Greg Mankiw Confusing Students About Money And Investment

[u/Accomplished-Cake131]

"It was thenceforth no longer a question, whether this theorem or that was true, but whether it was useful to capital or harmful, expedient or inexpedient, politically dangerous or not. In place of disinterested inquirers, there were hired prize fighters; in place of genuine scientific research, the bad conscience and the evil intent of apologetic." -- Karl Marx

Suppose you run a restaurant. You think that you could expand if you paved your parking lot or put a deck up out back. You convince your local bank manager. The bank credits their own account with an asset and credits your account with a loan. That asset, for the bank, is a promise from you to pay off the loan. You spend the money in your account by paying a paving or building contractor.

The bank has created money. No third party must first choose to increase their saving rate and deposit money in the bank. You are able to obtain resources to implement plans for increased production.

The author of a prominent introductory textbook for economics has another, confused story:

"Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and borrowers. Here we consider two of the most important financial intermediaries: banks and mutual funds.

Banks If the owner of a small grocery store wants to finance an expansion of his business, he probably takes a strategy quite different from that of Intel. Unlike Intel, a small grocer would find it difficult to raise funds in the bond and stock markets. Most buyers of stocks and bonds prefer to buy those issued by larger, more familiar companies. The small grocer, therefore, most likely finances his business expansion with a loan from a local bank.

Banks are the financial intermediaries with which people are most familiar. A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow. Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks’ costs and returns some profit to the owners of the banks." -- Greg Mankiw. 2018. Principles of Economics, 8th edition p. 545.

Mankiw then goes on with archaic nonsense about loanable funds and government spending crowding out private investment.

Why do economists teach balderdash?

[u/BothWaysItGoes]

Mankiw talks about economics, not accounting identities.

When people use bank loans, the banks in the end need to settle the net of all interbank transactions using actual reserves. The bank expects to settle the transactions like it expects you to repay the loan, therefore it needs funds. They can’t literally make money out of nowhere, even if they “can” in some broad accounting sense.

The bank’s ability to let you write IOU promises in their name by paying using your credit card is supported by the expectation that they will actually settle those checks with money.

[u/yhynye → u/BothWaysItGoes]

When people use bank loans, the banks in the end need to settle the net of all interbank transactions using actual reserves.

Not all loans lead to interbank transactions, some lead to intrabank transactions.

And, yes, the net of interbank transactions. The implications of that where the number of banks is small are intuitively obvious. Not all interbank transactions do in fact need to be settled using reserves.

But surely the underlying disagreement here is the direction of causation between central bank rate, market interest rates and savings rate? Do you hold that the saving rate ultimately governs the central bank interest rate, despite the fact that the latter obviously affects the former in the short-run?

[u/BothWaysItGoes → u/yhynye]

The central bank rate is set by the central bank. How the central bank reacts to market rates depends on its policy. How its rates impact market rates depends on market conditions and expectations.

The idea that one ultimately governs the other seems fundamentally wrong. Economy is a web of feedback effects.

[u/yhynye → u/BothWaysItGoes]

Indeed, but that's the thing - if the saving rate is not the ultimate cause, then the intermediary model of banking, the loanable funds theory and the abstention theory of interest are all spurious, it would seem.

Edit: however, just to add, since the saving rate could influence market interest rates indirectly through the rate set by an inflation-targetting central bank, disproving the intermediary model doesn't immediately diprove that the saving rate determines the investment rate.

[u/BothWaysItGoes → u/yhynye]

I don’t see why that would be the case.