The Irrelevance of Private Money Creation to Loanable Funds Critiques

A frequently repeated claim deployed in critiques of loanable funds theory is that private bank money creation removes the constraint on investment being limited by "prior" savings.  In a generally good article on loanable funds here, Servaas Storm spends a lot of time discussing the ex nihilo creation of private money.

I think this is highly misleading.  Whilst not denying that understanding bank behaviour is important,  the savings constraint issue is simply a result of having a monetary exchange economy and has nothing to do with where the money comes from.    

First some clarification.  It is sometimes suggested that the constraint in question is that saving must take place before investment.  To the extent this really does refer to the order of events in time, it is clearly wrong.  Saving and investment must always take place simultaneously, by their very definition, regardless of whether we are talking about a barter or monetary economy.  

What does matter is the relationship between plans and outcomes, specifically when agents have plans that are inconsistent.[1]  In a normal market for some commodity, if planned demand is different from planned supply, the amount actually traded will be the lower of the two.  Neither buyer or seller will trade more than they want. 

Translated into a loanable funds market, this means that the amount of actual saving would be the lower of planned saving and planned investment.  Savers cannot end up saving more than they planned.  And this is indeed what we find in a barter economy, where all saving is in the form of commodities.

The difference with a monetary economy is that actual saving is not constrained by planned saving.  This is because actual saving must be equal to actual investment and actual investment is not constrained by planned saving. 

The easiest way to see this is to think about bank lending and recognise that banks can provide finance to enable new investment without first needing to check the plans of their depositors.  Although this is a useful picture, it can lead to the mistaken view that it is private bank money creation that removes the planned saving constraint.  This is not correct.  What removes that constraint is monetary exchange and that holds even with a fixed, exogenous money supply.

Consider an economy where there is a fixed money supply of $100, all held by households.  Households also hold $100 in loans to firms, so $200 in total financial assets.  Firms would like to borrow more and invest more, but households do not wish to take on more credit risk.

Now assume that households become less risk averse and wish to change their portfolio to $50 money and $150 loans.  Note the important distinction here between saving and lending.  Households are planning additional lending, but they are not planning any increase in holding of financial assets (which we can equate to saving here, as we will assume households do not undertake investment expenditure).  Although we talk about loanable funds, we don't mean what is actually loaned but what is saved.  Here, the planned saving is zero.

However, if the $50 of additional loans to firms is spend on investment then it ends up back in the hands of households again.  Household income has risen and they end up still holding $100 of money, even though they planned to only hold $50.  Total financial assets has risen to $250.  There has been actual saving of $50, unconstrained by planned saving of zero, without any new money being created.

The point here is that what facilitates the change in investment and therefore actual saving, is not a savings decision, but a portfolio decision.  The reason bank lending matters is because it is a form of portfolio decision and, indeed, banks play a large part in the overall portfolio decisions.  Money creation matters because it changes the portfolio options for households and may therefore influence their portfolio decisions.  It is not the magic ingredient that undoes the loanable funds model.

---

[1] Part of the reason this whole issue doesn't figure much in more mainstream economics is that there is a tendency to focus on analysing outcomes that are consistent with plans, and less attention is given to the question of what happens when they are not.

Comparative Advantage With Labour Inflexibility

My last post adapted Ricardo's model of comparative advantage to include internationally mobile capital.  However, what I think is much more important is the ability of labour to be redeployed between industries when production patterns are disrupted by trade liberalisation.

So I thought I'd have a go at a version of Ricardo's model that included just that.

The Model

There are two countries: England and Portugal, and three goods: wine, cloth and cars.  Each country consumes all three goods and can produce all three.  Each country has its own currency. 

Labour is the only factor input and there are constant returns to scale.  Prices are set at a fixed mark-up to unit cost, with the same mark-up in both countries and all industries.  Within each country, a single fixed nominal wage applies to all industries.  (For simplicity, the nominal wage per unit of labour, grossed up for the mark-up, is set here at one unit of the local currency, so the price of local produce is simply equal to the requisite labour input.)

Labour cannot move between countries.  Within a country, labour can generally be redeployed between different industries, with the single exception that labour currently employed in car production cannot be redeployed to wine or cloth production.  The number of labour units required to produce one unit of goods varies between industry and country as follows:

	Wine	Cloth	Cars
England	1.00	1.00	1.00
Portugal	0.80	0.90	0.95

There is free trade in wine and cloth but (at least, initially) no trade in cars.  In each case of wine, cloth and cars, Portugese made versions are perfect substitutes for English made ones and there are no transport costs so, where there is free trade,  everyone just buys the cheapest.  However, wine, cloth and cars are imperfect substitutes for each other with a constant elasticity of substitution.  All income is spent currently on consumption, with a weighting in both countries of 0.45 on each of wine and cloth and 0.10 on cars.  The exact specification of consumer spending is given in the technical note at the end of the post.

As there is no saving, trade must be balanced, which is achieved by a variable exchange rate.

(To get the numbers to show what I want, I have assumed a slightly higher labour supply in England than Portugal.)

1. No International Trade in Cars

Because of the comparative advantages in wine and cloth, England ends up importing all its wine and Portugal all its cloth.  Both countries produce their own cars.

	England					Portugal
	Wine	Cloth	Cars	Total		Wine	Cloth	Cars	Total
Labour	0	1,081	119	1,200		913	0	87	1,000
Goods
Produced	0	1,081	119			1,142	0	91
Traded	563	-548	0			-563	548	0
Consumed	563	533	119			579	548	91
Expenditure
Domestic	548	533	119	1,200		463	450	87	1,000
Exports		548	0	548		450			450
Imports	-548			-548			-450	0	-450
Income	0	1,081	119	1,200		913	0	87	1,000
Prices	Wine	Cloth	Cars	Index		Wine	Cloth	Cars	Index
Domestic	1.000	1.000	1.000	1.000		0.800	0.900	0.950	0.856
Import	0.973	1.095	n/a			0.822	0.822	n/a
Consumer	0.973	1.000	1.000	0.988		0.800	0.822	0.950	0.823
Exchange rate (£/€)	1.217

Expenditure and prices are shown in the local currency.

The domestic producer prices shown are the prices that would be paid for domestically produced product, even though there is no actual production in industries with import penetration.  The index for these prices is weighted by consumption preference, so it is the price index that would apply with no trade.  This is higher for both countries than the actual consumer price index, showing that the trade in wine and cloth benefits both nations.

The nominal wage (expressed in the local currency) is the same in each country, so the fact that the consumer price index is higher in England implies that real wages are lower in England than Portugal.

2 After Trade Liberalisation in Cars

At the prevailing exchange rate, England can produce cars more cheaply than Portugal.  This means that Portugal starts to import cars and closes down its own production.  By assumption, these workers cannot be employed elsewhere, so overall income in Portugal is reduced.  This reduces demand for cloth imports but, because of the additional import of cars, demand for foreign exchange is increased overall.  This causes the exchange rate to change, worsening the terms of trade for Portugal (making Portugese cars cheaper but still not as cheap as English ones).

	England					Portugal
	Wine	Cloth	Cars	Total		Wine	Cloth	Cars	Total
Labour	0	982	218	1,200		913	0	0	913
Goods
Produced	0	982	218			1,142	0	0
Traded	607	-460	-102			-607	460	102
Consumed	607	522	116			535	460	102
Expenditure
Domestic	562	522	116	1,200		428	397	88	913
Exports		460	102	562		485			485
Imports	-562			-562			-397	-88	-485
Income	0	982	218	1,200		913	0	0	913
Prices	Wine	Cloth	Cars	Index		Wine	Cloth	Cars	Index
Domestic	1.000	1.000	1.000	1.000		0.800	0.900	0.950	0.856
Import	0.927	1.043	1.101			0.863	0.863	0.863
Consumer	0.927	1.000	1.000	0.966		0.800	0.863	0.863	0.833
Exchange rate (£/€)	1.159

England responds to falling cloth exports by redeploying labour to production of more cars.

Conclusions

The main result here is that, if trade liberalisation results in job losses and those workers cannot be employed elsewhere, then overall output will be impaired.  This is perhaps not entirely surprising.  But there are some more interesting points here:

Trade liberalisation results in production of cars switching to England even though Portugal can produce cars with fewer labour units and thus has an absolute advantage in car production.  The reason is that English wages are lower when expressed in a common currency.  The lower wage offsets the less efficient production (less efficient in an absolute sense, not a comparative one).

In this example trade liberalisation in car production not only results in unemployment for Portugese car workers, but actually reduces the real wages of Portugese wine workers.  This is because the increased demand for imports worsens the terms of trade.  Although they can now buy cheap imported cars, cloth has become more expensive.  Everyone in Portugal has lost out.

The same is true here even if we relax the assumption that Portugese car workers cannot be employed in other industries.  As a natural importer of cars, Portugal benefits when international trade in cars is restricted, even though that means that cars are more expensive there.  However, it is still better off than if there were no trade at all.

Reducing the nominal wage in Portugal makes no difference, as it simply leads to an offsetting exchange rate movement.  However, relative wages between industries do matter.  I have assumed that the same wage applies across industries, so that wages for Portugese car workers remain the same as for wine workers, even when they cannot be employed elsewhere.  If they were to fall (relatively), then Portugese car production could be preserved.

This change in relative wages is what standard economics says should happen.  It all comes down to opportunity cost.  The opportunity cost of Portugese car production is in fact zero, because the car workers have no alternative use.  Portugese car production is lost, because the cost to producers does not reflect the true opportunity cost.

Although trade liberalisation in the car industry is damaging in this example, that does not imply that introducing measures to restrict existing trade will be beneficial.  In fact any such measures would reduce welfare here.  If we extend the assumption on labour inflexibility, then such measures may be even more damaging as workers made unemployed from exporting industries might not be employed elsewhere.  It is the fact of change that matters here, not whether it is liberalisation or protectionism.

However, being able to adapt to change is crucial to an economy's ability to develop and grow.  Even without trade, progress involves old products and procedures dying out and being replaced.  Job losses and job creation is an inevitable part of that.  Whilst there is a strong case for factoring in the dynamic consequences of trade liberalisation, that cannot be an excuse for avoiding the need for flexibility, if an economy is to secure long-term growth.

Technical Note

Consumption of good i in each country is given by  

C_i = a_i . (P_i / P )^-σ . Y / P

where: a_i is the weighting,  C_i is number of units consumed, P_i is the price of good, Y is nominal income and P is the price index, which is given by:

P = { sum for i [ a_i . p_i^(1-σ) ] }^1/(1-σ)

σ is the price elasticity of demand, set at 2 for both countries.