Thursday, July 24, 2014

The myth of loanable funds

This one is a biggie! It has been referenced a number of times in previous posts but it warrants further explanation as it underlies many of the misplaced fears about government spending and debt. 

The "loanable funds market" does not exist in the real world, and yet remarkably, the belief in it is held by most economists and almost all politicians. And that means it drives policy decisions - in a wrong direction on both sides! This is one deadly myth!

The idea is this: 

  • savings create deposits (see this myth exposed here); 
  • the pool of savings is available for lending by banks etc.; 
  • to the extent the government increases deficits, a greater share of the "pool of loanable funds" gets used up by government debt (bonds); 
  • this takes away from (or "crowds out") private sector investment.

Look at this quote from the Congressional Budget Office (CBO):

Large federal budget deficits over the long term would reduce investment, resulting in lower national income and higher interest rates than would otherwise occur. Increased government borrowing would cause a larger share of the savings potentially available for investment to be used for purchasing government securities, such as Treasury bonds. Those purchases would crowd out investment in capital goods—factories and computers, for example—which makes workers more productive.

Here we have a classic example of how pervasive is the complete misunderstanding of how modern money functions. Our policy-makers are guided by this kind of economic nonsense into foolish decisions that constrain use of government fiscal activity to address critical issues and desirable outcomes. 

Scott Fullwiler has an excellent piece explaining how the CBO is still following an outdated paradigm - read it here. It's quite shocking to see how perilously wrong they are about such an important topic. 

As explained previously, banks are NEVER constrained in their lending by the amount of deposits they have. If they find a good lending opportunity, they will write the loan. The creation of the loan creates a new deposit (literally new bank money created by computer entries). They can either obtain the required reserves from another bank or the Central Bank will always provide reserves if there is a shortfall in order to keep their target interest rate. 

Some might say we should have a 100% reserve requirement for banks so they don't create so much debt. The concern is valid as irresponsible lending/speculation by banks is a real problem. However, having a 100% reserve requirement doesn't change anything. Banks are not constrained by reserves (or deposits). They can still create loans at will, so the key to limiting the inappropriate lending is to change and enforce the rule - i.e. proper regulation and criminal prosecutions for fraud etc.  

So let's turn back to the government. Does the government debt take away anything from the private sector? No! No business suffers from an inability to obtain financing for a good investment because there are too many government bonds for sale. In fact, the so-called "debt" is actually the only "net" financial savings in an economy. For every dollar saved by one person, another person must become indebted a dollar (all money is debt) - there's no net monetary savings in the economy except for government injections of money which get turned into what we call the national debt. 

Wars can be very helpful to illustrate monetary operations (unfortunately we don't learn from then and apply the same approach in peacetime for national interests!) How did the US fund WWII? It created new money in large quantities and spent it into the economy. Since the economy reached a level of almost full productivity and employment, tax increases were needed to avoid inflation (we are a long way from that problem today!) Did the US need to collect from a pool of savings before it spent? No. It spent, and then taxed/sold bonds in order to drain excess dollars from the economy.

Look at the combination of the GW Bush tax cuts and wars. How was it paid for? New money created and spent. So why are we happy to do this when it's for the wrong reasons but we don't do it for what we really need to take our economy into the next century and meet the needs of its citizens?

What do you think we should use the people's money for? 

How about a national high-speed electric train system to reduce dependence on flights between major metro areas and reduce oil usage and pollution?

How about taking care of our growing elderly population with leading edge housing designs and care?

How about improving the care for our veterans and their families?

What about a job guarantee so that everyone who wants to work can work and provide for their families so everyone can contribute to society and productivity?

How about both parties getting together to create medical care for everyone while still using the best of the private sector's capabilities and lowering medical costs for businesses?

Why wouldn't we accelerate the move to a clean and sustainable energy  

It is ALL affordable. There is NO constraint in terms of "savings" - in fact such initiatives would increase the net financial wealth of the country since government funding ends up in private sector bank accounts.

Share the positive news and let's end the deadly myths that hold back our nation. We need a congress that understands this stuff, and it will take all of us spreading the word to get there.