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Loanable funds

from Lars Syll

Economic models that integrate banking with macroeconomics are clearly of the greatest practical relevance at the present time. The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist. Instead, banks create new funds in the act of lending, through matching loan and deposit entries, both in the name of the same customer, on their balance sheets. The financing through money creation (FMC) model reflects this, and therefore views banks as fundamentally monetary institutions. The FMC model also recognises that, in the real world, there is no deposit multiplier mechanism that imposes quantitative constraints on banks’ ability to create money in this fashion. The main constraint is banks’ expectations concerning their profitability and solvency.

Zoltan Jakab & Michael Kumhof 

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.

As argued by Jakab and Kumhof in their interesting new working paper quoted above, 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 it definitely is 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 shift, 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 channeling money/savings/credit — are more or less left in the dark in modern formalizations of the loanable funds theory.

  1. June 2, 2015 at 4:29 pm

    And the financial “industry” has found it very convenient to disconnect from the real world and create its own “products” and “services” in La-La land and proceed to create the funds to trade those entities without constraints.
    In other words, the individuals in the “industry” have imported the virtual world of computer games which they occupied as kids into their adult world, dragging the rest of us into their fantasy land.
    The problem arises when the money they use in La-La land is the same money we use to produce goods and services to stay alive and well.

  2. June 2, 2015 at 10:19 pm

    Totem, voodoo, and tabu
    Comment on ‘Loanable funds’

    “Economic models that integrate banking with macroeconomics are clearly of the greatest practical relevance at the present time.” (See intro)

    This is certainly a point we all can agree upon. The challenge for theoretical economics is, first of all, to explain how the undifferentiated product market, the labor market, the secondary market, and the financial market (including money) fits together.

    Economists habitually think they can solve any problem by painting supply-demand-equilibrium and taking Walras’s Law into account. In the apt characterization of Leijonhufvud economists either summon up the spirits of the ‘totem of the micro’ or the ‘totem of the macro’ with the mantra of market forces.

    All this has nothing to do with a scientific explanation because (i) supply function, demand function, equilibrium are nonentities, and (ii) the markets are in intricate ways interlocked (the quantitative volume of the financial market is the numerical integral of flow-differences in the product market; the real wage is uno actu determined in the product market; etcetera).

    The loanable funds theory is a case in point for the failure of supply-demand-equilibrium economics. The argument in the intro is a telling example for the actual state of theoretical ignorance and confusion.

    What first has to be done is to taboo supply-demand-equilibrium. All equilibrium models are false. A set of equations is not the suitable mathematical tool, but a stochastic simulation is. Second, both Walrasian and Keynesian approaches have to be put aside as useless and misleading.

    This clears the ground for Constructive Heterodoxy and the consistent and comprehensive theory of how the various financial markets emerge as integral parts of the monetary circuit which links all markets (2015).

    Egmont Kakarot-Handtke

    References
    Kakarot-Handtke, E. (2015). Essentials of Constructive Heterodoxy: Financial
    Markets. SSRN Working Paper Series, 2607032: 1–31. URL http://papers.ssrn.
    com/sol3/papers.cfm?abstract_id=2607032.

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