I wanted to say something about how the existence of a bank
intermediary relates to the idea of loanable funds, as I often see it suggested
that the ability of banks to create money is what removes the loanable funds
constraint.
Consider an economy with only two private agents - Patient
and Impatient. Impatient always spends
all his income plus anything he can borrow.
There is also a government which occasionally spends and occasionally
taxes. Any difference it funds by printing
money. Right now it is spending, but not
taxing, so it is increasing the supply of money.
Patient has three possible uses for his income:
1. Consumption spending
2. Making loans to Impatient
3. Increasing his holding of money
The total of these three must equal his income. He therefore has two and only two independent
choices. What happens in the economy
depends critically on these choices.
Aggregate spending will increase if he increases either consumption
spending or loans to Impatient (the latter because, by assumption, Impatient
will immediately spend the amount loaned).
The only choice that will reduce aggregate spending is one that involves
trying to increase his holding of money.
Making loans funds Impatient and accumulating money funds the
government. However, a decision to lend
to Impatient dictates Impatient's spending; a decision to accumulate money has
no impact on the government's spending.
Patient's two choices are independent. It might be that Patient decides that if he
makes a loan to Impatient he will cut his own spending by an equivalent
amount. In that case, lending to
Impatient would have no impact on aggregate demand. We would have what looked like a loanable
funds model.
However, there is no reason Patient has to behave this way. He could equally decide to fund a loan to
Impatient by reducing his holding of money.
In that case, the increased lending would lead to greater aggregate
expenditure.
So greater debt can lead to greater aggregate demand, but it
depends on the various choices made by the lender. This has nothing to do with the endogeneity
or otherwise of money. So how might
banks and financial intermediaries matter here?
Let's now suppose that the government's money and the loans to
Impatient are held by a bank and all Patient holds is bank deposits. Now Patient only has one choice to make -
whether to spend or accumulate bank deposits.
The other decision - how much to lend to Impatient - is now taken by the
bank. So, whereas before there might possibly
have been some connection between how much Patient spent and how much was
loaned to Impatient, there are now likely to be unrelated. Intermediation splits the decision taking.
Financial intermediation (or "endogenous money" or
whatever) is not at all necessary for the loanable funds constraint not to
apply. What it does do is distance
saving and lending decisions, making it less likely that the two are correlated.
Nick, can I ask what inspired this post?
ReplyDeleteIt was prompted by the title of the first article in this publication (http://rwer.wordpress.com/comments-on-rwer-issue-no-67/), but it's not about that article.
DeleteNick, a few questions:
ReplyDeleteYou write:
"There is also a government which occasionally spends and occasionally taxes. Any difference it funds by printing money."
Can we assume an all cash economy here at this point? So if spending exceeds taxes it prints money. And if it collects more money in taxes than it spends, then it effectively unprints money right?
"accumulating money funds the government."
OK, this is probably obvious, but not to me. Why does this fund the government?
"all Patient holds is bank deposits."
Does it matter at all what Impatient is loaned? Can we also assume impatient is loaned money in the form of bank deposits? He spends the money immediately anyway, right/
"What it does do is distance saving and lending decisions, making it less likely that the two are correlated."
Does that pretty much describe all financial intermediary does? Do we need to make any simplifying assumptions on the financial intermediaries to come to that conclusion? (e.g. that it has 0 equity at all times and doesn't make a profit).
Thanks.
Tom Brown, people say that China funds the USA because China holds US treasury bonds. I read it as like that. If all of the monetary authority's liabilities are printed bank notes, then holding them funds the government in that sense. The government has received real goods and services in exchange for acceptance of that paper.
DeleteIt wouldn't have made any difference to include government bonds, but I wanted to keep Patient's choices to the bear minimum.
DeleteAs stone says on what "funding" means.
Talking about loaning bank deposits can get a little confusing. Let's say Impatient has a bank account. When the bank loans, it credits his account. When he spends (which he does right away), the bank debits his account and credits that of Patient.
No, I don't think we have to make any simplifying assumptions, for the purpose of what I'm saying here. But what I've skipped over here is how the intermediary makes its decision. The intermediary will be owned by its equity holders, who will ultimately be households. So its decisons should in theory reflect the choices of its owners and therefore should not make any difference - which is why neo-classicals question what difference it makes having an intermediary. That is a more tricky question - another post maybe.
So case 1, w/o the bank: One way to describe the two independent choices of Patient would be:
ReplyDeletechoice #1: How much government money to hold?
choice #2: What percentage of money not held do I lend to impatient?
In case 2, with the bank
choice #1 (made by Patient): How much money to hold?
choice #2 (made by the bank): How much money to lend to impatient?
Is that a fair way to state it? Or can #2 be framed as a percentage too? Are case #1 and case #2 identical otherwise (given the right set of simplifying assumptions on the bank)? Or are they inherently different in some other regards?
We have to be careful here. Patient cannot choose an absolute additional amount of government money to hold at the same time as the government chooses how much to spend, becasue the two must be equal. We can do two things. We can assume that Patient plans to increase his money holdings by a certain amount, based on what he expects to receve, but then he actually receives a different amount. Or we can say that the actual amount of additional money Patient wants to accumulate depends on his income. So if he receives more he spends it, which increases his income and so on, until the amount of additional money he actually holds (dictated by how much the government spends) is the amount he is happy with.
DeleteOn your case 1, I personally think the more realistic way to frame the question is: first - how much does he spend and how much does he save. Second, how much of the saved amount does he keep as cash and how much is he prepared to lend.
Nick, say we have three cases (lets also assume all government money is in the form of cash):
ReplyDeleteCase #1: bankless (same as your case above). Only when Patient decides not to hold any money do we have the loanable funds case.
Case #2: with a bank, but the bank is certain that 100% of all money spent will be in the form of cash.
Case #3: with a bank, but the bank is certain that no more than 10% of all money spent will be in the form of cash.
Are there any differences between Case 2 and Case 3 in terms of aggregate demand (AD)? How about in terms of the circumstances under which either 2 or 3 reduce to Loanable Funds (if they can)? Maybe I'm just confusing myself here with the extra case... I'm not sure!
Not sure I understand this.
DeleteIs there any real life situation where a coherent case has been made for the loanable funds mechanism prevailing?
ReplyDeleteI think I saw a Mankiw post where he used a loanable funds story to explain why we ought to pander to his political ideas but it seemed utterly ruthless bullshitting as far as I could discern.
Well, it depends what is meant, really.
DeleteWhat I have talked about here is whether there is some kind of theoretical constraint on lending, or rather what the absence of any such constraint depends on. But actually, loanable funds is just about saying that for every borrower, there is a saver (which is just an accounting identity) and that the interest rate must be such that the two are brought together (which must also be true in equilibrium). So it's not really about whether this is true or not - just about how useful it is in understanding what is going on.
Hi Nick
DeleteTo my mind, this:
But actually, loanable funds is just about saying that for every borrower, there is a saver (which is just an accounting identity) and that the interest rate must be such that the two are brought together (which must also be true in equilibrium).
is a contradiction in terms. The identity says that saving and lending must always, that is at every point in time, be equal whereas the equilibrium position says that they are generally not equal but must be brought together by means of some equilibrating mechanism, such as the interest rate. This is a logical fallacy, in my opinion. In theory, only one or the other can be true. And in reality, I think any accountant would tell you that only the prior can be true, finance being an accounting construct.
That is also why I find this: Financial intermediation (or "endogenous money" or whatever) is not at all necessary for the loanable funds constraint not to apply. What it does do is distance saving and lending decisions, making it less likely that the two are correlated. a bit confusing.
I can see and agree that loanable funds, in the sense of a limited supply of funds, does not apply no matter which financial system is in place. But I would say this is actually equal to saying that the amount of money is always determined endogenously, that is by the simultaneous willingness of borrowers to borrow and lenders to lend. Endogenous money is an accounting tautology in itself, really. No matter which system we choose (banks or no banks), both must always coincide for there to be any measurable economic activity. A borrower wanting to borrow but not receiving funds may be a frustrated individual but no amount of economists or accountants will be able to measure his frustration in money terms. Until, that is, he finds a willing lender, whether bank or non-bank. The same goes for willing lenders, bank or non-bank who cannot find willing borrowers. It always takes two to tango, so any story that separates the two is a story about psychology, not about economics in any measurable monetary terms.
I guess what I'm trying to say is that the existence of banks does not suspend the accounting identity that there is a borrower for every lender in the same way that the non-existence of banks doesn't imply that funds are in limited supply.
(And just to clarify, what I'm not trying to say is that there is, for every given distribution, not an optimal / full employment amount of marginal borrowing / lending and that this cannot be influenced somewhat by an exogenously set interest rate).
Hope that makes sense...
I'm at a bit of a loss at understanding the loanable funds reasoning. wikipedia says "Another term for financial assets is "loanable funds", funds that are available for borrowing, which consist of household savings and sometimes bank loans. Loanable funds are often used to invest in new capital goods, therefore, the demand and supply of capital is usually discussed in terms of the demand and supply of loanable funds."
Deletehttp://en.wikipedia.org/wiki/Loanable_funds
The hint that seems to lurk behind that is that loanable funds are not so much a product of lending but a fuel for lending.
I'm also trying to get my head around how the loanable funds concept causes "Gibsons Paradox" to be seen as paradoxical. I have the feeling that understanding why it was/is seen as paradoxical offers a key into what people are making of the whole loanable funds concept. Gibson's Paradox held during the 1821-1913 "true gold standard" period. Then, nominal interest rates were very tightly correlated to the price level but entirely uncorrelated to inflation/deflation. wikipedia says
"The Quantity Theory of Money predicts that a slower money-growth creates slower price-rise. In addition, slower money-growth means slower growth of loanable funds and thus raises interest rates. If both these premises are true, slower money-growth should mean lower prices and higher interest rates. However, Gibson observed that lower prices were accompanied by a drop—rather than a rise—in interest rates. This is the paradox that needs to be explained."
http://en.wikipedia.org/wiki/Gibson's_paradox
I don't get the paradox. From my view point, the Bank of England could not provide enough bank reserves when the price level (aka NGDP) was high because they were constrained by the limited stock of monetary gold so interest rates became high whenever NGDP was high enough to provide a strain on settlement of payments using the limited stock of bank reserves.
Yes, I probably expressed that is a rather sloppy way, there. Actual saving and actual lending must necessarily be equal at all times, but desired saving and desired saving need not be. Equilibrium involves making desired saving and desired lending equal.
DeleteOn your latter part, I would say that the stock of financial assets is always determined endogenously, but it's not always money, as the latter is usually thought of a particular sub-class of financial assets. But that's sort of the point here - it's the endogeneity of financial assets generally, rather than money specifically, that means that there is no loanable funds constraint.
Nick, " it's the endogeneity of financial assets generally, rather than money specifically, that means that there is no loanable funds constraint."
DeleteI get the impression that some of the stuff on the positive money site doesn't seem to take that on board. It is as though they are saying that lending activity will be constrained if lending is funded with longer term financial assets rather than with bank deposits.
I have wondered the same thing.
DeleteYes, I probably expressed that in a rather sloppy way, there. Actual saving and actual lending must necessarily be equal at all times, but desired saving and desired lending need not be. Equilibrium involvesn making desired saving and desired lending equal.
DeleteI have no doubt that it was only a case of econ shorthand and not fundamental misunderstansing on your behalf. On the other hand, I'm not at all certain that this applies to many others who use the same terms. In fact, I think it's baked into the terms themselves.
E.g. the word equilibrium implies a self-correcting (or at least self-sustaining) mechanism which, if we accept for a moment that it is brought upon by movements in the interest rate, in turn implies all other parts,and that includes. the pool of lonable funds, remain equal. It is a monocausal and static model that feels very far removed from reality in that it implies a strong natural bias towards an optimal / natural outcome - something that is hardly observable in reality, unless you're a Hindu or something like that.
From Wiki:
In economics, economic equilibrium is a state where economic forces such as supply and demand are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change.
Whereas you write:
Equilibrium involves making desired saving and desired lending equal.
The word 'making' implies volition, i.e. not a natural or stable state.
But anyway
# ends off-topic rant and moves on to tangential hair-splitting
On your latter part, I would say that the stock of financial assets is always determined endogenously, but it's not always money, as the latter is usually thought of a particular sub-class of financial assets. But that's sort of the point here - it's the endogeneity of financial assets generally, rather than money specifically, that means that there is no loanable funds constraint.
Yes, I can see that. I guess my point regarding endogeneity of money is that the same concept that applies to different classes of financial assets, necessarily also applies within them.
First of all I meant lending and borrowing, not saving and lending - what was I thinking there - I don't know.
DeleteHaving clarified that, it would probably have been better to have said that in equilibrium, desired lending and desired borrowing are equal, rather than that it makes them equal.
No worries, I know what you meant. I actually corrected what you had written and made the same mistake :-).
DeleteAs for equilibrium being the state of equalised desires, I'm having some trouble grasping the concept.
My take: For a loan to be made, desired borrowing and desired lending must be equal. Otherwise the deal doesn't materialise. For every given interest rate, desired lending and desired borrowing are always in equilibrium, individually and in aggregate. So to my mind, it cannot be about the desires of borrowers or lenders. Rather it must be about an authority that seeks to influence the total level of activity according to its own desires / goals. Equilibrium being short-hand for whatever the desired state comprises.
We can think of equilibrium in terms of pressure on prices to change. If there are more buyers than sellers, there will be a pressure for the price to rise and if there are more sellers than buyers, pressure for the price to fall. Equilibrium is when forces pushing prices up balance those pushing it down.
DeleteSorry, don't want to bore you with things that are probably glaringly obvious to you. But just out of curiosity:
DeleteYou say the equilibrium interest rate is that at which prices do not change. How does one know that a: prices are not changing because of that interest rate and b: that prices would change (or, more importantly would keep on changing) if a different interest rate were implemented? And c: why is the place at which things don't change a good place to be? Imo on needs a benchmark against which to measure goodness or badness. But then maybe you weren't implying any of this anyway. Equilibrium just seems a bit of a superfluous concept...
I was being rather general there, so when I talked about buyers, sellers and the price, I was meant buyers and sellers of apples and the price of apples. In the loanable funds market, you have lenders, borrowers and the rate of interest. I didn't say that the equilibrium interest rate is one that keeps general prices constant.
DeleteHowever, I would add to what I said that if buyers and sellers of apples are not equal, it does not need to be the price of apples that changes to make them equal - a change in the price of bananas can also do it. Likewise, if there are more lenders than borrowers, it does not need to be a change in the interest rate that makes them equal.
I think this all depends on a very precise definition of what loanable funds is.
ReplyDeleteWhat's yours?
What is the precise relationship of loanable funds to (Hicks') ISLM?
thanks
A good question. Which I tried to duck here by talking about a loanable funds constraint, rather than loanable funds.
DeleteBy that I meant a constraint whereby if a loan was made from A to B to facilitate B's expenditure, it required that someone else (A or maybe another party to whom A would have otherwise made a loan) would have to cut their own expenditure by an equivalent amount. That seems to me to the context in which it is used by those that want to show that bank credit creation makes new funds available in a way that nothing else can.
In general though, I'm not sure that the concept of loanable funds is anything more than talking about the equality of lending and borrowing and the idea of the rate of interest as the thing that clears the market. I'd say this relates to IS/LM through the IS curve, which would show the interest rate which clears the loanable funds market for any given level of income. This is of course equivalent to saying the level of income which results from spending given a particular interest rate. Does that sound right?
I think its a good question as well because my sense is that there is a lot of very loose thinking particularly in the blogosphere around what exactly is meant by it. And to the extent that's the case, there's a lot of corresponding very loose thinking going on around "rejections" of it.
DeleteAnd because of all that, it is not clear to me at all that "loanable funds" - whatever that is - is necessarily inconsistent with an endogenous money concept at all.
I'm not sure I've ever seen a fully coherent stand-alone explanation of what it means. And by that I mean a verbal explanation - not one that depends on a graph to fill in the blanks.
I'm not referring to your post in particular at all here. I think you're making a point that can be "backed into" a loanable funds concept, and the point you're making is really the important thing rather than the fit to a particular definitional framework.
My understanding of loanable funds is that it is an idea that is represented by the intersection of an I curve and an S curve at the "equilibrium" level of interest rates.
My understanding is that the IS curve of ISLM is actually carved out by a continuous sequence of IS "loanable funds" equilibrium points, where each point corresponds to a particular level of output on the x axis of the ISLM diagram.
Setting that aside for a moment, one interesting thing about the definition is that I and S are Keynesian income identity variables - i.e. national income accounting variables. And those variables have NO direct technical association with "funds" of any type in a monetary economy.
I.e. there is no monetary finance explicitly in C + I + G + X = C + S + T + M.
To get that finance connection, you have to go to a flow of funds accounting framework.
And then to integrate finance with the national income identity, you have to integrate national income accounting with flow of funds accounting.
Which is exactly what Godley and Lavoie did of course.
My point here being that there is no explicit "funds" variable in the I x S framework. There is no monetary variable there.
So I think that's interesting and to me that is a source of fundamental confusion just due to the language that is used in the "loanable funds" definition.
Apart from that, and forgetting that for a moment, I see absolutely no harm done in observing that for the set of balance sheets that exists in the global economy at any time, there is a momentary "equilibrium" where all of the interest rates that exist have conspired to help create that particular "equilibrium". And that to me is merely an extension of IS loanable funds to the full set of flow of funds possibilities, in which I and S are embedded as underlying income output variables to any finance or "funds" lending that may be going on. At the end of the day, S equals I in the global context, and the flow of funds connects those two things as well as a whole bunch of other non-income transactions that are essentially asset swaps.
So my deep seated suspicion as far as the evident broad econ blogosphere attack on loanable funds is concerned, which is typically positioned as an enlightened endogenous money memo, is that people really don't know what they're talking about.
And that's not a judgement on the ability of people to understand what they mean themselves. It's just that not everybody is talking about the same thing, and maybe everybody is even talking about a different thing. Because there's a lot of complexity in the flow of funds and the role that lending plays in that flow of funds. So there are many ways to approach the subject broadly.
And because of all that, its not clear to me at all that "loanable funds" - whatever that means - necessarily contradicts an endogenous money concept - which of course is the way that one usually hears about it these days.
i.e. I'm saying that I'm not at all so sure "loanable funds" has to be interpreted as this sort of evil impediment to the accurate comprehension of funds flows that it is typically made out to be by endogenous money "chanters" (as Nick Rowe likes to call them).
DeleteEndogenous money is a fact based on how you want to define it in the context of a simple, correct understanding of the flow of funds in banking. But I'm really starting to doubt that "loanable funds" is its legitimate foe.
I think I'd agree with you. It seems to me that the endogenous money "chanters" are attacking the idea that borrowing requires a prior decision by someone else to change their savings behaviour. There are two things wrong with this:
Delete1. You don't need endogenous money to show this - that's what I was looking at in this post.
2. The idea that "for every borrower, there's a lender" is not the same thing as saying that the lender has to decide to change their behaviour first. It's this phrase that gets people worked up, but it's really just a statement of accounting.
I interpret loanable funds as just being about the demand and supply for borrowing and lending. if there is a problem with it, it the suggestion that the interest rate plays the main role in clearing the market, when a Keynesian view would emphasise the role of aggregate demand.
I think some people have an idea of the loanable funds market as involving savers bringing a quantity of savings to the market, based on the prevailing interest rate. Borrowers then take what's available, again given the interest rate. So borrowers are somehow limited by what savers "bring along" to the market. Then when they discover that banks can led without first waiting for depositors, they think this somehow removes a constraint. But this is to fail to see that the decision to offer to lend new funds is not the same as the decision to save, i.e. to spend less than income.
Yes, with IS/LM, I tend to think of I as being fully funded by borrowing and C being only funded by income, but you're right there no reason why the lending quantities should relate to the spending quantities at all.
JKH, "chanters?" ... I've seen him use "cultists." Lol
DeleteG&L's loanable funds interpretation (from their book Monetary economics): banks provide loans only insofar as they have the financial resources to do so; in other words, banks make loans only when they have prior access to deposits.
ReplyDeleteTo me, this seems to contradict the endogenous money concept that banks can create bank deposits if they want to.
Anton
I'm not disagreeing, but would you happen to have a page number reference for that?
DeleteAre they saying that's what they think loanable funds means? I'm not sure I'd necessarily agree, although that is the sort of thing I meant by a "loanable funds constraint".
DeleteAt the bottom of page 48. The full text:
ReplyDeleteComing back to Table 2.8A, a very important point, related to the dangers of confusing semantics, must be made. Recall that a minus sign in the transaction matrix is associated with the use of funds, while a positive sign implies the source of funds. In Table 2.8A, in the column of banks, the addition to money deposits is associated with a plus sign, while the addition to bank loans is associated to a minus sign. From a flow-of-funds standpoint, increased deposits are thus a source of funds while increased loans are a use of funds for the banks. For some, this terminology seems to reinforce the mainstream belief, associated with the loanable funds approach, that banks provide loans only insofar as they have the financial resources to do so; in other words, banks make loans only when they have prior access to deposits. The source of the funds to be lent, in Table 2.8A, is the money deposits, as the minus sign would show. Needless to say, this loanable funds interpretation is not being defended
here. On the contrary, a key feature of the banking system is its ability to create deposits ex nihilo. More precisely, when agents in the economy are willing to increase their liabilities, banks can increase the size of both sides of their balance sheet, by granting loans and simultaneously creating deposits.
As neatly summarized by Earley, Parsons and Thomson (1976, 1996: 159), ‘to encapsulate, we see fluctuations in borrowing as the primary cause of changes in spending’. It may be that, in flow-of-funds terminology, money deposits is the source of funds allowing the use of bank loans. But the cause of this increase in deposits and loans is the willingness to contract an additional liability and the desire of the borrower, here the production firm, to expand its expenditures.
OK, so they're saying the idea that deposits must precede loans is associated with the loanable funds approach. I can see that. Again, that was again what I was trying to get at by talking about a loanable funds constraint, even though I'm not sure that loanable funds theory necessarily requires that.
Deletethanks very much
Deletethat doesn't surprise me and is roughly what I recall from last time looking at it
that said, notice the language:
"ASSOCIATED with the loanable funds approach"
G&L are extremely careful with language
so they've left an opening for an ambiguity in the mainstream interpretation of exactly what it is
note also that the "association" is one of banking sources of funds with the loanable funds idea
that's orthogonal to the other idea of loanable funds representing an equilibrium of sorts between saving and investment, where there is no direct monetary association
and it is a certainty that the saving investment monetary nexus is not entirely attributable to banking finance
the simplest case is that investment can be financed from pre-existing funds; that creates an incremental saving investment flow that does not depend on new bank deposits
there are many other examples where the banking interpretation does not map nicely into the ISLM interpretation or the basic IS interpretation
Steve Keen is treading over a wobbly bridge on this issue
I sometimes wonder whether unclear language is actually favored as a rhetorical tool. It allows something to be said that can both not be shown to be false whilst at the same time imparting a misunderstanding. Loanable funds might be just such a rhetorical weapon -used with the intention of spreading a misunderstanding.
DeleteI suspect Bill Mitchell also is a bit guilty of similar rhetorical devices with his pro-deficit message.
Excellent analysis as usual!
ReplyDeleteIn my view, the loanable funds idea originates from an essentially barter economy and tries to apply that concept to a financial economy and gets muddles. Take an economy with just Robinson Crusoe--he wears two hats--one consumer and another producer. there is only one good corn, which both a consumption and investment good. If produces 100 bushels and wants to invest 50 bushels, then he has to save 50 bushels. The 50 bushels of saving are needed to finance 50 bushels of investing. Of course, I am making the implicit assumption that he is at full employment and cannot produce more than 100 bushels. So, even in this simple example, saving is not required to finance investment if he can produce more than 100. In that case, the decision to invest will create the saving. So, the key question is whether resources are generally unemployed. (we can add bells and whistles with intertemporal decisions and production possibility frontier etc. But if we are operating well inside the PPF, then loanable funds is not a constraint.)
In practice, lot of transactions take place on credit--trade receivables and payables, installment purchases, etc. So, as long as resources are not being fully employed, there does not have to be any saving needed to finance borrowing. In practice, we are also probably operating well below capacity most of the time. That is general glut is a feature of capitalism--how often do you see shortages or stockouts, that too widespread?
Srini
This discussion on here made me wonder whether it is all just Blogosphere bother about nothing. Whether there is no problem with policy makers being worried about loanable fund constraint type ideas. Whether actually no waste comes from under-utilization due to misguided ideas that we should save first financially as a way to build up financial capacity for subsequent real investment. Whether in the real world all policy makers realize that saving is the accounting record of investment so we need to encourage constructive real investment directly if we want better machines and such like.
DeleteI Googled about saving and straight up came this from The Economist.
http://www.economist.com/node/3839554
"To maintain high productivity growth, investment rates probably need to rise. Add together the need for greater investment and the likelihood of less easy access to foreign borrowing, and the conclusion is clear: Anglo-Saxon economies with low national saving rates, particularly America, need to save more........
But how, if at all, can governments encourage people to save? Monetary policy is one tool, albeit a blunt one. In recent years, unusually low interest rates have encouraged borrowing and caused asset bubbles, particularly in Anglo-Saxon economies. While this consumption in the short term supported the global economy, it has accelerated the saving decline. A return to more normal levels of interest rates ought to boost saving.
Another approach is simply to force people to save more, for instance by introducing compulsory contributions to new pension accounts. Australia and Switzerland have both done this. (In Australia's case the impact on saving is not clear cut: the saving rate has fallen nonetheless, though arguably by less than it would have done without the mandatory component.) While compulsion may be an important possibility for extreme low-savers, it is decidedly illiberal and most countries have tried to encourage rather than compel more saving.
Their main route has been the tax code. Income-tax systems deter saving by taxing the returns twice (first when the company makes a profit and again when an individual receives the investment income). From the perspective of maximising the incentive to save, the best policy would be a wholesale shift to a consumption-based tax system."
Tell me if I'm wrong, but to me it is very difficult to read it and not get the message that we need to be encouraged to consume less as a way to get more constructive investment (better machines or whatever rather than unsold inventory that goes to waste) that will somehow come about as a result of having financial savings. It seems to entirely miss the crucial point (that Srini here pointed out again) that there is MASSIVE under-utilization of real resources so making a nonsense of the idea that less consumption is conducive to more investment.
Just to clarify, I realize saving=investment.
DeleteI just mean that "good investment" (ie better machines, insulating buildings, transport links etc) is not what we get as a consequence of pressure to increase financial saving. We get that "good investment" as a consequence of actually doing that good investment intentionally. Financial saving for the hell of it can lead to unsold inventory, unemployment, waste and losses and so a subsequent consequential reduction in both real investment and financial saving (trying to save financially reduces the size of the pie from which savings can be taken).
Actually can I voice the seething rant that is at the back of my mind through all of this :).
DeleteThat quote from The Economist exemplifies a frankly evil campaign to sacrifice economic development in favor of gaining a short term valuation boost to pre-existing assets. The intention is to get financial saving as a means towards asset price inflation rather than getting real investment that could disrupt the value of existing capital. They are happy for everyone overall to be poorer if that is what it takes to maintain/increase inequality.
Thanks Srini. I agree the monetray aspect of the economy is a game changer here.
Deletestone - if we are to have more growth, that probably implies a higher saving ratio in the long run. that does not mean however, that simply trying to save more will make the additional investment happen. Also, it doesn't necessarily apply in the short run if capacity is under-utilized. You can increase I / K even if I / Y falls (I = investment, K = capital stock, Y = output)
Yes, monetary aspect of the economy is a game-changer, but not in its role as a medium of exchange for goods. Rather it is money's role as a generalized claim and the desire to have generalized financial claims that share the upside of growth but which can be converted to money when things turn down completely change the nature of the economy.
DeleteBut I also think that the assumption of full employment, explicit or implicit, is the big culprit. And not just in the short-run. In the long-run, demand can create its own supply by increasing investment and incentivizing innovation. So, it is not clear that the world will look "as if" loanable funds holds even in the long run as Nick Rowe often tries to argue.
Srini
Srini,
ReplyDeleteI did think about writing this with government bonds and no mention of money, to emphasise the point that the medium of exchange did not matter, but I thought it would take a bit too much explaning.
As full employment assumption is certainly relevant. If you are assuming that the level of output is given then it is not available as a variable to clear the market for loans, so you have to look to interest rates.
JKH,
ReplyDeleteGood points. "Loanable funds model" is wrong but people think "loanable funds" itself is wrong.