Come back “loanable funds” – all is forgiven.

It has become fashionable recently to criticise the idea that banks intermediate between lenders and borrowers – an idea sometimes referred to as “loanable funds”. That’s the idea that a bank cannot lend money unless it first obtains money from savers (i.e. depositors, bondholders or shareholders).

Instead, so the recently fashionable story goes, when a bank spots a viable borrower, the bank allegedly simply credits the account of the borrower with money produced from thin air. And the borrower then spends the money, which means other entities RECEIVE the money, and deposit most of it at other banks. Hence the popular phrase “loans precede deposits”.

I’ll argue below that it’s all a bit more complicated than that.


A hypothetical economy.

Let’s start with a very simple economy: one where there is no economic growth and no inflation. Let’s also assume that everything else is constant and in equilibrium, e.g. the average age of the population remains constant, educational standards remain constant, etc.

More importantly there is equilibrium as regards the total amount borrowed / loaned.

Now let’s consider first, an INDIVIDUAL bank, and then the bank system AS A WHOLE.

If an individual bank spots loads more viable potential borrowers, the bank cannot simply create new money from thin air and lend it out willy nilly: if it did, it would run out of reserves. Of course to deal with that problem such a bank can always borrow reserves from other banks, but no bank wants to go too far into debt with other banks for too long. So sooner or later, the above “individual” bank must obtain money from savers (i.e. depositors, bondholders or shareholders).


The bank system as a whole.

As regards the bank system as a whole, if that system tries to lend more, that would increase aggregate demand, and assuming the economy is already at capacity, that extra demand just isn't possible unless there is some compensating CUT IN DEMAND brought about, for example, by increased savings. If there were no increased saving, the extra lending would result in excess demand and thus excess inflation.

Absent that increased saving, the central bank would clamp down on that attempt to lend more by raising interest rates: the object of the exercise being to ensure there is no extra lending.

To summarise so far, in the above simple economy, loanable funds is a valid idea


Growth and inflation.

In contrast, the appearance of growth and inflation makes a big difference. On the not unreasonable assumption that loans will expand (in real terms) at the same pace as the economy expands, then extra loans WILL BE NEEDED. In that case, banks can indeed create money from thin air and lend it out.

Moreover, inflation eats away at the real value of existing loans, thus if total loans are to remain constant in real terms relative to GDP, they would need to grow by enough every year to compensate for inflation. E.g. if inflation was 2%, then to compensate for that, loans would need to expand in terms of dollars, pounds etc at 2%pa.

To summarise, if growth was 2% and inflation was also 2%, then loans would need to grow at 4%pa in terms of dollars.


Conclusion.

On the simplifying assumption that loans remain constant relative to GDP, then:

1. To the extent that an economy enjoys no growth and no inflation, loanable funds is a valid idea.

2. To the extent that there is growth in real terms and inflation, it will be necessary for banks to do their “money creation” or “loans create deposits” trick.

3. Of course there has been a dramatic increase in debt over the last twenty years or so, thus the above 4% figure will be an underestimate. But over the longer term, e.g. since WWII or over the last century, that 4% won’t be too far out: I doubt the real figure will be as much as 10%.

So the conclusion is that while banks do indeed create and lend out money, they certainly cannot do so willy nilly. That is, to a very significant extent, they have to abide by the loanable funds idea.