I’m rather lucky with the calibre of my blog members, and that’s been in evidence in the discussion over Krugman here in the last few days. One comment by Andrew Lainton simply has to be shared more widely:
Welcome to London Steve
I hope people have spotted that Krugman isnt simply proposing a loanable funds approach to banks, where loans are based on the inflow and outflow of savings by saying that banks ‘must buy assets with funds they have on hand’ he is going back to a mid 19th century wages fund theory. Krugmans world isn’t even Ptolemaic, the world doesn’t even turn and time doesn’t exist.
In such doctrines transactions are all paid out of a pot of money ‘on hand’. A stock. But this doctrine was disproven as early ago as the 1870s by Krugmans equivalent as America’s most famous economist, Francis Amasa Walker:
Walker proved that it is future anticipated cash flows rather than initial stocks of cash which form the basis for economic decisions. Investment decisions are based on anticipated profits. Furthermore investment allows for the creation of additional employment to be employed in activities which generate growth. Rational economic decisions therefore are not constrained by cash on hand but by the ability to see cash advanced to be repaid by growth and future cash flows to the investor and his creditors.
This led to his successor FW Taussig Developing the modern theory of credit money ( independently of Hawtry in the same year 1919):
Page 357: ‘Money Means are created, and the command of capital is supplied, without cost or sacrifice on the part of any saver’
It is precisely because of the payment of interest from future cash flows that bankers can credit credit with accounting operations only, all a bank needs to do is ensure that overnight it remains net cash positive, and if it would not be various interbank and central bank means are available.
It is if Krugman had regressed to the mid 19th Century forgetting most of the advances since. Even the most basic banking 101 book published in the last century has this balance sheet model of banking. Some with sophisticated mathematics, and yet since the 60s most mainstream economic textbook dont even have a chapter on banking.
The version of the multiplier so vociferously defended by Krugman is known as the Friedman-Swartz-Cagan Model — it is a monetarist idea and if you read Richard Koo you will see that the research that caused economists to use it — the claim that government high powered money drives the money supply is bunkum. Friedman-Swartz-Cagan is based on a mathematical identity, but makes a false assumption about the direction of causation. It became popular precisely because it enabled simplified treatment of money in macro. Indeed it could simply be assumed away by being folded into the IS/LM model. Thats why Krugman loves it it is simple but dangerous and wrong.
Ironically Phillip Cagan, who perfected the math of the model later estimated that 91% of US money was endogenous rather than government created.
What Krugman doesnt like his his favourite macro tools being slagged. But if he could be presented with new tools, or demonstrations of how old ones such as the Cagan identity could be recast he might be less grumpy. Steve needs to confront Krugman on his own ground, not Steves, Krugman ain’t going to go there.
Andrew has his own blog: http://andrewlainton.wordpress.com/.