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Lets Talk About Economics

Horton

Cat
Administrator
So I've noticed we have a few members who like talking about this and are interested in it.

So lets talk, today I'll be looking at a post on a hetrodox blog and pointing out the issues with it.

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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 — as Bertil Ohlin put it — "in the same way as the price of eggs and strawberries on a village market."

It's 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.

While true to some extent, this is wrong empirically.

1462

So, what's the issue with the argument here? I mean banks do create credit, right? If interest rates rise due to increased demand, the demand should result in more loans being made out, increasing the supply of money to offset this problem. The logic stands, but why doesn't it work?

Banks however, do have a theoretical cap on how much they can lend out. They need to hold fractional reserves and mixed in with that, there's also a level of required reserves by the central bank. So imagine a bank, the bank has 100 units in cash, the bank is required to hold 20% in reserves and the bank also holds an extra 5% based on habit as well, so this means 25% of the cash in the bank has to be covered by actual liquid assets. The central bank then gives the bank an extra 100 units, so it keeps 25% which is 25 and lends out 75 units. As this process repeats itself, we can calculate the total in the long run as 1464 . That being an approximation due to the fact taking the summation to infinity would require infinite time. To calculate however much reserves the banks would have kept over that period, we can in turn do 1465 . So the ratio between the two will be the following equation 1466 , in this case which is 1467 . So in this case 400 units will flow into the economy in the long run and 133 units will remain in various banks, which is the same as the original variables in the equation, overall the supply of loanable funds is going up and the bank is capped by this. M being the amount of money, RR being the reserve requirements and ER being excess reserves.

So why do we have a demand for loanable funds? Well it follows on that if there's a lot of demand and the bank in question hits the point where it's reserves are RR + ER or even near, it will start increasing it's interest rates in response to that, which is basic supply/demand microeconomics for a product, the product in questionbeing loanable funds. If taken on a much larger scale, it means that intrest rates will rise if there's large amount of excess demand in the market for loanable funds, like the original model itself suggests.

But...

The line of reasoning that the blog posts is ALSO true, increasing demand for money tends to result in the banks giving out credit, increase the supply of loanable funds and you counteract the increased demand. So to combine these two theories, we must assume that the PED for loanable funds is inelastic for a decent part of the way and then suddenly becomes very elastic once you start hitting the point in which I've highlighted,. This will be even more so seeing the economy will likely be running on steroids at this point, assuming that it's been boasted lots by gov spending. So the supply curve in the LF model is flatish, until it reaches a point and then it shoots up exponentially.

What does it mean for policy? Well it means that the "crowding out" effect is much lesser then what we imagined it was, meaning the option for fiscal stimulus should be on the table a lot more then it already is. BUT to go the way of the PKs here and think there's NO limit to this? That is mistaken, unless you remove reserve requirements entirely, which comes with other massive problems.

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.
Well yes, other factors do effect investment, but so does the cost of borrowing. If it didn't, then Volcker hiking interest rates should've had little to no effect on investment. Wouldn't mind seeing the empirical research here, as I just went and looked and there are papers showing otherwise.

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,

What.

I mean if it's arguing that we don't go into every little detail, well duh or we'd be here for ever. Interest rates typically flow together anyway, so seems a little nitpicky to go after that part. If we're saying that mainstream economics doesn't use empirical data, then that strikes me as being flat out false. The Austrians on the other hand...

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.
Ok, Walras' law in the original approach was a way of assuming that if we have a system of partial equilibriums, like 1468 , with the 0 implying that there's no excess demand in the function and assuming that supply = demand, due to the fact that people creating a supply of something are creating a demand in the product, then it follows that changing the function to 1469 must mean y is 0, due to the following:

1468

and also

1470

Hence

1471

So y = 0.

Now that law has long been debunked, as the demand for money is also a thing that effects both supply and demand, meaning Walras and Say's Law fall apart once this aspect is included. The mainstream consensus doesn't believe in Say's Law nor do the PKs, the only people I think believe in it are the Austrians, but I'm unsure, so don't cite me here. Though the law doesn't matter as it doesn't really have anything to do with the quote here or what the central bank is doing, it just seems to be added on to make the writer seem "smart".

As for Endogenous Vs Exogenous money, they're basically both true, the Central Bank has control of the money supply via the tools available for it and can influence the economy by messing with the money multiplier, but it's also true that banks create money effectively when they hand out loans. What we're looking at is a composite function of both.

Not sure what the Taylor rule being unpopular these days really when modern Central Banks often do use expectations for their own advantage, one type of policy going out of use doesn't mean that economists have changed their views on Monetary Policy and don't now not see stable policy and modifying expectations as a good thing.

A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities.

...the IS-LM model in undergraduate economics textbooks, which uses the loanable funds in the same textbook, literally stands for Investment/Saving - Liquidity/Money Supply

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):
That I can agree with, finance is an important aspect of an economy. I suppose that line of reasoning though can be applied to ALL models, don't use them in isolation and watch out for feedback loops. It doesn't "debunk" it, as the article tries to put forward, as much as the fact money supply effects prices doesn't mean we should chuck out supply-demand.

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So what we have here, is a guy that's found flaws in mainstream economics, COMPLETELY thrown out the insights in modern economics, even though the logic still works and is true and then gone back to older theory and used that, pretending the newer advances don't exist. The reverse is true with mainstream economics, ie ignore older stuff for new. It seems to me that he's seen part of the truth, but not the whole truth and that's a thing, as he does bring up some decent points.

You've got two sides, one is saying we should stick with Friedman's opinion that it doesn't matter if the model has issues, but if it's backed by stats it's true and the other side is putting forward alternative models with also work, but not giving decent stats. Both have issues and I think the profession needs to do what I've done and worked out how they BOTH work.

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So yeh guys. Post away!
 
As far as I can tell, loanable funds is one particular argument to prop up the orthodox (ed.) macroeconomic view that the financial sector doesn't matter, that it can be abstracted away. Under such models, banks are connectors between patient people (creditors) and impatient people (debtors), and so has negligible effect to the macroeconomy.

Following the financial crisis, the Bank of England and the Bundesbank basically explicitly told some mainstream economists that banks and money doesn't work the way they they think they do. The main reponse was apparently to try to treat banks as frictions on the return to equilibrium, which seems a bit odd.

Rather, I think it makes more sense to 'abstract away' the required reserve ratio, since in many significant economies, the banks are either under no strict RR obligations (including the UK btw, where the concept of excess reserves no longer makes sense), or as a factual matter of policy, the central banks almost never refuse to lend money to the major players. So treating the banking system as whole, increasing reserves per se is almost never a serious issue; instead, the interest rates that it would cost is.

Under this view, the purpose of a reserve ratio is primarily to enable easy settlement of accounts between banks, and secondarily as cushion against bank runs. I'm not sure there's much room for exogenous money left there.

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I'm not sure I understand the specific Walras' law argument; it doesn't follow unless f is both linear and that adding it in doesn't alter the demand for everything else, which it should because the agent budget constraints have to spread more. Well, Walras law seems true by definition given its assumptions on consumer behaviour (which may be rather dubious).
 
I don't think it's fair on saying that the sole mainstream view is that the financial sector doesn't matter when it comes to macro analysis, I think that was more the case prior to the crisis with some economists, but not all. As an example, here is a course from LSE in that subject and searching "macrofinance" seems to get me results, though I don't know the context of such courses. There does seem to be quite a large lack of literature on the subject though, but not completely, so maybe your concern is partly true. I found this though, so not 100% sure.

Also, I'm not exactly sure how the loanable funds model props up the idea that the financial sector doesn't matter, it more as such states that it does matter, with regards to interest rates for borrowing effecting investment in the private sector, but utterly misinterprets the role of banks in doing so. I'm not a 100% sure about the mainstream part either, as later on in one of the books I have that covers the loanable funds model, it also then covers it again later in the book and factors in endogenous money and strongly suggests a flat supply curve in the UK. Is it the case then that all mainstream economists use it or it's more of an introductory tool for undergraduates? And is it then built upon later? Or as another option, is it known to be flawed, but the lack of quality control has meant biased economists have used it? I dunno, as I've read a few economics related things in books, ended up forming my opinion based on that when I started and not realising there's a a lot of stuff on top, which was admittedly foolish of me.

Heh, Central Banks are typically run by Mainstream Economists as well. I think that event is more in line with my theory that the profession suffers lack of quality control.

Yeh, I'm not the most clear, but my point was that it was incorrect to state the model doesn't apply in the US, as heavy borrowing will raise intrest rates, just at a much lesser rate. Personally, I expect the Fisher Effect to be the main cause of rising interest, as deficit spending leads to little effect on interest rates in itself due to endogenous money, but with investors expecting inflation, you might get the same effect. But this is a lot less of an issue when you're discussing policy before full employment, so I guess the main issue with the left in the US would be politicians wanting to increase gov spending, but not being able to cut our military spending to stabilise things, which is exactly what happened to Lyndon B Johnson with Vietnam.

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Oh yeh. Walras Law is dubious, the original function was set up as being homogeneous of degree 1, so you're correct on linearity there. But ignoring the monetary criticism of it, there's also the factor of time it ignores, like slow downs in one part of the economy could mean the demand isn't satisfied in the short run and that can ripple further and further out...

But yeh, it was more the blog was flipping weird, rather then I agreed with Walras Law lol
 
The mainstream is probably never of a single mind about any nontrivial issue, but back towards its roots, a key difference between LFT and its critics (e.g. Keynes, Schumpeter) is regarding whether or not banks alter the nature of credit by their very existence, specifically on whether they introduce a disconnect credit supply from saving decisions.

In trying to put it into slightly more empirical terms, this might be put as: to what extent does propensity to save actually drive interest rates? Are multiple investment-saving equilbria even possible?

Perhaps a distinction should be made between some narrower sense of loanable funds theory and the intermediation theory of banking, though in practice they go hand in hand. A difference is drawn between the monetary rate of interest and the natural rate of interest, the latter characterising an idealised economy without banks, and to which an economy on credit money is claimed to converge as to the equilibrium. Hence treating the banking system as a friction on the return to that. Let's call it 'intermediation of loanable funds':
"In the loanable funds model, banks are modelled as resource-trading intermediaries that receive deposits of physical savings from savers before lending them to borrowers. In the financing model, banks are modelled as financial intermediaries whose loans are funded by ex-nihilo creation of deposits that facilitate physical trading among non-banks. ... Macroeconomicswas initially only able to offer limited analytical support because banks, with few exceptions, had been ignored in theoretical and empirical work. " — Jakab & Kumhof
That's functionally yet another admonishent from someone at the Bank of England that banks don't work the way common treatments imply they do; I recall that started around 2010 or thereabout and some mainstream economists wondering about why that matters.

Finally, there is also a more pernicious but loosely related position, that since a debt is somebody else's asset, it represents a pure redistribution and hence is macroeconomically insignificant. Bernanke was complaining in the mid-1990s about the academic neglect of the macroeconomic non-neutrality of redistribution, attributing this neglect to exactly that reasoning, and arguing for a more Fisherian view [Bernanke 1995, p.17].

It may be notable that Krugman et al writing post-crisis say that it's 'common' to abstract from debt altogether in macroeconomic models, noting that people like Bernanke are 'exceptions' [ref]. Krugman goes on to be more sensible, and by implication uncommon (wow!), by having debt part of the macroeconomic model. But not banks.
 
There is another problem with the economics -as well as several other fields- field as a whole: it can't be modeled. Economics is considered a 'soft' science, as you can't actually model it with precision that the 'hard' sciences have. Given how often that 'soft' sciences get to be screwed over by universities and education in general, which causes immense problems in terms of understanding the 'soft' sciences.
 
I wish I had the mathematical background nessissery to participate.
 
Also, as this thread is for empirical discussion. I've allowed it in the science area, but keep politics to a min please and use the goddamn scientific method here. As I made this thread with the purpose of that in mind and so we can learn stuff, due to the issues prevalent in the mainstream and lack of scientific rigour.

It's both more and less than just mathematical background. I've started diving into this shitte a few months ago and it gives me headaches at times while being blindingly obvious at others.
I swear economists like to use massive equations for simple stuff, I think it's partially for modelling. But it's a great way of slowing you down.

There is another problem with the economics -as well as several other fields- field as a whole: it can't be modeled. Economics is considered a 'soft' science, as you can't actually model it with precision that the 'hard' sciences have. Given how often that 'soft' sciences get to be screwed over by universities and education in general, which causes immense problems in terms of understanding the 'soft' sciences.
I agree. But it doesn't mean we can't get closer to the truth, then we would without doing nothing.
 
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