Why Krugman is wrong, and how. The importance of debt.

Finally a clear description of how the economics profession is failing us.  I’ve heard time and again that they don’t include banks in their equations, and never quite understood what that meant.  Leave it to the very clear writing of Steve Keen at debtdeflation.com/blog:

“…how they get it wrong: by ignoring banks, and treating loans as transfers from “savers” to “spenders” with no bank in between…. the borrower’s increase in spending power is counteracted by the lender’s fall in spending power.

Yet, what really happens with most loans is that banks create new money out of thin air when they make a loan.  You show up for a mortgage of $100,000, the bank approves it, and places $100,000 in your account.  Where did they get the money from?  They created it.  Sure they input a liability on their books, and may have to go to the Fed for reserves, but the money did not have to exist any where in the system for them to place a real $100,000 into your account.

I’d suggestion reading the full article on Keen’s site, but you can also skip to the part that intrigued me the most by scrolling down to “Neoclassical Misinterpretations of Fisher, Minsky & Banking”

Why is this so important?  Keen explains as well.  My explanation is that new money creation expanded the economy – and many, many trillions of dollars of debt money has been created by the private sector since the 1980’s, which a rapid expansion in the oughts.  This money creation was understood by the mainstream. Worse, paying those debts back isn’t understood either.  What the banks created was temporary money.  They don’t get to keep that $100,000 loan after it is paid back.  When principle payments are made it cancels out the liability the bank created.  The banks get to keep fees and interest payments, but that’s it.  But the problem for the economy is that the private sector is taking today’s paychecks, and instead of buying goods and services which expands the economy, they are paying down yesterday’s debts.  It literally makes the banks liability disappear, and nothing more.  As you can imagine, this is a huge reason why Steve Keen would call his blog “debt deflation”.  And it is the reason why the US Gov’s debt has had to go through the roof.  If the disappearing money wasn’t replaced, the economy would collapse into a new Great Depression.

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