Europe, Sick Man of the World Economy — Europa, kranker Mann der Weltwirtschaft?

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Zwei Zitate: Bridgewater vermutet, dass die nächste Krise von Europa ausgehen wird, und Draghi bestätigt prompt wenige Tage später, dass das Wirtschaftswachstum in Europa zunehmenden Risiken ausgesetzt sei.

Two quotes: Bridgewater suspects that the next crisis will emerge from Europe, and just a few days later Draghi confirms that economic growth in Europe is facing increased risks.

Quote 1:

And while Bridgewater is clearly bearish on developed markets such as the US  [... c]uriously, Jensen does not believe the next market swoon will emerge from the US; instead he said "European markets will be the first test" as the region is "starting from a worse level in terms of the economy, lower inflation - close to deflation in many places - and already have negative interest rates" adding that "their movement will be kind of a leading indicator because they’re going to struggle more with easing” than the U.S. or China, which have "more tools available to them."

The source.

Quote 2:

"The risks surrounding the euro area growth outlook have moved to the downside on account of the persistence of uncertainties related to geopolitical factors and the threat of protectionism, vulnerabilities in emerging markets and financial market volatility"

As a reminder, in Draghi's last statement, the central banker said "the balance of risks is moving to the downside" confirming not only that the European economy is now on the verge of contraction, but that this chart, showing that the Eurozone is now effectively in a recession has not been lost on the ECB.

The source.

A Look at the Money Supply — Ein Blick auf die Geldmenge (2)

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Continued from here.


... as the chart below suggests, lower money supply growth has always pointed to weaker global economic momentum going forward. In fact, if one uses Global Industrial Production growth as a proxy for the global economic expansion, or contraction, the World is now almost certainly in a recession ...

Make sure to read the entire article here.

A Look at the Money Supply — Ein Blick auf die Geldmenge (1)

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A post in German and English.

Könnte es sich so verhalten?

Could it be like this?

Warum ist die Geldmenge ein Indiktor für die Gesundheit einer Wirtschaft? Antwort: Wirtschaftswachstum bedarf der Ausweitung der Geldmenge.

Why is the money supply an indicator for the health of an economy? Answer: economic growth depends on a growing money supply.

Wenn aber Banken die Geldmenge ausweiten, sollten sie damit produktive Projekte finanzieren. Tun sie das nicht, entsteht unproduktives, inflationäres Wirtschaftswachstum, es werden Blasen an den Finanzmräkten, im Immobiliensektor etc. aufgepumpt.

When banks increase the money supply by extending loans, they ought to be targeting productive investments. Otherwise economic growth will be unproductive and inflationary, pumping up bubbles in financial and other markets (real estate etc.)

Quantitative Easing scheint genau das bewirkt zu haben. Während der Aktienmarkt von weiterer geldpolitischer Lockerung abhängig geworden ist, haben sich die grundlegenden konjunkturellen Bedingungen nicht durch QE verbessert – vielmehr scheinen sie sich eher abgeschwächt zu haben.

Quatitative easing appears to have achieved precisely that. While the stock market has become dependent on continued quantitative easing, QE has not ameliorated the fundamental condition of the economiy, which indeed seem to have deteriorated.

Die Ausdehnung der Geldmenge mihilfe der Geldpolitik hat also kaum Erfolg gezeitigt, was die Verfassung der Realwirtschaft angeht. Wenn die Zentralbanken jedoch an diesem Instrument festhalten, werden nur die Marktblasen am Leben gehalten, während sich die fundamentale Lage der Wirtschaft nicht verbessert.

Increasing the money supply by means of monetary policy has hardly been successful in  improving the real economy. Should central banks adhere to this instrument, the bubbles will be granted another lease of life while the fundamental economic situation will not become any better.

Gezielte Fiskalpolitik ist gefragt. Geldpolitik bringt Geld in die Wirtschaft ein, das nicht zweckgebuden ist: Statt Kredite auszureichen, können Banken in Finanztitel investieren. Direkte fiskalpolitische Ausgaben zur Finanzierung z. B. von Infrastrukturprojekten gewährleisten, wenn klug gewählt, dass die zusätzliche Geldmenge in produktive Investitionen gesteckt wird, die die grundlegende Verfassung der Wirtschaft verbessern.

Targeted fiscal policy is needed. Monetary policy injects money into the economy that is not designated for a specific purpose; monetary policy is not a tool compelling banks to extend (productive) loans; the latter may decide to make or support (unproductive but lucrative) investments in financial titles instead. Prudently earmarked fiscal spending is called for, financing (, say, infrastructure) projects capable of improving the condition of the economy.

Continued here / fortgesetzt hier.

Economy Driven by Quantity of Money Not Price of Money

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A post in German and Englisch.

Ich zitiere Richard Werner aus seinem von mir übersetzten Buch New Paradigm in Macroeconomics mit dem nicht so schönen deutschen Titel (stammt nicht von mir): Neue Wirtschaftspolitik. Was Europa aus Japans Fehlern lernen kann.

Wenn das nächste Mal ein Zentralbanker ankündigt, die Zinsen anzuheben, um das Wachstum zu verlangsamen oder die Zinsen zu senken, um die Wirtschaft zu beleben, wissen wir nunmehr, dass er einen ausgemachten Unsinn von sich gibt. (S. 148)

Was er damit meint, erklärt er im Video unten auf Englisch.

Richard Werner argues that interest rates precede rather than antecede changes in the economy, implying that central bankers are unable to do what they claim they are doing — slow down or boost the economy by increasing or cutting interest rates. Economies are not driven by the price of money (interest rates) but by the quantity of money (created by the banking system) which is either productively invested leading to sustainable growth or unproductively creating inflation. He explains his thinking in the video below:

See also Princes of the Yen.

Fed's Defensive Rate Cut Sign of Recession — Defensive Zinssenkung verrät bevorstehende Rezession

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Der verräterischste Vorbote für eine Rezession ist nicht das Anziehen des Leitzins, sondern die erste Leitzinssenkung nach einer längeren Phase, in der die Zinsen wieder gestiegen sind/angehoben wurden.

Over the weekend, we pointed out a concerning statistic: it's not the rate hikes that stifle economic growth and send stocks sliding that traditionally telegraph the start of a recession - it's the first rate cut following a tightening cycle that is usually the trigger. Case in point: the last three recessions were all preceded with the Fed cutting, i.e., the Fed loosened policy within three months before the previous three recessions, cutting by 0.25% in 1991, 1.5% in 2001 and 0.5% in 2007.

Source/Quelle.

Wall Street Journal At Its Worst? — WSJ so schlecht wie noch nie?

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Hat das Wall Street Journal je einen schlechteren Artikel geschrieben? 

So lautet ein interessanter Blog-Beitrag von Cullen Roche: Is This The Worst Thing The WSJ Has Ever Published?

Der Autor beklagt unter anderem folgende sachlichen Irrtümer im Artikel des WSJ: 

(1) Die Zentralbank zahlt Zinsen auf Reserven, um ihren Leitzins zu verteidigen, und nicht um Banken auf diese Weise effektiv dafür zu belohnen, dass sie KEIN Geld verleihen. Die Banken hätten gerne Kredite vergeben, wenn sich Kreditnehmer von ausreichender Bonität gefunden hätten, was nach der Finanzkrise aber nicht der Fall war.

(2) Obama war nicht „schuld“ an höheren Staatsschulden nach der Finanzkrise; die Staatsschulden  sind gestiegen, weil die „automatischen Stabilisatoren“ wirksam wurden – das Zusammenspiel schwächeren Wachstums, geringerer Steuereinnahmen und höherer Staatsausgaben vor allem für sozialpolitische Zwecke (Arbeitslosengeld etc.).

(3) Banken leihen nicht ihre Reserven aus. Die brauchen sie nur, um Nettozahlungen untereinander zu ermöglichen. Bankreserven sind ein "Spezialgeld", dass nur zwischen Banken und der Zentralbank zirkuliert. Sie sind das Zahlungsmittel, das von der Zentralbank verrechnet wird, um Nettozahlungen zwischen Banken zu dokumentieren und zu vollziehen.

(4) Die an den meisten Universitäten noch heute gelehrte Theorie vom Banken-Multiplikator ist pure Fantasie. Weder leihen Banken ihre Reserven aus, noch sind die von ihnen ausgereichten Kredite an einen solchen Multiplikator (einen Prozentsatz der Mindestreserven) gebunden.

(5) Nein, es ist nicht richtig zu sagen, die Banken hätten früher keine Überschussreserven bereitgehalten (oder nicht in der Größenordnung wie dies seit der Politik der quantitativen Lockerung (QE = Quantitative Easing) der Fall sein sollte), weil ihnen dafür kein Zins geboten worden ist. Die Banken sind von der Zentralbank dazu gezwungen worden, Überschussreserven zu halten, weil die Fed das QE einigermaßen kompromisslos durchgezogen hat (den Banken gegen Bankreserven Aktiva abgekauft, als einen Aktiventausch in den Bilanzen der Banken bewirkt hat). Die auf die Überschussreserven gezahlten Zinsen hatten die Funktion, den Leitzins zu verteidigen, d. h. die Banken daran zu hindern, den Leitzins – im Bemühen unrentierliche Bankreserven untereinander wenigstens gegen eine geringe Zinszahlung zu verleihen – bis auf null Prozent herabzubieten.

Asset Bubble Pricker (Powell) versus Bubble Blower (Trump)?

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Put very crudely, Nomura suggests that Powell is not willing to countenance a Fed stance that has enhanced systemic risk by blowing up a huge equity bubble — very interesting article, make sure to follow up the historical statements by Powell.

Nomura's

McElligott writes that "it is increasingly obvious to me that J. Powell believes that the balance sheet expansion has engendered excessive risk-taking and outright asset bubbles, which in-turn are likely the largest systemic risks to the US financial system." 

If the Nomura strategist is correct, that would have epic consequences for a market which is convinced that it is only a matter of time before the Fed put is hit for the simple reason that... there is no Fed put. As McElligott concludes, "speculation has always been that Powell and Jeremy Stein were the “catalysts” behind what ultimately became the “taper tantrum” episode in 2013 as well—and as a smart client said last night, "Just wait until the 2013 transcripts come out…the notion of the policy put is sorely mistaken." 

The good news is that once the current pension fund reallocation concludes and the bear market rally ends and the vicious selling resumes, Charlie's theory can easily be tested if when the S&P drops back below 2,400.... then 2,300.... then 2,200... then 2,100 and 2,000... Powell still does nothing - much to the fury of President Trump - then yes, it will indeed be the case that any hopes for a Fed put will have been "sorely mistaken."

The source. (Emphasis added)

Borio on Money, Debt, Trust and Central Banking

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For future reference:

Borio and Mason.

Geldpolitik: Quantitative Lockerung – Warum Banken Vermögenswerte an die Zentralbank veräußern

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Es gibt zentrale Fragen, die beantwortet werden müssen, wenn man einen größeren Zusammenhang verstehen will. Und doch werden sie nirgends beantwortet. 

Das ist mir beim Thema Quantitative Lockerung so ergangen. 

Wieder und wieder heißt es, die Zentralbank kaufe Vermögenswerte von den Banken (die dafür Bankreserven erhalten). Aber warum sollten Banken bereit sein, der Zentralbank Vermögenswerte zu verkaufen? 

Im Video unten stoße ich erstmals auf eine Antwort. 

Den Banken drückt der Schuh – sie haben nämlich Vermögenswerte im Portfolio, die ihnen gar nicht behagen – Anleihen von hoch riskanten Emittenten. Diese Aktiva sind die Banken gerne bereit zu verkaufen.

Eigentlich möchte die Zentralbank, die Banken dazu bewegen, Kredite auszureichen, um so die Wirtschaft zu stimulieren. Nun ist es aber so, dass die Banken das Nullzins-Niveau nutzen, um billiges Geld aufzunehmen, um damit sichere Staatsanleihen zu erwerben, die eine geringe, aber positive Rendite abwerfen. Die Banken nehmen Geld zu nur wenig über null Prozent auf und kaufen Anleihen, die 2 % rentieren. Ein risikoloser Ertrag von fast 2% ist den Banken sicher.

Nun schickt sich die Zentralbank an, diese Staatsanleihen zu kaufen, d. h. der Preis dieser Papiere steigt und ihre Rendite sinkt - sinkt so sehr, dass sie den Banken kaum noch lohnend erscheint. Im Vergleich dazu wäre es interessanter, Kredit zu vergeben – mit einer Rendite von 5%, vielleicht sogar 7% oder 8%.

Das alles kommt mir ziemlich "hebgedreht" vor – zumal vor dem Hintergrund  dieser Analyse der Irrtümer, die der Quantitativen Lockerung zugrunde liegen. 

Was man nicht alles tut für seine ideologischen Götzen. Der Neoliberalismus verteufelt die Fiskalpolitik, mit der sich wirkungsvolle Konjunkturpolitik aber viel eher verwirklichen lässt. Stattdessen wird darauf bestanden, es müsse die Geldpolitik sein, an der die Wirtschaft genesen solle. Und schon ist der Tunnelblick aktiviert und alle Fantasie beschränkt sich auf die Möglichkeiten, die uns das Instrument der Leitzinsgestaltung an die Hand gibt.

Geldpolitik: Quantitative Lockerung

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In diesem Post habe ich auf einen guten Artikel hingewiesen, in dem vom aktuellen Übergang von einer Geldpolitik der Quantitativen Lockerung zu einer restriktiveren Vorgehensweise der Zentralbanken die Rede ist.

Was ist eigentlich Quantitative Lockerung und warum wird sie betrieben?

Der größere Rahmen, innerhalb dessen diese Form der expansiven Geldpolitik gewählt wird, ist ideologisch gefärbt und beruht auf sachlichen Irrtümern.

Geldpolitik sei wirkungsvoller als Fiskalpolitik, die mit dem ideologisch abgelehnten Staatsinterventionismus gleichgesetzt wird. Tatsächlich ist der geldpolitische Impuls, der von Quantitativer Lockerung ausgeht weniger wirkungsvoll als fiskalpolitische Maßnahmen. 

Außerdem muss man sich die Frage stellen, warum geldpolitische Eingriffe weniger staatsinterventionistisch sein sollen – ist das durch die ineffektive Quantitative Lockerung unnötig perpetuierte Brachliegen volkswirtschaftlicher Ressourcen (siehe unten) nicht ein massiver Eingriff des Staats in die Wirtschaft? Und wäre es nicht gescheiter, den Staat dazu zu benutzen, um die Gesamtnachfrage anzukurbeln, wozu keine Eingriffe in die Wirtschaft erforderlich sind, die wir nicht schon längst praktizieren und allerseits gutheißen, wie etwa den Straßenbau oder die Bereitstellung finanzieller Mittel für privatwirtschaftlich betriebene Projekte? 

Und schließlich sind die Gründe für die Quantitative Lockerung (QL) und deren vermeintliche Wirkungsweise irrig.

Die falsche Theorie hinter der QL nimmt an, dass Banken zuerst mit Reserven versorgt werden müssen, bevor sie weitere Kredite ausreichen können (Falsch!). Diese Kredite sollen die Wirtschaft ankurbeln. Doch der Grund, wieso die Banken das Kreditvolumen nicht ausweiten besteht darin, dass die beiden unerlässlichen Voraussetzungen für die Bereitschaft von Banken Kredite auszureichen, nicht gegeben sind: Kreditnehmer, die Kredit nachfragen und ausreichende Bonität aufweisen.

Wären letztere Voraussetzungen erfüllt, bedürfte es keiner QL. Die Banken könnten Kredite nach Herzenslust ausreichen und sich gegebenenfalls nachträglich mit Reserven versorgen. 

Die Reserven werden also nicht benötigt, um die Kreditvergabe durch die Banken, sondern um den Zahlungsverkehr zu ermöglichen, der einsetzt, wenn Kreditnehmer Kreditmittel an Kunden anderer Banken überweisen. Diese Überweisungen zwischen Banken erfolgen durch Übertragung von Bankreserven  von der zahlenden an die empfangende Bank.

Zurück zur QL.

Nachdem die Zentralbanken mit ihrem herkömmlichen geldpolitischen Latein am Ende sind – die Zinsen lassen sich nicht mehr senken, da sie auf null abgesunken sind –, soll nun ein besonderer Einfall die Lösung bringen. 

Wenn die Wirtschaft schwächelt, bedeutet herkömmliche Geldpolitik: Zinsen senken. Die Hoffnung ist, dass niedrigere Zinsen, Unternehmen dazu bewegen, Investitionen zu wagen, die sie bei höherem Zinsniveau nicht in Angriff nehmen würden. Für sich schon eine fragwürdige Annahme, denn in einem günstigen Wirtschaftsumfeld werden Investitionen auch auf hohem Zinsniveau vorgenommen. Geht es der Wirtschaft hingegen schlecht, werden auch dann keine Investitionen getätigt, wenn die Zinsen niedrig sind. Letzteres haben die Erfinder der QL nicht begriffen. Sie versuchen etwas anzuschieben, in dem sie eine Schnur nach vorne drücken – die aber legt sich nur in Falten.

Die Zentralbanken hängen einer irrigen Theorie an, nämlich dass Banken Kundeneinlagen einsammeln, um so Reserven aufzubauen und einen Teil davon mit einem entsprechenden Aufschlag in Form von Krediten an Investoren weiterzugeben.

Basierend auf einer falschen Vorstellung von der Arbeitsweise des Banksystems, ist man mit der Politik der QL also darum bemüht, etwas zu bewirken, was nicht nötig ist und nicht funktionieren kann, nämlich Banken mit Reserven zu versorgen, auf dass diese ihr Kreditvolumen (trotz fehlender Kreditierungsanlässe) ausdehnen mögen. 

Zu diesem Zweck ermutigt die Zentralbank Banken zu Asset-Swaps, dem Tausch von Vermögenswerten bestimmten Typs gegen solche anderen Typs. Sie kauft den Banken z. B. Staatsanleihen ab und schreibt diesen den Kaufpreis als Guthaben auf deren Konten für Bankreserven bei der Zentralbank gut.

So, nun haben die Banken Reserven, aber noch immer keinen Grund, Kredite zu vergeben.  

Die andere Idee, die hinter der QL steckt ist, dass der Ankauf langlaufender Anleihen durch die Zentralbank die Zinsstrukturkurve am langen Ende herabdrückt und somit auch die Zinsen für längerfristige Investitionen. Doch ist ungewiss, ob dieser Effekt in nennenswertem Umfang greift  – warum sollen Unternehmen Investitionen tätigen, wenn sie selbst oder ihre Kunden überschuldet sind – und ob er nicht wieder zunichtegemacht wird durch die Nachteile, die Anlegern und letztlich der Wirtschaft (aufgrund geringer Zinseinnahmen und geringerer Konsumneigung) daraus erwachsen.

Eine falsche ökonomische Theorie lässt Zentralbanken die im Vergleich zu fiskalpolitischen Maßnahmen (Staatsausgaben/Steuersenkungen) viel ineffektivere Geldpolitik (Leitzinsgestaltung) favorisieren.

Ergebnis: Viel Lärm um Nichts.

Halt. Gleichgültig ist der Irrtum nicht. Es findet eine enorme Ressourcenverschwendung durch Nichtnutzung statt.

For an English account click here.

Government Money versus Bank Money

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An excellent outline of the difference between government money and bank money demonstrating that addition to and or substraction from net financial assets (held by the non-government sector) can only be effected by government spending (its own new money) or the reverse: government withdrawing (largely by taxation) more of its money from the economy than it puts into it.

The below excerpt is from here. The author reponds to this title of an article by Steve Roth: Actually, Only Banks Print Money.

Actually, not really. Only governments have "printing presses" and other attempts to "print money" are called counterfeiting. Steve Roth knows this, of course, so he must being using "printing money" in another sense. Banks don't have printing presses in the basement, literally or figuratively. Governments that issue their currencies as government liabilities do.

Banks increase M1 money supply by adding assets as receivables to their balance sheets as receivables  and booking corresponding liabilities as payables. The reverse shows up on the borrower's balance sheet. Both sets of books are in balance, with net zero on the respective balance sheet. Credit and debit entires match. Now the bank has an asset on its balance sheet and the customer has a credit in a deposit account. So even though the net is zero in the financial system, purchasing power increases in nongovernment owing to the increase in M1 money supply as a result of the deposit in the customer's deposit account.

Why is this not a form of "printing money" then, as Steve Roth claims?

When a central bank issues the government's currency it creates liabilities on its balance sheet and assets on the balance sheets of banks as deposits at the central bank. Assets increase in nongovernment as a whole without a corresponding liability in nongovernment. There is a change in aggregate nongovernment financial assets.

When banks create a deposit by extending a loan, there is no change in aggregate net financial assets in nongovernment. The net is zero. When central banks deficit spend, there is. The net is the amount of the deficit.

A currency is the unit of account that which the government sets and which it accepts as payment of obligations it imposes on nongovernment, chiefly taxes but also tariffs, fees and fines. When banks settle accounts with the government as proxies for customers, they have to settle in the government's liabilities, either cash or bank reserves in the central bank payments system. This is what "printing money" implies. 

All currency users including banks have to obtain the currency as government liabilities, and the only source is government issuance of the currency through spending or lending, since only government can create government liabilities. In modern monetary production economies, governments delegate this power to their central bank as the government's financial agent. 

The currency sovereign's ability to create its own liabilities is unlimited. The constraint is the availability of real resources for sale in the currency, since over-issuance risks inflation. Correspondingly, under-issuance risks contraction and ultimately deflation.

For example, when a taxpayer pays taxes to the government that issues the currency, one of two things happen. Either the taxpayer pays in cash at a government office, or tenders payment through a bank, e.g., a paper check or electronic check. If cash, that cash is deducted from currency in circulation, reducing M1. 

If by check, the check has to clear in the government's payment system. In this case, the government charges the bank's account in the payments system and the bank corresponding charges the customer's account at the bank. If there are insufficient funds in the customer's account, then the bank bounces the check and the funds are not deducted from the banks' account at the central bank. This illustrates the huge difference in kind between the "money" banks generate through credit issuance in M1, and the "money" that the government issues through its financial agent, the central bank.

What happens if the bank doesn't have enough funds in its account at the central banks to cover its obligations? Either the bank borrows in the interbank market at the policy rate set the central banks sets, or the central bank just lends the funds to the bank so the payment system to clear. But the bank is charged a penalty rate set above the policy rate to discourage this, and a bank that abuses the "discount window" risks its standing and ultimately its position in the payments system.

Again, a pseudo-problem arises from using "money" without a proper technical definition, or else not paying attention to the existing definitions. Similar problems arise with other key financial and economic terms, such "the interest rate," "capital," and "saving."

SteveRoth is correct that loans creating deposits adds to the M1 money supply, but this is not currency issuance in the customary meaning of the phrase. Government's issuance of liabilities in the government's unit of account is not the same as banks creation of its own liabilities in the government's unit of account, which the bank cannot issue, being currency users and not issuers. 

If banks could "print money" in the sense of issue currency as the government creates its own liabilities by marking up accounts on its spreadsheet, banks' risking would not risk insolvency owing to default on loans they extend. This is not the case. Conversely, government bonds are default-risk free since the government can always issue currency to cover its obligations to security holders.

However, because bank credit increases M1, which adds to purchasing power in nongovernment, bank lending can affect the price level and spur inflation. Similarly, contraction in bank lending that is not offset is deflationary.

Steve Roth also thinks that issuance of government securities to offset deficits, which is mandatory in the US, sterilizes those funds so that they don’t add to money in the sense of M1. This is not the case. The funds that government injects increase M1 since currency is issued by crediting deposit account, which adds to M1. 

Taxes subtract from both M1and also aggregate nongovernment financial assets. Payment for purchase of newly issued government securities decreases M1, but those government liabilities are simply switched from deposit accounts in the payments system to time deposits at the central bank. The amount of nongovernment net financial assets remain the same in aggregate.

Moreover, government securities are the most liquid form of financial asset after cash, short term bills are essentially cash equivalents, and government securities are the best form of collateral, spending is not affected by draining the monetary base as deposit accounts at the central bank to time deposits at the central bank. 

Issuance of government securities does not sterilize deficit spending. There are other reasons to issue government securities, but this is not one of them. Chiefly, government securities issuance drains the monetary base, facilitating the central bank hitting its target when not paying interest on excess reserves and not choosing to set the policy rate to zero. Government securities also provide interest-bearing default-free risk instruments for the financial community and nongovernment savers. Issuance of government securities is not necessary operationally. It is a policy choice, hence political.

Ok, this looks like semantics and logic-chopping. But it is not. It’s just as important to create conceptual models that are correct as it is formal models. This means weeding out the weasel words, clarifying concepts and getting description right. Some formalism in needed in this regard, but it is not econometric but double-entry accounting. This requires thinking in terms of T-accounts, and that needs to be check by writing it out.

See Eric Tymoigne, The Financial System and the Economy: Principles of Money & Banking, v. 2.1. 

Asymptosis

Actually, Only Banks Print Money

Steve Roth

Loanable Funds Theory and Financial Crowding Out

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Bill Mitchell offers an excellent exposition of the false loanable funds theory on which the inaccurate argument is based that government deficits supposedly locks out the private sector from sources of funding. 

In reality, a government's ability to finance its spending is unlimited. It neither requires government to bar out private investors from markets providing funds, nor does it inevitably cause interest rates to rise — in fact, it will tend to put downward pressure on the rate at which banks can borrow reserves. At the same time, the level of interest rates is controlled by government, who may or may not alter — at its discretion — the interest rate determined in the interbanking market.

In addition to this, the loanable funds theory (LFT) has a number of serious problems.

(1) LFT begs the question where the money comes from that savers are supposedly lending to banks which, according to LFT, in turn lend it on to investors. Of course, LFT does not have the right answer to that question, as it fails to account for the fact that ultimately new money is spent into existence by deficit spending government and banks empowered to issue credit money ex nihilo. 

(2) How is significant non-deflationary economic growth supposed to be brought about, when consumers turn into non-consumers by becoming lending savers. To put it less awkwardly: the funds that go into funding investments are no longer available to fuel effective demand. Logically related to this is the question:

(3) How are temporal lags avoided, when changing interest rates shift the relative proportions of investments and savings? And then there is the Achilles heel of classical economics: Say's Law (supply creates its own demand and thus equilibrium) — what is it that ensures correct investment decisions and successful implementation? It is not clear how changed interest rates per se achieve these twin requirements.

On a technical note, I am sick and tired of having to go through all that reformatting in Blogger that needs to be done when using the function that makes quotes visible by indentation. So, I italicise my writing, the remainder is the quoted piece. 

ooo

The normal presentation of the crowding out hypothesis, which is a central plank in the mainstream economics attack on government fiscal intervention is more accurately called financial crowding out.

At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

In Mankiw, which is representative, we are taken back in time, to the theories that were prevalent before being destroyed by the intellectual advances provided in Keynes’ General Theory. Mankiw assumes that it is reasonable to represent the financial system as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”

This is back in the pre-Keynesian world of the loanable funds doctrine (first developed by Wicksell).

This doctrine was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.

So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

The following diagram shows the market for loanable funds.

The current real interest rate that balances supply (saving) and demand (investment) is 5 per cent (the equilibrium rate).

The supply of funds comes from those people who have some extra income they want to save and lend out.

The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc).

The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.

Note that the entire analysis is in real terms with the real interest rate equal to the nominal rate minus the inflation rate.

This is because inflation “erodes the value of money” which has different consequences for savers and investors.

Mankiw claims that this “market works much like other markets in the economy” and thus argues that (p. 551):

The adjustment of the interest rate to the equilibrium occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage … would encourage lenders to raise the interest rate they charge.

The converse then follows if the interest rate is above the equilibrium.

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Mankiw also says that the “supply of loanable funds comes from national saving including both private saving and public saving.” Think about that for a moment.

Clearly private saving is stockpiled in financial assets somewhere in the system – maybe it remains in bank deposits maybe not. But it can be drawn down at some future point for consumption purposes.

Mankiw thinks that fiscal surpluses are akin to this. They are not even remotely like private saving. They actually destroy liquidity in the non-government sector (by destroying net financial assets held by that sector).

They squeeze the capacity of the non-government sector to spend and save. If there are no other behavioural changes in the economy to accompany the pursuit of fiscal surpluses, then as we will explain soon, income adjustments (as aggregate demand falls) wipe out non-government saving.

So this conception of a loanable funds market bears no relation to “any other market in the economy” despite the myths that Mankiw uses to brainwash the students who use the book and sit in the lectures.

Also reflect on the way the banking system operates – read Money multiplier and other myths if you are unsure.

The idea that banks sit there waiting for savers and then once they have their savings as deposits they then lend to investors is not even remotely like the way the banking system works.

This framework is then used to analyse fiscal policy impacts and the alleged negative consequences of fiscal deficits – the so-called financial crowding out – is derived.

Mankiw says:

One of the most pressing policy issues … has been the government budget deficit … In recent years, the U.S. federal government has run large budget deficits, resulting in a rapidly growing government debt. As a result, much public debate has centred on the effect of these deficits both on the allocation of the economy’s scarce resources and on long-term economic growth.

So what would happen if there is a fiscal deficit. Mankiw asks: “which curve shifts when the budget deficit rises?”

Consider the next diagram, which is used to answer this question. The mainstream paradigm argue that the supply curve shifts to S₂.

Why does that happen? The twisted logic is as follows: national saving is the source of loanable funds and is composed (allegedly) of the sum of private and public saving. A rising fiscal deficit reduces public saving and available national saving.

The fiscal deficit doesn’t influence the demand for funds (allegedly) so that line remains unchanged.

The claimed impacts are: (a) “A budget deficit decreases the supply of loanable funds”; (b) “… which raises the interest rate”; (c) “… and reduces the equilibrium quantity of loanable funds”.

Mankiw says that:

The fall in investment because of the government borrowing is called crowding out …That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment. Thus, the most basic lesson about budget deficits … When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.

The analysis relies on layers of myths which have permeated the public space to become almost “self-evident truths”.

Sometimes, this makes is hard to know where to start in debunking it.

Obviously, national governments are not revenue-constrained so their borrowing is for other reasons – we have discussed this at length.

This trilogy of blog posts will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 | Deficit spending 101 – Part 2 | Deficit spending 101 – Part 3.

But governments do borrow – for ideological reasons and to facilitate central bank operations – so doesn’t this increase the claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?

The answer to both questions is no!

Modern Monetary Theory (MMT) does not claim that central bank interest rate hikes are not possible.

There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.

MMT proposes that the demand impact of interest rate rises are unclear and may not even be negative depending on rather complex distributional factors.

Remember that rising interest rates represent both a cost and a benefit depending on which side of the equation you are on.

Interest rate changes also influence aggregate demand – if at all – in an indirect fashion whereas government spending injects spending immediately into the economy.

But having said that, the Classical claims about crowding out are not based on these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans.

The result competition for the ‘finite’ saving pool drives interest rates up and damages private spending. This is what is taught under the heading ‘financial crowding out’.

A related theory which is taught under the banner of IS-LM theory (in macroeconomic textbooks) assumes that the central bank can exogenously set the money supply. Then the rising income from the deficit spending pushes up money demand and this squeezes interest rates up to clear the money market. This is the Bastard Keynesian approach to financial crowding out.

Neither theory is remotely correct and is not related to the fact that central banks push up interest rates up because they believe they should be fighting inflation and interest rate rises stifle aggregate demand.

However, other forms of crowding out are possible.

In particular, MMT recognises the need to avoid or manage real crowding out which arises from there being insufficient real resources being available to satisfy all the nominal demands for such resources at any point in time.

In these situation, the competing demands will drive inflation pressures and ultimately demand contraction is required to resolve the conflict and to bring the nominal demand growth into line with the growth in real output capacity.

Further, while there is mounting hysteria about the problems the changing demographics will introduce to government fiscal capacity all the arguments presented are based upon spurious financial reasoning – that the government will not be able to afford to fund health programs (for example) and that taxes will have to rise to punitive levels to make provision possible but in doing so growth will be damaged.

However, MMT dismisses these “financial” arguments and instead emphasises the possibility of real problems – a lack of productivity growth; a lack of goods and services; environment impingements; etc.

Then the argument can be seen quite differently. The responses the mainstream are proposing (and introducing in some nations) which emphasise fiscal surpluses (as demonstrations of fiscal discipline) are shown by MMT to actually undermine the real capacity of the economy to address the actual future issues surrounding rising dependency ratios.

So by cutting funding to education now or leaving people unemployed or underemployed now, governments reduce the future income generating potential and the likely provision of required goods and services in the future.

The idea of real crowding out also invokes and emphasis on political issues.

If there is full capacity utilisation and the government wants to increase its share of full employment output then it has to crowd the private sector out in real terms to accomplish that. It can achieve this aim via tax policy (as an example).

But ultimately this trade-off would be a political choice – rather than financial.