The Biggest Myth Preventing an Economic Recovery: "Private Debt Doesn't Matter"
The Myth that Private Debt DoesnÂ’t Matter
Before we can address the myth about how banks make loans and as a way to understand the deadly effect of that misconception, we need to talk about debt.
As economics professor Steve Keen documents in his must-read book, Debunking Economics: The Naked Emperor Dethroned, mainstream economists - from both the left and the right – don’t even take debt into consideration in their models of what makes for healthy economies.
As Keen noted in September:
The vast majority of economists were taken completely by surprise by this crisis—including not just … the ubiquitous “market economists” that pepper the evening news, but the big fish of academic, professional and regulatory economics as well.
Why did conventional economists not see this crisis coming, while I and a handful of non-orthodox economists did [?] Because we focus upon the role of private debt, while they, for three main reasons, ignore it:
They believed that the level of private debt—and therefore also its rate of change—had no major macroeconomic significance:
Finally, the most remarkable reason of all is that debt, money and the financial system itself play no role in conventional neoclassical economic models. Many non-economists expect economists to be experts on money, but the belief that money is merely a “veil over barter”—and that therefore the economy can be modeled without taking into account money and how it is created—is fundamental to neoclassical economics. Only economic dissidents from other schools of thought … take money seriously, and only a handful of them—including myself
Solving the Paradox of Monetary Profits — Economics E-Journal
Even the most “avant-garde” of neoclassical economists … have only just begun to consider the role that debt might play in the economy ….
In other words, most economists think that debt – and our money system – don’t matter.
L. Randall Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri–Kansas City. Wray is one of the country’s top experts on money creation.
Wray is the author of Money and Credit in Capitalist Economies, 1990, and Understanding Modern Money: The Key to Full Employment and Price Stability, 1998. He is also coeditor of, and a contributor to, Money, Financial Instability, and Stabilization Policy, 2006, and Keynes for the 21st Century: The Continuing Relevance of The General Theory, 2008.
Wray was asked:
As you might have heard – Paul Krugman argues that banks only loan out based upon their deposits, while Steve Keen argues that loans are created through double entry bookkeeping, so that money is created endogenously [i.e. banks create their own money].
For example, here is Scott FullwilerÂ’s (Associate Professor of Economics and James A. Leach Chair in Banking and Monetary Economics at Wartburg College) take on the debate:
Scott Fullwiler: Krugman or
The Keen/Krugman Debate: A Summary « Unlearning Economics
As a leading expert on modern monetary theory, who do you think is right? Do banks need deposits before they can lend Â… or do they lend regardless of deposits, and only bounded by reserve and capital requirements (or access to Fed monies)?
Wray responded:
Bank deposits are bank IOUs; an IOU can only come from the issuer. Where do your IOUs come from? Do you borrow them? NO. [Professor] Scott [Fullwiler] is right, Krugman does not know what he is talking about.
Indeed, economics professor and money expert Fullwiler says that Krugman should wear a flashing neon sign saying “I don’t know what I’m talking about”, and explains:
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.
[Krugman writes:]
And currency is in limited supply — with the limit set by Fed decisions.
This statement is simply mindboggling. ItÂ’s so wrong I donÂ’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.
Economics professor Michael Hudson also slams Krugman for having a blindspot on debt:
Mr. Krugman’s failure to see today’s economic problem as one of debt deflation reflects his failure (suffered by most economists, to be sure) to recognize the need for debt writedowns, for restructuring the banking and financial system, and for shifting taxes off labor back onto property, economic rent and asset-price (“capital”) gains. The effect of his narrow set of recommendations is to defend the status quo – and for my money, despite his reputation as a liberal, that makes Mr. Krugman a conservative. I see little in his logic that would oppose Rubinomics, which has remained the Democratic Party’s program under the Obama administration.
Mr. Krugman got lost in the black hole of banking, finance and international trade theory that has engulfed so many neoclassical and old-style Keynesian economists. Last month Mr. Krugman insisted that banks do not create credit, except by borrowing reserves that (in his view) merely shifts lending savings from wealthy people to those with a higher propensity to consume. Criticizing Steve Keen (who has just published a second edition of his excellent Debunking Economics to explain the dynamics of endogenous money creation), he wrote:
Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. I guess I donÂ’t get that at all. If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesnÂ’t have to represent a net increase in demand. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and IÂ’m not sure what. I think it has something to do with the notion that creating money = creating demand, but again that isnÂ’t right in any model I understand.Keen says that itÂ’s because once you include banks, lending increases the money supply. OK, but why does that matter? He seems to assume that aggregate demand canÂ’t increase unless the money supply rises, but thatÂ’s only true if the velocity of money is fixed;
But “velocity” is just a dummy variable to “balance” any given equation – a tautology, not an analytic tool. As a neoclassical economist, Mr. Krugman is unwilling to acknowledge that banks not only create credit; in doing so, they create debt. That is the essence of balance sheet accounting. But … Krugman offers the mythology of banks that can only lend out money taken in from depositors (as though these banks were good old-fashioned savings banks or S&Ls, not what Mr. Keen calls “endogenous money creators”). Banks create deposits electronically in the process of making loans.
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The Biggest Myth Preventing an Economic Recovery: "Private Debt Doesn't Matter"
gains. The effect of his narrow set of recommendations is to defend the status quo – and for my money, despite his reputation as a liberal, that makes Mr. Krugman a conservative. I see little in his logic that would oppose Rubinomics, which has remained the Democratic Party’s program under the Obama administration.
