This clearly isn’t official IMF policy, but the fact that it has been released by the IMF is noteworthy, and the paper deserves careful attention. It is an enormous paper, not just in length (56 pages of text) but also in the range of topics covered, and it will take at least three posts to do it justice. In this one, I’ll focus on its analysis of today’s monetary system.
I had better declare an interest at the outset. I have met chief author of the paper, Michael Kumhof, at several conferences now – twice at the American Monetary Institute, once at INET in Berlin, and once at Ireland's Institute for International Affairs – and I consider him a friend. What I especially like about Michael is his intellectual openness. Though he works strictly in the neoclassical paradigm, unlike the vast majority of neoclassical economists, Michael is open to other approaches. Most importantly, Kumhof takes money, debt and banks seriously, whereas most neclassical economists delude themselves about banks with the naive "loanable funds” model.
This realistic perspective on banking is the hallmark of the first, very literary, section of the paper, which discusses both the actual mechanisms of money creation now and the historical debate about the nature of money and the proper role of banks. I do urge everyone to read this section, since it is so rare to have the actual practices of banking realistically discussed in a formal academic paper, let alone one issued by the IMF.
The contrast between Kumhof and Jaromir Benes (the paper's co-author) and run-of-the-mill neoclassicals like Paul Krugman on the role of banks is quite stark. Krugman stated the essence of the Loanable Funds model in his opening salvo on my primer on Minsky earlier this year:
"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.”
Benes and Kumhof describe this perception of banks as mere intermediaries between savers and borrowers as the hallmark of someone who doesn’t understand banking:
"The critical feature of our theoretical model is that it exhibits the key function of banks in modern economies, which is not their largely incidental function as financial intermediaries between depositors and borrowers, but rather their central function as creators and destroyers of money. A realistic model needs to reflect the fact that under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries."
Table one shows a very parsimonious vision of the "resulting book entries” for both models – abstracting from all intermediate steps.
Table 1: Parsimonious comparison of Loanable Funds and Bank Lending
|Models of Lending|
In Krugman’s "loanable funds” model, all the action is on the liabilities side of the banking system’s ledger: money is taken out of 'Patient’s' deposit account (a debit, shown as DR in the table) and transferred to 'Impatient’s' (a credit, shown as CR). Patient’s deposit account falls and patient has less spending power; Ipatient’s account has risen and he/she has more spending power, and in the aggregate, the two cancel each other out. Neither new money nor additional spending power has been created (except at the margin, if Impatient is a spendthrift and Patient is a miser).
In Kumhof’s model, there’s action on both sides of the ledger: the banking sector’s level of loans rises by $X, and the deposit account of the "Impatient agent” (to use Krugman’s terminology for borrowers) is credited with $X. Money and additional spending power has been created pari passu with additional bank debt. Impatient’s spending power has risen, without any offsetting fall in patient’s spending power. Bank reserves also play no role in the process (they have a transitory role in a slightly more complicated example here, but the end result is the same).
Kumhof’s model accords with the "endogenous money” approach that I take, and as he notes emphatically in the paper, this is the actual process of lending that some central banks have been trying to get academic economists to understand for decades – and so far to no avail. He cites two central bank papers that add to my arsenal of similar statements. Here’s the one from the New York Fed:
"Suppose that bank A gives a new loan of $20 to Firm X, which continues to hold a deposit account with bank A. Bank A does this by crediting Firm X’s account by $20. The bank now has a new asset (the loan to Firm X) and an offsetting liability (the increase in Firm X’s deposit at the bank). Importantly, bank A still has $90 of reserves in its account. In other words, the loan to Firm X does not decrease bank A’s reserve holdings at all."
One wonders how much longer neoclassical economists like Krugman will continue to dismiss such views as the province of "Banking Mystics”. To Kumhof’s great credit (pardon the pun), his is the first theoretical neoclassical paper to acknowledge the actual nature of banking, and to try to take this into account in a mathematical model.
I’ll cover the model in a future post, but there’s also much more to the literary section of the paper that is worth reading – in particular, his treatment of the history of money, banks, debt, and Debt Jubilees. I’ll cover those issues next week.