Wednesday, 22 April 2015

New law of lending and borrowing.

Least I think it’s new?!?

There has been an argument in recent years between those who adhere to the so called “loanable funds” theory and those who adhere to the endogenous money theory.

The first lot claim that banks intermediate between borrowers and lenders and that one person cannot borrow till another has saved up and loaned money to a bank. In contrast, the endogenous money lot claim that saving is not needed because a bank can simply create money out of then air and lend it out. That is, commercial banks when they see creditworthy potential borrowers can simply open accounts for them and credit them with money (perhaps after having taken collateral off the borrowers, or perhaps not).  

Well now, if an economy is at capacity (aka full employment), then the extra aggregate demand (AD) that stems from creating and spending that new money is just not permissible: else excess inflation ensues, unless savings are increased (which has a deflationary effect). If savings DON’T increase and if market forces don’t raise interst rates and choke off additional borrowing, then the central bank will raise interest rates so as to bring AD back to its “acceptable inflation” level (NAIRU, if you like acronyms).

On the other hand, if the economy is NOT AT capacity, then there is no need for new lending to be constrained by how much is saved.

So the loanable funds lot are right where the economy is at capacity, and the endogenous money lot are right where the economy is NOT AT capacity. So the new law (untill such time as I decide it’s nonsense and withdraw it…:-)) runs as follows.

“Where, or to the extent that an economy is at capacity, lending is constrained by saving. But where or to the extent that an economy is NOT AT capacity, lending is NOT constrained by saving.”

(Incidentally, the latter law occurred to me while taking part in a discussion on this blog about the loanable funds v endogenous money argument. That’s the beauty of blogging: it forces you to THINK!)


P.S. (24th April 2015). Re my above suspicion that the above "law" is not original, it actually looks like Keynes said something similar: i.e. that when it comes to the effect of additional loans on interest rates, there is a difference between where the economy is at capacity and where it is not.


  1. "Where, or to the extent that an economy is at capacity, lending is constrained by saving."

    This is certainly not a Law. Indeed it is an abject Fallacy because:
    1. Even at full capacity banks can make new loans without having new deposits in advance.
    2. Of course, excess demand has various consequences for prices, imports and the government's fiscal and monetary policies. These may well have further repercussions on the demand for and/or supply of loans. But it is highly misleading to describe such repercussions as a "constraint".
    3. Suppose that the economy was managed as closely as possible to full capacity (by fiscal and monetary policies). Even then it would still be possible, and indeed likely, that private sector investment, the demand for loans from firms and consumers, and the preparedness of banks to take risks in their lending, would fluctuate substantially due to changes in confidence/animal spirits.

    1. KK,

      Re your No.1, I didn’t deny in the above article that at capacity, the total amount loaned can be expanded. The thrust of my article was about what happens next, given that those additional loans will cause excess demand.

      Re your No.2, when the total amount loaned is increased at capacity, then there will be “excess demand” as you rightly say. But it is not true to that “may well further repercussions..”. There will DEFINITELY be repercussions (unless there is a totally irresponsible government and central bank in place which don’t give a hoot about inflation). That is, the repercussion will be that the authorities will curb demand somehow. And that curbing will be a “constraint” on the above lending. Incidentally, I’m using the word constraint as per dictionary definitons, namely to refer to a “tendency to reduce or curb something”, not to a total prohibition of that thing.

      Re your No.3, I agree. That is, given a desire to borrow and lend more at capacity, that desire will be TO SOME EXTENT inhibited or thwarted or “constrained” by a rise in interest rates (brought about by market forces or the central bank).

      Finally, re my suspicion that my point was not original, I have since discovered that Keynes said something very similar. See:


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