Home > Uncategorized > The loanable funds fallacy

The loanable funds fallacy

from Lars Syll

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 notbarter 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.

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 gibbering about ZLB — and start using good old Keynesian fiscal policies.

  1. April 27, 2018 at 8:48 am

    ” Banks create new funds — credit — only if someone has previously got into debt! ” It is very unclear what this statement means or refers to. Banks create new credit money when they both lend and spend into the real economy. In what way is bank spending associated with debt?

    • April 28, 2018 at 3:36 pm

      Banks do not spend money, except trivially to pay salaries and run their buildings, etc. When someone walks into a bank and gets a mortgage loan, the following happens:

      1. The banks writes in its books that person X owes the bank $100k plus interest over some years. That’s a loan.
      2. The bank and person X write a contract that if X is unable to repay the loan the bank has a right to repossess and sell the house. That’s collateral.
      3. The bank writes in its books that the bank credits X’s account $100k, which means the bank promises to pay X $100k whenever they ask. That’s a deposit.
      4. At the end of that day the bank checks that it has enough credit with the central bank (the Fed, ECB, etc.) to meet some legal targets, which are fairly low. If not, the bank takes a loan from the central bank. That’s reserves.

      Money gets created at step 3, when the bank writes out the loan amount into the customer’s account. That money doesn’t come from anywhere, not from the central bank. The bank creates it. The bank can create money like this because:

      * It’s a bank. It has a special license that makes it different from a person or bakery.
      * The bank has assets to match or exceed the amount it created (the loan and collateral).
      * People accept bank credit as money, and call it money for all intents and purposes.
      * The central bank and the government have the bank’s back and promise to guarantee it all if it goes wrong. Except in Europe where they don’t so there’s constant crisis.

      I hope this helps.

      • Craig
        April 28, 2018 at 6:56 pm

        Nice, succinct analysis.

        Now consider that we currently give one business model (finance) the sole monopolistic right to create the life’s blood (credit/money in the paradigmatic form of debt ONLY) for the survival of every business and every individual.

        This is domination and felonious temptation waiting to happen, and because old paradigms are largely unconscious and new ones require a new conscious realization…..all we have to do is “stand in the light” of the new paradigm of Direct and Reciprocal Monetary Gifting long enough to perceive it.

  2. David Harold Chester
    April 27, 2018 at 9:27 am

    The current theory is that when a bank extends credit to a borrower, it derives this credit from nothing more than the agreement of the government for it to do so, but for a large and limited degree. I wish to add that unlike regular currency, this money has to be returned to its source after a specific time, so although these credit payment are continuous the returns are also continuous and consequently we should be examining only the rate at which it grows or shrinks.

    Your question about the borrower being in debt first suggests that he/she has not yet managed to cover (by return) a previous similar crediting, but in fact this cannot be extended indefinitely and so the above criterion for rate of change is all that is relevant.

    I should add that the opposite side of the bank’s activity, that of borrowing from savers and paying interest on this loan and its return, should be included in this examination of the bigger picture of the bank’s activity. Whilst savers probably are less active than creditors, the bank would presumably prefer to lend in the “old fashioned” way without having to extend this modern un-backed credit.

  3. rddulin
    April 27, 2018 at 12:20 pm

    Bank or private lending creates velocity not money.
    Only when a loan is defaulted on, or interest is spent, is debt free money created in the economy.
    Debt is evidence of active purchased velocity.
    The bank regards deposits as loans to the bank to cover the bank’s shorts in whatever schemes the bank is involved in.

  4. April 27, 2018 at 5:17 pm

    Banks lend if:
    They are not capital impaired, and they have found a credit worthy borrower.
    Minsky observed that in aggregate banks can never be capital impaired because if banks in aggregate were capital impaired this would threaten the functioning of the payment system and thus freeze the economy so the Fed must intervene. As to credit worthy borrowers, as we have seen, banks (again in aggregate) can create a situation where asset prices used by borrowers as collateral can take on a self fulfilling nature where banks lend against collateral whose price rises due to bank lending. In this eventuality a credit worthy borrower becomes anyone who can fog a mirror. At least in this sense it’s not too complicated.

    • Craig
      April 27, 2018 at 6:28 pm

      Loanable funds is a fallacy. What needs to occur is the economy must become a true abundant individual and commercial money economy instead of an onerous and austere Debt Only one, and finance and banking to become a public utility. The net effect of this would be a tremendous reduction in the need for personal and commercial borrowing and a tremendous increase in the government’s ability to self fund its legitimate obligations and services.

  5. lobdillj
    April 27, 2018 at 7:30 pm

    I usually begin a comment here by posting the disclaimer, “I am not an economist.” Now I will add this: “I am not an economics historian.” I issue the first disclaimer because there is so much stilted language and arcane jargon in discussions of economics that an educated general reader senses could be deliberate obfuscation. I issue the second disclaimer because the history of a concept, while perhaps interesting, is not of help to me in understanding the implications of it.
    I know enough about monetary systems to realize that all of them have implied intended beneficiaries whose identity is usually not a subject for polite discussion.

  6. April 28, 2018 at 3:31 am

    I do not explain why, because it takes me too much space and this is not the place here. Let me simply state that the proposition “the equality between savings and investment … will be valid under all circumstances” is wrong.

    Saving and investment can move (within a certain range of limits) independently. If this is true, Kalecki (cited above) was wrong as well as Keynes of General Theory. Equality of saving and investment holds only on the assumptions that the economy is in equilibrium in which the state remains invariant. Out of equilibrium, investment is not necessarily equal to saving and vice versa. To believe Keynes’s General Theory like a Holy Scripture is a silly fact. We should see what is his real discovery and discard many of Keynes’s wrong theories. Lars Syll should be more conscious that the anti-Keynesian revolution in 1970’s is in fact the theoretical result of Keynes’s confusing and confused construction of the General Theory.

  7. Edward K Ross
    April 28, 2018 at 7:06 am

    Dear Yoshinori Shiozawa While respect your economic knowledge as far superior to my very limited economic knowledge I wish to comment from lived experienced on;

    “Lars Syll should be more conscious that the anti- Keynesian revolution in the 1970’s is in fact the theoretical result of confusing and confused construction of the general theory”

    Firstly from experience when my wife and I settled in Queensland Australia when we left Papua New Guinea, the daily political economic rhetoric saturated the media with the concept that Keynes ideas had reached their use by date and that the new economic rationalism was the solution to nations economic problems. How this was achieved is described very well by Ted Weelwright in The Complicity of think-Tanks cited in The Human Costs of Managerialism (1995) Apart from the fact that I was born in 1936 and grew up listening to adults recounting how Keynes ideas lifted people out of the great depression I do not have the economic knowledge to argue , wether his general theory was confusing or not. however from experience and observation I think it is essential to read and understand Ted Wheelwright’s description of the driving force of the powerful wealthy elite to discredit Keynes’ ,before dismissing Keynes General Theory. Ted.

    • May 3, 2018 at 8:06 am

      Thank you, Edward K Ross, for recommending me to read Ted Weelright’s chapter. I have searched it in the WW if I can get a free copy of it but I could not find one. However, I guess what Wheelright had written is right.

      You may be misunderstanding me with my post above. I am not asking to abandon Keynesian theory as a whole. I think Keynes’s great contribution was his discovery of the principle of effective demand. However, Keynesian theory was overturned by anti-Keynesian revolution in 1970’s, because (1) Keynes could not present his theory in a logically coherent way and (2) followers of Keynes’s General Theory could not develop Keynes’s idea in a consistent theory. This is the reason why I am arguing that it is necessary that we should be more conscious and aware of Keynes’s errors.

      Keynes denied loanable funds theory but has introduced an error that I = S for all circumstances. What he has established was in fact the equality of two quantities at the period of stable equilibrium. It cannot be applied to the dynamically changing period. This deprived the possibility of dynamical analysis from so-called Keynesian economics and introduced many wrong reasoning with regards to economic change and growth. What I am asking is to re-construct Keynesian theory into a more consistent theory that permits to analyse dynamically changing processes. Lars Syll defends Keynes, but does not present any direction for the reconstruction of Keynesian economics.

  8. intajake
    May 2, 2018 at 4:23 pm

    Banks need to finance their lending book
    Via;either
    Deposits
    Wholesale funding
    Expensive shorterm liquidity funding from Central Bank.

    The cost of funding;especially in wholsale markets operate very much like a market with supply and demand.during ’08 supply vanished.

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