October 16, 2016

A new episode of one of the worst blunders of economics

Comment on Jo Michell on ‘What is the loanable funds theory?’

Blog-Reference

“Throughout the 1920s and 1930s the focus was increasingly on the role of the equality of saving and investment, but the semantic squabbles that dominated much of the debate (the distinctions between ‘ex ante,’ and ‘ex post,’ ‘planned’ and ‘realized’ saving and investment, the discussion of whether the equality of saving and investment was an identity or an equilibrium condition) reflected a deeper confusion.” (Blanchard, 2000, p. 1378)

As always in economics, confusion is not resolved but warmed up in irregular intervals. Jo Michell starts a new episode of loanable funds storytelling with this statement: “OK, but saving equals investment by definition in macroeconomic terms: the famous S = I identity. How can there be a market which operates to ensure equality between two identically equal magnitudes?”

This statement, which has been already false in the 1930s, is a paradigmatic example of the enduring scientific incompetence of economists.

Roughly speaking, the loanable funds theory says that saving and investment are equalized by the interest rate mechanism, which is a variant of standard supply-demand-equilibrium. What the representative economist has not realized until this day is that all three elements of the general market model (supply function, demand function, equilibrium) are NONENTITIES. This means that Wicksell’s natural-rate model has already been dead in the cradle. However, as the saying goes: “The difficulty lies, not in the new ideas, but in escaping from the old ones …”. This applies to Walrasians AND Keynesians.

Keynes formulated the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

This elementary syllogism is conceptually and logically defective because Keynes never came to grips with profit (Tómasson et al., 2010, p. 12).*

Let this sink in: Keynes had NO idea of the fundamental concepts of economics, that is, of profit and income. His error/mistake carried over to National Accounting. Post-New-After-Keynesians never detected and rectified Keynes’s lethal blunder.

The correct profit equation for the investment economy reads: Qm=Yd+I-Sm. Legend Qm: monetary profit, Yd: distributed profit, Sm: monetary saving, I: investment expenditures. The profit equation gets a bit longer when government and foreign trade is included.

The difference between investment and saving I-Sm plus distributed profit Yd determines monetary profit Qm for the economy as a whole. Saving is NEVER equal to investment, neither ex ante nor ex post nor otherwise, and there is NO mechanism to equalize them, that is, NO such thing as supply-demand-equilibrium. The whole discussion about whether the Wicksellian interest rate mechanism or the Keynesian income mechanism establishes the equality/equilibrium of saving and investment is entirely vacuous. BOTH models are provable false. Because of this, the discussion about monetary and fiscal policy NEVER had a sound scientific foundation and as a consequence economic policy guidance became the very CAUSE of unemployment/deflation/depression/stagnation.

To conclude:**
(i) All I=S/IS-LM models from Keynes/Hicks to the present are provable false.
(ii) The loanable funds/natural interest rate theory is provable false.
(iii) The classical and Keynesian profit theories are provable false.

The representative economist has not gotten (i) to (iii) since 80 years. This includes Joe Michell. Whoever states in 2016: “... saving equals investment by definition in macroeconomic terms...” flunks the entry level intelligence test of science.

Egmont Kakarot-Handtke

* See post ‘How Keynes got macro wrong and Allais got it right
** For details and formal proofs see cross-references

Related 'Macrofoundations, too, are defective'