Sunday, 24 December 2017

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.


  1. Money creation by banks can be divided into private creation and public creation. There can be a big macro economic differences between the two categories.

    Money created by bank lending to the private sector carries expectations of specific behavior by the borrowing individual. In other words, the borrowing individual or entity is expected to behave in predictable way during the life of the loan (which is the same as the life of the money created). Failure to perform has consequences to the borrower.

    On the other hand, bank loans to government carry only the promise that the money will be repaid. It is socially acceptable for government to roll loans over, which amounts to a strategy to NEVER repay the money (as observed from a macro economic perspective). Government typically allows no consequences for failure-to-perform such as descend upon a non-performing private borrower.

    I don't have enough understanding of the loanable funds model to integrate this perceived difference between private and government borrowing.

    1. I don't think the difference between private and government borrowing will matter here. What I am saying is that what really matters is having monetary exchange, specifically that there is no market where current goods are exchanged for future goods. All exchange is against a limited set of assets which can store value (money). What form that money takes and how it arises doesn't matter.

  2. Hmmm.

    "specifically that there is no market where current goods are exchanged for future goods."

    Isn't that what happens in a monetary exchange system when labor is traded for money?

    "All exchange is against a limited set of assets which can store value (money)."

    Yes, but the creation of such a "set of assets" is itself a unique event. I think such an event would occur if a merchant paid for labor with gift certificates, not fiat money. This gift certificate would be a claim on merchandise contained in the owner's store. This gift certificate would exist (and could be traded) until recovered by the owner.

    I frequently point out the similarity of fiat money and gift certificates. The analogy brings focus to the links between ownership, perishable resources, stored value, and monetary exchange.

    1. By "exchanged for future goods" I meant for promise of delivery of specific goods at a specific time, rather than simply the future purchasing power provided by money.

      I think such certificates would be money-like, but again I don't this this distinction matters (here).

  3. Great post.

    Questions: What does loanable fund theory tell us in the case where planned household saving is zero (or subdued), but there are great investment projects? With endogenous money those investments are probably allowed/credited by the banks and I think inflation then "forces" the necessary and simultaneous savings? Is that correct view?

    1. Thank you.

      By definition, saving (S) = income (Y) less consumption (C), so if actual S differs from planned S, this must involve either actual Y or actual C being different to plans. One way that could happen would certainly be if additional investment crowds out consumption spending through higher prices.

      Ultimately, if we assume Y is unchanged and there is additional investment, C must give. If higher prices don't induce lower C, then it will happen simply because of shortages. The goods won't be there to buy.

      Of course, there will most likely be some difference in Y as well.