The 'Loanable Funds' Idea Is Partially Valid

by: Ralph Musgrave

It has become fashionable in the last few years to claim that banks do not intermediate between lenders and borrowers (as per the traditional view of banks) and that instead, banks simply print and lend out money whenever they spot viable borrowers. That traditional view is sometimes call the "loanable funds" idea or theory.

The idea that loanable funds is totally obsolete was repeated in an article by Michael Kumhof and Zoltán Jakab, published by the IMF in March 2016. The article was entitled "The Truth About Banks". Presumably the article represents the views of K&J rather than being official IMF policy.

Incidentally, for verification of the idea that private banks create or print new money, see the opening sentences of a Bank of England article entitled "Money Creation in the Modern Economy" by Michael McLeay and co-authors.

The economy is at capacity.

In fact where, or to the extent that an economy is at capacity, the loanable funds view is valid. Here's why.

Assume an economy is at capacity: i.e. further demand is not possible without causing an unacceptable rise in inflation. Also assume banks spot new and viable borrowers. What happens if banks do create money out of thin air and lend? Well that money will be spent, which will raise demand which is not acceptable. So the central bank will raise interest rates so as to choke off the extra borrowing.

To be more exact, the rise in interest rates will encourage more saving (i.e. abstaining from spending), which will make room for at least SOME extra borrowing and spending.

In short, in that scenario, it just isn't possible for one set of people or other entities to lend, unless another set save more. So in that scenario, the loanable funds idea is valid.

The economy is not at capacity.

In contrast, where or to the extent that an economy is NOT AT capacity, things are a bit different. It's true that in that scenario commercial banks can print new money and lend it out. But assuming that prior to that hypothetical new lending the maximum possible amount of lending had already been done at the prevailing rate of interest, then private banks just won't lend more unless the central bank cuts interest rates.

But cutting interest rates is not the only way of implementing stimulus: the alternative is more public spending (funded for example with STATE issued money) and/or using that extra money to fund tax cuts.

So even where the economy is NOT AT capacity, if extra lending and investment is to take place, saving has to be done in the sense that if all the necessary stimulus comes from more lending, then none can come from extra public or consumer spending (else inflation would take off). Thus even where the economy is not at capacity, the loanable funds idea is not totally invalid.

And that all raises a question which is a bit incidental to the above points, but I'll deal with it briefly anyway. That's the question as to which is the best form of stimulus: interest rate cuts or extra public and/or private spending? Well I suggest the latter extra spending is better, with interest rates being left to find their free market level.

After all, the basic purpose of the economy is to produce what people want (in the form of both public and private spending). Thus given scope for producing more, it is not unreasonable to assume that expanding ALL FORMS of spending by the same percentage will maximise utility. In contrast, I just don't see the case for concentrating stimulus on a relatively NARROW set of products, whether that's "lending and investment", or "education, whiskey and chocolate cake."