The Central Flaw in Krugman’s Argument Against Keen

The key failing in Krugman’s response to Steve Keen’s response to Krugman’s paper (PDF) is here:

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.

Krugman assumes here that people have to save (spend less) in order for other people to borrow. It’s actually the fundamental assumption, the sine qua non, of his paper (and of Krugman’s beloved IS-LM — the linch-pin of “New” Keynesianism — created by Hicks to subsume Keynes into neoclassicism, and later disclaimed and discredited by Hicks as a “classroom gadget”; see my post, and Philip Pilkington here).

But that’s not how things work (and it’s the very assumption that Keen is disputing). I tried to explain this in clear and simple terms here:

Think about it:

You get $100,000 in wages. Your employers’ bank account is debited, and yours is credited. Your bank can lend against your higher balance; your employer’s bank can’t. Net zero.*

You spend $75,000. It’s transferred from your account to other people’s/businesses’ bank accounts. Their banks can lend more, yours can lend less.

Is the total stock of loanable funds affected by whether the money is on deposit at your bank, your employer’s bank, or the banks of people you bought stuff from? No.

Meantime, you don’t spend $25,000. You “save” it. The money sits there in your checking account. If the action of spending — transferring money from one account to another — doesn’t change the total stock, how could not transferring money do so? Your bank still has the money, which it can lend out. Other banks still don’t, and can’t.

So here’s how the argument plays out:

Krugman assumes that people need to save in order for others to borrow.

Keen points out that they don’t.

Krugman explains that Keen is wrong by … assuming that people need to save in order for others to borrow.

And so the world goes round.

Cross-posted at Asymptosis and Angry Bear and here with permission.

5 Responses to “The Central Flaw in Krugman’s Argument Against Keen”

R. CoutinhoMarch 28th, 2012 at 8:18 pm

And even that is wrong. The banks create a double entry when they lend. Thus they credit your account with the money you borrow and credit their account with a loan to be received. The Fed then adjusts the reserve account that it holds. The act of lending creates the money that is lent. Presto change-o, there is no requirement to have the money from the depositor in the first place (so long as the Fed will accept the loan as collateral–which it will).

brhMarch 29th, 2012 at 10:16 am

Logically, I'm not sure how you get from savings "doesn't have to represent" increased demand to the idea that Krugman "assumes here that people have to save (spend less) in order for other people to borrow". I don't find that statement in Krugman's post, and it cannot be logically inferred from the statement you quoted. The fact that one allows a possible path for banks to finance borrowing through savings isn't the same as stating it is the only path. However, it appears that is the argument you are attributing to Krugman and then knocking down. Can you explain how this isn't simply a straw man?

George IrvinApril 17th, 2012 at 6:01 am

I find the whole debate a bit of a 'storm in a teacup'. Hicks quite rightly recognised that IS-LM reircorporated the neo-classical link between investment and the rate of interest, and those of us who were Keynesians but taught IS-LM explicitly pointed out that the 'liquidity trap' was approximated by a 'flat' LM, rising only at full emploment. Equally, the MMT argument that 'the act of lending creates the money that is lent' (correct) was put by Kaldor back in the 70s. What's new here?

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Håvard Halland Håvard Halland

PHåvard Halland is a natural resource economist at the World Bank, where he leads research and policy agendas in the fields of resource-backed infrastructure finance, sovereign wealth fund policy, extractive industries revenue management, and public financial management for the extractive industries sector. Prior to joining the World Bank, he was a delegate and program manager for the International Committee of the Red Cross (ICRC) in the Democratic Republic of the Congo and Colombia. He earned a PhD in economics from the University of Cambridge.