In-depth analysis on Credit Writedowns Pro.

On bank lending’s creating deposits and Paul Krugman’s response

Paul Krugman has just commented (twice) on my most recent blog about my paper for INET. In one sense, I’m delighted. The Neoclassical Establishment (yes Paul, you’re part of the Establishment) has ignored non-Neoclassical researchers like me for decades, so it’s good to see engagement rather than wilful (or more probably blind) ignorance of alternative approaches.

Click here for this post in PDF

Figure 1: Krugman’s first piece

There is a bizarre asymmetry in economics: critics of Neoclassical economics like myself read Neoclassical literature avidly, no because we agree with it—far from it—but because we feel obliged to understand why they hold to their counterfactual views on the economy.

Most Neoclassical economists, on the other hand, don’t even bother to consider critics within their own ranks—let alone critics from without. So to have a paper referred to is definitely a plus.

In another sense, I’m appalled, because Krugman’s comments put on display that very ignorance of Neoclassical literature—let alone of alternative economic thought.

For instance, Paul refers to many of the propositions in my blog (it’s clear that he hadn’t read the paper on which it is based) as “assertions about what is crucial, without much explanation of why these things are crucial.”

One of these “assertions” is the key role of the change in debt—rather than saving out of current income—in financing investment.

Well Paul, in that paper you will find references to the extensive theoretical and empirical literature from which that assertion was derived. I could start with non-Neoclassical authors like Schumpeter, but let’s lead with someone from within The Citadel (as Alan Kirman once called the Neoclassical orthodoxy: Alan Kirman, 1989, p. 126): Eugene Fama. The “assertion” that the change in debt was the main source of funding for investment was confirmed by Fama and French in a pair of empirical papers:

The source of financing most correlated with investment is long term debt. The correlation between I and dLTD is 0.79… These correlations confirm the impression … that debt plays a key role in accommodating year-by-year variation in investment.” (Eugene F. Fama and Kenneth R. French, 1999, p. 1954)

“Debt seems to be the residual variable in financing decisions. Investment increases debt, and higher earnings tend to reduce debt.” (in an unpublished draft of the same paper).

Or consider Alan Holmes’s crucial paper in 1969, in which he fought an unsuccessful campaign against the later experiment in Monetarism (far from being a “strict Monetarist”, as Paul jibes at one point, I and my Post-Keynesian colleagues and forebears take money seriously while simultaneously being trenchant critics of Friedman’s simplistic Monetarism—see for example Nicholas Kaldor, 1982). Holmes, then Senior Vice-President of the New York Federal Reserve, noted that the key Monetarist policy prescription of regulating the economy by “a regular injection of reserves” was based on “a naïve assumption” about the nature of the money creation process:

The idea of a regular injection of reserves—in some approaches at least—also suffers from a naïve assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. (Alan R. Holmes, 1969, p. 73)

Holmes would turn in his grave at Krugman’s naïve assertion, half a century later, that banks need deposits before they can lend:

If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand. (Paul Krugman, 2012)

As Randy Wray observed, that is “the description of a loan shark, not a bank”—or of a hypothetical world in which banks need deposits before they can lend. In the real world, as Holmes points out above, bank lending creates deposits. That’s why banks matter in macroeconomics, and it’s not “Banking Mysticism” to point this out: it is “Banking Armchair Theorism” to ignore them in macroeconomics.

Neoclassical economists have ignored this point for decades, which is why you have to look to the non-Neoclassical literature to truly understand money creation and the crucial role of banks. Schumpeter put it clearly during the last Depression: he described the view that Krugman puts today, that investment (which is what the most important class of borrowers do) is financed by savings, as “not obviously absurd”, but clearly secondary to the main way that investment was financed, by the “creation of purchasing power by banks … out of nothing“. This is not “Banking Mysticism”: this is double-entry bookkeeping:

Even though the conventional answer to our question is not obviously absurd, yet there is another method of obtaining money for this purpose, which … does not presuppose the existence of accumulated results of previous development, and hence may be considered as the only one which is available in strict logic. This method of obtaining money is the creation of purchasing power by banks… It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing. (Joseph Alois Schumpeter, 1934, p. 73)

Figure 2: Krugman’s second piece

Why does it matter that “once you include banks, lending increases the money supply”? Simply, because the endogenous increase in the stock of money caused by the banking sector creating new money is a far larger determinant of changes in aggregate demand than changes in the velocity of an unchanging stock of money. And in reverse, the reduction in demand caused by borrowers repaying debt rather than spending is the cause of the downturn we are now in—and of the Great Depression too.

Figure 3 shows the ratios of private and public debt to GDP in America from 1920 till now. Non-neoclassical economists like myself, Michael Hudson, Ann Pettifor, the late Wynne Godley, Randy Wray and many others (see Dirk J Bezemer, 2009, and Edward Fullbrook, 2010 for fuller lists of those who warned of this crisis before it happened–including of course Nouriel Roubini, Dean Baker, Robert Shiller, and Peter Schiff) were shouting that the post-1993 explosion in private debt was unsustainable, and would necessarily lead to a crisis when its rate of growth slowed (let alone turned negative), for years before the crisis began (my first academic warning of the dangers of rising private debt is shown as SK1, and my first public warning that a crisis was imminent is shown as SK2 on Figure 3). We were ignored, in large part because only Neoclassical economists like Krugman, Bernanke and Greenspan had the ear of the public and politicians.

Now the crisis is the defining economic event of our times, and years after it began, the only period to which the recent boom and bust in the private debt to GDP ratio can be compared is the Great Depression.

Figure 3: Aggregate Private and Public Debt

Yet Neoclassical economists like Krugman continue to assert that the aggregate level of private debt, and changes in that level, are macroeconomically irrelevant, when even casual empiricism implies that changes in the aggregate level of private debt are associated with Depressions.

So while I welcome any Neoclassical economist at the forthcoming INET conference taking up Krugman’s call (“I hope someone in Berlin presses Keen on all this”), in reality Paul, empirically oriented non-Neoclassical economists like myself are the ones challenging the unsupported assertions of Neoclassical economics—not the other way round.

Bezemer, Dirk J. 2009. “”No One Saw This Coming”: Understanding Financial Crisis through Accounting Models,” Groningen, The Netherlands: Faculty of Economics University of Groningen,

Fama, Eugene F. and Kenneth R. French. 1999. “The Corporate Cost of Capital and the Return on Corporate Investment.” Journal of Finance, 54(6), 1939-67.

Fullbrook, Edward. 2010. “Keen, Roubini and Baker Win Revere Award for Economics,” E. Fullbrook, Real World Economics Review Blog. New York: Real World Economics Review,

Holmes, Alan R. 1969. “Operational Constraints on the Stabilization of Money Supply Growth,” F. E. Morris, Controlling Monetary Aggregates. Nantucket Island: The Federal Reserve Bank of Boston, 65-77.

Kaldor, Nicholas. 1982. The Scourge of Monetarism. Oxford: Oxford University Press.

Kirman, Alan. 1989. “The Intrinsic Limits of Modern Economic Theory: The Emperor Has No Clothes.” Economic Journal, 99(395), 126-39.

Krugman, Paul. 2012. “Minsky and Methodology (Wonkish),” The Conscience of a Liberal. New York: New York Times,

Schumpeter, Joseph Alois. 1934. The Theory of Economic Development : An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle. Cambridge, Massachusetts: Harvard University Press.

Steve Keen

About 

Steve Keen is Professor of Economics & Finance at the University of Western Sydney with over 60 academic publications, and author of the popular book ,a href="http://www.amazon.com/Debunking-Economics-Revised-Expanded-Dethroned/dp/1848139926">Debunking Economics. 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. Follow Steve on his blog or Twitter.

20 Comments

  1. Greg Ransom says:

    “In the real world, banks extend credit, creating deposits in the process.”

    This is at the core of Hayek’s “monetary” theory of the trade cycle, see _Monetary Theory and the Trade Cycle, Book IV, 1929/1933.

  2. Greg Ransom says:

    Schumpeter’s attack on Keynes’ savings = investment identity can already be found in Hayek’s review of Keynes’ _Treatise_, and it needs be said that Keynes tells us he derived his notions of savings and investment and their identity from Mises — Hayek was not kind in explaining how Keynes had botched both Mises and Wicksell on these issues, and gotten the issues involving investment, savings, money, production goods, credit and interest impossibly confused and just plain wrong.

  3. Greg Ransom says:

    You can fin this mechanism already in Hayek, _Monetary Theory and the Trade Cycle_, Book IV:

    the endogenous increase in the stock of money caused by the banking sector creating new money is a far larger determinant of changes in aggregate demand than changes in the velocity of an unchanging stock of money. And in reverse, the reduction in demand caused by borrowers repaying debt rather than spending is the cause of the downturn

  4. I sort of wonder why ideas from neo-clasical economics, takes up so much of the public discourse when, whenever I’ve scene these simplistic ideas attacked, I also see the defensive response that, “economists do study these complexities”.

    However, well such work MAY be well known to economists, it is not well-known to the political and media classes. If the political and media classes have studied economics it was likely neoclasical economics and if they are old enough it may have been presented in more of a literary and philosophical manner then it is today.

    The entrenchent of neoclasical economics in the public dogma may be due to that it supports the the current edifice of our present market capitalism. Because old interests are tied up in these beliefs this viewpoint may get more funding than more relevant work which moreso, furthers our understanding. It is hard to know to what extent our system (industrial-complex, super-structure) is self reinforcing but views which do not support our financial institutions will, be less likely to receive support from them for their work.

    I saw a seminar the other day that asked the question, “Does philosophy still matter” and one of the comments was much philosophy is buried in Journals so that professors will be as small a target as possible. Perhaps economists suffer from a similar dysfunction where success in their field is more important than bringing the interesting questions to the public.
    http://www.youtube.com/watch?feature=player_embedded&v=RBmlRihA9_s

  5. fresno dan says:

    When I was young and attended economics class, it was stated that “every debt is somebody’s asset.”
    And that actually made sense – after all, loans were hard to get, and the default rate was low, and the asset was held as collateral, and the value of the collateral was – gasp – actually very close to the price you would get if you sold it! (I know children, but this was when I was young and dinosaurs roamed the land and 8-tracks inhabited the car stereos).
    I have no “moral” problem with banks or the FED creating money out of thin air. But was the “investment” in housing, at the prices the houses were “sold” for of the last decade a good idea? And I guess now that the government bought all the banks’ debt, we are all richer now? Funny how we have all this unemployment with all these “assets”…

  6. Martin Lowy says:

    You discuss two ideas that seem separate to me: (1) increases in the money supply that result from bank lending, and (2) levels of private debt. Much of the private debt, as I understand it, was not funded by banks. Therefore its creation (that is, the part that was not funded by banks)should not have expanded the money supply. That debt did, nevertheless, contribute to the growth of consumer demand, and its repayment–or even the cessation of its growth–would be reflected in decreased demand.

    The consumer stopped spending in October 2008. The loss of demand, not the difficulties of the financial system, as far as I can tell, led to the economic implosion. The financial system could have been just fine, but if consumers stopped spending, the lack of final demand would cause a deep recession in any event. I will admit that the difficulties of the financial system most likely influenced the timing when demand “fell off the table”–but demand did have to fall off the table eventually because the continued borrowing was unsustainable.

  7. flow5 says:

    “the real world, banks extend credit, creating deposits in the process, and look for the reserves later. (Alan R. Holmes, 1969, p. 73)”

    That’s slightly mis-construed. The Keynesian technicians in charge of the administration of open market operations believe that there is, at any given time, a federal funds rate, that is consonant with a proper rate of change in the money supply. They have in fact plugged this concept into a computer model, i.e., (a policy rule, or Taylor like rule).

    What they have actually “plugged in” is an open ended device through which the commercial banks can decide whether or not there should be an expansion in the legal lending capacity of the banking system – the capacity to create credit (money) and to acquire additional earning assets.

    This has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the Fed assures the banks access to free-gratis legal reserves whenever the banks need to cover their expanding loans – deposits.

    The fed cannot control interest rates, even in the short end of the market except temporarily.

    As long as it is profitable for borrowers to borrow and commercial banks to lend, money creation is not self regulatory. This observation would be valid even though the Fed did not use interest rates as a guide to open market operations.

    With the use of this device the Fed has actually pursued a policy of automatic accommodation. That is, additional costless reserves, & excess reserves, were made available to the banking system whenever the bankers and their customers saw an advantage in expanding loans. The member banks, lacking excess reserves, would just bid up the federal funds rate to the top of the bracket thus triggering open market purchases, free-gratis bank reserves, more money creation, larger monetary flows (MVt), higher rates of inflation – and higher federal funds rates, more open market purchases, etc.

    • @flow5 “The fed cannot control interest rates, even in the short end of the market except temporarily.”

      When has the Fed been unable to hit its interest rate target?

      • flow5 says:

        @Tschäff Reisberg says: “When has the Fed been unable to hit its interest rate target?”

        The answer is that they have never been able to hit their targets.

        Our excessive rates of inflation (especially since 1965), has been due to irresponsibly easy monetary policies. Our monetary mis-management has been the assumption that the money supply can be managed through interest rates.

        Between 1965 and June of 1989, the operation of the NY Fed’s “trading desk” was dictated by the federal funds “bracket racket”. Even when the level of non-borrowed reserves was used as the operating objective (by Paul Volcker), the federal funds brackets were widened, not eliminated.

        Ever since 1989 this monetary policy procedure has been executed by setting a series of creeping, or cascading, interest rate pegs.
        This has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the Fed assures the banks access to costless legal reserves, whenever the banks need to cover their expanding loans – deposits.

        We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

        The effect of tying open market policy to a fed Funds rate is to supply additional (and excessive, & costless legal reserves) to the banking system when loan demand increases.

        Since the member banks (when reserves were binding), operated without any excess reserves of significance (beginning in 1942), the banks had to acquire additional reserves, to support the expansion of deposits, resulting from their loan expansion.

        Apparently, the Fed’s technical staff either never learned, or forgot, how Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2 -1/2 percent, and all other obligations in between.

        This was achieved through totalitarian means; involving the control of total bank credit and the specific rationing of that credit we had official price stability and “black market” inflation.

        The production of houses and automobiles was virtually stopped, and credit rationing severely reduced the demand for all types of goods and services not directly connected to the war effort. This plus controls on prices and wages kept the reported rate of inflation down.

        Financing nearly 40% of WWII’s deficits through the creation of new money laid the basis for the chronic inflation this country has experienced since 1945. Interest rates, especially long-term, would have averaged much higher had investors foreseen this inflation. This was reflected in the price indices as soon as price controls were removed.

        There were recently 5 interest rates (ceilings tied to the Primary Credit Rate @.50%), that the Fed could directly control in the short-run; the effect of Fed operations on all other interest rates is still INDIRECT, and varies WIDELY over time, and in MAGNITUDE.

        It is an historical fact. The money supply can never be managed by any attempt to control the cost of credit (i.e., thru interest rates pegging governments; or thru “floors”, “ceilings”, “corridors”, “brackets”, etc). IOeRs simply exacerbate this operating problem. I.e., Keynes’s liquidity preference curve is a false doctrine.

        As long as it is profitable for borrowers to borrow and commercial banks to lend, money creation is not self regulatory. This observation would be valid even though the Fed did not use interest rates as a guide to open market operations.

        With the use of this device the Fed has actually pursued a policy of automatic accommodation. That is, additional costless reserves, & excess reserves, were made available to the banking system whenever the bankers and their customers saw an advantage in expanding loans. The member banks, lacking excess reserves, would just bid up the federal funds rate to the top of the bracket thus triggering open market purchases, free-gratis bank reserves, more money creation, larger monetary flows (MVt), higher rates of inflation – and higher federal funds rates, more open market purchases, etc.

        • “The answer is that they have never been able to hit their targets.”

          Give me a break. The FOMC sits down, agrees on a nominal interest rate target for its Fed Funds Rate and hits it every time whenever they target it, which is always except for one experiment in the early eighties when they targeted quantity of money aggregates and reserves. Show me one piece of evidence that they can’t hit their Fed Funds Rate that they set, and why it is that they can’t.

          ” Our monetary mis-management has been the assumption that the money supply can be managed through interest rates.”

          Actually I wouldn’t disagree. Targeting a money supply failed, they couldn’t hit the broad side of a truck when they tried, and subsequently gave up. That’s why MMTers prefer fiscal policy to monetary policy.

  8. flow5 says:

    “as Holmes points out above, bank lending creates deposits”

    Holmes’ conclusion is simplistic: A member commercial bank (depository institution) only becomes a financial intermediary when there is a 100% reserve ratio applied to all its deposit liabilities. The high point for reserve ratios, (the weighed arithmetic average of reserve ratios applicable to deposit liabilities), stood at 91.1, in at the beginning of WWII (1942 – a considerably higher level even with a trillion + dollars of excess reserves).

    Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, via data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

    From a systems viewpoint, commercial banks (DFIs), as contrasted to financial intermediaries: never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity, or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money- (demand deposits -TRs) — somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

    The non-bank public includes every institution, the U.S. Treasury, the U.S. Government, State, and other Governmental Jurisdictions, and every person, except the commercial and the Reserve banks.

    That said, monetary savings are impounded within the commercial banking system. Banks collectively (as a system of banks), pay for what they already own. In other words the source of savings/investment type accounts wihtin the CB system is demand deposits, directly or indirectly thru currency or via the banks undivided profits accounts.

    The Keynesian mis-conception that there is no difference between our money supply & liquid assets is the foundation for Bernanke’s introduction of IOeRs. IOeRs are contractionary & induce dis-intermediation within the non-banks (the real intermediaries between savers & borrowers). To the extent that the CBs (FED policy), succeed in inducing dis-intermediation within the financial intermediares (non-banks), our economy will continue to endure an endless stagflation.

  9. Ritwik says:

    Steve,

    Not to defend Paul, whose dismissal of your post is rubbish, but this double entry book keeping argument that MMT/Circuitists espouse is itself quite thin. Double entry book-keeping is an after-the-fact process. Accounting reflects what happened. It does not capture what was *intended to happen*, or *expected to happen*. Plus, it is a one period process. It does not describe enough to perform a difference analysis.

    Neo-classical/ monetarist economics, including the loanable funds model, relies fundamentally and implicitly on expectations. Thus when PK says ‘If I decide to cut back on consumption and stash the funds .. ‘ he is not referring literally (I hope) to the actual act of adding to your savings/current deposits to your account. It is obvious that such an act does not increase the stock of loanable funds anyway, which is a cash flow process and must cancel out in the aggregate net of the central bank’s actions. The overall stock of loanable funds is completely in the control(proximate) of the central bank – I understand that you argue that this is endogenously determined and that exogenous central bank actions have no effect.

    But do note the irony that in ridiculing the loanable funds model through this cash flow process, you are holding income constant. This is not an argument that scales up in the aggregate, because in the aggregate income adjusts. Plus, how does double entry book-keeping validate/invalidate a fundamental two-period sentence (‘If I decide to cut back on spending’) which necessitates that there must be a planned/expected/former level of spending (that the book-keeping is missing) and there is now a new level of spending.

    There’s a lot of talking past each other that happens in these debates, with the neo-classicals failing to emphasize the central role that expectations play in their theories and the MMT/Circuitists pretending that a cash flow entry invalidates arguments about income.

  10. Martin Lowy says:

    I continue to wonder about whether it makes a difference to the “money supply” that the entity extending a loan is a bank.

    When a bank establishes a deposit, that is a liability on the bank’s books. The borrower accepts the bank’s credit. Thus both parties are extending credit to each other. When the “borrower” uses the money–i.e., takes it out of that bank–that bank must find someone else to give it an identical amount of credit or must sell an asset having a value in the same amount.

    The “deposit” ends up at some other bank. Thus the system as a whole has been increased by the corresponding “credits” on both sides.

    The same thing would occur if the original “loan” were made by a non-bank, so long as the original “borrower” also were willing to extend credit to the original “lender”, as the borrower would do for a bank. In fact, this does occur in commerce. Non-banks do establish variously described “credit balances” when they make loans. And those credit balancess perform just like deposits at a bank that has made the loan. The amount of outstanding credit in the overall system is affected exactly the same way. So is the “money supply”, if by money supply we mean the aggregate amount of outstanding credit.

    In neither case did the actual store of “money” change. Neither the Fed nor the Treasury needed to be involved, and nothing need have changed on any governmental balance sheet.

    So why should a loan made by a bank be said to increase the money supply but a loan made by any other entity not be said to do so?

    And is it not true that it is the aggregate amount of credit in the economy that we should care about, not whether the transactions involve a bank as debtor and creditor?

  11. So which came first the chicken or the egg? Or are we discussing how does the chicken produce an egg such that it produces more chickens? Frankly I think it’s both discussions going on at once and neither side is listening.

    Yes, demand drops because consumer stops spending. This is assumed to mean debt is being paid down thus savings?

    The US economy was declining from the summer of 2006 and it’s not just my flower shop that said so. In August of 2008 people were looking at heating oil of $4/gallon. Hey it’s October and puff, spending stopped. Can you say “WINTER”?

    Which gets to the issue, where are all the roosters sitting? If there are not enough roosters in the hands of as many people as possible, then the chicken population and thus the egg population is going to decline.

    The reason debt became unsustainable was because at the base of all the debt the part that supported all the debt that created currency (digital or electronic) the money to pay the monthly nut became earmarked for something else that was just as life sustaining important. Put another way, the rooster issue of income inequality came home to rest.

    In the presentation that Alan Kruger made 1/12/12 everyone harped on the coined “Great Gatsby Curve”. Big deal! What they missed as evident by the question of “where did you get that number” when I posted it at Angry Bear was:
    “As I mentioned, the share of income going to the top 1% increased… the equivalent of about $1.1 trillion dollars per year in 2007. This implies that if another $1.1 trillion had been earned by the bottom 99% instead of the top 1% annual consumption would be about $440 billion higher. This would be a 5% boost to aggregate consumption.”

    “And this does not say that the rise in inequality cut aggregate demand by $440 billion because households could have (and probably did) borrow to make up for weak growth.

    Yah think? I can’t find my link but I read another piece of research that showed that all the borrowing by the 99% was not for improving their economic position it was purely sustaining what one had.

    Which came first and how does the chicken produce chicken producing eggs while the issue is that the chicken and eggs exist and are doing their thing but the roosters are not in the hands of enough people.

  12. flow5 says:

    “…In neither case did the actual store of “money” change…”

    Patently false. The non-banks (intermediaries between savers & borrowers), are customers of the member (money creating), depository banks. Money flowing to the non-banks actually never leaves the CB system as anyone who has applied double entry bookkeeping to the CB system on a national scale should already know.

    Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through the intermediaries.

    Shifts from time deposits (TDs) to transaction deposits (TRs) within the CBs and the transfer of the ownership of these deposits to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs, or the volume of their earnings assets.

    THE SAVINGS-INVESTMENT PROCESS OF THE COMMERCIAL BANKS CONTRASTED TO THAT OF FINANCIAL INTERMEDIARIES:

    (A) The commercial banks create new money (in the form of demand deposits) when making loans to, or buying securities from the non-bank public; whereas lending by financial intermediaries simply activates existing money.
    (B) Bank lending expands the volume of money & directly affects the velocity of money, while intermediary lending directly affects only the velocity.
    (C) The lending capacity of the commercial banks is determined by monetary policy, not the savings practices of the public.
    (D) The lending capacity of financial intermediaries is almost exclusively dependent on the volume of monetary savings placed at their disposal. The commercial banks, on the other hand, could continue to lend if the public should cease to save altogether.
    (E) Financial intermediaries lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the commercial banks lend no existing deposits or savings: they always, create new money in the lending & investing process.
    (F) Whereas monetary savings received by financial intermediaries originate outside the intermediaries, monetary savings held in the commercial banks (time deposits & the saved portion of demand deposits) originate, with immaterial exceptions, within he commercial banking system. This is demand deposits constitute almost the exclusive net source of item deposits.
    (G) The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can bank loans (if monetary policy permits & the opportunity is present ).
    (H) Monetary savings are never transferred from the commercial banks to the intermediaries; rather are monetary savings always transferred through the intermediaries. The funds do not leave the banking system.

  13. flow5 says:

    Loans=deposits (before Bernanke inverted the short-end of the yield curve):

    Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

    The expansion of bank credit and new money-TRs (transaction deposits) by the CBs can be demonstrated by examining the differences in the consolidated condition statements for the banks and the monetary system at two points in time.

    Increases in CB loans and investments/earning assets/bank credit, are approximately the same as increases in TRs & time deposits/savings deposits (TDs)/bank liabilities/bank credit proxy (excluding IBDDs).

    That the net absolute increase in these two figures is so nearly identical is no happenstance, for TRs largely come into being through the credit creating process, and TDs owe their origin almost exclusively to TRs – either directly through transfer from TRs or indirectly via the currency route.

    There are many factors, which can, and do, alter the volume of bank deposits, including: (1) changes in currency held by the non-bank public, (2) in bank capital accounts, (3) in reverse repurchase agreements, (4) in the volume of Treasury currency issued and outstanding, and (5) in Reserve Bank credit. Although these principle items are largest in aggregate, they nevertheless have been peripheral in altering the aggregate total of bank deposits.

    For the Monetary System:

    Thus the vast expansion of deposits occurred despite:
    (1) an increase in the non-bank public’s holdings of currency $801.2b
    (2) an increase in other liabilities & bank capital $39b
    (3) an increase in matched-sale purchase agreements $32.2b
    (4) an increase in required-clearing balances $6.7b
    (5) the diminution of our monetary gold & silver stocks; etc.(-)$6.6
    (6) an increase in the Treasury’s general fund account $4.9b

    Factors offset by:
    (1) the expansion of Reserve Bank credit $847.5b
    (2) the issuance of Treasury currency; $35.9b

    These “outside” factors made a negligible contribution in bank deposit growth the last 67 years of $4.4b (deposits declined by $877.4b and were offset by the expansion of $883.4b).

    For the incredulous reader I make this assignment: Please explain how the volume of TRs and TDs could grow since 1939 from $48 billion, to $ 8,490 (NSA) billion, even while the banks were paying out to the non-bank public a net amount of (-)$801.2 billion (NSA) in currency.

    Federal Reserve Bank credit since 1939 (2.6b), has expanded by billion 847.5 (NSA), (-$801.2 of which was required to offset the currency drain from the commercial banks. The difference in the above figures outlined above was sufficient to supply the member banks with $46b of legal reserves.

    And it is on the basis of these legal reserves that the banking system has been able to expand its outstanding credit (loans and investments) by over (+) $8,462 trillion (SA) since 1939. (40.7)

    From a System’s standpoint, time deposits represent savings that have a velocity of zero. As long as savings are impounded within the commercial banking system, they are lost to investment or to any type of expenditure. The savings held in the commercial banks, in whatever deposit classification, can only be spent by their owners; they are not, and cannot, be spent by the banks.

    From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

  14. flow5 says:

    For the commercial banking system, the whole is not the sum of its parts. I.e., what is true for an individual bank is not true for the system as a whole.

    In Keynesian National Income Accounting, saving does not equal investment. Monetary savings are impounded within the CB system. Savings held by the commercial banks represent a leakage (unspent savings). I.e., the commercial banks do not loan out existing deposits (saved or otherwise).

    And lending by the CBs is inflationary (where savings does not equal investment). Lending by the non-banks is non-inflationary (where savings equal investment), ceteris paribus.

    Why is this analysis especially important now? It’s because Bernanke’s new policy instrument (IOeRs), induce dis-intermediation (where the intermediaries shrink in size but the CB system stays the same), i.e., within the confines of the money market . IOeRs have altered the construction of a normal yield curve, they have INVERTED the short-end segment (i.e., the remuneration rate @ .25% is higher than the daily Treasury yield curve 2 years out – .26% on 01/09/12). The 5 1/2 percent increase in REG Q ceilings on December 6, 1965 (applicable only to the commercial banking system), is analogous to the .25% remuneration rate on excess reserves today

    I.e.: “it’s that money will flow OUT of the economy into the banking system” The most important lending sector in our economy (our financial intermediaries, i.e., non-banks) — or pre-Great Recession, represents 82% of the pooling & lending markets (Z.1 release, sectors, e.g., MMMFs, commercial paper, GSEs, etc.).

    IOeRs cause a cessation of circuit income & the transactions velocity of funds. IOeRs absorb bank deposits, savings, & and reduce real-output.

  15. Jeff says:

    OK. Professor Krugman can be snarky, but nothing written here undermines his economic models. I’m also not convinced that Professor Keen didn’t put words into Krugman’s mouth with statements like: “Yet Neoclassical economists like Krugman continue to assert that the aggregate level of private debt, and changes in that level, are macroeconomically irrelevant…” That strikes me as making a sloppy argument. Not to mention this post uses historical references and states theoretical assumptions, rather than arguing within the framework of IS=LM.

  16. flow5 says:

    Jeff: IS does not even equal LM. Who’s really “grasping at straws” ?