Krugman and ‘neutral money’

5 October, 2018 at 09:21 | Posted in Economics | 5 Comments

Paul Krugman has repeatedly over the years argued that we should continue to use mainstream hobby horses like IS-LM and AS-AD models. Here’s one example:

Neutrality-of-moneySo why do AS-AD? … We do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run.

I seriously doubt that Keynes would have been impressed by having his theory being characterized by​ catchwords like “tendency to return to full employment” and “money is neutral in the long run.”

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One of Keynes’ central tenets — in clear contradistinction to the beliefs of mainstream economists — is that there is no strong automatic tendency for economies to move toward full employment levels in monetary economies.

Money does not matter in mainstream macroeconomic models. That is true. According to the ‘classical dichotomy,’ real variables — output and employment — are independent of monetary variables, and so enables mainstream economics to depict the economy as basically a barter system.

But in the real world in which we happen to live, money certainly does matter. Money is not neutral and money matters in both the short run and the long run:

Banks are authorized to create credit, ex nihilo (“out of nothing”) so credit (money) cannot be neutral. In creating credit, a bank creates money that a borrower uses to purchase goods and services that add to aggregate demand and economic growth. Banks are not limited to acting only as intermediaries that move money from savers to borrowers. Importantly, banks also determine how credit and money are allocated. In the real world​, money creation distinguishes banks from other financial intermediaries (e.g., shadow banks) that can extend credit but do not possess the authority to create money. Within the financial sector, only banks are granted this authority. Money is a form of credit, an obligation to pay. In Werner’s (2012) words, “banks are the creators of the money supply” and “this is the missing link that causes credit rationing to have macroeconomic consequences.” In short, finance (banking, money and credit) matter!

John Balder

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5 Comments »

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  1. Money is actually kind of a marvelous invention, and accomplishes some remarkable feats for distributed social cooperation. A visitor from Mars might naïvely imagine economists celebrating the wondrous complexity of money, explicating the many functions of finance, while qualifying themselves as managers in the public interest of this most ubiquitous of public goods.
    .
    But, instead we have spectacle of leading economists like Krugman propounding the dogma that money scarcely exists at all, that it is nothing more than a nearly transparent veil and can be safely disregarded in thinking about a political economy organized in every detail by . . . money. It is bizarre.
    .
    For a profession that prattles endlessly about how rigorous their theory is, AS / AD ought to be an excruciating embarrassment. Nothing about the concept can be defined, let alone defended: from the dubious intuition that a system of markets can arrive at a general equilbrium in price we have migrated without a critical thought clouding the mind for a second to a completely undefined notion of a “price level” that in the aggregate behaves precisely like a price in a single market. Are these fools mad?

    • It’s very much Krugman to be disinterested in how fascinating the world actually is. If he was genuinely interested in Japan’s liquidity trap he would have talked to historians who would have told him what it was about Japanese capitalism that it grew so fast (real historians would also show him that economic theory tells us nothing, and when it does it is almost certainly wrong) and how it arrived at the situation it did in the 1990s. Of course this work is in Japanese, and it is generally not done in economic departments (more likely history and social science departments). But there would be people around to help him access the Japanese language literature.

      • I don’t know much about Japan, but I know I usually cringe when Krugman makes historical references. His notes on European feudalism and Evsey Domar’s thesis are classic examples of his affection for dubious “insight” and immunity to factual evidence.
        .
        This is not, I think, a mere idiosyncracy of the Great Krugman. Forcing the ergodic hypothesis onto economic theory as an axiom makes economics “history-less”. It is foundational to the intellectual enterprise, this disregard for and disinterest in history and, not incidentally, institutional detail.

  2. The money supply grows much faster than prices increase. The private financial sector creates money for itself and its friends faster than asset prices rise, thus increasing their purchasing power. Please do your own research to verify.


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