A commentator on my last post at Mike Norman Economics, who gives his name simply as ‘John’, made the following interesting comment:
I heard a nice, intuitive and very easy argument recently that puts loanable funds to bed. No fancy mathematics, no convoluted diagrams, just a straight simple argument that goes like this:
When the government borrows, from whom does it borrow? The private sector who have funds in the financial system, right? The government borrows these funds and spends it directly back into the economy. Where do these spent funds find their way to? Back into the private sector who on aggregate have the same amount of funds in the financial system that they had prior to the government borrowing. Where else can the government spending and private funds go, but back into the financial system?
At first I thought that surely even neoclassical economists who believe in the loanable funds model can’t be making such an elementary error.
And yet… if you look at the way national accounting gets treated in the textbooks I mentioned, it seems as if that’s exactly the error being taught. Here I want to explain why they make that mistake. But first, let’s look at the mistake in some detail.
The textbook loanable funds model is based on the idea that ‘when the government spends more than it taxes, the resulting deficit lowers national saving’ (Mankiw, see last post). National saving is explained in national accounting terms as follows (I’m sticking with the closed economy model – no net exports or imports):
S ≡ Y – C – G,
where Y is total income (GDP), C is expenditure on consumption, and G is expenditure by the government. Meanwhile Y is defined as the sum of consumption, investment (I) and government expenditure:
Y ≡ C + I + G.
How do we get to the idea that government deficits reduce national savings? The idea is that if G increases then Y – C – G will have to decrease. But so far it seems just as logical to argue that Y must increase, since G is a component of Y.
What we need to ask about any accounting identity is, of course, what the relevant accounts are. If we’re talking about bank deposits, then G will represent total credits to the accounts of sellers of public goods to the government (henceforth ‘public goods accounts’), C will represent total credits to the accounts of sellers of consumption goods (henceforth ‘consumption accounts’), I will represent total credits to deposits of sellers of investment goods (‘investment accounts’), and Y will represent the sum of these.
So suppose the government borrows £10m out of the ‘investment accounts’ (loanable funds seems to assume a fixed supply of deposits). Then we have this:
There is no change in Y, since one of its summands has only fallen by the same value as another has increased. And thus national savings, S, must have fallen, since S ≡ Y – C – G, Y and C have stayed the same, and G has increased. This is where we get the idea that government deficits reduce national savings:
But this shows that John is correct. If private investors want to borrow money to invest, the money is right there in the public goods accounts. The national savings level is irrelevant, because it doesn’t represent the amount of available funds to borrow. It’s an idle accounting construct, representing nothing of significance.
You can see how irrelevant the national savings measure is if you imagine the same scenario with one difference: the government borrows out of consumption accounts instead of investment accounts. Then we have:
There is now no change in national savings, Y – C – G, since C has come down by the amount that G has gone up, and again Y has stayed the same. How could the effect of government borrowing on national savings depend on which private accounts the government borrows from? The whole thing is a disaster of accounting.
The point becomes even clearer when we disaggregate the components of national saving into the government’s savings and the private sector’s savings. This is done in the textbooks in the following way:
S ≡ (Y – T – C) + (T – G)
T is tax revenue. Since we’re dealing with bank deposits, this will be credits to tax accounts. In the first pair of parentheses we have private saving. In the second, we have public saving. In terms of bank deposits, these represent, respectively:
- Total credits to all bank accounts minus credits to public goods accounts and consumption accounts, and
- Total credits to tax accounts minus credits to public goods accounts.
So what happens if the government borrows £10m from investment accounts? It will look like this:
Public saving falls by £10m, since £10m is credited to public goods accounts and nothing is credited to tax accounts to offset this. Private saving doesn’t change, since there are no new net payments into total bank accounts, Y, nor are there any credits or debits to tax accounts or consumption accounts.
This balance sheet should look very alarming to an accountant. Funds have flowed out of public savings, but there is no accounting for where they have gone. We have a debit but no corresponding credit. Anybody familiar with the sectoral balance approach will know how to account for this missing credit, but that’s not the point here.
The question is: where does this bizarre accounting in the textbooks come from? The answer is, of course, that even though the textbooks go on to talk about funds, the accounting is all in terms of real goods.
Suppose we switch from talking about bank deposits to talking about real resources. Imagine a simple Ricardian corn economy: all the economy produces is corn, and all it needs to produce corn is corn and labour. Y is now the total harvest of corn in some period, measured in terms of (say) weight. C is the corn eaten during that period. I is the corn planted as seed corn in order to grow more corn (yes, I know corn doesn’t work like this). T is the corn handed over to the government and put in its ‘tax silo’. G is the corn eaten by the government (no wonder William Cobbett called them ‘tax-eaters’). Now things begin to make a bit more sense.
First, it’s clear why there is less corn available for investment when the government runs a deficit – that is, T – G is negative. The government has eaten the corn, so it can’t be invested. Ingesting precludes investing. It’s also clear why the government can only ‘borrow’ out of I, not out of C. C represents corn that is eaten, and the government can’t ‘borrow’ this without resorting to unspeakable procedures. It can, however, borrow out of I – the corn planted as seed corn; it just has to dig it out. A seedbed is a granary in the ground. Finally, the measures of private and public saving now make sense. Private saving, Y – C – T, represents the corn that the private sector still has – what isn’t eaten or handed over to the tax-eaters. Public saving, T – G, represents the corn the government still has – whatever is in the tax silo that the tax-eaters haven’t eaten yet. If T – G is negative – a deficit – then the government must have eaten everything in the tax silo and more besides; this more can only come from the seedbeds accounted for in I.
The explanation of this:
is now clear enough. G is a measure of eating, not of spending, so we don’t need to ask where the corn has gone. In fact, maybe you’d rather not.
So loanable funds makes perfect sense in a world where the government taxes and borrows corn and eats it rather than spending it. If you find yourself in that possible world, remember your loanable funds training. But here we are in the actual world, so why are we talking about this?
I hesitate to suggest that mainstream economists fail to recognise the relevant difference between money and corn. And yet look at this blog post by Nick Rowe, arguing that deficits do, in fact, burden future generations (even though they patently don’t). His argument depends on a model in which the government borrows apples, people buy bonds using apples, and people eat the apples. Rowe happily extrapolates from this model to the case in which the government borrows money, unbothered by the crashingly obvious disanalogy. Maybe if you go into an economics department when they’re not expecting you, you will witness an unearthly feast of notes and coins. That would explain a bit.
Of course it isn’t just economists who are oblivious to the difference between corn (or apples) and money. People who complain about ‘their taxes’ going to benefit cheats, who spend it all on booze, fags, and big TVs, never consider that this means income for the (taxpaying) employees of supermarkets, indeed that most of the money flows back to all of us. They view the benefit cheats simultaneously as irresponsible spenders and as tax-eaters, failing to consider that you can’t spend your money and eat it too.
All the same, whether accounting in corn or in money, loanable funds is still based on the national accounting identity. Accounting must be done properly or not at all. So we still need to track all the relevant flows. A debit to public savings must be matched to a credit of some sort. So where does the corn go after being eaten? We all know the answer, but it would be indelicate to make it explicit. Let’s just call it ‘the mystery account’. Now:
This mystery account is the receptacle of all the corn-debits represented in consumption and government spending. Whenever there is negative public or private saving, the debits flow into the mystery account. But nothing ever flows out of the mystery account: the sources of public and private saving are the harvest, Y. Whatever isn’t saved out of the harvest goes into the mystery account.
And that’s what mainstream economics gets us: a ceaseless accumulation of the contents of that mystery account.