their lending rates so that more people are willing to borrow at the new, lowered rate.”
    Kervick takes it wrong. Krugman knows full well that QE is a voluntary process, but the profit that a bank makes by selling its securities to the Fed is an inducement to do just that. Business is business, profit is profit. Now the bank has cash money from the Fed. Oh, what to do with cash?
    Invest it in something better that what one just unloaded onto the Fed. Equities! And the stock market indices prove that the demand increased. The investing public, including banks, see the bull market and jump onto the gravy train. Expected profit is the inducement.

    1. Ben Johannson

      Krugman didn’t write about inducements to banks and financial institutions, he wrote about inducing the public which means retail customers. The Fed wants flows in the real economy rather than boosting speculative activity and the only tool it has for this is lowering interest rates so customers will take out loans for productive investment.

  6. Dan Kervick

    I agree part of the purpose of QE is to drive up equity and others asset prices and create a “wealth effect”. Bernanke has said so. But I don’t think this is what Krugman means when he says banks will “induce the public to hold money”. He’s using the standard mainstream idea that adding money to reserve accounts provides a new incentive for banks to lend that they didnt have before.

  7. TimR

    I was trying to explain MMT ideas to somebody last night (in part to see how well I understand them) and one of their arguments to me was that the US would “go broke” the same way the British did post-WWII when they handed their Empire to the US. Well, I’m pretty clueless about the monetary system of that period so I didn’t have much response. Anybody have any thoughts (unless this is too far off-topic)?

      1. profoundlogic

        No, they went broke because their expenses exceeded their income.

        Gold won’t make a country insolvent. We have asinine government bureaucrats and central bankers for that!

          1. F. Beard

            Are you implying that profoundlogic is not logical but is driven BY HIS FEELINGS?

            But gold, it’s so SHINY! And it’s heavy too!

    1. Ben Johannson

      Britain suffered the problem of having its productive industries flattened by the war, which meant it had little to export. Exporting is the primary method by which nations get hold of another nation’s currency: so for example if Britain needed oil or food but those commodities were denominated in U.S. dollars, Britain would have to sell things to the U.S. first, then use the dollars we paid them with to buy the food and oil from us.

      In 1945 Britain was incapable of obtaining through trade the food, oil and raw materials it needed and was forced to ask the U.S. for $4.4 billion in aid, which it then used to buy things it needed that were sold in dollars. Remember that a government can purchase anything for sale in its own currency, it’s just that there wasn’t much stuff to buy that was for sale in British pounds because Hitler smashed everything.

    2. from Mexico

      @ TimR

      Great Britain’s decline was a slow process that began in the 1870s.

      Aaron L. Friedberg does an outstanding job of documenting this in The Weary Titan: Britain and the Experience of Relative Decline 1895-1905.

      Here are some figures from a chart from the book that will give you some idea:

      Percentage Share of World Manufacturing Production


      Germany had passed up Britain in 1906-1910 with a 15.9% share of world manufacturing production.

      Two world wars, which some theorize were irrational, compensatory, imperial wars egged on if not instigated by the British ruling class, finished Britain off as world hegemon.

      Joseph Chamberlain, speaking to a group of London bankers in 1904, warned of the economic decadence that was consuming Great Britain:

      Granted that you are the clearing-house of the world, but are you entirely beyond anxiety as to the permanence of your great position?… Banking is not the creator of our prosperity, but is the creation of it. It is not the cause of our wealth, but it is the consequence of our wealth; and if the industrial energy and development which has been going on for so many years in this country were to be hindered or relaxed, then finance, and all that finance means, will follow trade to the countries which are more successful than ourselves.

    3. Dan Kervick

      MMT is not the view that the government doesn’t need a responsible monetary policy and price stability policy, or that we can solve all of our problems simply by printing money. MMT does not confuse money with intrinsic wealth, or suggest that if the government emits twice as much money, we all suddenly become twice as rich. Unfortunately, given the theoretical interest of MMT, the MMT blogs seem to attract a lot of people who do have views that vaguely tend in that direction. This creates a buzz around the MMT discussion which can appear silly and needs to be cut through.

      Here I think is the core idea: Countries get wealthier and make progress by mobilizing their real material resources, and their people and skills, in the most effective way they can. Monetary instruments and financial instruments and systems are tools for doing that, and those tools can always be created and modified at very low intrinsic cost. So when a country has massive unemployment and is obviously therefore performing far below its capacity, it can never be an excuse for that sad performance to say “there isn’t enough money.”

      1. Nathanael

        I think that is an excellent summary, Dan. Not that I’m an MMT practicioner, but that’s what I got out of it.

  8. BITFU

    After doing a BITFU search on MMT “BITFU on MMT” it is interesting to get a sense of the back-and-forth b/w the two sides of this monetary debate. [If you have an issue with our Left/Right divide, we certainly understand: The line is way too crude for complex issues. But, on MMT you get the idea: The Right almost unanimously is negative, while the Left is more nuanced, but divided.]

    The impression I get is the same impression I get after reading the Two Envelopes Paradox from philosophy: http://en.wikipedia.org/wiki/Two_envelopes_problem

    Here’s the summation of the problem, and it really does seem reminiscent of MMT:

    “It can be argued that it is to your advantage to swap envelopes by showing that your expected return on swapping exceeds the sum in your envelope. This leads to the absurdity that it is beneficial to continue to swap envelopes indefinitely.”

    Yeah, I know–it’s essentially Krugman’s point: It’s a Big Word Game.

    Which maybe helps to explain why there is the reference to the fact that Dan Kervick “does research analytic metaphysics” in his by-line. As in, “It’s really NOT a word game. Dan Kervick should know because he’s an expert on ‘analytic metaphysics’ for cryin’ out loud.”

    Getting beyond Kervick vs Krugman, though I leave you with this thought from The Two Envelopes link about the proposed solutions.

    It absolutely nails the current state of monetary debate:

    A large number of solutions have been proposed. The usual scenario is that one writer proposes a solution that solves the problem as stated, but then another writer discovers that altering the problem slightly revives the paradox. In this way, a family of closely related formulations of the problem have been created, which are discussed in the literature.

    No proposed solution is widely accepted as correct. Despite this it is common for authors to claim that the solution to the problem is easy, even elementary. However, when investigating these elementary solutions they often differ from one author to the next. In the last two decades, several new papers have been published every year.”

    1. F. Beard

      What difference does it make if one swaps envelopes or not? Since one chose at random then a swap is just as random only opposite.

      1. BITFU

        That’s a funny response–even if it is unintentional.

        Of course it makes no difference to switch envelopes. That’s the whole point. It’s a logical absurdity, and yet–the reasoning behind switch is remarkably compelling.

        Variants of this theme have been discussed by Bertrand Russell, Wittgenstein,among many other philosophers and mathematicians across cultures for 50 years. Erwin Schroedinger is credited with developing it. Look at the bottom of the Wikipedia link for a half page of references of scholarly articles on this trivial, but vexing problem. Some pretty f*ing intelligent people are still submitting papers on Two Envelopes.

        And yet, here comes F. Beard, finally putting the matter to rest.

        One can only imagine the humiliation of three towering minds, like Russell, Wittgenstein and Schroedinger as they had the misfortune of standing before the searing intellect of F. Beard.

        “Sir, we stand before you with what we think this is a compelling problem of language and logic.”

        Prof Beard, yawns and dismisses them with a wave before uttering the answer which –up to this moment– had stumped the sages of the day: “It’s so obvious. Don’t switch stupid.”

        “Thank you, sir! We had no idea. Thank you! We are honored and humbled to stand in your presence.”

        1. F. Beard

          Oh, so the point is that at least form of logic is crap? Since it leads to an absurd conclusion?

          I can buy that.

          As for me, no towering intellect here, but at least I read the entire Bible so it’d be no surprise if I were a one-eyed prince in the land of the blind.

          1. Nathanael

            It’s not really about the logic.

            The problem with the envelope swapping is a problem with the conception of probability on infinite spaces. Math involving infinities is notoriously hard to get right and very easy to get wrong.

            In practice the key problem with the Two Envelopes “paradox” is that the supposed probability distribution of the numbers — equal chance of any positive number — is not actually a possible probability distribution. If you played the game in real life, the probability distribution would tail off at some point, because some unduly large numbers are, effectively, *prohibited by law*.

    2. Dan Kervick

      There is an excellent and short article on the two envelopes paradox written by the logician Graham Priest (with a co-author whose name escapes me.) In my opinion that is the best discussion out there.

        1. Dan Kervick

          Thanks Chris. Yes that’s the one I was thinking of. I have it here in my files of decision-theory papers but I was too lazy to dig it up.

  9. profoundlogic

    “If Congress took steps to increase aggregate demand and move toward full employment by undertaking a large program of expansion of government gross investment and consumption, then bank lending would expand as a result, and the Fed would accommodate that expansion.

    But our incompetent and malevolent Congress refuses to act.”

    No, the Fed would do whatever the bankers wanted them to do to keep the year-end bonuses on track.

    Praying for Utopia won’t make is so. Your delusions regarding central bank incompetence and malevolence are quite entertaining. Do you seriously think the Fed is independent of Congress?

    1. from Mexico


      Bankers are not in the productive (or real) capital business. They’re in the fictitious capital business. They are in the business of charging rent, not producing. And the way they charge rent is through the creation of debt.

      The Fed represents the rentiers, not the producers. So when I see statements like this one by Ben Johannson back up the thread, I don’t know whether to laugh or to cry:

      The Fed wants flows in the real economy rather than boosting speculative activity and the only tool it has for this is lowering interest rates so customers will take out loans for productive investment.

  10. clarence swinney

    In this Congress 22 bills have been signed into law
    88 in 1995 lowest since Great Depression
    David Koch zillions hired Tea Party to cut government and he is succeeding
    at the expense of millions without jobs and more millions with low pay.
    In OECD nations we now rank #1 as largest number working for low wages.
    44 million for minimum wages.
    Newt Gingrich was accurate to say the GOP is on a cycle that is negative and vicious.
    We closed 58,000 plants in the first decade of this century and it has not been stopped.
    Smart Socks recently moved our 45 jobs to Mexico.
    President Obama was correct to say we have had a decline in good jobs.
    He explained that the income of the top 1% nearly quadrupled from 1979 to 2007, while the typical family’s barely budget. As the recovery continues the earnings of the average worker are down. Newly hired auto workers make a fraction of what the industry historically paid.
    There does not seem to be any good answer to better paying jobs.

    1. MaroonBulldog

      My mother was a child during the Great Depression. She tells me that politcians in the ’40s promised we would never experience another depression, because they and learned and so knew how to avoid them.

      Do politicians and economic advisers really know how to avoid them? Or have they only learned to hide their existence through statistical manipulation and abuse of the meaning of words?

      1. Dan Kervick

        I think people know how to avoid them, but avoiding them means following a conservative, low-growth social policy toward investment and capital development, and people are typically unwilling to pay that price.

        The potential for financial crisis and depression is built into the structure of capitalist finance. If you have a society in which people are free to finance whatever projects they like, and to so so not out of savings, but by selling promises of shares in the future return from those projects, and are also permitted to finance promises with other promises, then you get exponentially increasing risk that the future will not turn out as anticipate, projects will fail, promises will fail, and promises that depend on promises will fail. You can get faster growth with debt financing, but also more risk and financial fragility.

        1. Nathanael

          In fact, even that isn’t a problem, as long as the *important* sectors of the economy are kept out of it.

          This is the “Swedish model”, if you will: the crucial sectors of the economy are socialized, guaranteeing everyone a decent living, and then the capitalists are allowed to play in the unimportant sectors.

          So there’s a big bust, like the dotcom bust. If the result of that is that everyone shrugs, goes home, and goes back to their day jobs, then — no problem!

          If the result is hungry people in the streets — problem!

  11. MaroonBulldog

    Why would anyone expect customers will line up to take out loans for productive investment–when the big corporations are using their cash for anything but productive investment?–hoarding it, buying back shares, paying dividends, whatever it takes to support share prices and executive compensation plans derived from share prices. ZIRP should imply the cost of capital is so low that any capital investment that would return more than beta should be undertaken, but we don’t see all the capital investments that QE is supposed to be “inducing”. Why isn’t it time to admit this experiment has failed? Because bankers are making funny money on it, that’s why.

    1. Dan Kervick

      Agree entirely.

      Think about what happens when the government announces it is building an interstate highway, and announces the route. Then everybody knows that there will be a market for rest areas, restaurants and hotels along that route. They know locations within easy access to the highway will be good places to live and commute, and so those locations are developed.

      When the government takes the lead and sets a strategic direction, and also invests in the most expensive, key components of that strategy, it reduces confusion, guesswork and risk in the private economy, and liberates the productive potential of private enterprise.

      But no, here in the US we’re too smart for that, what with our brilliant laissez faire ethos and hatred of government at all levels.

  12. Hugh

    The Fed is a tool of kleptocracy. Its monetary policies are not meant to stimulate the real economy for the benefit of the many but to blow bubbles of virtual wealth for the profit of the few.

    The question of reserves is irrelevant at the zero bound because banks can just borrow money from the Fed at zero or close to zero and have the Fed pay the banks interest on the reserves, that is the Fed’s own money. This is effectively a subsidy to, not a constraint on, the banks.

    I would further ask what is a bank’s capital? If it is just cash on hand. Increasing capital requirements would be a way of working around the failure of reserve requirements at the zero bound. But there are two problems with this. First, in a major crisis, these capital requirements will be insufficient to deal with a bank’s losses, and calls on its resources from depositors and creditors. Second, if we look at the totality of a bank’s assets, the current value of them is distorted by allowing banks to cook their books and value their assets to fantasy and to bubble-pricing.

    In another crisis, their positions won’t net out and this will expose, as happened during the last financial crisis, their underlying insolvency.

    As far as I can tell, the Fed’s only real policy these last 5 years has been to blow bubbles, pump up asset prices, and delay the inevitable day of reckoning as long as possible. Who knows? maybe Bernanke actually thinks the economy is doing better. It really doesn’t matter. He can’t keep markets stoked by his asset buying and they will blow up if he stops, hence this weasely “taper”.

    1. skippy

      At the present I’m prepared to distinguish the Fed as where “The Magic Happens” aka the “Temples of Old”… cough… pay us in your toil and we will grant blessings upon you… if the Gawds are willing.

      skippy… invisible thingy strikes again~~~

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