Home > New vs. Old Paradigm > Greg Mankiw on loanable funds — so wrong, so wrong

Greg Mankiw on loanable funds — so wrong, so wrong

from Lars Syll

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 credit, 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.”

loanIn the traditional loanable funds theory — as presented in mainstream macroeconomics textbooks like Greg Mankiw’s — 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.

From a more Post-Keynesian-Minskyite point of view the problems with the standard presentation and formalization of the loanable funds theory by Greg Mankiw and other “New Keynesian” macroeconomists  are quite obvious:

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 it definitely is 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 ad 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 shift, 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.

So, in way of conclusion, what I think “New Keynesians” like Greg Mankiw “forget” when they hold to the loanable funds theory, is the Keynes-Minsky wisdom of truly acknowledging 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 channeling money/savings/credit — are more or less left in the dark in “New Keynesian” formalizations of the loanable funds theory to the real world target system.

I may be too bold, but I’m willing to take the risk, and so recommend Mankiw and other “New Keynesians” to make the following additions 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

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.’

  1. BC
    February 4, 2015 at 8:15 pm

    Renegade Economist on debt-money and the non-productive, prohibitively costly, extractive, rentier-parasitic int’l banking syndicate:

    “Money as Debt”:

    Money as debt and the cumulative differential exponential order of growth of debt to wages and GDP since the early 1980s (since 1950 for public debt) has resulted in total annual net flows to the financial sector equaling, and periodically exceeding, total annual GDP output.

    Moreover, cumulative imputed compounding interest to total credit market debt outstanding to average term is now at or more than 100% of GDP in perpetuity.

    The extractive, non-productive, neo-feudal/neo-manorial financial sector (and its top 0.001-0.1% principal owners) is an increasingly prohibitive net cost to the economy and civil society.

    Real GDP per capita cannot grow (nor even be maintained) and universalist humanist objectives cannot be achieved with the rentier Power Elite maintaining a stranglehold on productive resources, having captured the system of governance, and with a perpetual rentier claim on labor product, profits, and gov’t receipts in perpetuity.

    The rentier Power Elite would rather crash the system than give an inch to the bottom 99.9%.

    Economists will NEVER tell us this because they have been utterly co-opted by the rentier Power Elite top 0.001-0.1% and the Wall St. and int’l banking syndicate’s oligarch bankers and CEOs, Ivy League economic intelligentsia, and the Establishment mass-media influentials.

  2. February 5, 2015 at 7:07 am

    Economists — sloppy, stupid, or scientifically incompetent?
    Comment on ‘Greg Mankiw on loanable funds — so wrong, so wrong’

    “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 credit, 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.’” (see intro)

    Economists think they have explained something when they paint a supply-demand-equilibrium cross or what Leijonhufvud called the totem of the micro. However, already Schumpeter found it necessary to diffuse doubts about the scientific content of the whole exercise.

    “The primitive apparatus of the theory of supply and demand is scientific. But the scientific achievement is so modest, and common sense and scientific knowledge are logically such close neighbors in this case, that any assertion about the precise point at which the one turned into the other must of necessity remain arbitrary.” (Schumpeter, 1994, p. 9)

    As a matter of fact, the ‘primitive apparatus of the theory of supply and demand’ is a thoroughly faulty construct.

    “There is little or nothing in existing micro- or macroeconomics texts that is of value for understanding real markets. Economists have not understood how to model markets mathematically in an empirically correct way.” (McCauley, 2006, p. 16), see also (2014; 2015)

    Because the generic supply-demand-equilibrium apparatus has to be rejected the specific loanable funds application also goes out of the window. Keynes was right in this respect (see intro and 2014).

    However, Keynes got it also wrong. The formal core of the General Theory is given with:

    “Income = value of output = consumption + investment. Saving = income – consumption. Therefore saving = investment.” (Keynes, 1973, p. 63)

    This is rather elementary mathematics and pure conceptual sloppiness. Keynesians and the rest of the profession simply cannot tell the fundamental difference between income and profit (2011). As can be seen from the intro, Kalecki too got it wrong.

    “It should be emphasized that the equality between savings and investment … will be valid under all circumstances.”

    As a matter of fact the equality is INVALID under ALL circumstances. The correct relationship is given with this equation:

    It says: the business sector’s monetary profit Qm is equal to distributed profit Yd plus investment expenditure I minus the household sector’s monetary saving Sm (2014, Sec. 3). Alternatively: The business sector’s retained profit Qm-Yd is equal to the difference between investment and saving. Seen from the business sector as a WHOLE, with retained profit investment ‘finances itself.’ What has to be clearly seen, though, is that the firm with retained profit is normally not the same firm that finances investment. This establishes a direct or indirect financing relationship WITHIN the business sector. This is something quite different from financing relationships between the business and the household sector.

    The representative economist has always argued that this is all a matter of definition and everybody is free to define whatever seems convenient. This ‘anything goes’ methodology fully explains the failure of economics. The representative economist has always been a scientific write-off.

    Egmont Kakarot-Handtke

    References
    Kakarot-Handtke, E. (2011). Why Post Keynesianism is Not Yet a Science. SSRN
    Working Paper Series, 1966438: 1–15. URL http://ssrn.com/abstract=1966438.
    Kakarot-Handtke, E. (2014a). Economics for Economists. SSRN Working Paper
    Series, 2517242: 1–29. URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id=
    2517242.
    Kakarot-Handtke, E. (2014b). Loanable Funds vs. Endogenous Money: Krugman
    is Wrong, Keen is Right. SSRN Working Paper Series, 2389341: 1–17. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2389341.
    Kakarot-Handtke, E. (2014c). The Three Fatal Mistakes of Yesterday Economics:
    Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792.
    Kakarot-Handtke, E. (2015). Essentials of Constructive Heterodoxy: The Market.
    SSRN Working Paper Series, 2547098: 1–10. URL http://papers.ssrn.com/sol3/
    papers.cfm?abstract_id=2547098.
    Keynes, J. M. (1973). The General Theory of Employment Interest and Money.
    The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke:
    Macmillan. (1936).
    McCauley, J. L. (2006). Response to “Worrying Trends in Econophysics”. Econo-
    Physics Forum, 0601001: 1–26. URL http://www.unifr.ch/econophysics/paper/
    show/id/doc_0601001.
    Schumpeter, J. A. (1994). History of Economic Analysis. New York, NY: Oxford
    University Press.

  3. Macrocompassion
    February 5, 2015 at 3:15 pm

    Your first video production is excellent in that it places much emphasis on what appear to be several problems. However it does not make this picture sufficiently clear in that there is actually only one problem, nor is this shown to be sufficiently simple in a general way so that we can all see it. The problem is due to the ownership and monopolization of land and other natural resources including the electromagnetic spectrum for communications. What is being held back by monopolists in the land and natural facilities is not simple equality per-see but EQUALITY OF OPPORTUNITY for the fair chance for access to these resources.

    Speculation in the value of natural resources, particularly the land causes its prices to rise due to the relative scarcity of new sites and the greater competition for their access. The greater ground-rents or purchase prices for the sites means that the production and residential costs to the average household are raised. This results in less demand and more unemployment. The poverty gap widens and the progress of the nation staggers to a halt.

    Have you shown how this can be stopped? Your videos don’t do this. But Henry George did in 1879 with his seminal book “Progress and Poverty”, when then as now the technological change was fast and the benefits could be milked off by the capitalists. George proposed a tax on land values to replace the taxes on wages and purchases. This has secondary effects in that it discourages speculators in land values and with more land becoming available, the cost of production falls. Since many wage earners and homes would be less severely burdened with production-based taxes, the greater demand would come from this direction too.

    Political control of what is being taught about macroeconomics has been eliminating the effects of land since about 1900 when John Bates Clerk brought together land and durable capital goods as if they were one entity. The capitalists rejoiced with this news, but the population was (and is) so badly equipped to understand what happened as to loose their political savvy. The effects of land privatization is disastrous, because it stops the equality of opportunity to earn to be fairly expressed in a socially just or ethical way. Monopoly of land provides the land owner with an unfair advantage over the majority of landless population. This situation must be remedied and soon!

    TAX LAND NOT PEOPLE; TAX TAKINGS NOT MAKINGS!

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