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.