"We are not in a corn economy where banks serve as an intermediary between farmers who have excess seed and farmers who want more seed. We are in an economy where banks actually create credit. And that makes a very big difference."
Certainly the ordinary man — banker, civil servant or politician — brought up on the traditional theory, and the trained economist also, has carried away with him the idea that whenever an individual performs an act of saving he has done something which automatically brings down the rate of interest, that this automatically stimulates the output of capital, and that the fall in the rate of interest is just so much as is necessary to stimulate the output of capital to an extent which is equal to the increment of saving; and, further, that this is a self-regulatory process of adjustment which takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority. Similarly — and this is an even more general belief, even today — each additional act of investment will necessarily raise the rate of interest, if it is not offset by a change in the readiness to save.In a recent post, Paul Krugman dismissed the relevance of the traditional loanable funds model for the real world, pointing out the basic Keynesian insight that the theory is only relevant if the level of income in the economy is fixed. In reality, as Krugman correctly argues, given that income is not fixed, all the traditional loanable funds theory does is "define a relationship between interest rates and income, the IS curve of the conventional Keynesian IS-LM model".
The Fed sets interest rates, whether it wants to or not — even a supposed hands-off policy has to involve choosing the level of the monetary base somehow, which means that it’s a monetary policy choice.
The Times has an interesting headline here: Richard Fisher, Often Wrong but Seldom Boring, Leaves the Fed. Because entertainment value is what we want from central bankers, right? I mean, Janet Yellen is such a drag — she just keeps being right about the economy, and that gets old really fast, you know?It really is too bad that it's these 'entertainers' -- they range from the likes of Rick Santelli and Larry Kudlow to the establishment types like Fisher -- get such media attention. I mean, it's not like decent analysis doesn't exist, especially since the appearance of websites like Vox and the increased popularity of economics blogs.
Robert Gordon...criticized the assumption in Krugman's models that the monetary authorities can easily change inflationary expectations for the future -- that the announcement of a policy will change expectations despite present slack in the economy. He believed that agents' expectations depend largely on actual experience, and that they will experience increased inflation only when there is pressure in the markets for goods, services, and labor. Alan Blinder agreed. He thought that Krugman's inflationary policy would work if it could be implemented; but that would require the Bank of Japan to create expected inflation, which, in turn, would require persuading people that the future was going to be fundamentally different from the past. Japan had zero inflation in the past six years, and the average in the previous decade was 1.8 percent per year. Thus to create expected inflation of 4 percent, with actual inflation lagging behind, would be difficult.[Martin] Baily concurred, observing that it would be easy for Russia to be credible in announcing inflationary policy but hard for Japan. (Krugman, 1998:201)True believers in the power of central banks will respond to this line of criticism by reverting to this old saw: a credible central bank would not have let inflation get too low in the first place, thus people's expectations would never had been unhinged as a consequence. To this, I say: wishful thinking!
...[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at the data. (Solow and Taylor, 1998:93)The problem with economics and economic policymaking these days is that too much of it relies on monetary policy and the role of the central bank. There are limits to what central banks can do because people do not believe central banks are omnipotent and have the ability to control inflation expectations on demand. For this reason, Old Keynesians had it right: fiscal policy must be resorted to bring about normal economic activity.
|Samuelson and Scott (1971:437)|
For every buyer there must be a seller, and for every lender a borrower. One man's expenditure is another's receipt. My debts are your assets, my deficits your surplus.
If each of us was consistently "neither borrower nor lender," as Polonius advised, no one would ever need to violate the revered wisdom of Mr. Micawber. But if the prudent among us insist on running and lending surpluses, some of the rest of us are willy-nilly going to borrow to finance budget deficits.
In the United States today one budget that is usually left holding a deficit is that of the federal government. When no one else borrows the surpluses of the thrifty, the Treasury ends up doing so. Since the role of debtor and borrower is thought to be particularly unbecoming to the federal government , the nation feels frustated and guilty.
Unhappily, crucial decisions of economic policy too often reflect blind reactions to these feelings. The truisms that borrowing is the counterpart of lending and deficits the counterpart of surpluses are overlooked in popular and Congressional discussions of government budgets and taxes. Both guilt feelings and policy are based serious misunderstanding of the origin of federal budget and surpluses. (1963:10)Tobin then goes on to explain that both the household and financial sectors were running large financial surpluses (worth $20 billion combined in 1963):
American households and financial institutions consistently run financial surpluses. They have money to lend, beyond their own needs to borrow. As a group American households and non-profit institutions have in recent years shown a net financial surplus averaging about $15 billion a year -- that is, households are ready to lend, or to put into equity investments...more than they are ready to borrow. [...] In addition, financial institutions regularly generate a lendable surplus, now of the order of $5 billion a year. For the most part these institutions -- banks, saving and loans associations, insurance companies, pension funds, and like -- are simply intermediaries which borrow and relend the public's money. Their surpluses result from the fact that they earn more their lending operations than they distribute or credit to their depositors, shareowners, and policyholders. [...]The article goes on to list the sectors of the economy that must borrow the $20 billion in surplus funds available from households and financial institutions:
State and local governments as a group have been averaging $3-4 billion a year of net borrowing...Unincorporated businesses, including farms, absorb another 3-4 billion a year. To the rest of the world we can lend perhaps $2 billion a year. We cannot lend abroad -- net -- more than the surplus of our exports over our imports of goods and services, and some of that surplus we give away in foreign aid. [...]
The remainder -- some $10-12 billion -- must be used either by nonfinancial corporate business or by the federal government. Only if corporations as a group take $10-12 billion of external funds, by borrowing or issuing new equities, can the federal government expect to break even. [...]Tobin then follows into a discussion about the policy implications of these lending and borrowing dynamics:
The moral is inescapable, if startling. If you would like the federal deficit to be smaller, the deficits of business must be bigger. Would you like the federal government to run a surplus and reduce its debt? Then the business deficits must be big enough to absorb that surplus as well as the funds available from households and financial institutions.
That does not mean business must run at a loss -- quite the contrary. Sometimes, it is true, unprofitable business are forced to borrow or to spend financial reserves just to stay afloat; this was a major reason for business deficits in the depths of the Great Depression. But normally it is business with good profits and good prospects that borrow and sell new shares of stock, in order to finance expansion and modernization...The incurring of financial deficits by business firms -- or by households and governments for that matter -- does not usually mean that such institutions are living beyond their means and consuming their capital. Financial deficits are typically the means of accumulating nonfinancial assets -- real property in the form of inventories, buildings and equipment.
When does business run big deficits? When do corporations draw heavily on the capital markets? The record is clear: when business is very good, when sales are pressing hard on capacity, when businessmen see further expansion ahead. Though corporations' internal funds -- depreciation allowances and plowed-back profits -- are large during boom times, their investment programs are even larger. [...]
Recession, idle capacity, unemployment, economic slack -- these are the enemies of the balanced government budget. When the economy is faltering, households have more surpluses available to lend, and business firms are less inclined to borrow them. (1963:11)The Corporate Sector: From Deficits to Large Surpluses
In the United States, at least, business investment has recovered only partially from the recession, although corporate profits have been very strong. The result, as pointed out in an unpublished paper by Brookings Institution Senior Fellows Martin Baily and Barry Bosworth, is that business saving has exceeded business investment since 2009. The corporate sector, normally a net borrower, became a net lender to the rest of the economy. This does smell rather like a reaction to an expected fall in the rate of return on investment, as the stagnation hypothesis suggests. (see chart below)
|Source: Baily and Bosworth, 2013|
What if our continental economy is in for what Harvard's Alvin Hansen called "secular stagnation"? - which means a long period in which slowing population increase, [...], high corporate saving, the vast piling up of capital goods, and a bias toward capital-saving inventions will imply depressed investment schedules relative to saving schedules? Will not active fiscal policy designed to wipe out such deflationary gaps then result in running a deficit most of the time, leading to a secular growth in the public debt? The modern answer is "Under these conditions, yes; and over the decades the budget should not necessarily be balanced." (1971:436-7)In my next post, I'll write more about secular stagnation and policy responses to address its possible eventuality.
The problem, you see, is that the same rules that prevent Argentina from printing money for bad reasons--to pay for populist schemes or foolish wars--also prevent it from printing money for good reasons such as fighting recessions or rescuing the financial system. [...]
Now, these problems with a rigidly fixed exchange rate are not news. But for a while, currency-board enthusiasts managed to convince themselves that they weren't significant. They argued that as long as governments themselves followed stable policies--and as long as the economy was sufficiently 'flexible' (the all-purpose answer to economic difficulties)--there would be few serious recessions.
But it turns out that history does not stop just because the currency is stable. And faced with a politically inconvenient recession, the Peronists find that there is nothing they can do. They cannot print money. They cannot even borrow money for some employment-generating public spending, because fiscal indiscipline would undermine the peso's hard-won credibility.Read the entire column here.