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Mainstream economist discovers that banks create money (Krugman vs. Keen continued)

If you don’t realise something is broken, how do you know you need to fix it? One of the major problems monetary reformers face is that by and large the economics profession does not understand money and banking. This leads to them giving bad advice to policymakers, with bad policy leads to bad outcomes for everyone.

The reason that money is misunderstood is partly down to Adam Smith’s book, The Wealth of Nations. Smith essentially popularised the view that money naturally emerged from barter. As barter was inconvenient, so the story goes, people began to switch to using things which the majority found valuable, would accept in exchange for their goods and was easily divisible.

Gold and silver therefore naturally emerged as currency, and over time governments began minting coins in order to ensure the coins held the amount of gold they claimed to. Eventually the precious metal content was removed by governments in order to gain a source of revenue, yet the trust in the coins remained and they continued to be used by the people.

This ‘historical’ story leads to a view of money as merely a token which people use to transact with each other. In this view money is simply a veil over barter – emerging out of convenience. As such it has no economic effect other than to ‘oil the wheels’ of trade. With money economically insignificant, economists can then go about their work safely ignoring the role of banks, money, and debt.

However, if rather than coming out of barter relations money originated as a debt-credit relationship (see David Graeber’s ‘Debt, the first 5000 years’ for an explanation) the creation of money would have real economic affects. In the modern world banks have created almost all money as debt, yet the majority of economists are still stuck with their view of money as a veil over barter, and so see no need to think about money, banks or debt.

A good example of this can be found in the ongoing debate between Paul Krugman and Steve Keen.

Paul Krugman was the 2008 Nobel Laureate in Economic Sciences “for his analysis of trade patterns and location of economic activity”.

Steve Keen is Professor of Economics & Finance at the University of Western Sydney, and author of the popular book Debunking Economics.

It all started with a paper by Steve Keen on Hyman Minsky, an American economist who well understood that banks can create money and saw this as an inherent cause of instability in the economy.

In this paper Steve Keen criticised a paper by Krugman which attempted to model Minsky’s ‘Financial Instability Hypothesis’ without incorporating the central tenet that banks create money.

Krugman responded to the criticism by writing a blog which claimed that banks don’t really create money, by explaining that in the economics textbook version of banking banks don’t create money.

And then posted a second after almost all of the commenters pointed out how wrong he was.

And then a third.

To which Keen replied here, and then posted again here.

Several other economists and commentators have got involved on Keen’s side, including Steve Roth, Randall Wray and Scott Fullwiler.

What is great about this is that those economists who don’t understand how banks work are finally being taken to task by the people who comment on their blogs. An understanding of what banks actually do is coming to light, and as long as economists like Krugman are big enough to admit that they might have got something wrong, we might begin to see more economists treating banks and money in a realistic manner.

Once this happens the ability to push for monetary reform will be greatly enhanced – at the moment the economists to whom governments turn for advice on fixing the banks don’t understand what banks do and so don’t see a problem. Of course, when they do understand what banks do they might still not see a problem, but at least we will all be singing off the same hymn sheet, which is a start.

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  • http://www.economania.co.uk/ Bill Kruse

    Krugman should realise that the victors don’t just write history to suit themselves, they write the economics textbooks that way too.

  • Ian

    Brilliant. Keen’s book is well worth reading by the way.

  • GWHodgson

    Sorry Drew, another typo. The link to the seminal paper “It all started with a paper by Steve Keen on Hyman Minsky, ” ends with an extraneous “)”. Delete this in the browser address bar and the link works.

  • DavidSammons

    I remember learning how banks created money in 1967, I was 15 at the time. Unfortunately our Economics teacher obviously had no idea of the true effect of this. Pity I had to wait until the last year or two to find out!

  • Drew Jackson

    The version of this post which appeared earlier was a first
    draft that was mistakenly posted by another Positive Money employee. Thanks to
    everyone who highlighted the typos, you saved me a job!

  • http://www.facebook.com/janos.abel Janos Abel

    If mainstream economists are so incompetent about how economies, is there no way we can call for their resignation?

  • Sandra

    Paul Krugman is supposed to be a Keynesian. Well, I am reading an eighty year old treatise on Money by J M Keynes called a tract on Monetary Reform, and in it Keynes is quite clear in chapter five that banks create money. Why has this been so ignored by modern economics courses.

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  • John Souter

    Money is a concept  that has been given prominance over reallity. As a concept it suffers no finite restraints which by definition cannot apply to any natural resource or commodity.

    From this surreal base it distorts real values of sustainability of natural recources and the innovation necessary to maximise their sustainability alongside the introduction of new innovative solutions.

    In this respect Krugman and his Chicago team are Luddites. Metaphorically, American luddites driving American style down a UK motorway. No matter how adept or clever their driving, it is bound to result in disastrous chaos with more innocent victims killed or maimed than there are perpretators.

    This is a toll, either rung or paid, humanity cannot afford.

  • Alankrayner

    Good summary of this disagreement: Keen is correct, and Krugman unknowing. Pedantic point:-para5, line 3,  drew Jackson writes “affect” : he means “effect”.

  • vdsa

    If you actually read Krugman’s blog that you linked to, he isn’t saying that banks don’t create money. He’s saying the research he was doing on demand didn’t have to take that into account.

  • vdsa

    Krugman responds “It’s obvious that many commenters don’t get the distinction between the
    proposition that banks create money — which every economics textbook,
    mine included, says they do (that’s what the money multiplier is all
    about) — and the proposition that their ability to create money is not
    constrained by the monetary base. Sigh.”

    It’s amazing that someone can actually link to a blog that refutes there misunderstanding completely yet not realize it.

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