Krugman and Mankiw on loanable funds — so wrong, so wrong

16 Sep, 2014 at 09:50 | Posted in Economics | 19 Comments

Earlier this autumn yours truly was invited to participate in the New York Rethinking Economics conference. A busy schedule didn’t allow me to “go over there.” Fortunately some of the debates and presentations have been made available on the web, as for example here. Listening a couple of minutes into that video one can hear Paul Krugman strongly defending the loanable funds theory.

Unfortunately this is not an exception among “New Keynesian” economists.

Neglecting anything resembling a real-world finance system, Greg Mankiw — in the 8th edition of his intermediate textbook Macroeconomics — has appended a new chapter to the other nineteen chapters where finance more or less is equated to the neoclassical thought-construction of a “market for loanable funds.”

On the subject of financial crises he admits that

perhaps we should view speculative excess and its ramifications as an inherent feature of market economies … but preventing them entirely may be too much to ask given our current knowledge.

This is of course self-evident for all of us who understand that both ontologically and epistemologically founded uncertainty makes any such hopes totally unfounded. But it’s rather odd to read this in a book that bases its models on assumptions of rational expectations, representative actors and dynamically stochastic general equilibrium – assumptions that convey the view that markets – give or take a few rigidities and menu costs – are efficient! For being one of many neoclassical economists so proud of their (unreal, yes, but) consistent models, Mankiw here certainly is flagrantly inconsistent!

And as if being afraid that all the talk of financial crises might weaken the student’s faith in the financial system, Mankiw, in his concluding remarks, has to add a more Panglossian warning that we

should not lose sight of the great benefits that the system brings … By bringing together those who want to save and those who want to invest, the financial system promotes economic growth and overall prosperity

Really?

Finance has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

I may be too bold, but I’m willing to take the risk, and so recommend Krugman and Mankiw to make the following addition to their reading lists …

Fallacy 2

Urging or providing incentives for individuals to try to save more is said to stimulate investment and economic growth.

This seems to derive from an assumption of an unchanged aggregate output so that what is not used for consumption will necessarily and automatically be devoted to capital formation.

Again, actually the exact reverse is true. In a money economy, for most individuals a decision to try to save more means a decision to spend less; less spending by a saver means less income and less saving for the vendors and producers, and aggregate saving is not increased, but diminished as vendors in turn reduce their purchases, national income is reduced and with it national saving. A given individual may indeed succeed in increasing his own saving, but only at the expense of reducing the income and saving of others by even more.

Where the saving consists of reduced spending on nonstorable services, such as a haircut, the effect on the vendor’s income and saving is immediate and obvious. Where a storable commodity is involved, there may be an immediate temporary investment in inventory, but this will soon disappear as the vendor cuts back on orders from his suppliers to return the inventory to a normal level, eventually leading to a cutback of production, employment, and income.

Saving does not create “loanable funds” out of thin air. There is no presumption that the additional bank balance of the saver will increase the ability of his bank to extend credit by more than the credit supplying ability of the vendor’s bank will be reduced. If anything, the vendor is more likely to be active in equities markets or to use credit enhanced by the sale to invest in his business, than a saver responding to inducements such as IRA’s, exemption or deferral of taxes on pension fund accruals, and the like, so that the net effect of the saving inducement is to reduce the overall extension of bank loans. Attempted saving, with corresponding reduction in spending, does nothing to enhance the willingness of banks and other lenders to finance adequately promising investment projects. With unemployed resources available, saving is neither a prerequisite nor a stimulus to, but a consequence of capital formation, as the income generated by capital formation provides a source of additional savings.

Fallacy 3

Government borrowing is supposed to “crowd out” private investment.

The current reality is that on the contrary, the expenditure of the borrowed funds (unlike the expenditure of tax revenues) will generate added disposable income, enhance the demand for the products of private industry, and make private investment more profitable. As long as there are plenty of idle resources lying around, and monetary authorities behave sensibly, (instead of trying to counter the supposedly inflationary effect of the deficit) those with a prospect for profitable investment can be enabled to obtain financing. Under these circumstances, each additional dollar of deficit will in the medium long run induce two or more additional dollars of private investment. The capital created is an increment to someone’s wealth and ipso facto someone’s saving. “Supply creates its own demand” fails as soon as some of the income generated by the supply is saved, but investment does create its own saving, and more. Any crowding out that may occur is the result, not of underlying economic reality, but of inappropriate restrictive reactions on the part of a monetary authority in response to the deficit.

William Vickrey Fifteen Fatal Fallacies of Financial Fundamentalism

19 Comments

  1. The response you get is exactly the same cognitive dissonance waffle you get from a vicar if you ask them how famine and war are compatible with the existence of a benevolent God.

    Economics is modern religion – people believing in their own set of stories and getting annoyed at those that don’t.

  2. Krugman often claims that economists come to the wrong policy conclusions because they don’t understand the ISLM.

    But if the ISLM can be specified in any way — as he now claims — this cannot be true. I can make a case for austerity if I specify the ISLM in certain ways.

    Frankly, I think that the vast majority of the time Krugman is writing words with very little meaning when he intrudes into the territory of applied theory.

  3. […] Krugman’s position at Rethinking Economics has come in for some strong criticism by ‘post-Keynesians’ like Philip Pilkington and Lars Syll (https://fixingtheeconomists.wordpress.com/2014/09/15/krugman-at-the-rethinking-economics-conference-still-wrong-on-monetary-theory/ and https://larspsyll.wordpress.com/2014/09/16/krugman-and-mankiw-on-loanable-funds-so-wrong-so-wrong/). […]

  4. Americans consume and borrow and the Chinese save. So there is no fallacy, The fallacy emerges when one loses sight of globalization professor. These guys do not care if you or a guy in China will get rich as long as inflation remains low and their stakes in public companies gains in value. Yes, economics is religion, it is a stupid practice and economic departments should be abolished. http://www.digitalcosmology.com/Blog/2014/02/12/a-call-to-action-abolish-economics-departments-now/

  5. “But it’s rather odd to read this in a book that bases its models on assumptions of rational expectations, representative actors and dynamically stochastic general equilibrium…”

    No, it doesn’t. Mankiw’s book, just like most others intermediate macro textbooks, uses Solow model for long-run growth, and IS/LM and AS/AD model for fluctuations. The one chapter on “dynamic model” features a simple 3-equation New-Keynesian model (not microfounded) with adaptive expectations.

    • Really?

      Mankiw writes on his blog: “The 7th edition of my intermediate macroeconomics textbook is coming out this summer, ready for fall classes. As well as being updated for current events, including the recent housing bubble and financial crisis, the book has a new chapter, called A Dynamic Model of Aggregate Demand and Aggregate Supply. The model is intended to give the student a basic understanding of modern DSGE models.”

      And in the book: “The dynamic AD-AS model we have presented in this chapter is a simpolified version of these DSGE models.”

      So, Ivan, please discuss some real things, and let’s not quibble over words!

      • Uhm, did you even read Mankiw’s book? Because that’s exactly the chapter I was discussing (also, it’s one chapter – all the rest is about static, nonstochastic models). It can give students some limited idea how a simple mainstream dynamic model looks like, but it’s still very far from modern macroeconomics that you so love to criticize here.
        Yes, let’s not quibble over words. Only I don’t think that grossly misrepresenting style and content of a whole textbook is mere quibble, especially when it’s common knowledge that there’s currently a large gap between undergraduate and graduate level of economics teaching.

      • It is funny that economics books are updated after the fact rather than predicting the fact, even with some probability. Isn’t this a real case of outcome bias?

        If the original Mankiw book did not provide the tools to predict the 2007 crisis, then the author should apologize and refrain from editing it but withdraw instead of retrofitting it with the fixes. I find this “curve-fitting” both dangerous and even not so ethical. The excuse that we live and we learn is not accepted by me. A bridge engineer goes to jail, does not live to learn. The same standard should apply to economists. (hmmm…. nice topic for my blog)

      • Outcome bias? If anyone suffers from an outcome bias it’s people that claim that those who predicted the crisis is in possession of the best model.

        To quote an not to unknown author to readers of this blog: “When the facts change, I change my mind. What do you do, sir?”

  6. Even Vickrey falls into the trap of assuming one sector can net save before another sector net deficit spends in his fundamental fallacies piece. You see this when he writes of using fiscal deficits to mobilize private savings. The private savings cannot exist unless some other sector is already deficit spending. The two are interdependent. So it takes a lot of discipline to break these old habits of thought and get to a stock/flow consistent way of looking at macroeconomics.

  7. I love that you used the adjective “Panglossian” to describe Mankiw’s remarks! I just commented to Noah Smith that economists imagine they are Newton when in reality they are Leibniz, such an epic fool (but great mathematician) that he was parodied as Dr. Pangloss in Candide.

  8. […] Read rest here. […]

  9. The loanable funds idea is valid in the sense that assuming constant aggregate demand (e.g. assuming there is competent government in control which keeps AD constant) if one person is to borrow and spend $X, then someone else has to save and not spend $X. Whether the borrowing and spending takes place a few weeks before or after the saving is immaterial.

    That is consistent with Vickrey’s Fallacy No. 2. He’s assuming there is NO MECHANISM for keeping demand constant, i.e. he assumes that the fact of saving influences demand.

  10. ““When the facts change, I change my mind. What do you do, sir?”

    Changing facts is different from changing predictions. You are setting up a little fallacy here that will not go unnoticed. When predictions change posteriori, you are dealing with fraud in most cases or stupidity or ignorance. What is your pick Sir?

    • Neither. And there is no fallacy. The procedure of allowing, nay forcing, theories to change when reality stand in their way is a sign of a healthy science, not of outcome bias. This occurs all the time in both science and social science. Outcome bias is about putting unwarranted trust in any theory that happened to be correct in some dimension, but possibly not in others. The “layman economics” emerging from the financial crisis epitomizes this quite well.

      • Theories hardly change after new facts. They die and new theories emerge. This was always true in physics and it should also be true in every field. As soon as people realized that Newtonian mechanics could not explain the change in the perihelion of Mercury, the theory died despite attempts to fix it. General relativity came to fill in the gap. If some new fact emerges that cannot be explained by GR, this theory will die too.

        Changing a book in economics to include a new fact that was not predicted by its material in the first place is retrofitting and maybe cheating. You just have to throw the theory away and look for somethi9gn else. Adding auxiliary hypotheses all the time is a sign of weakness and borderline fraud.

        I do not understand your definition of outcome bias. This bias results from evaluating a theory given that the outcome is known. The theory must be evaluated based on its ability to predict unknown outcomes, like the financial crisis of 2007. Evaluating the theory knowing the fact, is exercising outcome bias. So is adding the chapter in the book AFTER the crisis occurred. The chapter should have been there before. Adding it after the fact may be borderline fraud. I am sorry you cannot see that but I am not surprised either.
        The state is current economic theories is that there are extremely naïve because they ignore how digital technology and globalization has changed the world. Neither the authors of those textbooks understand that but rely on their status of authority when in reality they are totally ignorant of what is going on. The system takes advantage of their ignorance by maintaining their status to maintain in turn its benefits. Students come out of economic departments and are basically brainwashed with garbage. At the same time, the technology oligarchs and their counterparts in Asian, the slave labor oligarchs, collect all the benefits of their ignorance. This is the current system. I predicted the financial crisis but not its exact timing in 2000. Now I tell you there will be a more severe financial crisis in the near future that will give rise to new paradigms and people will remember DSGE and New Keynesian models as artifacts of a dark age in humanity.

  11. […] Krugman’s position at Rethinking Economics has come in for some strong criticism by ‘post-Keynesians’ like Philip Pilkington and Lars Syll (https://fixingtheeconomists.wordpress.com/2014/09/15/krugman-at-the-rethinking-economics-conference-still-wrong-on-monetary-theory/ and https://larspsyll.wordpress.com/2014/09/16/krugman-and-mankiw-on-loanable-funds-so-wrong-so-wrong/). […]

  12. Lars: I was going to ask you a question. But it got too long for a comment, so I wrote a post. http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/09/the-orthodox-new-keynesian-position-on-liquidity-preference-vs-loanable-funds.html

    • Nick: Busy today, but I will have a look at your post and reply tomorrow 🙂


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