Home > Uncategorized > We need a ‘Fridays for Keynesianism’ movement!

We need a ‘Fridays for Keynesianism’ movement!

from Lars Syll

Basically, the classical model is a model for a corn economy: households decide whether to consume the corn or to save it. If it is saved it can be supplied to investors who sow the grains, repaying to the households one period later the credit amount plus interest.

keynes_vert-b496c6e9f20ef97ddbb4491927240bb38e458854-s800-c85In the Keynesian model the ‘funds’ exchanged on the capital market are made up of money—‘funds’ are bank deposits. Funds are not created here by a renunciation of consumption but by the banks granting credit …

In the classical model, there is a strict crowding out of private investors on the capital market by government deficits. The all-purpose good, which functions equally as ‘funds’ and as investment good, can only be used once.

In the Keynesian model, on the other hand, ‘funds’ (money) and investment goods are independent of each other. Therefore there is no crowding out on the capital market, if deficits are financed by banks or the central bank. This is the fundamental insight of Modern Monetary Theory …

Young students need to wake up and realise they are being taught models whose laws of motion are as inconsistent with reality as Ptolemy’s world view. We need a ‘Fridays for Keynesianism’ movement.

Peter Bofinger

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 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.”

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.

As Bofinger touches on, there are many problems with the standard presentation and formalization of the loanable funds theory. And more can be added to the list:

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.’

  1. gerald holtham
    February 21, 2020 at 4:09 pm

    Hicks in 1937 tried to combine a flow theory of interest rates in his investment-saving schedule with an asset or stock theory via his LM curve. That combined and generalized the Keynes liquidity-preference story of “the” interest rate and the Robertson loanable funds theory. The problem was that the LM function was mis-specified in that it supposed the supply of money was exogenous or controlled by the monetary authority. Like Keynes, himself, Hicks also took liberties in talking of “the” interest rate, which in both Hicks and Keynes is the rate on government bonds.
    In practice the money supply is endogenous and all central banks attempt to control it on the demand side by altering interest rates to reduce credit demand. The rates they control, however are money market rates. These have only a very loose connection to the government bond rate and that in turn is loosely related, via the credit spread between government and private debt, to the rate at which commercial enterprises can borrow. Monetary policy is a very blunt instrument.
    Hicks over-simplified and mischaracterised the monetary system which has been consistently misrepresented in economics text-books ever since.
    Nevertheless, Hicks’ great insight was that the Keynesian system was basically slump economics where idle resources of labour and capital could be taken for granted. A sustainable situation generally requires not only that financial asset demands and supplies be in balance but that supply and demand for real goods and services needs to be in balance too. And while supply will respond to demand there are limits to that response. Devotees of MMT go astray when they focus purely on monetary mechanisms and forget there is a real economy out there with fundamental constraints that cannot be evaded indefinitely. In the UK this lesson had to be relearned several times as governments made “dashes for growth” in 1958, 1962 and 1972, believing that demand would create its own supply. Mitterand in France and Lynch in the Republic of Ireland tried the same policy later with the same result – soaring external deficits, exchange-rate pressures and rising inflation. LBJ and Nixon in the US tested the same limits, leading to the breakdown of the adjustable-peg exchange-rate system.
    They all misapplied Keynesian policies in a period of full employment. Currently we are back in a Keynesian era with global deficient demand and leading countries have been practising “austerity”. Many economists and nearly all politicians, like generals, fight the last war.
    Keynes was unquestionably a great economist but his great book was mistitled. It should not have been called “The General Theory.. ” but “The Special Theory of Employment, Interest and Money.” The relations it emphasizes are dominant in some states of the economy but not in all.

    • Calgacus
      February 22, 2020 at 3:37 am

      Devotees of MMT go astray when they focus purely on monetary mechanisms and forget there is a real economy out there with fundamental constraints that cannot be evaded indefinitely.

      No they don’t go astray. Nor did Keynes, whose theory certainly was General, not Special –
      a tired old accusation dating to his first reviewers who were so controlled by neoclassical categories and thought that they could not understand what he was saying. Unfortunately, the majority of “Keynesians” and readers of Keynes have been trapped in the same way.

      Such accusations might have some small justice against postwar Keynesianism, but they have none at all against Keynes, MMT or Lerner’s functional finance. Which is quite clear if one reads the relevant works. All of these were obsessed with “the real economy” – and understood and explained the aspects and effects that they are falsely asserted to have ignored.

      The list of failures is equally defective. Take Mitterrand – the problem is the frequent one of the Left being its own worst enemy, of snatching defeat out of the jaws of victory, The turn to austerity in France was completely unnecessary, perverse and destructive. The socialist policies were succeeding, the problems like a declining exchange rate were completely to be expected and trivial.

      What that and some of the other examples display is the particularly European insane obsession with exchange rates and the foreign sector, wildly disproportionate to their importance in the real economy – an insane obsession that almost always works against the real economy, as Mitterrand’s betrayal did in France. Mitterrand commissioned a study by Robert Eisner of his socialist policies, later published in Challenge – but he completely ignored the results and advice of this study – which was that the socialist policies were succeeding splendidly and should be continued.

    • Craig
      February 22, 2020 at 6:22 pm

      “believing that demand would create its own supply.”

      Demand doesn’t create its own supply unless it is supplementary and direct to the individual, and is designed to encourage actually productive (read not financialized) investment.

      Change the monetary and financial paradigm and with commonsense regulations the new economic paradigm will emerge as well.

    • Craig
      February 22, 2020 at 7:59 pm

      The 50% discount/rebate policy at retail sale and also at the point of note signing….too simple for the intellectual vanities of the erudite, too obviously beneficial and problem resolving to be denied by anyone who actually looks at its effects.

    • February 23, 2020 at 4:18 pm

      I quote Calgacus:
      “No they don’t go astray. Nor did Keynes, whose theory certainly was General, not Special – a tired old accusation dating to his first reviewers who were so controlled by neoclassical categories and thought that they could not understand what he was saying.”

    • Yoshinori Shiozawa
      February 24, 2020 at 9:21 am

      I quote gerald holtham:

      “Keynes was unquestionably a great economist but his great book was mistitled. It should not have been called “The General Theory.. ” but “The Special Theory of Employment, Interest and Money.” The relations it emphasizes are dominant in some states of the economy but not in all.”

      Keynes was a great economist but was not almighty. He maid many erroneous, ambiguous and incoherent claims. To worship him as almighty being and to deny his great contribution to economics are both wrong. Keynes made an undeniable contribution to economics by his principle of effective demand, but in a quite confused way. Economists after him should try to elucidate this principle. New Keynesians simply abolished this principle and returned to neoclassical economics, but the work of elucidating the principle is not yet done even by Post Keynesians.

      See the discussion in this page. This is a question I posed just two years ago.

      • Calgacus
        February 28, 2020 at 4:26 pm

        It is not hero worship to point out the flaws of criticism that is much more confused than the object of criticism, than Keynes was. It is/was very common to assert that Keynes, Lerner, MMT are “special” rather than general, in particular that they are depression economics and ignore inflation.

        This completely untenable criticism can be refuted by pointing at books, chapters and papers devoted to the purportedly ignored topics, where the relationships are shown to be “general” rather than “special.” It’s as if people seriously insisted that Keynes would have been more successful if his middle name were Maynard.Well, his middle name was Maynard.

  2. February 21, 2020 at 5:43 pm

    Not clear how Kalecki was supposed to fit in here. It looks as though the quote may have come from a pre-General Theory 1933 essay. Gerald’s “Special” doesn’t seem to fit either. Perhaps “Macro” might have been better, but was that word around prior to Keynes’ book?

    Great thought-provoking comment anyway, Gerald.

  3. Craig
    February 21, 2020 at 7:05 pm

    The problems with both fiscal and monetary policy are their indirectness, their inadequacy and their failure to recognize how a particular policy at a specifically powerful point in the economic process can resolve all of the problems the heterodox all agree need to be resolved.

    “It’s the monetary and financial paradigm and its policies, stupid!”

  4. gerald holtham
    February 24, 2020 at 9:57 am

    If memory serves Keynes himself said he accepted Hicks’ characterisation of his system – writing in haste and no time to look up the reference . Kalecki later devised his political theory of the business cycle in “Political Aspects of Full Employment” 1943.. He knew that if Keynesian policies produced full employment there would be a problem of incipient inflation and he predicted periodic policy-induced recessions to discipline the workers and keep inflation under control. That pattern did occur post-WWII and Mitterand did not escape it.

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