Paul Krugman and Loanable Funds

November 24th, 2013
in Op Ed

Why Does Paul Krugman Still Think in Terms of Loanable Funds?

by Dirk Ehnts, Econoblog101

It is a little bit disappointed to see Paul Krugman still married to the loanable funds theory (my highlighting):

So with all that household borrowing, you might have expected the period 1985-2007 to be one of strong inflationary pressure, high interest rates, or both. In fact, you see neither - this was the era of the Great Moderation, a time of low inflation and generally low interest rates. Without all that increase in household debt, interest rates would presumably have to have been considerably lower - maybe negative. In other words, you can argue that our economy has been trying to get into the liquidity trap for a number of years, and that it only avoided the trap for a while thanks to successive bubbles.

Follow up:

The same Paul Krugman has pointed out that "central banks clearly retained the power to set short-term interest rates" (his words). So, households and firms and even governments borrow what they want to borrow and that will not move the short-term interest rate. The spread between long-term rates relevant for borrowers and short-term rates set by the central bank changes over time, as can be seen below.


Nevertheless, to argue that demand for loans influenced interest rates is utterly incompatible with the idea of short-term rates set by the central bank. You cannot be Keynesian on the short-term rate and neo-classical on the long-term rate. As we see in the graph, the long rates are always above the short rate, with the spread varying. The spread normally has something to do with risk aversion, as the spike in 2009 shows (Lehman Brothers). What did not happen in 2009 is that households and firms wanted to borrow more (look at the graph below for one half of the story). Regarding causality, either long rates rising make short-term rates rise, too, or vice versa. Given that central banks set the short-term interest rate I think that the answer to this question is quite clear. If you think that interest rates rise when loan demand rises, how would you explain that:


1950s to 1980: interest rates rise because debt rises. After that: rising debt leads to falling interest rates. Hmmm...

Will the real Paul Krugman please stand up?

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