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Reply to Pedro Al Sombrero Negro.

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Commenting on my Krugman article, Pedro Al Sombrero Negro raised many interesting points. I’m going to copy his full comment here, and add my response. As always, all quotes from anyone in italics, my comments in regular font.

But first, an apology in advance for using a writing style to reply that Pedro may not deserve. I am thankful that you read my article, Pedro, and still more thankful that you bother to comment on them. So there is nothing personal in the sarcastic style that follows. It’s just the way my mind thinks, for some reason.

Pedro starts right in:

It seems your whole point is built on the assumption that bank can choose to lend as much as they legally can: this is just not true, nor observed in real life. Banks only lend to creditworthy borrowers, and that is if they show up !

Have you been living in a cave with that sombrero, Pedro? Have you not heard of toxic assets [=loans to uncreditworthy borrowers], bank bailouts, the current recession we are in? That happened in real life. On such a vast scale that all the banks went bankrupt [=lost all their money] because of loans to the uncreditworthy.

And you assume they won’t show up? That is what lowering interest rates is for.

The whole reason keynesianism exist in the first place is because there is such a thing as a situation in which the effective private sector demand for loans is lower than the total debt repayment mometum, hence triggering a debt deflation movement.

Not exactly. In fact the reverse is true. The whole reason it exists , meaning the false assumption Keynes made, it that people will have money lying around that they don’t want to lend, despite businesses dying for the money.

But hey, don’t take my word for it. Let’s go the source. Here’s Keynes in Chapter 3:

Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members.

If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest. 

But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate; which ‘brings us to the theory of the rate of interest and to the reasons why it does not automatically fall to the appropriate level, which will occupy Book IV.

For those who don’t want to bother deciphering that stuff, here’s Mises paraphrase:

John Maynard Keynes [1883–1946] succeeded with his anti-saving program. According to him, there is danger in over-saving. He believed, and many people accepted his view, that opportunities for investment were limited. There may not be sufficient investment opportunities to absorb all the income that is set aside as savings. Business will become bad because there is too much savings. Therefore, it was possible to save too much.

The same doctrine from another point of view had been prevalent for a very long time. People believed that a new invention—a labor-saving device—would produce what was called “technological unemployment.” This was the idea that led the early unions to destroy machines. Present-day unions still have the same idea, but they are not so unsophisticated as to destroy the machines—they have more refined methods.

And by the way, why does Mises think the Keynesian thing is ridiculous?

As far as we can see, human wants are practically unlimited. What we need to fulfill satisfactions is more accumulation of capital goods. The only reason we don’t have a higher standard of living in this country is that we don’t have enough capital goods to produce all the things that people would like to have. I don’t want to say that people always make the best use of economic improvements. But whatever it is that you want, it requires more investment and more manpower to satisfy it. We could improve conditions, we could think of more ways to employ capital, even in the wealthiest parts of the United States, even in California.

There will always be plenty of room for investment as long as there is scarcity of the material factors of production. We cannot imagine a state of affairs without this scarcity. We cannot imagine life in a “Land of Cockaigne,” where people have only to open their mouths and let food enter and where everything else people wanted was available.

Bottom line, Keynes wasn’t talking about “no effective demand” for loans. Businesses are dying for those loans, so they can, you know, stay in business. But they won’t get them.

Also of interest is that Keynes does not say a word about the “problem” you mention, “debt repayment momentum” being larger than “effective demand” for loans. Not a word about that. All he talks about is not enough consumer spending, and not enough profitable investment opportunities. In fact, he explicitly stated that if effective demand for loans gets out of hand, then we are doomed. He called it “debauching the currency”. Here’s the quote:

Lenin is said to have declared that the best way to destroy the Capitalistic System was to debauch the currency… Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose. [Source: The Economic Consequences of the Peace, 1920, page 235]

Now I know that Keynesianism nowadays is very different from Keynesianism in 1936. Facts just kept slapping Keynesianism in the face, so new versions of it had to be thought up every few years. In fact, Wikipedia quotes economists who write that Keynes’s actual book is actually useless nowadays. The only thing that has been retained through all the reincarnations of Keynesianism is the notion that the govt has to spend a lot of money, or we are all doomed.

So it may very well be that the latest teachings in the schools is what Pedro Al Sombrero Negro is saying, that the problem govt has to solve is that people are paying their debts faster than they are taking on new debt. This is terrible, apparently, and so we need the govt to step in and borrow lots of money. Ths schools may have even rewritten history, Joseph Stalin style, and claim that Keynes said the same thing.

OK, Let’s look into it. What is so terrible if people are not constantly getting into greater and greater debt? Pedro tells us:

…(A fast decrease in broad money as opposed to a healthy economy that sees a steady increase in the monetary mass)…

So that’s what they are telling the gullible nowadays. A healthy economy sees a steady increase in the monetary mass [=inflation of the money supply], they taught poor Pedro. Obviously, he hasn’t read any Austrian economics, or my blog, or even what Keynes had to say about inflation [see above], or he would know better. So go to mises.org and do a search for inflation, or go there and get a free copy of Hazlitt’s books on inflation, or search my blog [this article for example, in which a Nobel Prize winner lays out the case for inflation, and Smiling Dave leaves him as the dust beneath his chariot wheels].

Firstly, you cannot compare a debt repayment with a traditional transaction because the former reduces the monetary mass when the latter simply transfer money from one person to another;

To be crystal clear, my position is twofold. My basic one is that of the great Austrians, that a decrease in the “monetary mass” does no harm. As Mises said, all the achievements of Capitalism would have happened no matter what the monetary mass. [See this article for more about this point. It talks about the monetary mass dwindling because people hoard their money, but the principles are the same].

In the Krugman article I was doing something else, hoisting Krugman on his own petard. I was addressing Krugman’s fears of a shrinkage of spending when people pay their debts, and taking the position that even in his own twisted view of things, paying your debts does not mean less spending. The guy you repaid the money to will spend it, never fear. That’s why he wanted the money in the first place. To use it.

I mean, think about it. If the money you repay the bank “disappears”, why do they even want it back in the first place? Obviously, it doesn’t really disappear. As I explained in earlier replies.

…then most importantly, and correct me if I’m wrong, but you seem to miss a major feature of the banking system: the endogeneity of money. Banks don’t choose to lend money out, they can only lend if, and only if, there are profitable projects and creditworhty borrowers to ask for loans, in other words, it is the demand side for loans that determines the total size of the market. Banks cannot force entire populations to get in debt against their will (they can try to influence them, think revolving credit and the like, but that’s nowhere near deciding to lend out money at will).

I dunno. The whole reason banks are banks is to lend people money. That’s how they pay their salaries and make their profits.

Wikipedia says the first banks opened up in 2000 B.C. Since then, no bank has ever closed down because “we had nobody to lend to.” It just doesn’t happen. Is that what Krugman is afraid of? That J P Morgan Chase and Citibank and all the others will lock their doors because they have nothing to do?

Banks are never reserve constrained, and there is no such thing as a “money multiplier” that would suppose an increase in reserves or depostis would automatically trigger an increase in loans, even the Fed admitted it.

Again, why do they bother to collect the loans? Why do they go bankrupt when they are not repaid? Why is there a recession now? Why did the Fed buy up toxic assets [=loans that will not be repaid]? The money disappears even if they get paid back, you and Krugman say, so what difference does it make?

The whole problem lies in the fact that a sharp decrease in the money supply can have (and recently had) massive spillover effects that artificially reduce money velocity and demand in industry otherwise not particularly malinvested:

Prove this, don’t assert it. Mises laid out his case that a sharp decrease in the money supply does nothing. I elaborated on it in this article. What is your refutation?

some keynesians (among others) uses this as a argument to justify deficit spending to compensate this phenomenon: this is debattable, and very much so, but the underlying problem is there, and I see no point in avoiding to expose it. Cheers.

There is no underlying “problem”, and even if there was, it is not really a problem, all as explained above.



  1. Pedro says:

    Thank you for your detailed answer. I didn’t expect such a thourough response, that’s interesting, here’s what I see. (please note that I am not affiliated with the Keynesian school of thought – if anything I’d be something of a market monetarist but that’s another matter; I’m just not especially advocating for Krugman or anyone, just pointing out what seems wrong to me)

    You raise the example of the 2006 real estate bubble: it was not a consequence of low interest rates but of implicit and explicit governement insurance for lenders, and overleveraging of the financial system as a result. Banks have been around for centuries, and if there is one thing they know, it’s that low interest rates today mean high interest rates tomorrow. Bankers are not near-sighted, they are perfectly aware that if they lend money at a low, but flexible rate, over a long-enough period of time (typically a mortgage), interest rates will rise and borrowers will be underwater. Thats why there is a rate-related risk premium, it’s pretty common procedure and banks have made money for decades even with rising rates. Banks forecast the potential risks over the course of the loan, and price them in what they sell to their clients. Smart bankers and well managed banks had little problem during the last crisis. The reason why major banks in the US and in Europe had so much trouble a few years ago is because they had received, since Clinton with Fannie and Freddie, the implicit garantee that the gov would bail them out and insure their assets were things to go south a little too fast. And they did bail them out. (Then there is problem of asymmetry of information, but that’d be too long to detail). On a reasonnably free market, there is no interest for a bank to lend money to people who could not pay back in case of rising rates, so they don’t do it, basic responsibility. The government intervened to buy votes, and triggered a chain of problematic events, independently of interest rates (even if this possibly amplified the underlying phenomenon).

    Then about banking and loans. Banks, for the last ~ 400 years or so, never needed “cash lying around” to be able to lend. Banks are never reserve constrained, they are only capital constrained. When a bank grants a loan, it doesn’t debit its depositors’ accounts of the same amount : the credit is just written on its balance sheet and IOUs emitted to the borrower. There is no “if” as you seem to imply, when a loan is paid back, the money does disappear, that’s an undisputable fact and the very nature of the banking system. If a trustworthy borrower comes along, the bank can always lend money to him regardless of its current deposits, and then, later on, borrow reserves from another bank to equilibrate its balance sheet and respect regulations. So the problem with credit crunches is not banks refusing to lend as much as the private sector demand for loans that drops too low relatively to the needs of banks. Keynes did not, apparently, understand the endogeneity of money and its implications on this matter (more on this here: http://pragcap.com/did-keynes-understand-endogenous-money).
    Now during a deflationary event, liquidity preference rises, sometimes a lot. People save and reduce their spending and their borrowing. Banks consolidate their balance sheet, but the total credit emission dwindles because the demand is so low, what can lead to a debt deflation, and subsequent recession. This must be put in context of the general credit cycle: during deleveraging, business don’t want to borrow money, they want to reduce their debt burden, but they still need sales to stay in business. So business are not “dying for loans” (there would be no credit crunch if this was the case !), on the contrary they want to reduce their debt and crave sales, not loans. Hence the keynesian focus on aggregate demand, which is not a meaningless concept, very not so.

    Now, inflation. I know some austrians want to label any increase in the money supply as “inflation”, but this is assinine. Inflation is a rise in the price level, and nothing else. Even Mises view on the question is misunderstood (http://socialdemocracy21stcentury.blogspot.fr/2010/04/austrian-theory-of-inflation-myths-and.html) as he admitted himself that prices will only rise if the money supply exceeds the demand for money and the productive capacity of the economy, big difference! So I’ll only use the term “inflation” to mean “increase in the price level” as it’s its only valid definition.
    A steady increase in the monetary mass is an empirical observation that goes back for centuries. Even Mises admitted it was sustainable (http://uneasymoney.com/2012/10/10/on-the-unsustainability-of-austrian-business-cycle-theory-or-how-i-discovered-that-ludwig-von-mises-actually-rejected-his-own-theory/), so there is nothing more to say about this: an increase in the money supply is not necessarily inflationary and will not necessarily be unsustainable, no immediate problem here.

    The crux of your misunderstanding of the monetary system is, in my opinion, that you don’t admit that money is endogenous (http://pragcap.com/the-broad-money-supply-is-always-endogenous), and you think as if we were still in the monetary system that prevailed centuries ago, with convertible currencies. With sea shells as money istead of debt, a decrease in the money supply may possibly translate to a harmless deflation (although that’s not what happened during gold-standard era deflations), but it is not a valid model in our world. Nowadays money is bank credit, not high powered currency (97% actually, you can look it up). It means that for every $ in circulation, there is a $ of debt somewhere else. When the currency in circulation decreases, debt remains, since it’s nominally fixed. Hence a very strong price (and esp. wages !) rigidity on the lower bound: companies go bankrupt instead of lowering their prices, people get fired instead of lowering their wages, total output decreases in real terms as a result of a decrease in nominal terms. The problem thus spreads from one industry to the next, spills over, and unfairly and unnecessarily hinders otherwise good companies and responsible individuals. That’s the simple debt deflation phenomenon, basic economics, really (and one of the many reasons why deflation is so harmful to complex economies with higly leveraged financial systems). Other concerns arise when the bulk of new loans goes to leverage financial operations and not traditional businesses, which causes controversy as to which transmission mecanism would prevent debt deflation to hit poor people harder, but that’s another debate.

    Finally, I’ll answer quickly to some of your final remarks and questions:

    “no bank has ever closed down because “we had nobody to lend to.”” >> Thats not the point, a bank closes when she does not make enough to honor its engagements.

    “why do they bother to collect the loans?” >> Because otherwise they would lose the amount of the loan, and mark it as a loss on their income statement. Shareholders usually don’t like it.

    “Why do they go bankrupt when they are not repaid?” >> Same as above.

    “Why is there a recession now?” >> Debt deflation. Nominal shocks translate to real shock and a brutal decrease in the monetary mass lead to a brutal decrease in real production. In one chart: http://1.bp.blogspot.com/-3wqBNsoCoh4/Tgt1FWMh8lI/AAAAAAAACIE/XL8zxG95PIE/s320/usa.jpg

    “Why did the Fed buy up toxic assets [=loans that will not be repaid]?” >> To remove strains on bank balance sheets and avoid ruining depositors and asset holders, what would further the recession.

    “The money disappears even if they get paid back, you and Krugman say, so what difference does it make?” >> I’m not just saying so, it is so, that’s the way banks work. Credit is created as an IOU from the bank, and when it’s repaid the IOU cancels itself. That implies the entire economy can reach a situation in which there are less $ available for circulation than there is debt yet to be repaid. If new $ don’t appear somewhere, you can see we’re in a dead end where blood and tears will be unnecessarily shed. Money matters, it’s not just a neutral veil over barter-like transactions.

    So yeah, 10% unemployment and negative real growth is definitely a problem, otherwise we would not even talk about a “crisis”. Its an empirical observation more than a mere theoretical assertion.

    I’m sorry that is a little too long, but I wanted to make my point a little clearer, and I hope it is now.
    All the best. Pedro.


  2. Smiling Dave says:

    I too, did not expect such a long response to my response.
    Obviously, a serious reply will take a while to put together.
    So I’m approving your comment right now, and hopefully will respond in due course.
    In the meanwhile, you can search my site for MMT, read this article https://smilingdavesblog.wordpress.com/2011/08/17/mises-enlightens-yet-again/, and this one https://smilingdavesblog.wordpress.com/2011/08/23/are-mmt-and-ae-compatible/ [with the links they contain].

    Just a short q for now, if you will. How did you find my site, hidden as it is in the backwaters of the internet?


  3. Pedro says:

    If I recall correctly, I read one of your comments on Reddit.

    If you have some time, I’m sure you will be greatly interested in this debate between Bob Murphy (AE) and Warren Mosler (MMT) where they talk about some points we approached here: http://www.youtube.com/watch?v=cUTLCDBONok

    I think MMT must be divided in two parts: descriptive and prescriptive. On the description side, they basically get it right, and concur with the “monetary realism” folks, as in this (great, must-read) paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1905625 . On the prescriptive side, it gets political, so it’s very debatable and I find they put too much faith in the public sector, but that’s maybe my conservative side who talks, nobody is objective !

    Market Monetarism is a different thing altogether. Put simply, they want NGDP targeting, and here’s what they say: http://marketmonetarist.com/2012/07/19/the-ngdp-level-targeting-the-true-free-market-alternative-we-try-again/ . Given that a/ endogenous bank-credit money is a very good kind of money and b/ it is possible to remove governement intervention thanks to this simple NGDPLT rule, I think their positions are not-only politically very pragmatic and easy to enforce without big-banging everything, but also have a significant chance of removing many governmental interventionisms that hinders the normal operations of markets and promote as a result socialist ideologies.

    Now I just took a few days off for family reasons, but I’m going back to work and I may not have a lot of free time from now on to answer you in details, but I’ll read your response attentively no matter what. If anything, writers such as Cullen Roche, Lars Christenen or Scott Sumner explain what I’m traying to say here much better than I could.

    Regards. Pedro.


  4. Smiling Dave says:

    1. What you call asinine was the standard definition of inflation from the beginning of time until only very recently.
    See https://mises.org/daily/2914. If you don’t believe him, get any old dictionary or encyclopedia online and see how it defines inflation.
    Also see HA chapter 17, section 6, about why politicians decided to use your definition. [Hint: precisely to create the confusion you have].

    As for LK, he is intellectually dishonest, as is well known to those who read his stuff. Here’s are two examples right in the article you linked to. In the very Shostak article he quotes, Mises is quoted as saying this:
    “Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise.” [Written in 1951]. In other words, he ignores a quote that contradicts his thesis from later work of Mises.

    Also, LK is intellectually dishonest in that article by starting off with a Ron Paul link, then attacking those who say money supply linearly increases prices. The clear implication is that Ron Paul believes that, which is false. No Austrian believes that. [Proof: LK did not produce a single quote of anyone who says it, yet another intellectual dishonesty]. Or else LK is just stupid, and thinks that an increase of money supply can either influence prices linearly or not at all.

    Now you may ask that Mises here contradicts what he wrote in his 1912 book. Either he changed his mind and uses this definition, as he did in all his works for over fifty years after the 1912 book, or there is a way of reconciling the two, which I may write an article about.

    Bottom line. Do not make LK’s mistake. Inflation of money supply may not create linear increase of prices, but it will create an increase [or prevent a decrease that would have happened otherwise]. The laws of supply and demand prove that.

    2. That guy on uneasymoney.com knows not of what he speaks. His argument is as follows. Mises claimed increasing the money supply will cause malinvestment. He claims that the companies that malinvested can be prevented from going bankrupt by constantly increasing the money supply. This is the same, that guy thinks, as there not being any malinvestments in the first place, his first blunder. But this cannot go on forever, Mises claims, because it will lead to collapse of the currency. So that guy now thinks he found a brilliant refutation of Mises by pointing out that historically this has never happened, and instead there was a stop to an increase of the money supply instead. What? Does he even understand what a chain of reasoning is? That’s his second blunder.

    To elaborate on his first blunder, the guy thinks that if only the inflation of money supply had not stopped, all would be well. Let me explain with an analogy. The Post Office loses a lot of money every single year. Clearly, it is a terrible idea to keep it running, a horrendous waste of manpower and other resources. [I hope our common economic background is such that you understand this]. But the govt gives the PO money every year to help it keep functioning, despite their tremendous losses. That guy on uneasymoney.com would say that the bottom line is that the post office is doing just fine, what’s not to like?

    3. I asked you why do banks bother to collect the loans? You replied because otherwise they would lose the amount of the loan, and mark it as a loss on their income statement. Shareholders usually don’t like it.

    I’m not sure what you mean. How do they lose the amount of the loan? When they get repaid, the amount of the loan disappears, right? What could they do now they were repaid that they could not do before they were repaid? Now if you mean that in reality there is no difference, but it just looks bad on the income statement, and shareholders who don’t understand the subtleties will foolishly think something is wrong, that is absurd. Why did Lehman Brothers choose to go bankrupt instead of business as usual? Shareholders usually don’t like losing all their money even more than they don’t like seeing something that “looks bad” on a balance sheet but making big profits at the same time.

    4. You write that in reality reserve requirements are not a constraint, because the bank will first lend the money then find somewhere to borrow enough cash to meet the reserve requirement. But this is only true with petty cash. If they would try to do that with really large amounts of money, they would not get away with it. Do you really think that if they made a multi trillion dollar loan with no reserves to back it, that the fed or some other bank would pony up the reserves they need? What about if it was a million dollars less? They also wouldn’t, right? In other words, there exists a limit beyond which they cannot go.

    5. The whole idea that more money means an improved economy is a huge blunder. Think about it. People do not eat money, they eat tomatoes. If you grow more tomatoes, the country is better off. If you print more money but do not grow more tomatoes, how are they better off? They aren’t.

    Now you may think that there is an indirect benefit, that giving more money to the farmers means they will be able to expand their farm bla bla. But that means they will be taking resources away from someone else. There has not been an increase in the amount of chemicals to make fertilizers, or in the amount of steel to make tractors because there is more money. So every ounce of more fertilizer means an ounce less of make up available for some woman. And the consumers preferred the make up, obviously, or else the framer would have been able to outbid Revlon for the chemicals in the first place.

    You may respond that maybe there are idle resources nobody wanted, and printing money and giving it to the farmers will enable them to get those idle resources. Which is absurd. First of all, if no one wants them, the farmers will get them free. That’s what no one wants them means. Second, it is a superficial way of looking at things. Why are those resources idle? No serious economic analysis is possible if we do not address that q and give a satisfactory answer.

    6. As for NGDP, do a search on my blog for that acronym if you want to see my take on it.

    7. This response would be incomplete without some Smiling Dave arrogance and preaching, so here goes: Some people are too far gone and even when presented with irrefutable logical reasoning are unable to see it, because their minds have been twisted from years of reading mainstream nonsense, or because they are not that bright to begin with. The very fact that you felt drawn to my website indicates that either all hope is not lost for you, or you just want to argue. Hope it’s the former.


  5. Lio says:

    Hi Dave,

    “That guy on uneasymoney.com knows not of what he speaks.”

    That guy is David Laidler. I stopped going on his blog (too much silliness). He was interviewed recently by Russ Roberts at econtalk.org (September 16, 2013). Also take a look at what Bob Murphy recently wrote about it on his blog September 16, 2013 (http://consultingbyrpm.com/blog). As Murphy said: “Laidler threw Market Monetarism under the bus”.

    I am flabbergasted by the nonsense that some market monetarists may sometimes write on their blog. These guys are really Keynesians, in terms of monetary theory and policy.


  6. Smiling Dave says:

    Nice to see Laidler is coming round.
    Be nice if he would withdraw his blog articles.

    I think it should be Sep 24 for that Murphy article.


  7. Pedro says:

    Hey Smiling Dave, thanks for your answer, my $0.02 quickly:

    1. Inflation is a rise in the price level, that’s its current meaning; I see no point in endless quibbles about it. And it’s also a fact that you can have a rise in price when growth occurs and when the money supply exceeds the productive capacity of an economy, which is the important point at stake when trying to evaluate the relationship between the two.

    2. I disagree. The way I see it he only says that a/ an expansion of the money supply does not necessarily lead to “malinvestments” (or at least not in dangerous proportions); and b/ that a steady monetary mass growth (as opposed to a brutal decline as seen during crisis) can allow the failed investments to unwind without hurting other sectors and without causing widespread trouble, which is morally laudable. That’s a far cry from your odd interpretation of his words.

    3. Banks lend money, they don’t give it away, it’s their business model. That’s pretty straightforward, I don’t see why you’d have trouble grasping this point. I never meant there were no difference between repaying and not repaying a loan, that’d be absurd, there is an obvious difference. But banks don’t lend their depositors money (i.e. lent money is not deducted from depositors accounts), they emit credit that’s backed by their depositors’ deposits, that’s the important yet not so evident difference that must be understood when studying the banking sector.
    And Lehman was a pure investment bank, they just took too much risks on assets that were wrongly labeled as “safe”, that’s all.

    4. The only limit is the bank’s capital, and the risk its shareholders are willing to take. But every single loan granted by a bank follow this process, whether it’s a credit card short-term or a 40-yr mortgage. It’s well explained here: http://pragcap.com/banks-are-not-mystical, for instance.

    5. You’re missing the point, it’s not saying that more money = more wealth, that would be absurd, it’s merely observing that there is such a thing as “not enough currency in the system given current debt levels”, which lead to unemployment and the like. Statistically, a proper growth in the money supply is much more compatible with high real growth than not, that’s all, in other terms: more money is what happens spontaneously in times of growth (money is endogenous), so when things get abruptly ugly (credit crunch) restoring a proper monetary mass can lead to increased growth in real terms, provided transmission mechanisms are adequately chosen. Of course people don’t eat money, that’s not the point, it’s about there being enough cash around so as the private sector don’t fall below optimal capacity. Then you go on to make two mistakes: a/ you believe that “giving more money to the farmers” means “taking resources away from someone else”, that’s not true, supply is elastic (and increasingly so, thanks robots and software), prices are sticky and the money stock is not constant (as opposed to barter-like systems where, indeed, giving money to somebody implies taking resources from somebody else): and b/ “idle resources” are mostly workers (increasingly so since we’re in a services-based economy) which means nobody will get them “for free”, that’d be slavery. Durable downward prices stickiness explains the rest, and is observed through the output gap.

    6. I skimmed the first result, where it seems you forget NGDP target is simply the long term trend in healthy free markets (i.e. the Fed wouldn’t do anything under such a system as long as markets don’t show signs of bubble or crisis), but I’ll get back to it more deeply when I get some time off.

    7. I’m just curious and I think that Austrians should get more credit from what they produced, not in macro but in micro and on the capital structure theory. So it’s the former, even if I don’t dislike respectful and constructive discussions with people I don’t necessarily agree with, especially on the policy side, since almost all economics punditry is moralizing in disguise, and austrianism is no exception 😉



  8. Smiling Dave says:

    1. That’s its current meaning in your circle, but not in Austrian circles. But let’s not quibble.

    2. Oh, he can assert all he wants, but he has no refutation of Mises’s impeccable logical argument that it will cause malinvestemnts, as is always historically the case.
    And for something to be morally laudable, it first of all has to be correct. For example, one might say it is morally laudable to save lots of money by not feeding newborn children, because he has a theory that they will do just fine. But if the reality is that they will starve do death, it’s not morally laudable at all. So too, that website has some wild eyed theory that you can print all the money you want and everything will be fine. But if he is wrong, as he is, then it’s morally reprehensible. By the way he has since retreated from his position, as the other commenters here have pointed out.

    3. You think I’m the one having trouble grasping the point? I think it’s you. Please explain to me what the difference is. If they “emit” credit, which disappears the moment they get it back, why do they want it back? The point is that there is a huge difference, as we now agree, between a bank getting it’s money back or not. If they get it back, even though it technically disappears for a moment, the return frees them to lend more money. Which is precisely why Krugman is wrong, as I explained in my original article. Every loan repaid means that same amount of money going right back out there. As you say, banks lend money. That’s how they make their living.

    That Lehman Bros was an investment bank makes no difference, since first of all they were a private bank as well. Second, it is a distinction without a difference. You agree that if they don’t get repaid they don’t have the money, which is why they went bankrupt. If they do get repaid, they do have the money, or at least the possibility of creating more than if they did not get repaid. It’s that simple.

    4. The link you provided asserts many things, but does not explain anything. Of course there are reserve requirements in the US, and of course if a bank tries to go way beyond them they won’t get the money. Who will give it to them? Note that the link does not explain what capital position means. But since we have agreed that when a bank gets repaid it is a lot different than if it doesn’t get repaid, and the only possible difference is that if they get repaid they have more money now one way or another, and if they don’t get repaid they don’t have the money, then the conclusion follows that Krugman is wrong. Paying a debt just shuffles the money around, but it will get spent or lent by the guy getting paid back, especially if he is a bank. That’s what banks do.

    5. Yes, they do teach in the govt schools that “not enough currency in the system given current debt levels”, leads to unemployment and the like. And indeed, people have been making that same blunder for hundreds of years. The economists of the late 1800’s went out of their way to prove how silly such a concept is. Keynes, like Don Quixote fighting the windmills, valiantly defended the mistaken and disproven theory of old. Govts love hearing it, which is why it’s the only thing taught in the schools, and why Keynes was seized upon by everyone.

    Think how absurd it is to say “more money is what happens spontaneously in times of growth”. Money doesn’t grow on trees. Money is printed by someone. So how can one call a decision by a central banker to print money something spontaneous. As for saying statistically this and that, you have certainly heard about confusing correlation with causation.

    Here’s what really happens, and we will explain it with a thought experiment [the kind of thing Einstein did with physics]. Say you have an island where there is no money. Thus GDP must be zero, because there is no money to measure GDP with. But there can be growth even when the GDP is zero, if the islanders discover ways to increase production. Now let’s island hop to a different thought experiment. You have a desert island with nothing but some apple trees. Suddenly a helicopter dumps many millions of dollars on the island, and the people start buying the apples with the money. There is a tremendous spike in GDP, but no growth.

    What we see from all this is that growth and money increases are independent of each other. Not only that, we see that for a ofced money supply, there can be growth, but that growth cannot show up in increased GDP. If there is no new money to spend, there cannot be more dollar amounts of spending, and thus no increase in the number called GDP.

    Mises figured out and proved what really happens. When the govt increases the money supply, there is phony growth, like the growth on the desert island that got money dumped on it. People think they are rich, and spend lavishly. [In the desert island analogy, they throw wild parties and chop down the apple trees for furniture, thinking they are rich and so have plenty more apples. Little do they realize they are destroying their capital base]. Which is why a recession always follows an increase in the money supply.

    Current debt levels do not change the amount of money needed for the economy to thrive. It will do just fine with any amount of money. The thing is, money is magical, in that it’s purchasing power can rise and fall, which it will do to meet every contingency. What’s more, debt levels do not affect the amount of money needed, even if one mistakenly think money is needed for spending, as we explained in the article.

    Thinking that supply is elastic because of robots and software is a big mistake. As is thinking that prices being sticky is some kind of immutable law, like gravity. I mean, do the laws of supply and demand not apply to labor?

    It’s funny that Marxists think supply and demand doesn’t apply to labor, in that labor is forced to accept a pittance. Do what I tell you, or starve, they call it. Keynesians err to the other side, that laborers are somehow exempt from the laws of supply and demand, and can somehow resist the pressures that sellers of every other commodity give in to. The Austrian position is that labor is subject to the laws of supply and demand just like anything else. In a free market, labor prices would not be sticky. They are so nowadays only because of artificial laws making them so. And it is those very laws, that supposedly were meant to protect labor, that makes them lose their jobs.

    But these are known Keynesian mistakes that have been refuted many times over by Austrians. I refer you to mises.org and my humble blog and in particular Henry Hazlitt’s two free books refuting these very ideas. But there is no point reviewing it all here, because it’s already out there.

    Of course giving more money to farmers means taking something away from somebody else. The farmers can now outbid whoever used to buy whatever it is the farmers are now buying. How interesting that they are now teaching that we live in a world where there is no scarcity, thanks to robots and software.

    7. The standard perception is that Austrian micro has pretty much been accepted by the mainstream, and vice versa. It’s in macro where the big differences lie, and thus where Austrian E. has the most to contribute.

    Finally, I think we have reached the point of knowing each others positions. I know where we are both coming from, and exactly why we disagree. i have not read my last economics book, so wil continue to explore these ideas.


  9. Smiling Dave

    Sadly you have the causation reversed a lot of the time. I agree that a rising money supply causes malinvestment. But you seem to think that somehow the money precedes the malinvestment. It does not. A fast rising broad money supply is a consequence (or perhaps more accurately an indicator) of malinvestment. This is because of the endogeneity of money, which Pedro tried to explain but you don’t seem to have understood. So let me try.

    Banks do not “lend out” existing money. They agree a loan, then obtain the funds to enable the borrower to pay the money. Let’s use a mortgage as an example. The bank lends say $100,000 as an advance against a property that the borrower intends to purchase. The accounting entries are CR loan account (asset), CR customer checking account (liability). At that point the bank’s balance sheet has expanded by $100,000 and M2 has also increased by $100,000. But because the entries are balanced, there is no need for additional reserves at this point.

    When the customer actually pays for the house, he withdraws $100,000 from his checking account. The entries are DR customer checking account, DR reserve account. I don’t know about the US, but in the UK the payment can be days or weeks after the accounting entries have been made for the loan itself. The money supply therefore increases as an inevitable consequence of lending.

    When the customer makes that payment from his checking account, the bank has to obtain funds if funding that payment would take its reserve account below the required reserve limit. It does so by borrowing from other banks, or as a last resort by borrowing from the central bank. In these days of instantaneous funds transfer, you could even say that the bank funds the payment by borrowing back the $100,000 it has created from the bank it has just paid it to. Making payments has no effect on broad money, but if a bank has to obtain additional reserves from the central bank then it can result in the monetary base increasing. Monetary base expansion therefore tends to lag broad money expansion.

    When the loan is repaid (let’s assume bullet repayment to keep it simple) the entries are DR customer checking account, DR loan account. The bank’s balance sheet has shrunk by $100,000 and so has M2 by the same amount. Repaying a loan actually destroys money. Yes, the bank may make another loan of $100,000 to someone else, but it doesn’t have to. It will only do so if the risk versus return profile at that point in time is in its favour. And this is where you make your fundamental error.

    You assume that the demand for bank credit remains constant. And you assume that banks’ risk appetite remains constant. Neither is true. Post-2008, banks are more risk-averse than they were, not least because of regulatory changes that force them to include more equity in their funding mix, which is expensive for them. And they are still unloading malinvestments from before the crisis. Therefore they are not lending as much as they were prior to 2008. They discourage demand in two ways – firstly by charging higher interest rates on loans, particularly to poorer risks (that’s why interest rates to SMEs have gone up considerably since 2008), and by refusing to lend at all. Yes, banks DO refuse to lend – a point that Pedro made and you ignored. They lend ONLY if the return makes the risk worthwhile. Furthermore, there is considerable evidence that households and corporates simply are not borrowing to the extent that they were before the crisis. They are paying off debt and not taking out new loans.

    The problem prior to 2008 was that banks mispriced risk and therefore lent far more than they should have done at too low a price. The result was the malinvestment that you correctly identified (sub-prime loans and their derivatives, dodgy corporate lending and so forth). And the result was also a sharply rising money supply AS A CONSEQUENCE of that malinvestment.

    We now have the opposite problem: banks don’t want to lend, and households and corporates don’t want to borrow. The result is a falling money supply. Central banks (with the notable exception so far of the ECB) are attempting to counter that by increasing the monetary base – with some success, though mainly through portfolio effects.

    Because of the ECB’s inaction, the Eurozone is currently giving a particularly good demonstration of the endogeneity of money, which you may find interesting. Banks in the Eurozone are deleveraging at a rate of knots:

    And because of this, Eurozone M3 has been falling for the whole of 2013 – oh and notice the much bigger fall in M3 during the financial crisis, too, which pretty much parallels the fall in bank lending at that time:


    So banks do not always replace loans paid off or written down, and when they do not, the money supply shrinks, because a loan destroyed is money destroyed.

    There are lots of other things I could pick apart, but as this comment is already very long I will leave it there. Except for one last thing. You ask, “why do banks want loans repaid”? Actually, they don’t. They want the interest receipts, and they would (in theory) be quite happy to lend forever if interest receipts forever could be guaranteed. The problem is that interest receipts can’t be guaranteed, and the longer the term of the loan the greater the risk to the interest receipts. Therefore banks prefer to lend shorter-term and roll over loans. Or, if they must lend longer-term (as with mortgages), they prefer to lend at variable rate. Long-term fixed-rate loans are bad news for banks, even if collateralised.


  10. Smiling Dave says:

    So you really think a bank loses nothing by giving out gifts of money to everyone. Then we have a simple solution to all our problems, don’t we. Surely the banks will have no problem finding someone who will accept a free gift of money. Like me, for instance. Send me a check for a billion bucks and I will not complain in the slightest. And of course, since the banks gain nothing by getting the money back, they might as well let me keep it.

    So: Take Keynesian assumption that spending cures recessions. Add F. C.’s assumption that banks neither gain nor lose by writing checks to all and sundry. What’s not to like?
    For that matter, why don’t the CEO’s of every bank write themselves and their families huge checks every day? The bank loses nothing by it.

    What I’m trying to say is that someone is fooling you. The phony accounting scheme they taught you is wrong. Anyone who thinks banks don’t need to collect the principal of loans to survive is making a huge mistake.


  11. I think you have rather missed the point. I’ve explained why a bank would not in practice issue a perpetual loan. But as long as it can fund the liability side of its balance sheet (i.e. payments), it can roll loans forever. Banks do not “need to collect the principal of loans in order to survive”. They need to BELIEVE they can collect the principal. And the reason they need to believe that is that otherwise it becomes far more difficult for them to fund their obligations (payments). Impairment of loans happens when the likelihood of collection diminishes. It’s all about risk and the valuation of risk.

    By the way, there is nothing “phony” about the loan accounting I outlined. I designed computer systems that do loan accounting for banks. I know how it works.


  12. Smiling Dave says:

    I’m glad you are gainfully employed. I wrote a whole article just for you.


  13. […] booms – Ludwig von Mises (excerpt) The Trading Dead – Tom Papworth, Adam Smith Institute Reply to Pedro al Sombrero Negro – Smiling Dave’s […]


  14. me says:

    Frances and Pedro concentrate too much on the money side.
    They describe how banks work correctly. That being said their conclusion is Shrinking money mass causes less spending ergo busnesses lose money for not selling that much, which is correct.
    Therefore we need to print and spend to counter balance … which is picking winners and losers.

    – A point they didn’t make and should have is that shrinking the “money mass” also increases the purchasing power of the money in circulation i.e. the cost of bussnesses go down.

    Now the contrapoint which they seem to not grasp is that artifically increasing “money mass” :

    – will cause prices to stay the same or increase i.e. hurting busnesses who predicted the predicament correctly and would have greatly benefited of such course of action.

    – second holding % rates to zero hurts the savers (200-300 billions per year at least)

    – distorts all the supply/demand mechanisms as Smilling Dave explained, which have long term consequnces. Which when happen they will ask for another intervention, which will cause another dislocation … until everything crashes big time, instead of allowing temporary contraction to clean up the slate.

    It is easy to make conclusion w/o looking at the unintended consequences.

    As SD logically deduced correctly with examples, market economy will work with any amount of money by adjusting prices. Tinkering with money mass always causes distortion which begets another intervention to correct the new missallocations … i.e. intervention begets intervention.


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