August 16, 2017

Fixing the loanable funds blunder

Comment on Lars Syll on ‘Krugman and Mankiw on loanable funds — so wrong, so wrong’


The loanable funds theory, as presented since time immemorial in the textbooks, is proto-scientific garbage. There is no use at all to discuss one more time what Krugman or Mankiw has to say about the issue. As a matter of principle, constructive Heterodoxy does not waste time criticizing the incompetence of Orthodoxy but fixes matters.

So, let us first put the elementary mathematics of accounting right. At first, we have only the business- and the household sector.#1 The two sectoral balances are given as follows:
Qm≡C−Yw   profit Qm is the household sector’s spending C minus wages Yw,
Sm≡Yw−C    saving Sm is wage income Yw minus consumption expenditures C,
Qm+Sm=0    or Qm≡−Sm.

The business sector’s monetary profit Qm is equal to the household sector’s dissaving. This is the most elementary form of the Profit Law.

For a start, the household sector’s budget is balanced, i.e. C=Yw, hence profit is zero.

Money is needed by the business sector to pay the workers who receive the wage income Yw per period. Money is provided by the central bank in the form of deposits. The average stock of transaction money is given as M=κYw, with κ determined by the payment pattern. In other words, the ‘quantity of money’ M is determined by the AUTONOMOUS transactions of the household and business sector and created out of nothing by the central bank in the form of deposits and overdrafts which are always equal. The economy never runs out of money. The idealized transaction pattern is shown on Wikimedia.#2

The household sector’s deposits/overdrafts are zero at the beginning and end of the period. The business sector’s transaction pattern is the exact mirror image. Money, that is, deposits at the central bank is continually created and destroyed during the period under consideration.

Now, the government sector GS is added. The three sectoral balances are given as follows:
Qm≡C+G−Yw     profit Qm is HS and GS spending C+G minus wages Yw,
Sm≡Yw−T−C      saving Sm is wage income Yw minus taxes T and expenditures C,
Bm≡T−G            budget surplus Bm is taxes T minus government expenditures G,
Qm+Sm+Bm=0   or Qm≡−Sm−Bm.

The business sector’s monetary profit Qm is equal to the household sector’s dissaving plus the government sector’s budget deficit. For a start, taxes T are set to zero and the household sector’s budget is balanced, i.e. C=Yw, i.e Sm=0. In this case, the business sector’s profit is equal to the government’s deficit, i.e. Qm =−G.

The combined transaction pattern of the household- and the government sector is shown on Wikimedia.#3

The transaction pattern of the business sector is the exact mirror image. So, while the government sector ends up with overdrafts, the business sector ends up with deposits of equal magnitude.

Positive/negative balances are the interface between the sphere of production and the financial sphere.

Let us call the deposits loanable funds then it can be said that the ‘supply of loanable funds’ is always quantitatively equal to the ‘demand’. At the end of the period, the accounts of the central bank ― which has created the money for deficit spending out of nothing ―, the business sector, and the government sector look as shown on Wikimedia.#4

The government’s deficit spending causes an increase in the financial assets of the business sector. At first, the financial asset consists of deposits at the central bank that bears zero interest.

In the second step, the public debt is consolidated by the issuance of long-term government bonds or other types of securities. Government securities are offered with a certain maturity and interest rate. In the present case, the business sector is in possession of loanable funds and decides which amount to buy. It is here assumed for simplicity that the whole government debt is consolidated. After the switch from non-interest bearing deposits to interest-bearing bonds, the newly created money vanishes again and the accounts look as shown on Wikimedia.#5

Note that the creation of deposits/overdrafts, i.e. money, is temporally disconnected from the consolidation. The long-term financing of a government deficit may happen before or after the spending has taken place.

As a matter of principle, the ‘supply of loanable funds’ = deposits is ALWAYS quantitatively equal to the ‘demand’ = overdrafts. The terms supply and demand make NO sense at all in the context of money creation.

Matters are analogous with household sector saving and business sector investment. In this case, the monetary profit of the business sector is given by Qm≡I−Sm. By consequence, the increase of loanable funds of the household sector is given by monetary saving Sm and that of the business sector by Qm. The total financing requirement, on the other hand, is given by I.#6 The most important thing to notice is that business sector’s investment expenditure I and household sector’s saving Sm is NEVER equal. To assume that the interest rate equalizes both magnitudes is the lethal blunder of the familiar loanable funds approach.#7

Egmont Kakarot-Handtke

#1 The pure production-consumption economy is defined by the macro axiom set: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X. For a start X=O.
#2 Wikimedia AXEC98 Transaction pattern C=Yw
#3 Wikimedia AXEC99 Transaction pattern C+G greater than Yw
#4 Wikimedia AXEC102 Government deficit spending, creation of money
#5 Wikimedia AXEC103 Government deficit spending, consolidation
#6 For details see ‘Squaring the Investment Cycle
#7 For more details see cross-references Refutation of I=S and cross-references Debt

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