Back to the Basics: ‘commodity paradigm’ vs. ‘monetary analysis’
Understanding the saving-investment process via the demand for liquidity
A key reason for not having been able to perceive the problematic developments prior to the Transatlantic Financial Crisis 2007/08 was a way of thinking about economics via the classic equilibrium of goods model. By far being the most dominant theory that proposes that banks are not at all special institutions but mere financial intermediaries, it is rooted in perceiving money as an ‘all-purpose good’ that can be utilised both as a consumption good and an investment good. Interest rate appears in this model as being determined through savings and investment plans; savings is assumed as identical to the supply of funds, investments with the demand for funds. Financial transactions are conceptualised as not being independent from real economic transactions. Financial markets are assumed to be the mirror image of goods markets. Banks and other financial intermediaries are pure middleman and distributors for the ‘all-purpose good’. This seems all-to-familiar to the loanable funds theory. However, it turns out that the financial and economic crises post-2008 gave just enough momentum to question such models and presumed knowledge of the economy:
“The progression of economic knowledge is comparable with a walk on a tightrope. Progressing without taking into account past and present (real world) developments risks the foundations of that construed knowledge to be exposed and to be challenged due to having reached an impasse. Knowledge is not neutral and hence must be continually subject to scrutiny. Power dynamics may initially prohibit the modification of economic knowledge by denouncing fresh insights as inscientific but will not in themselves preclude the emergence of the need to review previous assumptions and theorems.” [1]
The classic equilibrium of goods model is now increasingly deemed no longer fit for purpose in depicting the reality of financial markets as it is based on commodity money (compare the evolution of monetary practice - Part II / Part III). [2]
Loans for investment create deposits and savings:
This theoretical underpinning relates to a serious macroeconomic misconception that concerns the assumption that savings in the form of deposits create investment:
“[P]rivate saving, interpreted as forgoing consumption in order to free real resources, was the major determinant of a nation's level of investment so that policy should be designed to increase individuals' desired savings.” [3]
Bofinger advocates in his 5th text book edition a monetary model to help explain developments in the financial system based on fiat money, a.k.a. credit money. [4]
In a monetary model,
“financial markets (LM curve) are conceptualised as independent from the goods markets (IS curve). Interest rate is no longer assumed to be determined by savings and investment decisions alone, but also through the interaction of financial markets and goods markets. Banks in this monetary model have the capacity to create money and there are pure financial transactions, i.e. investment in monetary stocks on capital markets. Savings is thus no longer perceived as a prerequisite for investments as investments generate via higher earnings more savings and deposits are thus no condition for awarding loans: loans create deposits.” [5] (own emphasis)
It is thus not a coincidence that the classic equilibrium of goods model posits saving as a prerequisite for investment as it does not consider money as a legally enforcing debt but merely as an ‘all-purpose good’. [6] What is thus vital to distinguish is furthermore that not every bank deposit is an expression of saving, since the purchase or sale of realty is, for instance, not a form of saving but is an expression of the redeployment of wealth. [7] The modelling of financial systems via a ‘commodity paradigm’ thus radically differs from modelling such systems through a ‘monetary analysis’, a distinction already key to approaches developed by Keynes and Schumpeter. [8]
Under the loanable funds theory banks need the standard good from savers in order to be able to grant loans, it is however that loans for investment purposes create money that ‘triggers investment. […] Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does. To argue otherwise confuses the respective macroeconomic roles of resources (savings) and debt-financed money (financing):’ [9]
“a loan is extended precisely because the funds are to be used to support additional economic activity, which in turn generates additional demand for liquidity and thus for bank deposits.” [10]
As the so-called Radcliffe school (in the tradition of the Banking School) puts it: ‘it is the general liquidity of the economy, rather than the supply of money narrowly defined, which is the prime financial influence on the level of spending.’ [11]
This means that the focus of a ‘monetary analysis’ lies in emphasising the liquidity-oriented effects within the modern economy meaning also a more elastic view of it centering around investors whereas the analytical framework in line with the ‘commodity paradigm’ gravitating around savers explicitly involving an inelastic view of the changes in the money supply. [12]
Sources:
[1] Barta, A. (2022) ‘The Order of Money and Finance: Exploring epistemes in the history of economic imaginative power’, [online] available at: <https://alexanderbarta.substack.com/p/epistemes> [Last accessed 30th August 2024].
[2] Bofinger, P. (2020) Grundzüge der Volkswirtschaftslehre: Eine Einführung in die Wissenschaft von Märkten, Munich: Pearson, p. 486.
[3] Kregel, J. A. (1986) ‘A Note on Finance, Liquidity, Saving, and Investment’, in Journal of Post Keynesian Economics, Vol. 9, No. 1, p. 91.
[4] Bofinger, P. (2020) Grundzüge der Volkswirtschaftslehre: Eine Einführung in die Wissenschaft von Märkten, Munich: Pearson, pp. 492f.
[5] Ibid., p. 484.
[6] Bofinger, P. (2017) ‘“Realwirtschaftliche Modelle sind überholt”’, in Braunberger, G. (ed.) FAZIT, [online] available at: <https://blogs.faz.net/fazit/2017/07/19/realwirtschaftliche-modelle-sind-ueberholt-8932/> [Last accessed 30th August 2024].
[7] Ibid.
[8] Bofinger, P. & Ries, M. (2017) ‘Excess Saving and Low Interest Rates: Theory and Empirical Evidence’, CEPR Discussion Paper, No. DP12111, [online] available at: <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2992561> [Last accessed 30th August 2024].
[9] Jakab, Z. & Kumhof, M. (2014) ‘Banks are not intermediaries of loanable funds - and why this matters’, in Bank of England Working Paper No. 529, [online] available at: <https://www.bankofengland.co.uk/working-paper/2015/banks-are-not-intermediaries-of-loanable-funds-and-why-this-matters> [Last accessed 30th August 2024], p. ii.
[10] Kumhof, M. & Jakab, Z. (2016) ‘The Truth about Banks’, in IMF Finance & Development, Vol. 53 No. 1, March 2016, [online] available at: <https://www.imf.org/external/pubs/ft/fandd/2016/03/pdf/kumhof.pdf> [Last accessed 30th August 2024], p. 52.
[11] Cramp, A. B. (1962) ‘Two Views on Money’, in Lloyds Bank Review, No. 65, p. 3.
[12] Davidson, P. (2006) ‘Exogeneous versus endogeneous money: the conceptual foundations’, in Setterfield, M. (ed.) Complexity, Endogeneous Money and Macroeconomic Theory, Cheltenham, UK: Edward Elgar, p. 143.