Kalecki and Keynes on the loanable funds fallacy

14 Nov, 2018 at 23:17 | Posted in Economics | 8 Comments

kal It should be emphasized that the equality between savings and investment … will be valid under all circumstances. 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.’

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.”

loanIt is 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 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:

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.

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.

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.

A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. This is 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.

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.

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


  1. Degree of monopoly and class struggle:
    political aspects of Kalecki’s pricing and
    distribution theory by Fernando M. Rugitsky

    “The aim of this paper is to analyse the concept of class struggle in Michal Kalecki’s writings.
    First, his inclusion of trade unions’ strength as one of the determining elements of the degreeof monopoly is examined, taking into consideration Abba Lerner’s formulation of the latter and its development by Kalecki. Then, the limits of this understanding of class struggle are pointed out from the standpoint of Karl Marx’s conceptual distinction between labor and labor-power.
    Finally, a reinterpretation of Kalecki’s ‘Political aspects of full employment’is provided, indicating the broader conception of class struggle implicit in this work and its usefulness to a better understanding of capital–labor conflicts in contemporary capitalism”

    Click to access Degree%20of%20monopoly%20and%20class%20struggle%20political%20aspects%20of%20Kalecki’s%20pricing%20and%20distribution%20theory.pdf

  2. Loanable funds models a system ordered by an homeostatic equilibrium and in which all the actors are free of illusion.

    The actual economy of money finance features both plenty of illusion and remarkable volatility.

    Of course economists are going to choose to expound loadable funds — it is ready-made to serve as a civic myth covering for all manner of capitalist foolishness and predation. Reality, by contrast, promises to be both too complex to fully comprehend and too often, ugly, requiring remedy but not furnishing remedy.

  3. Lars’s opening paragraph claims that because commercial banks create money from thin air, that therefor banks do not need pre-existing savings in order to fund investments. As Lars puts it (quoting Kalecki, I think), “investment, once carried out, automatically provides the savings necessary to finance it.” Well there’s a problem with that idea, as follows.

    Suppose an economy is at capacity and a firm wants to borrow from a bank and invest. The bank will provide the money and the investment gets made. But wait a moment: if the economy is at capacity, no more demand is permissible. Moreover, if that money IS SPENT, it will end up in the bank accounts of A, B & C etc. But A,B,C, etc will then have more than their preferred stock of money at the going rate of interest. They will therefor try to spend away that excess. Thus quite apart from the excess demand caused by the latter investment spending, there is a CONTINUOUS excess demand problem.

    The result is the central bank will raise interest rates, which will snuff out at least some of the above extra investment spending. Plus the higher rate of interest will make A,B,C etc more willing to hold onto their newly acquired money, rather than spend it away.

    In short, the fact that commercial banks create money out of thin air does not invalidate the idea that the supply of and demand for savings works much the same way as supply for and demand for apples. At least that’s true where the economy is at capacity.

    • Why doesn’t the additional investment in a full-employment economy simply drive up prices?

      • It does. That was my point. At least it does till the central bank cools things down with an interest rate hike.

    • Ralph, out of curiosity, what percentage of time do you think most economies are operating at “capacity”? Is it most of the time, like classical economics seems to assume? Or is it really rather pretty rarely?

      • There’s no sharp dividing line between being at capacity and not. But if you take an inflation rate of above 2% as being “at capacity” (obviously a far from perfect measure), the UK economy has been “at capacity” about half the time since 1990.

        • ‘Far from perfect’ is right considering that inflation can occur from supply shocks and even sales tax increases. But I get your point that rising inflation, if you can pin it to excess demand, might point to an economy close to output capacity. I would have a hard time believing the UK economy has been “at capacity” half the time since 1990. But I don’t live there and I assume you do 🙂 Thanks Ralph.

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