The dying embers of New Keynesian reasoning

Lawrence Summers is a New Keynesian economist. That means something. While there are nuances that exist between members of that school of thought, mostly to do with policy sensitivities and speeds of adjustment, the New Keynesian paradigm has demonstrated clearly that it is incapable of capturing the macroeconomic dynamics in any consistent manner, despite it being the dominant approach in the profession. So, it is no wonder when Summers provides opinions the underlying logic he demonstrates is similarly flawed. Unfortunately, he keeps getting important platforms to express these opinions, which continues to blight the public policy debate. He was at it again when he started lecturing the US Federal Reserve Bank on the conduct of its asset-purchasing program.

Recall that Lawrence Summers, signed a memorandum in December 1991, when he worked at the World Bank, that indicated that it would be economically efficient to send toxic waste from advanced countries to the lowest wage countries in Africa.

Recall during his time as a bureaucrat in the Clinton Administration that that he was directly involved in a number of highly questionable matters.

Don’t forget that he and Rubin when they ran the US Treasury were resistant to the idea that the US should participate in the Kyto protocol – see the National Archive documents accompanying this briefing – Kyoto Redux? Obama’s Challenges at Copenhagen Echo Clinton’s at Kyoto (December 18, 2009).

And during this period, think about Summers and his role, with Robert Rubin and Alan Greenspan before the GFC to promote increasing financial market deregulation and his demonisation of Brooksley Born, who became the head of the US federal Commodity Futures Trading Commission.

She tried to warn the US government of the increasing dangers of unregulated financial markets and was undermined by Summers.

I wrote about that in this blog post – Being shamed and disgraced is not enough (December 18, 2009).

And, the Enron scandal – Larry Summers’ Enron Problem (November 12, 2008).

Recall that Lawrence Summers was warning the US government that it was dangerous to continue to be ‘dependent’ on China to fund the US deficits by purchasing government bonds.

And don’t forget that he has coveted the position as boss of the Federal Reserve (to succeed Ben Bernanke)

And many more instances of flawed analysis and judgements.

Most recently, Summers and his New Keynesian mates (such as, Kenneth Rogoff) have been beating up the inflation mania story – which I addressed in this two-part series:

1. Is the $US900 billion stimulus in the US likely to overheat the economy – Part 1? (December 30, 2020).

2. Is the $US900 billion stimulus in the US likely to overheat the economy – Part 2? (December 31, 2020).

I have made this point before, but the public debate is biased against progress because characters like Summers can continue to command a platform and are given elite access to the public via the mainstream media, even when there is a litany of failed steps and poor predictions.

Anyway, onto the recent Op Ed, which appeared in the The Washington Post (August 26, 2021) – Opinion: It’s time for the Fed to rethink quantitative easing.

There we learn about a number of key differences between the way a New Keynesian economist thinks and the way an Modern Monetary Theory (MMT) economist understands reality.

Summers starts by drawing an analogy between Vietnam and Afghanistan and economic policy.

I won’t pursue that, but, I don’t think any American that has been close to policy has anything much to say about either US war defeat.

Both were disastrous choices from the outset and were always doomed to failure.

Yes, I know that the US could have nuked both countries and claimed victory. I have been told that before. But that doesn’t get us very far.

The point Summers is making in terms of economic policy is that one should have a long-term vision of where the policy will take us rather than adjust it “incrementally … to avoid near-term pain”.

I agree with that statement.

Knee-jerk adjustments to policies that are well thought out, just to appease the uninformed media etc is poor practice.

But I disagree with his conclusion that:

… continuing quantitative easing … has gone on for too long … [and] … cannot be justified and presents its own danger.

My disagreement goes under the conclusion to his logic – the New Keynesian logic.

First, he claims that:

Quantitative easing is a policy of creating money in the form of providing interest-paying reserves to banks and buying up Treasury bonds and other government-guaranteed securities.

Which is highly misleading.

Usually, we consider money to be a means of payment.

Commercial banks, operating under government license, are typically required to hold accounts with the relevant central bank, which contain balances that are used as part of the ‘settlement’ process to reconcile daily transactions across banks.

Banks don’t loan out reserves and do not need reserves to make loans.

Loans create deposits, which, in turn, are liquid funds that can be spent to purchase things.

Say Bank A makes a loan to Customer A who buys something from Seller A who also banks with Bank A. All the transactions are dealt with within the accounting system of Bank A and no reserve transactions are involved.

If Customer A buys off Seller B who banks with Bank B, then Banks A and Banks B reconcile the transaction through electronic accounting adjustments to their respective reserve balances at the central bank.

Reserve accounts are also adjusted if a customer asks their bank for actual ‘cash’ (physical notes and coins).

While only the central bank can create reserves, any individual bank can acquire them from another bank, which might have an excess, relative to their expected ‘clearance’ needs on any one day.

But, if there is an overall shortage of reserves in the banking system, then the central bank is the only source and it, historically, has provided those reserves through open market operations (buying government debt instruments, usually, from the banks).

Similarly, an excess reserve situation can only be resolved if the central bank drains them by selling government debt (usually).

I explain in this early introductory suite of blog posts why central banks will mop up excesses or provide in the case of shortages:

1. Deficit spending 101 – Part 1 (February 21, 2009).

2. Deficit spending 101 – Part 2 (February 23, 2009)

3. Deficit spending 101 – Part 3 (March 2, 2009).

Mainstream economists call reserves ‘high powered money’, because they think somehow the provision of reserves then drives (multiplies) into a higher money supply (broad money).

This is the flawed money multiplier idea, that New Keynesians still teach in their university courses.

I considered that idea in this blog post – Money multiplier and other myths (April 21, 2009) – among others.

The point is that what Summers wanted to then say is that QE, which involves the central bank purchasing financial assets held in the non-government sector, was designed to pump cash into the system – “clearly warranted when bond markets were illiquid” – in his words.

The mistake then mainstream economists make is to assume bank lend is ‘reserve-constrained’.

It is not, as described above.

Loans create deposits and any necessary reserve consequences of the transactions that follow the loan creation follow after the fact and are not part of the lending process.

QE does affect asset prices in the maturity segment that the central bank is buying the assets within (say, 3-year bonds, or 10-year bonds).

The higher demand for the bonds resulting from the central bank purchases pushes up prices and drives down yields on those assets (returns), which then by competitive forces, realigns all returns on all similar financial assets in that temporal segment of the market.

In that way, QE, arguably, influences aggregate spending – by changing the ‘cost’ of borrowing.

The sale of assets in exchange for bank reserves does not increase or decrease the bank’s ability to make loans on demand from credit-worthy borrowers.

The impact that QE has, if any, is via the interest rate effect, which is then effective or not, depending on the interest-rate sensitivity of spending (consumer and business investment, primarily).

Summers wants the reader to assume banks are reserve-constrained in their lending practices – a major plank in New Keynesian monetary theory.

The fact is they are not and this flaw in reasoning then leads to a range of false conclusions.

Why does continuing QE make “little sense today”?

Well, according to Summers:

It is unwise at a time of unprecedented growth in federal debt and prospective deficits, along with record-low real long-term borrowing costs. If ever there were a moment to increase longer-term borrowing, it is now.

Effectively, Summers is thinking of QE as funding government deficits (“since the Treasury is the economic owner of the Fed and receives its net income, when the Fed substitutes short-term bank reserves for longer-term debt, the government is unaccountably “terming in” the debt and shortening the maturity of its liabilities”).

And he thinks it is better, with interest rates so low, for the government to fund itself with debt than with central bank reserve creation.

The way I have expressed that is in terms of mainstream logic.

Every bit of it is incorrect at the most elemental level.

The US government can always instruct the US Federal Reserve to make certain transactions in favour of the Treasury.

There are voluntary institutional arrangements that are embedded in law (rather than being inherent) that provide an accounting trail for these transactions but the US central bank can create reserves out of thin air and can facilitate the creation of deposits within the non-government banking sector out of thin air to facilitate government spending.

Note that the two capacities are not equivalent.

When the government spends some bank account is marked up (a deposit account somewhere) to reflect the transaction.

The reserve accounting that follows depends on who holds the deposit account, what they do with it, and whether more than one bank is involved (as above).

But the fact that the US central bank now holds a large slab of government debt as a result of buying it up in the secondary market, means that the liability inherent in the debt instrument that is a Treasury liability is now held and due to the central bank (an agency of government).

The interest flows go from government left pocket to government right pocket, which then go back to the left pocket under current institutional arrangements.

The non-government sector is not involved after the primary issuance and the initial QE secondary bond market transaction.

Which means that, even under current institutional arrangements, the government is ‘funding’ its own expenditure and is not reliant on issuing private bond markets at all to ‘fund’ its spending.

But deeper down, into intrinsic capacity territory, these accounting arrangements are smokescreens, and we know that a currency-issuing government can always spend what it likes, whenever, and if the rules intervene, it can change the rules or invoke exceptions, emergency powers, whatever.

The point is that Summers is perpetuating the New Keynesian myth that the US government is financially constrained and spends non-government money that it borrows in one way or another.

In relation to QE, ask yourself the question: Where does the non-government sector get the net funds from to buy the government debt in the first place that it then sells back to the central bank?

Tracing the provenance of the funds leads you back to previous fiscal deficits that have not yet been taxed back.

A wash as they say!

The government really just borrows its own prior spending back.

Summers’ second point somewhat contradicts his first, because, now he recognises that any stimulative effect comes via the interest rate effect rather than providing reserves that can be loaned out (which was his first inference).

We are asked: “Why is this still a sensible objective when job openings are at a record high, inflation is running well above the Fed’s target, and housing inflation is not yet reflected in official indices even though the average new tenant is paying 17 percent more than her predecessor?”

Job openings might be rising but there are still, at my last count, 5,702 thousand jobs short from where it was at the end of February 2020, and, even then, February 2020 was hardly a point of full employment.

There is still massive poverty to be dealt with in the US society.

The urban systems in poorer segments of the city require massive injections of funds.

Perhaps his opening line about Afghanistan might be reworked to recognise that the US government wastes massive amounts of public spending on its external terrorist activities – illegally invading countries and then arming their enemies as they conduct inglorious exits.

There is an argument for dramatic recomposition of US government spending, especially in relation to climate change imperatives, but my assessment is that there is still considerable spare capacity in the US economy that needs to be absorbed before any hint of fiscal austerity is entertained.

And I don’t think rampant inflation is likely to ensue (see links to my blog posts on that topic above).

His third point that QE inflates asset prices which “supports the wealthy who hold these assets, rather than the bulk of the population, at a moment of nearly unprecedented inequality” has currency but only tells us that the government should stop speculating in financial assets and cut to the chase and use the capacity of the central bank to facilitate government spending directly without the charade of issuing debt in the first place.

If the government still wants to issue the debt, then just instruct the central bank to buy it up in the primary issue.

Then the charade is open to all.

He then morphs back into his inflation hysteria arguments, which I have dealt with elsewhere.


New Keynesian thinking is the old way.

It will take time for all economists to recognise that.

But its ongoing failure to deliver credible policy advice is slowly but surely eroding its credibility.

Summers will retire eventually.

Which will be a service to the world.

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.

This Post Has 19 Comments

  1. bill, you touch on QE inflating asset prices and say “the government should stop speculating in financial assets”. Could you elaborate on that point? This has confused me for a while – the argument commercial banks have invested the money from selling TSY bonds through QE, driving up share prices and other speculative assets. But how, as surely CB reserves can’t be used in that way? Or is the Fed also buying non-TSY bonds and other assets directly?

  2. A tad tangential: “arming their enemies as they conduct inglorious exits” — This is a tad misleading as it might lead a reader to think that, in every inglorious exit, the US government directly arms the ‘enemy’ they are leaving. Rather, such arming is indirect. In WW2, when a unit retreated they tried to render the equipment they had to leave behind inoperable, either by blowing it up or by removing a central component part rendering the equipment useless to the enemy. Now, it seems that they just leave equipment behind, much of which the Taliban, for instance, have simply begun using. It could be argued that what was left behind was inessential and that the really important equipment was actually removed. Some of it certainly was. But all of it? How do we know?

    As for Summers, I never believe anything he says. He seems to stick his head up when he thinks he needs public exposure for whatever reason. I agree that the sooner he retires, or for any other reason, the better for public discourse and the public’s mental health.

  3. I see it as about having the interest rate thing backwards.

    He warns that if the Fed hikes rates to fight inflation interest on reserves will go up, so it would be better to leave the longer term Treasury bonds outstanding.

    The understanding that rate hikes instead support inflation is what obviates this argument.

  4. “The government really just borrows its own prior spending back…. It will take time for all economists to recognise that” (among other things). Time never seems to cause a conceptual breakthrough, except in the case of one generation, exposed to new ideas, gradually succeeding another. No, what it will take for a near-term paradigm shift in economic thought toward MMT will be a champion who gets it and drives it forward, a new Napoleon able to seize history and alter it by sheer force of will. Such figures are rare. Such figures may be impossible in the postmodern neoliberal era when all things BIG–people and ideas–are deemed inherently oppressive. As a candidate for mayor in my town once said: “It all comes back to leadership. Without it, nothing happens, nothing works.” And leadership, in this sense, does not come from academia. People like Bill, bless them, create the ammo, but only a political leader who galvanizes the people can shoot it.

  5. I would like to point out that Summers has publicly admitted ignorance about the detail operation of FED, nevertheless we fought hard to be appointed as its chairman.
    Yes, the sooner he retires the better for the world, but again as Max Planck said paradigm shifts take a generation at a time. So, it will take a very long time before Neo-Keynesian economics fade away, unfortunately.

  6. Demetrious, you are mixing two ‘sayings’ of Planck’s. One is that ‘science progresses one funeral at a time’ while the other is (paraphrasing) ‘science triumphs not through having its opponents see the light, as it were, but by dying off and allowiing a new generation to become used to it.’. However, you are mostly right. It is easier, at least for me, to remember the simpler aphorism, though the second, I suppose, is the more informative, if my paraphrase is reasonably close. Thanks for bring Planck into the discussion.

  7. Larry, thanks for the correction but I actually mixed Kuhn and Planck. I hesitated to use the word funeral because the other Larry might get offended!

  8. Replying to @Justin who posted on August 31, 2021 at 17:10:
    “bill, you touch on QE inflating asset prices…”

    One way QE can alter asset prices is via secondary market effects. When the CB buys up bonds it creates a shortage of bonds in the secondary markets, that pushes up secondary bond trade prices and thus lowers yields, thus altering the price structure of other inter-linked assets. investors might go into other assets, pushing up those prices. (In other words, it is not an effect of the added bank reserves available, which as MMT analysis points out are not available to purchase assets.)

    (Prof Mitchell can correct me if I’m wrong (and I would be happy to be corrected, since I’m just an MMTed student showing the worth of Bill’s courses, for good or bad!))

  9. I have to try to remember this little gem, such a subtle yet unsubtle insult, almost Shakespearean in the play on the usual obituary line “we will miss his/her service.”:
    “{{So-and-so}} will retire eventually.
    Which will be a service to the world.”

  10. Very cool, Demetrios. Nice one. I missed it. Could Kuhn be ‘copying’ Planck? What do you think?

  11. “One way QE can alter asset prices is via secondary market effects.”

    Is it altering asset prices, or is it simply allowing them to return to their correct value without the artificial market intervention of interest rates set above their natural rate of zero and providing ‘welfare for the rich’ in the form of bond interest payments?

    You could say that providing free money from government via interest payments suppresses asset prices.

  12. @warren mosler,

    “He warns that if the Fed hikes rates to fight inflation interest on reserves will go up, so it would be better to leave the longer term Treasury bonds outstanding.

    The understanding that rate hikes instead support inflation is what obviates this argument.”

    a couple of question marks here.

    firstly doesnt the peg on the short end of the yield curve eventually effect the long end of the yield curve. and the fed can intervene to shape the curve at any point in the maturity structure, so it can flatten whatever it likes.

    and secondly , i am not sure there is a positive correlation between higher rates and higher inflation, or am i misreading the statement.

    depending on the market , prices are sticky , so interest costs may not be able to be passed on through higher prices. there is the interest income channel, but i am unsure as to whether that will over ride the impacts of higher borrowing costs.

  13. “I won’t pursue that, but, I don’t think any American that has been close to policy has anything much to say about either US war defeat.

    Both were disastrous choices from the outset and were always doomed to failure.”

    this is what happens when the locals get there hands on a tidy bit of kit, that can fire back at you at 1800 miles an hour.

    the yanks have always got hollywood to try and take over the joint 😉

  14. larry (2021/9/1 at 21:36)
    The brief answer to your question is that I don’t think Kuhn copied Planck. Although I’m not a physicist, my encounter with Kuhn is through reading his most famous book “The Structure of Scientific Revolution” in which he advances the thesis of paradigm shift. To my knowledge, Planck spent his entire life on theoretical physics and won a Nobel prize for his discovery of quantum mechanics whereas Kuhn devoted his life to the philosophy of science.
    Both extraordinary men in their own discipline!

  15. The major downside of asset price inflation as a result of QE diverting private sector financial investment into alternative areas would appear to be the most damaging where it relates to the ongoing increase in house prices, making home ownership, and even, in some cases, rental costs, unachievable for anyone other than millionaires and their offspring, particularly in the large cities.

    There are certainly remedies; restriction of residential property ownership to national, individual, residents, restricting the availability of credit for property purchases, and a large scale housebuilding program for low-rental accomodation – all of which would put a brake on property speculation.

    None of which will happen under current leadership of course – if ever – so we carry on heading miserably back to the C18th, where the wealthy few owned everything in sight, and the impoverished majority were lucky to own the shirt on their back, let alone a dwelling.

  16. @MrShigemitsu: There is a simple way to remedy house price inflation, which is affecting every developed country, even China – land value tax paid by owners at a high rate on all income-generating land (or potentially income-generating land, e.g. second homes) with a transitionary concessionary rate for the owners of principal homes. It is inherently ‘affordable’ as businesses locate according to the benefits that location offers.
    The land market is the problem, it does not allocate to best use. Economist have forgotten about land. LVT in effect nationalises the rent of land.

  17. I have been asking this qn over and over.
    How can banks make loans without surplus reserves?
    Btw, I am a fan of mmt.

  18. Well, the fundamental deal that a customer has with a bank is that
    the bank will spend its money to do the customer’s business.

    Sometimes this is easy to understand. I give my pension cheques to the credit union, and they agree to spend money on my behalf when I tell them to. As long as they keep that part of the bargain, I don’t care what they do with the money; it’s theirs.

    When a bank extends a loan, it’s the same idea, except without a deposit up front. The bank agrees to spend its money on the borrower’s behalf and the deposits that complete the quid pro quo will happen in the future, rather than the past. But apart from that, it all works the same: when the borrower writes a cheque against their new expanded account balance, the bank has to cover the cheque, from their own assets. Reserves are an important portion of those assets.

    Strictly speaking, the bank doesn’t fund the created loan, they fund the spending that eventually results from the loan. There’s a time-gap in between, and if you’re a bank rolling money around, you can do so much with a time-gap.

  19. [quote]recneps
    Friday, June 24, 2022 at 1:39
    I have been asking this qn over and over.
    How can banks make loans without surplus reserves?
    Btw, I am a fan of mmt.[/quote]

    The answer to your question is that they create the dollars out of thin air and deposit them into the borrower’s account.
    Yes, they must have enough reserves to do this, but not for a few days.
    During those few days they may get enough deposits, but if they don’t, some other banks have the amount of the loan on deposit in a checking or savings acc.
    Because those banks do have the amount of the loan, they have excess reserves to loan to the 1st bank.
    The 1st bank can therefore always borrow (on the overnight loan system) the reserves they need to cover the loan. As long as the “overnight” interest rate is lower than the 1 day interest rate on the loan, they will be making a profit on that loan.
    Because the dollars of the loan are in the economy, almost always pretty soon those dollars end up back in the 1st bank as deposits. Also, other banks are also making loans that get into all banks deposits to some small extent.

    Don’t feel bad. The Fed Chairman doesn’t grok those facts. He also thinks that banks will make more loans if they have a lot of reserves. That a lack of reserves stops them from lending. At least, that is what he has said. [Or was it the previous Fed Chairmen?]

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