European Disunion and Endogenous Money

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Steve Keen, Uni­ver­si­ty of West­ern Syd­ney
Matheus Gras­sel­li, Fields Insti­tute, Toron­to

It ain’t what you don’t know that gets you into trou­ble. It’s what you know for sure that just ain’t so.” (Mark Twain)


That the Euro has fall­en into cri­sis a mere decade after its intro­duc­tion is hard­ly sur­pris­ing. The intrin­sic prob­lems in its design were evi­dent to econ­o­mists as wide­ly sep­a­rat­ed intel­lec­tu­al­ly as Wynne God­ley and Mil­ton Fried­man. Writ­ing in 1992, God­ley observed that

The cen­tral idea of the Maas­tricht Treaty is that the EC coun­tries should move towards an eco­nom­ic and mon­e­tary union, with a sin­gle cur­ren­cy man­aged by an inde­pen­dent cen­tral bank. But how is the rest of eco­nom­ic pol­i­cy to be run? As the treaty pro­pos­es no new insti­tu­tions oth­er than a Euro­pean bank, its spon­sors must sup­pose that noth­ing more is need­ed. But this could only be cor­rect if mod­ern economies were self-adjust­ing sys­tems that did­n’t need any man­age­ment at all.

I am dri­ven to the con­clu­sion that such a view – that economies are self-right­ing organ­isms which nev­er under any cir­cum­stances need man­age­ment at all – did indeed deter­mine the way in which the Maas­tricht Treaty was framed… All that can legit­i­mate­ly be done, accord­ing to this view, is to con­trol the mon­ey sup­ply and bal­ance the bud­get…

If a coun­try or region has no pow­er to deval­ue, and if it is not the ben­e­fi­cia­ry of a sys­tem of fis­cal equal­i­sa­tion, then there is noth­ing to stop it suf­fer­ing a process of cumu­la­tive and ter­mi­nal decline lead­ing, in the end, to emi­gra­tion as the only alter­na­tive to pover­ty or star­va­tion. (God­ley 1992, pp. 3–4)

As the father of Mon­e­tarism (Fried­man 1969), Fried­man can be count­ed as one who did believe that “All that can legit­i­mate­ly be done is to con­trol the mon­ey sup­ply and bal­ance the bud­get”. Yet in 1997, he too dis­par­aged the prospects for the Euro, because Europe did not meet the require­ments for a suc­cess­ful cur­ren­cy union:

A com­mon cur­ren­cy is an excel­lent mon­e­tary arrange­ment under some cir­cum­stances, a poor mon­e­tary arrange­ment under oth­ers…

Europe’s com­mon mar­ket exem­pli­fies a sit­u­a­tion that is unfa­vor­able to a com­mon cur­ren­cy. It is com­posed of sep­a­rate nations, whose res­i­dents … have far greater loy­al­ty and attach­ment to their own coun­try than to … the idea of “Europe.”… goods move less freely than in the Unit­ed States, and so does cap­i­tal. The Euro­pean Com­mis­sion … spends a small frac­tion of the total spent by gov­ern­ments in the mem­ber coun­tries. They, not the Euro­pean Union’s bureau­cra­cies, are the impor­tant polit­i­cal enti­ties… wages and prices in Europe are more rigid, and labor less mobile. In those cir­cum­stances, flex­i­ble exchange rates pro­vide an extreme­ly use­ful adjust­ment mech­a­nism. (Fried­man 1997)

One might hope that, with econ­o­mists as dis­parate as God­ley & Fried­man able to agree that the Euro was always a bad idea, its unwinding—or at least the addi­tion of the miss­ing ele­ments from a gen­uine com­mon cur­ren­cy, such as fis­cal union—could also be eas­i­ly achieved. But cur­rent events indi­cate that Europe may per­sist with its unsus­tain­able sys­tem until the social col­lapse and polit­i­cal dis­uni­ty that God­ley and Fried­man antic­i­pat­ed final­ly destroys per­haps even the EEC itself.

There are many polit­i­cal rea­sons for this dogged deter­mi­na­tion to fol­low fol­ly to its end—including the dis­parate ben­e­fits and costs of the Euro to dif­fer­ent coun­tries, the inher­ent iner­tia in mul­ti-coun­try polit­i­cal agree­ments, and Weimar Repub­lic-based fears that fis­cal expan­sion will cause hyper­in­fla­tion.

But eco­nom­ic the­o­ry has also played a role, by pro­mul­gat­ing the belief that gov­ern­ment debt should be con­strained, while pri­vate debt can be left unmon­i­tored. This belief was entrenched in the Maas­tricht Treaty’s lim­its on pub­lic debt, and is being enforced today via the selec­tive impo­si­tion of aus­ter­i­ty pro­grams on the weak­er economies that are in breach of these lim­its.

Table 1: Selec­tive enforce­ment of Maas­tricht rules; coun­tries not in breach show in ital­ics (OCED Data)

Coun­try Debt 2010 Deficit 2012







































Slo­vak Repub­lic












The root of this belief is the Neo­clas­si­cal “exoge­nous” mod­el of mon­ey cre­ation, in which “noth­ing is so unim­por­tant as the quan­ti­ty of mon­ey expressed in terms of the nom­i­nal mon­e­tary unit” (Fried­man 1969, p. 1), the mon­ey sup­ply is deter­mined by the actions of the Cen­tral Bank, the lev­el of pri­vate debt is deter­mined by the sup­ply of and demand for loan­able funds, and pri­vate banks, as mere inter­me­di­aries between savers and bor­row­ers in the loan­able funds mar­ket, can be ignored in macro­eco­nom­ics.

Iron­i­cal­ly, though belief in this vision of mon­ey played a major role in the design of the Euro­pean Mon­e­tary Union, and it is accept­ed by Neo­clas­si­cal econ­o­mists who argue for aus­ter­i­ty as the solu­tion to the cri­sis, it is also adhered to by Neo­clas­si­cal crit­ics of aus­ter­i­ty. With unabashed hubris, this lat­ter group—the self-described New Keynesians—are now claim­ing to be vin­di­cat­ed by the cri­sis, while appro­pri­at­ing Hyman Min­sky and cast­ing them­selves as the future of eco­nom­ics in the process:

We econ­o­mists who are steeped in eco­nom­ic and finan­cial his­to­ry – and aware of the his­to­ry of eco­nom­ic thought con­cern­ing finan­cial crises and their effects – have rea­son to be proud of our analy­ses over the past five years…

So the big les­son is sim­ple: trust those who work in the tra­di­tion of Wal­ter Bage­hot, Hyman Min­sky, and Charles Kindle­berg­er. That means trust­ing econ­o­mists like Paul Krug­man, Paul Romer, Gary Gor­ton, Car­men Rein­hart, Ken Rogoff, Raghu­ram Rajan, Lar­ry Sum­mers, Bar­ry Eichen­green, Olivi­er Blan­chard, and their peers. Just as they got the recent past right, so they are the ones most like­ly to get the dis­tri­b­u­tion of pos­si­ble futures right. (deLong 2012)

The revi­sion­ism in this argu­ment is breath­tak­ing. As late as Sep­tem­ber 2009, Blan­chard was pro­claim­ing that “the stage of macro [by which he meant DSGE mod­el­ing] is good” (O. J. Blan­chard 2008, p. 210; O. Blan­chard 2009, p. 2). Krug­man, described here as work­ing “in the tra­di­tion of Min­sky” first actu­al­ly read Min­sky in May 2009 (Krug­man 2009)—and found what he read (Min­sky 1986) rather dif­fi­cult to fath­om. And non-Neo­clas­si­cal experts on Min­sky with a long pedigree—like Randy Wray (Lar­ry Ran­dall Wray 1988) and myself (Keen 1995)—were com­plete­ly ignored.

Though it is laugh­able, this revi­sion­ism should not be treat­ed light­ly. IS-LM analy­sis, which those who are tru­ly aware of the his­to­ry of eco­nom­ic thought know was a Wal­rasian mod­el mas­querad­ing as Keynes (J. R. Hicks 1935; J. Hicks 1981), was orig­i­nal­ly devel­oped in what pur­port­ed to be a book review (J. R. Hicks 1937) of The Gen­er­al The­o­ry (Keynes 1936). There is thus a prospect that a dis­as­ter caused in large mea­sure by impos­ing a Neo­clas­si­cal fan­ta­sy on the real world (the belief in self-equi­li­brat­ing mar­kets) and which is being ampli­fied by impos­ing yet anoth­er Neo­clas­si­cal fan­ta­sy (aus­ter­i­ty as an eco­nom­ic stim­u­lus) will be used to entrench still a third Neo­clas­si­cal fan­ta­sy as the pin­na­cle of post-cri­sis macro­eco­nom­ics (exoge­nous mon­ey and a neo-Wal­rasian macro­eco­nom­ics derived from it by adding in a pinch of imper­fect com­pe­ti­tion and incom­plete infor­ma­tion).

While there is no cer­tain­ty that this Neo­clas­si­cal jug­ger­naut can be stopped, it is cer­tain that it will roll over non-Neo­clas­si­cal oppo­si­tion unless a coher­ent, empir­i­cal­ly accu­rate, and com­pelling alter­na­tive the­o­ry is devel­oped. In what fol­lows I set out essen­tial ele­ments of that alternative—starting with the empir­i­cal point of diver­gence between the dom­i­nant Neo­clas­si­cal expla­na­tion for the sever­i­ty and longevi­ty of this cri­sis, and an endoge­nous mon­ey expla­na­tion.

Private Debt and Aggregate Demand

The New Keynesian Analysis: a “Liquidity Trap”

The New Key­ne­sian expla­na­tion for the cri­sis is that we are in a liq­uid­i­ty trap as defined by Hicks (J. R. Hicks 1937, pp. 154–155), when the capac­i­ty of mon­e­tary pol­i­cy to stim­u­late the econ­o­my fails:

For the last fifty years the busi­ness of end­ing reces­sions has basi­cal­ly been the job of the Fed­er­al Reserve, which … con­trols the “mon­e­tary base,” … Well, the Fed has tripled the size of the mon­e­tary base since 2008; yet the econ­o­my remains depressed… What the Fed can do by push­ing more cash into the banks is dri­ve down inter­est rates… But … it can’t push them below zero… Unfor­tu­nate­ly, a zero rate turned out not to be low enough, because the burst­ing of the hous­ing bub­ble had done so much dam­age… And that’s the liq­uid­i­ty trap: it’s what hap­pens when zero isn’t low enough. (Krug­man 2012f, pp. 31–33)

Krug­man asserts that this alters an essen­tial reg­u­lar­i­ty in macro­eco­nom­ics. Nor­mal­ly, the lev­el and rate of change of pri­vate debt are irrel­e­vant to macro­eco­nom­ics, because pri­vate debt is sim­ply a trans­fer from one agent to anoth­er, with a net sum impact on the macro­econ­o­my of very near­ly zero:

to a first approx­i­ma­tion debt is mon­ey we owe to our­selves… the over­all lev­el of debt makes no dif­fer­ence to aggre­gate net worth—one per­son­’s lia­bil­i­ty is anoth­er per­son­’s asset. It fol­lows that the lev­el of debt mat­ters only if the dis­tri­b­u­tion of net worth mat­ters, if high­ly indebt­ed play­ers face dif­fer­ent con­straints from play­ers with low debt.… when debt is ris­ing, it’s not the econ­o­my as a whole bor­row­ing more mon­ey. It is, rather, a case of less patient peo­ple … bor­row­ing from more patient peo­ple. The main lim­it on this kind of bor­row­ing is the con­cern of those patient lenders about whether they will be repaid, which sets some kind of ceil­ing on each indi­vid­u­al’s abil­i­ty to bor­row. (Krug­man 2012f, pp. 146–147, empha­sis added)

The cri­sis occurred—and pri­vate debt assumed macro­eco­nom­ic significance—because “for some rea­son” (Krug­man and Eggerts­son 2010, p. 3), this ceil­ing was reduced. The asym­met­ric con­se­quences this had for spend­ing is why debt mat­ters: because decreased spend­ing by indebt­ed indi­vid­u­als was not off­set by ris­ing spend­ing by savers. This itself could have been coun­tered had the Fed­er­al Reserve had the flex­i­bil­i­ty need­ed to drop inter­est rates, but nom­i­nal rates were already his­tor­i­cal­ly low, and the Fed­er­al Reserve rapid­ly came up against the zero low­er bound:

What hap­pened in 2008 was a sud­den down­ward revi­sion of those ceil­ings. This down­ward revi­sion has forced the debtors to pay down their debt, rapid­ly, which means spend­ing much less. And the prob­lem is that the cred­i­tors don’t face any equiv­a­lent incen­tive to spend more… because of the sever­i­ty of the “delever­ag­ing shock,” even a zero inter­est rate isn’t low enough to get them to fill the hole left by the col­lapse in debtors’ demand… (Krug­man 2012f, p. 147)

This in turn means that fis­cal pol­i­cy must be used to sup­port mon­e­tary pol­i­cy, so that ris­ing pub­lic-sec­tor spend­ing can fill the gap between exces­sive delever­ag­ing by bor­row­ers and insuf­fi­cient addi­tion­al spend­ing by savers:

we had a peri­od of too much opti­mism about debt, in which debtors bor­rowed and spent too much; since one per­son­’s debt is anoth­er’s asset, cred­i­tors had to be induced to spend less via high real inter­est rates. Then peo­ple remem­bered the dan­gers of debt, and we moved from lever­ag­ing to delever­ag­ing. But the prob­lem is that this isn’t sym­met­ric, because you can’t get real inter­est rates low enough to induce suf­fi­cient spend­ing on the part of those not deep in debt.

So one way to explain our depres­sion is to say that debtors, as a group, are try­ing to delever­age too fast, in the sense that the col­lec­tive rate at which they are try­ing to pay down debt isn’t fea­si­ble giv­en the zero low­er bound on inter­est rates.

And that’s the role of fis­cal pol­i­cy: its goal is not to stop aggre­gate delever­ag­ing … but to slow it down to a pace that can be accom­mo­dat­ed by mon­e­tary pol­i­cy.(Krug­man 2012e)

Like almost all Post Key­ne­sian econ­o­mists, I sup­port gov­ern­ment deficit spend­ing dur­ing this cri­sis (though I argue it alone is not enough). But Krug­man’s argu­ment about why deficits are need­ed is strong­ly fal­si­fied by the empir­i­cal data.

Testing the “Liquidity Trap”

Two key empir­i­cal propo­si­tions can be derived from Krug­man’s analy­sis:

  1. High real inter­est rates should be cor­re­lat­ed with high rates of growth of real debt; and
  2. The lev­el and rate of change of debt should only mat­ter when the zero low­er bound caus­es a liq­uid­i­ty trap

The first propo­si­tion is mod­er­ate­ly sup­port­ed by the data. Fig­ure 1 shows the two fac­tors deter­min­ing the real Reserve inter­est rate: the Fed­er­al Reserve Funds rate and the infla­tion rate.

Fig­ure 1: Fed­er­al Funds Rate and Infla­tion

Fig­ure 2 shows the cor­re­la­tion between the real Reserve rate and the infla­tion-adjust­ed change in the lev­el of pri­vate debt (derived from the Flow of Funds Table L.1). It is a rea­son­ably strong 0.46 across the whole time series, but only 0.21 for the peri­od pri­or to the Zero Low­er Bound (the ZLB—defined as when the Fed­er­al Fund tar­get rate dropped to 0.125 per cent in Jan­u­ary 2009). Most of the strength of the cor­re­la­tion comes from after the ZLB was reached, when the cor­re­la­tion ris­es to 0.65. Krug­man’s first propo­si­tion is thus at best only weak­ly sup­port­ed by the data.

Fig­ure 2: Real inter­est rates and pri­vate debt growth

His sec­ond proposition—that pri­vate debt should have no macro­eco­nom­ic sig­nif­i­cance except after the ZLB—is strong­ly con­tra­dict­ed by the data. First­ly, the neg­a­tive cor­re­la­tion that Krug­man expect­ed to apply between change in debt and unem­ploy­ment after the ZLB is there, but it is weak—only ‑0.27. How­ev­er, his expec­ta­tion that there would be no rela­tion­ship between the change in debt and unem­ploy­ment pri­or to the ZLB is wrong: the cor­re­la­tion between changes in real pri­vate debt and unem­ploy­ment is sub­stan­tial­ly stronger before the ZLB: ‑0.69. Over the whole time peri­od, the cor­re­la­tion is ‑0.55.

Krug­man’s “liq­uid­i­ty trap” expla­na­tion for why debt mat­ters can thus com­fort­ably be reject­ed: changes in the aggre­gate lev­el of debt have macro­eco­nom­ic sig­nif­i­cance at all times, even when there is clear­ly no liq­uid­i­ty trap.

Fig­ure 3: Real change in pri­vate debt and unem­ploy­ment

The fail­ure of the “liq­uid­i­ty trap” hypoth­e­sis as to and when why pri­vate debt mat­ters, paves the way to test an alter­na­tive: that pri­vate debt always mat­ters, because changes in pri­vate debt add to aggre­gate demand.

Testing Endogenous Money

The propo­si­tion that changes in pri­vate debt add to aggre­gate demand sparked Krug­man’s blo­gos­phere stoush with me (Keen, 2012; Krug­man 2012d, 2012c, 2012g, 2012a, 2012b) in ear­ly 2012:

Keen then goes on to assert that lend­ing is, by def­i­n­i­tion (at least as I under­stand it), an addi­tion to aggre­gate demand. I guess I don’t get that at all. If I decide to cut back on my spend­ing and stash the funds in a bank, which lends them out to some­one else, this does­n’t have to rep­re­sent a net increase in demand. Yes, in some (many) cas­es lend­ing is asso­ci­at­ed with high­er demand, because resources are being trans­ferred to peo­ple with a high­er propen­si­ty to spend; but Keen seems to be say­ing some­thing else, and I’m not sure what. I think it has some­thing to do with the notion that cre­at­ing mon­ey = cre­at­ing demand, but again that isn’t right in any mod­el I under­stand. (Krug­man 2012c)

To test this propo­si­tion, the change in debt needs to be com­pared to GDP, since we are mea­sur­ing its con­tri­bu­tion to aggre­gate demand, and a 10% change in debt rep­re­sent­ed a 10% increase in demand above GDP in 1970 (when the debt to GDP ratio was 100%) but a 30% increase in 2009 (when the ratio peaked at 300%)—see Fig­ure 4.

Fig­ure 4: The impact of a giv­en per­cent­age change in debt has grown as debt has grown rel­a­tive to GDP

Fig­ure 5 shows that the empir­i­cal rela­tion­ship between unem­ploy­ment and the change in pri­vate debt (mea­sured as a per­cent­age of GDP) is high and rel­a­tive­ly sta­ble either side of the ZLB. It is ‑0.76 for the entire time peri­od from Jan­u­ary 1980 till March 2012, ‑0.63 since the ZLB, and ‑0.84 pri­or to the ZLB.

Fig­ure 5: Change in pri­vate debt and unem­ploy­ment

Table 2 sum­ma­rizes the cor­re­la­tions uncov­ered here. Clear­ly, there is a strong empir­i­cal reg­u­lar­i­ty between change in debt and macro­eco­nom­ic per­for­mance that sur­vives peri­ods of both boom and bust, and low and high real and nom­i­nal inter­est rates.

Table 2: Sum­ma­ry of cor­re­la­tions

Cor­re­la­tion Coef­fi­cients Before ZLB After ZLB 1980–2012
Real inter­est rate & change in real pri­vate debt p.a. 0.21 0.65 0.46
Change in real pri­vate debt & unem­ploy­ment -0.69 -0.27 -0.55
Change in debt per­cent of GDP & unem­ploy­ment -0.84 -0.63 -0.76

These results call for a hypoth­e­sis that is con­sis­tent with them: the endoge­nous mon­ey hypoth­e­sis.

Endogenous Money

The essence of endoge­nous mon­ey hypoth­e­sis is that banks cre­ate spend­ing pow­er for bor­row­ers with­out reduc­ing the spend­ing pow­er of savers. If true, this makes banks far more than mere inter­me­di­aries, and a cru­cial part of a valid the­o­ry of macro­eco­nom­ics. An essen­tial pre-req­ui­site of this the­o­ry is that bank lend­ing is not effec­tive­ly con­strained by the Cen­tral Bank.

Both the essence and the pre-req­ui­site receive sub­stan­tial sup­port from exist­ing empir­i­cal research (as well as the results above), and from infor­ma­tion on the actu­al prac­tices of Cen­tral Banks.

Empirical Data

While test­ing the “peck­ing order” the­o­ry of cor­po­rate div­i­dends, Fama and French uncov­ered a strong rela­tion­ship between changes in aggre­gate cor­po­rate debt and the lev­el of cor­po­rate invest­ment. Using the Com­pu­s­tat data­base of com­pa­ny reports from pub­licly-trad­ed US non-finan­cial cor­po­ra­tions between 1951 & 1996, Fama and French cal­cu­lat­ed aggre­gate non-finan­cial cor­po­rate invest­ment, and cor­re­lat­ed it with equi­ty issue, retained earn­ings, and new debt (see Fig­ure 6).

Fig­ure 6: Cor­re­la­tions of invest­ment to new equi­ty, retained earn­ings and new debt (Fama & French 1999, p. 1954)

They con­clud­ed that “the source of financ­ing most cor­re­lat­ed with invest­ment is long-term debt”:

new net issues of stock do not move close­ly with invest­ment… the cor­re­la­tion of invest­ment, It, and new net issues of stock, dSt, is only 0.19… retained cash earn­ings move more close­ly with invest­ment. The cor­re­la­tion between It and RCEt is indeed high­er, 0.56, but far from per­fect. The source of financ­ing most cor­re­lat­ed with invest­ment is long-term debt. The cor­re­la­tion between It and dLT­Dt is 0.79…These cor­re­la­tions con­firm the impres­sion from Fig­ure 3 that debt plays a key role in accom­mo­dat­ing year-by-year vari­a­tion in invest­ment. (Fama and French 1999, p. 1954)


Kyd­land and Prescott devel­oped a nov­el method for test­ing eco­nom­ic mod­els, and were can­did that their results con­tra­dict­ed Neo­clas­si­cal the­o­ry:

The pur­pose of this arti­cle is to present the busi­ness cycle facts in light of estab­lished neo­clas­si­cal growth the­o­ry… We find these fea­tures inter­est­ing because the pat­terns they seem to dis­play are incon­sis­tent with the the­o­ry. (Kyd­land and Prescott 1990, p. 4)

On the rela­tion­ship between reserves and cred­it, they con­clud­ed that:

the mon­e­tary base lags the cycle slight­ly… The dif­fer­ence of M2-M1 leads the cycle by … about three quar­ters… The fact that the trans­ac­tion com­po­nent of real cash bal­ances (M1) moves con­tem­po­ra­ne­ous­ly with the cycle while the much larg­er non­trans­ac­tion com­po­nent (M2) leads the cycle sug­gests that cred­it arrange­ments could play a sig­nif­i­cant role in future busi­ness cycle the­o­ry… (Kyd­land and Prescott 1990, p. 15)

These find­ings con­firmed the results of the Post Key­ne­sian econ­o­mist Basil Moore (Moore 1979, 1983, 1988), that bank lend­ing was not reserve-con­strained. The “Hor­i­zon­tal­ist” mod­el he devised (Moore 1988, 1997) sparked the devel­op­ment of the endoge­nous mon­ey hypoth­e­sis by Post Key­ne­sian econ­o­mists.

Practical issues

The tim­ing rela­tion between bank loans and deposits and reserves is the oppo­site of what would be required for reserves to act as a con­straint on lend­ing. Fed­er­al Reserve Bank of New York Vice Pres­i­dent Alan Holmes put it this way when express­ing his oppo­si­tion to Mon­e­tarism in 1969:

The idea of a reg­u­lar injec­tion of reserves … also suf­fers from a naive assump­tion that the bank­ing sys­tem only expands loans after the Sys­tem (or mar­ket fac­tors) have put reserves in the bank­ing sys­tem. In the real world, banks extend cred­it, cre­at­ing deposits in the process, and look for the reserves lat­er… the reserves required to be main­tained by the bank­ing sys­tem are pre­de­ter­mined by the lev­el of deposits exist­ing two weeks ear­li­er. (Holmes 1969, p. 73)

The rela­tion­ship that loans and deposits lead and reserves lag is more pro­nounced today, with the reserve lag in the USA now being 30 days (O’Brien 2007, Table 12, p. 52). The Euro­pean Cen­tral Bank has also recent­ly con­firmed that the Post Key­ne­sian posi­tion that “loans cre­ate deposits, and deter­mine reserves with a lag” accu­rate­ly describes pri­vate and Cen­tral Bank pro­ce­dures in the EU:

In fact, the ECB’s reserve require­ments are back­ward-look­ing, i.e. they depend on the stock of deposits (and oth­er lia­bil­i­ties of cred­it insti­tu­tions) sub­ject to reserve require­ments as it stood in the pre­vi­ous peri­od, and thus after banks have extend­ed the cred­it demand­ed by their cus­tomers. (ECB 2012, p. 21, empha­sis added)

Last­ly, the col­lapse in the ratio of broad mon­ey to base mon­ey dur­ing and after the cri­sis inspired an FRB Dis­cus­sion Paper which con­clud­ed that the “mon­ey mul­ti­pli­er” mod­el of mon­ey cre­ation, which is an intrin­sic part of the “exoge­nous mon­ey hypoth­e­sis”, is false:

the rela­tion­ships implied by the mon­ey mul­ti­pli­er do not exist in the data for the most liq­uid and well-cap­i­tal­ized banks. Changes in reserves are unre­lat­ed to changes in lend­ing, and open mar­ket oper­a­tions do not have a direct impact on lend­ing. We con­clude that the text­book treat­ment of mon­ey in the trans­mis­sion mech­a­nism can be reject­ed. (Car­pen­ter and Demi­ralp 2010, pp. 27–28)

Theoretical arguments

Though the con­cept that changes in the lev­el of pri­vate debt affect aggre­gate demand had sev­er­al prog­en­i­tors, the direct antecedent of today’s endoge­nous mon­ey the­o­rists was Joseph Schum­peter. In try­ing to explain the ori­gin of prof­its (while start­ing from a Wal­rasian gen­er­al equi­lib­ri­um in which prof­its were zero), Schum­peter linked dis­con­tin­u­ous change by entre­pre­neurs with endoge­nous mon­ey cre­ation by banks. He argued that an entre­pre­neur was the pos­ses­sor of an idea that could trans­form pro­duc­tion who lacked the mon­e­tary means to put that idea into oper­a­tion (Schum­peter acknowl­edged but down­played the pos­si­bil­i­ty of invest­ing out of retained earn­ings). Lack­ing rev­enue from sell­ing goods in “the cir­cu­lar flow”, to acquire mon­ey the entre­pre­neur had to get a bank loan:

the entrepreneur—in prin­ci­ple and as a rule—does need cred­it … in order to pro­duce at all… And this pur­chas­ing pow­er does not flow towards him auto­mat­i­cal­ly, as to the pro­duc­er in the cir­cu­lar flow, by the sale of what he pro­duced in pre­ced­ing peri­ods… he must bor­row it… He can only become an entre­pre­neur by pre­vi­ous­ly becom­ing a debtor… He is the typ­i­cal debtor in cap­i­tal­ist soci­ety. (Schum­peter 1934, p. 102).

This bank loan in turn did not require a saver to forego spend­ing pow­er, because banks could cre­ate addi­tion­al spend­ing pow­er sim­ply by dou­ble-entry book­keep­ing:

Even though the con­ven­tion­al answer to our ques­tion is not obvi­ous­ly absurd, yet there is anoth­er method of obtain­ing mon­ey for this pur­pose … the cre­ation of pur­chas­ing pow­er by banks… It is always a ques­tion, not of trans­form­ing pur­chas­ing pow­er which already exists in some­one’s pos­ses­sion, but of the cre­ation of new pur­chas­ing pow­er out of noth­ing. (Schum­peter 1934, pp. 72–73).

This meant that total demand (which Schum­peter con­fus­ing­ly describes as “total cred­it”) in a grow­ing cap­i­tal­ist econ­o­my exceeds demand from the sale of goods and ser­vices alone (which he con­fus­ing­ly describes as “ful­ly cov­ered cred­it”, in con­trast to “abnor­mal credit”—which isn’t abnor­mal at all!—that emanates from bank loans to entre­pre­neurs):

From this it fol­lows, there­fore, that in real life total cred­it must be greater than it could be if there were only ful­ly cov­ered cred­it. The cred­it struc­ture projects … beyond the exist­ing com­mod­i­ty basis… Nor­mal cred­it cre­ates claims to the social div­i­dend, which rep­re­sent … pre­vi­ous deliv­ery of exist­ing goods. That kind of cred­it, which is des­ig­nat­ed by tra­di­tion­al opin­ion as abnor­mal, also cre­ates claims to the social prod­uct, which … could only be described as cer­tifi­cates of future ser­vices or of goods yet to be pro­duced. Thus there is a fun­da­men­tal dif­fer­ence between the two cat­e­gories, in their nature as well as in their effects. Both serve the same pur­pose as means of pay­ment and are exter­nal­ly indis­tin­guish­able. But the one embraces means of pay­ment to which there is a cor­re­spond­ing con­tri­bu­tion to the social prod­uct, the oth­er means of pay­ment to which so far noth­ing cor­re­sponds…. (Schum­peter 1934, pp. 101–102).

In rather clear­er lan­guage, Min­sky elab­o­rat­ed Schum­peter’s key point—that aggre­gate demand in a grow­ing cap­i­tal­ist econ­o­my exceeds income, and the dif­fer­ence is made up by ris­ing debt:

If income is to grow, the finan­cial mar­kets, where the var­i­ous plans to save and invest are rec­on­ciled, must gen­er­ate an aggre­gate demand that, aside from brief inter­vals, is ever ris­ing. For real aggre­gate demand to be increas­ing, … it is nec­es­sary that cur­rent spend­ing plans, summed over all sec­tors, be greater than cur­rent received income and that some mar­ket tech­nique exist by which aggre­gate spend­ing in excess of aggre­gate antic­i­pat­ed income can be financed. It fol­lows that over a peri­od dur­ing which eco­nom­ic growth takes place, at least some sec­tors finance a part of their spend­ing by emit­ting debt or sell­ing assets. (Min­sky 1982, p. 6, empha­sis added)

Min­sky added that mon­ey was bor­rowed not only by Schum­peter­ian entre­pre­neurs, whose spend­ing would ulti­mate­ly increase soci­ety’s pro­duc­tive capac­i­ty, but also by Ponzi Financiers, who would dri­ve up asset prices and finan­cial fragili­ty:

A Ponzi finance unit is a spec­u­la­tive financ­ing unit for which the income com­po­nent of the near term cash flows falls short of the near term inter­est pay­ments on debt so that for some time in the future the out­stand­ing debt will grow due to inter­est on exist­ing debt… Ponzi units can ful­fill their pay­ment com­mit­ments on debts only by bor­row­ing (or dis­pos­ing of assets)… a Ponzi unit must increase its out­stand­ing debts. (Min­sky 1982, p. 24)

There are there­fore two sources of mon­e­tary aggre­gate demand—income gained from sell­ing goods and ser­vices, and new cred­it cre­at­ed by debt issued by banks—and two broad class­es of expenditure—newly pro­duced goods and ser­vices, and finan­cial claims on exist­ing assets. This can be sum­ma­rized in the fol­low­ing state­ment:

Aggre­gate Demand equals income plus the change in debt, and Aggre­gate Sup­ply equals Out­put plus new pur­chas­es of finan­cial assets.

The ini­tial reac­tion of most econ­o­mists to this propo­si­tion is that it must involve dou­ble-count­ing. In the next sec­tion, I resort to math­e­mat­i­cal log­ic to show that this is not so.

Mathematical Proof

Econ­o­mists cus­tom­ar­i­ly think in “dis­crete time” when writ­ing equa­tions; this sec­tion will be eas­i­er to fol­low if the read­er instead thinks in “con­tin­u­ous time”—so that any term of the form X implies “the val­ue of X at time t” while rates of change expres­sions refer to the change in a vari­able at an instant in time. Through­out I will use for income, for expen­di­ture, W for Wages, for prof­it, and D for debt. I begin with a sim­ple mod­el in which all wages are con­sumed, and cap­i­tal­ists can both con­sume and invest but do not spec­u­late (i.e., the pur­chas­ing of exist­ing assets is not con­sid­ered), and pro­gres­sive­ly con­sid­er more com­plex arrange­ments.

Closed Economy, no government or speculation

We start with the iden­ti­ty that total income equals wages plus prof­its:

Prof­its are either con­sumed or retained for invest­ment:

Expen­di­ture is either on con­sumer goods or invest­ment goods:

Con­sump­tion is financed by wages and retained earn­ings, so that the sum expend­ed buy­ing con­sumer goods equals wages plus retained earn­ings:

Invest­ment, as Fama and French’s empir­i­cal research con­firmed, is financed by invest­ment plus the change in debt:

Expen­di­ture and income are there­fore:

Sub­tract­ing income from expen­di­ture yields the result that the dif­fer­ence between expen­di­ture and income equals the change in debt—which is the argu­ment put by both Schum­peter and Min­sky:

There­fore aggre­gate demand equals income plus the change in debt:

Closed economy with speculation by capitalists

Dis­trib­uted prof­its are now either con­sumed or used for spec­u­la­tion:

Expen­di­ture is on both goods and ser­vices and assets:

Pur­chas­es of assets are financed out of prof­its and mon­ey bor­rowed for spec­u­la­tion:

Two types of debt are now con­sid­ered: debt for invest­ment and debt for spec­u­la­tion . Expen­di­ture and income are now respec­tive­ly:

Sub­tract­ing from yields:

Closed economy with speculation and government

Expen­di­ture now includes net gov­ern­ment spend­ing :

Gov­ern­ment spend­ing equals the change in gov­ern­ment debt:

Expen­di­ture is thus equal to income plus the sum of the change in invest­ment, spec­u­la­tive and gov­ern­ment debt:

Though the maths is easy to fol­low, I am aware that the argu­ment still appears to involve dou­ble-count­ing to many econ­o­mists, so some fur­ther clar­i­fi­ca­tion is in order. I believe that this con­fu­sion aris­es from a ten­den­cy to think about this rela­tion­ship in an “ex post” manner—comparing record­ed expen­di­ture with record­ed income. This com­par­i­son is valid for record­ing what has hap­pened, but not valid for con­sid­er­ing the causal process in which, as Keynes empha­sized, expen­di­ture pre­cedes income, and the income for invest­ment is in part bor­rowed:

I pro­ceed to the third pos­si­ble source of con­fu­sion, due to the fact (which may deserve more empha­sis than I have giv­en it pre­vi­ous­ly) that an invest­ment deci­sion (Prof. Ohlin’s invest­ment ex-ante) may some­times involve a tem­po­rary demand for mon­ey before it is car­ried out, quite dis­tinct from the demand for active bal­ances which will arise as a result of the invest­ment activ­i­ty whilst it is going on. This demand may arise in the fol­low­ing way.

Planned investment—i.e. invest­ment ex-ante—may have to secure its ” finan­cial pro­vi­sion ” before the invest­ment takes place…There has, there­fore, to be a tech­nique to bridge this gap between the time when the deci­sion to invest is tak­en and the time when the cor­rel­a­tive invest­ment and sav­ing actu­al­ly occur. This ser­vice may be pro­vid­ed either by the new issue mar­ket or by the banks;—which it is, makes no dif­fer­ence.” (Keynes 1937, p. 246)

A styl­ized flow dia­gram might also help. Incomes from “the cir­cu­lar flow” are gen­er­at­ed by the turnover of the exist­ing stock of mon­ey, while new­ly bor­rowed mon­ey adds spend­ing pow­er of an equiv­a­lent amount when it is spent into the econ­o­my, and also boosts the amount of mon­ey in circulation—thus enabling incomes to grow as well.

Fig­ure 7: A styl­ized cir­cu­lar flow plus new debt dia­gram

Final­ly, con­sid­er the rela­tion­ship at a moment in time . Wage income for that instant will be , while prof­its are and the change in debt is . Total spend­ing between two instants t1 and t2 is thus the inte­gral of these flows over that time peri­od (where all 3 can change in mag­ni­tude over the inter­val, and influ­ence each oth­er as well:

The change in expen­di­ture between two time peri­ods will there­fore be the dif­fer­ences in wages and prof­its plus the dif­fer­ences in the rate of change of debt:

This in turn means that the change in expen­di­ture equals the change in incomes plus the accel­er­a­tion of debt—a point first not­ed by Big­gs, Mey­er and Pick (Big­gs et al. 2010; Big­gs and May­er 2010), when they chris­tened the accel­er­a­tion in debt (divid­ed by GDP) as the “Cred­it Impulse”. I pre­fer to call the “Cred­it Accel­er­a­tor” to empha­size that it is not an occa­sion­al and tran­sient phe­nom­e­non, but a per­ma­nent fea­ture of a cred­it-based econ­o­my.

This leaves one last issue: what is the mech­a­nism by which banks endoge­nous­ly cre­ate cred­it with­out being con­strained by exist­ing sav­ings or the reserve require­ments set by the Cen­tral Bank?

The Mechanism

Neo­clas­si­cal econ­o­mists accept that the Cen­tral Bank has the capac­i­ty to cre­ate mon­ey “out of thin air”:

The cru­cial thing is where the Fed gets the funds with which it pur­chas­es assets. And the answer is that it cre­ates them out of thin air… there’s noth­ing behind that cred­it; the Fed has the unique right to con­jure mon­ey into exis­tence when­ev­er it choos­es. (Krug­man 2012f, p. 153)

This unique right is the essen­tial­ly infi­nite licence to cre­ate the cur­ren­cy that a Cen­tral Bank of a sov­er­eign nation possesses—or rather has con­ferred upon it by the gov­ern­ment. But Neo­clas­si­cal econ­o­mists ignore the fact that the pos­ses­sion of a pri­vate bank­ing licence con­fers a similar—though not infinite—capacity to a bank to cre­ate mon­ey “out of thin air”. The exer­cise of both these capac­i­ties deter­mines the mon­ey sup­ply in our mixed state-cred­it finan­cial sys­tem.

The mech­a­nism, in both cas­es, com­mences with the capac­i­ty to cre­ate match­ing assets and lia­bil­i­ties via dou­ble-entry book­keep­ing, as “Mod­ern Mon­e­tary The­o­ry” (MMT) econ­o­mists empha­size:

Cred­it and debt are two sides of the same coin. Both cred­i­tor and debtor are sin­ful. They bal­ance. Exact­ly. The sin­ful bal­ance is ensured by dou­ble-entry book-keep­ing. (L. R. Wray 2011)

In its mod­el of gov­ern­ment mon­ey cre­ation, MMT has to date treat­ed the gov­ern­ment and the cen­tral bank as a sin­gle enti­ty for the sake of sim­plic­i­ty (Full­wiler et al. 2012).

it is con­ve­nient to con­sol­i­date the trea­sury and cen­tral bank accounts into a “gov­ern­ment account”. To be sure, the real world is more com­pli­cat­ed… But, as Paul David­son has fre­quent­ly not­ed, the appro­pri­ate gen­er­al case is the one that makes the fewest assump­tions while enabling analy­sis or under­stand­ing of the fun­da­men­tal or “true” nature of the object of inquiry. (Full­wiler et al. 2012, p. 20)

This con­sol­i­da­tion has been sub­ject to crit­i­cism by oth­er Post Key­ne­sians (Fiebiger 2012). I will start with a dou­ble-entry book­keep­ing rep­re­sen­ta­tion of this arguably over-sim­pli­fied model—and an equal­ly over-sim­pli­fied mod­el of pri­vate banking—before mov­ing on to a more gen­er­al rep­re­sen­ta­tion of both.

Simplified double-entry model of mixed state-credit money creation

Kel­ton, Full­wiler & Wray describe their sim­plest mod­el in the fol­low­ing terms:

con­sid­er a con­sol­i­dat­ed gov­ern­ment (cen­tral bank plus trea­sury) run­ning a deficit. The basic trans­ac­tions could be list­ed as the fol­low­ing:

1A. The gov­ern­men­t’s spend­ing cred­its bank accounts with reserve bal­ances (HPM). These accounts are lia­bil­i­ties of the government/central bank.

2A. Banks cred­it the deposit accounts of the spend­ing recip­i­ents. So, over­all, the increased reserve bal­ances have raised bank assets while the increased deposits have increased bank lia­bil­i­ties by the same amount. (Full­wiler et al. 2012, p. 21)

The sim­plest dou­ble-entry-con­sis­tent ren­di­tion of this mod­el that I can devel­op is shown in Fig­ure 8 and Fig­ure 9. The capac­i­ty of a sov­er­eign gov­ern­ment to cre­ate its own cur­ren­cy is shown as the intan­gi­ble asset of a “Fiat Licence”, with an ini­tial val­ue that is essen­tial­ly lim­it­less. That in turn lets it cre­ate the lia­bil­i­ty of its cur­ren­cy, which is stored in a “Cen­tral Bank Vault”.

Gov­ern­ment spend­ing begins with a trans­fer from this Vault to the Trea­sury’s Deposit account (labeled row 1 in Fig­ure 8), and its record­ing as a trans­fer of Assets from the Fiat Licence to the Trea­sury’s Loan account (row 2). Spend­ing of this bor­rowed mon­ey into the econ­o­my is shown on row 3 of Fig­ure 8 and row 1 of Fig­ure 9. The reverse oper­a­tions of tax­a­tion are shown on rows 4–6 of Fig­ure 8 and row 2 of Fig­ure 9.

The pri­vate sec­tor’s mon­ey-cre­ation process is shown on rows 3 and 4 of Fig­ure 9.

Fig­ure 8: Gov­ern­ment com­po­nent of the sim­plest MMT mon­ey cre­ation mod­el

Fig­ure 9: Pri­vate bank com­po­nent of the sim­plest MMT mon­ey cre­ation mod­el

Since all these oper­a­tions are flows, the sym­bol­ic sum of each col­umn rep­re­sents the rate of change of the account shown in that col­umn. The cru­cial flow equa­tions are the fol­low­ing:

Two phe­nom­e­na are evi­dent in this high­ly sim­pli­fied mod­el:

  1. The total amount of mon­ey in cir­cu­la­tion in the econ­o­my is increased by gov­ern­ment deficits, and by the pri­vate bank­ing sec­tor’s loans to the non-bank pub­lic (when they exceed the non-bank pub­lic’s repay­ments of those loans).
  2. Gov­ern­ment deficit oper­a­tions affect pri­vate bank reserves, but pri­vate bank reserves play no role in pri­vate bank lend­ing.

How­ev­er, these results could be arti­facts of the exces­sive­ly sim­pli­fied nature of the mod­el. I now con­sid­er a more com­plete (but by no means full and final) mod­el in which:

  1. The Cen­tral Bank and Trea­sury are sep­a­rat­ed;
  2. Trea­sury must sell bonds to bond pur­chasers to raise rev­enue;
  3. The Cen­tral Bank can at its dis­cre­tion pur­chase gov­ern­ment bonds of pri­vate bond hold­ers; and
  4. Pri­vate banks lend from reserves.

More complete double-entry model of mixed state-credit money creation

Three accounts are now nec­es­sary:

  1. The Trea­sury;
  2. The Cen­tral Bank; and
  3. The Pri­vate Bank Sec­tor

The Trea­sury has the intan­gi­ble asset of a licence to cre­ate gov­ern­ment bonds, which is matched by the lia­bil­i­ty of the bonds it cre­ates. Hav­ing planned its spend­ing, it then sells bonds to bond dealers—and these bonds can in turn be pur­chased either by the non-bank pub­lic, or by the Cen­tral Bank.

Fig­ure 10: The Trea­sury

Hav­ing sold those bonds, the Trea­sury now has mon­ey in its deposit account at the Cen­tral Bank, from which it can spend. As before, this spend­ing increas­es the reserves of the pri­vate banks (which are a lia­bil­i­ty of the Cen­tral Bank) and increas­es the non-bank pub­lic’s deposits at the pri­vate banks by the same amount.

Fig­ure 11: The Cen­tral Bank

The flow of loans by the pri­vate bank­ing sec­tor to the non-bank pub­lic is mod­eled as a trans­fer of the bank­ing sec­tor’s assets from reserves to loans, matched by the pri­vate non-bank sec­tor deposit­ing the flow in its deposit accounts. The two oper­a­tions can­cel each oth­er out on the aggre­gate pri­vate bank­ing sec­tor reserve account, but increase the loan assets of the bank­ing sec­tor and the deposit lia­bil­i­ties at the same time. Reserves are thus need­ed to set­tle trans­ac­tions between indi­vid­ual banks, and as a con­duit for the gov­ern­ment sec­tor’s finan­cial deal­ings with the pri­vate non-bank sec­tor, but at the aggre­gate lev­el are nei­ther a require­ment for, nor a con­straint upon, pri­vate bank lend­ing.

Fig­ure 12: The Pri­vate Bank Sec­tor

The cru­cial flow equa­tions in this mod­el are:

The change in the lev­el of mon­ey in cir­cu­la­tion is thus deter­mined by net pri­vate sec­tor lend­ing, the gov­ern­ment deficit, and the mon­e­tary oper­a­tions of the Cen­tral Bank. This gen­er­al­izes, but does not con­tra­dict, the results of the ear­li­er more sim­pli­fied mod­el.


The endo­gene­ity of the mon­ey sup­ply means that banks, debt and mon­ey are essen­tial com­po­nents of macro­eco­nom­ics: they can­not be ignored as in stan­dard Neo­clas­si­cal macro­eco­nom­ics, nor car­i­ca­tured by “patient lends to impa­tient” bank-less mod­i­fied DSGE mod­els (Krug­man and Eggerts­son 2010). An alter­na­tive mon­e­tary macro­eco­nom­ics is required, and one can be con­struct­ed eas­i­ly from the prin­ci­ples of dou­ble-entry book­keep­ing, as I have shown here.

Even at this rudi­men­ta­ry lev­el, this mon­e­tary per­spec­tive has lessons for the EU cri­sis. Since the pri­vate sec­tor is now delever­ag­ing, its actions are reduc­ing the mon­ey sup­ply. If the gov­ern­ment runs a sur­plus, this fur­ther reduces the mon­ey supply—and hence eco­nom­ic activ­i­ty. Aus­ter­i­ty there­fore ampli­fies the down­turn caused by pri­vate sec­tor delever­ag­ing.

At the same time, a gov­ern­ment deficit is less effec­tive than pro­po­nents of a gov­ern­ment stim­u­lus approach to the cri­sis have argued (Krug­man 2012f), since on the his­tor­i­cal evi­dence, pri­vate sec­tor delever­ag­ing is like­ly to con­tin­ue for a decade or more, giv­en the lev­el of accu­mu­lat­ed pri­vate debt. Debt can­cel­la­tion will be required as well if pol­i­cy is to res­cue us from this cri­sis.


We present here a sim­ple way to rep­re­sent the con­cep­tu­al dif­fer­ence between spend­ing plans and cur­rent received income using the lan­guage of continuous–time func­tions with dis­con­ti­nu­ities.

Fig­ure 13: Change in debt as a jump func­tion

We start by defin­ing aggre­gate income flow as a func­tion with the prop­er­ty shown in Fig­ure 13, where rep­re­sents the val­ue of the func­tion at time t and

cor­re­sponds to the lim­it of the val­ues of as time approach­es t from the above (that is, from instants imme­di­ate­ly after t, and there­fore after the injec­tion of new debt). The dif­fer­ence is a “jump” in the flow of aggre­gate income, which we argue is caused by a cor­re­spond­ing change in the stock of debt. Expressed in this way, equa­tion (1.8) sim­ply says that

That is, the flow of expen­di­ture always equals the ex-post flow of income, which in turn equals the flow of income plus change in the stock of debt. In par­tic­u­lar, observe that flows of expen­di­ture and income coin­cide except at the points of dis­con­ti­nu­ity, which are exact­ly the points when change in the stock of debt is assumed to occur.

Now the total expen­di­ture and income between times and is giv­en by the inte­grals of the cor­re­spond­ing flows. But it fol­lows from the prop­er­ties of inte­gra­tion that func­tions dif­fer­ing only at finite­ly many points of dis­con­ti­nu­ities must have iden­ti­cal inte­grals. There­fore, pro­vid­ed the change in debt occurs at finite­ly many points, we have that

which means that record­ed expen­di­ture and income over a finite peri­od , such as those found in NIPA tables, nec­es­sar­i­ly agree. This does not mean, how­ev­er, that changes in debt do not affect the inte­grals, but rather that they affect both inte­grals in exact­ly the same way. Put in anoth­er way, where­as com­par­ing record­ed expen­di­ture and income over a peri­od does not explic­it­ly reveal changes in debt, ignor­ing the effect of change in debt in the flows of expen­di­ture and income leads to a gross­ly incor­rect mod­el.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.