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MMT basics

from Lars Syll

We have already shown that deficit spending increases our collective savings. But what happens if Uncle Sam borrows when he runs a deficit? Is that wht eats up savings and forces interest rates higher? The answer is no.

Image result for kelton deficitThe financial crowding-out story asks us to imagine that there’s a fixed supply of savings from which anyone can attempt to borrow …

MMT rejects the loanable funds story, which is rooted in the idea that borrowing is limited by access to scarce financial resources …

Government deficits always lead to a dollar-for-dollar increase in the supply of net financial assets held in the nongovernment bucket. That’s not a theory. That’s not an opinion. It’s just the cold hard reality of stock-flow consistent accounting.

So fiscal deficits — even with government borrowing — can’t leave behind a smaller supply of dollar savings. And if that can’t happen, then a shrinking pool of dollar savings can’t be responsible for driving borrowing costs higher. Clearly, this presents a problem for the conventional crowding-out theory, which claims that government spending and private investment compete for a finite pool of savings.

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 in the same way as the price of bread and butter 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 argued by Kelton in The Deficit Myth 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 labeled 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. As he wrote in General Theory:

The 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 shift 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 afterward, 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 modern formalizations of the loanable funds theory.

Fallacy 2
Urging or providing incentives for individuals to try to save more is said to stimulate investment and economic growth.

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 … 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. Cristi C
    February 14, 2021 at 8:37 pm

    I lack a systematic and in-depth knowledge of economic theory. That said, I find it interesting to see again what seems to be a debate on fiscal conservatism and Keynesians views. That not “a dog called saving wagged its tail labeled investment”, but it is the other way around.
    I’m starting to believe (as it seems that believing is what puts you in a camp or the other) that the debate is as relative as it is to say about the human behavior that to be cautious and save first to know how much is the limit to spend, is less desirable or even wrong compared to other human behavior which is to be reckless, to be exuberantly optimist and spend first while worrying later about how to pay it back, if ever.

    Neither camp is wrong about the human behavior. Both are considered “normal” or within the normal range of human psychology. The trouble starts when a single budget of one country is the instrument which sets the rules of the economic game where both types of participants play. If the budget (and the institutions that run or finance it) is built based on fiscal prudence (show me your creditworthiness first, then I will invest), the fiscal conservators will have an advantage as they will be able to access a larger portion of the investment pool. The exuberant guy, however, will cry that life is not fair, that life is too short, that you only live it once and they should have access to more and free money, regardless of their previous failures. Make the budget more Keynesian, and the deluge of money will erode the assets of the fiscal conservators, while pushing the exuberance of some to smoking limits, under the safety net of guaranteeing bailouts for all.

    I find that to be disturbing. I want fiscal conservatism as I believe that it is a modern human right. Everyone has the right to enjoy and use the benefits of his/her savings. Depending on where the State is vs its citizens (the State is made of citizens, or the Citizens created the State for we the people), money can be seen as an attribute of the People, not an abstract policy instrument of a State/Central Bank (which today does a much better job of counting the growth, or the lack of it, instead of doing a proper job of counting the accurate cost of living into CPI and savings depreciation as policies). I strongly believe that in any poll, in any Constitutional act that would be put to the vote, the people will choose to have the savings protected instead of having more of the exuberant kind of money.

    To quote William Vickrey who said it is “unreasoned ideological goal of reducing the so-called deficit”, I believe that Vickrey is simply a believer in the exuberant king of money lifestyle and that he is as equally ideological when punishing the savers by devaluing the money that belongs to everyone. What would Vickrey (who said the deficit is not a sin but a necessity) think about Germany, Sweden, Norway which rarely had budget deficits in the last 30 years?

    • February 15, 2021 at 12:50 am

      William Vickrey would say that Germany, Sweden and Norway have large positive trade balances.

  2. February 15, 2021 at 3:10 pm

    Christi, your lacking “systematic and in-depth knowledge of economic theory” ought to be an advantage, because the theory predominantly taught is a complete waste of time. Sadly, you appear to believe what you’ve heard from the “fiscal conservatives” (i.e. those who don’t want to pay taxes, so want the costs and budgets of governing reduced) among the vast majority of people who have never read and put themselves in the shoes of unorthodox thinkers like Keynes, Vickrey and a lot more before them and since, who not only had different priorities but were not ashamed to say why. You should listen to what the defendents were saying before believing their enemies. In fact the strength of the opposition is a good indicator the enemies know but don’t want to admit they are wrong, even if not wanting to pay taxes isn’t.

    Your acknowledging the human differences between optimists and pessimists is, I believe, spot on, but not addressing the issue. Surely what you are saying is that when optimists are in government it may print more money then they need (to finance vanity projects, pay blackmail to rentiers and buy off opposition)? But there again they may not. The pessimists may allow their banks to dictate austere budgets, cutting local government and public services to fit their Procrustean bed; but there again they may not; they may transfer profligate costs into private purses by privatising everything in sight, claiming “There is no alternative”. But of course there is. Optimists can rebel and pessimists can live within their budget by organising foodbanks and unpaid voluntary service. The disorganisation and shame of rejection when forced to live this way is, however, not lost on first hand observers like myself. It was far better when local governments were allowed to organise and finance the necessary services.

    So I’m with MMT insofar as the issue isn’t printing of money, but if you had taken the trouble to look at what I have been writing in this blog you will have seen me arguing that personal credit cards are the answer, leaving governments and bankers advising us on what needs doing, not telling us what we can and cannot do. Credit cards are a relatively new invention, involving concepts that even unorthodox thinkers shy away from because of their association with profligate spending and high interest rates. The first of these concepts is the credit limit, which in effect comes down if you spend but goes up if you save. It isn’t actually money, so you don’t get charged interest on it. The second concept is the retrospective repayment contract, so if (as we currently see it) you borrow money to make purchases, no interest is charged if the “borrowed” money is repaid in full by the due date. In my own case, with a generous credit limit and a pension usually more than my expenditure, that means I can use my credit card more or less interchangeably with my debit card. My bank account lets me see standing orders paying creditors for services continuously provided. My credit account lets me see what might be called “optional” expenditure, which we don’t have to be “austere” with but may ourselves chose to be, not least because our buying rubbish has almost ruined our word. And that again (along with the fact that privatising government doesn’t pay for it, merely transferring its finances into unaccountable pockets) doesn’t appear in the “orthodox” theories financed largely by private banks, whose incentive is to sell credit limits and government budgets in the form of loans, thereby evading scrutiny and claiming interest on them all..

    So far as I have been able to discover, then, MMT has recognised that money can be created at will, but its “guaranteed job for all” doesn’t resolve the issue of how those who can’t work or aren’t working, for a firm able to pay adequate wages, can (in today’s terms) “repay their debt”, or in the credit system “restore their credit worthiness”: their ‘effective limit’. Our regular ‘budget’ is normally set by our income and our expenditure by our responsibilities, but a few genuinely profligate credit card uses have given a bad name to the vast number who have simply had to ‘borrow’ in order to fulfill their on-going responsibilities. First among these are looking after ourselves and our families, though you wouldn’t think so reading “orthodox” (self-righteous) economic textbooks.

    Unlike MMT’s “jobs for all”, a “universal basic income” can in principle resolve the problem. Credit limits cost nothing to create, so we can afford to make them generous, but they are supposed to reflect our credit-worthiness, which we reduce when we spend some of it and renew, not by working for others, but simply by working: “doing what needs to be done”. For example, when we buy, the vendor does his job by accepting our credit-worthiness, and is repaid by our expenditure being written off the restocking costs in his account. The same is true when we work for wages: we sell our work and our expenditure is written off by our banking it. However, not only shop care but the likes of self-care, mother-care, study and old folk volunteering count as much as workshop maintenance in this work metric.

    There is a whole other layer to this discussion, about pricing, which I can’t go into here, except to say again that the last chapter of Edward Fullbrook’s book “Market-value” suggests that we stop pretending to count incommensurates and represent the current value of the whole world by 1, so that our incomes and what we can buy with them can represent some fraction of it and go down insofar as we continue to destroy it.

    • February 15, 2021 at 3:44 pm

      “my eyes are dim, I cannot see …”! Apologies for a few typos. One I think worth correcting to emphasise the point is in my third paragraph, six lines up, which say “word” instead of “world”.

      “… buying rubbish has almost ruined our world. “

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