Thursday, 7 November 2013

Keen on Krugman Again



Steve Keen comments again on Paul Krugman and endogenous money.

Keen has done much to highlight the important role of debt in driving demand in recent years.  However, in doing so, he appeals to the role of money as a key element.  I think this is a mistake.

Keen's analysis can be illustrated by the tables below showing changes in balance sheets (a +ve indicates an increase in an asset or a decrease in a liability; a -ve indicates an increase in a liability or a decrease in an asset).

Following Krugman, he has patient entities (lenders) and impatient entities (borrowers), but he also has banks.  He distinguishes two cases.  In the first, patient lends directly to impatient.  This increases direct loans, decreases patient's deposits and increases impatient's deposits.  In the second, a bank lends to impatient  This increases bank loans and increases impatient's deposits.

First scenario

Patient
Impatient

Bank
Bank Loans



Direct Loans
+Ld
-Ld

Deposits
-Dp
+Di


 Second scenario

Patient
Impatient

Bank
Bank Loans

-Lb
+Lb
Direct Loans



Deposits

+Di
-Di

Keen believes these two scenarios will have a different result, because of the position of patient.  In the first scenario, patient's overall asset remain the same, but he has reduced his claims on the bank and increased his claims on impatient by the same amount.  We can presume that he did so willingly - the terms of his loan to impatient must have been attractive enough - so he probably does not feel any less well off as a result.

Nevertheless, Keen's position (and in fact his entire result) rests on the assumption that patient will respond to this loan by cutting his own spending by an amount equivalent to that loaned.  The reasoning behind this seems to based on the importance of money, i.e. bank debt.  As patient's holding of bank debt has decreased, he will want to save more, to make it up again.

I find this highly implausible.  That is not to say that I don't think there are important differences between bank lending and non-bank lending, but suggesting that spending is based on holding of bank debt only, with everything else is ignored, just doesn't ring true.  I think the problem here is that a focus on the mechanics of money creation has distracted from the real relationship between debt and spending.

Interestingly, one of the papers Keen references is this one.  In my view, Krugman and Eggertsson's approach in this paper actually picks up quite well one of the important features of intermediated lending, even though it doesn't actually mention banks.

The paper uses a simple New Keynesian style model.  Its particular feature is the two distinct groups of entities: patient and impatient.  However, the amount of debt in this economy is not determined as an amount that patient consumers wish to save.  Instead, there is a separate exogenous debt level (described as a limit, but functioning as an actual amount).  This level is not explained in the paper, but could easily be interpreted as a bank lending limit.

This model does not then function as a loanable funds model.  If the patient consumer suddenly becomes even more patient and wishes to save more, this does not enable the impatient consumer to spend more, because this is determined by the debt limit.  All that happens is that overall spending drops until the patient consumer's expected consumption path meets with his new super-patient preferences.  In the end, the patient consumer can only save an amount equal to the debt limit, since the two amounts are equal by accounting necessity.  If he tries to save a greater share of his income, it is the absolute amount of income that has to give.

On the other hand, if we suddenly raised the debt limit this would lead to increased overall spending without any change in consumer preferences.  In fact, the scenario considered in the paper is a deflation caused by a sudden reduction in the debt limit.

This distinction exactly captures the point about intermediated lending.  The issue is whether the decision by a household to consume less today and save more automatically implies a decision to provide more loans to credit constrained borrowers.  If it does not, then the lending decision will drive saving and not visa versa.  And this is much more likely with intermediated lending, particularly with banks but also with other types of intermediary.  It has nothing to do with whether the intermediary's liabilities count as money.

15 comments:

  1. If we look at "patient" a little more carefully, we need to distinguish between a lifestyle of "patient" and goal oriented patience such as saving for a down-payment on a house. Lifestyle patience is continuing but goal oriented patience is sporadic. Peer-to-peer (PTP) lending is often cited as a example of lending with no influence on the money supply or GDP, but I think PTP lending does move GDP but not money supply.

    On the other hand, bank lending can be considered as identical to PTP lending if the bank is lending only a small portion of the deposits owned by customers. When the bank loans exceed 50% of deposits, the bank MUST be expanding the money supply.

    The logic behind this unequivocal assertion is based on the "loans create deposits" maxim. We can not allow the bank to lend vapor so an initial deposit must exist. If the bank lends the entire first deposit, the bank is acting as a simple intermediary, no different than PTP lending. Notice, following the loan, that the bank will record total deposits as twice the initial/original deposit. The bank has reached the 50% limit suggested earlier.

    If the bank, in ignorance or greed, decides to make a second loan, also equal to the deposits on hand, then the original loan has been used to support deposits four times the value of the initial/original deposit. All depositors think their deposit is valid, but the bank has only the original deposit as unambiguous monetary collateral. The money supply is considered to have been expanded without backup monetary support.

    At this point, the role of the Central Bank becomes important. The CB is the issuer of unambiguous monetary collateral.

    I don't think any of my comment contradicts or detracts from your post. My suggestion of a break-over-point where a bank moves from intermediary-lending to money-supply-creation is offered to identify a transition line where arguments change perspective.

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    1. Roger,

      I think it's a good point you make about the difference between permanent and temporary patience. Most models assume entities that display the same degree of patience forever. This makes the calculations much easier, but risks missing some important dynamics.

      You are also right there there would need to be a lot more going on than I've shown in the tables here, particularly with bank balance sheets. My tables really just illustrate the "quadruple-entry" for a single step.

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  2. Nice,

    Nice presentation of Keen's idea - which I couldn't manage to figure out in my first reading of his post.

    I think the problem is not worrying too much about the mechanics of money creation but actually doing it wrong or in haphazard manner. I think Keen and many people tend to think of "loans create deposits" as some sort of end point whereas it is just a starting point.

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    1. Yes, and this is where I think Keen's weakness on the accounting lets him down. For example, I'm not sure he appreciates that even when loans don't create deposits in the double entry sense, for example if loans are made in cash, that you can still get loan and deposit growth.

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    2. Yeah accounting just one part of the reason. I think general lack of awareness of how the Yale asset allocation ideas fit in. IMO Post-Keynesians themselves - with obvious exceptions - do not know how that fit in with their ideas of endogenous money.

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  3. I'm interested in economics without having any great facility with the subject, but I have been waiting for a post of this type ever since I fell across your blog, it being quite clear that you had conceptual differences with Steve Keen.

    Your post and Roger's comment reminds me of a blog post I read some time ago about endogenous money that I will have to dig out and read again as I think I will make some more progress with it having read your exchange.

    You say that there are important differences between bank and non-bank lending could you elaborate on these diffrences at some point? I think in previous posts you have touched on their similarities: increasing of purchasing power and creating a liability that has to be serviced some years into the future. And you also referred to the BIS study that suggested an increase in overall lending/indebtedness was a better indication of financial fragility and possible pending crisis than just the increase in bank lending/indebtedness to banks.

    Keen's Debtwatch blog certainly re-ignited my interest in economics some four years ago and I have moved on from there to the likes of Godley, Kaldor and Kalecki. I get from Ramanan's blog that I am probably reading the "right stuff" but it is quite tough going for the general reader.

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    1. What I really meant there was that there are important differences in the roles that banks play in the economy, rather than their lending as such. Part of the point of this post is that it doesn't make much difference to the borrower who they have borrowed from. But I do think that growth in non-bank balance sheets has different consequences to growth in bank balance sheets. I said a bit about this in this post: http://monetaryreflections.blogspot.co.uk/2013/09/banks-non-banks-and-interest-rate-effect.html, from September. On reflection, I think that post is on the right track, but hasn't quite got the issue buttoned down, so I might write on it again. I think this article has some really good insights on the issue: http://www.minneapolisfed.org/pubs/ar/ar1982a.cfm?

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  4. It seems to me that this debate is largely irrelevant. New Keynesians like Romer have been using Taylor Rules rather than LM-curves for years. That effectively makes money endogenous. Arestis and Lavoie have pointed this out recently. Krugman's stripped down Mundell-Fleming model does the same thing. The real difference is that Krugman et al believe in a natural rate of interest whereas Post-Keynesians don't. This is a far stronger point of attack as NKs are completely inconsistent on this point because they largely accept behavioral economics and the two things don't square. See here:

    http://www.nakedcapitalism.com/2013/06/philip-pilkington-paul-krugman-and-the-fatherless-keynesians.html

    Time to move this debate forward, I think.

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    1. Thanks for the link - I like the article. I think the description of Bastard Keynesianism as based on a shallow reading whilst missing the nuances is a good one. In some ways, that is what I am accusing Keen of here, by appealing to a quantity theory type explanation, rather than sticking to more Keynesian reasoning. But maybe, he's not trying to be Keynesian here anyway.

      In any event, I think I'd agree that the question of endogenous money is not really the main point of weakness of the New Keynesian approach. I'm not sure I'd say that the real difference is the NRoI, but I'd agree that it is a difference.

      However, my purpose in this post was not to critique (or defend) the NK approach. I just wanted to look (again) at the mechanics of how intermediated lending impacts on demand. I simply used the Keen - Krugman disagreement as a prompt.

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  5. I am surprised that comments are still coming on this post. The continuing comments indicate that you have captured some portion of a not-yet-crystallized-description of base money.

    Could I suggest that we use "velocity of money" as a tool here? I think the velocity of money is different with bank loans and Peer-to-Peer (PtP) loans.

    GDP is a measure of the entire economy. There are a number of ways to describe "money supply" (MS) and each could be expressed as a ratio to GDP. Velocity (V) is the inverse of MS to GDP, V = GDP/MS.

    With PtP loans, we assume that there is no change in MS but GDP will increase because impatient will spend; the GDP would be smaller if patient had not made the loan. An increasing GDP but constant MS will result in an increased Velocity.

    With bank loans, we have a different situation depending upon how we measure money supply. When bank deposits are part of the money supply measurement, we can see that a bank loan will increase the amount on deposit at the bank. The money supply would be seen as increasing. Following a bank loan, when we calculate Velocity, we can expect that GDP and MS will both increase. This will result in a smaller Velocity number than would occur if the loan was PtP.

    This Velocity test would counter the argument I made in an earlier comment here (for this post) that a "break-over-point where a bank moves from intermediary-lending to money-supply-creation" actually does exist. The velocity test would indicate that all bank lending expands the money supply so long as bank deposits are part of the money supply calculation.

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    1. I don't actually like the concept of velocity very much, because it implies that something is circulating and I don't think that is necessarily a very good description of what actually happens with modern money. (See for example some points I made in the post http://monetaryreflections.blogspot.co.uk/2013/10/ledger-accounting-for-monetary-circuit.html). However, I think other people would interpret it as you suggest.

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  6. Dear Nick, I've only just seen this post by coincidence after following a link to another of your posts, and I don't have time to comment in detail now (I'm flying to Ecuador today), so just a quick observation that the difference between "patient lends to impatient" and "bank lends to impatient" in my analysis is that the liabilities of the latter are accepted as money, but not those of the former. The lending thus creates money in the latter case but not the former. This means the former financial system is a conservative one in dynamic systems parlance ; the latter is a dissipative one. That is an enormous difference over and above behavioral factors

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    1. Hi Steve,

      Nice to hear from you. I would have posted a comment on your original post on this, but I was unable to work out how to register.

      I understand that the difference in your two cases comes down to the creation of money, but I don't think that distinction is very important (in the real world - I know we can construct models where it matters).

      Probably the best explanation of why I think so is my earlier post on why both bank lending and non-bank lending can increase the amount of medium of exchange money (http://monetaryreflections.blogspot.co.uk/2013/09/banks-non-banks-and-medium-of-exchange.html). The essential point here is noting that bank lending does not necessarily increase the amount of medium of exchange - what it does is increase the total amount of bank deposits. What determines the amount of medium of exchange is what proportion of bank deposits the public wish to hold as medium of exchange and what proportion they wish to hold as time deposits. Non-bank lending can cause that to change, without any increase in bank lending.

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  7. Continuing (I found I can't hit backspace on m my iPad without stuffing up the entry for some reason) I'll finish a paper and blog entry highlighting this in January I hope. Cheers, Steve

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