Steve Roth — Asset Reflux Disease: Explaining Koo to Krugman

Steve Roth:

Dean Baker told me once in person that Paul “doesn’t believe in loanable funds.” I’m finally feeling confident enough to respectfully disagree. IS/LM is all about the logic of loanable funds, even while acknowledging that banks create new money for lending. Schizo?

I think that schizo is the likely answer. First, Krugman probably doesn't believe in loanable funds. I assume Dean Baker has some way of verifying that.

Secondly, my reading of Krugman is that he knows that ISLM is simplistic but is convinced that ISLM is useful to account for events in terms of a model, which he considers to be a requirement for doing economics the right way.

Krugman then seems to go on and conflate explanation as accounting for events with explanation in the scientific sense of enabling prediction of events. So he draws policy conclusions from ISLM that the model doesn't actually warrant. And he doesn't seem to be aware of this.

This seems to result from his flawed understanding of money and banking, and finance, and how they relate to the non-financial economy.

Krugman seems to be under the impression that the interest rate is the interface between finance and economics through its effect on borrowers and savers. He often states that for every borrower there is a saver, thinking that banks borrow to lend. But this is not how banking and finance actually work in the context of the non-financial economy. It's an idealized model.

For example, when banks lend that lend money into existence. As loans are paid down that flow draws down credit money bought into existence by lending. While loan repayment is considered increased saving, this saving is neither needs nor used by banks in future lending. This the point that Koo and Steve make that Krugman seems to miss. He seems to think that banks just turn money around when they don't.

What this shows is that Krugman believes in an equilibrium-based economics that entails natural rates of interest and employment. Everything will correct itself if the central bank can find the natural rate.

Krugman also believes that an explanation must involves a model, even if somewhat simplistic as long as it accounts for the data. So he uses ISLM to account for past events and then make an illicit jump to the future, presuming that the model is ergodic, when it is not, and the context of the future is different from that of the past.

And when the emergence of a "liquidity trap" suggests that it is not. When the model breaks down at the lower bound, why, exactly, would it work by lowering rates further, other than confidence (belief) if the assumptions on which the model is based?

(Where we do see a balance, however, is in the graphs of the sectoral balances, a model that applies across countries in all contexts, which the Krugman Cross gets essentially correct. Hint, hint, Professor Krugman.)

Different situations call forth different responses based on context. Krugman presumes that negative rates will force holders of "money" as cash, deposits and, in the case of banks, reserve balances, to consume or invest, not only out of holding money byt also into new spending.

What is more likely is that holders of money that are not faced with having to delever will instead be driven into speculative assets, including commodities, which will drive up cost of materials, energy and food. The result will be lower economic activity and more risky financial activity, possibly spilling over into higher prices for necessities, leading to stagflation.

n addition, why would lenders be induced to extend credit at negative rates?  It might incentivize borrowers but savers don't lend to borrowers as Krugman's model assumes. Banks and brokerages do, and they don't intermediate between borrowers and savers, e.g., in supplying margin. Banks with access to the central bank create credit money denominated in the currency due to their special relationship with the monetary authority, and they are not limited or encouraged by savers in doing risk management in lending, or taking on risk for themselves in hedging.

Aysmptosis
Asset Reflux Disease: Explaining Koo to Krugman — Or: Why Banks Aren’t Like People
Steve Roth