Home > The Economics Profession > Krugman and Mankiw on loanable funds — so wrong, so wrong

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

from Lars Syll

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


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

  1. Fabian Lindner
    September 16, 2014 at 2:25 pm

    Dear Lars,

    I have written a paper on that which I handed in for the World Economic Review (http://werdiscussion.worldeconomicsassociation.org/wp-content/uploads/WER-Lindner-supply-of-credit-II.pdf) where I critizize in much detail the theory of loanable funds and its application by Mankiw, Krugman and Benanke inter alia. That might be of interest. Best, Fabian

    • September 16, 2014 at 6:00 pm

      Thanks for the link. I will sure have a look :)

  2. Steve
    September 16, 2014 at 3:38 pm

    The belief in general economic equilibrium is a fallacy. It must be provided….by macro-economic policy.

  3. F. Beard
    September 16, 2014 at 9:19 pm

    Massive cognitive dissonance must forbid Mr. “Conscience of a Liberal” from admitting what banks are – a government-privileged counterfeiting cartel that systematically loots and oppresses the poor and other less so-called “credit-worthy.”

    Ethical hint: NO ONE is (credit) worthy of stolen purchasing power, no matter how much equity they possess. Let them either sell some of that equity, honestly borrow existing fiat, or learn to share that equity.

  4. Macrocompassion
    September 17, 2014 at 9:56 am

    Steve, general economic equilibrium is an ideal situation to which the actual economy is continuously trying to achieve. Since there are frequent changes and disturbances being introduced, the perfectly balanced macroeconomy (in ideal equilibrium) never arrives, but that does not stop us using this concept in our analysis of the actual state that it has at any moment. Indeed without this theoretical concept and its means for self-achievement, there would be no logical means for the analysis and understanding of the whole system.

    • chdwr
      September 17, 2014 at 2:50 pm

      Yes, that’s the theory. Only two problems with that…belief, is it’s completely false and it encourages market worshiping which is an incredible mental impediment to change….which is what we see in academia and in policymakers inaction. The economy is radically unstable, and economists have not cognited on that fact and neither have they discovered the true metric that confronted would actually resolve that radical instability.

      • Macrocompassion
        September 19, 2014 at 10:58 am

        Will somebody please explain what they mean by unstable?
        As far as my analysis goes short-term sudden changes are always absorbed by the system and a state of equilibrium is quickly restored. These apply to changes over a 6 month time scale.
        However when we come to “business cycles” (between 5 and 20 years periods) the degree of instability varies and it is quite often the case that the trend goes the wrong way for a limited time before having to accept a new stabilizing effect and returning to a more normal balance. How unstable does a system have to be in order to be claimed to be unstable? Please define.

      • chdwr
        September 19, 2014 at 2:48 pm

        It’s inherently unstable, because the rate of flow of costs/prices exceeds the rate of flow of individual incomes simultaneously and continually produced. It is this way by the rules of the most deeply embedded discipline in all of commerce itself, the conventions of cost accounting. And so that makes it both a statistical and a dynamic reality.

    • Liam B Allone
      September 17, 2014 at 5:25 pm

      There is no equilibrium when the cost of making a good exceeds the money in peoples’ pockets to buy it. Since this is true of all goods and services, it follows that the economy is continuously in a state of money shortage. It has always been so and will continue to be so until so-called “practicing economists” (i.e. still practicing because they have never been able to get it right!) finally figure this simple truth. Two separate people have figured it out almost a century ago and there are still very few who even know. We suffer from Rumfeld’s Paradox – the vast majority simply don’t know what they don’t know. We all suffer because there are so few of us who “get it.”

  5. Steve
    September 17, 2014 at 4:31 pm

    Yes, that is the theory. However, there are numerous things wrong with it.
    1) The economy is actually radically unstable
    2) The stable hypothesis encourages market worship (Austrian denial, unwillingness or ability to look)
    3) The stable hypothesis encourages a palliative mindset instead of actually solving it. (Keynesianism of all stripes)
    4) It projects consciousness and orderliness onto the mindless and actually chaotic entity of the economy, and so is both errant and in complete cognitive dissonance with human freedom.

    The adult, responsible and awake response to the above is to look at these facts and craft policies that actually resolve the economy’s instability.

    It is an absurd world that enforces poverty and austerity when our technological capabilities are already incredibly abundant and artificial intelligence, which is just getting started, is reducing the rational need for human employment. Give the individual immanent economic freedom with a variable universal Dividend payment, maintain that abundant situation with a general Discount on prices, regulate the obviously anti-social tendencies of the Financial sector and so make it take its legitimate place in the overall economy instead of a dangerously dominating and manipulating force….and then graciously and commonsensically encourage personal virtues in the individual. That way human mental clarity and freedom is enabled and encouraged…instead of inhibited…as it is now.

  6. Wallace Klinck
    September 18, 2014 at 8:33 am

    The financial system is neither stable nor self-liquidating. Financial costs and prices incurred by production are generated at an increasing rate of flow as compared to payments of consumer income, which in final analysis, must liquidate all financial costs.

    This fundamental flaw in the price-system is closely related to the increasing displacement of labour by non-labour (i.e., technological factors) and becomes greater with every new labour-displacing efficient process or device. The more physically efficient we become the more the deficiency of consumer purchasing-power becomes and the more dependent we must become on credit, i.e., debt, created and issued by the banking system.

    Essentially, because of additional and increasing allocated charges in the price of consumer goods in respect of capital recovery, the consumer is charged properly with capital depreciation but wrongly not credited with capital appreciation which greatly exceeds depreciation. We pre-maturely cancel consumer credit as though we are contemporaneously consuming our real capital as we produce it. This is absurd inasmuch as real capital has a variable but often considerable shelf-life.

    The real cost of production is consumption and is actually falling rapidly. We should enjoy greater purchasing-power in conjunction with falling prices. We need National (Consumer) Dividends an Compensated Prices to balance incomes with prices. Bank credit does haphazardly and inadequately “bridge” the gap between prices and incomes. But bank credit is an inflationary debt due for recovery from future sales and these bank credits do not liquidate costs of production but merely pass them on as accumulating charges to be recovered from future production.

    The physical costs of production have fully been met when any good is completed and ready for final use. Money in the modern economy is simply accountancy. We need to adopt a sound and rational system of national cost accountancy which reflects facts rather than fantasy.

    The community’s credit has been appropriated by the banking institutions which falsely regard the credit they issue to monetize the community’s real credit or productive potential as belonging to themselves. The price-system requires to be balanced by debt-free credits which are available to cancel excess financial costs as they appear in prices without creating financial obligations against future production accountancy cycles. There is no real need or justification for aggregate consumer debt whatsoever.

    Refer: http://www.socred.org
    Youtube – “Social Credit Table Talk”
    Wikipedia – “Social Credit”

  7. September 23, 2014 at 7:25 pm

    “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. ”

    I am skeptical about the “unlike the expenditure of tax revenues part”. You should remember the important lesson that Reagan taught us. Before Reagan, everybody was interested in the debate whether deficit spending on tax cuts or actual deficit spending would have a more stimulative effect. In other words, you can pay a long-term cost for short term growth and people were wondering whether tax cuts or additional spending would find a return.

    As far as I know, very few economists were predicting what actually occurred: that we could, at the expense of the long term, buy a *decrease* in economic growth with just the right balance of tax cuts. This is pretty counter-intuitive, so people might be justified in missing it, but the important thing is that we know now.

    If government borrowing for expenditure was the chief driver of these things than the Reagan “Miracle” would be impossible, as would the massive growth we saw 1933-1937 while debt remained flat as a percentage of GDP (or for that matter, the smaller, but still massive growth we saw under Truman while the War debt shrank rapidly as a percentage of GDP). Government borrowing vs government non-borrowing surely plays an impact, but this is a pretty minor impact compared with the government supporting wage growth vs the government supporting asset bubbles.

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