ZLB Redux

I could have been an historian, you know. Antiquity, particularly Rome, is my greatest interest when it comes to history. But no. I had to join what amounts to a carnival and tolerate the nonsensical ramblings of “elevated” alchemists who, in all reality, amount to little more than pixie dust spreaders on a Tilt-A-Whirl called the economy. Stagnant economy? No problem. Just call up Tinkerbell, have her sprinkle some pixie dust over the Fed, wave her magic wand and out of the zero lower bound we go. Weeee! Disneyland Economics – It’s what happens when you take the words of a duck wearing a shirt but no pants, a flying boy in tights and a singing cricket seriously.

Looking back over the last week’s activity and drama, I now realize that I could have better spent my free time edging the lawn, pruning a bush, washing the car, or perhaps watching a Buster Keaton film. But no. Instead, I chose to argue that fiscal rules are nonsense, which they are, and that there should be but one rule if we are going to have rules – The fiscal rule should target prosperity and nothing else. I chose to argue that monetary policy was inept; helpless against a dramatic fall in non-government spending and so, monetary policy cannot possibly be “all that we need”.

One would think that such an endeavor would have its predictable effects: confuse New Keynesians which is par for the course. They would then call me confused, issue a few useless, snide comments about how I should go spend time with Bill Mitchell (as though such a thing would be bad), state that they have no idea what I am talking about because I’m rationalizing, perform their celebratory declaration of victory and that would be that. And they did pretty much as I expected, though the thing that I cannot understand is why I even bothered in the first place to do something that I knew would be pointless. You can’t reason with New Keynesians, on professional grounds or taking the gloves off. Nothing works. It’s an exercise in futility. Look at how Krugman brushed Steve Keen off. Simply put, if there is ever going to be any progress, the neoclassical view of interest rates needs to be crucified then burnt to ashes. If we cannot manage that, then there is no hope of placing a dunce cap on New Keynesians and making them sit in front of the class. They’re the kind of people who tell you that a financial sector is utterly meaningless to understanding the economy. But, later on, when a financial crisis hits, they’d add a financial sector to their models, claim that they were never wrong it’s just that no economists ever attempted to deal with the financial sector, because it’s not part of macroeconomics. But through their current models, the crisis is easily understood now – even though the financial sector “isn’t part of” macroeconomics.

It’s kind of like a group of accountants screwing up everyone’s tax returns, then claiming that they were never wrong, it’s just that previously, the thing that contributed to the screw up wasn’t part of the accounting profession.

But anyway, it didn’t entirely have its predictable effects. For instance, though I was arguing against New Keynesian gobbledygook, I also manage to attract a Post-Keynesian who wanted to argue that my statements concerning QE isn’t what QE is about. Excuse me, but could you try missing my point just a little further over in that direction? Thanks. You’re a peach.

My point centered around mainstream views of banking. If it is assumed by the mainstream that banks lend out reserves and QE swaps assets for reserves, then it is quite obvious that one of the intents is to stimulate lending. See how that works, Mr. Academic Man? The point then is that since QE failed to stimulate lending, NIRP will fail as well given the mainstream’s Loanable Funds Theory assumption. Over reliance on the “Go my team!” mentality means that there is a very real danger one will lose their grip on reality. If you are so deep into the rabbit hole that you can easily miss such a simple point, then perhaps it’s time for you to take an extremely long sabbatical.

Then to top it all off, on Friday, my son came home early from school with a fever and threw up all over the place. New Keynesians would tell me that their models show that my son needs venesections in order to deal with the fever. Instead, I gave him children’s Tylenol for his fever and it worked. Of course, New Keynesians would assert that everyone knew this already, but that I am horribly confused: Administering Tylenol was a mere adjustment to the four humors seeking equilibrium.


As I am on a brief vacation until Sunday, I’ll keep this article short. There still remains a bit of confusion as to my point concerning fiscal rules and the zero lower bound. As I’ve said many times, some of the concepts I talk about are difficult to whittle down for people with no background and sometimes, in the interests of brevity, I let important things fall by the wayside when I know that I really shouldn’t. So, in my next two posts, I will try to address the things I let slide in the hope of facilitating a better understanding. Today, I’ll discuss the zero lower bound nonsense and in my next article, I’ll talk about fiscal rules. Let’s get started.

Loanable Funds Theory is Fantasy

I discussed LFT in my previous article, but we will go a bit deeper. Firstly, as I and many others have said a trillion times now, Loanable Funds Theory is total nonsense, regardless of what the Holy Father of the Church of Confusion, Paul Krugman says is contained in the Book of Bewilderment. Let’s take a quick gander at the verse of scripture:

“At that time the market god spake saying, ‘Behold! Thou shalt depositeth money into divers banks and divers banks must loaneth those deposits out forthwith to divers people who shall invest it in divers good things. I shall causeth the real interest rate to adjusteth from time to time for aggregate demand to equal aggregate supply and ye shall enjoyeth full employment. But lo! Verily, verily I say unto you, beware of the Evil One who walketh to and fro amongst thee. For he doth worketh iniquity, crowding out mine holy investment commandment that I giveth thee and also inflicteth he upon thee the plague of the zero lower bound. He doth seeketh to interfereth with mine will and stuff, don’t you knoweth. Therefore, enter thee not into his temptation.’ And it came to pass that the people feared the market god and cursed the Evil One. They placed their money into banks and interest rates did ration the people’s finite savings for investment, even unto prosperity.”

Here endeth the lesson: Loanable Funds may exist in the imagination of Pope Krugman the Questionable, but it doesn’t exist in the real world. Again, for those with a more advanced understanding, here is the link to the Bank of England paper. Now, you might ask why I am taking a “vicious” swipe at Paul Krugman. The answer to that question is because Paul is largely responsible for this silly Zero Lower Bound (ZLB) nonsense as the explanation for stagnation post-financial crisis which Wren-Lewis holds as reality. I’ll discuss the ZLB propaganda in a moment.

So, to reiterate, the Lord of the Loanable Funds bank operations fantasy epic says that customer deposits provide the funds for banks to lend. Banks are then intermediaries that bring savers and investors together and the interest rate is determined by the demand for and the supply of loanable funds. Savings is finite and is rationed out by interest rates. It is this last sentence, “savings is finite and is rationed out by interest rates.” that enables you to understand two important things: 1.) why mainstream opinion errantly focuses on monetary policy (interest rates) and 2.) why I did not need to discuss monetary policy to attack fiscal rules: Because loanable funds doesn’t exist.

There is no lending of customer deposits. Banks operate on the credit creation model. They create their own little IOU which they then denominate in the government’s currency. Loans create deposits. The deposit is a bunch of bank IOUs conjured out of thin air. Once the borrower spends the deposit, the IOUs then behave as money in the private sector for two reasons:

1.) Since the IOUs are denominated in the government’s unit of account, they can satisfy any tax obligations owed to the national government and,

2.) by spending the deposit, the borrower demands the government’s currency and that currency which is sitting in a reserve account at the central bank then merely shifts from the borrower’s bank’s reserve account to another bank’s reserve account completing the transaction, all the while never entering the economy. In other words, reserves are not there to be lent out. They ensure that the payment system operates. The bank IOUs remain until the loan is paid off at which time, the IOUs are destroyed.

Again, an easy to understand description can be found here.

Another important aspect of reality is that banks are incapable of destroying the government’s currency. For instance, should there be excess reserves system-wide, banks can only shift those reserves between reserve accounts through interbank market activity. They cannot rid the system of the excess. Think of it this way: if the government dumped a pile of sand in your living room and bedroom, then you moved some sand from the bedroom and living room to the bathroom and the dining room, you are not reducing the amount of sand in your house. You are just moving it around. That is what banks do. Banks maintain reserve accounts at the Federal Reserve and they move reserves around between themselves. Thus, this activity can result in a few banks being short of reserves, but not the entire system itself. The activity in no way destroys net financial assets. For that to occur, you need the national government to intervene.

Furthermore, as I mention in my previous article, the money multiplier, which goes hand in hand with Loanable Funds Theory, is extreme mainstream nonsense as explained by this Federal Reserve paper. It is pure prophecy of doom mythology found in the Church of Confusion’s “Book of Financial Armageddon” that is presented as the way things really are in economics textbooks. Yet another reason why students should burn their textbooks. Belief in the money multiplier can lead to all sorts of delusional fantasies, such as this paper by Christopher Phelan Should We Worry About Excess Reserves?

Of course, given our understanding of how the system actually works, the real question is, should we worry about Christopher Phelan? Now, given these facts, I can explain Krugman and Wren-Lewis’s ZLB nonsense.

As I mentioned a moment ago, Paul Krugman is largely responsible for the zero lower bound explanation of stagnation. See “Debt, deleveraging, and the liquidity trap: a Fisher-Minsky-Koo approach” (Eggertsson and Krugman, 2012).

The way Krugman pieces the argument together is that initially aggregate supply (AS) equals aggregate demand (AD) and all was right with the world. After the crisis when deleveraging increased savings, AD was forced downward and a negative real interest rate was needed to clear the goods market and achieve equilibrium. The ZLB interfered with a return to equilibrium. With the nominal interest rate at zero, the real interest rate wasn’t low enough to push AD upward and so, the excess supply of loanable funds resulted in decreased output. The decrease in output causes a decrease in both income and savings along with a decrease in investment activity. Output then continues to fall until savings and investment equal one another. Therefore, as long as we are in the ZLB, monetary policy cannot support full employment.

In layperson’s terms, after the financial crisis in 2008, households had way too much private debt on their books and decided to deleverage. Deleveraging means to pay down debt, so dollars that consumers had to spend now shifted to debt payments. Deleveraging resulted in an increase in savings which then decreased the real interest rate. But instead of – and here it comes – the loanable funds market achieving nirvana, the darned ZLB interfered with everything that was good and decent in the world, leaving an excess supply of loanable funds floating around. The next thing you know, that non-existent excess supply of loanable funds magically resulted in decreased output and increased unemployment. Stagnation then set in and we simply cannot get to full employment while the evil eye of the ZLB rules the world.

So, first, Krugman did not see the crisis coming, but through his reliance on the non-existent Loanable Funds Theory, after the financial crisis of 2008 he can easily explain why there is stagnation and his explanation should be trusted as a foundation to set further economic policy. I say, no! No, no, no, no, no, NO! In no way should Paul Krugman be trusted in this context and yes, I question Krugman’s veracity. The ZLB explanation is entirely absurd. Thus, I said to Wren-Lewis: “ZLB is rationalisation.” which it is. It is an excuse by Krugman to justify the continued reliance on monetary policy which in no way, shape, or form can reverse a massive collapse in consumer spending.

The point here then, which you can easily gather, is that Wren-Lewis’s ZLB argument hinges on something that simply doesn’t exist – Loanable Funds Theory.