Home > Uncategorized > Kalecki and Keynes on the loanable funds fallacy

Kalecki and Keynes on the loanable funds fallacy

from Lars Syll

kalIt 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. November 21, 2018 at 6:17 pm

    There are two distinct aspects to the behavior of banks and financiers. One is mechanistic and deterministic, the other is psychological and socialogical. For example consider banking: on one hand banks operate by simple mechanistic rules, loan to value ratios, borrowers income to debt service ratio, and so on. Bankers turn the crank, and decision wether to lend comes out.
    On the other hand, psychologically, bankers episodically get it into their heads that a certain asset class can never decline in market value (price). This psychological shift induces bankers to break their own mechanistic rules. Combine this with the fact that banks create new credit money by lending and the stage is set for a feedback instability where banks lend against the chosen collateral class who’s value keeps rising because banks lend against that class.
    In 1929 the chosen class was stocks. In 2008 it was houses.
    When central banks say they intend to enforce macroprudential oversight, they are saying they don’t like seeing banks ignoring their own mechanistic rules. When financial experts warn that they see a bubble forming, they are saying prices of a selected asset class are too high by historical norms for psychological reasons. Keynes saw the psychology aspect of this phenomena while Minsky saw the credit money creation aspect. Steve Keen has done a stellar job modeling the Minsky aspect of this. The psychological market mania aspect will be more difficult.

  2. Craig
    November 21, 2018 at 9:21 pm

    It’s a monetary economy that’s perfectly obvious. The question is whether we want it to remain one that is dominated by private banks who mysteriously and stupidly are allowed to maintain their monopolistic paradigm of Debt-Burden for the creation and sole form and vehicle for the distribution of money/credit…..because economists are apparently unable to think outside of that paradigm and find effective, beneficial and much more ethical ways of integrating a new paradigm into the economic system.

    Finance is needed of course, but it must serve humanity and the economic system not dominate, manipulate and destabilize it. As I have floated here before the best thing we could do is take away private banking’s money creating charter, create a national publicly administered banking system and central bank guided by the new paradigm of Direct and Reciprocal Monetary Gifting and its policies and then, because neither the government of a public utility need to make a profit, make finance/the creation of a 0% note the new terminal ending point of the economic process for large purchases like mortgages, autos etc……and thus for those items it could also take advantage of the 50% discount/rebate policy making the 50% reduced $100k price for a $200k house….$50k changing finance into an angel instead of a demon. Ah, the inversion signature of paradigm change is not only just, but delightful.

  3. Craig
    November 21, 2018 at 9:23 pm

    Make that “because neither the government or a public utility need to make a profit” …

  4. David Richardson
    November 22, 2018 at 3:51 am

    in addition to everything Lars said note that the investment on the part of the investor involves reducing the investor’s assets or incurring additional debt and passing on the resulting financial instrument/s to the recipient of the investment expenditure. It might even be as simple as the investor giving the supplier an IOU. No matter how it is done the reduced assets and/or increased debt is given to the supplier/s of the investment goods who initially holds the payment as a new financial asset. Hence the new supply and demand of financial assets is automatically equal.
    At that point the supplier of the investment goods or services may well decide to spend the additional financial resources and we get the beginnings of the Keynesian multiplier. That can all be traced through and it can be verified at every stage that the demand for and supply of financial assets is never anything but equal. All this is clear in the stock-flow adjustment processes described by Godley and Lavoie’s Monetary Economics with some of the implications drawn out in my RWER paper in issue 73 of 2015.
    So if we think of loanable funds in terms of stocks of some sort of financial assets/liabilities the two are necessarily always equal. The loanable funds theory is sometimes expressed as flows and sometimes as stocks. Lars spelled out why the proposition in terms of flows is wrong and it is also wrong when expressed in terms of stocks.

  5. November 22, 2018 at 9:36 pm

    Aldous Huxley: The Ultimate Revolution (1962), 1 hr 22 min https://www.youtube.com/watch?v=2WaUkZXKA30

  6. Helen Sakho
    November 23, 2018 at 2:12 am

    Please take this as a genuine IOU if anything new has been pinpointed?

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