Mainstream nonsense about budget deficits

13 March, 2019 at 13:54 | Posted in Economics | 8 Comments

The standard mainstream textbook argument about budget deficits goes something like this: Assume that total output is given. If government expenditures are increased, then this has to be met by an equally large decrease in investment, which can only come forth by rising interest rates. ‘Crowding out’ reduces public saving and causes interest rates to rise. Then, applying the logic of the Solow growth model, it is concluded that (Mankiw, Macroeconomics, 8th ed., p. 221)

the long-run consequences of a reduced saving rate are a lower capital stock and lower national income. This is why many economists are critical of persistent budget deficits.

Now, what’s wrong with this? Everything! To a considerable extent because the reasoning is based on the loanable funds theory — which has no room for the simple fact that the rate of interest is not determined by the demand for and supply of capital since investment basically finances itself.

The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credits set by banks and determined by supply and demand — as Bertil Ohlin put it — “in the same way as the price of eggs and strawberries on a village market.”

loanIt is a beautiful fairy tale, but the problem is that banks are not barter institutions that transfer pre-existing loanable funds from depositors to borrowers. Why? Because, in the real world, there simply are no pre-existing loanable funds. Banks create new funds — credit — only if someone has previously got into debt! Banks are monetary institutions, not barter vehicles.

In the traditional loanable funds theory — as presented in mainstream macroeconomics textbooks — the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving is the supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate. Lowering households’ consumption means increasing savings via a lower interest.

That view has been shown to have very little to do with reality. It’s nothing but an otherworldly mainstream model fantasy. But there are many other problems as well with the standard presentation and formalization of the loanable funds theory:

As already noticed by James Meade decades ago, the causal story told to explicate the accounting identities used gives the picture of “a dog called saving wagged its tail labelled investment.” In Keynes’s view — and later over and over again confirmed by empirical research — it’s not so much the interest rate at which firms can borrow that causally determines the amount of investment undertaken, but rather their internal funds, profit expectations and capacity utilization.

As is typical of most mainstream macroeconomic formalizations and models, there is pretty little mention of real-world phenomena, like e. g. real money, credit rationing and the existence of multiple interest rates, in the loanable funds theory. Loanable funds theory essentially reduces modern monetary economies to something akin to barter systems — something they definitely are not. As emphasized especially by Minsky, to understand and explain how much investment/loaning/crediting is going on in an economy, it’s much more important to focus on the working of financial markets than staring at accounting identities like S = Y – C – G. The problems we meet on modern markets today have more to do with inadequate financial institutions than with the size of loanable-funds-savings.

The loanable funds theory in the ‘New Keynesian’ approach means that the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras’ law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks’ interest rate adjustments. From a realist Keynes-Minsky point of view, this can’t be considered anything else than a belief resting on nothing but sheer hope. [Not to mention that more and more Central Banks actually choose not to follow Taylor-like policy rules.] The age-old belief that Central Banks control the money supply has more an more come to be questioned and replaced by an ‘endogenous’ money view, and I think the same will happen to the view that Central Banks determine “the” rate of interest.

A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. This is seriously wrong:

gtThe classical theory of the rate of interest [the loanable funds theory] seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shifts​, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down … In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

There are always (at least) two parts in an economic transaction. Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no ‘direct and immediate’ automatic interest mechanism at work in modern monetary economies. What this ultimately boils done to is — iter — that what happens at the microeconomic level — both in and out of equilibrium —  is not always compatible with the macroeconomic outcome. The fallacy of composition (the ‘atomistic fallacy’ of Keynes) has many faces — loanable funds is one of them.

Contrary to the loanable funds theory, finance in the world of Keynes and Minsky precedes investment and saving. What is ‘forgotten’ in the loanable funds theory, is the insight that finance — in all its different shapes — 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.

All real economic activities nowadays depend on a functioning financial machinery. But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc. — things that play decisive roles in channelling money/savings/credit — are more or less left in the dark in modern mainstream formalizations of the loanable funds theory.


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  1. The fact that commercial banks, as Lars Syll rightly says, “create new funds” does not rule out the loanable funds idea. Reason is this.

    When a bank “creates new funds” and gives them to someone who borrows from the bank, that money is quickly spent, and ends up in a variety of depositors’ accounts. If those depositors are happy to hold those funds at the existing rate of interest, then clearly creating those funds will not raise interest rates.

    But a more reasonable assumption is that the more funds depositors have to hold (after their need for transaction and precautionary money is met) the higher the rate of interest they’ll charge for holding those surplus funds.

    In short, the loanable funds idea is more robust than Lars seems to think. Put another way, whether potentially loanable funds are created and put into the accounts of depositor/lenders a day or two before or after the funds are given to borrowers is irrelevant.

    • The key dynamic is banks create new credit money by lending. This expansion of the money supply typically ends up chasing financial assets like bonds. If bond prices rise per this new demand created by bank credit, rates fall axiomatically. This is the main channel for how rates are set, not loanable funds. For thirty years plus total private debt has climbed exponentially while interest rates have fallen in tandem. We would do better if we focused on this as an important empirical relation.

      • I realize that a substantial proportion of bank loans fund the financial industry itself, but I’ve always been puzzled as to what those loans are actually used for. Do you know of any research into this?

        Re your claim that people borrow money from banks to fund the purchase of bonds, I’m puzzled as to why those issuing the bonds don’t cut out the middle-man and just borrow direct from banks themselves.

      • Peter,

        What sort of bonds are you talking about – government or private?

        • Eventually, most new credit money is swept out of the payments system and ends up in the money markets. These funds buy both public and private debt. Of these two, letting private debt get too large is more serious than too large public debt. This is because high private debt suppresses aggregate demand while run away public debt dilutes the currency. Inflation is a bad thing but not nearly as bad as a debt deflation.

    • “When a bank “creates new funds” and gives them to someone who borrows from the bank, that money is quickly spent, and ends up in a variety of depositors’ accounts.” Which the depositors then hold at the current interest rate that satisfies them, or at a higher rate which they demand.

      I wonder about this. Why should borrowed money take one trip through the market, an stop cold in a stock of savings? It could be spent with people and businesses that have expenses of their own, and debts of their own to pay off, and therefore either continue to circulate or disappear. Either way, no pressure on the interest rate.

    • No a more reasonable assumption is that the rate of interest will decline!

  2. “But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc.”
    You leave out derivatives, which address fundamental uncertainties by hedging them in such a way the counterparties can all be matched book. Derivatives deal with fundamental uncertainty by splitting up the risk so that different counterparties can take on just the exposure they want to hedge other bets they’ve made. Derivative volumes are vast, ten times world GDP, but economists don’t understand them and so ignore them and even leave them out when they are listing financial sector things that economists leave out!

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