The causes of secular stagnation and the loanable funds theory

28 Dec, 2017 at 09:34 | Posted in Economics | 6 Comments

What are the causes of secular stagnation? What are the solutions to revive growth and get the U.S. economy out of the doldrums? …

Growth_cartoon_05.19.2015_normalOne headline conclusion stands out: the secular stagnation is caused by a heavy overdose of savings … All these savings end up as deposits, or ‘loanable funds’ (LF), in commercial banks … The glut in savings supply is so large that banks cannot get rid of all the loanable funds even when they offer firms free loans—that is, even after they reduce the interest rate to zero, firms are not willing to borrow more in order to invest. The result is inadequate investment and a shortage of aggregate demand in the short run, which lead to long-term stagnation as long as the savings-investment imbalance persists …

This is clearly a depressing conclusion, but it is also wrong …

Ever since Knut Wicksell’s (1898) restatement of the doctrine, the loanable funds approach has exerted a surprisingly strong influence upon some of the best minds in the profession …

Due to our inability to free ourselves from the discredited loanable funds doctrine, we have lost the forest for the trees. We cannot see that the solution to the real problem underlying secular stagnation (a structural shortage of aggregate demand) is by no means difficult: use fiscal policy—a package of spending on infrastructure, green energy systems, public transportation and public services, and progressive income taxation—and raise (median) wages. The stagnation will soon be over, relegating all the scholastic talk about the ZLB to the dustbin of a Christmas past.

Servaas Storm

loanable_funds_curve-13FEC80C6110B93D6D9It is difficult not to agree with Servaas here. 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 credits set by banks and 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.”

It’s a beautiful fairy tale, but the problem is that banks are not barter institutions that transfer pre-existing loanable funds from depositors to borrowers. Why? Because, in the real world, there simply are no pre-existing loanable funds. Banks create new funds — credit — only if someone has previously got into debt! Banks are monetary institutions, not barter vehicles.

In 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.

That view has been shown to have very little to do with reality. It’s nothing but an otherworldly neoclassical fantasy. But there are many other problems as well with the standard presentation and formalization of the loanable funds theory:

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 shifts​, 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 channelling 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.’

So, yes, the ‘secular stagnation’ will be over, as soon as we free ourselves from the loanable funds theory and “scholastic talk about ZLB” and start using good old Keynesian fiscal policies.

[h/t Lance Taylor]


  1. I agree with Servas Storm’s conclusion, i.e. that secular stagnation is a complete non-problem because fiscal stimulus can always overcome it.

    However, strikes me it’s going too far to say that the loanable funds idea dominates economic thinking nowadays. That is, what might be called “extreme loanable funds” (i.e. the idea that recessions automatically cure themselves because interest rates fall far enough to cause an investment boom which gets us out of recessions) is obvious nonsense. That’s why we’ve implemented Keynsian style stimulus since WWII when recessions hit.

    At the other extreme, the idea that loanable funds is 100% invalid is also nonsense: a big increase in the desire to save will tend to reduce interest rates surely? The fact is that interest rates have fallen over the last 20 years or so, and that’s widely attributed to an increased supply of savings from non-Western countries.

    • As I see it, finance constructs synthetic risk-free bonds and traders, often colluding, bid them up in derivatives markets. Lower official interest rates are superseded by derivative returns. If there is more money in money-market funds, there is more money to fund shadow banking’s derivative creation which results in a multiplication of the face value of underlying real assets such as mortgages. “Money-market funding of capital market lending” is how Mehrling describes shadow banking. For shadow banks, the more money market money the more they can expand their balance sheets. They can sell homes to money market investors who see high returns no matter what the Fed has set …

  2. “Loanable funds – 75 years later

    by Severin Reissl- Glasgow University Real World Economics Society

    The recent discussion I had about Keynes’ article The Process of Capital Formation with Phil Pilkington (he wrote an excellent post about the paper) reminded me of a conversation I had with one of my lecturers some time ago. For a reason I cannot remember we were talking about saving and investment, and I voiced some criticism of the savings-cause/finance-investment view. She actually agreed with most of what I said (although she evidently believed that I was not saying anything new – a common attitude of the mainstream when confronted with criticism), and I ended up recommending a great working paper by Fabian Lindner of the Macroeconomic Policy Institute in Düsseldorf which debunks these notions quite skilfully.

    Yet I remain puzzled about why, then, this same lecturer is prepared to keep teaching models that happily accept this erroneous view. Keynes, in the article mentioned above, is able to strike a quite critical blow to the loanable funds theory in the simplest terms possible. That was in 1939, and a lot has happened since then to complete the theory’s intellectual collapse (but, unfortunately, not its abandonment). 75 years later, I am confronted on my Macroeconomics module with the Solow model of economic growth. Now, there is a truckload of stuff that is wrong with this model and concepts related to it (reliance on the marginal productivity theory of income distribution; all the problems related to “growth accounting” and the “Solow residual” as analysed by Felipe & McCombie …), but what I want to focus on is that this model tells me that poor countries will become rich if they save more. The savings rate is a key determinant of an economy’s “steady state” level of income in this model, and the savings-investment identity is clearly presented to mean that a higher savings rate will cause more investment and hence growth. Yet this idea is just as false in the “long run” as it is in the “short run”. In fact, the distinction between short run and long run is particularly unhelpful in this context. The long run is itself just the result of a series of short runs and its character is determined by these. Therefore, if the paradox of thrift holds in the short run, there is no sense in saying that somehow, saving still magically causes investment and growth in the long run. The trick is achieved by assuming that full employment prevails at any point in the Solow model, which amounts to assuming away the paradox of thrift altogether, at all points in (logical) time.

    “[…] if households cut their consumption expenses by a certain amount because they plan to increase their financial net worth (believing in accordance with loanable funds theory that higher financial saving meant higher investment), corporations would immediately and mechanically see their revenues and profits from the sale of consumption goods fall by the same amount. […] As is rather obvious, there is no ex ante certainty that corporations, seeing their sales drop, will maintain their previous level of expenses – as loanable funds theory would like us to believe – or even increase their production of investment goods. Further, it is neither certain nor likely ex ante that firms would now borrow and increase their future debt service in the face of lower profits” (Lindner, 2012)

    By assuming full employment at any point, we are assuming exactly this type of counterintuitive behaviour from agents in our model. It still does not mean that saving causes investment, but rather that we are imposing that there will always be sufficient outlays to maintain full employment at any desired rate of saving. Keynes reminds us in Chapter 21 of the General Theory that we use models “to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking “. And this is precisely what the Solow model does not do, by assuming away the complications pointed out through simply imposing full employment at all times.

    I believe that this is an enormously important thing to point out. I am quite convinced that even many mainstream economists would agree with the analysis above, yet the Solow model is still being taught and, along with some other common culprits, contributes to forcing these erroneous views into students’ heads. The saving-causes/finances-investment view has a massive superficial appeal, because it is something we can metaphorically relate to our own lives. A big part of the problem is that, in my experience, the terms “investment” and particularly “saving” are notoriously liable to being ill-defined in economics courses. The crucial distinction between how they are used in everyday parlance and what they mean in an aggregate/national accounting sense is seldom pointed out. Indeed, the confusion is being encouraged, whether intentionally or not, by the way concepts such as the Solow model are presented. I would urge any student to read Lindner’s paper to get a grip on this distinction.

    Since I am planning further posts on this blog, I should say that although I am an officer of Glasgow University Real World Economics Society, the views expressed in my posts do not necessarily represent the views of the society (although of course I hope that they do). Once this blog gets going properly (hopefully after our AGM), there will likely be posts from other members as well, and it will be used as a forum for expression of many different points of view.”

    • Thank you for posting these Jan- I think they are great comments.
      I am still very confused about the whole savings-investment thing even though I have decided the loanable funds idea is pretty much worthless in societies that use fiat currencies as funds.

      Unfortunately maybe, I have spent considerable time trying to figure out why so many economists believe that prior savings are both necessary for investment and indeed lead (or induce) that investment. I am guessing that they believe economies are always at full employment and always ‘supply’ constrained all the time.

      • Thank you Jerry.
        It Still stuns me this old theory,debunked so many times ,over and over, even is mentioned today! All the best,Jan

  3. Fabian Lindner-
    Institut für Makroökonomie und Konjunkturforschung
    Macroeconomic Policy Institute

    “Saving does not finance Investment:
    Accounting as an indispensable
    guide to economic theory

    The paper analyses the accounting relationships between the
    financial and the real economy. It will be shown that accounting
    can clarify the nature of economic phenomena and be an important
    building block for economic theory. The paper will argue that there
    is much confusion about key macroeconomic concepts like saving,
    investment and finance. This confusion is best summarised
    in the statement “saving finances investment”. After clearly defining
    the accounting relationships between lending, financial saving and
    physical investment it will be shown that this is a nonsense
    statement. The theory behind it – the loanable funds theory – will
    be analysed and critiqued. It will be shown that the loanable funds
    theory confuses the concepts of income and production, lending and
    saving, and financial saving and non-financial saving. It will further
    be shown that this has not only theoretical but also important policy

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