Tuesday, 12 November 2013

The loanable funds doctrine is not totally invalid.

The loanable funds doctrine is the idea that banks simply connect borrowers and lenders. Nowadays, that is regarded as an over simple view of what banks do. However, a baby has been thrown out with the bathwater: the loanable funds idea is not totally invalid, and for the following reasons.
 The flaw in the loanable funds idea is that a bank (and more particularly the bank system as a whole) does not need deposits in order to make loans: that is, when a bank spots a credit worthy borrower, the bank can simply credit the account of the borrower, and regardless of how much money has been deposited at the bank.
However, an INDIVIDUAL bank can’t take that activity too far, else it runs out of reserves. Reason is that most of the money that a bank lends into existence will be deposited at other banks, and the latter will want “proper” central bank money, i.e. reserves, in exchange for the first bank’s “created out of thin air” funny money.
It is thus largely true to say of an INDIVIDUAL bank that the amount of lending it can do is dependent on how much is deposited at that bank. So to that extent the loanable fund idea is valid.
In contrast, there are no such constraints on the bank system AS A WHOLE. That is, if every bank expands the amount it lends out by the same percentage, no individual bank will run out of reserves. So to that extent, the loanable funds idea would seem to be INVALID. (And if the bank system as a whole runs short of reserves, the central bank has to supply more reserves if the central bank wants to keep control of interest rates.)
So it seems there are no constraints on the commercial bank system’s freedom to lend money into existence.
However it’s not quite that simple, and for the following reasons. When a loan is made, the relevant sum is deposited in the accounts of sundry depositors fairly soon after the loan is made: after all, there is no point in getting a loan and paying interest and/or other bank charges and then not making use of the loan.
Now suppose those “other depositors” want to use their newly acquired money AS MONEY rather than to make a longish term loan to anyone: that is suppose those depositors want to use their newly acquired wealth as day to day spending money. The relevant depositors would put their money in a CURRENT account rather than in a term or deposit account.
Now that’s a problem for the banks concerned and the problem has to do with maturity transformation. Maturity transformation (MT) is the process of borrowing short and lending long, which is one of the basic activities of banks. But MT is a risky activity if taken too far, and indeed hundreds of banks thru history have failed because they’ve taken the process too far.
So, suppose the bank system as a whole expands the amount it lends, and suppose that system has already taken MT as far as is prudent, and suppose the depositors whose stock of cash expands as a result of the new loans don’t want to see their money loaned on long term (i.e. assume they want to use that money as day to day spending money). In that scenario, banks have a problem: the problem is that there is a shortage of depositors who want their money loaned on long term.
While the commercial bank system can certainly create money out of thin air and lend it out, it is nevertheless constrained by the extent to which recipients of that new money want their money loaned on. So to that extent, banks are in the business of connecting borrowers to lenders: the loanable funds doctrine has some validity.

The above ideas occurred to me as a result of an exchange of views with Clint Ballinger. That’s the beauty of blogging: it forces you to think thru, and defend statements you make.


  1. Ralph - I have to run so this is quick - but even individual banks can make loans with no reserves - they then seek out the reserves after the fact, and the Fed (in the US) has to give them bc it targets interest rates.

  2. I just read this paper, which might interest you, regarding 'loanable funds':


  3. Ralph - sorry, I was dashing out the door before & had only skimmed your article and commented quickly - I will look more carefully at it. I wonder what real numbers the circuit theorists would/could put on what you write about.(?)
    y - thanks for the link - looks interesting.

  4. @ y
    Please explain the relevance of this academic paper.

    1. It discusses the 'loanable funds' theory. I happened to be reading it the day Ralph wrote this post and thought it was interesting.

      "Another aspect of the importance of the contractual nature of income is demonstrated by the investment-saving identity and the related ‘loanable funds’ fallacy. Despite Keynes having devoted so much effort to defining income and its consequence in terms of the equality of the values of aggregate investment and saving, many economists persist in the view that an imbalance of some kind between saving and investment can affect the rate of interest. This is a further example of real-exchange economic thinking that breaks down when applied to the observable monetary economy.
      The idea that interest is the price that clears the market for loanable funds can only make
      sense in a non-monetary, corn model with a single form of homogeneous output that can be
      consumed, stored (saved) or planted (invested)."


      By the way there are lots of other interesting post-Keynesian papers and talks on this site:


  5. BTW this is the comment I think you were mainly responding to on my page
    As always, good points.

    However, on one point there is a problem.
    You write: “I suggest the above “asset” point is not relevant. The money supply increase comes about as follows. Someone deposits $X at a bank, and the bank lends that money on, then both the depositor and borrower have access to $X: i.e. $X has been turned into $2X.”

    This is not correct – this is the old discredited “loanable funds” idea [and, incidentally, the reason some people get hung up on reserve requirements, which are not important bc the system does not work that way].

    Banks do NOT wait for anyone to deposit before they loan. They loan to any creditworthy person who walks in the door, regardless of their reserves. They then find reserves, and the Fed (in the US) has to accommodate them since they target interest rates. So the tail wags the dog here – the private banks force the hand of the Fed on money creation. This is what is usually meant when people talk about money being “endogenous” – its creation comes from “within” the economy, and is not dictated by “outside”, by the government.

    It is crucial to understand that the “loanable funds” model is false to understand why quantitative easing does not work. Mainstream economists still believe in QE, because they still DO think banks are waiting to have money to be able to loan it.

    So they gave the banks money and…..nothing happened.

    That is because the loanable funds model is false. Banks make loans whenever there are creditworthy customers, and after 2008, there aren’t many.
    So it is the desire and quality of borrowers that allows banks to lend, and private bank-credit money rises and falls with this process. Some people see this as a good thing – an elegant system that allows the private sector to create the funds needed to make the economy work without the government interfering. They think anyone who criticizes this system just doesn’t “get it”.
    I think they are mesmerized by the elegance of it.
    Box- jellyfish are also elegant, but I don’t want to swim with them.

    A system of only circulating Treasury notes as money seems overall much fairer, more functional, and more stable. A nice golden retriever instead of a box-jellyfish."



    1. Hi Clint,

      I wasn’t trying to argue in the above post that the loanable funds idea is TOTALLY invalid. Hence the title of the post. I’m saying it has SOME VALIDITY and in the following sense.

      Suppose the private banking system spots a series of viable lending opportunities. It will simply credit the account of relevant borrowers without bothering to see if it has enough depositors’ money in place to cover the loans. So to that extent the loanable funds idea is invalid.

      However, assuming the economy is at capacity, then sundry households have to be persuaded to abstain from consumption in order to make available resources to the new borrowers. And that can only be done if interest rates rise. I.e. ASSUMING CONSTANT INTEREST RATES, private banks do have to find new long term depositors to cover new loans, or a net increase in loans. So to that extent the loanable funds idea is valid.

      Alternatively, if interest rates don’t rise of their own accord, then the additional spending arising from those new borrowers will be inflationary, so the central bank will raise interest rates . . . much the same outcome.

  6. "That is, if every bank expands the amount it lends out by the same percentage, no individual bank will run out of reserves"

    It still could because most financial transactions involve the payment of some tax. 20% VAT for example. So every transaction handled by the bank means they will have to

    1. (continued) ultimately settle some part of that transaction from their reserves.
      Also the money created by the bank could be used to purchase imports. The Chinese and Germans don't want bank created money. They want real Fed created dollars or real BoE created pounds. Again the bank needs to make these payments from its reserves.
      So I would tend to agree that the loanable funds theory needs to be modified to reflect the reality of banks creating their own money rather than being completely discarded.

    2. Hi Peter,

      I didn’t think of that VAT point. However that point is not a problem if one assumes the VAT money collected is spent by government on the usual public spending items: education, roads or whatever. And I think that’s a reasonable assumption.

    3. Hi Ralph,

      Well its not just VAT. Its all taxes. The best way to think about all this is that Government creates money when it spends and destroys it when it taxes. But it wants to destroy its own IOUs just like you or I would. It's not interested in destroying any IOUs written by Barclays or Lloyds Bank.

      I think this is the point that the Positive Money misses and by missing that they end up with a completely the wrong impression about how the monetary system works.

      The theory of loanable funds is essentially about the limits to bank lending. If you take the argument about 'banks creating money out of thin air' then there isn't any limit. Banks can never go bust which is just absurd.

      But when you realise that banks have to support the IOUs they create then there is obviously a limit. Each bank essentially creates its own currency like a Lloyds Pound, a Santander Pound etc which is pegged on a 1:1 basis with BoE pounds.

      There has to be a finite limit on any organisation's ability to maintain that peg which will depend on their financial capitalisation rather than the amount of reserves held by them

    4. Peter,

      I think Pos Money does get SOME THINGS wrong – see section 3 of my forthcoming book featured at the top of the left hand column. However, PM are perfectly well aware that when government spends, it feeds base money (or national debt) into the private sector. In fact they SPECIFICALLY ADVOCATE having government create and spend new base money into the private sector when stimulus is needed.

      Re the rest of your comment, yes, clearly there are limits to how much thin air money the commercial bank system can create and lend out. The main constraint is the willingness of borrowers to borrow. But I’d argue that that constraint is not enough. Certainly when the private sector goes into a fit of irrational exuberance, lending can get excessive (e.g. NINJA mortgages).


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