Keynes vs. Wicksell — the loanable funds theory

13 August, 2017 at 17:06 | Posted in Economics | 7 Comments

WicksellThe fundamental difference between Keynes and Wicksell and in general the
supporters of the LFT [Loanable Funds Theory] lies in the specification of the consequences of the presence of bank money. Introducing the distinction between the natural rate of interest and interest rate on money, Wicksell and the LFT supporters state that an economy that uses bank money converges towards the equilibrium position that characterises an economy without banks, in which there is no credit market, but just a capital market where the resources not consumed by savers are exchanged. The presence of bank money does not alter the structure of the economic system; the only element that distinguishes a pure credit economy is the presence of an adjustment mechanism that drives the rate of interest on money, determined within the credit market, towards the natural rate of interest. The working of a pure credit economy can therefore be described using a theory that applies to a world without banks.

In contrast, Keynes states that the spread of a fiat money such as bank money changes the structure of the economic system. He underscores this point by introducing the distinction between a real exchange economy and a monetary economy. As is well known, Keynes uses the former term to refer to an economy in which money is merely a tool to reduce the cost of exchange and whose presence does not alter the structure of the economic system, which remains substantially a barter economy. Keynes notes that the classical economists formulated an explanation of how the real-exchange economy works, convinced that this explanation could be easily applied to a monetary economy. He believed that this conviction was unfounded …

Giancarlo Bertocco



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  1. “Loanable funds” is absurd (except between banks and other account holders at the central bank) since, except for physical fiat, aka “cash”, the non-bank private sector cannot even receive fiat. There’s literally no place* for it to go since they may not have accounts at the central bank themselves.

    Instead, “Bank loans create bank deposits”. But bank deposits are not fiat itself, as deposits at the central bank are, but mere liabilities (IOUs) for fiat.

    So “loanable funds” is absurd except between banks and other account holders at the central bank. It certainly does not apply to bank loans to the general population.

    *an exception is US citizens might deposit a bank loan to US Treasury Direct but the loan would be largely useless there since US Treasury Direct does not offer checking or debit services.

  2. I clicked thru to read Bertocco’s essay, and I admit I was a trifle disappointed.
    The hydraulic intuition provided by the quantity theory of money apparently infects every thought. But, a payments system based on a fiat currency and credit is pure scorekeeping. There is no “quantity” constraint. The banking system can no more run out of money than the referees at a basketball game can run out of points.
    But in a system of scorekeeping, it is not clear to me what reason there could be to believe in a single market rate of interest controlling an allocation of “capital”. LFT is not just preposterous, it is irrelevant.

    • Yes, I came to the “money is like points” realization after hearing Sister Simone (from Sisters on a Bus) describe a talk she was asked to give to a conference of CEOs. She asked them, do you really need such high compensation, millions of dollars, just to put food on the table? She said one answered her, No Sister Simone, it’s not that we need the money to live, it’s about making more than the other guy.

      Thus (my story goes) money is a scorekeeping system for the rich, and the financial sector has figured out how to rig the rules so that they can create credit that turns into money as they wish.

  3. It seems to me that whenever we think about a bank lending money it is either money that comes from prior savings or money that is issued by the treasury through the banks.

    What is not mentioned is that as savings accumulate so do exiting or returning savings that lenders are withdrawing for their use elsewhere in the social system. By looking at the borrowing/savings process as a continuous operation we can see that it is only the increments of change in new money that have been previously explained (as if that was all that is involved). We need to look at the big picture more completely.

    • I do not think it is helpful to imagine either money generally, or a money fund of savings as a liquid with hydraulic force. Banks are not transferring funds between savers and borrowers, so much as they are simply mirroring everyone’s desired portfolios, while managing the payments system.
      The tricky thing about the big picture is keeping money prices stable enough thru time. Money, of course, is neither created nor destroyed in a transaction involving payments to factors or for commodities. Only debts are extinguished by cash payments and only new debts create new effective demand.
      A bank or financial intermediary must struggle to avoid investments that will return a negative present value. This is a particular challenge in an uncertain world because in an uncertain world, investments tend to take the form of sunk-cost commitments. Once, they are made, they have no bargaining leverage going forward. The cost of widgets have been reduced, but the price of widgets falls accordingly and absent a political power there is no revenue stream to repay the investment.
      LFT bypasses the uncertainty by making money supply a stable numeraire without reference to mechanisms of finance or price formation or risk-taking.
      In real life, investors hedge their bets and entrepreneurs seek out “business models” that identify pricing power. The key to hedging is many, many marketable securities (did I mention portfolios?) founded on the “riskless” debt of the sovereign, continuously turning over in a market made and managed by the central bank. That great torrent of taxes and national debt is the ballast that keeps the money economy’s ship upright, to mix metaphors.
      sunk cost investments in public goods that cannot efficiently command a return can be financed by taxes on land and more generally economic rents and externalities, while the banks and business enterprise hedge private risk-taking.
      Would that more economists had a clue about how this system works, we might hire them to run it with less risk of catastrophe.

      • “The tricky thing about the big picture is keeping money prices stable enough thru time.”

        I agree that the current thinking runs along these lines, but I dispute the current wisdom. I think the goal should be to keep real income purchasing power stable over time. Since prices can only be proven efficient using assumptions that the largest market players violate (advertising manipulates preferences into intransitive relations, for example), inflation should be seen as arbitrary. If inflation is not a price signal but psychological noise, we can treat it by raising everyone’s income in lockstep with prices. Inflation thus becomes neutralized. (Israel used such a linkage mechanism for decades successfully.)

        ” The key to hedging is many, many marketable securities (did I mention portfolios?) founded on the “riskless” debt of the sovereign, continuously turning over in a market made and managed by the central bank.”

        I think you are neglecting the private money markets. Private dealers deal in Treasuries and other “risk-free” instruments such as derivatives and swaps. Private insurers also provide hedges against downside risk. Thus the market in Mortgage-backed Securities was not really “made and managed by the central bank”, yet it provided a lot of hedges until a panic set in and everyone stopped accepting MBS (even the top tranches which are performing very well today for the Fed after being bought as “toxic assets”). At that point, the Fed started making a market in MBS because no one else would. As Prof. Mehrling says, the Fed stepped in to act as a “value investor” who buys when the market is so low it can only go up.

        Even when MBS were being devalued by traders, the insurance piece should have covered the MBS holders. But the insurance on the relatively new derivatives was immature and broke. Again, the Fed stepped in to bail out AIG …

        • I would not confuse my “stable” for low rates of inflation per se. Inflation at even moderate rates can be stabilizing in the right context. Volatility to my mind would be exemplified by deflation and financial crisis.

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