The loanable funds fallacy

6 July, 2016 at 10:24 | Posted in Economics | 5 Comments

loanable_funds_curve-13FEC80C6110B93D6D9The 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.”

The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist. Instead, banks create new funds in the act of lending, through matching loan and deposit entries, both in the name of the same customer, on their balance sheets. The financing through money creation (FMC) model reflects this, and therefore views banks as fundamentally monetary institutions.

Zoltan Jakab & Michael Kumhof 

loanIn the traditional loanable funds theory — as presented in mainstream macroeconomics textbooks — 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.

As argued by Jakab and Kumhof in the paper quoted above, there are many problems with the standard presentation and formalization of the loanable funds theory. And more can be added to the list:

1 As already noticed by James Meade decades ago, the causal story told to explicate the accounting identities used 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 they definitely are 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 The loanable funds theory in the “New Keynesian” 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 and 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.

What is “forgotten” in the loanable funds theory, is the insight 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 modern formalizations of the loanable funds theory.

It should be emphasized that the equality between savings and investment … will be valid under all circumstances.kalecki In particular, it will be independent of the level of the rate of interest which was customarily considered in economic theory to be the factor equilibrating the demand for and supply of new capital. In the present conception investment, once carried out, automatically provides the savings necessary to finance it. Indeed, in our simplified model, profits in a given period are the direct outcome of capitalists’ consumption and investment in that period. If investment increases by a certain amount, savings out of profits are pro tanto higher …

One important consequence of the above is that the rate of interest cannot be determined by the demand for and supply of new capital because investment ‘finances itself.’



  1. How can I be sure when I lend money that the borrower will pay it back with interest? How can I ensure that his borrowing is not an excuse to spend today and to hell with tomorrow?

    • That’s why to save most people lend money to banks rather than to other economic entities. A deposit is a customer’s loan to a bank. Bank deposits carry a government guarantee against default. Deposits can be diversified to avoid guarantee ceilings. Savers can also take advantage of default risk-free government securities that pay interest. This allows savers to avoid default risk that they do not wish to assume. Non-bank economic entities only assume default risk to increase reward over the default risk-free rates available at various maturities. It would not be rational economically to do otherwise, although one might do so for other reasons, such as lending to friends and family, or to a firm for like reasons of affinity or other advantage.

      Banks don’t loan out those customer deposits or against them. Loans create deposits and banks loan against (risk) capital. Banks do not risk customer deposits when they lend, although customers do assume risk in the case of deposits above the guarantee in the event of a bank’s becoming insolvent and not being able to cover its liabilities, deposits being liabilties

      Banks are only intermediaries in the sense that they serve as agents of the government in assessing risk in loan extension and taking profits by risking their own capital in doing to. The government allows banks to create deposits denominated in the currency, guarantees deposits to a certain amount, and provides banks with direct access to the central bank as currency issuer and lender of last resort. For this privilege banks accept government regulation and oversight.

      In this system, depositors are protected as savers when they lend to banks and banks don’t risk depositors’ funds. In extending loans banks assume the risk of default, as well as certain obligations, for the rewards accruing from prudent risk assessment.

      It’s a very simple system that is guaranteed to clear by the central bank through its lender of last resort function in providing liquidity in the payments system. For example, in the 2008 crisis, the commercial paper market froze up, threatening to take down the global financial system through systemic risk. The Fed stepped in and unleashed unlimited liquidity to ensure than market cleared. The last figure for the amount of short-term loans the Fed rolled over was 30 trillion in order to ensure that there were no cash-flow issues in the financial system for lack of liquidity.

      Other lenders fully assume the risk of default without the advantages banks have through their relationship with government. This is why modern banking is called a public-private partnership in which banks act as agents to whom limited power of money creation is delegated, while the government remains the sole issuer of currency, using the central bank as its fiscal agent.

  2. So when it boils down to it, the banks are not infallible and their “big” borrowers (like Greece, Spain and Italy) can also default in their intended returns. This means that somewhere, somehow, somebody has to print more money to cover the loss, and for the tax payer and for the savers to experience losses, both due to small-bank failures and inflationary trends.

    We need to examine the whole macroeconomic picture and to find that there are no free lunches, somebody always has to pay. Without this knowledge and philosophy all of the modern money theorists can have a ball in describing parts of the big picture and avoiding the truth, but in fact they are unable to see the whole wood for the trees.

    • Default of private institutions is always possible. In the US when banks are found to be insolvent, then they are put into resolution. Depending on available funds, equity holders lose out, and debt is crammed down to equity. Generally this happens after closing on Friday and the bank opens on Monday under new management. Customers notice nothing. This is just how capitalism works.

      In the event of a financial crisis in which there is systemic risk, the first priority of government is to keep the financial sector operating, since financial collapse would spread through the real economy and in the case of the US, the global economy. The central bank does by providing unlimited liquidity to ensure that the system clears. (You may remember that the financial system froze up when the commerce paper market collapsed.) Government may also chose to nationalize certain key institutions, or recapitalize them as was done in the 2008 crisis.

      Finance in a capitalistic system is key because it provides the funds and financing to business (producers) and increasingly to consumers as well. It is the lynch pin of the system. Without getting banking and finance right, a capitalist economic system is fragile. Economically, it is necessary to have a flexible banking and financial system for growth, but also a safe one for confidence.

      Warren Mosler, one of the founders of MMT, has put forward proposals for reforming the banking and financial system so as to prevent the issues of the previous crisis from arising again, based on causes he identifies and addresses. He formerly owned a small bank and is familiar with the banking system. He was also a fixed-income fund manager, and understands the broader financial system as well. Based on experience, if anyone is capable of seeing the woods, it is him.

    • . . . there are no free lunches, somebody always has to pay.
      Cliches are always such a good answer, aren’t they?
      No, there are no free lunches. Consumption requires production, production requires resources, and though banks can print money, they cannot print oil or clean water or effective schools.
      So, good sense says that it makes no sense to idle production capacity in order to pay off loans. Money can be created by the merest gesture; we should not pretend that money is a scarce resource, when money is neither scarce nor a resource.
      When banks make mistakes — and they will make — the sensible thing to do is to correct those mistakes, not convert them into full faith and credit obligations of the government. Erase the debts with the same decisive ease with which they were created. There are always consequences for error, but those consequences are simply compounded by the stubborn refusals to correct the error. The only pain we can escape in this life is the pain caused by trying in vain to avoid pain.

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