Steve Keen: Krugman vs. Richard Koo on Bank Lending

     I'm glad to see that Keen has a piece on Koo and Krugman. Richard Koo is one of those economists that many other economists don't seem to get. Krugman doesn't, but of course, Sumner doesn't either and probably few mainstream-Neoclassical-economists would get him. The differences between he and Krugman go back to the start of Japan's stagnation. 

    Koo's explained this as being a 'balance sheet recession' and this is an idea that Krugman, Sumner, and the Neoclassical school more broadly doesn't put any stock in. 

   Keen begins his analysis by saying, regarding Krugman-Koo-that the 'failure to communicate' a la Cool Hand Luke-is that 'birds got to fly, but fish got to swim.' Keen thinks Krugman is just a bird who can't get how a fish like Koo can swim. 

    "The extent to which this time really is different appears to be causing some thawing in the extreme hostility between economists of different ilks. But there’s still incomprehension because, when economists of different ilks argue, they try to understand their rivals’ perspectives from their own point of view. This is a bit like a bird trying to comprehend how a fish can live in the ocean – “OK, I have to admit that they exist, but why don’t they drown instead, since their lungs must fill up with water?”

This duality – acknowledgement that positions you don’t understand still deserve to be taken seriously, combined with incredulity about those positions – turns up in Paul Krugman’s recent comments on Richard Koo. In a New York Times article earlier this month, he firstly acknowledges that Koo’s analysis has to be considered, even if he doesn’t understand it."

Read more: http://www.businessspectator.com.au/article/2013/6/24/economy/gasping-krugman%E2%80%99s-ocean-theory#ixzz2XbWmywqI

     Of course, we could play around with this analogy. I mean isn't the bird as big a mystery to the fish as vice versa? Because the fish lacks wings he might think the bird should fall. Then again, considered from the perspective of evolution itself, didn't fish come first? Ergo, we could say that the fish is the 'flat earther' rather than the bird? Yet Keen argues that he understands both the bird and the fish-and presumably he's a fish as well. So he credits the fish with being 'more evolved.'

      I'm having a little fun. I get Keen's point of course. His point is that Krugman and Koo have two very different models of the economy. Actually, I was never sure what Koo's model was-not to say I thought he was wrong, I haven't really seen enough of him to really be sure I take his fundamental point. Keen here speaks as if Koo accepts the same endogenous money model of the economy he does-and he may well be right, I wasn't aware of that until now. My main impression of Koo is that he might be Sumner's middle image, if he truly claims that the Fed and BOJ shouldn't try to 

     So according to Keen there are two models in question: Krugman's Loanable Funds model and Koo's Endogenous money model. 

     The big difference rests on what happens to the economy when there is an increase-or decrease-in lending? In the Loanable Funds model, changes in the rate of lending don't effect the overall economy. Krugman clearly doesn't see why a change in lending should-necessarily-have any net effect on spending in the economy. 

     "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."

      http://krugman.blogs.nytimes.com/2012/03/27/minksy-and-methodology-wonkish/?_r=1

     Keen argues that the Endogenous Money model does show that creating money=creating demand. 

     "So it comes down to which world do we actually inhabit? Are we airborne with the birds in a loanable funds world, where banks, debt and money are macroeconomic irrelevances, or are we underwater with the fish in an endogenous money one where banks are – like gills on a fish – crucial? No prizes for guessing my answer. Glug glug."

     It is clearly true that most of the money supply is created through bank lending. As this is true, doesn't this  mean that most of what happens to the money supply is outside the province of the Fed?

     I'm reading Hank Paulson's On the Brink right now. It's all about the 2008 crisis and his fight to save the banking system. He and Bernanke believed that if the banking system collapsed it would be the end our economy. Isn't this more plausible in the endogenous money model? The reason that it would be cataclysmic for the banking system to blow up is that it would lead to a huge contraction of business investment and consumer spending. 

     Indeed, Schumpeter was one of the early ones to show that an economy can't grow if businesses and consumers only can spend the money they already have on hand. Keynesians-including Krugman-have rightly heaped scorn on the idea that the government must 'live within its means during a recession' and that since individuals are having to cut back, shouldn't the government cut back too? This, of course, is terrible reasoning. When private spending contracts, we want the government to pick up the slack. If the government cuts back along with the private sector we get a deep contraction. 

     Yet, fundamentally, the very premise of 'we must live within our means' is wrong. Our economy can grow as it has done only when financing-lending-is available to fund business investment and projects beyond what businesses have in hand. If they could only spend the money they already have, we'd have a huge contraction in investment, and many, many worthwhile projects wouldn't get done and there would be no hiring-and lots of layoffs. 

     Krugman agrees that lending can increase aggregate demand:

     "Keen says that it’s because once you include banks, lending increases the money supply. OK, but why does that matter? He seems to assume that aggregate demand can’t increase unless the money supply rises, but that’s only true if the velocity of money is fixed; so have we suddenly become strict monetarists while I wasn’t looking? In the kind of model Gauti and I use, lending very much can and does increase aggregate demand, so what is the problem?"

    So he agrees that it can but through an increase of velocity-the number of times the money stock turns over.  While Krugman claims that Keen only thinks changes in the money supply can increase AD, Keen suggests that Krugman thinks only change in velocity can alter it:

   "The reason for this drastic change in behaviour is that in both these models – and roughly speaking, in the real world too – money is the sum of the banking sector’s liabilities to the rest of society. In loanable funds, lending simply changes who holds these liabilities, and the level of debt doesn’t matter at all in macroeconomics – just as Krugman says. Only changes in the velocity of circulation can affect aggregate economic activity. But in endogenous money, lending increases the sum of liabilities in circulation, and repayment of debt reduces them, so that changing the sum in circulation can and does alter aggregate economic activity. So while we haven’t “suddenly become strict monetarists while [Paul] wasn’t looking?”, changing the volume of money in circulation by bank lending and repayment is a significant aspect of lending that the loanable funds model ignores."

   As Keen says, because this downturn really has been different there has been a thaw in relations between different types of economists-with some willingness to listen to some heterdox economists even, though only some. It seems to me that on balance Keen and company is right-lending does increase AD, not just through velocity but also through an increase or decrease of the money supply. 

   However, these debates are good. Time will tell who is judged right in many of these debates but I think economics will certainly be the richer for them. 

     "