Krugman vs Kelton on the fiscal-monetary tradeoff

26 February, 2019 at 16:01 | Posted in Economics | 
 

Paul Krugman is back again telling us that 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:

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 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.