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Some fallacies of financial fundamentalism

Lars Syll

In some recent critiques of functional finance and modern monetary theory, prominent US economist Paul Krugman has claimed that Stephanie Kelton and other MMT economists have gotten things terribly wrong:

“ Anyway, what actually happens at least much of the time – although, crucially, not when we’re at the zero lower [interest] bound – is more or less the opposite: the political trade-offs determine taxes and spending, and monetary policy adjusts the interest rate to achieve full employment without inflation. Under those conditions budget deficits do crowd out private spending, because tax cuts or spending increases will lead to higher interest rates. “

And this comes from someone who calls himself a Keynesian economist! The problem with his view is, of course, that it has nothing at all in common with the views of Keynes.

What Krugman is reiterating here is nothing but his version of Say’s law, basically saying that savings have to equal investments and that if the state increases investments, then private investments have to come down (i.e. ‘crowding out’). As an accounting identity, there is, of course, nothing to say about the law, but as such, it is also totally uninteresting from an economic point of view. As some of my Swedish forerunners — Gunnar Myrdal and Erik Lindahl — stressed more than 80 years ago, it’s really a question of ex-ante and ex-post adjustments. And as further stressed by Keynes about the same time, what happens when ex-ante savings and investments differ, is that we basically get output adjustments.

GDP changes and so makes saving and investments equal ex-post. And this, nota bene, says nothing at all about the success or failure of fiscal policies!

For the benefit of Krugman and other latter-day mainstream economists, let’s see what a real Keynesian economist has to say about crowding out and government deficits. The following two extracts are from “Fifteen Fatal Fallacies of Financial Fundamentalism” by William Vickrey:

Fallacy 2: Urging or providing incentives for individuals to try to save more is said to stimulate investment and economic growth.

Actually the exact reverse is true. In a money economy, for most individuals a decision to try to save more means a decision to spend less; less spending by a saver means less income and less saving for the vendors and producers, and aggregate saving is not increased, but diminished as the vendors in turn reduce their purchases, national income is reduced and with it national saving. A given individual may indeed succeed in increasing his/her own saving, but only at the expense of reducing the income and saving of others by even more …

Saving does not create “loanable funds” out of thin air. There is no presumption that the additional bank balance of the saver will increase the ability of his bank to extend credit by more than the credit supplying ability of the vendor’s bank will be reduced … Attempted saving, with corresponding reduction in spending, does nothing to enhance the willingness of banks and other lenders to finance adequately promising investment projects. With idle or unemployed resources available, saving is neither a prerequisite nor a stimulus to, but a consequence of capital formation, as the income generated by capital formation provides a source of additional savings.

Fallacy 3: Government borrowing is supposed to “crowd out” private investment.

On the contrary, the current reality is that the expenditure of the borrowed funds (unlike the expenditure of tax revenues) will generate added disposable income, enhance the demand for the products of private industry, and make private investment more profit- able. As long as there are plenty of idle resources lying around, and monetary authorities behave sensibly (instead of trying to counter the supposedly inflationary effect of the government budget deficit), those with a prospect for profit- able investment can be enabled to obtain financing. Under these circumstances, each additional dollar of deficit will – in the medium long run – induce two or more additional dollars of private investment. The capital created is an increment to someone’s wealth and ipso facto someone’s saving. “Supply creates its own demand” fails as soon as some of the income generated by the supply is saved, but investment does create its own saving, and more.

Any crowding out that may occur is the result, not of underlying economic reality, but of inappropriate restrictive reactions on the part of a monetary authority in response to the deficit.

William Vickrey


  1. Real World Econ Rev, 7 Feb 2019

  2. Real World Econ Rev, 8 Mar 2019

Editor’s comments:

The background to the dispute between Krugman and Kelton may be found in a recent blog by Lars Syll [1] as well as a longer article by Stephanie Kelton [2] produced in response to Paul Krugman’s criticism of modern monetary theory and functional finance (as described by British economist Abba Lerner) [3]:




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