Posted by: Dirk | November 20, 2013

Paul Krugman still thinks in terms of loanable funds

It is a little bit disappointed to see Paul Krugman still married to the loanable funds theory (my highlighting):

So with all that household borrowing, you might have expected the period 1985-2007 to be one of strong inflationary pressure, high interest rates, or both. In fact, you see neither – this was the era of the Great Moderation, a time of low inflation and generally low interest rates. Without all that increase in household debt, interest rates would presumably have to have been considerably lower – maybe negative. In other words, you can argue that our economy has been trying to get into the liquidity trap for a number of years, and that it only avoided the trap for a while thanks to successive bubbles.

The same Paul Krugman has pointed out that “central banks clearly retained the power to set shortterm interest rates” (his words). So, households and firms and even governments borrow what they want to borrow and that will not move the short-term interest rate. The spread between long-term rates relevant for borrowers and short-term rates set by the central bank changes over time, as can be seen below.

fredgraph222Nevertheless, to argue that demand for loans influenced interest rates is utterly incompatible with the idea of short-term rates set by the central bank. You cannot be Keynesian on the short-term rate and neo-classical on the long-term rate. As we see in the graph, the long rates are always above the short rate, with the spread varying. The spread normally has something to do with risk aversion, as the spike in 2009 shows (Lehman Brothers). What did not happen in 2009 is that households and firms wanted to borrow more (look at the graph below for one half of the story). Regarding causality, either long rates rising make short-term rates rise, too, or vice versa. Given that central banks set the short-term interest rate I think that the answer to this question is quite clear. If you think that interest rates rise when loan demand rises, how would you explain that:

fredgraph3331950s to 1980: interest rates rise because debt rises. After that: rising debt leads to falling interest rates. Hmmm…

Will the real Paul Krugman please stand up?

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Responses

  1. Hi Dirk.
    “If you think that interest rates rise when loan demand rises, how would you explain that [graph]”

    Supply increased. I was looking at BOGMBASE/GDP, percent change from year ago. It is much higher since the 1980s, than it is before.

    Oh! FRED has suddenly changed everything they do.

    Art Shipman

  2. “Nevertheless, to argue that demand for loans influenced interest rates is utterly incompatible with the idea of short-term rates set by the central bank”

    I don’t think that’s what Krugman is saying in the quote above.

    “Without all that increase in household debt, interest rates would presumably have to have been considerably lower – maybe negative. In other words, you can argue that our economy has been trying to get into the liquidity trap for a number of years, and that it only avoided the trap for a while thanks to successive bubbles.”

    What I think he means is that the short-term rate set by the central bank would have had to be lower in order to generate the required level of private investment and saving for the economy to attain ‘full employment’ with low inflation, if it hadn’t been for the debt bubbles.

  3. OK, that did not occur to me. I would have thought that up until the 1980s demand gaps in the US would have been filled by fiscal policy, not monetary policy. ‘We are all Keynesians now’ has been attributed to Nixon, and Reagan used tax cuts and government spending to restart growth. I still think that this was default policy and find the alternative scenario with lower interest rates unlikely. But maybe you are right and that was not Krugman’s point. These “as if” comparisons are very typical of him (‘What if we had used only monetary policy from the end of WWII onwards?’). But then, why should the economy by default use only monetary policy? It seems to me that many assumptions lie behind his argument. Hopefully he spells it out clearer.

    • Krugman and Mankiw on “loanable funds” — so wrong, so wrong-
      Professor Lars Pålsson Syll- Malmö University
      larspsyll.wordpress.com/2013/11/21/krugman-and-mankiw-on-loanable-funds-so-wrong-so-wrong/

  4. My initial thinking was along y’s and did not change yet. Krugman’s admission that he finally realized the difference of countries with full sovereign currency and those without are pointing towards his thinking that he knows that FED controls interest rate, not the market.
    And also he did not indicate causality in highlighted sentence, but that Taylor rule would force interest rates down, not increase in debt.

    He is really comming ever closer to MMT, so i had to think about why would he endorse Lary Summers’ bubble economy. I believe, it is done in order to persuade economists and central bankers that there is no recovery. It is such minimal progress required in order to restart debates about what to do about lack of recovery which many economists do not see.
    Krugman’s IMF speech was clear aproach from MMT view which did not start any debate, it was ignored, but Summers’ talk about bubble as the solution did start big debate about what bubbles do actually.

  5. Dirk,

    I think New Keynesians like Krugman believe that fiscal policy is only really effective in a ‘liquidity trap’. Outside of a liquidity trap they advocate lowering the short term rate of interest to stimulate the economy.

  6. […] Dirk Ehnts has an interesting post up where he takes Paul Krugman to task for still being married to the loanable funds theory. […]

  7. “to argue that demand for loans influenced interest rates is utterly incompatible with the idea of short-term rates set by the central bank”

    What about when the yield curve inverts, i.e. long term rates fall below short term rates? This seems to be a clear example of market rates not being related to the current short term rate set by the central bank

  8. […] year Dirk Ehnts had an interesting post up where he took Paul Krugman to task for still being married to the […]

  9. […] On the Krugman front Dirk Ehnts did a nice job last year showing how the good doctor flip-flops on this issue. When I read Krugman and Wells’ macroeconomic textbook I got the distinct impression that […]

  10. […] year Dirk Ehnts had an interesting post up where he took Paul Krugman to task for still being married to the […]


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