Monetary Realism

Understanding The Modern Monetary System…

Banks Are Not Mystical

The recent crisis has been beneficial in at least one way – it has begun to shed light on some of the myths of our monetary system that have poisoned economics and politics for many decades.  If I had to rank some of these myths I would almost certainly put the currency user vs. currency issuer myth at the top of the list.  But a close second is the myth of the money multiplier.  Students are generally taught that our banking system works through some sort of “loanable funds” market or “money multiplier” whereby banks obtain deposits so they can then loan them out.  There’s just one problem with these ideas – they’re not right.

These ideas have all come to a head in recent weeks when Paul Krugman and Steve Keen got into a bit of a back and forth about the operational realities of the banking system.  I won’t comment specifically on the ideas of either men, both of whom are fantastic economists, but I think this conversation exposes the degree to which most people continue to misinterpret modern banking and requires some brief discussion.

The standard banking model says that banks are reserve constrained and that the amount of loans a given bank can make is a multiple of its reserves.   But the recent crisis has shot king sized holes in this myth.  The Fed has substantially expanded the amount of reserves in the banking system, but lending has flat-lined:

This is a monumentally important chart so it’s important to understand a few points if you’re going to understand why the above chart looks the way it does:

  • Reserve balances are determined by the Federal Reserve who acts as the supplier of reserves to the banking system.  Banks can never “get rid” of reserves in the aggregate.  They can shuffle them among each other, but only the Fed can destroy or create reserves through open market operations.   The Fed oversees the payments system and in doing so must act to ensure that banks can obtain reserves in order to settle payments and meet reserve requirements as needed.
  • Bank lending is not reserve constrained (in fact, many countries don’t even have reserve requirements at all).  This means that banks do not need reserves before they make loans.  Instead, banks make loans first and obtain reserves in the overnight market (from other banks) or from the Fed after the fact (if needed).   New loans result in a newly created deposit in the banking system.
  • Banks are capital constrained.  Banks can always find reserves from the central bank so banks do not check reserve balances before making loans.  Instead, they will check the creditworthiness of the borrower and their own capital position to ensure that the loan is consistent with the goal of their business – earning a profit on the spread between their assets and liabilities.
  • Banks attract deposits because they want to maintain the cheapest liabilities possible in order to maximize this spread on assets and liabilities.   Banks are, after all, in the business of making a profit!
That pretty much sums up the above chart.  You don’t need to understand balance sheet recessions or liquidity traps to know what’s going on there.  You just need to understand how banking works.   Yes, it’s true that the balance sheet recession has been a truly unique period in American history.  But the above chart is only unique in that it exposed this great myth to the public.   When the demand for credit collapsed the Fed was nearly helpless in reviving the credit markets.   Despite a $1.6 trillion reserve injection the lending markets just didn’t budge.  This might have appeared like an anomaly to some, but to those who understood banking this made perfect sense.  More reserves were never going to result in more loans.  This was not because it had temporarily become true, but because this is the way banking works.  Not just inside a balance sheet recession or liquidity trap or whatever you want to call it, but always….


Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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130 Responses

  1. Fed Up says

    I’d like some comments on this “gem” from nick rowe.

    anon: yes, there are legal capital requirements. I don’t see how they create a multiplier. Central banks don’t normally (to my knowledge) use changes in capital ratios as an instrument of monetary policy (maybe China??). It’s more about financial stability, and so the government doesn’t need to bail out bust banks.

    Posted by: Nick Rowe | April 03, 2012 at 04:27 PM

    Does that mean he thinks there is no such thing as a capital multiplier?

  2. Jussi says

    I just wanna support Cullen’s approach. What is more important here, trying to push PK (which will prolly not happen / is not important as such) to admit that he was wrong or leverage the MMT/MMR approach?

    Overall I just like the way Cullen try to avoid ego clashes and push the well thought agenda. Thanks.

  3. wh10 says

    Cullen I internally really resist labeling Fullwiler as such. I respect him greatly, and I know you do too. To be frank, I felt personally attacked by Krugman as a crazy mystic when he was pointing to Rowe’s blog, since my involvement over there was prominent, extensive, but civil (at least I think so). So when I saw Fullwiler’s piece, my emotions got the best of me and I couldn’t help but feel like the side commentary did us all “justice.” That all said, I think you’re right. Putting the emotions aside likely could have only resulted in a better outcome. Maybe not though.

  4. AndyCFC says

    nah I mean we dont get many french, italian, dutch, scandies etc etc wasnt some racist rant was curiousity, take the MMT italian thing it was organised by an italian journo that read some MMT… where were the Italian economists in all this?
    Im not telling what my hobby is but its seriously sad/geeky and the forums get loads of non anglos on the subject we talk about from all over, but the economics sites which is a far more important subject dont seem to get that, was wondering why?

    • Cullen Roche says

      Little off topic, but now the discussion has totally veered off course. They’ve let the monetarists think they’ve won by changing it into a discussion on endogenous and exogenous rates….

      • Dan M. says


        Can you please explain what Warren Mosler means when he says the following:

        “I believe you are all missing the point.

        First, there is a distinction between fixed fx policy and floating fx policy.

        With fixed fx lending is continuously reserve constrained and the interest rate is endogenous via competition for reserves.

        With floating lending is never reserve constrained, as this particular institutional structure allows banks to create their own reserves.

        that is, with floating fx/non convertible currency,
        loans create deposits and reserves as a matter of accounting

        any ‘needed’ reserves are, functionally, overdrafts in fed reserve accounts, and overdrafts are loans. so when the ‘need’ arises the deed is done. CB choice never enters into it. For the CB, it’s necessarily about price, and never quantity. I call it hard endogeneity and have been pointing this out for going on 20 years. ”

        Allows banks to create THEIR OWN reserves?

        Loans create deposits AND reserves as a matter of accounting?

        I’m confused… royally.

        Thanks for any clarification.

        • Cullen Roche says

          This debate is silly. The monetarists are basically trying to change the point. The point Warren makes is that loans come first and reserves are supplied as a matter of necessity after the fact. The monetarists are trying to change the point to interest rates by claiming that rates are not set endogenously by the central bank. This isn’t an unreasonable point though I would argue that it’s kind of a semantic point. The market technically wields some will over what the CB does with rates, but that’s kind of the design. The Fed is a reactive entity. But that’s really a separate point from the loans create deposits point. The main takeaway is that reserves will ALWAYS be supplied because the Fed has to maintain a healthy payments system. It can be no other way.

        • wh10 says

          Which is maybe why Mosler’s way of explaining this is the best?

        • Cullen Roche says

          Mosler’s always the best. He should just tell everyone else in the MMT attack dog gang to shut up and let him explain Mosler Monetary Theory. :-)

        • wh10 says

          This is Warren’s accounting brilliance I think.

        • wh10 says

          The way I understand this is that the banking system is one big spreadsheet with debits and credits. The CB permits overdrafts so that the payments system doesn’t go haywire. A shortage of reserves is fundamentally an overdraft in the banking system’s clearance system. The master bank, the Fed, is the sole determinant of the cost of overdrafts.

        • Dan M. says

          Sorry, wh10… I need more than this… he’s saying that banks create their own reserves… is this through overnight lending to each other or borrowing reserves from the fed. I feel like I’m missing something here.


        • Tom Hickey says

          Warren is not implying that banks create reserves directly. Only the Fed can do that, since it owns the spreadsheet. But loans creating deposits creating a need for the quantity of reserves in the payment system to expand to settle and meet RR. The Fed always insures that there are sufficient reserves in the payment system made available to clear interbank transactions, as well as to meet requirements. As lender of last resort the Fed will provide a bank that comes up short at the end of a period with sufficient reserves to clear as wellas meet RR, charging the penalty rate. So the quantity of reserves is determined endogenously by demand for credit, while the Fed sets the price (interest rate) exogenously to conduct monetary policy. The quantity of reserves is immaterial to monetary policy, Krugman not withstanding.

        • Dan M. says

          Tom… best explanation (for me) yet… Thank you!

          To clarify, what your saying is that while the fed isn’t going to manage whether any one bank has enough reserves, they’re always going to make sure the system has enough as a whole to not be limited by the RR.

          Is this correct?

          What about when the fed tries to enact a tight money policy like in 1981 or something.

          Thanks guys… I think this topic deserves its own blog post. I feel like this is both very important and very unintuitive/technical.

        • Tom Hickey says

          “To clarify, what your saying is that while the fed isn’t going to manage whether any one bank has enough reserves, they’re always going to make sure the system has enough as a whole to not be limited by the RR.”

          The Fed has to insure that every bank meets its need to settle and for RR. This is the lender of last resort function. If any bank comes up short at the close of period, the Fed provides the needed reserves at the penalty rate. Banks are aware of this and take steps to manage liquidity and RR so that they don’t have to pay the penalty, which cuts into profits.

          The Fed manages reserve quantity so as to hit the target rate with enough reserves in the system to settle and for RR. Banks should therefore be able to get needed reserves by borrowing from other banks in the interbank market at the rate the Fed sets. Or they can borrow from the Fed by putting up collateral. Generally, banks don’t come up short and get stuck with a penalty. They have a department dedicated to this. As Scott Fullwiler has said, all this involves minute by minute tactics to make sure that everything balances at the desired rate.

        • Michael Sankowski says

          This gets back to the fixed/floating fx through the management of the fixed fx rate.

          In a fixed fx regime, the central bank commits to defending an fx level. This means the cb will expand or contract potential reserves to defend this target. It must do this to defend the fx target.

          In a floating fx world, the central bank cares about defending a short term interest rate. To do this they must make reserves available when requested otherwise the short term interest rate would rise above their target.

          I think this is what Mosler means when he refers to hard endogenity. If you fix one, you need to let the other float. You can’t defend both at the same time.

        • wh10 says

          remember that RR aren’t inherent to banking systems (e.g. Canada doesn’t have them). to simplify, take them out of the picture. then transactions just need to clear. the Fed can choose if they want to charge banks interest on such overdraft transfers.

        • Dan M. says

          Ok… now I know Cullen has already tried to explain this, but why would paying interest on reserves induce banks to lend more as opposed to less? Interest on reserves, it would seem to me, would induce banks to want to hold reserves, or not loose depositors to other banks… I don’t see how it would affect lending though.

          I’ll get there, guys.. I promise.

        • Cullen Roche says

          Banks make loans based on how profitable it is to make loans. Banks make money based on their net interest margin (well, at least pure banks do). IOR is not intended to bolster or reduce lending. It’s a policy tool implemented by the Fed that allows them to flood the system with reserves and still maintain control of the overnight rate. The Fed Funds Rate would sink to 0% if they didn’t pay IOR. So it’s best to think of this measure as a sort of emergency policy in case the Fed’s balance sheet is still large and they need to raise rates. In that case they’ll raise the IOR so this essentially serves as a de facto FFR. But it doesn’t stop banks from lending. What stops banks from lending is when it’s not profitable or excessively risky to make loans. IOR actually sucked about 70B in interest income out of the banking system so there’s an argument to be made that this policy hurts lending in that it makes banks less profitable. But there’s a counterargument that QE has added substantial stability to bank balance sheets by removing some toxic assets. So it’s probably a wash in my opinion. Regardless, banks make loans based on their capital position. Not their reserve position. And while 0.25% is a nice little subsidy it’s not making or breaking the banks. And in some cases, it’s marginally hurting since the Fed is taking a 3% int bearing piece of paper and replacing it with a 0.25% piece of paper. Bank would MUCH rather supplement this with higher interest earning loans since their net interest margins are declining….So they’re on the hunt for creditworthy customers just like they always are. The problem is getting the customers to walk in the door.

        • Cullen Roche says

          They’re trying to change the point on you guys Tom. Don’t let them off the hook that easy. :-)

        • Tom Hickey says

          I think this has a way to run, Cullen. Ed Harrison is just up with a drill down post at Yves’ place. I think that the debate is progressing, and I expect Nick will engage at WCI, too. Krugman? He is kind of in a bind here, it seems to me. His escape is to stay very theoretical and say he isn’t concerned with tactics (ops). He has already done that to a degree, and that will be his fall back position.

        • Michael Sankowski says

          That’s what wh10 means. The overdraft “creates” reserves. An overdraft is a short term loan with a penalty (think “interest payment”) set by the fed.

          But I am having a hard time thinking through the fixed floating fx well enough to explain it. But it seems in a floating fx world the fed has to allow overdrafts making reserve requirements irrelevant, while in a fixed world, they enforce the quantity of reserves.

          You’ll either have endogenous interest rates or endogenous money, depending on the fx regime.

        • Cullen Roche says

          Yeah, with fixed FX the money supply can’t just expand and contract because JP Morgan wants it to. Instead, JP Morgan has to fight CitBank for the reserves. But we obviously don’t live in that world. The Fed just supplies the reserves to meet the expansion in credit creation.

        • wh10 says

          Right. Good point. Okay I am not sure about this but here goes. I think he is saying reserves are an artifice of the system. Eliminate the vertical channel. Pretend there is only a horizontal system of credits. Bank A creates a loan and deposit. Bank A then needs to transfer that deposit to Bank B. The transfer needs to clear on the books of the Fed. The transfer creates something artificial – we call them “reserves.” It’s the choice of the Fed, the master bank, to set the price of that overdraft resulting from the transfer to Bank B…

          Does that make any sense???

  5. AndyCFC says

    Cullen Roche
    Yeah, we’re worried about Mexico also. Hence the Mexican wrestling masks. Just kidding. You’re right. This is a global movement and the face of this thing does need a global presence. Galbraith is not that well known outside the USA and Marc isn’t either. I wish Jamie would be more active writing. He’s not nearly as famous as he should or could be.
    Getting Martin Wolf on board would be nice. Got anyone from the UK whose hat you can throw in the ring?

    lol is there a mexican PK movement btw? on a more serious note shame we dont get more non anglos, why is that? (Ramanan an exception of course but in this context would treat him as anglo) Wolf yeh, Goodhart maybe but thats about it, considering its descended from JMK (and the original PKs being at cambridge) im thinking wtf happened or didnt happen more to the point,

    • beowulf says

      If you mean culturally, It might have something to do with we’re all writing in the English language. And if you mean ethnically, we Americans are mutts. Just like Law and Order actor Benjamin Bratt and confessed killer George Zimmerman, I’m half Peruvian myself.

  6. AndyCFC says
      • Cullen Roche says

        So now the whole conversation has devolved into nonsense. Even Thoma is responding with negative rhetoric. What a waste of time.

        • Michael Sankowski says

          This is actually a huge setback. Back to the minors for PK for a few years. Get Marc and Jamie back out in front. :(

        • AndyCFC says

          Maybe Mike maybe not, would everyone get behind either Marc or Jamie? it seems nearly everyone would support SK, if this was politics (well really it isnt far from it is it) he seems the perfect candidate from the PK/MMT world.

        • beowulf says

          Wait, isn’t Keen a horizontalist? I didn’t think he was fully on board with MMT.

        • AndyCFC says

          Exactly B, this started between SK and Krugman, and as has been pointed out it was MMTers mostly ripping into Krugman in support of SK.
          Look at what Ramanan said he in this case supports SK, you have a whole lot of different groups in the PK world supporting him. Noone is going to be perfect to everyone but it doesnt work like that, even us MMT supporters would compromise (yeh shock isnt it lol)
          This whole row was going to happen sooner rather than later, im not that surprised its come from SK watching him over the last couple of years though,

        • Cullen Roche says

          Keen’s too extreme. My vote is still for Mosler to take a much more active role in writing these definitive response pieces. He’d need an editor though. :-)

        • Michael Sankowski says

          I totally agree about the editor. Philip P has been a good match for Warren. I really wish we could get PP on board, but he’s 80% commie! 😉

        • Michael Sankowski says

          Keen is too touchy. He’s extreme too. Mosler is a very friendly guy and people like him, plus you can say crazy stuff to Warren and he doesn’t get angry.

          Because Warren isn’t officially an economist, he’s less threatening. I’d agree- get Warren to write these pieces. I am surprised he’s not talking with Soros more. MMT, PK and reflexive thinking have more in common than anything else, and Soros is a pragmatist.

          Jamie is the unofficial leader of the insurgency, and lots of people like him in the profession.

          Marc seems likes PK’s Woodford to me.

          JKH – well, I am biased! 😉

          Scott’s response to Paul was fantastic.

        • beowulf says

          “Jamie is the unofficial leader of the insurgency, and lots of people like him in the profession.”

          Agreed, and he’s been politically active for years. He knows more about politics than anyone else in economics and more about economics than anyone else in politics. I’d vote for him. :o)

        • AndyCFC says

          But how many people know him outside of North America… sorry guys but this isnt just about USA & Canada.

        • Cullen Roche says

          Yeah, we’re worried about Mexico also. Hence the Mexican wrestling masks. Just kidding. You’re right. This is a global movement and the face of this thing does need a global presence. Galbraith is not that well known outside the USA and Marc isn’t either. I wish Jamie would be more active writing. He’s not nearly as famous as he should or could be.

          Getting Martin Wolf on board would be nice. Got anyone from the UK whose hat you can throw in the ring?

        • AndyCFC says

          As it happens Cullen i would prefer Warren as well, noone is going to be perfect for everyone its always going to be some sort of compromise. A lot of the PK crowd arnt going to want an MMTer.
          But SK has support elsewhere in the world, take a group like renegade economist over here they show lots of his stuff.

        • Cullen Roche says

          How about an MMRist from Canada? I nominate JKH!!!! :-)

        • AndyCFC says

          But theres only a couple of you who know who he is pmsl!
          seriously though, extreme on or not SK has a lot of support and im English supporting an Aussie you really dont know how much that hurts me to say :)

        • beowulf says

          Yes but to continue hiding his identity, when he appears in public he’ll have to wear a Mexican wrestling mask. Some economists (fairly or not) might find that off-putting.

        • Cullen Roche says

          He’s in Mexico right now. I’ll tell him to grab one before he comes back. :-)

        • Ramanan says

          The Neoclassicals or whatever their school of thought is (NKE, RBC or whatever) and just the same … just some slight tweaks from each other. They have changed the topic about what NKE is or what NC is … what a waste of time!

        • Michael Sankowski says

          I found it a bit odd Thoma was making such a big stink bout the difference between NC and RBC, because it seems to me NC is so dang close to RBC it’s like talking about pink vs. light red flowers.

        • vimothy says


          I guess it’s a matter of perspective. NK DSGEs are closer to RBC DSGEs than, say, Godley style SFC models. But there are still pretty important differences between the two.

        • vimothy says

          Yes, it’s silly because the jist of what Keen says is not correct in exactly the sense Nick meant–in the models that dominate macro, it’s not necessarily the case that perfect competition is assumed and equilibria are efficient. You can call those models “DSGE” or something else if you’d prefer, but that doesn’t change their essence.

          But instead these guys are now making strained arguments about what constitutes a DSGE.

        • Ramanan says

          I believe Keen said these are just tweaks to the same old same old.

          Seen this

          I find troubles with Keen’s models but except for that, I support him on this.

          IMO, Krugman just found a “Oh I am done with this” … escapism…

        • vimothy says

          If you forget about the word “DSGE”, Keen makes three claims about the models that “dominate neoclassical macro”. It seems to me that Nick is correct in his criticism of Keen’s claims, with or without Keen’s strange and contradictory qualification.

          Let’s take the efficient equilibria claim. In the models that dominate macro, equilibria are not necessarily efficient. Keen can of course call this a “tweak” if he chooses to but it actually totally contradicts his claim #3.

          The argument about what constitutes a DSGE is boring and semantic, though.

        • Ramanan says

          “Did you catch it? It makes all the difference. Keen is talking about the core DSGE model at this point in his conversation not New Keynesian versions which throw a little sand into the DSGE gear box to get a little friction and sometimes that includes money. Look if I know the basic differences between New Keynesian modified DSGE models and the core DSGE model then Keen certainly does”

          – that’s from the post … which sums up …

        • vimothy says

          Ram, That seems like quite a semantic argument.

          What’s the real issue here? Either it’s true that, for example, equilibria are socially optimal in the models that are important for mainstream macro, or it is not.

          As it happens, it is not, Keen describes structure that produces this effect as a “tweak”, which I take to mean a superficial change that does not affect the underlying logic of the original RBC model.

          Keen’s argument appears to proceed as follows:

          1, The optimality properties of the cycle in an RBC model are unrealistic;
          2, Models that don’t have this property are just as unrealistic because mumble mumble.

          This doesn’t make much sense. If socially efficient equilibria are a bad thing to have as a necessarily effect of your model, then we should do away with them, Given that they have been done away with, we can hardly criticise models that do not have them for having them. And Keen’s three “underlying principles” reduce to two.

    • Cullen Roche says

      Keen’s post is self defeating and he doesn’t even know it. He might as well have called Krugman a “doodoo face” and stopped. It would have saved him a lot of time.

  7. BT says

    Nick Rowe admits his mistake:

    Nick Rowe on April 3, 2012 at 4:49 am said:

    Just for the record: I did not email Paul Krugman. That’s not what “Nick Rowe sends me to…” means. Any “communication” between me and Paul Krugman is right there on the blogs.

    Yep, I learned later that Steve Keen had partly qualified what he had written a few paragraphs further down. I should probably have kept reading rather than getting mad at that point, stopped reading, and firing off my comment.

  8. Detroit Dan says

    IS-LM is complete bullshit, yet that’s what Krugman always resorts to. MMT (and MMR) are much better at describing the workings of the modern economy. Krugman is part of the problem…

    • Dan M. says


      IS-LM and PK are telling us, for the most part, the right things that we need to be doing right now in the economy. The loanable funds model may not be correct, but it’s an intutive way to get people to the right conclusion about what needs to be done and what we have the flexibility to do… even if it’s for the wrong reasons or not correctly describing our economy’s limitations.

      At this point, I’ll take a loanable funds model if that’s what people will understand.

      He’s absolutely not part of the problem. He points out the true problem almost daily (Paul Ryan, etc).

      • beowulf says

        I agree with you Dan M.
        MMTers need to be proposing solutions and then explaining to the Krugmans and the Rowes of the world why it would be sound policy even under their own worldviews. Sometimes its easier to change reality than to change anyone’s mind.

        • Pierce Inverarity says

          Cobb: What do you want?
          Saito: Inception. Is it possible?
          Arthur: Of course not.
          Saito: If you can steal an idea, why can’t you plant one there instead?
          Arthur: Okay, this is me, planting an idea in your mind. I say: don’t think about elephants. What are you thinking about?
          Saito: Elephants?
          Arthur: Right, but it’s not your idea. The dreamer can always remember the genesis of the idea. True inspiration is impossible to fake.
          Cobb: No, it’s not.

        • Michael Sankowski says

          People are still wondering about the reasons we started MMR.

          Let’s see…

          Economic reasons:

          1. CAD
          2. Keep some focus on private sector interactions
          3. Domestic production is worthwhile

          and let’s not forget

          1. PK’s are…unsociable
          2. the JG can’t happen

          We like it when more people are working, even if my preferred policies are not enacted.

        • Dunce Cap Aficionado says

          SUPPLY SIDER!!!!!!!! :(

        • Dunce Cap Aficionado says

          Agree. Perception is reality.

      • Dan Kervick says

        The loanable funds model may not be correct, but it’s an intutive way to get people to the right conclusion about what needs to be done and what we have the flexibility to do.

        I don’t think this is quite right Dan M. The loanable funds model leads people to believe that the Fed can eventually boost bank lending if they just shove enough additional reserves into reserve accounts.

        And look at the interest on reserves issue. The loanable funds model leads people to believe that a bank’s reserves are the bank’s stock of money available for lending, and that interest on reserves causes banks to hoard those stocks. They also think IoR exacerbates the “liquidity trap” which is supposed to be another reason banks are hoarding reserves.

        But this is just wrong. Banks don’t make loans by going into their reserves vault and taking some reserves out to lend to people.

        • Dan M. says

          So if it’s good for lending today to pay interest on reserves (I still can’t figure this part out), then is it good to pay higher rates on t-bills?

          If not, why not?

          Sorry. This is very foreign stuff for me.

        • Dan M. says

          To be clear, I am of the understanding that lowering tbill rates gives banks and savers lower risk free rates in the market and make it more likely for them to lend cheaply, invest in stocks or otherwise increase the velocity of money.

          Why interest on reserves would be different is beyond me.

      • Detroit Dan says

        Mighty low standards, Dan M.

        I’ll stick with the MMT folks who know what they are talking about.

  9. wh10 says

    lol here is Alan Blinder today:

    “Remember “conventional” monetary policy? The Federal Reserve shortens recessions by creating more bank reserves (“printing money”), which fuels a multiple expansion of the money supply and credit because banks don’t want to hold excess reserves. So they get rid of them making more loans and deposits, which also lowers short-term interest rates. Compare that to current reality: Banks are content to hold over $1.6 trillion in excess reserves, short-term interest rates are stuck near zero, and Fed policy often works on long-term interest rates instead. No, this is not your father’s monetary policy, and the old ways of teaching about it simply won’t do.”

    • Ramanan says


      But Paul Krugman has an answer – liquidity trap!

  10. Detroit Dan says

    Well’s here what JKH had to say:

    “My God.
    K really doesn’t understand banking operations, does he?
    He’s really exposed himself here.”

    It’s hard not to be condescending, or something, when you’re dealing with someone who has been exposed as a fraud…

    • JKH says

      Ironically, my usual mode in the past has been to try and find a bridge to Krugman`s view for the same reasons as Cullen points out. I`ve also defended or explained MMT technical views in commenting on his blog.

      This one is different because of his point on currency. Neoclassical economists seem to have a blind spot on this, something about controlling the quantity of currency outstanding. And its important, because in normal times it constitutes most of the monetary base. This point is something on which Krugman, Rowe, and Sumner are all aligned.

      For me, its the point of inflection at which both ISLMers and monetarists should be pulling back and acknowledging the facts on the ground as a constraint on their models. ISLM in particular can be adapted to most facts in a flexible way, and Krugman is highly skilled at doing this.

      But I think one thing the financial crisis demonstrates is that bank reserves and currency should be treated as remarkably heterogenous components of the monetary base. The blurr doesn`t work particularly when trying to adapt old orthodox theories to explanations of existing monetary operations.

      • Greg says

        Question for you JKH regarding currency. This comes after reading Scott Fullwilers post over at Naked capitalism. He had this to say in his post

        “Actually, withdrawing funds—spending them, in other words—via check or electronic transfer is far and away more common than withdrawing via currency”

        Is he saying that a withdrawal via currency is operationally spending? Ive never heard this stated in this manner and if this is true it explains a little of the monetarists fears to me.

        • JKH says

          He´s associating cheque writing directly with spending, which is reasonable.

          Although spending is separate operationally from the bank account debit that follows subsequent to cheque writing and presentation.

          In a reversal of that order of things, currency withdrawal is separate operationally from the spending that follows it.

        • JKH says

          He´s associating cheque writing directly with spending, which is reasonable.

          Although spending is separate operationally from the bank account debit that follows subsequent to the cheque writing and presentation.

          In a reversal of that order of things, currency withdrawal is separate operationally from the spending that follows it.

        • Greg says

          So I was reading too much into his statement.

      • JKH says

        Massive dysfunction also in the use of the word ¨target¨across all camps who are interested in this stuff.

        And the dysfunction is nobody`s fault in particular, because nobody has a monopoly on the meaning of that word in context. Better always to clarify context before using the word.

    • Dan Kervick says

      He’s not a fraud. Brilliant people can be wrong about many things. But they should have the decency to give a hat tip when the errors are corrected, instead of continuing to mock and deride the critics as “wasting their time”, and insisting on enforcing the in group pecking order.

      Anyway, he did link to Scott’s post, and I think any fair reader who contrasts Scott’s care and accuracy with Krugman’s earlier goofs will know what is going on.

    • Cullen Roche says

      Well, I’ve certainly been guilty of saying things like this in the past, but I just think it’s unfortunate that we seem destined to remain heterodox just because we can’t be more agreeable. I just think it’s something we should all be more cognizant of.

      • JK says

        Between MMT and MMR, I don’t see any value in the condescension. It’s a big distraction.

        But there may be some value in sending the attack dogs on Krugman. It’s like that phrase “no news is bad news.” (or is it “all publicity is good publicity” ?) Whatever. There definitely is some downside to attacking Krugman and making him look like an idiot (he might begin to ignore us), but that doesn’t mean there isn’t any possible upside, too. Krugman probably has as many readers as any economist in this country. Making a big fuss of Krugman being wrong may capture a lot of his reader’s interest. Who are these people possibly proving our beloved Krugman wrong?

        (anecdotally: this is how all of you won me over. I was a big fan of dean baker. about 8 months ago I came accross an MMTer putting the screws to him. This captured my interest… and ultimately, over time, won me over)

        If his readers get a whiff of monetary sovereignty/mmt/mmr etc.. they’ll start reading up. and in time, challenging him.

        Better to sway the man with the megaphone and hope he converts, or steal his followers and hope they force him to convert? No one knows.

      • Erik V says

        Or you could spawn a generation of young MMR Econ Ph.Ds to take over all the major universities and educate the world in a proper manner…

  11. KainIIIC says

    Oh wow, check out this pile of turd that Krugman layed out:

    Basically, he didn’t take the time to read two paragraphs down where he made pretty much the exact same point that Krugman harped against. I like Krugman, I really do, but I’m really starting to realize what people say when they say that PK is his own worst enemy. He seems to be melting down a bit.

    • Cullen Roche says

      It’s too bad because his critics have responded in such a demeaning manner that he’s just tuning them out. Fullwiler’s post at NEP was very good, but condescending as hell. If I’d won a Nobel in econ and read that I would have stopped after the title. Keen has the same approach. It’s not conducive to agreement and is really unfortunate because this was a great opportunity to find some common ground with PK….Instead, he’s being driven towards the monetarists.

      • beowulf says

        Agreed. Its funny how crowds would rather stone someone who agrees with them 90% of the time instead of those who agree with them 0% of the time.
        Paul Krugman may be wrong about this, that or the other but he’s sharp as hell, no other economist is more widely read and no other national columnist knows more about economics.
        So what’s the point of MMTers piling on a guy who is in sync with most of their positions? (hell, I wouldn’t be surprised if he was a fan of New Deal-style job guarantees). This is not how to win friends and influence people.

        • Dan Kervick says

          Actually, I don’t think there is piling on. Krugman has gone out of his way on this occasion to sneer at and attack both MMT and the other post-Keynesians in a series of posts. He then classlessly backed off from some major points he was clearly wrong about, while mocking his critics as the idiots and pretending he was right all along. So his readers deserve to hear the other side of the story and take the measure of his pontifications and vanity.

        • Nell says

          I appreciate your position and it is off putting when an important point of debate descends into a playground fight. However, I think you are mistaken in the believe that this is an argument that can be won by logic. I think that mainstream economists, particularly well-known and highly regarded mainstream economists behave more like religious believers than scientists. There is no logic that can convert them, because to convert they have to renounce not only their models, but their position in academia and the business world. Yes we should behave politely, but not to convince economists like Krugman, but to avoid alienating those who are learning from the debates. For example, I found SFW’s post most illuminating. As I did your post above. The graph is very helpful.

        • Cullen Roche says

          Agreed. That’s why MMR is trying to remove politics. We’re trying to make this as close to scientific as possible. If we can hammer out how the system actually works and offer people a better understanding then they can’t argue with certain conclusions on political grounds. That’s our approach at least. Clearly, it’s not an easy one to take, but it’s a fight worth fighting.

        • vimothy says


          I think those are wise words and very reasonable.

          Something else to bear in mind is that Krugman is not a macroeconomist or a monetary economist. His field is international trade. He’s not a particularly technically minded economist, and he hasn’t done a lot of research in recent years (AFAIK)–instead he’s got a brilliant sense of economic intuition, and an ability to communicate that intuition in a clear and understandable fashion. Hence the blog.

        • Ramanan says

          I seriously disagree with the intuition part.

          For Krugman money is exogenous. I really like Scott’s post taking him to task – maybe some commenters on Krugman’s blog misbehaved – I haven’t checked but hear a lot of people saying that. The fact that Krugman says things outright wrong and comes to say it is straightforward shows his weakness.

          What Scott wrote are not unimportant technicalities. It is important and fundamental…. but Krugman writes a post on a “teaching moment” !!

        • vimothy says

          Right–but why should someone in international trade who doesn’t really keep up with modern research have a modern view of the economics of money?

        • Ramanan says

          Monetary economies have always behaved in a way.

          A physicist working in rocket making cannot ignore Newton’s laws and insist that Aristotle’s world view is better and write a teaching moment post on Aristotle’s laws! :)

          Krugman has written a paper on Eggertson on debt which is where the debate began but that’s close to Monetary Economics …

          You are arguing he hasn’t kept himself updated – but that sort of thing is more like updating oneself on improving the efficiency of a car etc. That sort of discussion may be important if one knows how to make a car – if one doesn’t even know how a car runs … being updated is a secondary thing.

        • Ramanan says


          I think Keen was quite right in taking Krugman to task and Krugman responded by saying things which proved that Keen was right about Krugman and his view of money exogeneity!

        • vimothy says


          I’m not sure how I feel about that post–I’d have to go back and read up on everything that has gone before it and I don’t have time to do that. It might well be the case that Krugman is overreaching; alternatively, he might have a reasonable point that his opponents don’t see because they don’t understand where he’s coming from.

        • Ramanan says


          True a train mechanic may not be up to date with what is happening with cars but if he understands it by Aristotelian principles then he neither knows how to fix the car nor the train.

          Worse is if he writes a blog on a teaching moment on how cars work!

          Sorry don’t follow your part regarding institutional features.

        • wh10 says

          Yeah I’ll admit I’ve become a bit flustered.

        • vimothy says

          wh10, Not sure. I’d guess that I agree with you guys on some stuff and with Nick on some other stuff. Haven’t followed this too closely though.

        • wh10 says

          Vimothy, you aren’t on Nick Rowe’s side of the debate here?

        • vimothy says

          R, A mechanic who works on trains might not know how to repair a car, though. Why should he?

          One of the things that I haven’t seen in this debate is an argument for why Eggertsson & Krugman 2011 should have a different model of banking, and what that model should look like. Instead the arguments have centred around what specific institutional features actually are in reality, without tying those institutional features into any economic theory. I haven’t followed particularly closely, so could you perhaps point me at a blog where someone lays this out? Cheers.

        • Cullen Roche says

          Krugman isn’t pointing out how to fix the train. He’s describing how it works (incorrectly). Ray Dalio uses the machine analogy often. Not because we need to know how to fix the machine in case it breaks down, but because we need to understand how it operates so we will know how it navigates certain environments.

        • Michael Sankowski says

          Yep, this was a massive setback for MMT. :( Nick is a nice guy too.

          Many people are wrong on the internets. It happens all the time.

        • Cullen Roche says

          Talk about an air ball. The heterodox schools are given a HUGE window of opportunity to engage the good professor and this is how he comes away from this feeling:

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

          He’s so fed up he’s not even going to explore something that we probably could have gotten him to be open minded about….The mentality of the heterodox schools needs to change. Otherwise, we’ll always be on the outside looking in….I bet he tries to never mention Keen or MMT again….

        • Detroit Dan says

          Right. It’s our fault that Krugman doesn’t know what he’s talking about. That is a really poor justification, Cullen. You’re basically saying that you care more about appearances than substance. That seems to be the way MMR is going…

        • Cullen Roche says

          Geez Dan. I am trying to bring some calm to these discussions and you’re responding to my comments with the same thing that drives people away from all of us. I never said it was our fault that PK misunderstands these facts. But if we want him to learn from us then it’s our responsibility to reach out in a manner that doesn’t distract from our point and turn him off. Ie, don’t respond like you just did to me…..

        • Dan M. says

          To be fair, he completely bungled the Keen quote, and a bunch of people called him out for it in the comments section in direct, if a bit rude, ways…

          I think he’s on the right side of all this, but he can be a bit arrogant. He probably got offended, but I’ve heard MUCH worse said about him that he doesn’t mind rebutting, simply because most of the people who attack him (the Austrians) don’t have much idea what they’re talking about in terms of macro, and he has fun picking the low-hanging fruit. This obviously isn’t low-hanging fruit. He was way off, and I think he knows it, and THAT is the main reason he’s disengaging the conversation… not because someone was too mean.

          At least that’s my analysis based on the arguments I’ve seen him approach in the past.

        • Cullen Roche says

          I think the key thing we have to realize when debating someone like PK is that he has nothing to lose. No one is going to look at Krugman and say “oh, he’s a crappy economist because he doesn’t fully understand banking”. Whereas we have everything to lose by coming off as jerks when we basically write hundreds of comments calling him an idiot rather than trying to win him over. And we’ve won nothing through these debates….And he’s lost nothing except the respect of some heterodoc thinkers (which he never had in the first place).

        • John Carney says

          This is a very important point.

          I really do think the MMTers didn’t handle this very well. I tried to give some of them advice on how to proceed rhetorically. Seems to have fallen on deaf ears.

        • Detroit Dan says

          He is not “sharp as hell”. He’s very dull as far as I can tell. What has Krugman ever contributed to economics?

        • beowulf says

          Dan, he wasn’t awarded a Nobel Prize for his charm and good looks.

        • Detroit Dan says

          I know Krugman has a good reputation, but in economics it seems that reputation is not a guarantee of brilliance…

        • Detroit Dan says

          Politically, I agree with Krugman most of the time. However, as JKH said, he’s been exposed as not knowing the fundamentals of banking operations, which are in turn fundamental to macroeconomics. And he lashes out at those who know more than he does with “wonkish” bullshit.

          So he’s net minus as an economist. Time for him to get out of the way…

      • KainIIIC says

        It’s true. The more argumentative that you get, the more defensive you get. That post was so defensive that he forgot to read anything past it, which made the exact same point as he made. Let’s face it though, economists tend to have big egos, whether it’s Krugman, Keen or Cochrane. That’s probably one of the downfalls of the ‘dismal science’.

  12. Erik V says

    Krugman’s arguement is that the Fed could change they way it conducts policy in the future and therefore we should not consider our current monetary system as “some kind of fundamental law about how monetary policy does or doesn’t work”. That’s fine. Any MMT/Rer would acknowledge the Fed could theoretically stop supplying the reserves required to meet its target rate and let the Fed funds rate do what it would. But that would be a different monetary system than the one we have. Seems like much less disagreement that he wants to admit.

    • Dan M. says

      I agree… really do… but I still think there is a “constraint” there. In aggregate, the banking system has no “overnight market” it can access (on a macro level). Therefore, as the banking system as a whole approaches their reserve requirement, they will start having to pay interest on the reserves that they’ll now need to borrow from the fed.

      I can’t imagine that that event (the banking system having to go to the fed window) isn’t at least SOMEWHAT of a “constraint.” I’m probably way more MMT than PK on this, but I still think that saying “banks aren’t reserve-constrained” is a BIT of an exaggeration… maybe I’m wrong, though.

      • Erik V says

        You’re not far off from understanding it. The constraint is a soft constraint (price), not a hard constraint (quantity). The quantity of reserves will always be sufficient to fufill reserve requirements, no matter how many loans banks originate. However, if the Fed started raising the Fed funds rate (and Discount window rate), then other short term rates would rise and the spread on bank lending would become less profitable, which may lead to less credit creation. Banks could try to maintain profitability by increasing the rates on loans, but borrowers may (and at some point definitely will) demand less credit at higher rates. So the Fed can influence credit creation, but as long as it is profitable, banks can create as much as they want.

        • Dan M. says

          Ok, I think we’re in agreement, then… I guess it comes down to semantics of the word constraint… and the quantity vs price thing helps a lot with visualization.

  13. Dan M. says
    • Cullen Roche says


      Just got around to the STF piece. He’s as sharp as ever. Not surprisingly. This is his arena and you’d be a fool to challenge him in it. :-)

    • Dunce Cap Aficionado says

      I read that and I’m not entirely sure what he’s getting at. Can anyone breakdown what PK’s saying there? He seems to be saying ‘Fullwiler’s wrong because at one time the ‘cost’ of getting the reserves in the overnight market fluctated wildly.’

      But he’s not an idiot so I must be reading him wrong, because that in no way prevents banks from obtaining reserves.

      • Cullen Roche says

        He seems to be making the argument that if the Fed doesn’t supply the funds then the banking system will seize up. But he seems to be missing the fact that the Fed’s job is to ensure smooth functioning payments. So they’d essentially be in violation of their responsibilities by not doing this….It’s not a strong position.

        • Dunce Cap Aficionado says

          Odd, it strikes me as very Tea-party-ish (not in nature but in attitude). That argument is based on the idea of either a potential and massive mismanagement or outright malevolence on the part of the CB.

          Not PKs usual style. (also, Thanks Dan M. for your reply too!)

      • Dan M. says

        Like I said at Pragcap, it seems to me that the bank is taking on additional risk to secure funds from the fed than if they were to simply hold reserves, so there is some form of “constraint” to their lending because all of a sudden they have a line of credit liability that 1) costs them more money than the reserves they hold, and 2), could go up in price.

        I’m probably viewing this wrong but that’s my 2 cents… for now.

    • Cullen Roche says

      PK is just assuming the CB won’t supply funds if needed? It’s the CB’s job to ensure a smoothly functioning payments system.

  14. Dan M. says

    I’m very glad PK and MMT/MMR are hitting on this point, because it’s one area I feel like I still have left to 100% understand… before MMT, I loved the loanable funds model in terms of thinking about when the gov’t can borrow and what affect on business lending it was actually having, as well as what a “fair rate” of return people should be getting on their savings.

    A couple questions:

    1) If banks don’t need reserves, why did they offer us any interest at all? Further, if the fed window is an option, why would they ever offer depositors a higher rate of interest than the fed window charges them?

    2) Can you please explain more of the importance of this “overnight rate” and managing that? Why don’t we just tell banks what their reserve requirements have to be and call it a day? Why do we have to manage the risk-free rate?

    • Cullen Roche says

      Banks want cheap liabilities. Banking is a business of spreads. So they need to attract the cheapest liabilities possible. This generally involves deposits.

      Well, the overnight rate is now the IOR rate. Interest on reserves. It serves as a de facto FFR. But without IOR the central bank had to remove reserves to hit its overnight rate. Otherwise, it would decline to zero….

      • Dan M. says

        Can you back up a bit and explain to me a bit more like I’m a 15 year old on the second paragraph? What is the purpose of an “overnight rate” in modern finance? I really have little-to-no idea what the function of this “overnight rate” is or why it needs to be “managed.”

        • Cullen Roche says

          The O/N rate is the rate at which banks lend/borrow overnight. So, if a bank doesn’t have enough reserves it can borrow in the interbank market at the overnight rate generally.

        • Dan M. says

          Why does this need to be managed by the fed? If in aggregate no reserve amounts can increase, shouldn’t banks just figure that out on thier own based on prevailing interest rates and risk?


        • Dan Kervick says

          That’s the Fed’s tool for regulating lending. If the economy were overheating, they would target a higher rate. Commercial banks would have to charge higher rates in turn to maintain a profitable spread between the cost of reserves and the return on the loan, and in principle that would cool down the pace of lending. Similarly, if the economy is sluggish, the Fed could target a reduced overnight rate, which brings about reduced commercial rates as banks compete for a dwindling market for loan customers.

          This mechanism breaks down when the Fed Funds rate is at to the zero bound, because they can’t go lower. That’s one reason they have moved to paying interest on reserves – as a zero bound tool. Paying interest on reserves reduces the cost of acquiring the reserves. If the Fed Funds rate is near zero and the Fed pays interest on positive reserves, then the cost of the reserves is negative. So by paying interest on reserves, the Fed can pierce through the zero bound.

          Some of the mainstreamers have this precisely backward. They think banks lend their reserves, so interest on reserves reduces the incentive to lend. But actually, interest on reserves allow banks to charge even lower interest and maintain a profitable spread. So in theory they should stimulate lending.

        • Dan M. says

          I have been thinking about this… Why would an overnight rate on something that doesn’t restrain lending affect lending unless the banking system were to be running close to its reserve requirement?

          I just don’t see how giving banks interest on reserves would affect their willingness to lend when they’re capital, not reserve, constrained…. Thanks!

        • Cullen Roche says

          The flaw in the Fed’s balance sheet expansion is that it’s actually reducing the net interest of the banks even though it’s reducing some risk (for instance, removing the MBS junk helped the banks enormously at least at first). So the Fed has actually reduce net interest margins (reserves earn less than govt bonds), but has taken some risk off the banks at the same time. I really don’t think this is having a huge impact on the lending channels, but played an important role in stabilizing the markets and the payments system in 2008/2009. At the end of the day banks lend when creditworthy customers come in their doors. Just like an apple salesman sells apples when people want apples.

        • Dan M. says

          Wow. Just… Wow. Thank you.

        • Cullen Roche says

          If it was left to the banks the rate would be bid down to 0 as they all tried to get rid of their reserves. The Fed always manipulates the rate UP in order to set monetary policy.

        • Dan M. says

          Why would banks try to get rid of their reserves to such a degree? What if we simply set a reserve requirement, and not use rates to try to tempt them into holding reserves?

          Sorry for all the questions on this… this is one area I always feel like I have no idea what MMT/MMR is talking about… or at least not enough.