Liquidity preference, loanable funds, and Niall Ferguson (wonkish)

Joe Nocera writes about Thursday’s New York Revie/PEN event on the economy, but fails to mention what I found the most depressing aspect of the whole thing: further confirmation that we’re living in a Dark Age of macroeconomics, in which hard-won knowledge has simply been forgotten.

What’s the evidence? Niall Ferguson “explaining” that fiscal expansion will actually be contractionary, because it will drive up interest rates. At least that’s what I think he said; there were so many flourishes that it’s hard to tell. But in any case, this is really sad: John Hicks knew far more about this in 1937 than people who think they’re sophisticates know now.

In any case, I thought it might be useful to re-explain why our current predicament can be thought of as a global excess of desired savings — which means that fiscal deficits won’t drive up interest rates unless they also expand the economy.

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. It looks like this:

INSERT DESCRIPTION

where S is savings, I investment spending, and r the interest rate.

What Keynes pointed out was that this picture 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. Suppose GDP rises; some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls:

INSERT DESCRIPTION

So supply and demand for funds doesn’t tell you what the interest rate is — not by itself. It tells you what the interest rate would be conditional on the level of GDP; or to put it another way, it defines a relationship between the interest rate and GDP, like this:

INSERT DESCRIPTION

This is the IS curve, taught in Econ 101. Now, we usually explain how this curve is derived in a different way: we say that given the interest rate, you can determine investment demand, and then through the multiplier process this determines GDP. What you’re supposed to understand, however, is that the derivation I’ve just given is just a different way of arriving at the same result. It’s just different presentations of the same model.

So what determines the level of GDP, and hence also ties down the interest rate? The answer is that you need to add “liquidity preference”, the supply and demand for money. In the modern world, we often take a shortcut and just assume that the central bank adjusts the money supply so as to achieve a target interest rate, in effect choosing a point on the IS curve.

Which brings us to the current state of affairs. Right now the interest rate that the Fed can choose is essentially zero, but that’s not enough to achieve full employment. As shown above, the interest rate the Fed would like to have is negative. That’s not just what I say, by the way: the FT reports that the Fed’s own economists estimate the desired Fed funds rate at -5 percent.

What does this situation look like in terms of loanable funds? Draw the supply and demand for funds that would obtain if we were at full employment. They look like this:

INSERT DESCRIPTION

In effect, we have an incipient excess supply of savings even at a zero interest rate. And that’s our problem.

So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.

Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems; some countries, such as Ireland, are being forced into fiscal contraction even in the face of severe recession. But the fact remains that our current problem is, in effect, a problem of excess worldwide savings, looking for someplace to go.

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A.Swift May 2, 2009 · 9:06 am

I think you can see on a daily basis where some of this “excess savings” is “trying” to go, Just look at the daily volatility of the equity markets. Financial sector up 8% one day, down 10% the next. Same for technology and every other sector. So, the money that has been drained from the bank, real estate and investment schemes did go “somewhere” (money just doesn’t disappear into thin air). My question is: who ended up with it in their back pocket?

Smooth Sailing May 2, 2009 · 9:10 am

Excellent blog Dr. K. So when we mix in the Government taking control of banking and major corporations, and then making up their own rules willy nilly, we have people sitting on the side lines saying…..”I am not going to get into that blood bath” Which will have a profound effect on GDP negatively.

All of this would have a better chance of working out, if the Gov kept its paws off rather than what they are doing.

English Observer May 2, 2009 · 9:26 am

Don’t worry about Ferguson, Paul. He’s a highly literate but politically partisan historian. What matters for him is not getting the economics right but moving the public policy debate in a conservative direction. He’s completely instrumental. Brits of his type have never got over the fall of Margaret Thatcher and are always on the look-out for a new stick to beat liberals with.

Mark May 2, 2009 · 9:44 am

I saw your picture on the CNN.com frontpage …. Top 100 most influential people ….

Congrats…. compared to others on the list, yours is well deserved.

we_are_toast May 2, 2009 · 9:59 am

Don’t borrow the savings, TAX the income before it becomes savings! By raising the taxes on those who are saving (very wealthy) you avoid the medium and long term problems associated with borrowing, especially when we already are running huge deficits.

Reagan started all the deficit spending, and the excuse has always been that we will pay it back when GDP grows and revenues increase. We still haven’t payed those debts from 30 years ago. If this depression, and world resource problems, prevent GDP from growing, the FED will have no other choice than monetization of the debt!

TAX, don’t BORROW!

Kirk Tofte May 2, 2009 · 10:03 am

The debate about the American and world economies is starting to remind me of the one regarding torture. On the one hand we have people like Paul Krugman (in both debates, as it turns out) basing his points on solid facts and sound theories. On the other hand we have legions who are featured in the media that cannot keep their facts OR their theories straight.
For example, in the tortured torture debate those who support “enhanced interrogation techniques” conveniently forget what the rule of law means. They seem to believe that torture works, that it saves lives and that the United States is limited by existing treaties and laws to which it voluntarily became a party. Well, then, why not debate whether torture should be made legal or not? Because authoritarian types want it both ways. They want to claim that the United States never has and never will torture people but want us to be free to do so if the government says we must. My opinion is most of the people that argue this way are just ignorant. But some know exactly what they’re saying between the lines.
A similar description on the debate over economic policy can be made. It is clear that very few (as in, virtually no one) among investment bankers, politicians, economists and so forth knew what they were really doing with and to our economy over the past twenty years. That fact, however, doesn’t keep many of these same characters from wanting to be listened to and followed today. To put it into political terms: who would any sane political strategist listen to these days, Karl Rove or his conterparts on the Democratic Party’s side? Who would any sane public policymaker listen to on the economy, Summers/Geithner/CNBC types or Krugman/Stiglitz?

lisa May 2, 2009 · 10:11 am

Professor Krugman, This is hard to comprehend. If the “desired” interest rate is below zero, doesn’t that mean that the banks don’t want our savings, kind of implying that they would pay us not to put our money into their accounts? Obviously, no one is going to pay me not to put money into their bank, if it really is a bank, but they might make my life miserable if I try to do business with them. Oh, wait . . .

If there is a glut of savings, it is only in the hands of a few people and their institutions, no? Isn’t the problem more a political one about barriers to access, with insiders (who have money to burn, so to speak) and outsiders, who are being (in some cases) thrown out of their homes by banks who are foreclosing on the owners? If you saw Bill Moyer’s great show last night about people in Dorchester, south of Boston who are trying to pay rent to the banks who have foreclosed on their homes, in order to stay in their houses, when the banks reject any attempt to rewrite their mortgages for a lower principle amount, it seems clear that the banks don’t want their money. Now, it may be that this is just a matter of confusion on the part of bank middle managers who work in the mortgage/foreclosure/workout departments (because according to the guy on the show, once their organization gets involved, they are usually able to work something out with the banks).

But I still don’t get it: what you are saying implies that there is no free market and that the banks don’t want there to be a free market. I’m trying to figure out what is broken here.

Could it just be that, for some reason (tax codes? competition with non-interest moneywerks), the banks would rather deal in fees rather than interest? Is it possible that working with interest is too risky, and that the money people feel they can make more money by charging fees every which way, so they prefer that. And we peons have no say, no power, no leverage as “they” have cornered the market on “money” and other resources, while the rest of us are sit here while the rules change around us so fast we can never figure out what we should be doing to preserve and protect what little we do have.

When you say there is too much savings, I think for most of us, that is not a reality in our lives at all–as we see money going down the drain (to enhance the savings of who-knows-who).

John Bosma May 2, 2009 · 10:13 am

Professor Krugman, that’s a lovely explanation – even non-economists can follow the text portion of you post. A request – for the (many) non-sophisticates, could you provide a link or post an explanation of how to read the graphs, so that people can cross-reference and truly understand your point relative to the visuals? Or perhaps an analogy? My experience is that non-economists have a hard time following, but can pick up once the visuals are explained. Without an understanding of the visuals, people are uncertain if they understand the argument, and they are forced to rely on your authority. Unfortunately you’re not the only economist posting on these topics – so authority doesn’t help aid their understanding.

Is there a way for you to explain this so non-wonks can get the point? Many thanks.

Clifford Nelson May 2, 2009 · 10:23 am

Good post, but perhaps the issue is that the savings are in China and it is not clear at what rate they will finance our recovery.

I note that ABC news reported that the savings rate in the United States was negative is this decade – something they said had not happened since the depression.

Take care,

Abhijit Ranade May 2, 2009 · 10:47 am

Right on the Naill. It should be noted that this is not just a national excess of savings but a global excess of savings. It is necessary to have a fiscal expansion on a global scale, to put in dent in this global problem of excess savings (without the U.S government taking upon itself an excess debt burden financed via global savings).

Michael C. May 2, 2009 · 10:49 am

Great Explanation, Thanks Paul.
Problem is, these days when people can’t understand “complex” theories they simply turn to more easily understood and often ready-made ones that lean to their predetermined ideological interests.
whether it be even remotely true or not is not that important, unfortunately.

a consequence of extreme partisanship in general?

Michael C.

David Lentini May 2, 2009 · 10:50 am

Since when has Niall Ferguson said anything useful?

Bob K May 2, 2009 · 10:51 am

You claim the problem is excess *global* supply of savings, but it seems to me that US government borrowing of excess Chinese savings is a strange cure. If my neighbor continues to produce more than I, and I continually go in debt to purchase his goods, I am merely contributing to a positive feedback loop which will bankrupt me and enrich him.

Tom Walker May 2, 2009 · 10:52 am

Wonkish or delusional?

What we have here are dueling panaceas. Dr. Ferguson, in effect, prescribes bleeding the patient with deflation. Dr. Krugman, on the other hand, prescribes an emetic of inflation to purge the patient of its noxious humors. In either case, if the patient dies, the physician can always argue that death was due not to the remedy itself but to an insufficiently vigorous application of the curative regime. Bollocks. Where, oh where, is Moliere when we need him?

There should be a law that anyone citing John Hicks’s 1937 paper should also cite his 1975 repudiation of that “successful little analytical toy.”

Noah May 2, 2009 · 10:52 am

I think it would be helpful to help readers understand why we’re in a Dark Age of Macroeonomics if you took a blog post or two to explain the main alternatives to Keynesian theory that became dominant in the 80s and 90s – the RBC models, which deal with monetary issues by simply assuming they don’t exist…

baileyman May 2, 2009 · 11:13 am

This is like the bike pushing problem. You lean a fixed gear bike against the wall and then push backwards against the lower pedal. Thus you’re pushing the pedal in the direction for it to drive the bike forward. Yet you’re pushing toward the rear of the bike. Which way does the bike move?

Backwards, of course.

Dominic J May 2, 2009 · 11:19 am

The last global liquidity trap took a Second World (Stimulus Package) to escape from. Do you have any interpretation on how long it would have taken to escape without that stimulus? Would it have been a couple more years, or another depressed decade?

I confess, I’m not doing my bit – despite being in my early twenties (and earning far less than I expect to in future) I’m still saving, even at near-negligible returns.

wally May 2, 2009 · 11:20 am

“…we’re living in a Dark Age of macroeconomics, in which hard-won knowledge has simply been forgotten.”

You are giving too much credence to the thought that it was ever known in the first place.

cucaracha May 2, 2009 · 11:20 am

You are not computing medium/long term interest rates in your model.

More government issued medium/long term debt without the corresponding Central Bank purchases- financing – means more of a “safe haven” for those excess savings to go to.

It is just relocation from private to public investment.

The only advantage, in this case, is that the borrowed savings can be equaled to investment by the Government – You will have more of the latter but with a considerable risk of having not enough of it and reducing available resources for private investment.

Kevin Hundt May 2, 2009 · 11:21 am

Thank you for posting this. It seems the latest nonsense we are hearing from “Fixed News” and Dick Morris is that Obama’s spending is going to force a rise in interest rates that will hurt the economy, so it is ironic I am reading this post this morning. Anyone who wants to see Dick’s poor attempt at economics can just view his latest post:
//www.dickmorris.com/blog/2009/04/29/obama-sows-seeds-of-demise/

Frank Restly May 2, 2009 · 11:25 am

The crowd out phenomenon (as it applies to interest rates) that Mr. Nocera puts forth must make allowances for credit risk (perceived or real). The crowd out danger here is because of the lack of credit risk in U. S. government debt and the credit purchasing habits of our trading partners. The crowd out comes from the spread between public debt and private debt, not the nominal interest rate on either.

There is a tacked on effect of public finance crowding out the private sector that I believe worries Mr. Nocera more. When the public sector spends money it diverts more than savings away the private sector. It can tend to divert away other resources as well (labor, raw materials, etc.). After all Mr. Krugman, why would you continue to write for the New York Times if the federal government wanted to pay you three times for writing for them.

John Thomas May 2, 2009 · 11:27 am

I suspect the government support for debt and equity prices, particularly housing, but also in the finance industry, keeps savers liquid. That is, we have excess savings because prices in these massive industries are artificially inflated. If we would deal with the pain of the bubble (i.e. let prices go), we could get through the problem. I suspect we will eventually, but this method seems more painful.

This reminds me of when I was a kid and wanted to take the bandage off slowly because I did not want all the pain at once. Instead, I had pain for a long period of time. My Dad taught me getting through the pain quickly is probably best in the long run as he mopped the tears from my eyes after ripping the bandage off. Now that I am older, I think he is right.

Bill N May 2, 2009 · 11:28 am

“…our current problem is, in effect, a problem of excess worldwide savings, looking for someplace to go.”

So, do we have to save the world before we can save us? certainly don’t have an excess of savings.

vraiment confuse

Matthew May 2, 2009 · 11:28 am

I don’t understand why investment and savings need to be the same, as is shown in every graph.

Beezer May 2, 2009 · 11:32 am

OK. So that’s what Wall Street satisfied by concocting faux bonds called derivatives. They vaporized as much as was humanly possible that way.

And yet, there’s still more savings left? Whew. That must have been one huge savings pile a few years back.