Why MMT rejects the loanable funds theory

29 Jul, 2021 at 11:00 | Posted in Economics | 11 Comments

The Deficit Myth: Modern Monetary Theory and the Birth of the People's  Economy - Stephanie Kelton - Häftad (9781541736191) | BokusGovernment deficits always lead to a dollar-for-dollar increase in the supply of net financial assets held in the nongovernment bucket. That’s not a theory. That’s not an opinion. It’s just the cold hard reality of stock-flow consistent accounting. So fiscal deficits — even with government borrowing — can’t leave behind a smaller supply of dollar savings. And if that can’t happen, then a shrinking pool of dollar savings can’t be responsible for driving borrowing costs higher. Clearly, this presents a problem for the conventional crowding-out theory, which claims that government spending and private investment compete for a finite pool of savings.

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 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 Kelton, 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 and 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.

kaleckiIt 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.’


  1. My understanding is the following:
    Financial saving is the income not spent on consumption goods or investment goods, and is used to acquire financial assets. Sum of individual savings is not equal to S, as financial liabilities may be entirely used to purchase pnly consumption goods.
    At the macro level though I=S because unlike consumption goods investment goods are not exhausted at the end of the period but added to the K. Therefore at the macro level I is generated income which is saved by accumulating the K. Financial saving at the individual level has nothing to do with I at the macro level.

  2. I’ve always felt that as a theory explaining tradeoffs when capacity limits are hit, “loanable funds” works alright if seen as a theory about command over factor inputs rather than funds. It doesn’t work well when there is spare capacity, so just avoid using it then. You can’t be too doctrinal. E.g. low interest rates may not stimulate spending much during deep recessions, but high interest rates can definitely kill spending even in a boom. Just ask Volcker. E.g. Big government spending (with or without deficits) may not be a big issue when there is spare capacity, but can surely be a strong competitor for resources versus the private sector when there isn’t spare capacity.

    • In that case, what is “saving” as an economic act or behavior? It cannot be the hoarding of currency or specie, or even the accumulation of deposit credits as a savings bank. What is it then? How should we conceive of “savings”? What is this accumulation that waltzes before Walras, seeking tatonnement vis a vis investment?
      Loanable funds is not just incoherent, it is ridiculous.

  3. […] Why MMT rejects the loanable funds theory Lars P. Syll. The topic is a hardy perennial, but worth a read. […]

  4. I agree with Stephanie Kelton when she casts doubt on what she calls “conventional crowding out theory”, that conventional theory being that, as she puts it, “government spending and private investment compete for a finite pool of savings.” However it would still be possible for government to “drive borrowing costs higher” (to quote her) where government funds too much of its spending via borrowing rather than tax.

    E.g. if government runs a deficit despite no deficit being required (and politicians are always tempted to collect an insufficient amount of tax as David Hume pointed out 300 years ago), additional net financial assets are accumulated by the private sector. Government will have to offer an increased rate of interest on govt bonds so as to induce the private sector not to try to spend away its increased stock of net financial assets: after all, the increased spending that inherent to an increased deficit must be countered by a cut in spending somewhere else.

  5. I think we have to be very careful about Keynes position on the question of loanable funds.
    Keynes also said:
    “All these points of agreement can be summed up in a proposition which the classical school would accept and I should not dispute; namely, that, if the level of income is assumed to be given, we can infer that the current rate of interest must lie on the point where the demand curve for capital corresponding to different rates of interest cuts the curve of the amounts saved out of the given income corresponding to different rates of interest.” (GT p.178)
    So Keynes appears to contradict what Lars has quoted from Keynes above (GT p.179). He is happy to accept the proposition of the loanable funds argument if income is unchanged. But then he goes on to argue that the savings demand and investment supply functions are not independent and they themselves affect the level of income. So, in the real world he argues the loanable funds theory is not valid.
    But then in the dying pages of the GT, Keynes argues that at full employment Classical Theory is valid. (GT p. 378) At full employment income cannot increase. So the saving and investment functions do determine the rate of interest. Back to what he said on p.178.

    • Does full employment matter much as it is almost never achieved?

    • Billcinsd,
      The discussion is essentially about theory here.
      Reality is another matter.
      When is full employment? Blowed if I know.

  6. “…has more an more come…” In point 3 should be ”…has more and more come…”

    Excellent article; somewhat above my level, as an amateur economist/MMT enthusiast, but mostly understandable if I did some Googling and brief supplemental readings.

  7. Typo in the heading.

    Loanable (vs loanabe)

Sorry, the comment form is closed at this time.

Blog at WordPress.com.
Entries and Comments feeds.