Home > Uncategorized > Krugman vs Kelton on the fiscal-monetary tradeoff

Krugman vs Kelton on the fiscal-monetary tradeoff

from Lars Syll

stefPaul Krugman is back again telling usthat he doesn’t really want to spend time on arguing about MMT — and then goes on complaining that well-known MMTer Stephanie Kelton says things “obviously indefensible.” What has especially irritated the self-proclaimed ‘conventional’ Keynesian is that Kelton “seems to claim that expansionary fiscal policy … will lead to lower, not higher interest rates.”

Now, the logic behind Krugman’s “conventional Keynesian” loanable-funds-IS-LM-theory is that if the government is going to pursue an expansionary fiscal policy it will have to borrow money and thereby increase the demand for loanable funds which will — “other things equal” — lead to higher interest rates and less private investment.

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 in the same way as the price of cars and raincoats.

It 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 Krugman’s own 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.

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 Keynes-Minsky-MMT point of view, this can’t be considered anything else than a belief resting on nothing but sheer hope.

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.

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 happens at the microeconomic level is not always compatible with the macroeconomic outcome. The ‘atomistic fallacy’ has many faces — loanable funds is one of them.

We have to free ourselves from the loanable funds theory — and scholastic gibbering about ZLB — and start using good old Keynesian fiscal policies. Keynes — as did Lerner, Kaldor, Kalecki, and Robinson — showed that it was possible to promote economic growth with an “appropriate size of the budget deficit.” The stimulus a well-functioning fiscal policy aimed at full employment may have on investment and productivity does not necessarily have to be offset by higher interest rates.

  1. Timothy Nulty
    March 1, 2019 at 1:33 am

    I don’t always find the pieces on this site cogent and well argued……but this one is.
    Congratulations.

    This comes from someone who studied under Joan Robinson, was a friend of Hyman Minsky, a founder of URPE and DSA…and counts himself a full-blown Keynsian of the Robinson/Minsky ilk. I also have strong Marxist leanings–on intellectual, not political grounds. Marx was a political idiot but a very profound economic thinker–far more profound than he is, nowadays, given credit for. Ditto Keynes……who read Marx very closely, but never admitted it. A close reading of Marx’s last works, esp. Vol 3 of Das Kapital where Marx first begins to address the nature of money, finance and the business cycle in the capitalist system, reveals many clear parallels with Keynes’s central work….and message. The parallels are so close as to make it non-credible that Marx’s late works (which were, after all, written and published in England) did not play a roll in Keynes’ revolutionary insights and exposition. That might help explain why the political and economic Right finds Keynes so disturbing and objectionable. (Keynes himself, who was a political “liberal” in the old European sense of that word, definitely did not buy into Marx’s political views…but, I believe, did adopt and adapt important parts of Marx’s economic views….without admitting either (for obvious reasons).

    • Calgacus
      March 3, 2019 at 4:58 am

      I would not say that Marx was a political idiot, though clearly he was not as adroit as Keynes. But Keynes was in his own and stable land, while Marx was an exile in a more tumultuous period. Apples and oranges.

      Despite Keynes’s earlier disparaging comments, there is little question that Marx had some kind of influence on Keynes, very different people, but thinking along parallel lines and visions. See Steve Keen Debunking Economics: The Naked Emperor Dethroned 2e – Zed (2011) p. 218, based partly on Dudley Dillard- Keynes & Marx: A Centennial Appraisal- Journal of Post Keynesian Economics 6- 3 (1984), using Keynes’s Collected Works.

      In the published version of the General Theory Keynes says

      “The great puzzle of Effective Demand with which Malthus had wrestled . . . could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas.”

      But in a 1933 draft in his Collected Works, Keynes said more and praised Marx’s “pregnant observation” and put himself aside Major Douglas & Marx opposed to the neoclassicals, used clearer explanations about effective demand etc along Marx’s earlier lines. But eliminated it all in the final version in favor of his own “convoluted reasoning” (Keen) – probably because Keynes was a better politician (in the short-term) than Marx. :-)

      • Craig
        March 3, 2019 at 8:10 am

        Virtually everyone is hung up on the classical idea of equilibrium…ironically even Keen and other disequilibrium theorists. That’s because they’re still in the mindset of the paradigm of Debt Only, and they don’t see the significance of the summing,ending and terminal expression point of retail sale or the efficacy of a large percentage discount/rebate policy at that point.

        I’m sorry, they’re Ptolemaic tweakers and aren’t conscious of the concept behind the new paradigm….and every paradigm.

  2. March 1, 2019 at 3:46 am

    All these competing models and little mention in any of them about total private debt to GDP. And yet what we see over and over is a long term build up in bank debt that manifests as a burden on business and consumers, slow growth, weak demand, and finally Richard Koo’s balance sheet recession.
    Richard Vague explains here:
    https://democracyjournal.org/magazine/42/the-private-debt-crisis/
    Note as debt grows interest rates fall because there is only so much cash flow to service debt. This is what we have seen over the previous three decades. Fiscal policy has little to do with that interest rate.

    • Paul J-H
      March 1, 2019 at 6:17 am

      Tiny note: MMT does, in fact, include private debt in the analysis of sectoral balances.

  3. lobdillj
    March 1, 2019 at 1:31 pm

    “Loanable funds”…the man on the street, the man who works for his wherewithal, has a definite idea of “loanable funds”. He believes that the sovereign, the banker, Wall Street, etc. have the same idea that he has. They don’t, but it’s to their advantage that he does. It’s what keeps him in thrall to them. He thinks a “fund” is a stash of existing money that can be dispensed, and once dispensed it can’t be dispensed again until it is recovered in the future. He thinks that a “loanable” fund is conceptually identical to the cash in his pocket or the money in his checking account.

    Our capitalistic system relies on the implicit assumption that money cannot be created out of nothing. This assumption allows political policies that enrich the wealthy at the immediate expense of everyone else and the certain eventual destruction of the environment that sustains life.

  4. Trond Andresen
    March 1, 2019 at 2:03 pm

    Even many central bankers now recognise the fact that banks do not lend other people’s deposits.

    I prove how lending enables banks to create money ex nihilo in my recent phd. Se pages 113 – 128 here:

    Click to access andresen-phd-finished.pdf

    I derive an equation for the debt and money growth rate for a bank which is only restricted in its lending by staying above a BIS-type minimum capital adequacy requirement (reserve requirements are increasingly abandoned by countries today). This leads to a money growth rate that corresponds well to observed data. As far as I know, no other researchers have done that, even if they recognise endogenous credit money growth.

  5. March 1, 2019 at 9:14 pm

    It seems to me that there are much more pressing issues to argue than “loanable fund” theory. I don’t think anybody on this forum agrees with Krugman on this point. Central bankers since the ’30s have understood money to be a (resolvable) debt. What I’d like to know how this inherent negative turns into a positive stock physicality with attributes like velocity and power in even the most progressive monetary treatises. In a system wherein all economic activities are booked entries, that on the supply side of a to be continued process are indeterminate in value until resolved later in time through demand, its unit of account is incompatible with being a “thing” having those “stock” attributes. There is a reason why math is an inapplicable tool to use in cost accounting. Its elements aren’t approachable like physical entities of a determinable value in time are.

    Click to access MMT_Critique.pdf

  6. Craig
    March 1, 2019 at 10:23 pm

    Yes, MMT focuses too much on public debt, yes, loanable funds is fallacious for the umpteenth time, yes, Marx said more in vol. 3 and yes, the problem involves money, debt and the monopoly paradigm enjoyed by the private banking system.

    And looking where no one else is looking, that is, the actual economic process and day to day operations of the economy, deciphering the monetary and economic significances to be found at the point of retail sale and then crafting a direct and reciprocal monetary and price policy there….changes everything.

    It’s way too simple for the non-looking erudite, but the actual operations of historical paradigms have always been simple, elegant and profoundly significant because they resolve long standing problems of current orthodoxies.

  7. Helen Sakho
    March 2, 2019 at 2:21 am

    Anyone who has met Joan Robinson in person is in an enviable position. Her contributions are remarkable. She explains all economic concepts in a realistic and approachable manner, without making them so abstract and complicated that they become uselessly unbearable.

    Keynes, as I have repeatedly argued here, was an extremely competent (realistic) manager of capitalism. I was fortunate enough to have as and old friend and relative (E. Etzhaq of Wadham College – Oxford) who stood up to Keynes and got his admiration and encouragement when he corrected him on a few concepts of Economics based on his vast practical experience of economic growth, development, international financing institutions around the globe before settling at Oxford to teach Economics. We had our own differences of opinion, naturally and amicably.

    Marx, in my view, was a great philosopher, mathematician and agitator with a populist appeal to the masses, but he never fought their wars on their behalf and complained to Engles (who did) when Engles was late in sending him his expenses to practise his genius as well as feed his enormously large family (six children? and a wife, who also acted as his intellectual helper).

    Right now though, we really must take from each great contribution to social scientific dialogues and give a little bit to our students who are not even being taught anything worthwhile right now and being charged for it. (Please double check spelling of some names if you’re interested due to translation problems from the original.)

  8. Ken Zimmerman
    March 20, 2019 at 8:37 am

    Loanable funds and interest rate are not our biggest problems today. Jesus said, “It is easier for a camel to go through the eye of a needle than for a rich man to enter the kingdom of God” (Luke 18:25). In the 13th century, Thomas Aquinas argued that the perfect happiness we all seek cannot be found in wealth, because money is only a means to acquiring other things. It cannot satisfy all human desire, and it is easily lost. Money, though a good, is not the greatest good, and the pursuit of money must always be subordinate to the good of the human family and the greater glory of God. Each of the world’s other major religions views wealth and money similarly.

    Following on from its view of money and wealth the Christian church from its earliest days condemned usury. But the church had more in mind than theology when it made the condemnation. There were and are practical reasons to condemn usury. Aristotle concluded that “to make money by usury is exceedingly unnatural.” Thomas Aquinas offered what came to be the standard argument against usury: “It contradicts justice, and it is therefore incompatible with the happiness of the virtuous person in this life and with the rectitude of will required to enjoy perfect happiness in the life to come.” To take interest for money lent is unjust, because it sells what does not exist, leading to inequality and injustice. Social science, including economics does not contradict Aristotle or the church regarding usury and its results. No matter the claims of some economists’ theories.

    By 1750 the church’s doctrine on usury had changed. Collecting interest for money loaned was accepted by the church. Of more interest is why the church changed its views on usury. First, it has been suggested that condemning usury helped society more than it hurt society. That changed by the 18th century when loaning money at interest was a stable and profitable activity. Second, technology changed. Specifically, accounting developed sufficiently that cheating on loaning or borrowing at interest was uncommon. Usury remains morally impermissible for the church today and the church condemns it strongly when usurers’ dealings lead to the hunger and death of their fellow humans, viewing such actions as murder. Would that all the free-market credit and debt economists today had the integrity of the Catholic church. Or, at least the honesty.

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