from Lars Syll
As no one interested in macroeconomics has failed to notice, Ben Bernanke is having a debate with Larry Summers on what’s behind the slow recovery of growth rates since the financial crisis of 2007.
To Bernanke it’s basically a question of a savings glut.
To Summers it’s basically a question of a secular decline in the level of investment.
To me the debate is actually a non-starter, since they both rely on a loanable funds theory and a Wicksellian notion of a “natural” rate of interest — ideas that have been known to be dead wrong for at least 80 years …
Let’s start with the Wicksellian connection and consider what Keynes wrote in General Theory:
In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest, namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s ‘natural rate of interest’, which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.
I had, however, overlooked the fact that in any given society there is, on this definition, adifferent natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the ‘natural’ rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.
I am now no longer of the opinion that the [Wicksellian] concept of a ‘natural’ rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.
And when it comes to the loanable funds theory, this is really 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 credit, 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.”
In the traditional loanable funds theory — as presented in mainstream macroeconomics textbooks — the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving isthe supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate. Lowering households’ consumption means increasing savings that via a lower interest.
From a more Post-Keynesian-Minskyite point of view the problems with the standard presentation and formalization of the loanable funds theory are quite obvious.
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.
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, in the loanable funds theory. Loanable funds theory essentially reduces modern monetary economies to something akin to barter systems — something it definitely isnot. As emphasized especially by Minsky, to understand and explain how much investment/loaning/crediting is going on in an economy, it’s much more important to focus on the working of financial markets than staring at accounting identities like S = Y – C – G. The problems we meet on modern markets today have more to do with inadequate financial institutions than with the size of loanable-funds-savings.
The loanable funds theory 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.
A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. To Keynes this was 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 shift, 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.
There are always (at least) two parts in an economic transaction. 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 this ultimately boils done to is — iter — that what happens at the microeconomic level — both in and out of equilibrium — is not always compatible with the macroeconomic outcome. The fallacy of composition (the “atomistic fallacy” of Keynes) has many faces — loanable funds is one of them.
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):
Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving.
So, in way of conclusion, what I think both Bernanke and Summers “forget” when they hold to the loanable funds theory and the Wicksellian concept of a “natural” rate of interest, is the Keynes-Minsky wisdom of truly acknowledging that finance — in all its different shapes — has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.
I may be too bold, but I’m willing to take the risk, and so recommend both Bernanke and Summers to make the following addition to their reading lists …
It should be emphasized that the equality between savings and investment … will be valid under all circumstances. In particular, it will be independent of the level of the rate of interest which was customarily considered in economic theory to be the factor equilibrating the demand for and supply of new capital. In the present conception investment, once carried out, automatically provides the savings necessary to finance it. Indeed, in our simplified model, profits in a given period are the direct outcome of capitalists’ consumption and investment in that period. If investment increases by a certain amount, savings out of profits are pro tanto higher …
One important consequence of the above is that the rate of interest cannot be determined by the demand for and supply of new capital because investment ‘finances itself.’
Share this:
On the irrelevance of general equilibrium theory
from Lars Syll
The general equilibrium approach starts with individual decisions. It assumes that trades are voluntary and that there exist mutually advantageous opportunities of exchange. Up to here, everyone can agree. The problem lies in the next step. At this point, let us folllow David Kreps’s (1990) reasoning in his A Course in Microeconomic Theory. Kreps asks the reader to “imagine consumers wandering around a large market square” with different kinds of food in their bags. When two of them meet, “they examine what each has to offer, to see if they can arrange a mutually agreeable trade. To be precise, we might imagine that at every chance meeting of this sort, the two flip a coin and depending on the outcome, one is allowed to propose an exchange, which the other may either accept or reject. The rule is that you can’t eat until you leave the market square, so consumers wait until they are sat- isfied with what they possess” (196).
Kreps “imagines” other models of this kind. In each of them by the word “market” he means a “market square,” and he introduces rules (“flip a coin,” “nobody can leave before the end of the process”). He is aware that “exploration of more realistic models of markets is in relative infancy.” And when he speaks of “more realistic” models, he means more realistic with respect to perfect competition.
But the problem with perfect competition is not its “lack” of realism; it is its “irrelevancy” as it surreptitiously assumes an entity that gives prices (present and future) to price taking agents, that collects information about supplies and demands, adds these up, moves prices up and down until it finds their equilibrium value. Textbooks do not tell this story; they assume that a deus ex machina called the “market” does the job.
Sorry, but we do not want to teach these absurdities. In the real world, people trade with each other, not with “the market.” And some of them, at least, are price makers. To make things worse, textbooks generally allude to some mysterious “invisible hand” that allocates goods optimally. They wrongly attribute this idea to Adam Smith and make use of his authority so that students accept this magical way of thinking as a kind of proof.
Perfect competition in the general equilibrium mode is perhaps an interesting model for describing a central planner who is trying to find an efficient allocation of resources using prices as signals that guide price taker households and firms. But students should be told that the course they follow—on “general competitive analysis”—is irrelevant for understanding market economies.
Emmanuelle Benicourt & Bernard Guerrien
I can’t but agree with these two eminent French mathematical economists. You could, of course, as Brad DeLong has asserted, consider modern neoclassical economics to be in fine shape “as long as it is understood as the ideological and substantive legitimating doctrine of the political theory of possessive individualism” and you manage to put a blind eye to all the caveats to its general equilibrium models — markets must be in equilibrium and competitive, the goods traded must be excludable and non-rival, etc, etc. The list of caveats soon becomes impressively large — and not very much value is left of “modern neoclassical economics” if you ask me …
Still — almost a century and a half after Léon Walras founded neoclassical general equilibrium theory — “modern neoclassical economics” hasn’t been able to show that markets move economies to equilibria.
We do know that — under very restrictive assumptions — equilibria do exist, are unique and are Pareto-efficient. One however has to ask oneself — what good does that do?
As long as we cannot show, except under exceedingly special assumptions, that there are convincing reasons to suppose there are forces which lead economies to equilibria — the value of general equilibrium theory is negligible. As long as we cannot really demonstrate that there are forces operating — under reasonable, relevant and at least mildly realistic conditions — at moving markets to equilibria, there cannot really be any sustainable reason for anyone to pay any interest or attention to this theory.
A stability that can only be proved by assuming “Santa Claus” conditions is of no avail. Most people do not believe in Santa Claus anymore. And for good reasons. Santa Claus is for kids, and general equilibrium economists ought to grow up.
Continuing to model a world full of agents behaving as economists — “often wrong, but never uncertain” — and still not being able to show that the system under reasonable assumptions converges to equilibrium (or simply assume the problem away) is a gross misallocation of intellectual resources and time.