The loanable funds fallacy

21 Sep, 2014 at 18:51 | Posted in Economics | 16 Comments

The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credit, determined by supply and demand — as Bertil Ohlin put it — “in the same way as the price of eggs and strawberries on a village market.”

In the traditional loanable funds theory — as presented in maistream macroeconomics textbooks like e. g. Greg Mankiw’s — the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving is the supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate. Lowering households’ consumption means increasing savings that via a lower interest increase investment.

Nick Rowe has presented a formalization of New Keynesian loanable funds reasoning on his blog that goes like this:

Let output demanded (call it Yd) be a negative function of the rate of interest r, a positive function of actual income Y, and a function of other stuff X.

Yd = D(r,Y,X)

And the ONKM [orthodox New Keynesian macroeconomist] central bank wants to set r such that output demanded equals potential output Y*, so that:

D(r,Y*,X) = Y*

Assume a closed economy for simplicity, subtract Cd (consumption demand) plus Gd (government demand) from both sides, remember the accounting identities C+I+G=Y and S=Y-C-G, where I is investment and S is national saving, and we get:

Id(r,Y*,X) = Sd(r,Y*,X)

The central bank sets a rate of interest such that desired investment at potential output equals desired national saving at potential output. Which is precisely the loanable funds theory of the rate of interest.

From a more Post-Keynesian-Minskyite point of view the problem with this formalization is quite obvious:

1 As already noticed by James Meade decades ago, the causal story told to explicate these accounting identities gives the picture of “a dog called saving wagged its tail labelled investment.” In Keynes’s view — and later over and over again confirmed by empirical research — it’s not so much the interest rate at which firms can borrow that causally determines the amount of investment undertaken, but rather their internal funds, profit expectations and capacity utilization.

2 As is typical of most mainstream macroeconomic formalizations and models, there is pretty little mention of real world phenomena, like e. g. real money, credit rationing and the existence of multiple interest rates, in the loanable funds theory. Loanable funds theory essentially reduces modern monetary economies to something akin to barter systems — something it definitely is not. As emphasized especially by Minsky, to understand and explain how much investment/loaning/crediting is going on in an economy, it’s much more important to focus on the working of financial markets than staring at accounting identities like S = Y-C-G. The problems we meet on modern markets today have more to do with inadequate financial institutions than with the size of loanable-funds-savings.

3 As clearly noticed by Rowe — “it would be more correct to say that the central bank sets the rate of interest where it thinks the loanable funds theory says it will be” — the loanable funds theory in the ONKM approach means that the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras’ law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks’ interest rate adjustments. From a realist Keynes-Minsky point of view this can’t be considered anything else than a belief resting on nothing but sheer hope. [Not to mention that more ad more Central Banks actually choose not to follow Taylor-like policy rules.] The age-old belief that Central Banks control the money supply has more an more come to be questioned and replaced by an “endogenous” money view, and I think the same will happen to the view that Central Banks determine “the” rate of interest.

4 A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. To Keynes this was seriously wrong:

The classical theory of the rate of interest [the loanable funds theory] seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down … In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

There are always (at least) two parts in an economic transaction. Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no “direct and immediate” automatic interest mechanism at work in modern monetary economies. What this ultimately boils done to is — iter — that what happens at the microeconomic level — both in and out of equilibrium —  is not always compatible with the macroeconomic outcome. The fallacy of composition (the “atomistic fallacy” of Keynes) has many faces — loanable funds is one of them.

5 Contrary to the loanable funds theory, finance in the world of Keynes and Minsky precedes investment and saving. Highlighting the loanable funds fallacy, Keynes wrote in “The Process of Capital Formation” (1939):

Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving.

So, in way of conclusion, what I think New Keynesians — like Paul Krugman and Greg Mankiw — “forget” when they hold to the loanable funds theory, is the Keynes-Minsky wisdom of truly acknowledging that finance — in all its different shapes — has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

All real economic activities nowadays depend on a functioning financial machinery. But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc. — things that play decisive roles in channeling money/savings/credit — are more or less left in the dark in New Keynesian formalizations of the loanable funds theory to the real world target system.

 

Added 19:30 GMT: Nick Rowe has responded to this post here.

Added 20:00 GMT: Naked Keynesianism has an interesting post and link on the issue here.

Added September 30: Victoria Chick and Geoff Tily has a  good piece in CJE (March 2014) on the loanable funds theory (LPT) and the liquidity preference theory (LP) of interest, and why Keynes considered the two theories “radically opposed.” Since IS-LM can be shown to be essentially  equivalent to LPT, this is also a further argument to be sceptical of those who maintain that the Hicksian construct should be a good representation of Keynes’s thoughts.