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

9 August, 2017 at 10:42 | Posted in Economics | 1 Comment

slide_6A couple of years ago — in a debate with James Galbraith and Willem Buiter — Paul Krugman made it perfectly clear that he was a strong believer of 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 his intermediate textbook Macroeconomics — more or less equates finance 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 genuine 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 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


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.

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

The loanable funds hoax

8 August, 2017 at 21:11 | Posted in Economics | 1 Comment

loanable_funds_curve-13FEC80C6110B93D6D9The 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.”

It’s 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 that via a lower interest.

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

1 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.

2 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.

3 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.

4 A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. To Keynes this was 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.

5 Contrary to the loanable funds theory, finance in the world of Keynes and Minsky precedes investment and saving. Highlighting the loanable funds fallacy, Keynes wrote in “The Process of Capital Formation” (1939):

Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased 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 formalizations of the loanable funds theory.

It should be emphasized that the equality between savings and investment … will be valid under all circumstances.kalecki In particular, it will be independent of the level of the rate of interest which was customarily considered in economic theory to be the factor equilibrating the demand for and supply of new capital. In the present conception investment, once carried out, automatically provides the savings necessary to finance it. Indeed, in our simplified model, profits in a given period are the direct outcome of capitalists’ consumption and investment in that period. If investment increases by a certain amount, savings out of profits are pro tanto higher …

One important consequence of the above is that the rate of interest cannot be determined by the demand for and supply of new capital because investment ‘finances itself.’

DSGE ​​models — worse than useless

8 August, 2017 at 18:04 | Posted in Economics | 1 Comment

The main point of this book is to serve as an antidote to the intellectual poison of the erroneous’veil of ignorance’ aphorism … Accordingly [it] rejects as erroneous the standard macroeconomic model, whose assumptions have been built into DSGE models.

ehntsAmong other conceptual absurdities, such as the assumption that economic actors consist of identical omniscient ‘rational agents’ all of whom have perfect information about prices and quantities everywhere in the global economy, DSGE models generally incorporate the erroneous ‘veil of barter’ notion and ignore the functioning of real monetary systems …

DSGE models represent the distilled essence of the past three decades of dominant macroeconomic theory. Yet they are, to put it bluntly, nonsense, There is only one representative agent — no meaningful discussion of debt can take place in such a theoretical frame. These models are worse than useless — they are misleading.

Dirk Ehnts is, of course, absolutely right. DSGE models are worse than useless — and still mainstream economists seem to be impressed by the ‘rigour’ brought to macroeconomics by New-Classical-New-Keynesian DSGE models and its rational expectations and microfoundations!

It is difficult to see why.

Take the rational expectations assumption. Rational expectations in the mainstream economists’ world imply that relevant distributions have to be time independent. This amounts to assuming that an economy is like a closed system with known stochastic probability distributions for all different events. In reality it is straining one’s beliefs to try to represent economies as outcomes of stochastic processes. An existing economy is a single realization tout court, and hardly conceivable as one realization out of an ensemble of economy-worlds since an economy can hardly be conceived as being completely replicated over time. It is — to say the least — very difficult to see any similarity between these modelling assumptions and the expectations of real persons. In the world of the rational expectations hypothesis we are never disappointed in any other way than as when we lose at the roulette wheels. But real life is not an urn or a roulette wheel. And that’s also the reason why allowing for cases where agents make ‘predictable errors’ in DSGE models doesn’t take us any closer to a relevant and realist depiction of actual economic decisions and behaviours. If we really want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make we have to replace the rational expectations hypothesis with more relevant and realistic assumptions concerning economic agents and their expectations than childish roulette and urn analogies.

‘Rigorous’ and ‘precise’ DSGE models cannot be considered anything else than unsubstantiated conjectures as long as they aren’t supported by evidence from outside the theory or model. To my knowledge no in any way decisive empirical evidence has been presented.


No matter how precise and rigorous the analysis, and no matter how hard one tries to cast the argument in modern mathematical form, they do not push economic science forwards one single millimetre if they do not stand the acid test of relevance to the target. No matter how clear, precise, rigorous or certain the inferences delivered inside these models are, they do not say anything about real world economies.

Proving things ‘rigorously’ in DSGE models is at most a starting-point for doing an interesting and relevant economic analysis. Forgetting to supply export warrants to the real world makes the analysis an empty exercise in formalism without real scientific value.

Mainstream economists think there is a gain from the DSGE style of modelling in its capacity to offer some kind of structure around which to organise discussions. To me, that sounds more like a religious theoretical-methodological dogma, where one paradigm rules in divine hegemony. That’s not progress. That’s the death of economics as a science.

The bonus puzzle

8 August, 2017 at 16:31 | Posted in Economics | 2 Comments

If bonus or “incentive pay” schemes work so well for senior executives and bankers, why does everyone not get them?

The conventional answer is that a bonus scheme or incentive plan will indeed encourage the recipients to make more money for the shareholders or clients on whose behalf they act …

juggleA classic paper on the “principal-agent problem” … by Bengt Holmstrom and Paul Milgrom pointed out that the conventional answer makes the mistake of assuming that jobs are simple and consist only of one task. In reality, agents — such as executives acting on behalf of shareholders — have multiple tasks with many dimensions. Some of these will be easier to measure than others …

The more complex the job, the more dimensions involved — as in being a corporate chief executive, say — the less justification there is for an incentive reward scheme. This is reinforced in the specific context of shareholder principals and chief executives, when the latter are responsible for the value of the assets they are managing on behalf of the company’s owners. Incentives linked to whatever can easily be measured lead agents to turn their efforts away from maintaining and enhancing the value of the asset over time …

As the economy becomes increasingly complex and intangible, monitoring and measuring seem ever harder. The simplistic case for bonus and incentive pay schemes grows ever weaker.

Indeed, the best arrangement would seem to be the opposite of the pattern we observe now. Corporate executives and senior bankers doing complex jobs involving many impossible-to-monitor activities are the last people who ought to be paid via an incentive scheme; while bonuses for fast-food workers or shop-floor employees make more sense.

Diane Coyle

At a deeper level, this ‘puzzle’ confirms that the alleged close connection between productivity and remuneration postulated in mainstream income distribution theory simply does not exist.

The idea that capitalism is an expression of impartial market forces of supply and demand, bears but little resemblance to actual reality. Especially when it comes to people that basically set their own salaries, you find a rather strong inclination for generous self-rewarding.

economic-mythWealth and income distribution, both individual and functional, in a market society is to an overwhelmingly high degree influenced by bargaining power, institutionalized political and economic norms, things that have relatively little to do with marginal productivity in complete and profit-maximizing competitive market models – not to mention how extremely difficult, if not outright impossible it is to empirically disentangle and measure different individuals’ contributions in the typical team work production that characterize modern societies; or, especially when it comes to ‘capital,’ what it is supposed to mean and how to measure it. Remunerations, a fortiori, do not necessarily correspond to any marginal product of different factors of production – or to ‘compensating differentials’ due to non-monetary characteristics of different jobs, natural ability, effort or chance.

What is love (personal)

7 August, 2017 at 17:09 | Posted in Varia | Comments Off on What is love (personal)


How rigged markets make the rich richer

6 August, 2017 at 18:24 | Posted in Economics | 1 Comment

rigged_coverMarkets are never just given. Neither God nor nature hands us a worked-out set of rules determining the way property relations are defined, contracts are enforced, or macroeconomic policy is implemented. These matters are determined by policy choices. The elites have written these rules to redistribute income upward. Needless to say, they are not eager to have the rules rewritten — which means they also have no interest in even having them discussed.

But for progressive change to succeed, these rules must be addressed. While modest tweaks to tax and transfer policies can ameliorate the harm done by a regressive market structure, their effect will be limited. The complaint of conservatives — that tampering with market outcomes leads to inefficiencies and unintended outcomes — is largely correct, even if they may exaggerate the size of the distortions from policy interventions. Rather than tinker with badly designed rules, it is far more important to rewrite the rules so that markets lead to progressive and productive outcomes in which the benefits of economic growth and improving technology are broadly shared.

Dean Baker‘s new book forcefully argues that mainstream textbook economics has pretty little in common with the real world in which we actually live. Especially when it comes to the mainstream neoclassical paradigm of income distribution, Baker convincingly shows how wide is the gap between mainstream economic theory and reality.

Economics textbooks usually refer to the interrelationship between technological development and education as the main causal force behind increased inequality. If the educational system (supply) develops at the same pace as technology (demand), there should be no increase, ceteris paribus, in the ratio between high-income (highly educated) groups and low-income (low education) groups. In the race between technology and education, the proliferation of skilled-biased technological change has, however, allegedly increased the premium for the highly educated group.

Another prominent explanation is that globalization – in accordance with Ricardo’s theory of comparative advantage and the Wicksell-Heckscher-Ohlin-Stolper-Samuelson factor price theory – has benefited capital in the advanced countries and labour in the developing countries. The problem with these theories are that they explicitly assume full employment and international immobility of the factors of production. Globalization means more than anything else that capital and labour have to a large extent become mobile over country borders. These mainstream trade theories are really not applicable in the world of today, and they are certainly not able to explain the international trade pattern that has developed during the last decades. Although it seems as though capital in the developed countries has benefited from globalization, it is difficult to detect a similar positive effect on workers in the developing countries.

There are, however, also some other quite obvious problems with these kinds of inequality explanations. The World Top Incomes Database shows that the increase in incomes has been concentrated especially in the top 1%. If education was the main reason behind the increasing income gap, one would expect a much broader group of people in the upper echelons of the distribution taking part of this increase. It is dubious, to say the least, to try to explain, for example, the high wages in the finance sector with a marginal productivity argument. High-end wages seem to be more a result of pure luck or membership of the same ‘club’ as those who decide on the wages and bonuses, than of ‘marginal productivity.’

Mainstream economics, with its technologically determined marginal productivity theory, seems to be difficult to reconcile with reality. Although card-carrying neoclassical apologetics like Greg Mankiw want to recall John Bates Clark’s (1899) argument that marginal productivity results in an ethically just distribution, that is not something – even if it were true – we could confirm empirically, since it is impossible realiter to separate out what is the marginal contribution of any factor of production. The hypothetical ceteris paribus addition of only one factor in a production process is often heard of in textbooks, but never seen in reality.

When reading  mainstream economists like Mankiw, who argue for the ‘just desert’ of the 0.1 %, one gets a strong feeling that they are ultimately trying to argue that a market economy is some kind of moral free zone where, if left undisturbed, people get what they ‘deserve.’ To most social scientists that probably smacks more of being an evasive action trying to explain away a very disturbing structural ‘regime shift’ that has taken place in our societies. A shift that has very little to do with ‘stochastic returns to education.’ Those were in place also 30 or 40 years ago. At that time they meant that perhaps a top corporate manager earned 10–20 times more than ‘ordinary’ people earned. Today it means that they earn 100–200 times more than ‘ordinary’ people earn. A question of education? Hardly. It is probably more a question of greed and a lost sense of a common project of building a sustainable society.

Since the race between technology and education does not seem to explain the new growing income gap – and even if technological change has become more and more capital augmenting, it is also quite clear that not only the wages of low-skilled workers have fallen, but also the overall wage share – mainstream economists increasingly refer to ‘meritocratic extremism,’ ‘winners-take-all markets’ and ‘super star-theories’ for explanation. But this is also highly questionable.

Fans may want to pay extra to watch top-ranked athletes or movie stars performing on television and film, but corporate managers are hardly the stuff that people’s dreams are made of – and they seldom appear on television and in the movie theaters.

Everyone may prefer to employ the best corporate manager there is, but a corporate manager, unlike a movie star, can only provide his services to a limited number of customers. From the perspective of ‘super-star theories,’ a good corporate manager should only earn marginally better than an average corporate manager. The average earnings of corporate managers of the 50 biggest Swedish companies today, is equivalent to the wages of 46 blue-collar workers.

It is difficult to see the takeoff of the top executives as anything else but a reward for being a member of the same illustrious club. That they should be equivalent to indispensable and fair productive contributions – marginal products – is straining credulity too far. That so many corporate managers and top executives make fantastic earnings today, is strong evidence the theory is patently wrong and basically functions as a legitimizing device of indefensible and growing inequalities.

austerity22No one ought to doubt that the idea that capitalism is an expression of impartial market forces of supply and demand, bears but little resemblance to actual reality. Wealth and income distribution, both individual and functional, in a market society is to an overwhelmingly high degree influenced by institutionalized political and economic norms and power relations, things that have relatively little to do with marginal productivity in complete and profit-maximizing competitive market models – not to mention how extremely difficult, if not outright impossible it is to empirically disentangle and measure different individuals’ contributions in the typical team work production that characterize modern societies; or, especially when it comes to ‘capital,’ what it is supposed to mean and how to measure it. Remunerations do not necessarily correspond to any marginal product of different factors of production – or to ‘compensating differentials’ due to non-monetary characteristics of different jobs, natural ability, effort or chance.

Put simply – highly paid workers and corporate managers are not always highly productive workers and corporate managers, and less highly paid workers and corporate managers are not always less productive. History has over and over again disconfirmed the close connection between productivity and remuneration postulated in mainstream income distribution theory.

Neoclassical marginal productivity theory is obviously a collapsed theory from both a historical and a theoretical point of view, as shown already by Sraffa in the 1920s, and in the Cambridge capital controversy in the 1960s and 1970s.

When a theory is impossible to reconcile with facts there is only one thing to do — scrap it!

Former Swedish minister of finance showing off …

6 August, 2017 at 12:22 | Posted in Varia | 2 Comments

abAnders Borg, the former minister of finance in Sweden, shocked the guests at a party last weekend in the archipelago of Stockholm.

According to sources, Borg exposed his penis, threw sexist slurs at female guests and threatened the host.

”I feel a lot of disappointment and regret my behaviour”, Borg wrote in a Facebook post.

A party in the archipelago of Stockholm last Friday got out of hand. One of the guests were the former minister of finance, Anders Borg. At approximately 11.00 PM, he was exposing his penis and groping other men trying to compare penis sizes. He also called female guests ”sluts” and ”whores”, sources say.

– I don’t know what he drank, but it was a lot, says an anonymous partygoer.


Research shows that drinking moderate amounts of alcohol may protect healthy adults from, e.g., developing coronary heart disease. Heavy drinking, however, can lead to a variety of problems …

Stockholmsmelodi (personal)

30 July, 2017 at 12:44 | Posted in Varia | Comments Off on Stockholmsmelodi (personal)


Evert och Sven-Bertil i all ära, men för mig är det Tottes version som gäller!

The Venice of the North (personal)

30 July, 2017 at 09:49 | Posted in Varia | 1 Comment

For the third time in a year yours truly will make a guest appearance in Hamburg — The Venice of the North. Regular blogging will be resumed next weekend. Tschüss!

Ways in which economists overbid their cards

29 July, 2017 at 17:58 | Posted in Theory of Science & Methodology | 1 Comment


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