Mish & Steve Debate: Steve Says (I)

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I’ve just tak­en time-out from the pre-con­fer­ence social event at the Cen­tral Bank of Turkey annu­al con­fer­ence, and (as enjoy­able as that func­tion was) it’s lucky that I did: Mish Shed­lock has fol­lowed up on some crit­i­cisms of my “Mod­ern Debt Jubilee” pro­pos­al with a post on real solu­tions for the debt cri­sis. I will try to reply to Mish’s fol­low-up before I turn in for the night here in Cap­pado­cia.

First­ly, some praise: Mish and I come from very dif­fer­ent perspectives—Austrian ver­sus Post Keynesian—but through­out this cri­sis, we’ve learnt from each oth­er a great deal, and exchanged respect­ful­ly. When we dif­fer, we try to ascer­tain why—which is in stark con­trast to how Paul Krug­man react­ed to crit­i­cism. We became friends before we had any rea­son to dis­agree in pub­lic, and I’m sure we’ll be friends on the oth­er side of this debate.

Sec­ond­ly, there’s a has­sle with the Inter­net con­nec­tion from this semi-rur­al loca­tion in Turkey; it stopped some of the images being post­ed prop­er­ly. They’re OK in this PDF though–(which I’m mak­ing gen­er­al­ly avail­able rather than restrict­ing to Debt­watch and CfE­SI sub­scribers as I usu­al­ly do).

The key excerpts from Mish’s alter­na­tive to my pro­pos­al are as fol­lows:

Struc­tur­al Issues

Giv­ing mon­ey away will not cure any struc­tur­al issues such as the high cost of edu­ca­tion, pen­sion under­fund­ing, med­ical costs, pre­vail­ing wages, stu­dent loans, etc., etc.

Indeed, I think it would com­pound those prob­lems.

Like­wise, I think the sec­ond part of Keen’s idea about con­trol­ling debt in the future tied to GDP growth (or any­thing else for that mat­ter) would fail mis­er­ably.

A free mar­ket, not gov­ern­ment man­dat­ed fiat mon­ey is the solu­tion. We cer­tain­ly do not have a free mar­ket now. Instead, we have fiat man­date, com­pound­ed by fraud­u­lent frac­tion­al reserve bank­ing.

It is the frac­tion­al reserve bank­ing sys­tem that is the very root of the cred­it expan­sion prob­lem.

Frac­tion­al Reserve Lend­ing Is Fraud

By lend­ing out more mon­ey or gold than exists, asset prices reach unsus­tain­ably high lev­els before they crash. Sound famil­iar?…

For more on the case against Frac­tion­al Reserve Lend­ing please see
Frac­tion­al Reserve Bank­ing by Mur­ray Roth­bard.

Case Against The Fed by Mur­ray Roth­bard

On page 46 of the book Case Against The Fed Roth­bard says “By the very nature of frac­tion­al Reserve Lend­ing, banks can­not hon­or all its con­tracts”.

Since that is known upfront, in advance, how is that not fraud?


Before we can address solu­tions to the debt prob­lem, we have to under­stand what caused the debt prob­lem in the first place. In this case, FRL is at the heart of it.

Since FRL is at the heart of it, any per­ma­nent solu­tion must address that prob­lem.

I pro­pose we start by address­ing the root cause of the debt prob­lem which I state is frac­tion­al reserve lend­ing.

Not a Transition Plan

My first obser­va­tion here is that, even if I believed that Mish were cor­rect, his is not a tran­si­tion plan: this is a plan for an alter­na­tive sys­tem. But how do we make the move from where we are now, to an alter­na­tive?

Let’s imag­ine that we do, one day, make the tran­si­tion from the sys­tem Mish describes as “Frac­tion­al Reserve Bank­ing” to one that is ful­ly backed by gold. The day before that tran­si­tion, one individual—say, some­one called Jamie perhaps—may have a net claim to $10 bil­lion worth of fiat-backed mon­ey. Some­one else—say, Ma Ket­tle—might be effec­tive­ly bank­rupt with $10,000 more mort­gage debt than assets. It may be too that Jamie’s immense wealth arose from per­suad­ing mil­lions of peo­ple like Ma and her rel­a­tives to take out a reverse mort­gage, or some oth­er form of inno­v­a­tive lend­ing that was pop­u­lar in the pre-gold days.

How do we make the tran­si­tion? Do we give Jamie $10 bil­lion worth of gold-backed mon­ey, and sad­dle Ma with $10,000 of gold-based debt? Or what?

This is what my “Mod­ern Debt Jubilee” pro­pos­al is about. We cur­rent­ly have a dys­func­tion­al finan­cial sys­tem that has imposed uncon­scionable debt bur­dens upon some, and cre­at­ed enor­mous Ponzi-based wealth for oth­ers. Do we sim­ply accept that, and move to a new sys­tem which alleged­ly won’t have the flaws of the pre­vi­ous sys­tem, but sus­tain the dis­tri­b­u­tion of wealth that result­ed from that flawed sys­tem? Or do we reduce that unfair­ness under the cur­rent sys­tem before we move to a new one?

That is what my “Mod­ern Debt Jubilee”—or “Quan­ti­ta­tive Eas­ing for the Public”—proposal is about. By inject­ing mon­ey under the cur­rent sys­tem into the bank accounts of bank cus­tomers (rather than into their reserves as under actu­al QE), and requir­ing that the injec­tion be first used to pay down debts, it would dra­mat­i­cal­ly reduce the income and wealth of the finance-sec­tor, while being even-hand­ed in its treat­ment of bor­row­ers and savers. That would minimize—but far from eliminate—the dam­age done by the cur­rent sys­tem, before any tran­si­tion occurred.

To make a tran­si­tion to a new mon­e­tary sys­tem, with­out min­i­miz­ing the prob­lems caused by the pre­vi­ous sys­tem, would poten­tial­ly doom that new sys­tem to fail­ure, regard­less of its mer­its.

Not a Fractional Reserve System

My sec­ond obser­va­tion is that we don’t live under a Frac­tion­al Reserve Sys­tem at all; we live under a pri­vate bank­ing sys­tem in which there is a Cen­tral Bank that once sort-of attempt­ed, unsuc­cess­ful­ly, to reg­u­late pri­vate lend­ing by impos­ing a ratio require­ment between pri­vate bank mon­ey cre­ation and gov­ern­ment-cre­at­ed reserves.

I say “once sort-of attempt­ed” because the Fed long ago amend­ed its reserve require­ments (see Table 12 in O’Brien, Y.-Y. J. C., 2007. Reserve Require­ment Sys­tems in OECD Coun­tries.) so that they apply only to house­hold deposits, and because there is a lag between deposits and reserves of 30 days: reserve require­ments are based on loans and deposits exist­ing 30 days ear­li­er. This means that, as the Euro­pean Cen­tral Bank recent­ly polite­ly put it in rela­tion to its sys­tem:

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)

I say “unsuc­cess­ful­ly” because, as a sen­si­ble New York Fed Vice-Pres­i­dent admit­ted decades ago, the actu­al prac­tice of bank­ing, com­bined with the lagged nature of the reserve require­ment, means that loans deter­mine deposits and reserves fol­low rel­a­tive­ly pas­sive­ly afterwards—the reverse of the argu­ment that peo­ple who believe we live in a frac­tion­al reserve bank­ing sys­tem actu­al­ly put (rang­ing from Mil­ton Fried­man in the 1960s to crit­ics like Mish today):

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)

(Note that in the 1960s, there was a 2 week lag. Now, with a mod­ern bank­ing sys­tem using sophis­ti­cat­ed com­put­er tech­nol­o­gy, we have … a 30 day lag. Guess why!)

Mish has thus embraced the “loans cre­ate deposits” and “loans and deposits pre­cede lags” aspects of the empir­i­cal­ly-based Post Key­ne­sian analy­sis of mon­ey, with­out quite real­iz­ing that this means the mod­el of Frac­tion­al Reserve Bank­ing (FRB) is a false mod­el of what cur­rent­ly hap­pens. Instead of FRB explain­ing how banks are “lend­ing out more mon­ey or gold than exists”, some­thing else has to explain that phe­nom­e­non.

That some­thing else is the capac­i­ty of pri­vate banks to cre­ate mon­ey, and this capac­i­ty exists even under a sys­tem of “A free mar­ket, not gov­ern­ment man­dat­ed fiat mon­ey”. So abol­ish­ing “Frac­tion­al Reserve Bank­ing” won’t elim­i­nate the capac­i­ty of banks to “lend out more mon­ey or gold than exists”, or more strict­ly speak­ing, to cre­ate mon­ey “out of noth­ing”.

Money creation by private banking

There’s a fair­ly sim­ple way to show from dou­ble-entry account­ing that banks can’t lend from reserves, and that a sys­tem of pure pri­vate bank­ing can result in banks cre­at­ing mon­ey. I’ll start from the stan­dard Post Key­ne­sian analy­sis of mon­ey, which was devel­oped to try to explain the empir­i­cal data on debt and mon­ey cre­ation. It states in its sim­plest form that “loans cre­ate deposits”. The next table states this basic argu­ment in an absolute­ly par­si­mo­nious way, fol­low­ing the account­ing con­ven­tion that an increase in assets is shown as a plus and an increase in lia­bil­i­ties is shown as a minus:

Fig­ure 1

Pri­vate Bank Tan­gi­ble Asset Lia­bil­i­ty Equi­ty
Account Loans Firms Equi­ty
Type Ledger Mon­ey Ledger
Val­ue 0 0 0
Sym­bol LF DF EB
Make Loan Loan -Loan
Repay -Repay Repay

This implies that banks can cre­ate mon­ey indef­i­nite­ly, so long as the rate of cre­ation of new loans exceeds the rate of repay­ment of old ones:

Fig­ure 2

The more conventional–but not empir­i­cal­ly derived–“Fractional Reserve Bank­ing” mod­el argues that banks need reserves from which to lend. But even if we start from a mod­el in which banks lend from reserves, we can’t get the out­come that reserves play any part in lend­ing and remain con­sis­tent with dou­ble-entry book­keep­ing. The dilem­ma is that to make a trans­fer from Assets to Lia­bil­i­ties, the sum in account­ing terms must be zero: the change in assets (where an increase is shown as a plus) must be bal­anced by the change in lia­bil­i­ties (where an increase is shown as a minus).


So a direct loan from Reserves to a Depos­i­tor’s account is sim­ply impos­si­ble: that would involve a minus on the assets side and a plus on the lia­bil­i­ties side, which means that the deposit has fall­en, not risen!


A way around that is to record that is a two step (but simul­ta­ne­ous) process in which (a) the bank ear­marks the mon­ey for a loan by increas­ing its loan ledger and decreas­ing its reserves and (b) lends from reserves to the bor­row­er’s deposit account. That two-step process, togeth­er with repay­ment in the same way, is shown in the fol­low­ing table.

Fig­ure 3

That results in the fol­low­ing sys­tem, in which reserves play no part: all the action is between loans and deposits. We’re back to a sys­tem which, apart from an extra account, is oth­er­wise exact­ly the same mod­el as the par­si­mo­nious Post Key­ne­sian one.

Fig­ure 4

Anoth­er way to involve reserves and try to make them part of the sys­tem is to argue that banks lend from lia­bil­i­ties rather than assets, and that one of its lia­bil­i­ties is a work­ing cap­i­tal reserve–the bank­ing sec­tor’s own lia­bil­i­ties to itself. Then you can derive a sys­tem which appears to show that banks lend from reserves:

Fig­ure 5

Now we have a mod­el in which reserves do play a part in lend­ing:

Fig­ure 6

How­ev­er there’s a prob­lem with this rep­re­sen­ta­tion: the sec­ond row implies that the amount of mon­ey in the sys­tem (the lia­bil­i­ties of the bank­ing sec­tor) fall becase of the loan. But they don’t: instead the first row shows that the lia­bil­i­ties are sim­ply trans­ferred from the bank­ing sec­tor’s work­ing cap­i­tal to the Firm sec­tor’s deposit accounts. So the sec­ond row actu­al­ly makes a false claim (there may well be a fall in one bank’s reserves and an increase in anoth­er’s if a loan is made by one bank and deposit­ed in anoth­er; this trans­fer of funds with­in the bank­ing sec­tor is one of the main rea­sons for reserves, and also why they nor­mal­ly run at “fric­tion­al” lev­els).


This is why Neil Wil­son sug­gest­ed that we had to add an intan­gi­ble asset–the val­ue of the licence to be a bank–to the accounts. Then a loan could be shown as an exer­cise of the banks’ intan­gi­ble asset.

Fig­ure 7

So this is clos­er to the mark–and once again reserves play no role in lend­ing:

Fig­ure 8

But now we have a bank­ing sec­tor that is hap­pi­ly mark­ing the val­ue of its good­will down to zero as its loans increase. What if instead–bearing in mind that this is a mod­el of a pri­vate bank­ing system–the bank­ing sec­tor kept the record­ed val­ue of its good­will con­stant? How could it do that? It could add a pos­i­tive sum to its Good­will to off­set the Loan, and a neg­a­tive to its work­ing capital–so that it cre­ates new mon­ey by cre­at­ing a loan.

Fig­ure 9

We now have a sys­tem which is much more com­pli­cat­ed, but which dynam­i­cal­ly reduces back to the same par­si­mo­nious Post Key­ne­sian one we start­ed with.

Fig­ure 10

So the bot­tom line here is that elim­i­nat­ing “Frac­tion­al Reserve Bank­ing” does noth­ing to elim­i­nate the capac­i­ty for banks to cre­ate mon­ey: that will exist in a pure­ly free mar­ket sys­tem just as much as it does today.

There are also very good argu­ments, from a very good Austrian—Joseph Schumpeter—that this capac­i­ty to cre­ate mon­ey is a nec­es­sary part of the entre­pre­neur­ial process that makes cap­i­tal­ism a dynam­ic sys­tem. My oth­er pro­pos­als, Jubilee Shares and “The PILL”, are intend­ed to min­i­mize the dan­ger­ous use to which bank mon­ey cre­ation is put—financing Ponzi Scheme bub­bles in asset prices—and max­i­mize this cre­ative use of that pow­er.

OK; it’s now the morn­ing, and after anoth­er jet­lagged sleep I have to present a con­fer­ence paper in 4 hours. I’ll leave my con­tri­bu­tion at this point and await Mish’s reply.

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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.