Monday, August 5, 2013

Daniel Kuehn on Loanable Funds

Daniel Kuehn has a nice response to me on loanable funds:
Daniel Kuehn, “Keynes and Loanable Funds,” Facts and Other Stubborn Things, August 5, 2013.
First, I am happy to fold on a number of issues where I was wrong.

It is completely right to say that modern Keynesian economics should not be about who is more “faithful” to Keynes. Keynes made mistakes. He was not always right, and a proper Keynesian economic science must move beyond Keynes. I agree.

I was also wrong to imply that Daniel just self-identifies as a strict New Keynesian. Sorry about that!

Nor, when I cited an article in a previous post that happened to be called “Bastard Keynesianism,” did I mean to insult New Keynesians. On reflection, the term “Bastard Keynesianism” that was coined by Joan Robinson in 1962 to refer to the neoclassical synthesis (in addition to being rude!) gives the unfortunate impression that Keynesian economics is just about blindly following Keynes, which it certainly should not be.

And, yet, when it comes to the other issues I fear we may be talking past one another. Obviously, there is a flow of money into banks that represents funds people want to save, and in return they get an asset: either (1) the credit money we call demand deposits (or checking accounts or saving accounts) or (2) financial assets called time deposits.

But surely classical loanable funds theory is, fundamentally, a theory of interest rates, saving and investment. It makes many more claims than the simple observation that there is an annual flow and stock of savings.

Now I am sure Daniel is perfectly familiar with Keynes’s critique of loanable funds.

So the remarks that follow are really more for my benefit and other readers of this post.

Keynes’s critique of the loanable funds theory is summed up by Bill Mitchell:
“… the Classical belief [sc. was] that the household decision to save was determined by the preferences for current and future consumption mediated by the interest rate (the price that consumers traded current consumption for future consumption). Instead, … [sc. Keynes] considered aggregate saving was a positive function of national income.

So when national output and income rises, aggregate saving will rise. The amount of extra saving per dollar of additional disposable income is called the Marginal Propensity to Save (MPC). If the MPC = 0.20, then households will save 20 cents of every extra dollar of disposable income they receive.

The interest rate might have some influence on saving but Keynes considered the influence of changes in national income to the dominant factor determining the aggregate level of savings in any period.

The other consideration is that investment spending is a component of aggregate demand, which in turn, drives total national income in each period.

Taken together, these insights undermines the concept of a loanable funds market in the way conceived by the Classical economists. There could not be independent saving and investment functions brought together by movements in the interest rate as required by the loanable funds doctrine because investment drove income which influenced saving.

In Chapter 14 … of his General Theory of Employment, Interest and Money, he produced a diagram to illustrate his contention that this interdependency meant the loanable funds doctrine was a ‘nonsense theory.’”
Bill Mitchell, “Keynes and the Classics Part 6,” Billy Blog, January 24, 2013.
There is also the question of what information, if anything reliable, is communicated to businesses through interest rates about time preference.

And then we have more complicated issues about money and banking, such as endogenous money theory, relevant to the classical loanable funds.

Money saved adds to a bank’s reserves. But even at this point the standard story is flawed. Bank lending is not constrained in the way the standard theory requires. Loans create deposits (or new money), and most of the broad money stock is bank money held in the form of demand deposits. Prior monetary saving is not strictly necessary for investment. Then there is the issue of the mythical money multiplier.

At this point, however, we are simply revisiting some of the issues of the Krugman versus Keen debate on endogenous money from about a year ago, which I discussed here:
“Keen versus Krugman: The Great Debate!,” April 4, 2012.
Keen also gives a talk below that addresses some of these points.





Further Reading
“Keynes and the Classics Part 6,” January 24, 2013.

“Scott Fullwiler: Krugman’s Flashing Neon Sign,” Naked Capitalism, April 2, 2012.

16 comments:

  1. "most of the broad money stock is bank money held in the form of demand deposits"

    No, it's not. This is a common misconception. Most of the broad money stock is held in the form of savings deposits, not demand deposits.

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  2. All the loanable fund model is really claiming is that at any point in time the prevailing interest rate will be the rate that clears the loan market.

    You list a bunch of complexities that make this a bit of a moving target:

    - Savings will increase as income increases
    - Income is in fact dependent upon investments
    - A flexible money supply ("endogenous money" ) can cause the supply-curve in the loans market to shift.
    - Demand to hold money itself (liquidity preference) can vary over time.

    All of these things need to be included in a comprehensive theory of interest rates. Its unclear to me why one factor (liquidity preference) is called out as being the dominant one that drives interest rates.


    You say "There is also the question of what information, if anything reliable, is communicated to businesses through interest rates about time preference":

    The main aim of an effective loans market is to get funds from those who wish to save to those wish to invest those funds in the production of future goods. At any point in time there will be frictions and market imperfections (often driven by changes in the factors listed above) that mean that the interest rate will not accurately reflect this "time preference". However in a free market processes can be identified that will lead the interest rate (and prices) to gravitate towards the underlying "natural" rate and that will lead investment and savings to be in balance. This will include the evolution of institutions (free banks , private currencies etc) that will provide market-based solutions to the some of complexities (including changing liquidity preference) that cause distortions under a state-controlled monetary regime.

    Intervention , either via direct manipulation of the market rate to keep it below the natural rate (as described in ABCT ) or by creating distortions in the risk-structure of investments as happened during the lead up to both the Great Recession (the housing boom) and the Great Depression, can break these market processes with serious economic consequences.

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    1. "The main aim of an effective loans market is to get funds from those who wish to save to those wish to invest those funds in the production of future goods. "

      No, it isn't. And that you say this suggest you haven't really understood my main points.

      Prior monetary saying is not necessary for investment when real resources exist and you have an endogenous money system capable of creating both credit money (broad money) and the reserves to back it.

      As for the natural rate, this mythical entity is irrelevant for economics.

      Colin Rogers:

      The concept of the natural rate of interest is not merely non-operational: it is an abstract special case of no general theoretical significance. It cannot, therefore, provide the theoretical foundations for an operational loanable funds theory of the rate of interest” (Rogers, C. 2001. “Interest rate: natural,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy. Volume 1. A–K, Routledge, London and New York. 545–547. p. 546).

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  3. "Prior monetary saying is not necessary for investment when real resources exist and you have an endogenous money system capable of creating both credit money (broad money) and the reserves to back it."

    Are you saying that after the new loan and the new reserves have been created that the interest rate is not accurately reflecting the rate that will clear the loans market ? If not, why not ? What you are describing is simple a feature of the way the modern monetary system works and by no means undermines the (rather simple) loanable fund theory that does no more than explain short-term interest rates (and does so even under an interest-rate targeting regime.)

    It is also incorrect to say that prior monetary saving did not exist in this situation if you look at it from the position of monetary equilibrium. Say we're in position of underemployment and market frictions prevent the price adjustment that would address this from happening. In effect money is overvalued at the current price level. We need to increase the money supply to address this situation and under the current CB regime this would be done (in non-ZLB times) by via lowering the interest rate target.

    It is totally incorrect however to look at the new lending that results as somehow representing new savings. The important thing is the increase in the money supply that the CB drives via OMO to provide the reserves to fund these new loans. This increases the money supply and causes the value of money to decline. As it gets back to its correct value relative to the price level then investment will increase to the level needed for full employment.

    The fact that under interest-rate targeting regime's the loans precede the reserve increases is irrelevant. If the CB didn't target interest rates but simply used OMO to increase the money supply directly the economic results would be exactly the same but in this case the increase in reserves would precede the increase in lending.

    Savings were there all along - they were just mis-valued at the old money supply level.


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    1. (1) you are still confusing real savings with monetary savings.

      (2) The evidence of the real world from 2008-2013 and actually -- if people bothered to pay attention -- from Japan's experience in the 1990s refutes your theory.

      Despite record low interest rates and QE1, QE2, and QE3, has this induced a sufficiently high level of US private investment to restore full employment?

      Under your theory, the Fed has been desperately trying to find a natural rate to clear the loanable funds market, but it's been a failure.

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    2. And Japan did much the same thing in the 1990s, flogging the dead horse of monetary policy. It failed to achieve the aims they had in mind.

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    3. "you are still confusing real savings with monetary savings"

      Honestly not sure what you mean by this. In my model there needs to be real savings for any investment to take place, but sometimes monetary factors cause these real savings to be mis-allocated or underutiized. I think this is what are saying as well, you just disagree about the correction process.


      I think you need to do some more research on monetary expansions. It has had very limited scope in recent US and Japanese examples but by-and- large it achieved what it set out to do. In the Japanese examples this was to end deflation and in the US to end short-term economic deterioration.

      If current monetary policy was used to expressly maintain monetary equilibrium through time rather than used tactically to avert disaster then the economy might quickly be restored to health.

      The

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  4. Under your theory, the Fed has been desperately trying to find a natural rate to clear the loanable funds market, but it's been a failure.

    Isn't the latest "neomonetarist" thinking (HT: Miles Kimball) that nominal rates currently need to be pushed below zero?

    http://qz.com/21797/the-case-for-electric-money-the-end-of-inflation-and-recessions-as-we-know-it/

    In order to forestall any charges of being an Austrian hypocrite w.r.t. low int rates, I would ask you to please keep in mind this comment from George Selgin regarding the compatibility of Austrian and monetarist views:

    http://uneasymoney.com/2012/10/10/on-the-unsustainability-of-austrian-business-cycle-theory-or-how-i-discovered-that-ludwig-von-mises-actually-rejected-his-own-theory/#comment-10251

    Additionally, JP Koning has outlined scenarios in which profit-seeking banks in a Free Banking system would act to overcome the ZLB:

    http://jpkoning.blogspot.kr/2013/06/does-zero-lower-bound-exist-thanks-to.html

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  5. And Japan did much the same thing in the 1990s, flogging the dead horse of monetary policy. It failed to achieve the aims they had in mind.

    What about a David Beckworth-style direct heli-drop to households, combined with an explicit NGDP growth target?

    http://macromarketmusings.blogspot.kr/2013/08/helicopter-drops-as-insurance-against.html

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    1. John S,

      A "direct heli-drop to households", if this is supposed to mean giving money directly to households, is the effective equivalent of fiscal policy. So going down that route simply concedes that Keynesians are conceptually right to demand fiscal policy.

      As for explicit NGDP targets, how will the central bank achieve such a target?

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    2. Yes. The NGDP guys do not understand the difference between fiscal policy (which the government is mandated to do) and monetary policy (which the central bank is mandated to do).

      It's a bizarre misunderstanding.

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    3. It seems typical of Post-Keynsians that they would rather debate the definition of fiscal v monetary policy rather than agree on policies that might actually work !

      I define fiscal as policy that changes the distribution of income and monetary as policy that changes the money supply. Many policies (such as heli drops) are both, but it is the monetary bit that actually does most of the work.

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    4. Philip,

      I think they understand only too well. For them the central bank run by an autocratic cabal of the elite is what runs the monetary system.

      In that arrangement the government is treated as just another large corporate that borrows a lot.



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    5. Typical of Rob Rawlings/Austrians to just make up their own definition for terms and then pretend that they're saying something interesting when they're really just calling cats "dogs" and dogs "cats".

      :-D

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  6. Kuehn's post is unreadable. He has no idea what endogenous money is about -- it being a fundamentally institutional theory about how banking systems work in capitalist economies (something even the likes of David Romer have gotten their heads around and incorporated into New Keynesian theory albeit it not in a way I think ideal).

    I think he's the same guy who didn't understand what "index numbers" were on my blog the other day.

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  7. [Disclaimer: I am not necessarily endorsing Beckworth's idea. But if it's misguided, I would like to hear a valid counterargument, which Scott Sumner has failed to provide.]

    giving money directly to households, is the effective equivalent of fiscal policy.

    Suppose you were given the choice btw 1) maintaining the current situation (no increase in fiscal stimulus) and 2) giving money directly to households. Which would you choose?

    So going down that route simply concedes that Keynesians are conceptually right to demand fiscal policy.

    I'm willing to be converted. What are the advantages of increased govt spending over a heli-drop?

    "How will the central bank achieve such a target?"

    1) As Sumner emphasizes, the immediate goal is to "target the forecast," i.e. through an NGDP futures market or a similar prediction market.

    2) The Chuck Norris effect.

    http://marketmonetarist.com/2013/08/02/my-cnbc-interview-on-why-chuck-norris-should-be-the-next-fed-chairman/

    3) In terms of actual execution--by continuing/expanding the heli-drop annually until NGDP has risen to its previous trend line.

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