12 June 2011

Paul Krugman knows it all
Raghuram Rajan is a mild-mannered economist at Chicago's Booth School of Business, best known for having warned way back in 2005 that the banking system was taking unmanageable risks with the potential of causing serious damage to the real economy.

In a recent article, Money Magic Rajan suggested that low interest rates, far from promoting growth, may be hindering it. There is nothing outlandish about the idea. This decade has seen the lowest extended period of low interest rates and also the longest period of low growth. So any economist who has not absolutely shut his mind would at least consider the possibility of a connection between the two.

But of course not Paul Krugman. In his usual polemic style in which personal attacks are par for the course he accused Rajan of tricking his audience. The attack can be seen at Monetary Calvinball. In what follows I take up one statement by Krugman.

Krugman says:

"He [Rajan] simply takes it for granted that there's something unnatural about very low rates right now. But why? It's obvious that desired saving (or rather, the amount people would want to save if we were anywhere near full employment) is currently greater than desired investment. That suggests that the natural rate of interest right now is negative; only the zero lower bound keeps it from going there."

Now why would Krugman think that this is a clinching argument obvious to everyone except rentiers and their henchmen? Rentier, by the way, heads Krugman's current list of swear words.

The only explanation I can think of is that he is arguing by analogy. If the demand for wheat is too low and the supply too high, lowering the price of wheat would bring supply and demand into equilibrium by reducing supply and enhancing demand.

So far, so good. Unfortunately, the analogy does not carry over to money.

One, interest is not the price of money (Rajan too makes this error); it is the rent for money. The entity that lends money expects to get it back unlike the seller of wheat. So the risk of not getting back the money has to be priced into the interest rate. The entity does not buy money at one rate (x, close to zero) and sell it at a slightly higher rate (x plus a small mark-up).

Two, people save in the expectation of rainy days in future, not because of the interest rate. So lowering the interest rate won't persuade people to spend money instead of saving it; this happens during every recession and should be obvious to everyone except the absolutely blinkered like Krugman.

Three, the saver of money is not the lender of money. There is an intermediary, either a bank or some other financial institution. For the same reason that low rents reduce the quantity of housing brought to the market (a fact obvious to every economist), low interest rates discourage banks from lending money to firms. In other words, the exclusion of banks from Krugman's argument makes it appear that low interest rates enhance demand for loans, conveniently ignoring the fact that they diminish the incentive to supply loans. In other words, when it is favourable to Krugman, he ignores the supply side of the equation and considers only the demand side.

I have pointed out elsewhere that the whole Keynesian economic model depends on the absence of banks. The Keynesian model treats money as consisting entirely of currency and as soon as banks are introduced into the model the entire structure collapses. See John Maynard Keynes and the dog that did not mark

The same can be seen in Krugman. As I have pointed out above, his argument depends on the absence of banks and the direct transfer of money from savers to borrowers. In articles like Thinking about the liquidity trap too it can be seen that his models always treat money as cash and that there are no banks.

Category: Economics

Philip George
Understanding Keynes to go beyond him

Buy my new ebook
Contact Me
October 2022
September 2022
March 2022
January 2022
October 2021
August 2021
July 2021
August 2019
October 2018
April 2018
December 2016
October 2016
August 2016
July 2016
April 2016
March 2016
January 2016
December 2015
November 2015
October 2015
September 2015
August 2015
June 2015
May 2015
February 2015
November 2014
October 2014
August 2014
May 2014
April 2014
December 2013
October 2013
July 2013
May 2013
January 2013
November 2012
October 2012
August 2012
July 2012
June 2012
May 2012
March 2012
February 2012
January 2012
December 2011
November 2011
August 2011
July 2011
June 2011
May 2011
April 2011
March 2011
August 2010
October 2009
May 2009
June 2008
March 2008
February 2008
January 2008
December 2007
August 2007
June 2007
May 2007