Why Krugman’s view on MMMF is completely wrong

In a recent Mises Daily article Mark Thornton  has offered an excellent critique of why Krugman’s attack on the Austrian view of money market mutual funds (MMMF) is totally misplaced. I would like to add another angle as to why Krugman’s attack on the Austrian School of Economics is fundamentally flawed. According to Krugman as quoted in Thornton’s article:

How do the Austrians propose dealing with money market funds? I mean, it has always been a peculiarity of that school of thought that it praises markets and opposes government intervention — but that at the same time it demands that the government step in to prevent the free market from providing a certain kind of financial service. As I understand it, the intellectual trick here is to convince oneself that fractional reserve banking, in which banks don’t keep 100 percent of deposits in a vault, is somehow an artificial creation of the government. This is historically wrong, but maybe the actual history of banking is deep enough in the past for that wrongness to get missed.

But consider a more recent innovation: money market funds. Such funds are just a particular type of mutual fund — and surely the Austrians don’t want to ban financial intermediation (or do they?). Yet shares in a MMF are very clearly a form of money — you can even write checks on them — created out of thin air by financial institutions, with very few pieces of green paper behind them.

So are such funds illegitimate?

It seems that Krugman has a problem with the money supply definition. Once the definition is established even Krugman could see that the whole issue of the MMMF is irrelevant as far as the money supply issues are concerned.

The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are. To establish the definition of money we have to ascertain how the money economy came about.

Money emerged because barter could not support the market economy. A butcher who wanted to exchange his meat for fruit might not have been able to find a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not have been able to find a shoemaker who wanted his fruit.

The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity.

Through an ongoing selection process over thousands of years, people have settled on gold as money. In other words, gold served as the standard money. In today’s monetary system, the core of the money supply is no longer gold but coins and notes issued by the government and the central bank.

Consequently, coins and notes constitute the standard money, known as cash, that is employed in transactions. In other words, goods and services are sold for cash.

At any point in time part of the stock of cash is stored, that is, deposited in banks. Once an individual places his money in a bank’s warehouse he is in fact engaging in a claim transaction.

In depositing his money, he never relinquishes his ownership. No one else is expected to make use of it. When Bob stores his money with a bank, he continues to have an unlimited claim against it and is entitled to take charge of it at any time.  Consequently, these deposits, labeled demand deposits, are part of money.

Thus, if in an economy people hold $10,000 in cash, we would say that the money supply of this economy is $10,000. But, if some individuals have stored $2,000 in demand deposits, the total money supply will remain $10,000: $8,000 cash and $2,000 in demand deposits—that is, $2,000 cash is stored in bank warehouses. Finally, if individuals deposit their entire stock of cash, the total money supply will remain $10,000, all of it in demand deposits.

This must be contrasted with a credit transaction, in which the lender of money relinquishes his claim over the money for the duration of the loan. As a result, in a credit transaction, money is transferred from a lender to a borrower.

The distinction between a credit and a claim transaction serves as an important means of identifying the amount of money in an economy.

Following this approach, one could easily note that, notwithstanding popular practice, money invested with money market mutual funds (MMMF) must be excluded from the money supply definition. Investment in a money market mutual fund is in fact an investment in various money-market instruments.

The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed. Including investment in MMMFs in the money definition will only lead to a double-counting thereof.

The fact that mutual funds offer their clients cheque facilities has prompted some analysts to suggest that deposits with mutual funds are similar to bank demand deposits.

However, when an individual writes a cheque against his account with the money market fund, he in fact instructs them to sell some of his money market certificates for cash. The buyer of these certificates parts with his money, which is then transferred to the writer of the cheque; money changes hands, but no new money is created.

Furthermore, the fact that MMMF cheques are employed in payments does not mean that they are money. Cheques are a particular way of employing existing money in transactions.

The crux in identifying what must be included in the money supply definition is to adhere to the distinction between a claim transaction and a credit transaction.

Contrary to Krugman, Austrians are in favor of a free market in financial markets. Austrians, however, oppose the creation of money out of “thin air”, which sets in motion the consumption of capital and economic impoverishment. Austrians hold that the key to true free financial markets is to close all the loopholes that enable the creation of money supply out of “thin air”. This means the closure of the Central Bank and passing a law that forbids fractional reserve banking .

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5 replies on “Why Krugman’s view on MMMF is completely wrong”
  1. says: Paul Marks

    A lot of over complex, and misleading, language is used in this area.

    “Provding a finanial service”, when used by Paul Krugman, means “lending out money that no one really saved”.

    The Keynesian habit of treating credit expansion “as if” they were real savings does NOT make credit expansion real savings.

    For example, if only a billion Dollars is saved (i.e. if people choose to lend out, directly or via banks, only one billion Dollars of their income) then only one billion Dollars can be lent – unless credit expansion created “money” from nothing.

    This credit expansion, this “boom”, must (without government intervention – which prolongs the boom but makes the eventual bust WORSE) inevitably end in bust.

    As for Paul Krugman’s claim that allowing private banks to engage in credit expansion (i.e. to lend out “money” that no one really saved – i.e. to pretend that people can have the “cake” of their income and “eat it”, lend it out, AT THE SAME TIME) is the real free market position, for the sake of arugment let us assume this is true.

    When (and it is when – not if) the bust comes, the banks must be allowed to go bankrupt (no “suspension of cash payments” and other government interventions agains the normal law of contract) and the depositors to lose the money they have entrusted to the banks.

    Unacceptable? Do you demand bailouts and “deposit insurance”? If so do not bother claiming to hold the “free market” postion.

    There is a “bottom line” here.

    Borrowing is from savings. Savings must involve SACRIFICE – i.e. people choosing to not consume some of their income. They must also RISK this income – accept the risk that they by lending it out they run the risk of never seeing the money again. If people can lend with out risk – then the discipline of the market place is destroyed, and wild speculation will rule (and, eventually, there were be a terrible price for that).

    If someone claims to be able to finance more borrowing than there is saving (real saving) then, no matter how complex their scheme, what they are really offering is magic pixie dust kept in a fairy castle that floats in the air.

  2. I agree with Paul Marks that it is ridiculous to have government provide deposit insurance (and the consequent “too big to fail subsidy”) at the same time as claiming banks are viable free market businesses. There is a Bloomberg article that claims J.P.Morgan would make no profits were it not for government funded subsidies. See:


    As to Andrew Haldane of the Bank of England, he claims the situation is even more ridiculous. He claims that bank subsidies come to several times bank profits over the last decade or so. See 3rd paragraph under the heading “Implicit subsidies” here:


    1. says: Paul Marks


      For Paul Krugman to pretend that the pre 2008 situation was a free market is an absurd lie.

  3. says: AC

    While Krugman probably gets it wrong on MMMF his point about the problems of banker innovation is valid. Reading Rothbard it should be clear that getting to 100% reserves is not as easy as it sounds. Just passing a law might work for a while however like in the US in the 1920s banks will try to innovate around the rules. e.g. create accounts that they call time deposits but slowly they introduce new features like a limited number of demand withdraws. Now the calculation of the money supply is clearly muddied as is the 100% reserve rule.

    The point being that a free market in money and banking that had no central bank, that naturally reverted to gold and silver as reserves, that had real competition between banks that issued their own notes and e-cash, and perhaps stripped bank owners of limited liability in specific types of bank collapse, might be the long term solution to keeping reserves as close to 100% as possible ?

  4. says: Paul Marks

    AC – government was not trying to stop crazy banks in the 1920s. On the contrary it (Benjamim Strong of the New York Federal Reserve) was doing everything he could to EXPAND the credit-money bubble. Uust as government has been doing in modern times – at least since Alan Greenspan became head to of the Fed.

    Even before the existance of the Federal Reserve government was actually pushing the credit bubble – indeed, as Rothbard liked to point out, the National Banking Acts (of the Civil War era – but in effect till the new system of 1913) actually made ILLEGAL for local banks to “discount” the debt paper of the big New York “National Banks”.

    So it is not really the case of clever bankers outwitting government – government pushes the credit-money expansion (as much as it can) and then, when the inevitable bust comes, it blames the bankers and insists that “more regulation” is needed.

    Dodd-Frank is the latest manifestation of this – it will not stop monetary expansion. Not because of clever bankers – but because Dodd-Frank is NOT INTENDED TO stop the monetary expansion.

    What would bankers do on their own? Without bans on discounting, and government sanctioned “suspensions of cash payments” (and all the rest).

    I do not know.

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