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Why modern monetary economists reject the loanable funds theory

Lars Syll

Stephanie Kelton: “(Federal] Government deficits always lead to a dollar-for- dollar increase in the supply of net financial assets held in the non-government 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 story, 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 what saving is available. Saving is the supply of loan- able funds, investment is the demand for loanable funds and is assumed to be negatively related to interest rates. 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. Typically of most mainstream macro- economic formalizations and models, there is very little mention in loanable funds theory of real-world phenomena – like actual money, credit rationing and the existence of multiple interest rates.

    The loanable funds theory essentially reduces modern monetary economies to something akin to barter systems – something they definitely are not. As emphasized especially by Minsky, in order to understand and explain how much investment /lending /crediting is going on in an economy, it’s much more important to focus on the operations of the financial markets than to stare at accounting identities like S = Y – C – G. The problems we meet within 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 overnight 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 the law of Walras 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 choose not to follow Taylor-like policy rules). The age- old belief that Central Banks control the money supply has increasingly come to be questioned and to be 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 saving and investment may be treated as independent entities. To Keynes this was seriously wrong:

    John Maynard Keynes: “ The classical theory of the rate of interest (loanable funds theory) seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to 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 posit- ions 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 that what happens at the microeconomic level – 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 being one of them.

  5. Contrary to the loanable funds theory, finance within the world of Keynes and Minsky precedes both 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 cannot 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, rather than the twin, of increased saving.

“ What is usually ‘forgotten’ in the loan- able 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 added as an unsystematic appendage.

“ Finance is fundamental to our under- standing of modern economies and – acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it in the oven afterwards – simply isn’t enough.

“ All real economic activities nowadays depend on functioning financial machinery. But the institutional arrangements, states of confidence, basic 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.“

Michael Kalecki: “It 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 concept- ion, implemented investment automatically provides the savings necessary to finance it. And 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’.

Source Real-World Econ Rev blog 6 Aug 21

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