The Great Debate©: Keen and Krugman on Money and Banking

by Steve Keen, Debtwatch with extensive quotations from Paul Krugman

Editor’s note: There has been an ongoing exchange between Steve Keen and Paul Krugman over the way that money and banking should be accounted for in the macroeconomy.  Between spurts of invective there are some very important concepts being debated.

Jetlag has me up and at the keyboard at 5.54am here in London, 43 minutes before sunrise, which today is at 6.37am.

Only it’s not “sunrise”, is it? As we all know, it’s really “Earth Axial Rotate” at the point in its 24 hour axial rotation when the Sun—around which the Earth rotates once each year—becomes visible from London.

We still call it “sunrise” because it’s a lot less awkward—and a lot more romantic—than saying “Earth Axial Rotate Earth-Sun Radial Alignment”, which is what it really is. We all know that it’s not really the Sun “rising” at all: that implies that the Earth is fixed while the Sun rotates around it, whereas ever since Copernicus we have known that, though it looks that way to a naïve observer on Earth, that’s not what really happens.

However, not merely before Copernicus, but for a very long time after him, many people continued to believe that that was how it really is: that the Sun does rotate around the Earth, that the Earth is not merely fixed, but fixed at the Centre of the Universe, and not merely the Sun but all Celestial bodies rotate around it in perfect spheres.

What broke us from that belief was the empirical failure of the theory which encapsulated it and still made sense—as much as it could—of the anomalies between the predictions of that theory, and actual reality. Claudius Ptolemy‘s treatise the “Mathematike Syntaxis” (or Mathematical Composition), which became known as the Almagest (meaning “The Great Treatise”), was published in about 150 BC, and it provided a plausible model for earth-centric beliefs about the nature of the Universe that dated back millennia. It held sway not merely until Copernicus wrote his De revolutionibus orbium coelestium in 1543, but for many decades after, as not only the Church but also incensed Ptolemaic astronomers fought to suppress the new, more accurate, but to them heretical and false model of the Universe.

Why the brief discourse on Astronomy? Because reading what Paul Krugman is saying about banking feels like reading a Ptolemaic Astronomer describing sunrise today as if that’s actually what’s happening. He is dismissive of the view that banks can “create credit out of thin air”—so dismissive in fact, that anyone unacquainted with the empirical evidence might be fooled into believing that his case is so strongly supported by the facts that it’s not even worth the bother of citing the empirical data that backs it up.

That is so NOT the case: the empirical evidence overwhelmingly supports the case Krugman is trying to dismiss out of hand, that banks can and do “create credit out of thin air”, with the supposed regulatory controls over their capacity to do so being largely ineffective.

Figure 1: Krugman’s 3rd post on banking and money creation

In fact the evidence is so strongly in favour of the case that Krugman blithely dismisses that it’s difficult to decide where to begin in refuting his Ptolemaic fantasies to the contrary. I’ll lead with his “gotcha!” argument in this post, but before that I’ll return to the Ptolemaic Astronomy-Neoclassical Economics analogy—because it’s quite a strong one that deserves further elucidation.

Ptolemy and Walras—Brothers in Arcs

The Geocentric models of the universe, of which Ptolemy’s system was a variation, had 3 guiding principles, which Cardall describes as follows:

  1. All motion in the heavens is uniform circular motion.
  2. The objects in the heavens are made from perfect material, and cannot change their intrinsic properties (e.g., their brightness).
  3. The Earth is at the center of the Universe. (Cardall, 2000)

The key problem with this base theory is that it manifestly didn’t fit the facts, because of the behaviour of celestial bodies that we now call Planets—which is the ancient Greek word for “wanderers”. Far from obeying uniform circular motion, these Wanderers literally did wander all over the sky. We’re generally not aware of this today because it’s no big deal from our better-informed Heliocentric model of the solar system, but for the ancients it was a big deal. A simulation by David Colarusso indicates how much the apparent behaviour of the Wanderers violated the three core tenets of the Geocentric model.

Ptolemy’s contribution was to provide “tweaks” to this core vision, which maintained its overall integrity while fitting it much more closely to the data. He stuck with most of proposition (1) and all of (2), but modified (3) to “The Earth is near the center of the Universe”. With the Earth slightly off-center, the generally elliptical motion of The Wanderers could now be explained by what was called The Eccentric. But their habit of “retrograde” motion—the fact that they would occasionally reverse direction in the night sky—was still an anomaly.

To solve that, Ptolemy added circular motion on circular motion. All celestial bodies still followed a great circle—called the Deferent—but the planets also did their own rotations on the Deferent on mini-circles called Epicycles.

But even that wasn’t enough, because the planets also appeared to speed up on part of their motion through the heavens, and slow down on others (today we know this is just because sometimes they are closer to the earth on their elliptical orbits around the earth, and therefore appear to move more rapidly). So Ptolemy added “Equant” motion: the big “Deferent” circle each planet moved on was divided into segments by lines through a point which was not its center, and the planet moved through each differently sized slice in the same time—thus speeding up in the big slices and slowing down in the small ones.

By these tweaks, a paradigm which was utterly unlike the real world was actually able to mimic it to a tolerable level of accuracy. But the system was extremely complicated, and it took an enormous amount of brain power to be a Ptolemaic astronomer. Looking back on this once dominant theory, Cardall tellingly observes how the very complexity of this absolutely false mental construct helped preserve it despite mounting evidence that it did not describe reality:

That ancient astronomers could convince themselves that this elaborate scheme still corresponded to “uniform circular motion” is testament to the power of three ideas that we now know to be completely wrong, but that were so ingrained in the astronomers of an earlier age that they were essentially never questioned. (Cardall, 2000)

Why am I reminded of Neoclassical Economics? Let me count the ways…

Firstly, there are similar underlying principles to the DSGE models that now dominate Neoclassical macroeconomics, and as with Ptolemaic Astronomy, these underlying principles clearly fail to describe the real world. They are:

  1. All markets are barter systems which are in equilibrium at all times in the absence of exogenous shocks—even during recessions—and after a shock they will rapidly return to equilibrium via instantaneous adjustments to relative prices;
  2. The preferences of consumers and the technology employed by firms are the “deep parameters” of the economy, which are unaltered by any policies set by economic policy makers; and
  3. Perfect competition is universal, ensuring that the equilibrium described in (1) is socially optimal.

If that were actually the real world, then not only would there not be a crisis now, there would never have been a Great Depression either—and recessions would simply be minor statistically unpredictable but inevitable events when the majority of shocks hitting the economy were negative, and they would rapidly be resolved by adjustments to relative prices (wages included, of course).

So economists like Krugman—who describe themselves as “New Keynesians”—have tweaked the base case to derive models that “ape” real-world data, with “sticky” prices rather than perfectly flexible ones, “frictions” that slow down quantity adjustments, and imperfect competition to generate less-than-optimal social outcomes.

This is Ptolemaic Economics: take a model that is utterly unlike the real world, and which in its pure form can’t possibly fit real world data, and then add “imperfections” so that it can appear to do so.

Figure 2: Krugman’s 3rd post on banking and money creation

Walk like a Ptolemain

Krugman’s rejection of the proposition that banks can create money—in the sense that “their ability to create money is not constrained by the monetary base” as he puts it in an update—is also a vintage Ptolemain maneouvre.  A scientific response to this proposition would be to disprove it via empirical evidence. Krugman instead appeals to his own authority, relies on deductive logic—which I’ll return to shortly—and derides those who believe that banks and credit growth matter in macroeconomics as “Banking Mystics”.

What Krugman displays here is not greater insight but blind ignorance. A recent addition to the overwhelming evidence that credit growth is a crucial factor in macroeconomics is an empirical paper by those well-known bastions of Banking Mysticism, the National Bureau of Economic Research and the Federal Reserve Bank of San Francisco. The paper analyses 200 recessions in 14 countries over 140 years, and summarises its results as follows:

This paper studies the role of leverage in the business cycle. Based on a study of nearly 200 recession episodes in 14 advanced countries between 1870 and 2008, we document a new stylized fact of the modern business cycle: more credit-intensive booms tend to be followed by deeper recessions and slower recoveries. We find a close relationship between the rate of credit growth relative to GDP in the expansion phase and the severity of the subsequent recession. We use local projection methods to study how leverage impacts the behavior of key macroeconomic variables such as investment, ending, interest rates, and inflation. The effects of leverage are particularly pronounced in recessions that coincide with financial crises, but are also distinctly present in normal cycles. The stylized facts we uncover lend support to the idea that financial factors play an important role in the modern business cycle. (Oscar Jorda et al., 2011a, Oscar Jorda et al., 2011b)

That emphatically decides the key empirical dispute—whether the level and rate of growth of aggregate private debt has macroeconomic effects—in favour of the case I put.

Unreserved Lending

There is also a wealth of studies to support the contention that reserves don’t constrain lending—that if anything, the causal link runs from lending to reserves, and not the other way around. I referred to some of these in my last blog post, so I won’t repeat that issue here. Instead I’ll take up Paul’s “gotcha” argument to the contrary:

Yes, a loan normally gets deposited in another bank — but the recipient of the loan can and sometimes does quickly withdraw the funds, not as a check, but in currency. And currency is in limited supply — with the limit set by Fed decisions. 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.

Sigh. The level of currency retrains lending? So banks stop lending as they approach the limits to currency set by the Fed’s printing of notes?

I can’t improve on the comments of Neil Wilson on Krugman’s argument here:

Krugman needs to start attending the real world. The latest argument is utter tosh. For there to be a constraint in the real world, you have to have the actual power to stop another entity from doing something.

What Krugman is suggesting is that the Fed has the power to limit the amount of currency in issue. In other words he’s suggest that to control the economy the ATMs will be left to run dry and you will be told ‘no’ when you go and try and draw cash at the bank counter.

Sweepstake on how many attoseconds it would take to cause general pandemonium if that every happened. Here in the UK there has been a suggestion that the fuel pumps might be short of fuel if the tanker drivers did decide to go on strike. It has caused complete chaos even though nothing is different this weekend than last. Krugman is beyond grasping at straws now.

And even if the Fed could do that—even if it did attempt to control bank lending by manipulating reserves (something it gave up on doing about 30 years ago)—there are two factors needed to make manipulating reserves a control mechanism over bank lending:

  1. Reserves themselves; and
  2. A mandated ratio between deposits at banks and reserves

Paul doesn’t seem to have caught up with the fact that this mandated ratio no longer exists, for all practical purposes, in the USA and much of the rest of the OECD.  Six countries have no reserve requirements whatsoever; the USA still has one, but for household deposits only.  Figure 3 shows the actual rules for reserves in the USA—taken from an OECD paper in 2007 (Yueh-Yun June C. O’Brien, 2007).  The reserve ratio of 10% only applies to household deposits; corporate deposits have no reserve requirement.  And the reserves are required with a 30 day lag after lending has occurred—by which time the deposits created by the lending are percolating through the banking system.

Figure 3: USA Reserve Requirements

This, and the banking crisis we are now in, finally inspired the Federal Reserve’s research department to conclude that, effectively, the “money multiplier” doesn’t exist. Carpenter and Demiralp note that today reserve requirements “are assessed on only about one-tenth of M2,” and conclude that

the narrow, textbook money multiplier does not appear to be a useful means of assessing the implications of monetary policy for future money growth or bank lending. (Seth B. Carpenter and Selva Demiralp, 2010, p. 29)

So Paul’s “gotcha” lacks at least one of the blades needed to make it work—and if he cares to consult the extensive academic literature on the role of reserves post the failed Monetarist experiment of the 1970s, he will see that the other blade doesn’t exist either:  Central Banks now supply whatever level of reserves is needed to maintain their short-run interest rate target.

Who’s the Mystic then?

Krugman’s claim that those who argue banks play an essential role in macroeconomics are “Banking Mystics” has a natural riposte: Neoclassical economists like Krugman who believe that capitalism can be modeled without either money or banks are Barter Mystics (David Graeber, 2011). How on earth can someone believe that the manifest reality that transactions involve money being exchanged for goods can be ignored, and pretend instead that goods are exchanged for goods? How on earth can the institutional reality of banks be ignored by those who claim to be macroeconomists?

How on earth indeed. It’s because they’re still living in a pre-Copernican universe, deluded by the imagined perfection of the Spheres.

Editor’s note: Paul Krugman has produced one last post in this debate.  We thought it was the final word from him because he wrote:

OK, I’m done with this conversation. I’ve had enough back and forth, including off-the-record stuff, to confirm for myself that there’s no there there. And there are more important battles to fight.

But we can’t be sure.  After he wrote that Krugman came back with a further update:

Ah, so Keen didn’t mean DSGE — a term that refers only to New Keynesian models — when he said DSGE; he meant New Classical, which he somehow regards as the underlying principles for models that aren’t New Classical at all. OK. Anyway, enough of that. I’m all for listening to heretics when they offer insights I can use, but I’m not finding that at all in this conversation, just word games and continual insistence that the members of the sect have insights denied to us lesser mortals. Time to move on.

Added note by the author:

When someone refers to DSGE (Dynamic Stochastic General Equilibrium) the terminology may not have the same meaning to all.  This is explained in Wikipedia.  This section explains the problem well:

“At present two competing schools of thought form the bulk of DSGE modeling.[1]

  • Real business cycle (RBC) theory builds on the neoclassical growth model, under the assumption of flexible prices, to study how real shocks to the economy might cause business cycle fluctuations. The paper of Kydland and Prescott (1982) is often considered the starting point of RBC theory and of DSGE modeling in general.[2] The RBC point of view is surveyed in Cooley (1995).
  • New-Keynesian DSGE models build on a structure similar to RBC models, but instead assume that prices are set by monopolistically competitive firms, and cannot be instantaneously and costlessly adjusted. The paper that first introduced this framework was Rotemberg and Woodford (1997). Introductory and advanced textbook presentations are given by Galí (2008) and Woodford (2003). Monetary policy implications are surveyed by Clarida, Galí, and Gertler (1999).”

Econintersect thinks this debate has not really ended.

Keen’s References

Cardall. 2000. “The Universe of Aristotle and Ptolemy,”

Carpenter, Seth B. and Selva Demiralp. 2010. “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?,” Finance and Economics Discussion Series. Washington: Federal Reserve Board,

Graeber, David. 2011. Debt: The First 5,000 Years. New York: Melville House.

Jorda, Oscar; Moritz H. P. Schularick and Alan M. Taylor. 2011a. “When Credit Bites Back: Leverage, Business Cycles, and Crises,” National Bureau of Economic Research, Inc, NBER Working Papers: 17621,

Jorda, Oscar; Moritz Schularick and Alan M. Taylor. 2011b. “When Credit Bites Back: Leverage, Business Cycles, and Crises,” Federal Reserve Bank of San Francisco, Working Paper Series: 2011-27,

O’Brien, Yueh-Yun June C. 2007. “Reserve Requirement Systems in Oecd Countries.” SSRN eLibrary.

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About the Author

Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney, and author of the popular book Debunking Economics (Zed Books UK, 2010, 2nd Edition);

Steve predicted the financial crisis as long ago as December 2005, and warned that back in 1995 that a period of apparent stability could merely be “the calm before the storm”. His leading role as one of the tiny minority of economists to both foresee the crisis and warn of it was recognised by his peers when he received the Revere Award from the Real World Economics Review for being the economist who most cogently warned of the crisis, and whose work is most likely to prevent future crises.

He has over 50 academic publications on topics as diverse as financial instability, the money creation process, mathematical flaws in the conventional model of supply and demand, flaws in Marxian economics, the application of physics to economics, Islamic finance, and the role of chaos and complexity theory in economics. His work has been translated into Chinese, German and Russian.

4 replies on “The Great Debate©: Keen and Krugman on Money and Banking”

  1. Have not read Keene before so it is about time. Basically I agree with this type of comment. The existence of a potential mortgage and derivatives bubble was visible in the early 2000s when I started to discuss the likely time for a breakdown with friends interested in political economics. That w also the time when the first questions about Fanny May’s solvency started to appear in the press.
    Have a good day,

  2. Following is an oft quoted exchange between the first Governor of the Bank of Canada, Graham Towers, and the MP who is questioning him about the operations of the money and banking system. If we can assume that Mr. Towers understands the system that he has been put in charge of, then his testimony offers solid support to Keen and exposes Krugman’s blindness to the reality that banks, not governments, create the vast bulk of modern money.

    Appendix E – Money Is Created by Banks
    Evidence Given by Graham Towers
    Some of the most frank evidence on banking practices was given by Graham F. Towers, Governor of the Central Bank of Canada (from 1934 to 1955), before the Canadian Government’s Committee on Banking and Commerce, in 1939. Its proceedings cover 850 pages. (Standing Committee on Banking and Commerce, Minutes of Proceedings and Evidence Respecting the Bank of Canada, Ottawa, J.O. Patenaude, I.S.O., Printer to the King’s Most Excellent Majesty, 1939.) Most of the evidence quoted was the result of interrogation by Mr. “Gerry” McGeer, K.C., a former mayor of Vancouver, who clearly understood the essentials of central banking. Here are a few excerpts:
    Q. But there is no question about it that banks create the medium of exchange?
    Mr. Towers: That is right. That is what they are for… That is the Banking business, just in the same way that a steel plant makes steel. (p. 287)
    The manufacturing process consists of making a pen-and-ink or typewriter entry on a card in a book. That is all. (pp. 76 and 238)
    Each and every time a bank makes a loan (or purchases securities), new bank credit is created — new deposits — brand new money. (pp. 113 and 238)
    Broadly speaking, all new money comes out of a Bank in the form of loans.
    As loans are debts, then under the present system all money is debt. (p. 459)
    Q. When $1,000,000 worth of bonds is presented (by the government) to the bank, a million dollars of new money or the equivalent is created?
    Mr. Towers: Yes.
    Q. Is it a fact that a million dollars of new money is created?
    Mr. Towers: That is right.
    Q. Now, the same thing holds true when the municipality or the province goes to the bank?
    Mr. Towers: Or an individual borrower.
    Q. Or when a private person goes to a bank?
    Mr. Towers: Yes.
     Q. When I borrow $100 from the bank as a private citizen, the bank makes a bookkeeping entry, and there is a $100 increase in the deposits of that bank, in the total deposits of that bank?
    Mr. Towers: Yes. (p. 238)
    Q. Mr. Towers, when you allow the merchant banking system to issue bank deposits which, with the practice of using the cheques as we have it in vogue today, constitutes the medium of exchange upon which I think 95 per cent of our public and private business is transacted, you virtually allow the banks to issue an effective substitute for money, do you not?
    Mr. Towers: The bank deposits are actual money in that sense, yes.
    Q. In that sense they are actual money, but, as a matter of fact, they are not actual money but credit, bookkeeping accounts, which are used as a substitute for money?
    Mr. Towers: Yes.
    Q. Then we authorize the banks to issue a substitute for money?
    Mr. Towers: Yes, I think that is a very fair statement of banking. (p. 285)
    Q. 12 per cent of the money in use in Canada is issued by the Government through the Mint and the Bank of Canada, and 88 per cent is issued by the merchant banks of Canada on the reserves issued by the Bank of Canada?
    Mr. Towers: Yes.
    Q. But if the issue of currency and money is a high prerogative of government, then that high prerogative has been transferred to the extent of 88 per cent from the Government to the merchant banking system?
    Mr. Towers: Yes. (p. 286) 
    Q. Will you tell me why a government with power to create money, should give that power away to a private monopoly, and then borrow that which parliament can create itself, back at interest, to the point of national bankruptcy?
    Mr. Towers: If parliament wants to change the form of operating the banking system, then certainly that is within the power of parliament. (p. 394)
    Q. So far as war is concerned, to defend the integrity of the nation, there will be no difficulty in raising the means of financing, whatever those requirements may be?
    Mr. Towers: The limit of the possibilities depends on men and materials.
    Q. And where you have an abundance of men and materials, you have no difficulty, under our present banking system, in putting forth the medium of exchange that is necessary to put the men and materials to work in defence of the realm?
    Mr. Towers: That is right. (p. 649)
    Q. Would you admit that anything physically possible and desirable, can be made financially possible?
    Mr. Towers: Certainly. (p. 771)

  3. Most enlightening, including the comments. Thank you very much.

    The “world given” that Keen has exposed reminds me of the dystopian, fake world which “The Prisoner” must de-construct and escape in the great TV series called: “The Prisoner.” This series was re-issued in a boxed DVD set within the last few years. It will have extra layers of meaning upon re-visitation, within Steve Keen’s frame.

    As for the date 1995, I was wrapping up a book early that year, as developmental editor for a writer who had been a Professor of Accounting for a NY university. We often spoke of how the Dow bubble was inflated even then, @ 7000+, clearly beyond the scope of value in reality. The bubble was establishing itself then, with far to go.

    Steve Keen just spoke at the INET plenary conference in Berlin 2012 (“Paradigm Lost”), where Joseph Vogl spoke about the “coup d’etat” of finance. My memory of the “putsch” for “consumer credit” in the 1970’s–when credit card interest was as deductible as mortgage interest (this changed ca. 1980)–combines with the talks at the INET conference by Keen, Vogl, Hudson, and Kay to whisper “intent.” Prof. Vogl referred to a 17th century text, if memory serves, anent the the subversion and eventual replacement of legitimate governments by financiers in collusion, so this possibility was imagined that long ago. “O what a tangled web we weave/When first we practice to deceive.” Let’s hope that William K. Black will join with the above to “crack the NUT” of Elite Global Fascism by Systematic Fraud.

  4. Dr. Bernard – – –

    We hope to post videos and printed material from the INET conference. We had a couple of contributors in attendance and should get some perspectives from them. I saw an advance copy of one of the papers presented but unfortunately that cannot be posted because of copyright restrictions.

    There is a great hunger for new economic thought and analysis now that the emperor has been seen without his clothes. A rather impromtu conference in Italy in February attracted over 2,200 a day for three days and had to be held in a basketball arena. We covered that with several articles.

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