Dominance of the real analysis in macroeconomics and especially in financial economics

Monetary analysis versus real analysis:

What are the main differences?

Peter Bofinger

Universität Würzburg and CEPR German Council of Economic Experts

Motivation provided by John Maynard Keynes

• “Most treatises on the principles of economics are concerned mainly, if not entirely, with a real-exchange economy; and – which is more peculiar- the same thing is also true of most treatises on the theory of money. (…)

• The theory which I desiderate would deal, in contradistinction to this, with an economy in which money plays a part of its own and affects motives and decisions and is, in short, one of the operative factors in the situation, so that the course of events cannot be

predicted, either in the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy. (…)

• Everyone would, of course agree that it is in a monetary economy in my sense of the term that we actually live.(…) . The idea that it is comparatively easy to adapt the hypothetical conclusions of a real wage economics to the real world of monetary economics is a

mistake.”

John Maynard Keynes (1933), The monetary theory of production, in: C.W. XIV, pp. 408-411

Dominance of the real analysis in macroeconomics and especially in financial economics

• Debate on low interest rates, „saving(s) glut“ and „secular depression“

• Microeconomics of banking (Freixas/Rochet)

• DSGE models: Euler equation

• International macroeconomics (Krugman/Obstfeld)

• Fiscal policy: Overlapping generations models, theory of crowding-out

• Theories of economic growth

I. Theory

Real analyis: The loanable funds model of the financial market

• Larry Summers (2016): “Just as the price of wheat adjusts to balance the supply of and demand for wheat, it is natural to suppose that

interest rates—the price of money—adjust to balance the supply of savings and the demand for investment in an economy.”

i

S, I,

Volume of Lending Saving

(≡Supply of funds)

Investment

(≡Demand for funds)

i₀

S₀=I₀

i

S, I,

Volume of Lending S₀

I

i₀

S₀=I₀

S₁

i₁

S₁=I₁

Real analysis: one-way flow of funds

Freixas, Xavier, and Jean-Charles Rochet (2008), Microeconomics of Banking

Axioms of the Real Analysis

• Freixas/Rochet (2008): a model “with a unique physical good, owned initially by the consumers. Some of it will be consumed at date 1, the rest being invested by the firms to produce consumption at date 2.”

• Saving, i.e. abandonnement of consumption, is the precondition for investment

• Interest rate is the reward for saving

• Interest rate is a natural rate: units of the unique physical good tomorrow unit of the unique physical good today

• Banks and financial markets are pure intermediaries for the unique physical good

The effects of household saving in an

economy with money (Monetary Analysis)

Household decides to save 1,000 Euro by reducing his consumption by 1,000 Euro.

Balance sheet of the household

Assets Liabilities

Bank deposits + 1,000 Net worth + 1,000

Balance sheet of the firm

Assets Passiva

Bank deposits - 1.000 Net worth - 1.000

Balance sheet of the bank

Deposits household +1.000

Deposits firm - 1.000

Household saving in the Monetary Analysis

• Household saving does not generate additional funds. It simply redistributes existing funds (=bank deposits) from the corporate sector to the household sector.

• Household saving has a negative impact on the liquidity position of the corporate sector and on corporate profits (P_F ).

• Kalecki equation

P_F = 𝐼_𝐹 + ∆𝑁𝐹𝐴_𝐹

∆𝑁𝐹𝐴_F = − ∆𝑁𝐹𝐴 𝑂𝑇𝐻𝐸𝑅 𝑆𝐸𝐶𝑇𝑂𝑅𝑆

P_F = 𝐼_𝐹 − (𝑌_𝐻𝐻 − 𝐶_𝐻𝐻) + 𝑇 − 𝐺 + (𝑀 − 𝑋)

Household saving Government financial balance

Current account deficit

Monetary Analysis: real interest rate for saving = 0

Keynes: “It should be obvious that the rate of interest cannot be a

return to saving or waiting as such. For if a man hoards his savings in cash, he earns no

interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the

reward for parting with liquidity for a specified period.” (GT, p. 166)

-4 -2 0 2 4 6 8

1967-06 1969-07 1971-08 1973-09 1975-10 1977-11 1979-12 1982-01 1984-02 1986-03 1988-04 1990-05 1992-06 1994-07 1996-08 1998-09 2000-10 2002-11 2004-12 2007-01 2009-02 2011-03 2013-04 2015-05 2017-06

Germany: Real interest rate on saving deposits and on bonds

Real interest rate saving deposits Real interest rate bonds

Average real interest rate saving deposits Average real interest rate bonds

3,15%

0,001%

Anomaly of the Real Analysis: „Euler puzzle“

Canzoneri et al. (2007) „ (…) money market rates and the implied consumption Euler equation rates are negatively correlated.”

Monetary analyis in a very simple model (IS/LM-AS/AD)

• Multiple equilibria of saving and investment

• Separation of the financial

market from the goods market

• Investment creates saving

• Banks create money (Multiplier)

• Interest rate is a money rate

• Saving has no direct impact on the financial market

Axioms of two incompatible paradigms

Real Analysis Monetary Analysis

Saving Source for financial funds: Standard commodity becomes available for investment

- Irrelevant for the financial system. No impact on LM-curve.

- Reduction of aggregate demand Financing Identical with saving Provision of demand deposits

independently of saving

Investment Requires saving Generates Saving

Equilibrium of S and I One equilibrium Multiple equilibria (IS-curve, LM-curve, IS/LM, AS/AD)

Interest rate Real rate:Units of the standard commodity in t+1

Unit of standard commodity in t Money rate:Units of money in t+1 Unit of money in t

Banks - Pure intermediaries

- Deposits create loans

- Originators of money - Loans create deposits Financial markets Identical with banks: Intermediaries

between savers and investors

Fundamentally different from banks:

Redistribution of money created by banks Role of the central bank Powerless as it neither creates nor

destroys the standard commodity

Powerful as it can control the supply of money with its policy rate

13

Zero-lower bound

Real Analysis Monetary Analysis

Monetary Analysis: Circular flow of funds

Attempts to combine Real Analysis and Monetary Analysis

REAL MONETARY

Wicksell (1898) Equilibrium: monetary rate equals neutral rate

Disequilibrium: monetary rate differs from neutral rate

Neoclasssical Synthesis

e.g. Rachel and Smith (2015, p. 54)

“to the extent that prices are flexible in the long-run, money is neutral, and only real factors have a lasting effect on long-run real rates”

Short-run

Borio and Disyatad (2011, p. 22) “Real factors determine at least the steady state equilibrium level of real interest rates.”

“Monetary and financial factors determine the actual interest rates that prevail at any given point in time Krugman (2011) (…) the distinction between loanable funds and liquidity preference theories

of the rate of interest – or, rather, the ability to see how both can be

true at once, and the implications of that insight – seem to have been utterly forgotten by a large fraction of economists (…)

Krugman and Woodford: How to derive the IS-curve from the loanable funds modell

Woodford (2010)

Krugman (2011): “we imagine that a rise in GDP shifts the savings schedule out from S1 to S2, also shifts the investment schedule,

and, as drawn, reduces the interest rate in the market for loanable funds”

Higher income leads to higher interest rates

r

S, I I₁

I₂ S₁

S₂

II. Why are interest rates so low?

Real Analysis versus Monetary Analysis

Source: Rachel and Smith (2015)

Larry Summers: “The essence of secular stagnation is a chronic excess of saving over investment.”

Excess saving/Saving(s) glut:

• Sex ante > I_{ex ante}

• S_{ex ante} + C > I_{ex ante} + C

• Aggr. Supply > Aggr. Demand

Global demand deficiency ⁰

1 2 3 4 5 6 7 8

1980/1990 1990/2000 2001/2006 Saving(s) Glut

2000/2010 2010/2018 Sec.

Stagnation

%

GDP growth rates

World

Advanced economies

Emerging market and developing economies

Source: IMF, WEO Database

Excess saving of one sector (S

^A

>I

^A

) is possible, but it requires excess spending of a another sector (I

^B

>S

^B

)

-8 -7 -6 -5 -4 -3 -2 -1 0 1

-5000 -4500 -4000 -3500 -3000 -2500 -2000 -1500 -1000 -500 0 500

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 PercentofGDP

US$-Billion

Pubic sector balances (percent of GDP) Public excess spending and

private excess saving

Deficit advanced economies Deficit emerging and developing Percent of global GDP

-800 -600 -400 -200 0 200 400 600 800

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Current account balances (USD billion) Excess spending in advanced economies and

excess saving in developing economies

Advanced economies Emerging market and developing economies

Low interest rate caused by an increase in the global propensity to save?

0 5 10 15 20 25 30 35 40

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Gross saving rates

World Advanced economies Emerging and dev. Economies

Source: Rachel and Smith (2015)

1980-2015

Problem 1: Household saving has declined

Source: Peter Chen, Loukas Karabarbounis, Brent Neiman, VoxEU 05 April 2017

Problem 2: Trends of gross and net saving differ

-0,5 0 0,5 1 1,5 2 2,5 3 3,5 4 4,5 5

10 15 20 25 30 35 40

Gross saving rate and G7 real interest rate (1986-2014)

1986

-0,5 0 0,5 1 1,5 2 2,5 3 3,5 4 4,5 5

-1 0 1 2 3 4 5 6 7 8

Net saving rate and G7 real interest rate (1986-2014)

1986

I S

S

I

Problem 3: Early 1980s were an outlier

-6,00 -4,00 -2,00 0,00 2,00 4,00 6,00 8,00 10,00 12,00

Jul. 54 Jan. 56 Jul. 57 Jan. 59 Jul. 60 Jan. 62 Jul. 63 Jan. 65 Jul. 66 Jan. 68 Jul. 69 Jan. 71 Jul. 72 Jan. 74 Jul. 75 Jan. 77 Jul. 78 Jan. 80 Jul. 81 Jan. 83 Jul. 84 Jan. 86 Jul. 87 Jan. 89 Jul. 90 Jan. 92 Jul. 93 Jan. 95 Jul. 96 Jan. 98 Jul. 99 Jan. 01 Jul. 02 Jan. 04 Jul. 05 Jan. 07 Jul. 08 Jan. 10 Jul. 11 Jan. 13 Jul. 14 Jan. 16 Jul. 17

Real rate 10 year Treasury Real rate Fed Funds Average Real Fed Funds Average Real Treasury

Monetary Analysis: Focus on US-bond market

-0,50 0,00 0,50 1,00 1,50 2,00 2,50 3,00 3,50 4,00 4,50 5,00

0 5 10 15 20 25

Real interestrate

Change in outstanding US bonds (in percent of GDP)

30-year indexed US-Treasury yield and change in outstanding US-bonds

(1998-2015)

2005 2004

2006

2007 Positive supply shock until crisis („Financing glut“)

Negative demand shock after crisis („Borrowing dearth“)

1998

Source: Securities Industry and Financial Markets Association

Supply on the US bond market

-100000 -50000 0 50000 100000 150000 200000

Jän.99 Jän.00 Jän.01 Jän.02 Jän.03 Jän.04 Jän.05 Jän.06 Jän.07 Jän.08 Jän.09 Jän.10 Jän.11 Jän.12 Jän.13 Jän.14 Jän.15 Jän.16 Jän.17

Foreigners: net purchases of securitites in the United States

Treasury Bonds and Notes US GOVT Agency

Corp Bonds Corp Stocks

-10 -5 0 5 10 15 20

Change in bond holdings (percent of GDP)

Rest of the world; Domestic without Fed FED

Source: Board of Governors Source: US Treasury, tic data

Demand side of the US bond market

-15 -10 -5 0 5 10 15 20 25

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Change in outstanding amount of (percent of GDP)

Corporate Public Mortgage related/Federal Agencies Money Markets/Asset backed

Source: SIFMA

Real Analysis: Paradox of capital (Prasad et al. 2017)

• (…) this paradox has, if anything, intensified over time. (…) the average income, relative to the United States, of capital-exporting countries has fallen well below that of

capital-importing countries. In other words, capital has been flowing from poor to rich countries!

Capital

US$-Deposits

Monetary Analysis: The paradox vanishes

-900 -800 -700 -600 -500 -400 -300 -200 -100 0 100

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

US current account

US$-Deposits

US$-Bonds Consumer goods

Summary

• Real Analysis and Monetary Analysis are incompatible

• Real Analysis is an inadequate model for a reality with money

• The focus on the saver in Real Analysis is misguided. In Monetary Analysis banks and investors are the core actors

• Low interest rates cannot be explained with a higher propensity to save, global „excess saving(s)“ or a global saving(s) glut

• The Real analysis completely neglects the role of the central bank

• Bond market data and flow of funds data provide very useful information that has not been exploited so far

• It is time to save other fields of economics from the detrimental influence of the Real Analysis

China‘s debt-driven growth model

50,0 100,0 150,0 200,0 250,0 300,0

Dez. 01 Mai. 02 Okt. 02 Mrz. 03 Aug. 03 Jan. 04 Jun. 04 Nov. 04 Apr. 05 Sep. 05 Feb. 06 Jul. 06 Dez. 06 Mai. 07 Okt. 07 Mrz. 08 Aug. 08 Jan. 09 Jun. 09 Nov. 09 Apr. 10 Sep. 10 Feb. 11 Jul. 11 Dez. 11 Mai. 12 Okt. 12 Mrz. 13 Aug. 13 Jan. 14 Jun. 14 Nov. 14 Apr. 15 Sep. 15 Feb. 16 Jul. 16 Dez. 16 Mai. 17

Debt to GDP

Advanced economies: Credit to non-financial sector Advanced economies: Credit to private non-financial sector China: Credit to non-financial sector China: Credit to private non-financial sector

Equilibria

LFT

• Financial market equilium identical with goods market equilibrium (=neutral interest rate)

IS/LM-AS-AD

• Goods market equilibrium (IS-curve)

• Financial market equilibrium (LM- curve)

• IS/LM-equilibrium

• IS/LM-equilibrium at full employment

• AS/AD-equilibrium

• AS/AD-equilibrium with minimal loss

𝐿 = 𝑃 − 𝑃^{∗ 2} + λ (Y − YF)²

 „optimum interest rate“ (Keynes))