The Biggest Myth Preventing an Economic Recovery


The Widespread Economic Myths Destroying the Economy

There are many widespread myths preventing an economic recovery, including the following myths:

Obama’s belief that unemployment is good for the economy, and Greenspan’s belief that too little debt is bad for the country are also ridiculous.

But the most dangerous myth – because a lot of economic policy is based upon it, and because so few know that it is false – is the myth about how banks make loans.

The Myth that Private Debt Doesn’t Matter

Before we can address the myth about how banks make loans – and as a way to understand the deadly effect of that misconception, we need to talk about debt.

As economics professor Steve Keen documents in his must-read book, Debunking Economics: The Naked Emperor Dethroned, mainstream  economists – from both the left and the right – don’t even take debt into consideration in their models of what makes for healthy economies.

As Keen noted in September:

The vast majority of economists were taken completely by surprise by this crisis—including not just … the ubiquitous “market economists” that pepper the evening news, but the big fish of academic, professional and regulatory economics as well.


Why did conventional economists not see this crisis coming, while I and a handful of non-orthodox economists did [?] Because we focus upon the role of private debt, while they, for three main reasons, ignore it:


They believed that the level of private debt—and therefore also its rate of change—had no major macroeconomic significance:


Finally, the most remarkable reason of all is that debt, money and the financial system itself play no role in conventional neoclassical economic models. Many non-economists expect economists to be experts on money, but the belief that money is merely a “veil over barter”—and that therefore the economy can be modeled without taking into account money and how it is created—is fundamental to neoclassical economics. Only economic dissidents from other schools of thought … take money seriously, and only a handful of them—including myself (Steve Keen, 2010;—formally model money creation in their macroeconomics.

Even the most “avant-garde” of neoclassical economists … have only just begun to consider the role that debt might play in the economy ….

In other words, most economists think that debt – and our money system – don’t matter.

(Don’t freak out … this essay does not argue for ruthless austerity for Mom and Pop on Main Street.  Virtually all of the economists we quote  stress that the bondholders bad debt must be written down. And this post also focuses on private – rather than public – debt.)

For example, The economists who have the most influence over government policy – such as Ben Bernanke and Paul Krugman – think that the amount of private debt is  totally irrelevant to the health of the economy:

Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro-economic effects… (Bernanke 2000, p. 24)



In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents, but are subject to a debt limit. If this debt limit is, for some reason, suddenly reduced, the impatient agents are forced to cut spending… (Krugman and Eggertsson 2010, p. 3)


People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.

That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. (Krugman 2011)


To make this assumption, they rely on the myth that banks can only loan as much money out as they have in deposits.  In other words, they assume that if bank customer John Doe has $100 in the bank, then the bank can loan that $100 to someone else.

But as Keen notes, banks actually loan out money whether or not they have enough in deposits … and then borrow the shortfall from the Fed or other sources.

Keen therefore says that it is not a wash … and that high levels of private debt are the cause of the current economic crisis.

I wrote to L. Randall Wray to get his view on who is right.  Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri–Kansas City. Wray is one of the country’s top experts on money creation.


I asked Wray:

As you might have heard – Paul Krugman argues that banks only loan out based upon their deposits, while Steve Keen argues that loans are created through double entry bookkeeping, so that money is created endogenously [i.e. banks create their own money].

For example, here is Scott Fullwiler’s (Associate Professor of Economics and James A. Leach Chair in Banking and Monetary Economics at Wartburg College) take on the debate: Or summary here:

As a leading expert on modern monetary theory, who do you think is right? Do banks need deposits before they can lend … or do they lend regardless of deposits, and only bounded by reserve and capital requirements (or access to Fed monies)?

Wray responded:

Bank deposits are bank IOUs; an IOU can only come from the issuer. Where do your IOUs come from? Do you borrow them? NO. [Professor] Scott [Fullwiler] is right, Krugman does not know what he is talking about.

Indeed, economics professor and money expert Fullwiler says that Krugman should wear a flashing neon sign saying “I don’t know what I’m talking about”, and explains:

As is well known, and by the logic of double-entry accounting, the bank does make a loan out of thin air—no prior deposits or reserves necessary.


[Krugman writes:]


This statement is simply mindboggling. It’s so wrong I don’t know where to begin. The Fed NEVER limits the supply of currency. Never. Ever. To do otherwise would be to violate its mandate in the Federal Reserve Act to provide for an elastic currency and maintain stability of the payments system.

Economics professor Michael Hudson also slams Krugman for having a blindspot on debt:

Mr. Krugman’s failure to see today’s economic problem as one of debt deflation reflects his failure (suffered by most economists, to be sure) to recognize the need for debt writedowns, for restructuring the banking and financial system, and for shifting taxes off labor back onto property, economic rent and asset-price (“capital”) gains. The effect of his narrow set of recommendations is to defend the status quo – and for my money, despite his reputation as a liberal, that makes Mr. Krugman a conservative. I see little in his logic that would oppose Rubinomics, which has remained the Democratic Party’s program under the Obama administration.


Mr. Krugman got lost in the black hole of banking, finance and international trade theory that has engulfed so many neoclassical and old-style Keynesian economists. Last month Mr. Krugman insisted that banks do not create credit, except by borrowing reserves that (in his view) merely shifts lending savings from wealthy people to those with a higher propensity to consume. Criticizing Steve Keen (who has just published a second edition of his excellent Debunking Economics to explain the dynamics of endogenous money creation), he wrote:

Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. I guess I don’t get that at all. 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. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and I’m not sure what. I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand.Keen says that it’s because once you include banks, lending increases the money supply. OK, but why does that matter? He seems to assume that aggregate demand can’t increase unless the money supply rises, but that’s only true if the velocity of money is fixed;

But “velocity” is just a dummy variable to “balance” any given equation – a tautology, not an analytic tool. As a neoclassical economist, Mr. Krugman is unwilling to acknowledge that banks not only create credit; in doing so, they create debt. That is the essence of balance sheet accounting. But … Krugman offers the mythology of banks that can only lend out money taken in from depositors (as though these banks were good old-fashioned savings banks or S&Ls, not what Mr. Keen calls “endogenous money creators”). Banks create deposits electronically in the process of making loans.


Said Krugman:




The problem with Mr. Krugman’s analysis is that bank debt creation plays no analytic role in Mr. Krugman’s proposals to rescue the economy. It is as if the economy operates without wealth or debt, simply on the basis of spending power flowing into the economy from the government, and being spent on consumer goods, investment goods and taxes – not on debt service, pension fund set-asides or asset price inflation. If the government will spend enough – run up a large enough deficit to pump money into the spending stream, Keynesian-style – the economy can revive by enough to “earn its way out of debt.” The assumption is that the government will revive the economy on a broad enough scale to enable the individuals who owe the mortgages, student loans and other debts – and presumably even the states and localities that have fallen behind in their pension plan funding – to “catch up.”

Without recognizing the role of debt and taking into account the magnitude of negative equity and earnings shortfalls, one cannot see that what is preventing American industry from exporting more is the heavy debt overhead that diverts income to pay the Finance, Insurance and Real Estate (FIRE) sector. How can U.S. labor compete with foreign labor when employees and their employers are obliged to pay such high mortgage debt for its housing, such high student debt for its education, such high medical insurance and Social Security (FICA withholding), such high credit-card debt – all this even before spending on goods and services?

In fact, how can wage earners even afford to buy what they produce?

Banks DO, In Fact, Create Money Out of Thin Air

If you’re still not convinced that banks create money out of thin air, without regard to whether or not they have deposits on hand, please note that the Fed has said as much.










And there’s an overwhelming amount of additional proof:

As PhD economist Steve Keen pointed out recently, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:




Kydland and Prescott observed at the end of their paper that:



Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.

As Mish has previously noted:



– Economist John Kenneth Galbraith




– Graham Towers, Governor of the Bank of Canada from 1935 to 1955.

I’ve also noted:



The court also held:


(Here’s the case file).







Indeed, even Paul Krugman admits that “banks can create inside money”. Inside money is “debt that is used as money”.

Why Is The Myth About Banks So Dangerous?

Even if banks don’t really loan based on their deposits and reserves, who cares? Why is this such a dangerous myth?

Because, if banks don’t make loans based on available deposits or reserves, that means:

(1) This was never a liquidity crisis, but rather a solvency crisis. In other words, it was not a lack of available liquid funds which got the banks in trouble, it was the fact that they speculated and committed fraud, so that their liabilities far exceeded their assets. The government has been fighting the wrong battle, and has made the economic situation worse.

(2) The giant banks are not needed, as the federal, state or local governments or small local banks and credit unions can create the credit instead, if the near-monopoly power the too big to fails are enjoying is taken away, and others are allowed to fill the vacuum.

Indeed, the big banks do very little traditional banking. Most of their business is from financial speculation. For example, less than 10% of Bank of America’s assets come from traditional banking deposits.

Time Magazine gave some historical perspective in 1993:




So we the government has been barking up the wrong tree by propping up  the big banks.

Moreover, as discussed above, the fact that banks can create money means that the level of private debt does matter … and economists like Bernanke and Krugman who encourage massive levels of private debt are hurting the economy.

As professor Keen explains:

In a credit-based economy, aggregate demand is therefore the sum of income plus the change in debt, with the change in debt spending new money into existence in the economy. This is then spent not only goods and services, but on financial assets as well—shares and property. Changes in the level of debt therefore have direct and potentially enormous impacts on the macroeconomy and asset markets, as the GFC—which was predicted only by a handful of credit-aware economists (Bezemer 2009)—made abundantly clear.

If the change in debt is roughly equivalent to the growth in income—as applied in Australia from 1945 to 1965, when the private debt to GDP ratio fluctuated around 25 per cent (see Figure 1)—then nothing is amiss: the increase in debt mainly finances investment, investment causes incomes to grow, and the economy moves forward in a virtuous feedback cycle. But when debt rises faster than income, and finances not just investment but also speculation on asset prices, the virtuous cycle gives way to a vicious positive feedback process: asset prices rise when debt rises faster than income, and this encourages more borrowing still.

The result is a superficial economic boom driven by a debt-financed bubble in asset prices. To sustain a rise in asset prices relative to consumer prices, debt has to grow more rapidly than income—in other words, if asset prices are to rise faster than consumer prices, then rather than merely rising, debt has to accelerate. This in turn guarantees that the asset price bubble will burst at some point, because debt can’t accelerate forever. When debt growth slows, a boom can turn into a slump even if the rate of growth of GDP remains constant.

This process is easily illustrated in a numerical example. Consider an economy with a GDP of $1 trillion that is growing at 10% per annum, with real growth of 5% and inflation of 5%, and in which private debt is $1.25 trillion and growing at 20% p.a. Total spending on both goods & services and financial assets is therefore $1.25 trillion: $1 trillion is financed by income, and $250 billion is financed by the 20% increase in debt.

In the following year, if the growth of debt simply slows down to the same rate at which nominal GDP is growing (without affecting the rate of economic growth), then the growth in debt will be $150 billion (10% of the $1.5 trillion level reached at the end of the previous year). Total spending will therefore be exactly the same as the year before: $1.25 trillion, consisting of $1.1 trillion in GDP plus a $150 billion growth in debt. However, since inflation is running at 5%, this amounts to a 5% fall in the real level of economic activity—which would be spread across both commodity and asset markets.

If instead the growth of debt stopped, then total spending the next year will be $1.1 trillion, a 15% fall from the level of the previous year in nominal terms, and 20% in real terms. This would cause a massive slump in demand for goods & services, assets, or both, even without a slowdown in the rate of growth of GDP.

This hypothetical example is not far removed from the actual experience of the GFC. As the US experience illustrates most clearly, the switch from rising to falling private debt ushered in the biggest economic downturn since the Great Depression, a prolonged period of high unemployment, and sharp falls in asset markets—all of which are plotted in Figure 3.

Figure 3

This is why the shift from the Age of Leverage to the Age of Deleveraging was so dramatic, and yet so unforeseen by conventional economists: it was caused by a huge reduction in aggregate demand from a factor they ignore. This debt-induced reduction in aggregate demand will persist as long as private debt levels are falling—as they still are in the USA, though at a much reduced rate from the peak rate of fall in early 2010.

In 2008, the Bank for International Settlements (BIS) – often described as the central bank for central banks – said that failing to force companies to write off bad debts “will only make things worse”.

Indeed, Bernanke, Krugman and other mainstream economists from the left and the right who encourage more private debt are only creating a debt trap … where people take on new debt to try to pay for the old debt, and end up in a worse situation than they started:

  • mmckinl

    Excellent analysis … The problem is that that vast majority of economists today are trained to ignore the creation of currency and credit to protect the money monopoly of the banksters. Any economists stepping outside the paradigm of debt money soon find themselves cut off by colleagues and losing jobs …

    The privately owned and operated Federal Reserve with the help of think tanks and foundations have “ring fenced” the economics profession for all positions in academia, government and the corporate sector. Both “salt water” and “fresh water” economists fall into this category and that is why the MSM can play the argument of austerity vs. stimulus as a debt issue when it is insolvency of the financial system that is the problem.

    The easiest way to get out of the hole the banksters have created is to have the US Treasury print the money, not borrow it, and use it to pay for government services. In order that inflation is contained progressive taxation would Hoover up this sovereign money so that it doesn’t become inflationary. These taxes would make up the balance of government spending meaning there would be little need for sovereign debt … but … taking away the banksters monopoly would most probably require a revolution …

  • How about “Capitalism – Parasites’ Golden Calf”

  • gozounlimited

    The banksters solvency crisis has earned them the privilege of confiscating your property due to your failure to pay debt fraudulently loaned to you. The debt is not monetary, it is built on a theoretical model mired in ignorance, omission, and fraud and backed by the U.S. Corporate/Government. The banksters are taking possession of your home without presenting documentation showing chain of title and/or ownership (Robosigning). The result of this ongoing fraud isn’t only causing loss of economic recovery …. it is causing “The largest transfer of wealth from the public to private sector to begin. The federal government will be bulk-selling the massive portfolio of foreclosed homes now owned by HUD, Fannie Mae and Freddie Mac to private investors — vulture funds” in order to build CAPITOL. (The new BUZZ…..wordy)

    “These homes,” which are now the property of the U.S. government, the U.S. taxpayer, U.S. citizens collectively, are going to be sold to private investor conglomerates at extraordinarily large discounts to real value. You and I will not be allowed to participate. These investors will come from the private-equity and hedge-fund community, Goldman Sachs (GS) and its derivatives, as well as foreign sovereign wealth funds that can bring a billion dollars or more to each transaction.”

    Why Goldman is hiring prop traders. After stealing your homes and squelching the Volker rule, they are going to make a fortune on you again… do you stop the bankster fraud when our corporate/government keeps it going?

    For More Depth and background on the fusion of government and the businesses that own our government: (This forms part of the pretext for seizing properties from a private person and transferring them to government/corporate fused entities.) read more:
    #Anon #NewZ NEW FED PLAN Sell Foreclosed Properties To Investors To Rent Out

    see video:

    Anon #NewZ NEW FED PLAN Sell Foreclosed Properties To Investors To Rent Out BANKSTERS GO FOR THE JUGGLER…

    read more:
    The Obama Administration, in conjunction with federal regulators and led by the overseer of Fannie Mae and Freddie Mac, are very close to announcing a pilot program to sell government-owned foreclosures in bulk to investors as rentals, according to administration officials.

    There are currently about a quarter of a million foreclosed properties on the books of Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) and millions more are coming.

    The foreclosure processing delays of last year created a mammoth backlog of properties yet to be processed, which are just now being re-started. One of the initiatives of this program is for the federal government to be in the position to mitigate and manage any new wave of foreclosures, sources say. Late stage delinquencies still in the pipeline number close to two million, according to a new report from Lender Processing Services. Foreclosure starts outnumber foreclosure sales by two to one, and, “the trend toward fewer loans becoming delinquent, which dominated 2010 and the first quarter of 2011, appears to have halted,” according to LPS.

    Read more:

    • gozounlimited

      Matt Taibbi ……. Senators Grovel, Embarrass Themselves at Dimon Hearing

      This is a guy who just committed a massive blunder with federally-insured money, a guy who is here answering questions because his company, at his direction, clearly and intentionally violated the spirit of the Volcker rule, and these clowns on the Banking Committee are asking Dimon for advice on how to write the rule! It was incredible. Can you imagine senators asking the captain of the Exxon Valdez what his ideas are for new shipping safety regulations – and taking him seriously when he says he doesn’t think they’re a good idea?

      What was most disturbing was the tone of the hearing. The senators treated Dimon like a visiting dignitary and a teacher of great wisdom, not like a man who, after growing very rich off of public money, had put the whole economy at risk by engaging in wildly unsafe financial sex on a grand scale. Senators are like judges – the way they comport themselves in public is important, and it’s important that they work at maintaining the dignity of their offices. You don’t get to snort and roll your eyes in front of a judge, and you shouldn’t get to do on the floor of the senate, especially when you’re there because you violated the public trust. Somebody has to remind these legislators who it is they work for, and it’s not Jamie Dimon.

      Read more:

      • gozounlimited

        What We Can Learn From Iceland

        “For all the fearmongering we hear out of our politicians on the right about how heaven forbid we’re going to turn into Greece, the one country you never hear them talk about any more is Iceland. The reason they don’t is, as Cenk Uygur explained on his show this Tuesday, they took a different path than the United States after their financial crisis and nationalized the banks, threw some the people responsible for the crash in jail and bailed out the homeowners instead of worrying about only bailing out the banks. And now they’re coming back and their economy is growing again…”.*

        see video:
        Fed Members Gave Their Own Banks $4 Trillion In Secret Bailouts

        Details of a GAO audit of the Federal Reserve’s eye-popping secret $16 trillion-dollar bailout reveals that Federal Reserve board members gave their own banks $4 trillion.

        read more:

  • David G. Mills

    Since banks can create money out of thin air, the real problem for the world is when banks arbitrarily decide not to. So you need that business loan that just expired refinanced? So sorry, we can’t do that, so either you will have to pay us back in full or we will have to foreclose. You can’t pay us back in full? So sorry then.

    That of course is where we are now. We have less private debt because the banks decided not to lend, so the banks can take this opportunity to take our assets away for pennies on the dollar.

    In Bill Still’s classic video, “The Money Masters,” he quotes a directive from the President of the American Banker’s Association back in the late 1800’s, where the President of the association said this very thing — beginning on a certain date in September a couple of years hence, no loans would be made, collateral would be foreclosed upon and seized and the banks would profit handsomely. It was planned years in advance. It worked well. The rich got richer and the poor got poorer.

    The real myth is that the government prints money. If only it did. It could print that 4 billion it needs for an air craft carrier and would not have to borrow to do it or tax us to pay back what it borrowed.

  • Thanks for being open minded enough to seriously consider Post-Keynesian economics. It turns everything that you though you knew about economics upside down.

  • GinoT

    Careful listening to the MMT advocates like Wray and Fullwiler. These people are full blown socialists thought they’ll always deny it. Just read Wray’s latest piece from today. He hates capitalists and just wants the government to fix all of our problems. Their analysis should be read with a hefty grain of salt.

    • ggm

      Would you prefer our problems not be fixed? The private sector is certainly not stepping up.

    • Tom Paine

      Then we need more “full blown socialists.”

    • James

      MMT is just a description of how the monetary system actually works, whether or not the likes of Wray & Fullwiler believe it should be used for what you would describe as “socialist” policies is irrelevant.

  • Todd Millions

    The role of banks in setting up monopoly mafias is historic and can’t be ignored-particularly in the frosty bannana republic to the north of you.Years ago Stewart covered one aspect very well in”Towers od gold feet of clay”-the bank advisory boards.If you come up with a better widget,any financail work by chatered bank for your needs goes thru an established compeditor-who end up with your work and assets on a 85% right down after the bankruptcy sale.Our manufacturing and transport mafias were always run on this model.Which the vulture funds have copied and now our politicians(of any party)who lubricate this rape are lined up kissing Quayle butt,for their post goverment concultancies and board of director idiot seats-with the offshore payment naturally.This is the model for oil coal any food processing and storage ect-now global.Thus a billion people starving,increases profits 3 fold,and can be arranged by holding a few ships offshore for a week or two.Thus cars must waste 98% of the heat in the fuel-even while not moving at all,and houses require air conditioning and heating systens(see;PAHS Hait1983).So long as an unseen hand is on the pipes,wires,roads ectra this global interlinking of mafias rules.Therfore-as long as we keep chosing so very poorly,we have-” given them power,by loaning them our support”as Solon pointed out some time back.

  • Amazing. I read the whole article and all the comments and no one ever mentioned interest or usury.

    The problem isn’t debt or that banks create money out of thin air. The problem is usury.

    We live in a world ruled by compound interest. Mr. Keen missed the forest for the trees.

  • Angellight

    You got to be kidding when you say Obama believes unemployment is good for the economy. This is a lie and myth. Pres. Obama has worked on saving jobs and the economy from banks and predators. He has put student loans back into the gov’t where it belongs. He has been blocked by the GOP, Supreme Court in getting job plans and initiatives going to create more jobs. You should get your facts straight.