How Do Banks Work?

One quick take on the Krugman/Keen debate that’s been going on (hat tip: from comments). In summarizing the discussion Unlearning Economics writes:

2. Keen responds, noting that banks do not require savings before they make a loan, as they can create loans and deposits simultaneously through double entry bookkeeping. The CB has to provide the reserves required for whichever loans they do make in the short term, else the economy will grind to a halt.

That’s almost exactly what I learned in the banking course I took more than forty years ago, back when Paul Krugman was in high school. At that point, as I’ve mentioned before, Keynes was king. My courses covered neo-classical economics and Keynesian economics. As I’ve also said before I don’t think I heard the word “incentive” once, the term “rent-seeking” hadn’t been coined, I do not recall Pigou’s name ever being mentioned, and Coase’s thinking was slowly making its way into conventional economics (but not in an undergraduate course!). The fiscal multiplier and the Phillips curve were taught as gospel. You could take a specialty course (not one required for the major) and get some Marxist economics and I’d have to go back into old syllabuses to be sure but I think you could get a bit of monetarism in a graduate course.

I can only speculate that either Dr. Krugman learned something different at Yale, he never took a banking course, the economics presented in undergraduate courses changed enormously in just a few years, or he’s forgotten what he learned in undergraduate school.

My next door neighbor is the president of a small, local bank (yes, there are a few left). On the principle of the Greek philosophers, the Arab, and the horse maybe I should interview him and ask him how banks work.

7 comments… add one
  • I always thought banks used some variant of the underpants gnome model.

  • Ben Wolf Link

    A lot of libertarian/austrian commentors have criticized academia for failing to take into account how businesses actually work and relying instead on purely hypothetical models. Note how many bankers (assuming they aren’t lying; these IS the internets) commented on Krugman’s blog that his view of how bank lending works is not what actually happens.

    For me the hook is that Krugman & Co. have, as establishment progressives’ go-to-guys on economics, had their roles in the financial crisis whitewashed. Krugman’s model asserts that bank lending is limited by their deposits ( for every borrower there is a lender) and that aggregate debt levels are therefore macroeconomically meaningless because banks could never make more loans than the private sector could handle. So he spend the last decade and a half telling everyone not to worry about the credit bubble. Even today he resists the balance sheet recession model by buckling down on the idea private debt is self-limiting.

    But as Dave learned forty years ago, the structure of the Federal Reserve System allows banks to get hold of any amount of money they wish so long as they have adequate capital and customers coming through the door to borrow. Absent some form of regulation there’s nothing to prevent the banking system from repeatedly blowing itself up.

  • Ben Wolf Link

    “I always thought banks used some variant of the underpants gnome model.”

    Can that model be diagrammed? I want to use it in my prognostications.

  • Drew Link

    Dave

    I actually think you should speak with him regularly to take the pulse of the small business world. We used to deal with the JP Morgans and B of A’s of the world. Now just the specialized leveraged lenders, so my banking perspective is skewed.

    But the local banker has to be a great barometer of the appetite of small businesses to borrow to expand……..or not. I’ve been criticized here for doing t his with business owners…..it’s “anecdotal” and not generated by Ivy League economists. But guess what. I don’t have to revise my assertions “unexpectedly.”.

  • Ben Wolf Link

    This is the sort of thing I wish Krugman would offer an explanation for:
    http://monetaryrealism.com/wp-content/uploads/2012/04/stl12.png

    According to his model the more reserves there are, the more loans banks make. Yet that obviously isn’t happening.

  • Icepick Link
  • steve Link

    “How Do Banks Work?”

    From 2000-2012, not very well.

    Steve

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