Home > Uncategorized > Krugman’s misapplication of neoclassical growth models

Krugman’s misapplication of neoclassical growth models

from Lars Syll

The fallacies loanable funds theory commits might be explainable by the misapplication​ of some ideas and concepts of neoclassical growth models … to the sphere of money and finance …

The+Bankruptcy+of+Neoclassical+EconomicsThe Ramsey and Solow models are models of real investment only. Financial markets, financial assets and financial saving do not play any role in those models. There is only one good which, for simplicity, will be called “corn”. Corn has three functions: it can be consumed, invested and used as a means of payment since wages and interest payments are made with it. Full employment is assumed … Without money and other financial assets, the only way units can save is to increase their tangible assets, i.e. to invest …

Since the problems of different financial saving plans are not dealt with in Solow’s model, the model cannot be used to make any predictions about economic units’ financial saving behavior, its inconsistencies and thus about the paradox of thrift – neither in the short, medium or long run. There is no miraculous way of short-run financial saving somehow being transformed into long run investment in tangible assets. The two are simply quite different phenomena …

How pervasive this approach is, is shown by Eggertsson and Krugman (2012) who add some features … to a basic neoclassical model. Again, no money but goods are borrowed and lent. Naturally, potential lenders have to save some of their goods before they can lend them to borrowers. But since in the real world money is normally not eaten or planted and keeps circulating in the economy when it is spent or lent, those models cannot be any guide for the analysis of a monetary economy. Specifically, what is true in a one good economy – units have to consume less to lend and invest more – is fundamentally wrong in a monetary economy.

Fabian Lindner

This should come as no surprise. Paul Krugman has repeatedly over the years argued that we should continue to use neoclassical hobby horses like Ramsey style growth, IS-LM, and AS-AD models.

Money and finance don’t​ matter in mainstream neoclassical macroeconomic models. That’s true. According to the ‘classical dichotomy,’ real variables — output and employment — are independent of monetary variables, and so enables mainstream economics to depict the economy as basically a barter system.

But in the real world in which we happen to live, money certainly does matter. Money is not neutral and money matters in both the short run and the long run:

The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted in either the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.

J. M. Keynes A monetary theory of production (1933)

  1. January 2, 2018 at 12:11 am

    The blue “bankruptcy” list omits the most overriding “first principle”: the web of life. In neoclassical this web is a giant resource reservoir available for exploitation. This conceptual error is not mitigated by the euphemism “natural capital”. To say nothing of the altar of unlimited growth.

  2. January 2, 2018 at 2:10 am

    Yes, banks create money when they lend it, or when Central Banks buy stuff, but should they be allowed to?

    Wouldn’t it be a better idea to forbid bankers from pursuing such machinations?

    Now some might argue that insufficient spending is occurring most of the time—something I agree with—so why would it be a good idea to forbid banks from loaning any money out that they have not borrowed from depositors or from selling some of their assets?

    My response is that the needed spending could rather easily be arranged for if the central government were to simply start heavily taxing the economy’s biggest savers. The money they are removing from the economy would then be returned to the economy in the form of government investments.

    If for whatever reason the levels of investment generated by this kind of approach were insufficient to eliminate all unemployment, the government could simply become the lender of last resort, lending money it creates out of nothing to credit worthy firms and citizens for the sake of society as a whole instead of allowing private financiers to do this solely in pursuit of their own interests.

    Another reason to overhaul banking practices: the basic issue of fairness. Why should banks be allowed to create money out of thin air and then lend it to a borrower for a return of the principal plus interest? How is that a more fair practice than simply printing up counterfeit currency?

    A third reason: ending bank money-creation practices would give managers of the money supply a firmer grip on the means by which extra “inflation dollars/pounds/euros” make their way into the economy.

    Money does indeed matter, but I would suggest that the biggest problem with the whole loanable funds concept is not so much that it does such a poor job of modeling the realities of the financial sector, but rather that money lending institutions are allowed to deviate so profoundly from some of the foundational assumptions of the model.

  3. January 2, 2018 at 12:21 pm

    I’ve just written re Polanyi how hearing refreshing it is to hear what one already knows from a different point of view, and for this I want to thank Lars, Econoclast and especially James.

    Lars’s inset on The Bankruptcy of Neoclassical Economics came out at a recent IIPP conference as Victoria Chick showing how its teaching began with two downright lies. (https://www.youtube.com/watch?v=sUEWLqY9DEQ . Sumary and comment at:
    https://www.theguardian.com/business/2017/dec/17/heretics-welcome-economics-needs-a-new-reformation). The video is both fun and brilliant, but c.75 min. long,

    Econoclast’s version of the world as the neoclassical merchant’s barn reminded me of the difference between analog and digital logic, as when an analog clock uses a rotating hand as a surrogate for the earth’s rotation, but a digital clock translates this motion into numbers so it can be multiplied and divided systematically and indefinitely. What I’ve been suggesting is that the Representative Agent as a surrogate in macroeconomics ought now to be replaced by the distributed but networked Relational Databases accounting for virtually every transaction which already exist in company and banking records: their maths, methodologies and machinery being by now well established.

    James helps me by starting with questions whereas I tend to start with problems. Here he ends up with a concept of a concept, but suggests “the biggest problem with the whole loanable funds concept is” not the concept itself but what banks are allowed to do with it. That seems to me to be throwing the baby out with the bathwater. One has to understand what “loanable funds” are to establish what one CAN do with them, never mind be allowed to. James thus skips round my own fundamental argument that money is just one of several forms of credit, the conventions of which include credit worthiness, credit limits and the earning and reduction of these by giving back and expenditure. Considered in this light, money is merely a token of a credit limit, and only incidentally of prices paid in loss of credit worthiness during the particular expenditures on which our life and work are founded/funded.

    A discussion on the difference between the difference between Ian Duncan Smith’s mean-minded concept of Universal Credit (UC) , a more Georgian Universal Basic Income (UBI) and a newer concept of Universal Basic Services (UBS), i.e. free food, housing, transport and education as well as healthcare, had already had this issue of the nature of money dancing around again in my mind. I append my contribution to that debate as yet another view which may refresh someone’s perception of what we too often take for granted.

    “Interesting. What is missing from the argument is Professor Werner’s demonstration that the way money is actually created is as credit. That’s all one gets from banks in exchange for your mortgage, meaning an honest system would be like a credit card on which no interest (or penalty payment) is due so long as one repays it as agreed. But how can one repay credit with more credit? At the moment we do it by the banks running a Ponzi scheme which makes more credit available, inflating prices until buyers get cold feet, causing crashes like those of 1929 and 2007. The alternative is to REALLY repay the credit which sustains us by doing the work necessary to regenerate what we use; thus the more of our credit limit we use up the more work we owe. In other words, those who live frugally are not a problem if they don’t repay on time. It is those who want a large credit limit who need to justify it, and those who have bought or otherwise acquired more than they need who will exhaust their credit and need to sell or bequeath back their surplus.

    “So yes, UBS could even further simplify the administration of this, but price differences are surely needed to signal greater resource use, including employee time? What’s wrong with IDS’s universal credit was his seeing it not as a credit limit but as a loan of valuable money [actually fool’s gold], not seeing our suppliers and employers earning their own credit by accepting our creditworthiness for the goods and services they/we supply. What we need most, then, is honest money, and given that, paying for a combination of UBS and UBI is no longer a monetary issue but the real one of regenerating what we need and restoring our planet to a much more sustainable condition. That in turn requires education not so much of all the poor as of our policy-makers, about institutionalising the information systems needed for local population self-control.”

    Looking for the link for this I came across http://www.thinkingfaith.org/articles/20081017_1.htm which is, unusually, an article by the same author on Lonergan’s Macroeconomic Dynamics.

    • January 2, 2018 at 12:40 pm

      Hopefully the moderator will edit out the left-over “hearing” on the first line.

    • January 3, 2018 at 8:09 am

      Apologies, then, for the typos. A bigger one for “the same author” (at the end) not being, i.e the salisburycompass author was Peter Curbishley and the thinkingfaith one Peter Corbishley. There is however a content link from the first to the second, in how giving credit can finance the development and maintenance Lonergan takes into account.

    • January 3, 2018 at 8:27 am

      At my comment on Lars: on watching the Economic Reform video again I heard it recommending we follow up Victoria Chick relating Keynes and Schumacher. Here’s the link: https://www.theguardian.com/commentisfree/2011/nov/18/economics-keynes-schumacher .

  4. Craig
    January 2, 2018 at 9:07 pm

    The loanable funds financial model is indeed a fallacy, but solving the monetary and financial problem requires a deeper analysis than simply a new theory:


    The Hypnotic Effect of The Paradigm of Debt Only, Its Expose’and The New Paradigms

    Finance could be a legitimate retail business model. However, its monetary and economic paradigm of Debt Only has become a monopolistic, parasitical, dominating, incredibly costly and virtually hypnotic economic force that is post retail sale.

    Paradigms are always like this in that most people are unconscious of them entirely which makes them invisible, and it makes new paradigms, which are always conceptual opposites to the current paradigm, very difficult to perceive let alone think rationally and comprehensively about.

    The new monetary paradigm is Direct and Reciprocal Monetary Gifting and the new economic paradigm is Traditionally Productive Integral Economic Inclusion, and that means Finance must become a retail business model within the traditional economic process that ends at retail sale instead of the above described economically plaguing thing it has become.

    Reformers of every stripe pay heed.

  5. January 3, 2018 at 11:42 am

    Craig should follow the youtube link above and listen to what Steve Keen has to say on paradigms.

    Re the Lars comment again, it seems a huge apology is needed for an old man’s memory attaching the right words to the wrong vision. Checking by poring through the video, I eventually found it was Kate Raworth [of Doughnut Economics fame], not Victoria Chick, who objected to beginning economics with “two untruths in one sentence”. Her comments from 18 minutes into the video I found incredibly moving and constructive:

    ” … Economics is not about discovering laws of motion. It is about discovering, I believe, principles of design, designing complex adaptive systems of which we can be stewards. In which case, if that’s the twentyfirst century economics with which we can create economies that are distributive of opportunity and regenerating the natural world, I would be incredibly proud to be a twentyfirst century economist. If that was what was being taught. What frustrates me [sitting in on economics lectures, is that] they still always begin with supply and demand. As if to say the economy is the market and the market is in equilibrium. That’s two untruths in one sentence: its not a good way to start a degree! … “

    • Craig
      January 7, 2018 at 9:39 pm


      I listened to it when it was first posted on Keen’s patreon site. Keen and others are brilliant iconoclasts, but you can’t iconoclast your way to perceiving a new paradigm. In fact you can stand looking directly at it (it being a single concept that creates a whole new pattern) and even suggest policies that reflect it…and still not consciously or completely perceive it, that is perceive the single concept that IS the new paradigm and which all policy and regulation needs to align with.

      You have to have certain integrative mindset skills to perceive an entire new pattern/paradigm. Keen is a brilliant theorist and instructor, but paradigm perceivers and creators have generally had conflicts with even the best theorists and their instructors both because their vision is broader and deeper and because they as students have surpassed the instructor.

  6. January 3, 2018 at 9:17 pm

    New York governor says new U.S. tax code may be unconstitutional

    | | | New York governor says new U.S. tax code may be unconstitutional WASHINGTON/NEW YORK (Reuters) – The new U.S. tax code targets high-tax states and may be unconstitutional, New Y… | |


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