WWPKD? Much more than Ben Bernanke has done. In a recent New York Times op-ed, Krugman criticizes the Federal Reserve chairman following his much-anticipated Jackson Hole announcement for not doing enough to reduce unemployment and foster economic growth. But he spares Bernanke his strongest criticism, which he reserves for the “political intimidation” that has caused Bernanke to back away from what he regards as more sensible Fed policies. So would Krugman do? What Bernanke proposed for Japan in 2000. Krugman writes that “we learn a lot by asking why Ben Bernanke 2011 isn’t taking the advice of Ben Bernanke 2000.” He refers to a paper Bernanke wrote that Krugman thinks was “on the right track”—“as well I should,” he discloses, “since his paper was partly based on my own earlier work.” So here are Krugman’s proposals for what the Fed should do:
• Purchase U.S. “long-term government debt (to push interest rates, and hence private borrowing costs, down)”.
• Announce “that short-term interest rates would stay near zero for an extended period, to further reduce long-term rates”.
• Announce “that the bank was seeking moderate inflation, ‘setting a target in the 3-4% range for inflation, to be maintained for a number of years,’ which would encourage borrowing and discourage people from hoarding cash”.
• Depreciate the U.S. dollar, which is to say, to devalue it in terms of other currencies.
But hasn’t the Fed already done these things? Well, pretty much, Krugman admits. And, he admits, it hasn’t brought recovery. But, he insists, that’s not because they are bad ideas, it’s just because Bernanke wasn’t radical enough about implementing them. Krugman acknowledges, “Last year, the Fed actually did institute a policy of buying long-term debt, generally known as ‘quantitative easing’ (don’t ask).” In fact, the Fed has already instituted two rounds of “quantitative easing”, or “QE”, dubbed QE1 and QE2. Krugman is calling for QE3, but thinks Bernanke isn’t going to do it because he feels intimidated by opponents of QE.
It’s telling that Krugman urges his readers not to ask about “quantitative easing”. Former Fed Chairman Alan Greenspan once admitted that he engaged in “Fedspeak” to leave his listeners (e.g., members of Congress) completely befuddled about what he had just said. That’s not to say Fedspeak such as “quantitative easing” is never meaningful. Actually, in this case, it means pretty much what it says. The root of “quantitative” being “quantity”, it is the term given to the Fed’s purchase of U.S. Treasury bonds or other government securities, which increases the base money supply; that is, it increases the quantity of money in circulation, which in Keynesian economic theory is supposed to “ease” the pain of a hurting economy (for reasons we will return to).
It’s not as confusing as it sounds, and if you understand what “quantitative easing” really means, you will understand why you are not supposed to ask. Essentially, Treasury securities are I.O.U.’s—promises to pay at a future date the principle amount borrowed plus interest. They represent U.S. debt. So the Treasury issues these I.O.U.’s to buyers, including the Federal Reserve (which is not really federal at all, but is a system of for-profit privately owned banks that pays its stockholders an annual 6% dividend). In return for these I.O.U.’s, the Fed loans the government money. Where does it get this money that it loans out at interest to the government? Why, it simply creates it out of thin air! POOF! Neat magic trick, huh? The printing presses are turned on, and the fiat currency in the form of Federal Reserve Notes—that is, “dollars”—is created.
So these paper notes, which we think of as “money”, are spent into the economy and deposited in various banks across the country. And then comes the even neater magic trick of fractional-reserve banking. When you deposit your “money” in the bank, the bank then loans it out to others, with a requirement only to keep a certain “reserve” in the bank—say 10%—to give to depositors who wish to withdraw their “money” from their account. This is possible because usually less than 10% is ever withdrawn at any one time. In other words, the bank doesn’t actually have everyone’s deposits of “money” in its vault, which is why it is problematic if too many people wish to withdraw too much of their “money” at one time, which is called a run on the banks.
So if $10,000 in hard currency is deposited into bank A, it can then loan out $9,000, keeping $1,000 in reserve. Now say the borrower goes and spends that $9,000 to make a purchase, and the seller deposits his earnings in bank B, so that bank can now loan out $8,100, keeping $900 in reserve. The new borrower buys something and the new seller deposits the cash in bank C, which then loans out $7,290, keeping $810 in reserve. And so on.
Except that banks don’t really loan currency that way. That is to say, banks don’t really loan out their deposits of Federal Reserve Notes, but instead issue loans by expanding the money supply. Say that same $10,000 in hard currency is deposited into bank A, but this time, the bank doesn’t just loan out $9,000, keeping $1,000 in reserve. Rather, the $10,000 in deposits is the reserve from which the bank can then loan out an additional $90,000. It is still meeting its requirement to keep 10% in reserve. So if the deposits don’t account for the loans, where does that loaned “money” come from? Why, it is simply created out of thin air! The bank punches some keys on a computer and—POOF!—extra digits show up on a borrower’s account statement. Neat trick, huh? That’s the magic of fractional-reserve banking.
The bank hasn’t turned on some printing press and created more Federal Reserve Notes to place in its vault to represent the amount of the loan, the $90,000. The “credit” was just signed into existence when the borrower put his John Hancock on the loan agreement. So the “money” that was “borrowed” never existed in the first place. But the borrower can still go buy a car or a house or whatever, because the seller will accept those digital numbers being transferred to his or her own account as value for the item sold. Works great, doesn’t it? Well, sure, except that the borrower now owes the principal plus interest on the “money” the bank “loaned” him by creating it out of thin air, and, of course, if he doesn’t repay it, the bank will take the house he bought with the “money” he borrowed—which is to say, in either case, that the borrower must repay something of real value representing the fruit of his labor in return for having borrowed something of no real value representing no labor or production. But, hey, that’s fair because that’s what he agreed to when he signed his name to that contract. A deal is a deal.
So this is how most “money” comes into existence. Through the inflationary magic of fractional-reserve banking, the money supply is increased. And when a borrower repays his or her loan, it decreases the total money supply. That is, paying off debt is deflationary. Those digital numbers representing the principal return to the place from whence they came. Created out of nothing, they return to nothing. And then there is the interest…. Federal Reserve Notes actually account for only a small fraction of all the “money” that is transferred through the economy day to day.
Returning to “quantitative easing”, it is just another name for the expansion of the money supply. It is the monetization of U.S. debt. Every Federal Reserve Note in existence represents debt. To pay off that debt, every single Federal Reserve Note would have to be repaid to the Fed, which is to say every single paper dollar—each having been borrowed into existence in the first place—would have to be removed from circulation to pay the principle on Fed’s loan to the government.
Ah, but then there is the interest on that debt. If the total base money supply (that is, all the hard currency in the form of Federal Reserve Notes) is required to pay off the principal, where does the interest come from? Why, it has to be created into existence, too! That is done through the Fed “purchasing” more Treasury securities (it’s usually said the Fed “buys” securities, but what that really means is that the Fed is making a loan to the government at interest). Thus, the Federal Reserve monetary system requires that the U.S. government never be able to pay off its debt. (In fact, the only time the government has ever completely paid off its debt was during the presidency of Andrew Jackson, who killed the Second Bank of the United States, an early forerunner to the Federal Reserve modeled after the Bank of England.) When you hear the term “debt monetization”, it means just that: turning U.S. government debt into a supply of “money”. Under this system, money is debt.
The Federal Reserve monetary system not only requires that the government never be able to pay off its debt, but also that the money supply be steadily increased over time in order to create the “money” for borrowers to be able to repay the principle plus interest on their loans. That is why the Federal Reserve sets a target rate of steady inflation. Ever wonder why your grandparents could talk of paying 10 cents for a loaf of bread? Well, there you have it. Money is subject to the law of supply and demand like any other commodity. The more dollars there are in circulation, the less each dollar is actually worth. As a consequence, in order to stay profitable, businesses must raise their prices. So if a loaf of bread cost $0.10 in 1930, today the same loaf of broad would cost $1.35. One dollar in 1913—the year the Federal Reserve was created—was worth more than $22 in terms of 2011 dollars. The U.S. dollar has lost over 95% of its purchasing power since the Federal Reserve Act of 1913.
So you can begin to see why Krugman says to his readers, “don’t ask” about “quantitative easing”. It requires a little bit of explaining—too much to really cover in a New York Times op-ed—and you aren’t really supposed to know anyway (hence the existence of “Fedspeak” and other gibberish invented by economists to obfuscate how things really work).
So, to summarize, when Krugman prescribes QE3 as part of the solution to the U.S.’s economic troubles, what he is saying is that the U.S. government should borrow more money into existence (or, as he puts it, the Fed should make “purchases of long-term government debt”). This, Krugman argues, would “push interest rates, and hence private borrowing costs, down”. Naturally, if you borrow money, you want to get the lowest interest rate possible. So does the U.S. government. When U.S. securities are perceived as being a safe investment, purchasers of U.S. debt are willing to accept a low rate of return. Low risk, low return. If perceptions change, and Treasury securities are seen as riskier investments—for fear, say, that the U.S. government will not be able to make good on its debt, but might default—then they will want a bigger return on their investment, and thus the interest paid on securities rises. Higher risk, higher return. All Federal Reserve Notes come into existence through the monetization of debt. But when the Fed monetizes the debt for the purposes of pushing interest rates artificially low and creating economic “stimulus” during a crisis or recession, then it is known as “quantitative easing”. Same thing, different name.
So the prescription here includes the Federal Reserve manipulating interest rates, pushing them artificially lower than they would be if they were determined by the free market. This is also a manipulation of perception, creating the illusion of investor confidence in U.S. Treasury securities. When the government borrows at a low interest rate and that debt is monetized, it translates, as Krugman notes, into lower rates of interest on private borrowing (that is, the borrowing by private citizens of the “money” supply that was created from debt monetization and deposited in banks across the country). The point of this, of course, as Krugman says, is to encourage more people to borrow more money. That is to say, the purpose is to incentivize people to go into debt, or get further into debt. The incentive of artificially low interest rates played no small part in the housing bubble that led to the financial crisis in 2008.
Okay, so now we come to Krugman’s second prescription. Krugman acknowledges that the Fed did in fact announce that “conditions ‘are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013’”. That is to say, the Fed set a target of keeping interest rates low (near zero) for at least two more years. Krugman’s criticism here is that it wasn’t enough because it didn’t amount to a “promise” to keep interest rates low, but was rather merely a projection possibly subject to change given a change in economic “conditions”.
His third prescription follows logically from the first two, that the Fed set a target of “moderate inflation”—which is to say it should increase inflation from the “low” level of around 2% to the more “moderate” rate of 3-4%.
His fourth prescription—the devaluation of the U.S. dollar—also follows from the previous three, being a natural consequence of such monetary policies. Krugman’s criticism here is that the U.S. dollar hasn’t been devalued enough. That is to say, he doesn’t think Americans have lost enough of their purchasing power, but should sacrifice even more of the fruits of their labor, because that would be good for the economy.
How so? Well, devalued dollars make U.S. exports more attractive to foreign consumers, helping to offset the enormous U.S. trade deficit. Paying off government debt in devalued dollars is also effectively a form of default-by-stealth. And in the economic theory of John Maynard Keynes to which Paul Krugman subscribes, such policies are a “stimulus” to the economy because it encourages people to borrow more, and if they borrow more, they will spend more, and that’s a good thing—remember Krugman wants to “encourage borrowing and discourage people from hoarding cash” (with “hoarding” meaning a person saving more money than Krugman thinks they should). So going into debt and spending borrowed money is good for the economy. But doing the opposite, saving money to either pay down your debt or “hoarding”, is bad. In fact, if too many people pay down their debts, it leads to—gasp—deflation. Horror of horrors. Are you beginning to see the picture? In the prevailing economic theory that dominates mainstream thinking, the health of an economy is largely measured by how much people spend money they don’t have to buy shit they don’t need.
Krugman is also a firm believer in the Keynesian thinking that, during a crisis, such as a recession, the government should increase deficit spending in order to create jobs. If you’ve been reading his articles in the Times, you will have noticed this constant theme. Cut spending during a recession? The horror! No, rather, the government must spend more so it can create more jobs in the public sector. Of course, spending more means either raising taxes or borrowing more and going further into debt.
Raising taxes really just means taking money out of one person’s pocket to put it into another’s, so there is no real net benefit to the economy. Or it means taking money from a privately owned business to pay the wages of a government employee. Of course, that then has other unintended consequences. The business may need to lower the wages of its employees, or lay someone off, so that the government employee can have a job. Or, if the business wants to keep all its employees and maintain their wages, it may need to raise the cost of its goods or services in order to compensate for the loss of revenue from higher taxes, to pass the expense on to the consumers. In the end, the creation of public sector jobs comes at a cost to the private sector and/or to consumers. And that’s not even considering the question of whether the same job could be done more efficiently by the private sector or the public sector (hint: the government doesn’t exactly have a great record when it comes to wasteful spending).
The other way the government can increase spending in order to (ostensibly) create jobs is by borrowing the money. It could do so by borrowing from foreign nations or monetizing the debt. But every dollar borrowed must be repaid along with interest. So borrowing to create public sector jobs for people today simply places an extra burden upon future generations. It is still taking money out of one person’s pocket and putting it into another’s, only with a time differential (that is, taking from future generations) and now with an interest attachment, so that the effect on the economy over time is a net loss. And if the borrowing comes in the form of debt monetization, there is the inflationary effect on the economy and loss of purchasing power of the dollar.
And looking to the bigger picture, the idea that higher employment means a healthier economy should not be an unquestionable axiomatic assumption. If everyone could maintain a high standard of living while doing little to no work at all, wouldn’t we consider that to be a pretty healthy economy? Isn’t the whole point of “improving” the economy so that we can free up time from our jobs to do other things? Or to earn a living doing things we like to do, rather than having to labor from 9 to 5 doing something we hate? Money for nothing and chicks for free? What good is an economy in which everyone is employed but has to slave away in order to survive? In such an economy, how could art, literature, and science flourish? Must we have high employment for high employment’s sake?
Krugman has argued that “even useless spending” can be good for the economy. Unlike the disaster capitalists of the Chicago school of economics, he says he doesn’t think this makes war or natural disasters good things. But to the Keynesian economist, they can boost the economy by leading to an increase in public spending. So if a tornado sweeps through the town and destroys things, it can create jobs, because now there needs to be reconstruction. A lot of broken windows have to be replaced. And if one couples the idea that “useless” spending can be good with the idea that we must have full employment, a simple solution could be found by paying one group of people to go dig up a bunch of holes and another group to go fill them in. Would that increase in public spending boost the economy? If nothing of value is actually being produced, what is the net effect of such spending on the economy at large?
The trouble with most economic analysis is that it seeks policies with near-term, rather than long-term, interests in mind, and considers only the immediate, foreseen consequences, without consideration for the extended, unforeseen consequences. What is seen with increased public spending is a rise in employment in the public sector. But what is unseen is the consequent loss of jobs, the lowering of wages, and/or the rising of prices in the private sector. What is seen is a government employee who now has a job he didn’t have before and consequently has money that he can spend back into the economy (and spending, remember, is good). What is unseen is that a private-sector employee has lost his job and thus has no income to spend into the economy, or who has had his wages cut and thus has less money to spend into the economy. Unseen is the loss of purchasing power of the consumer who either has to pay higher costs for goods and services due to higher taxation or due to debt monetization and inflation.
So, yeah, the carpenters in the tornado-swept town can be put to work, and the window repairmen have plenty to do. These guys will have more money in their pockets to go spend into the economy (and spending, remember, is good). But what about the business owner whose storefront window was shattered? Now he’s out the same amount he paid to the fixer-uppers. Maybe he had planned to invest that money into machinery to increase production, but now those savings are gone and he will have to continue at his present level of production in order to accumulate the capital once more to be able to invest in the expansion of his business. Or maybe he will forge ahead with his plan to increase production, but now he will have to borrow the money and pay interest on the loan, an extra cost he will now have to pass on to his customers. Maybe the owner had planned to hire someone to sweep his shop and help out, but now he isn’t able to, and thus a potential job is lost. The job created is seen. The job lost is unseen. But both must be taken into consideration when assessing the net effect on the economy.
It should also not be seen as axiomatic that the “health” of an economy is measured by how much people spend. Krugman would have his readers believe that “hoarding”—that is, saving—is a bad thing. Say you have $5 dollars in your pocket as you walking downtown. You pass the bicycle shop and admire this great mountain bike. You imagine owning it and cruising down the bike trails. But, of course, $5 won’t buy the bike. You move on. You pass by the ice-cream parlor, and the smells waft out across the sidewalk. You go in and spend your cash on a waffle cone. You have just decided that that waffle cone is worth more to you than that five bucks in cash. Now let’s say the following week your downtown again with another $5 in your pocket and you pass the parlor, and you remember what a tasty treat you had had the week before. You turn to enter, but before you get to the door, you remember the bike. You think to yourself that if you can just avoid spending your money for two-months, you would have enough saved to actually buy it. You’re tempted, but in the end, you turn and walk away. You have just decided that the five bucks is worth more to you than the waffle cone, not because you think the greenback paper is really pretty or has any intrinsic value, but because you think you can better meet your wants/needs in the future with your accumulated cash balance. You have made a different subjective valuation than you had just the week before. You chose to be a saver instead of a spender. Now the ice-cream parlor owner may consider you a “hoarder” of your hard-earned wealth, but the bike shop guy will probably think your decision is financially sensible. What constitutes “hoarding” is also a subjective judgment.
Saving is really just offsetting spending from the present into the future. So instead of spending your earnings from your job every week, you begin to save for that bike. Now, you had been keeping your stash of cash in your piggy bank, hidden in the darkest recess of your closet. But with your increase in savings, that just won’t do anymore. So you go down to the bank and open an account and deposit your earnings there. So now, because of hoarders like you, the bank has greater reserves from which it can make loans. So maybe some young entrepreneur has an idea for a new product. He puts together a business plan and goes down to the bank to take out a loan to start it up. And he has to hire some employees, so some new jobs are created for the town.
The idea that spending is good and “hoarding” is bad is also an assumption that operates within a framework where only immediately foreseen consequences are taken into account. If you spend your five bucks, the ice-cream parlor owner makes a profit, and you have helped the local economy. But if you don’t spend your five bucks and instead save up and buy that bike, you have still helped the local economy, to an even greater extent, only at a later date.
It should be fairly obvious that the wealth of nations doesn’t really derive from its citizens spending and consuming, but rather from saving and producing. Unfortunately, this is not at all obvious when one reads the business and financial press, where we are told by guys like Paul Krugman that the government must go deeper into debt to provide “stimulus” to the economy, to incentivize people to go out and spend, spend, spend their hard-earned cash, to borrow more and more and go deeper and deeper into debt.
The crux of the problem should come clearly into view when one considers the debt problems of the United States. The U.S. national debt is currently at over $14.7 trillion dollars. The federal budget deficit, presently at over $1.4 trillion dollars, is adding to that debt. And that number doesn’t include “unfunded liabilities”, which are debts for which the public is ultimately liable, but for which there is currently no means of funding. This includes Medicare and Social Security. All told, U.S. unfunded liabilities currently total more than $115 trillion. Thus, the true total U.S. debt is around $130 trillion. That’s well over a million dollars for each and every American taxpayer.
It is in the face of numbers like these that Paul Krugman is encouraging more borrowing, more spending, more inflation, more devaluation of the dollar. What happens when the U.S. government is no longer able to pay even just the interest on its debt? Given a choice between default or debt monetization, what would the government do? WWAGD? As Alan Greenspan recently explained, “The United States can pay any debt it has because it can always print money to do that.” Yep. There you have it. Keynesian thinking pretty much dominates the thinking of economists like Paul Krugman, Ben Bernanke, and Alan Greenspan.
Keynesians seek to create a booming economy through interference in the free market and artificial manipulation of interest rates, inflation, and so on. The trouble is the forces of the free market eventually will try to restore balance, which is why every “boom” is followed by a “bust”. Keynesians labor to try to prevent the busts by a continuation of economic policies that created the problem in the first place. Thus it is that guys like Bernanke couldn’t foresee the financial crisis of 2008 and the collapse of the housing bubble—(why anyone still puts any faith in anyone who could be so consistently wrong as Ben Bernanke is surely one of the great mysteries of our time)—while guys like Ron Paul, Peter Schiff, and others of the Austrian school of economics who consider that the way to avoid the busts is to not create an artificial boom in the first place, were able to predict it years in advance.
And the guys who got it right on the 2008 financial crisis and predicted the recession to ridicule and scorn among the mainstream financial “experts” are also predicting the consequences of the kinds of policies that the Fed has implemented and which Krugman is calling for even more of, which include, if the ship doesn’t dramatically alter its course, hyperinflation, the collapse of the U.S. dollar, and the destruction of the U.S. economy. The standard of living Americans have come to expect and take for granted is unsustainable. Government spending is unsustainable. The monetary system itself is unsustainable.
Yet Krugman criticizes those who have opposed the Fed’s policies and the kinds of escalation of Fed policies Krugman is prescribing for “political intimidation that is killing our last remaining hope for economic recovery.”
So which group of prophets do you want to listen to? The guys who got it wrong and were blind to the consequences of their own economic policies, or the guys who got it right and tried to warn everyone of what was coming? Whose prescriptions would you put your faith in? What outcome will you bet your future on?
If the kinds of Fed policies Krugman prescribes are “our last remaining hope for economic recovery”, God help us all.
I don’t disagree with most of this; however:
Krugman was quick to say the US should not have taken on the debt during the booming years of 2000-2008
You fail to mention that the same way the $10K issued by the FED gets hyper inflated can also be hyper deflated out of the economy (the FED simply sells the assets that it is currently buying to reverse course)
Krugman/Keynes only prescribes fiscal and draconian FED action when the FED rate is zero (zero lower bound). He has stated this over and over yet people claim that Keynes is for spending all the time (not true)
Increasing bank reserves DOES NOT always lead directly to inflation. What if the banks refuse to lend (liquidity trap) or people don’t borrow? The money would not move into the economy (which is what is happening)
Deflation and lack of lending (monetary flow) is a very good indicator of economic health
One other thing…It is a misconception that the FED sets the Treasury Bill price. The MARKET sets the price. The FED may very well influence the price. But not as much as one thinks.
Example – Bill Gross, a member of the free market, purchases billions of dollars of T-Bills at the current yield. IF the FED was indeed creating a wrong value in the treasury market, why would so many investors buy the bad value at the prevailing price?
“It is a misconception that the FED sets the Treasury Bill price. The MARKET sets the price. The FED may very well influence the price.”
One can debate points of semantics, but the fact is that the Fed artificially determines what it thinks the federal funds rate should be and then buys or sells treasuries in order to set interest rates at that predetermined number. That is by definition not the free market determining the price.
As for the question, “IF the FED was indeed creating a wrong value in the treasury market, why would so many investors buy the bad value at the prevailing price?”
Because they are foolish? I don’t know, great question. Part of the the whole point of the Fed policy of artificially determining interest rates is to encourage investors to buy U.S. government debt. There is no “if”.
You argue that I “fail to mention” that the Fed could take a deflationary route and allow the depression to occur. You are right, the Fed theoretically could do that, but they aren’t going to, and they have already made that perfectly clear. They have made it totally clear that they are going to pursue the Keynesian inflationary route.
As for the “claim that Keynes is for spending all the time”, I believe I was clear with such statements as “Krugman is also a firm believer in the Keynesian thinking that, during a crisis, such as a recession, the government should increase deficit spending in order to create jobs.”
You are also right that increasing bank reserves does not always lead to inflation. Wise people may not have confidence in the dollar or banks and choose not to borrow, but to save, even to withdraw their money from the banks, etc. We’ve seen recently the M1 monetary base expanded while at the same time the M3 money supply contracted because people were saving and not borrowing!
Same thing happened during the late ’20s and early 30’s, when the money supply remained the same or actually contracted despite the Fed’s best efforts to implement inflationary policies.
But this misses the point that the intention of such policies is to create inflation! The fact that their inflationary goals don’t always work out the way they wish is not an argument in favor of their policies!
I agree deflation and lack of lending is a good indicator that people are wise to artificial booms, but it certainly does not necessarily indicate economic health. As I just pointed out, people were wise to the inflationary bubble that led to the Great Depression, but that certainly didn’t mean the economy was okay! The bust cycle still needed to occur.
The two descriptions of the fractional reserve system are mathematically identical. Whether the deposit of $10,000 is held and $90,000 is loaned on it or $1000 is held while $9000 is loaned and from the $9000, $900 is held… the total amount of money created is $100,000.00. Out of which, $10,000 will be held as a fractional reserve. The author seems to have the (all to common) misconception that when the $9000 is deposited at bank B that is unavailable for withdrawal while it is loaned out but of course that is not the banking system that we have. I stopped reading when I realized that he doesn’t know basic arithmetic.
You are correct, in both cases, money is effectively created out of nothing. I was perhaps unclear, but the point I was trying to make is that banks don’t really loan out deposits, but instead expand credit.
You say with regard to the first case, that there is a “misconception that when the $9000 is deposited at bank B that is unavailable for withdrawal while it is loaned out but of course that is not the banking system that we have”. So you are arguing that the $9000 is available for withdrawal after $8,100 of it has been loaned out? Please explain how that is mathematically possible!
As for the comment, referring to the first case, “that is not the banking system that we have”. I would observe that I wrote, “Except that banks don’t really loan currency that way.”
So you are arguing that the $9000 is available for withdrawal after $8,100 of it has been loaned out? Please explain how that is mathematically possible!
– Depositor gives Bank B $9,000. Bank gives $8,100 to Borrower. Depositor demands his deposit of $9k back.
The bank should be managing the loan portfolio in such a manner that the ebb and flow of deposits, withdrawals, loans and loans maturing provide the required liquidity (plus reserves).
However, if Bank B is unable to provide the call of the depositor, the Bank will borrow from other sources (mostly other banks but possibly equity). The bank will pledge the asset of the $8,100 loan (or other asset) and borrow the cash to meet the deposit demand. “Repurchase Agreement”
Remember, the initial loaned $9K is somewhere in the economy creating a deposit somewhere (in a functioning market). Such bank(s) with excess capital will be looking for ways to provide a return on the capital. These such banks will be the counter party of the “Repurchase Agreement”
Or – the bank can take the security and pledge it to the FED and borrow the capital to meet the deposit request.
You’re not really saying anything. You can move numbers around, but the sleight-of-hand remains the same. Okay, so the original depositor wants his $10,000 back, but Bank A can’t return it, because it’s loaned out $9,000 of it. Okay, you argue, but that $9,000 is still floating around in the economy somewhere. Indeed! So, okay, Bank A can just borrow the $9,000 from Bank B, where it was deposited by someone else. So now Bank A can return the depositor’s $10,000 to him. Yes, indeed. But what about the person who deposited that $9,000 at Bank B? What if that person also wants his full deposit back?! Whoops. It isn’t there. The point remains the same. So, okay, now Bank B can borrow the $8,100 from Bank C… It’s musical chairs. When the music stops, somebody is going to be without a chair, no matter how you move the numbers around. Sure, as long as the music keeps going, everyone is happy. But that is just an evasion of the underlying point.
It’s the same shell game.
We are both correct. The system we have is a game of musical chairs and the FED insures that there is music and chairs.
If the economy stops functioning and everybody wants their money then we have a run on the banking system. Then the FED steps in and takes all the banks assets and provides the liquidity to the depositors.
If the music stops nobody will care about the chairs…If you don’t like this system then try to pay your mortgage by sending over chickens that are equal in value to the mortgage payment. I bet they will request that you make an electronic transaction from your bank to theirs…
Your “If you don’t like this system…” comment assumes either we must accept the Federal Reserve system or we must return to bartering, a fallacy that requires no further comment.
You are not considering the velocity of money in your argument which really exposes your lack of understanding of basic economics theory. I would really like PK to respond to you but he will probably not waste his time reading this article like I unfortunately did.
There are a lot of things I don’t consider in my argument. That doesn’t make any statement of fact I made false or invalidate any logic I used. If you think my not having considered this or that falsified my argument, please go right ahead and offer your own argument.
As for your suggestion that the guy who wrote, “To fight this recession the Fed needs … soaring household spending to offset moribund business investment. And to do that … Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble” needs to school me in basic economics, what can I say? I am not an economist, and don’t pretend to be. But the arguments Paul Krugman makes for what to do to fix the broken economy expose his lack of understanding of basic economics, and the fundamental failure of Keynesian economic theory. I have a lot to learn about economics. I stipulate that Krugman certainly has more knowledge in the field. However, he constantly demonstrates a total lack of wisdom.
I think you would get less blow-back in the comments section if people were clearer on the basics of what you are arguing against. This clarity will provide a solid platform for your higher level analysis. Perhaps you could write a followup article – or maybe just in the comments give a brief discussion of basic Keynesian models and how they differ from Classical or Neo-Classical. I think just a quick overview of the Keynesian Cross and translation to IS/LM/(BP, since we are concerned with exchange rates, too) would suffice. If you are less comfortable with modeling, just show them Hanson’s Law and Say’s Law, and explain how the one you are arguing against falls down.
I applaud your challenge in the comments section, however there are a few ways in which you should revise your article so as to remove the easily confused from your potential pool of challengers. What I mean is, it is distraction enough from your time to handle the serious challenges (assuming you do not issue such challenges lightly) without having to deal with every undergraduate economics student with an internet connection and a chip on his/her shoulder.
For the sake of brevity, I will only touch on a few points. First of all, the paragraph which states,
“What good is an economy in which everyone is employed but has to slave away in order to survive? In such an economy, how could art, literature, and science flourish? Must we have high employment for high employment’s sake?”
While I agree in principle with your conclusion, this argument is going to confuse someone. Someone is going to think that you are actually discussing the labor force participation rate instead of the employment rate. Perhaps you should clarify the difference between the two. While at it, you should explain to them why art, literature, and science are not productive activities and therefore not considered true economic employment.
Also, don’t make the mistakes that others do when asserting, “Raising taxes really just means taking money out of one person’s pocket to put it into another’s, so there is no real net benefit to the economy.” I know that speakers and authors get away with it all the time, but you really need to head off the counterarguments you could get that involve market efficiencies and externalities – Please! before someone mentions Pigou.
This is a good start, if not too much for what can be accomplished in the comment section. Please don’t think me too harsh – I just feel that if one is going to provide analysis from outside the standard framework, that their readers have a good understanding of that framework in the first place.
Roger, comments appreciated. I’m not schooled in economics. I’m merely presenting some of my views here as a non-economist, in the hopes that I can offer others some things to think about. And if people challenge my points, I welcome that, too. I am learning, and writing and presenting my thoughts to others for criticism is part of that learning process for me.
There is empirical evidence of what PK is saying. Do some reading on how we got out of the great depression. There was a huge expansion in the currency base.
Funny you should say that, Brad, because as a matter of fact, I’m reading “A History of Money and Banking in the United States” by Murray Rothbard, and he shows how it was the inflationary monetary policy that both caused and prolonged the Great Depression.
The description of fractional reserve banking, wherein a bank may generate more in loans than it has in deposits, is incorrect. Please take a look at any bank’s balance sheet.
http://en.wikipedia.org/wiki/Fractional_reserve_banking#Money_creation
Yes, this is the basic function about which the author said, incorrectly, “banks don’t really loan currency that way.”
Banks can loan currency that way. The point I was making is that banks can and do also simply create credit out of thin air against their reserves.
But if a bank cannot generate more in loans than it has in deposits, you have a 100% reserve system, not a fractional-reserve system. Perhaps I’m misunderstanding your point?
Krugman (PK) stated that Greenspan needs to create a housing bubble if the US were to pull out of the recession since no one else was investing.
And then Greenspan arguably created a housing bubble. And then keep blowing…
PK may very well have prescribed a housing bubble to bump the economy but he came out very hard against the continuing bubble and warned of a crash. And he was right.
If a doctor prescribes you a weeks treatment of antibiotics for an infection, dont blame the doctor when your liver fails if you stay on the antibiotics for years…
I think a better analogy is if one doctor says you must be bled one pint in order to heal your illness and a second doctor bleeds you to death, against the first doctor’s warnings, you cannot say that the first doctor’s prescription was right.
An even better analogy:
You go to the doctor and your doctor discusses with colleagues a treatment of bleeding one pint over one hour. After such treatment you indeed get better. However, your doctor never tries to stop the bleeding even though his colleague is screaming that it is time to stop or your going to crash the patient.
PK was screaming for Greenspan to stop before the crash. You cant blame him for being right about both a housing inflation being advantages in the short run and his assessment that Greenspan was holding the accelerator to the floor for far to long…
I thought I had made myself clear that I don’t agree Paul Krugman’s advocacy for creating a housing bubble was “right” at all. So I can very well blame him for advocating something I think was absolutely foolish.
“And looking to the bigger picture, the idea that higher employment means a healthier economy should not be an unquestionable axiomatic assumption. If everyone could maintain a high standard of living while doing little to no work at all, wouldn’t we consider that to be a pretty healthy economy? Isn’t the whole point of “improving” the economy so that we can free up time from our jobs to do other things?”
And that is the difference between Krugman and you. Krugman is looking to get unemployed people working. You don’t really think their unemployment is a problem and you have no serious prescription for dealing with the problem.
Well, Mark, if what you got out of that was that I “don’t really think their unemployment is a problem”, then I suggest you read the paragraph that followed, because you are clearly not making much of an effort to comprehend the point I was making.
At least the author had the good sense to bring Andrew Jackson into the discussion. The author, Ben Bernanke, Alan Greenspan, Paul Krugman, et al. are married to the banks for the purposes of expanding the monetary supply. Jackson the Democrat was highly distrustful of banks and Wall Street. Had Milton Friedman’s advances in monetary policy come before Jackson, Jackson instantly would have recognized that the banks are not the place to expand the monetary supply. A little subjective, but most informed economists know that the monetary supply should increase to support increased economic productivity (thanks to Friedman). If you think democratically, then you can also suggest a democratic place for the monetary supply to expand, rather than at the banks and their support for a cradle to grave borrowing society and large scale debt servitude, our modern form of slavery (borrowing for education, for family, for your house, for your car, for your medical expenses).
Hmm, Mr. Hammond will not respond to utopian theories. More down to earth notions may be necessary.
Of the four main cornerstones of governmental economic policy (Taxes, spending, monetary policy, trade and tariffs) Congress concerns itself with two (taxes and spending). The fed concerns itself with monetary policy.
That leaves trade and tariffs as the orphan. The trade deficit is a major driver of unemployment and the federal deficit. Taxes, spending and monetary policy are at best indirect solutions to the trade deficit. At worst, they shuffle the economic deck with unclear to bad consequences (bubbles). Tariffs, such as the Richmans “scaled tariff” are the solution to the trade deficit.
Bernanke (and Friedman) is weak in his understanding of trade, especially since he has not come forth in favor of tariffs. Monetary policy is effective when policies concerning the other three economic cornerstones are in place. Most of American history has seen the economy assisted by tariffs. It’s only in the last 60 years that that policy has become unraveled. The rise in the understanding and sophistication in monetary policy has come at the same time as a loss of understanding about trade and tariffs.
Inasmuch as I understand what you are arguing, I disagree. Monetary policy is at the root. It is monetary policy that has allowed the enormous trade deficit to exist and persist. Tariffs are not the answer. If we had sound money and a free market economy, trade deficits would correct themselves. The American people could never have deluded themselves into thinking they can consume so much while producing so little if the monetary and economic policies that perpetuate this thinking didn’t exist in the first place.
Very good. I very much did like your column.
The “sound money” argument with restraint in monetary policy is very legitimate. William McKinley made the “sound money” many times when he was campaigning against William Jennings Bryan. But McKinley also had a strong platform on tariffs. “Sound money” is an incomplete argument without tariffs. Alexander Hamilton, the first Secretary of the Treasury created our first “sound money” and he too also had policies on tariffs.
Tariffs allow you to create and grow and industrial base, creating things from which you can trade, which give the value for which you can have that “sound money.” If there are no goods or services to trade, there is no value. The tariff argument has always been quite strong, and it’s even stronger with the “sound money” argument.
The self-correcting mechanisms to which you refer come from theories arrived at during times of “sound money,” where the monetary standard was gold or gold derivatives. The self-correcting mechanisms either do not work or work very badly in today’s environment of floating exchanges and manipulated currencies.
To compensate for the self-correcting mechanisms you describe, the first thing countries like China do is manipulate their currency to keep it artificially low. If they can keep it low, they can continue to maintain an absurd trade surplus. We get cheap goods yes, but we also lose industrial capacity, get a high trade deficit, high unemployment, and a high federal government deficit. An argument for fair and balanced trade is very good, with all of its Smithian (Adam) rewards, but to reach out further and inadvertently support the Chinese trade surplus because of free trade principles is quite absurd. It’s quite arguable that Smith himself would not have made this mistake.
The Secret of Oz – Winner, Best Docu of 2010 v.1.09.11
http://www.youtube.com/watch?v=swkq2E8mswI
Yes, thanks, Signe. I’ve actually directed readers to this documentary at FPJ: http://www.foreignpolicyjournal.com/2011/08/07/the-secret-of-oz/.
I also recommend: http://www.foreignpolicyjournal.com/2011/07/25/why-gold-silver/.