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.”

loanIn 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:

gtThe 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.

16 Comments

  1. Lars: thanks for the response. My thoughts in response to your points:

    1. There is no causal story needed to explicate an accounting identity between actual S and actual I. But we do need a causal story to explicate an equilibrium condition between desired S and desired I. And the ONKM story is that both Id and Sd are the tails wagging the dog. Which one does more wagging is an empirical question. Probably Id.

    2. Sure; like all simple models, the simple loanable funds model leaves stuff out. There is only one rate of interest, and no credit-rationing, etc. But the simple liquidity preference theory also leaves stuff out, and leaves much the same stuff out. Some (actually almost all) individuals cannot satisfy their demand for money by borrowing from the central bank at the rate of interest set by the central bank.

    3. “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.”

    I would say it’s Say’s Law, rather than Walras’ Law, that is relevant here. (I believe that both are false, in a monetary exchange economy, but that’s an aside.) I like the way Brad DeLong puts it: ‘Says Law is false in theory, but it is the job of the central bank to try to make it true in practice.’ (Not an exact quote, but close enough.)

    And in my post I did not assume that central banks follow a Taylor Rule. The Bank of Canada for example targets its internal inflation forecast, which is, both in theory and practice, quite different from following a Taylor Rule.

    4. But I addressed that point in my post. Keynes’ point is correct: either Y or r might adjust to bring about equality between desired saving and desired investment. But it is the job of the central bank to ensure it is r that adjusts, so that Y does not need to adjust, so that Y can stay at Y*.

    5. I’m not sure I understand this, but it sounds wrong. Suppose there is an increased desire to save. The central bank lowers r in response, to prevent Y falling below Y*. This causes desired investment to increase. So in this example, the change in desired saving precedes (at least causally) the change in desired investment.

  2. In the above, I was pretending to be an orthodox NK macroeconomist. Now let me be myself, and try to find some common ground with you.

    I fully agree that Sd =/= Id means something very very different in a monetary exchange economy than in a barter economy.

    Take an extremely simple example: a barter economy where there is no investment, and people swap services (like haircuts and manicures etc) so there isn’t even any inventory investment. And borrowing and lending is not allowed. The only way to save is to buy land. Suppose everyone wants to save more. There is simply no way that can cause a recession, even if the price of land was fixed by law, so couldn’t rise to eliminate the excess demand for land. Each individual would want to buy land, but couldn’t, because nobody would sell him land. Their excess demand for land would not prevent them swapping haircuts for manicures and staying at full employment Y.

    Now add money and monetary exchange to the model. Barter is ruled out by assumption. Suppose everyone wants to save more, by holding more money. There is nothing to prevent an individual hairdresser from saving more, in the form of money. He just buys fewer manicures. There is nothing to prevent an individual manicurist from saving more, in the form of money. He just buys fewer haircuts. So there will inevitably be a recession (unless the central bank supplies more money).

    It is saving *in the form of money* — the medium of exchange — that causes the problem. The medium of exchange is very very different from other assets like land.

    (I could do a similar example where an increased desire to invest is financed by printing more money, but it would be more complicated, so I won’t.)

    • What makes you think that trivial examples of closed economies reflect the realities of a globalized economy with continuous inflow of cheap immigrant labor,outsourced production and services and huge trade imbalances?

      You have chosen deliberately in you example services that must be performed locally like haircutting and manicure to create a strawman argument.

      The amount of loans and credit available for financing investment is NOT constrained by how much saving is available but by how much money the banking system can create through loans, Banks are not restricted to lend by savings. The can manage a gap and finance it through central bank and overnight funds.

      Let me suggest something to you for the betterment of society: abolish economic departments now. Do a favor to society. Along withy philosophy departments of course. Get the crap out of schools. Economics is common sense.
      http://www.digitalcosmology.com/Blog/2014/02/12/a-call-to-action-abolish-economics-departments-now/

    • “It is saving *in the form of money* — the medium of exchange — that causes the problem.”

      It’s not spending that causes the problem. You can also save by paying back a loan – forcing a bank’s balance sheet to shrink with no mechanical guarantee that it can expand it again.

      A very subtle, but important difference that few take into account.

      • NeilW: Yes. If I save by paying back a bank loan, and that causes the money supply to contract, then that is similar to my example. It’s a fall in Ms, holding Md constant, while mine was a rise in Md, holding Ms constant. Both create an excess demand for money, and a recession.

        But “saving” does not mean “not spending part of your income”. Saving means “not consuming part of your income”.

      • @ NeilW, Nick Rowe

        No spending is always the problem, whatever you do with your money – keep it, buy bonds (or equity etc.) or pay back debts. One agent not spending is another not earning.

        For instance: the household sector reduces its consumption spending. Effect: Firms make less sales, have less money available. 2nd effect: lower sales with same interest rate service = higher probability of default!

        If firms wanted to maintain ther previous liquidity position, they would have to borrow – but would then reduce their equity and INCREASE their default risk. So is it really likely that they want to borrow when households reduce their purchases in order to increase their saving – whatever form their saving takes?

        As far as households are concerned: Are they really willing to lend their saved money to firms whose default risk has risen? Given that both supply and demand for money (demand and supply for loans/bonds) are decreasing when firms’ default risk increases, we do not know whether interest rates go up, down or stay the same. But we know: It is likely that overall credit created will go down.

        That is the crux of loanable funds theory: They assume that households ALWAYS lend all their money to firms AND that firms are always willing to borrow. Problem: In that world, default is simply assumed away: You do not default if your debtors never stop lending.

    • Nick,

      Your own view is essentially identical to Krugman (1998) …

  3. Here is a good paper by Bertoccco: http://nakedkeynesianism.blogspot.com/2014/09/giancarlo-bertocco-on-keyness-criticism.html

  4. Dear Lars,

    I would go farther: Loanable Funds theory is not a theory that is valid with some exchange economy, but it is simply nonsense, given real world accounting rules.

    How can one save? One can save in two forms: a) Either one can increase one’s net financial assets (not only in the form of money!) by spending less than one earns or b) one can produce some tangible asset (a house, a machine) – both actions increase net worth. And changes in net worth are what saving is. Saving by buying a machine does not constitute saving if you reduce your net financial asset by the same amount.

    Now, looking at a): Since there is no expenditure without a revenue, in the aggregate, all expenditures have to be equal to all revenues; which by implication means: you can only realize a revenue surplus (increase your net financial assets) IF the rest of the economy has an expenditure surplus of the same amount.

    To put it another way: FINANCIAL saving (changes in net financial assets) are a zero-sum game. If workers spend less on goods produced by firms than they receive in wages, firms’ profits will be lower; if firms pay less in wages than they get in form of sales, workers will have to dissave.

    Looking at b): To the extent that anybody produces a new tangible asset in a period, he individually and the aggregate economy have saved – exactly by the amount of the new asset that has been produced.

    What about finance then? Saving form a) has NOTHING to do with financing! Net financial assets are the sum of money, m, other financial assets, ofa (bonds, loans etc.) minus liabilities, l:

    net financial assets = m + ofa + l.

    Now, if you reduce your spending relative to your earnings, you can do it in the following forms i) have more money, ii) have more other financial assets, iii) have LESS liabilities. Nobody has received a new loan only because you save. But all the rest of the economy has LESS financial means available (lower net financial assets) because you have saved!

    Now given net financial assets = m + ofa – l, one can also see what financing is: It is parting with m and getting more ofa – ie a financial claim vis-à-vis the borrower. The borrower on the other hand increases m but also l – since the new loan is his liability.

    Did the sum of net financial assets change by this transaction? No it did not – because financing has nothing to do with saving! Not because of some theory, but because of accounting. Financing is a “pure financial transaction” that does not change somebody’s net worth.

    The same goes for the creation of new money by a bank: If a bank creates money by creating a loan, it simultanously creates a deposit from which the borrower can take the money, so that both the bank’s ofa (its loan) and its l (the deposit) increase by the same amount. The borrower’s m and l also increase by the same amount. Again, neither the lender nor the borrower have changed their net financial assets – but they have changed the composition and / or length of their balance sheets!

  5. “To put it another way: FINANCIAL saving (changes in net financial assets) are a zero-sum game. If workers spend less on goods produced by firms than they receive in wages, firms’ profits will be lower; if firms pay less in wages than they get in form of sales, workers will have to dissave.”

    Simplistic statement. Stick wages, union contracts and globalization complicate things to the extent that NO model can describe what is going on other than empirical observation.

    ” Financing is a “pure financial transaction” that does not change somebody’s net worth. ”

    What about carry trades that were dominant in the late 2000s? For example borrow Yen at 0.5% and buying dollars to invest in a bubble stock market or real-estate market. You still think these did not change someone’s net worth? If not, ask their Swiss bankers. Looking at economics from the angle of accounting is a simplistic view because that is what accounting is supposed to achieve. Agents act because they want to change their net worth. If that is not possible, they wouldn’t get financing. Even the statement that in aggregate the game is zero-sum is false because somewhere some value is created by someone even if that value is related just to price discovery.

    Many bloggers do not understand the difference between accounting identities and dynamic models. Accounting identities do not have eigenvalues, they represent stead-state conditions that may be never achieved but theoretically they are useful for bookkeeping.

  6. Nick Rowe: “remember the accounting identities C+I+G=Y and S=Y-C-G, where I is investment and S is national saving”

    I am replying here because I have bugged Nick enough. 😉

    Doesn’t any economist know what an identity is? {sigh} S = I under certain conditions. That does not an identity make.

  7. “Contrary to the loanable funds theory, finance in the world of Keynes and Minsky precedes investment and saving.”

    Sorry to beat the drum, but that would be a distinction without a difference if S = I were an identity.

  8. Nick says:
    “2. Sure; like all simple models, the simple loanable funds model leaves stuff out. There is only one rate of interest, and no credit-rationing, etc. ”

    I think this is the perfect example of the fundamental confusion that plagues economists. They don’t understand the difference between scietific simplification and what they’re doing.

  9. In a science there is a methodology that tells you when a simplification is appropriate, eg, “at human scale quantum effects are negligible.”

    Economists have no such methodology and so make post hoc judgments about simplifications. Such judgments make up the bulk of economic story telling and seem to have empirical content. But they are actually meaningless “just so” stories.

  10. I would like to raise a very simple question.

    At first you say “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.”

    Later you conclude “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.”

    If firms mostly rely on internal funds, why is finance so important from a post-Keynesian perspective?

  11. “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”

    should read as:

    Since IS-LM can be shown to be essentially equivalent to LFT, 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

    i.e. LFT instead of LPT

    nice post otherwise…


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