Paul Krugman Has Got It Wrong on Debt

Every economist gets many things wrong. I get many things wrong. Unlike some other people, I am not going after Paul Krugman because I'm mad at him. I respect him, as I respect many other economists. But I think he has got the problem with debt all wrong.

On December 29, 2011, Krugman wrote:

I admit to having been surprised by the reaction to my two posts on the burden of debt. I thought I was saying something that would be obvious once it was pointed out; instead, many of the comments were baffled, and quite a few were utterly enraged.

I suggest you take the time to read all three posts -- they are short ones, as usual.

There is a certain attitude that guides Krugman's thinking on debt. It is linked to what I call the "Debt is one person's liability, but another person's asset" tautology. Why a tautology? Because debt is not debt if there is no creditor. In economics, this kind of tautology is also known as an accounting identity.

This particular tautology is often used to support the argument that debt is a lot more benign thing than an individual might think (the "micro-view"). This is also how Paul Krugman (implicitly) uses it in his posts. Yes, if there is a debt, a liability, there must be a credit (the flipside of debt, seen from creditor's perspective). What I call a credit is an asset in the tautology. I call it a credit to separate it clearly from non-financial assets.

Now, what if the people who use this tautology to prove that debt is a much more benign thing than many think, actually have got it the wrong way? What if it is credit (the asset), not debt (the liability), which is the real macroeconomic problem?

(All this is about "The Most Significant Problem in Economics". If you have time, it might be useful to also see my first post for an overview of how I view "money".)

Let us travel 300 years back in time, to early 18^th century France -- to the time of John Law and The Mississippi Bubble (1716-1720) *. This was one of the first well-documented, large-scale "credit explosions" -- not at all unlike the South Sea Bubble which took place more or less at the same time in England. When I look at the economic consequences -- short-term and longer-term, separately -- of these credit expansions, I fail to see how an economist back then should have found any comfort in the most obvious fact that there was not only debt, but also credit in the economy.

It is not debt, but credit which creates a sense of great prosperity across the economy when it expands. It lifts other asset prices (real, or financial, like stocks; which assets, depends on how the credit is used), and this increase in asset prices not only encourages/forces people to take on even more debt, but also makes more credit available, as these assets serve as collateral for debt. All this, simultaneously, makes people feel wealthier and so makes them spend more. The additional spending provides increased profits and jobs in industries where it is directed -- for instance, in the car and luxury goods industries. The economy is booming. What I describe here is a dynamic -- a positive feedback loop, or a spiral -- that Hyman Minsky studied closely. George Cooper has called it the "paradox of gluttony" (evidence here, and for instance, here), which is a smart way to point out that this can be seen as the other side of the better known "coin" called the "paradox of thrift".

I have a lot to say about why the paradox of gluttony must turn eventually to a paradox of thrift. About how, as William White puts it, "They have created so much debt that they may have turned a good deflation into a bad deflation after all.". It is all based on a fairly simple theory I have developed. But to keep the length of this post reasonable, I save it for later. (If you have any connections to Mr White or BIS, I would really like to hear from you.)

And don't get me wrong. I am not trying to make a historical argument here. This is about the logic behind credit and debt. I don't find much logic behind the attitude Paul Krugman and others profess as they try to comfort, or prove wrong, the thousands of experts like William White -- experts who are very worried about our national and global debt levels.





* Charles Mackay's "Extraordinary Popular Delusions and the Madness of Crowds" gives a good overview of the Mississippi Company bubble; Janet Gleeson's "The Moneymaker" is a very informative and entertaining biography of John Law.

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Further reading:


Jeffrey Sachs: "Paul Krugman has got it wrong on austerity"

Myself: "MMT Is The Most Flawed Monetary Theory..."

Myself: "Macroeconomics Is Not Yet a Science"

MMT Is The Most Flawed Monetary Theory...

... except for all the other monetary theories we have.

I said so in an update to my previous post, and now I have to back it with more specific criticism. I connect the Modern Monetary Theory (MMT) mostly with Abba Lerner. He made many good points and helped us realize how we have misunderstood money. But one reason this misunderstanding lives on is that Lerner's main thesis, Functional Finance theory, is wrong.

Money is not something that can be thrown into the economy in quantities required to maintain full employment. Money is credit. Credit cannot be thrown into the economy in quantities required to maintain full employment.

Credit, as trust, is a much more delicate thing, or non-thing. It takes a long time to earn it, but it can be lost in the blink of an eye. The easiest way to lose it is by using it excessively. By throwing it at the slightest problem and finally even at mere inconveniences. Credit gets often misused when one believes that it is impossible to lose it -- that it has always been there, for good reasons.

But if we give credit another name and make it appear as something tangible, perhaps it cannot be lost. And not just that, but more of it can be created at will. Let us call it "money".

I believe John Law was of good nature. But if he saw us now, I think he would have a laugh. He knew that credit can be created at will. That it can be taken as something tangible ("money") for a while, and that all this can create a very real sense of prosperity. Real houses and real cars are built and bought -- and assumed to have been paid -- with that credit. Had we not used credit, these houses and cars would have been built, and bought, much later in time. If ever.

It's like this magical credit just cannot run out. It sloshes around the world. They say there is a glut of it, and that thanks to this glut, it is even easier to create more of it. So the glut becomes bigger all the time.

Eventually, the false sense of prosperity will disappear, often in an abrupt manner. But life will go on and become in many ways much richer, deeper again. Of course there is pain involved in this transition, and minimizing this pain will become our top priority -- rightly so. But the first thing we do must be to stop making this false sense of prosperity even grander by throwing more and more credit at our problems and inconveniences.




p.s. I'm willing to be even more specific in the comments section, especially if there are MMTers who feel that this criticism misses their main thesis. Nothing beats a good discussion, and I'm willing to learn more. Let me hear from you.

Macroeconomics Is Not Yet a Science

Microeconomics is a science. Macroeconomics is a debate where the participants disagree on most of the important points of the subject. It is a debate that has been going on for centuries. Like any debate, it is cyclical.

In a debate, the participants are sometimes bored and it seems we are not moving anywhere. One person is speaking and the others either do not agree or they think that what is said is not relevant. They don't listen, but they let the person speak. Then there are times when the discussion heats up and it turns to a verbal fight. These periods are often preceded by someone bringing in a new argument, a new perspective, that sounds both interesting and threatening -- threatening from the viewpoint of those who disagree with the person bringing forth the argument. As a consequence, these people attack the argument with all the intellectual force they can gather. If they are smart and work together, they can try to shape the new argument -- using dirty tactics either knowingly or unknowingly (they are humans) -- so that it can be either ridiculed or, at best, included in their "model of the world" as a special case not worthy of too much attention.

J. M. Keynes's General Theory did not establish macroeconomics as a science. He brought a new perspective to the debate. It was an important perspective with a lot of potential, but he did not manage to establish much agreement among economists. Therefore similar debate rages on even today. Call it Keynes vs. Hayek, if you will. Like any scientific theory, Keynes's was supposed to help to solve the problems of his day. It isn't going to help us solve the problems of our day. Keynesianism has helped us to avoid certain mistakes, but there are worrying signs that it has also created significant problems. I don't blame Keynes. There could be more reasons to blame "extreme Keynesians", but finger-pointing doesn't do much good. If not now, then at least in another universe, we could blame "extreme Hayekians".

We will never know what Keynes would think of the situation we find ourselves in now. A guess about what Hyman Minsky would think would already be a much more educated one. Minsky thought that he understood better than other, more influential, economists what Keynes really wanted to say in his General Theory. Minsky's own "instability hypothesis" grew partly out of that.

I believe Minsky would think much the way William White thinks. But that is my Minsky. We all have our Keyneses and Minskys. My Keynes would not agree with many Keynesians today.

Science can be seen as a debate. But we could look at debate as a spectrum, one end of which we name "full agreement" ("I love you, guys! Let's be best friends forever!") and the other end "full disagreement" ("We will meet at dawn. Bring a second and a pistol."). Now, what we call science can never reach full agreement. But to be taken seriously by non-academics -- and this is especially important in the case of economics -- the scientific debate needs to be closer to full agreement than to full disagreement. We need a theory that is based on logical assumptions and which corresponds with reality. If there is a constant disagreement among economists around the main premises, so that wise and intelligent people don't seem to agree on the causality between certain central variables -- e.g. credit growth, GDP growth, money supply, inflation and unemployment -- then I don't see a science. These people may agree, for instance, that money supply and inflation correlate (in "the long term") but still disagree when you ask them about the cause and the effect.

We do not need to agree on a definition for "science". It is the debate that matters. Explain me how the causation works between any two central macroeconomic variables. Make me understand it. Then we speak science.

The Most Significant Problem in Economics

Ambrose Evans-Pritchard of The Telegraph writes in an article which covers the thoughts of William White (of OECD; ex-BIS):

Mr White's warnings are ominous. He acquired great authority in his long years at the BIS arguing that global central banks were falling into a trap by holding real rates too low in the 1990s, effectively stealing growth from the future through "intertemporal" effects.

He argues that this created a treacherous dynamic. The authorities kept having to push rates lower with the trough of each cycle, building up ever greater imbalances, in an ineluctable descent to the "zero bound", where monetary levers stop working properly.

The most significant problem of our time for economists to solve is this: an experienced and highly respected economist like Mr White thinks -- passionately -- as he thinks of the contemporary economy. At the same time we have many experienced and highly respected economists who do not agree with him at all.

We see signs of this same underlying problem almost daily, although it might be somewhat disguised. It can take the form of a shouting match between two economists: monetary stimulus or not; fiscal stimulus or not; stimulus or austerity; more debt or less debt. Sometimes there are two schools of economic thought against each other in similar arguments. Or Paul Krugman vs. the Bank for International Settlements. Eventually, whole nations get pulled in. It can be "Germany vs. the rest", like this article by Martin Wolf of Financial Times shows. What is so sad about this is that the two sides to the argument often end up thinking the other side "idiots". As a consequence, they drive each other mad. They cannot understand each other. This smells very much like "incommensurability", a term Thomas Kuhn popularized in the 1960s.

Paul Krugman says -- in his blog post I linked to above -- that BIS people have, instead of a method, a certain attitude that guides their thinking. If we were struggling with incommensurability, this would be a typical thing to say if you are an adherent of a prevailing theory. In our case, BIS people are the ones challenging this theory. They are saying: "If you like your inadequate theory, you can keep it. We move bravely on."

What we must be witnessing here is a huge gap in our common knowledge, mutual understanding. Nothing else could cause this seemingly hopeless disagreement. There could hardly be any clearer wake-up call for economists who consider themselves true scientists. We need to fill this gap, instead of arguing endlessly and often childishly for either "stimulus" or "austerity".We can let the scientists who consider themselves already having earned their place in the history books argue about silly things. They have done their science. For us mere mortals, there are much more important things to do.

How does one solve significant problems? Here I would follow the advice from a quote attributed to Albert Einstein:

The significant problems of our time cannot be solved by the same level of thinking that created them.

As a strong believer in this piece of wisdom, I've been happy to witness the emergence of groups like Post-Crash Economics Society, Rethinking Economics and The Institute for New Economic Thinking. I am not aware of everything they believe in, but the pressing need to find a new level of thinking is obviously present in all these and many other groups I fail to remember right now. It has also been delightful to see that intelligent and experienced people like Adair Turner, George Soros and Andy Haldane, to name a few, are giving their moral and financial support, and/or brain power to this cause. Whether they are fully aware of it or not, many of these people have identified the most pressing problem in economics. A problem that must have been there always, but which has become more and more obvious, and almost unbearable, during our latest financial crisis.

Here is the problem in its simplest form: We do not understand well enough how the monetary system works.

Money is an enigma. All who have studied it know that money is tightly connected to credit. During the last 200 years, we have had a "monetary theory of credit" and "a credit theory of money". These and some other monetary theories still live side by side and the fundamental problems remain unsolved. I have full understanding for the economists who have given up working on this issue. But luckily we have also people who are "crazy" enough to try. Even when they know that J. M. Keynes, Joseph Schumpeter, Irving Fisher, Henry Simons, Ludwig von Mises and all the other big names of the first half of the 20^th century also tried. And failed.

I have tried too. I'm mainly self-educated, both in economics and in life. My only degree is in accounting (master's). I have come to believe I'm a fairly rare type, "a crazy accountant", or "an accountant with imagination (and dry humor)". If I have some advantage, I think it lies mainly there. It might also lie in my questioning attitude towards any received wisdom. My brain just doesn't receive it. Therefore the fact that I enjoy reading Nassim Taleb should not come as a surprise. That I do not view even Nassim Taleb as an "authority" should also be self-evident. Having now tried to prepare you, I hope what I am going to say next will not be taken as impudent or arrogant. It is just how I see things at the moment. It is my truth.

I believe I have succeeded in solving our problem. How I have done it is by unlearning, painfully, what I thought money was, and finally, by divorcing money completely from credit. What I now sit with is a very simple theory with a huge explanatory power. Of course there is a "catch", and I already stated it. It is difficult to forget what one for a long time has considered true. In his preface to The General Theory of Employment, Interest and Money (1936), John Maynard Keynes put it like this:

The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

My hope is that someone will have the curiosity to follow my thought, criticize it and/or build on it. I do not want anyone to believe what I say. Do not believe me. Criticize. Find out why I am wrong, as I must be. If we follow this way, I am 100 % sure that we will learn a lot. I can see that there are many people who are working on this problem and some of them seem to be on their way to solve it ("thinking in terms of purchasing power" may ring a bell). It is a matter of time. But the sooner the better, as the problem seems to be becoming very, very pressing again (see, for instance, William White).

 In case I have managed to arouse even a little bit of curiosity: I would be happy to work with someone on the subject. I have worked on it alone for long enough. (Don't get me wrong: I am full of enthusiasm and will keep on working alone for another year or ten, if need be.) Send an email or contact me on Twitter. There are already many people who I view as like-minded, and I would like to work with this kind of people. If you find yourself somewhat in agreement (not to be confused with "believing"; neither do I suggest that these people would agree with each other) with people like John K. Galbraith, Hyman Minsky, William White, Claudio Borio, Raghuram Rajan, Stanley Druckenmiller, Bill Gross, Steve Keen or George Cooper, or even the Germans, then you probably fit my definition of like-mindedness. My goal is to prove the world that many of these people have been mostly right when it comes to the "big picture", or at least that they have "gone nuts" for a good reason -- the latter being, perhaps, another side of the same coin.




UPDATE 1: I read an interesting article from Steve Keen in Forbes and found myself surprisingly in full disagreement with his main thesis. I guess I should write a post about this...

UPDATE 2: To be more precise, I don't agree with the Modern Monetary Theory (MMT) view Mr Keen seems to take in the article I linked to above. MMT is the most flawed monetary theory, except for all the other theories we have. But I do agree, most of the time, with Mr Keen's overall view of the economy as it concerns credit growth and all the "bubbles" it has created. If he finds himself on the same page -- as I think he does -- with Hyman Minsky and William White, then I think we can sort this out :-)

Unlearning Money: Part 3

Can commercial banks create "money" as much as they want, or is their ability to do it constrained?

Individual banks face both capital and reserve requirements. But retained earnings from net interest income help in taking care of any increase in capital requirements. This is why capital requirements rarely pose any problems in an environment of economic growth. The economy is growing, credit is growing (the economy makes credit grow and credit makes the economy grow; go figure), and with aggregate credit growth comes usually growth in banks' net interest income. The capital requirement might become a real constraint only when credit, for other reasons, is either growing at a decreasing pace or outright contracting.

Reserve constraints, like capital constraints, pose a smaller problem when the banking system as a whole is increasing lending, i.e. there is aggregate credit growth. When Bank A makes a loan, a deposit created by it might end up being transferred to Bank B, but in similar fashion Bank A is a recipient of deposits created by other banks. This will lead to fairly small net payments between banks.

Let us go a bit further and assume we would like to remove nearly all reserve constraints --including all frictions arising from reserve requirements-- to credit growth. If we are to reduce any friction arising from the netting process itself, we can (in addition to operational and technological improvements) make most of the transactions take place between few "megabanks" in each economic area. If these megabanks view each other more or less "too big to fail", then we have established a large amount of trust (some might rather call it moral hazard) which will make the netting process even smoother and commercial banks more willing to lend reserves to each other. Now that we got started, we could also have the central bank and the government guarantee all loans between these megabanks and any remaining mid-sized banks too, and not only that, but the central bank could create new reserves if the aggregate amount of reserves falls too close to the required level. Required by who? Well, the authorities could simply remove any reserve requirements to start with. Does this mean that the reserve requirements are there only in case the central bank would some day like to resist credit growth, not fuel it? It could be. Someone better ask Paul Volcker -- he might remember.

(Readers familiar with our current monetary system might recognize some familiar aspects in the thought experiment above.)

I would thus argue that in a benevolent economic environment *, the credit supply is not really constrained at all. In a hostile environment, it is mainly constrained by banks' own risk considerations. There are good reasons to believe that the banks can be "irrationally" risk averse, but fortunately this can be countered by bold ("whatever it takes") and firm ("The US government has a technology, called a printing press") action taken by monetary authorities.

If the authorities are even partly successful in their attempt to sustain bank lending during an economic downturn --as currently seems to be the case in many economies--, we can fairly safely conclude that in our current monetary system the real credit growth constraints lie on the demand side. It is the public's, and increasingly the households' --not businesses'-- willingness to borrow that decides the pace of credit growth in most of the advanced economies today. And this in fact is how many academic economists and government officials would like it to be. They have worked hard to achieve this for some decades now. It is easy to track their related actions to the 1980s, and the underlying train of thought probably harks back to academic ideas that emerged in the 1950s.

I will come back to this in my coming posts. For now, I want to suggest the following: We should probably not lump household debt and business debt together in our analyses. They are two distinct forms of debt and taking them apart and studying them separately could be the most fruitful way to proceed in solving our current (scientific) problems in economics.


Some background information:

I have studied money and credit very intensively and, I believe, somewhat independently for about 10 months now and I am looking forward to sharing my major findings in the coming posts. By "intensively" I mean quitting any job you might have, living frugally on some savings, reading economics/philosophy/psychology/history/everything your intuition says you might want to read, thinking, writing, and waking up every morning with "monetary thoughts" racing in your head, making you wonder if those thoughts actually ever had a rest. This can hardly surprise any true monetary economist, a breed that reminds me more of Ludwig Wittgenstein than of Paul Samuelson. For my part, I am happy to say that I feel very good now and during the whole episode I did not use any medication or even professional help, although I have understanding for any colleagues who might have done so...

I consider as my main audience all the like-minded people who just cannot let "money" remain an enigma and are willing to risk their mental health in the name of increased understanding.



* My definition of a "benevolent economic environment": GDP growth fluctuates around its (abstract, and perhaps self-referential) trend and long-term inflation expectations remain well-anchored -- as judged by financial markets. This leaves some room for me to speculate whether half of the investors could be expecting very high inflation and the other half a "Fisherian debt-deflation", and inflation expectations would still seem "well-anchored".