Krugman at the Rethinking Economics Conference: Still Wrong on Monetary Theory

still wrong

The Rethinking Economics conference in New York took place over the weekend. Anyway, Paul Krugman was on a panel with James Galbraith and Willem Buiter. The panel was interesting in and of itself. But what really caught my eye was when Krugman was confronted by an audience member on his support of NAIRU, the loanable funds theory and the theory of the natural rate of interest.

The audience member who asked this question was Rohan Grey, a friend of mine who runs the Modern Money Network who helped co-organise the event. You can see the question and the response in this video clip.

I don’t really want to get into the question of NAIRU too much as this would take us too far off track. But the other two questions provoked an interesting response from Krugman. First of all, he simply asserted that the loanable funds was true. Then he went on to assert that the natural rate of interest was true. “Clearly,” he said, “there is always some rate of interest that would produce more or less full employment”.

Let’s take each one first. Because Krugman is wrong on both counts. In his textbook co-written with Robin Wells, Krugman outlines the loanable funds theory in the form of the money multiplier. In the video linked to above he alludes to the fact that this may break down in what he calls a ‘liquidity trap’ but that in normal times it is nevertheless true. This is simply false (Krugman has also misunderstood the concept of the liquidity trap but that is a story for another day). The Bank of England released a paper earlier this year which stated crystal clearly that this misrepresented how money is created.

The reality of how money is created today differs from the description found in some economics textbooks:
• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits. (p1)

If that is not a clear enough refutation of the loanable funds theory, here is another:

The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. (p2 — My Emphasis)

When I raised this point on this blog before Krugman did a blog post the next day saying that the Bank of England paper said nothing that he did not already know. In the same blog post alluded to James Tobin’s work on money creation.

If Tobin actually did make the case for endogenous money, and I am not entirely convinced of this, but if he did then he overturned the loanable funds theory. If Krugman states that he adheres to the view put forth in the Bank of England paper which he claims he learned from Tobin then why does he continue to endorse the loanable funds theory when asked about it? The two views are mutually exclusive and the Bank of England makes this clear in no uncertain terms.

The fact of the matter is that Krugman is self-contradictory on this point. And self-contradiction is the surest sign that one is simply incorrect or has not thought through a particular point on any great amount of detail.

Now, how about the idea that “there is always some rate of interest that will lead to more or less full employment”. This idea is grounded in the notion that there is a mechanical relationship between investment and the rate of interest. But anyone who has read Keynes — especially Chapter 11 of the General Theory — knows that this is not the case. Rather investment is driven primarily by the expectations of investors. The rate of interest plays an entirely secondary role — if it plays a role at all given that most studies have shown that businessmen do not think about the interest rate when they make investment decisions.

Tied to this last point, mainstream economists have now recognised that monetary policy actually works through some rather odd channels; its effects are not felt through the investment channel as such. So, even reading the recent literature on monetary policy from some mainstream economists makes clear that it does not work through the investment channel as is laid out in the ISLM model that Krugman constantly endorses.

But let us be less abstract and bring this discussion down to earth. What would likely happen if the rate of interest went substantially negative? Would investment and thus employment really increase? I don’t think that it would. Far more likely that, in a closed economy, money would flee safe assets as liquidity preference fell and would rush into riskier assets. This might just fuel a speculative credit bubble.

In an open economy money would probably partially run into the speculative financial markets and partially flee the country. This latter tendency would drive down the currency. Given that we must already assume some inflation since we are talking about negative real interest rates this could lead to a hyperinflationary collapse.

This is precisely what we see today in Venezuela where, as I have noted before, substantially negative real interest rates have resulted in a stock and housing market bubble. Meanwhile investment has not shot up and unemployment has stayed on trend and rather high (note that the significant negative real interest rates were enforced around the start of 2013).

venezuela investUNEMPLSubstantial negative real interest rates of around -20% to -30% were brought into effect in the second quarter of 2013. But the upswing in investment you see in the above chart occurred prior to this in the final quarter of 2012. There is absolutely no evidence that significant negative real interest rates have increased real investment or driven unemployment down in Venezuela. All they have done is led to massive bubbles in the financial and housing markets and to an enormous attempt by capital to flee the country which is reflected in the black market rate for dollars soaring. If there were not strict capital controls in place there is no doubt that Venezuela would be experiencing hyperinflation today.

What does this mean for policy in the advanced economies? If central banks in these countries were able to generate real negative interest rates — and I have outlined how they might do this before (Krugman says that it is impossible… wrong) — it is likely that this would simply generate stock and housing bubbles. Real investment and unemployment would probably not be much affected. But when the bubbles eventually collapsed this would likely have negative effects on both.

Krugman’s monetary theory is almost entirely wrong. He flip-flops on the loanable funds question and he is simply wrong on the question of a natural rate of interest. He also holds to an incorrect view of what a liquidity trap is that he picked up from John Hicks. While it is extraordinarily unlikely that he will give up on these ideas — he has dug in far too much now to concede these points and he seems unwilling to even openly debate them — I only hope that his errors will help to ensure that others do not make the same mistakes.


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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58 Responses to Krugman at the Rethinking Economics Conference: Still Wrong on Monetary Theory

  1. I suggest there is actually a fair bit of validity in the “loanable funds” theory, and for reasons I set out in section 1.12 here:

    Click to access MPRA_paper_57955.pdf

    Nick Rowe made a similar point recently when he said something to the effect that banks cannot extend loans unless there are willing savers.

    I.e. the fact that loans PRECEDE deposits does not prove that loans CAUSE deposits. Likewise the fact that apples are grown before they are eaten does not prove that the fact of growing apples causes them to be eaten. If anything, it’s the other way round: the demand for apples causes them to be grown.

    • …the demand for apples causes them to be grown…

      Lol. Really? So apple trees require humans to grow?

      If an apple tree grows in the woods and there is no one around to plant it… does it really grow!?

      Ha! Come on. Don’t be silly. Oh, the mysteries of causality!

      • Michael Robinson says:

        The quantity of apple trees on the planet whose fruit is sold, which came into existence independent of anticipated market demand for their fruit, is lost deep in the rounding of the total.

        So yes, for the purposes of any consequential non-wanking discussion, demand for apples does cause apple trees.

      • Of course I was implying that Musgrave’s grasp of causality was desperately poor and that the rest of his comment should probably be read in that manner. Between the lines, Mr. Robinson, between the lines!

      • As you probably know perfectly well, I meant apple growing in the sort of VAST QUANTITIES that occurs in the World at the moment compared to the amount that would grow in the wild absent human beings on planet Earth. The quantity in the British Isles in absence of humans would be next to zero.

        Any other simple / obvious points you need spelling out in monosyllables, please let me know.

      • Confusion of thought and feeling leads to confusion of speech. — JM Keynes

        Many of your comments exhibit this. As does Nick Rowes pretzel-economics.

    • Kieran Latty says:

      Ralph, are you sure you linked to the correct paper above. A cannot find a section 1.12 in it.

      • Kieran, It’s the right paper. However my organisaton of section numbers leaves something to be desired. 1.12 is “section No.1, item 12”. I’ve put that numbering cock up right in a forthcoming update of that paper.

  2. Senexx says:

    One small hiccough, in that the term full employment as used by Krugman was undefined.
    As you would be aware those that use loanable funds and interest rates to control unemployment have a different definition of full employment than those associated with the Marxian/Minsky/Godley/Institutional paradigm we follow.

  3. ivansml says:

    Krugman is correct – endogenous money is compatible with loanable funds. Even if banks accommodate demand for loans by creating deposits first, households must be induced to hold those deposits (= provide savings). Their willingness to do so in turn depends on, among other things, the interest rate. All this is discussed in both BoE paper and Tobin (whom the former cites several times):

    BoE paper:
    “But whether through deposits or other liabilities, the bank would need to make sure it was attracting and retaining some kind of funds in order to keep expanding lending.” (p. 5)

    Tobin (1963):
    “Clearly, then, there is at any moment a natural economic limit to the scale of commercial banking industry. Given the wealth and asset preferences of the community, the demand for bank deposits can increase only if yields of other assets fall. […] In this respect the commercial banking industry is not qualitatively different from any other financial intermediary system.” (p. 6-7)

    • This comment is confused. But the BoE quite clearly make the case that the loanable funds doctrine is wrong. I discussed this with people in the BoE. That was the purpose of the paper.

      Now, the BoE paper is compatible with the natural rate of interest theory. In fact, it endorses it. But that is a separate debate and I have dealt with that separately.

      • ivansml says:

        That’s curious, given that the phrase “loanable funds” is not mentioned once in the paper. So I highly doubt loanable funds is what BoE people meant – the paper is meant to refute “exogenous money + stable money multiplier”, but that’s a different concept.

      • Wikipedia:

        In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption.

        BoE Paper:

        One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them.

        Do you ever get the feeling that you are fighting a losing battle, ivansml? You should consider that you quite possibly are…

      • ivansml says:

        “…lending out the deposits that savers place with them.”

        That clause is there for a reason. They’re trying to refute a particular mechanism of intermediation, but as Tobin’s paper eloquently explains, even if banks don’t just passively lend out deposits, they’re still constrained by supply of deposits and are thus “intermediaries”.

        Which is why the passage you quote is rather confusing (the authors have probably taken their wording from reading too many blogs where the two concepts are conflated), but in a wider context it’s clear what they do and don’t mean.

        Yes, it sometimes feels like a losing battle. The whole “endogenous money” debate sometimes feels like speaking to a brick wall – the heterodox repeat their misconceptions and straw-men over and over again, no matter how many times they’re proven wrong.

      • Yes, yes, we all know that banks are capital constrained. But that’s not what Krugman’s textbook says. And it is not the argument he used to make on his blog. He made the case that there were reserve constraints. This is also implicit in the ISLM which he promotes all the time and which we are attacking.

        There is a tremendous amount of flipping and flopping going on here. But no one buys it. No one that doesn’t have a stake in the game, that is.

  4. The loanable funds theory at its most naïve, i.e. that banks lend out money already deposited with them is obviously wrong. Also the idea that commercial banks can simply lend out money created from thin air without there being people willing to deposit that money for extended periods (i.e. without savers) is also wrong.

    Ergo the reality is a sort of compromise. That’s why at the start of my first comment above I said there is a “fair bit of validity in the “loanable funds” theory”. I didn’t say it was “correct” or “100% true” or anything like that. I.e. I agree with Ivansml and Tobin.

    • Also the idea that commercial banks can simply lend out money created from thin air without there being people willing to deposit that money for extended periods (i.e. without savers) is also wrong.

      I know no one that holds this position.

      • “I know no one that holds this position”. Positive Money does, strikes me. Or at least they rather veer in the direction of “wicked private banks create money willy nilly out of thin air and push up house prices, plus they force everyone into debt”. The latter view obviously has great appeal for the less clued up section of the political left and those seeking victimhood.

    • Mark says:

      Correct me if I’m wrong, but don’t investment banks (which do not hold household or corporate deposits) lend all the time? They simply fund themselves using repo loans, which typically have a very short maturity (overnight to 3 months).

      Long-term lending doesn’t require long-term financing. You simply borrow short and recycle the debt once it matures. Of course, this is quite a risky practice, but such is life. After the crisis, the repo market more or less froze, so the Fed opened the discount window to investment banks and lent them against a wide range of collateral.

      • Yes. Now you’re getting into the whole quagmire of how much restrictions capital requirements actually place on lending. The answer: not many.

        I really don’t want to get into the weeds on this. It is a distraction that ivansml throws up to move the goalposts and Musgrave summons to distinguish himself from the MMT people who basically taught him what he knows about economics.

  5. jake says:

    Also the idea that commercial banks can simply lend out money created from thin air without there being people willing to deposit that money for extended periods (i.e. without savers) is also wrong.

    I know no one that holds this position.

    …….Errm I did.So how in practice are banks actually capital constrained if loans precede deposits?

    • Don’t buy this stuff. Capital constraints are an entirely different beast. Money remains endogenous but for different reasons. On this you have to get deep into financial economics, Minsky and how asset prices work. In the end you find that in a boom capital requirements are far more easily fulfilled. Thus banks do effectively create the money out of thin air. But at the same time they do need sufficient capital — the crux is that they effectively create much of this capital themselves.

      Ivansml is picking up on this to save face because he knows that he’s lost the debate. Musgrave is an amateur who, when he’s not “thinking” about economics, is pondering the finer points of racist genetics.

    • ivansml says:

      Phil is wrong. Capital requirements are completely different topic. Even if banks were financed 100% by deposits (no equity), still a) banking sector as a whole can create money through loans only to the extent that people are willing to hold additional deposits (how else could it be?), and b) any individual bank will still aim to have some target reserve-deposit ratio, since reserves are used to settle interbank transactions. Sure, it can borrow reserves from central bank, but CB controls the cost of doing so – and thus indirectly also demand for reserves.

      • philippe101 says:

        it might be worth clarifying exactly what is meant by ‘endogenous money’.

      • philippe101 says:

        from what I’ve read about ‘endogenous money’, the central bank is assumed to set the price of borrowing reserves…

      • Mark says:

        a) You are simply stating that the amount of private credit in the economy is constrained by the public’s demand for credit. Yes, banks can’t lend money if no one wants to borrow.

        b) If the bank is solvent and the markets are not stressed, then it will probably ask for a repo loan from another bank, while posting some high-quality asset as collateral (since the bank is solvent, I assume that it has such assets) . It can also borrow directly from the Fed, but the benefit of going to the repo market is that it allows the bank to borrow reserves against a wider range of collateral. Of course, interest rates in the repo market are linked to the CB rate. However, as long as the bank fulfills its capital requirements and has good assets which other institutions are willing to lend against, it has no funding problem. It is within the interest of the financial industry to act this way, both as a borrower and as a lender.

        A hike in the CB rate may increase the rate on repo loans and it may have an effect on the value of various financial assets. For instance, bonds usually drop in value as yields go up and house prices may go down since people get better yields on the bond market. Thus, it may increase the cost of capital in the economy and it may decrease the quantity of capital in the economy. But these two things do not have to happen. Also, note that firms and households mostly care about the long-term cost of capital. A hike in the CB rate may not move rates on long-term debt at all (they are determined by the market). The quantity of capital is also determined largely by the market- the value of various assets (stocks, bonds, derivatives, houses,…) is not set by the central bank. Even when a rate hike has a noticeable effect on the capital markets, the effect is usually not sufficient to bring down credit growth. As an example, if you expect house prices to rise 10% per year, then a 4% rate on your mortgage doesn’t sound much worse than a 3% rate

        If the CB hikes rates to 10% then this will be probably lead to a sufficient increase in the cost of capital and a decrease in the quantity of capital to force down lending. It will also probably kill the economy and cause every bank in the country to go bankrupt.

      • Neither of these points have anything to do with the debate. One of the points says “banks cannot lend money if people do not want to borrow money” which is about as profound as saying that a shopkeeper cannot sell apples if people do not want to buy apples. Oh, the insights that economics can generate, eh!? 😀

        You’ve got reading to do ivansml. Start with Mark’s comment.

  6. philippe101 says:

    Krugman says:

    “New Keynesians assert — as Keynes did, although I don’t think it matters for this debate what he said — that both liquidity preference and loanable funds are true. There are conditions under which one or the other is the main one to focus on — at full employment, loanable funds are crucial, in a liquidity trap, liquidity preference. But no modern Keynesian, new or paleo, forgets about the importance of liquidity preference.”

    Maybe his position is more nuanced than you think?

    He explains it in more detail here:

    “Here’s what I imagine Niall Ferguson was thinking: he was thinking of the interest rate as determined by the supply and demand for savings. This is the “loanable funds” model of the interest rate, which is in every textbook, mine included […] What Keynes pointed out was that this picture [loanable funds] is incomplete if you allow for the possibility that the economy is not at full employment. Why? Because saving and investment depend on the level of GDP…” etc

    • I know what his position is. I wrote in the piece:

      In the video linked to above he alludes to the fact that this may break down in what he calls a ‘liquidity trap’ but that in normal times it is nevertheless true.

      “Loanable funds” holds most of the time. But it breaks down in a liquidity trap. Yawn. Krugman has no nuance. Ever. He’s not that type of economist. It’s just the standard neo-Keynesian party line.

  7. LK says:

    Off topic, but I would be awfully gratefully if, when time permits, you could give your thoughts on this:

    Do you think this, suitably rewritten, could be a good basis of a critique of the quantity theory for my article?


  8. Ivansml is picking up on this to save face because he knows that he’s lost the debate. Musgrave is an amateur who, when he’s not “thinking” about economics, is pondering the finer points of racist genetics.,,,,,
    Then I guess he is a true “post-Keynesian” since John Maynard himself was the director of the Eugenics Society from 1937 to 1944, Good for him that Pilkington was not around at the time. You know, one of the reason MMT does not make as much progress as it should is because of attitudes like yours. Aren’t you a journalist ?

    • Something tells me that if I followed up on this comment things would get very weird very quickly…

    • Michael Robinson says:

      Phil is a professional journalist, which is exactly why he lets his sexually-frustrated, over-caffeinated teenage son run the unpaid comments section (in order to keep the traffic stats up), whilst he focuses his limited time and considerable intellect on above-the-fold remunerative writing.

      I believe the economists call it “specialisation”.

  9. philippe101 says:

    I’m surprised no one is talking about the amazing discovery of this telepathic kitten.

  10. ATR says:

    There’s a way to reconcile ‘loanable funds’ with the typical heterodox conception of endogenous money. Perhaps you’ve explained this is in prior posts, but the way to do it is:

    1. Throw out any relation of ‘loanable funds’ to bank lending mechanics / causality as insinuated in mainstream textbooks. (More on this below*.)

    2. Just conceive ‘loanable funds’ as a model describing the interest rate needed to bring desired aggregate demand into equilibrium with desired aggregate supply (the natural rate). Equivalently, this is the S/I diagram. You may disagree with the idea that the interest rate can do this, but at least will still have a theory that doesn’t contradict basic banking mechanics.

    3. The central bank has a variety of tools to achieve any interest rate target it so desires (and the leading mainstream economists who actually do research on central bank operations have a very sophisticated view of how interest rate targeting works, consistent with the ideas of endogenous money folk.). However, in the neoclassical model, it needs to set the interest rate target equal to the natural rate in order to avoid inflation or deflation.

    As such, it’s true the central bank sets the interest rate according to its own decisions – it’s not automatically determined by some market supply/demand process that drives the rate to whatever ‘loanable funds’ says. But the central bank may be ultimately compelled to set the rate according to what loanable funds says if it uses neoclassical models.

    *My theory on the connection between loanable funds and banking seen in intermediate macro texts is that it was an extremely short-handed but flawed attempt to translate what would happen in a barter economy to what happens in a financial economy (not saying this is correct, just what exists in the neoclassical model). Perhaps based on a flawed understanding of banking, authors thought they could get away with a ‘saving funding investment’ analogy to lending/borrowing deposits, and drop the barter story altogether. But all that is is a bad analogy – not a fundamental flaw in the model itself, properly understood. Instead, what these authors should do is tell the story of how rates adjust in the pretend barter economy, but then make clear that it doesn’t translate to the modern banking system. Instead, banking operations would be shown to work as you describe, but it would also be argued that it’s the central bank’s job to change rates as would naturally occur in the barter economy (natural rate).”

    I laid this out in more detail here – .

    • You seem to be referring to the Taylor Rule. That is a manifestation of the natural rate of interest that I dealt with in the second half of the post.

      But the central bank may be ultimately compelled to set the rate according to what loanable funds says if it uses neoclassical models.

      I know of no central bank in the world that uses such models to set policies. At best they are used as guides — but even that is a push. The models are completely dependent on how they are specified. Besides central bankers often go against the prescriptions of the modellers (thank God!), see for example Greenspan in the 90s boom.

      I rail against macroeconometric modeling all the time. One of the reasons why is that everyone in the profession knows that it is not taken seriously by anyone.

  11. ATR says:

    “Rather investment is driven primarily by the expectations of investors. The rate of interest plays an entirely secondary role — if it plays a role at all given that most studies have shown that businessmen do not think about the interest rate when they make investment decisions.”

    Can you link to articles arguing this? I’d presume a significant proportion of investment decisions are done through some form of NPV analysis, in which investor expectations play into forecasting cash flows, and interest rates play into the discount factor. Outcomes are sensitive to both. In classroom exercises, the outcome is often most sensitive to the interest rate, though I realize the real world is a different place. But it’s one thing to say the numerator or denominator typically plays a bigger role in the real world, and another to say the denominator plays zero role. The whole point is to hold everything else constant and see how varying the interest rate affects macroeconomic outcomes. If the interest rate plays a big role, macro outcomes are very sensitive. If it plays a small role, they’re less sensitive. But they still react in one direction or another…

    • Oh, these studies go back to the late-1930s. Details and links to a paper in here:

      Yes, you are being duped by that stuff you are being taught in class. Sorry. Please raise these issues with your lecturer. 😉

      • ATR says:

        Hi Phil,

        I don’t really see many empirical references in your prior post. A brief skim of the Mishkin paper (which seems to be your primary reference) seems to say that empirical studies are divided on the degree of impact of interest rates on business investment spending (e.g., Taylor versus Bernanke). Additionally, he proposes several other (now generally accepted) channels through which interest rates might affect investment spending.

        I’m not sure your charts provide the most compelling empirical evidence as they’re very simplistic analyses, but they’re good starting points to call something into question. But why do you use ‘investment rate’ instead of absolute investment? For example, in FRED, if you plot the FFR on the right y-axis and gross private domestic investment on the lift, you see a relatively consistent rise in investment with a bit more jerky fall in rates since 1980 – contrary to your argument. However, that broad relationship disappears pre-1980. Not saying this is much better, as it’s still too simplistic, but just a methodological question…

        Anyways, here’s an interesting paper that is somewhat in line with your and Michael’s view: . But I don’t interpret it to mean interest rates have zero impact on business investment spending. It’s just that this research suggests its effect is (much) less powerful than many people might think. Of course, this study doesn’t look at the empirical macro outcomes, and so it acknowledges it’s possible for the small percentage of businesses out there that are very sensitive to rate changes to have out-sized effects on the economy.

      • (1) The channels Mishkin raises are demand-determined channels. They fall in line with the Post-Keynesian view that investment is demand-led.

        (2) The data clearly shows no correlation at all. You can fiddle with it in any number of ways and you get the same result.

        (3) I use the rate of investment because I am running a regression. You cannot use absolute levels as these are non-stationary. This is standard statistical methodology.

      • ATR says:


        As far as it being demand-led or not, they’re still channels through which changes in rates impact the real economy…

        I still wonder why the mainstream economists doing the empirical heavy lifting are divided on the question, as I’m just not familiar enough with both sides of the research.

      • The research is divided, frankly, for the same that all research in macroeconomics is divided: because you can make the data say anything you want if you torture it enough. That is why on almost every “key issue” in economics studies turn out “divided”. It is one of the reasons why I often rail against econometric technique on this blog. Such techniques do not, as its inventors originally thought, allow us to resolve questions. Rather it allows these questions to be raised and re-raised ad infinitum. But then that is fantastic if you are looking for a grant — especially if the institution paying you kind-of-sort-of wants certain results that seem to run contrary to even a glance at the data.

        Most econometric technique is mysticism. Which is why most people in financial markets steer clear of such “studies” and do their own, supposedly more “primitive” empirics.

    • Michael Robinson says:

      In my entire career, I have never seen interest rates drive any investment decision in the real economy, for two primary reasons:

      1. Most real-world projects, if one were ever to honestly run out the statistical analysis of available data, would have error bars on projected future cash flows well outside any prevailing IRR or risk-free rate of return, or whatever one would use to rationalise the investment decision. Interest rates are a rounding error.

      2. For the most part, decision-makers are, for the most part, fairly stupid people without any interest or aptitude for the analysis required for an honest NPV calculation (they are usually obtain decision-making authority by some combination of luck, animal cunning, and political dexterity). They decide from their gut, and then instruct underlings to come up with data to support it.

      And, apropos, here’s a quote from one of Phil’s main haunts, just today:

      “In the early 2000s, we heard regularly from contacts at McKinsey that their clients had become so short-sighted that it was virtually impossible to get investments of any sort approved, even ones that on paper were no-brainers. Why? Any investment still has an expense component, meaning some costs will be reported as expenses on the income statement, as opposed to capitalized on the balance sheet. Companies were so loath to do anything that might blemish their quarterly earnings that they’d shun even remarkably attractive projects out of an antipathy for even a short-term lowering of quarterly profits.”

      • ATR says:

        Michael, what was your career?

        Regardless, I don’t think this is universally true. I have friends all through Wall Street and in consulting regularly using NPV models. I used them myself during my time in consulting. Whether they ultimately drove decisions is of course another story, but to rule them out entirely seems to be hyperbolism.

      • They simply do not drive decisions. And it is not hyperbole. ALL the evidence shows a lack of correlation.

      • Michael Robinson says:


        Firstly, “Wall Street” is emphatically not the real world. The value stream on Wall Street is derivative of the value stream in the real economy, and I used the qualifier “real-world” with specific and deliberate intent. Yes, of course interest rates affect NPV analysis of financing; the sine quo non of finance is aggregation of diversified real-world stochastic flows such that they become amenable to analytic valuation and decision-making.

        In the real-world economy (from primary production through to end consumption), I’ve never seen a project green-light decision driven by a credible NPV/IRR analysis. I’m not saying it doesn’t happen, but if it does, it’s exceedingly rare and I expect in niches like regulated utilities.

        Secondly, consultants who perform NPV analysis is exactly what I meant by “instruct underlings to come up with data to support it”. Most competent consultants are able to figure out soon enough the correlation between a healthy engagement pipeline and analyses which flatter the judgement of the parties wielding budget authority.

      • ATR says:

        Hi Michael,

        See the paper I posted above. I’d say it corroborates your view broadly, but leaves more room for rates to affect business decisions than you were suggesting.

        As for Wall Street, this is true for much of its business, but capital and debt raises are very much ‘real-world’ things as you put it, and most certainly affect investment spending. And NPV analysis is the central tool of investment banks that lead such activities.

        As for consulting, I’d also say you are painting with too broad a brush. Yes, the problem you reference is prevalent, but it doesn’t mean every single project’s outcome is predetermined by the client’s preferences. Sometimes clients are clueless and place significant trust in the consultant’s work, and if that consultant’s work includes an NPV analysis, it might carry significant weight in ultimate decision making.

  12. Dantey says:

    As an economics noob, I am sooo confused now that I want to run into a wall! 😦 Here I was thinking I had atleast this part of basic economics clear!

    1) What does endogenous money mean? Someone please give an exact definition

    2) What does loanable funds theory say, in particular about lending? Is it that a bank can only lend out money that has been deposited with it, plus its own, which it then multiplies up via the money multiplier effect?

    3) If banks don’t just passively lend out deposits, why are they’re still constrained by the supply of deposits, if they can simply use the mechanism highlighted in the BofE paper to create money? Is this limitation even technical? In other words, do they even need to be constrained by the supply of deposits?

    4) If banks dont just passively lend out deposits, why are they known as ‘intermediaries’?

  13. Anon says:

    “Now, how about the idea that “there is always some rate of interest that will lead to more or less full employment”. This idea is grounded in the notion that there is a mechanical relationship between investment and the rate of interest. But anyone who has read Keynes — especially Chapter 11 of the General Theory — knows that this is not the case. Rather investment is driven primarily by the expectations of investors.”

    Yep, we have been in deep sh*t so long because Obama is anti-business. All hail the confidence fairy.
    Keynes was one of the smartest economists of all time. Doesn’t imply though that everything he wrote was correct (how about that article of yours that links econ and religion :D). This stupid expectation argument is nowadays used by many demand deniers, not to mention that a multiple equilibrium story which hinges upon the brain farts of business men is virtually unscientific. There would aride a plethora of multiple equilibria (nothing wrong with that) which are unexplainable (a lot wrong with that) and as I already said, the way this theory is politically exploited is fairly obvious.

    • Do you pull all of your arguments straight off Krugman’s blog? God, it’s painfully vulgar.

      If you’d done your homework you would know that the key expectation in Keynes’ marginal efficiency argument is the expectation of future profits. Future profits are demand-determined. Thus, the key expectation is expectation of future demand. This has nothing to do with labour market flexibility — which is what Krugman is arguing against when he summons the “confidence fairy”.

      Do your homework. Your comments display both the brashness and the ignorance of a teenager.

  14. Jonas says:

    About what Keynes meant, sure, he did not like Hicks’ reintroduction of loanable funds but he also never embraced the Post-Keynesian notion that economies are always demand-constrained. So if you want to be pedantic, neither Post- nor Old-Keynesians are in snyc with the master.

    Now about the issue of loanable funds and liquidity preferences, I prefer approaches that do not merely focus on money as liqudity (although that is tremendously important and the new Nobel prize laureate has written a nice book on liquidity) but also on money as credit. Here I can recommend the work by Stiglitz&Greenwald. I don’t think that there is any merit in all the DSGE papers that try to introduce financial frictions (no microeconomists uses Arrow-Debreu and then introduces some market imperfections, he starts with the market failure itself) and while there is merit to some Post-Keynesian work like Minsky’s famous paper the main issue is that this is just descriptive, there is no explanation/mechanism in it.

    • About what Keynes meant, sure, he did not like Hicks’ reintroduction of loanable funds but he also never embraced the Post-Keynesian notion that economies are always demand-constrained.

      Could I please have a reference proving that this is what Post-Keynesians think? Thank you.

      • Jonas says:

        Gee, the notion that economies are not just demand-constrained in the short-run but also in the long-run is a key feature of Post-Keynesian thought, it is underlying virtually all analysis. That is the main difference between Post- and all other -Keynesians, you guys suggest structural changes like changes in income distribution and so on to make demand shortfalls less likely to occur whereas other Keynesians merely wanna put out the fire with monetary and fiscal policy.
        And while Keynesian himself thought otherwise, that classical econ is appropriate for the long-run (the neoclassical synthesis is not Samuelson’s idea, it is in the GE), I think that there is a lot of merit to this Post Keynesian idea. My point was that it is of little relevance what Keynes said, what matters is good economics. As a lot of Post Keynesians are obsessed about sticking with what the master said (which is really not how science should work although we are admittedly all humans and have our favourite academic writers) I think it is important to emphasize that it is precisely a Post-Keynesian idea which is contrary to what Keynes wrote that is important.

      • Saying that aggregate demand matters in the long-run is not equivalent to saying that economies are always demand-constrained.

        And yes, there is ample evidence that Keynes assumed that demand matters in the long-run. He says this over and over again both in the GT and in his letters from the late-20s on. There is plenty of work done on this.

  15. Pingback: Rethinking economics in the backwater | Redline

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