Banks are NOT intermediaries of loanable funds

27 Apr, 2019 at 10:05 | Posted in Economics | 4 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.”

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.

As argued by Kumhof in the video above (and here), 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 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.’


  1. “saving and investment can be treated as independent entities” — yes or no?
    In the national accounts, every purchase is a sale: that defines the double-entry bookkeeping at the core of the accounting system. Income equals spending. By definition. Every dollar spent is a dollar earned, because in every transaction in which money is exchanged for goods or services, there is a buyer and a seller.
    In the system of national accounts, to keep the accounting intact saving and investment mirror one another in the same double-entry fashion as buying and selling. This is an accounting convention, not a description of financial reality.
    Though national accounts were still in their infancy when The General Theory was published, Keynes followed the accounting convention and insisted upon its definitions. It did not make his argument either stronger or easier to follow.
    The accounting convention that defines saving and investment as identical does not coincide with everyday experience of saving money. A hoard of coins or a balance in a checking account at a bank is not an investment, at least not an investment in the same way as building a structure, accumulating an inventory of goods for sale or installing machinery in a factory to improve the efficiency with which goods are manufactured.
    Loanable funds theory exploits the intuitions of everyday experience and there is no point in denying the reality of that experience. We all of us have the experience of accumulating money funds in order to make some large purchase. People save money. It is a fact of everyday economic life. And, they often do so without personally “investing” in the sense of directly causing a building to be built or a piece of capital equipment to be built and placed into production, not do they invest all their money savings in an inventory of goods in the kitchen cupboard. They may “invest” with banks or other intermediaries in various kinds of financial instruments, so they certainly are aware of the role of intermediaries in finance.
    Loanable funds is a false doctrine. But, it is a persistent false doctrine and it persists, I believe, because the arguments against it are so often muddled by a wildly inconsistent resistance to the facts of everyday experience. It is just dumb to claim — or to insist on the basis of an ill-conceived convention of double-entry bookkeeping — that saving and investment are identical activities. People can save money without investing it (in the sense of spending on investment goods). Behaviorally saving is not-spending and the ability of households and firms as well as the state to spend more or less than their current income accounts for the instability in the macro-economy. Why obscure it with double-talk?
    Loanable funds is false in that it imagines in place of actual money a viscous fluid of barter sauce, in which a fund of “savings” is a magical bundle of bartered resources freed from the demands for consumption and furnished whole and intact to satisfy the demands of investment. Made explicit, it is an absurd image.
    The reality of money finance in an economy struggling to cope with uncertainty is far more complex with not one interest rate, but a great panoply of interest rates. Everywhere hedging and leverage are used to cope with uncertainty and every investment is a sunk-cost venture giving rise to risks, which may or may not be predictable enough to permit rational decision-making. Money is how we keep score, but not the prime mover.
    No realistic explanation will ever be as easy to grasp, or as totally misleading in every respect as loanable funds.

    • I hope people won’t be too mad, if I amend my own comment with a reply.
      That money is basically a score-keeping device is a concept that responsible economists ought to press home. As some wag had it, the referees at a basketball game do not run out of points. However much as a player, we may want to run up a high score, it makes no sense for points to be scarce on a system level. The important thing is that there be rules of the game, and enforcement of the rules, that prevent scoring points by assaults on the other players (“fouls”) that undermine the social integrity of the game as one with a positive sum of benefits for all the players.
      Financial intermediaries — not just banks, but a vast array of appraisers, auditors, regulators, speculators, accountants, tax assessors, administrators and managers — function for the system as player-referees, awarding money and credit like points in a game. Maturity transformation, arbitrage, rent-seeking and leverage shape behavior, in part by meliorating risk aversion while enabling inherently risky sunk-cost investments to earn sufficient prospective return to mobilize resources to make those sunk-cost investments in the first place and then to manage them well.
      It is a complex system in which a quantitatively scarce money is a political pathology, but also one in which political struggles over the distribution of income and risk — the distribution of income and risk become much the same thing in a money economy — are inevitable.

  2. If investment finances itself, why does a firm need internal funds?

    • Could it be that it is cheaper and less risk to use previous profits for investment than to use bank created credit money that create its own savings/financing?

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