Philip Pilkington: Keynes and Loanable Funds

By Philip Pilkington, a writer and research assistant at Kingston University in London. You can follow him on Twitter @pilkingtonphil. Originally published at Fixing the Economists


I was recently discussing econometrics and Keynes’ critique of it with Severin Reissl, a particularly clever student currently attending the University of Glasgow who is critical of mainstream economics. (You can find some examples of his writing here in which I am quoted to criticise some of the assumptions in a mainstream macroeconomic textbook).

Anyway, I sent Reissl a copy of Keynes’ famous paper on econometrics entitled Professor Tinbergen’s Method and while we were discussing it Reissl pointed out the short piece that appeared below it. The paper, you see, was a book review published in The Economic Journal in 1939 and below it was another review by Keynes. This review was entitled The Process of Capital Formation and it dealt with an early statistical attempt to formalise the national accounts — something that Keynes would become deeply involved in during the war years and after.

I had never read the paper before but Reissl said that it contained within it a lucid critique of the loanable funds theory. I want to examine this here because I think it’s a very important point. By studying this paper I think that we can indeed understand better Keynes’ ideas about loanable funds.

The relevant discussion begins when Keynes discusses the savings/investment identity and clearly states that it is investment that drives savings, not savings that allow for investment. Using his typically brilliant ability for metaphor he writes,

For example, [the reader] might naturally suppose — for anything the Committee say to the contrary — that the right way to prepare for an increase of investment is to save more at an appropriately prior date. But the corollary shows that this is impossible. Saving at the prior date cannot be greater than the investment at that date. Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving. (p527 — My Emphasis)

Let us translate that into more formal terms before we move on. ‘Dishoarding’ would entail an increase in the velocity of money — as funds that were left dormant were reactivated they would begin the process of circulation. ‘Credit expansion’ while it clearly means some sort of borrowing is, at this moment in time, ambiguous and we shall deal with this point in a moment.

Keynes then goes on to show that funds that are invested add to savings and so, thinking that there is some pool of savings out of which investment is drawn is misleading because the money that is so invested is then added to the pool of savings. If there is £1m in savings in a country (assuming a closed economy) and £100,000 of these funds are invested then at the end of the period there will still be £1m in savings because the money invested will accrue as savings. This process is instantaneous because when I take the £100,000 and spend it on wages and investment goods that money is instantaneously credited to the bank accounts of workers and other capitalists where it then sits waiting to be spent as savings.

Or, as Keynes puts,

Prior saving has no more tendency to release funds available for subsequent investment than prior spending has. (pp572-573)

He then goes on to discuss the fact that what we are really dealing with when new investment is forthcoming is not the demand for savings but rather the demand for money. This ties in with his liquidity preference theory of the interest rate wherein the interest rate is determined as much by financial considerations — liquidity preference as a sort of ‘insurance’ against uncertainty — as by the considerations of the demand for money to finance investment.

At this point I think that Keynes has little to say that we can use today. The rest of the paper is written in a manner that implies that this quantity of money is somehow fixed at any moment in time. Thus, if the demand for money increases for any reason the interest rate should rise. This is the same assumption as the ISLM model with the upward-sloping LM curve. But as we now know, in a regime where the central bank targets the interest rate and not the quantity of money then the quantity of money will increase if there is any upward pressure on the interest rate.

While Keynes did indeed strike the first blow against the loanable funds theory in this review in that he got rid of the silly notion that investment out of savings ‘used up’ said savings, he nevertheless did not overturn it completely. That would have to wait for Robinson and Kaldor’s early formulations of the endogenous money theory.

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  1. allcoppedout

    All these economic ‘money conservation laws or tautologies’ give me the willies. We seem to forget the heuristic purpose (anyone else remember contorting fingers to work out which way an electric current is flowing?) – and in the process why we might put in hard work to create capital. Northern England is littered with ‘thwaites’ cleared by Vikings – hard work done for survival and community security. One guesses Olaf and Ragnor would not be impressed when we were always missing at tree uprooting fixing money velocity problems. We seem stuck in ‘money never sleeps’ issues and confusing balance sheets and double-entry book-keeping generally with scientific conservation laws.

    The limitations of maths in Keynes’ time compared with now make me feel we should be working out what we can organise with modern technology and in freeing ourselves from medieval ideology. I’m not sure economics has much more of a role in this than fine art. It may be a kind of sunk cost fetish. It’s really amazing what clubs people form. The conservation laws seem not to help distinguish social capital from binge drinking or the 24/7 Billing Company.

    The modern equivalent of clearing land might be seen as building green energy on a massive scale and secure homes, maybe even to the extent of ‘tornado walls’ and leaving this planet. Where is this represented in tautological money equations? Economics is some form of positivist control engine, but we don’t really know whether and how it connects with getting what we want to do done. The aspect Philip puts forward here reminds me of stamp collecting. I don’t want to get into it. We can break sod without money, whatever relations between savings and investment. Money comes ‘after’ as record. Once we are suckered into monetary control of what we can do we are slaves to economic rent and no longer “breaking land” for our own use or uses we approve. When the hoard is brought into circulation it seeks return without effort, a share of work it will not do in the future and we are not free people at all. Because we can’t allocate capital. Maybe we should be less grandiose on money and just use it as food and beer vouchers?

    1. Samuel Conner

      I strongly sympathize with this thought. And I’m confident that MMT people agree that the real economy is what matters. But at the macro level, the real economy is significantly influenced by policy choices, and errors such as “loanable funds” influence policy in ways that harm people. Macro policy is a constraint on the economy, but does not guarantee that what is produced will be useful or even “not harmful.” But if you want useful things like massive green energy investment, you will be more likely to get that if macro policy is not constrained by errors such as “loanable funds” or “government budget constraint.”

      At the micro level, we ought to be able to find ways to do useful things locally that are less dependent on the state of macro policy. Perhaps that could be a direction of practical reflection as MMT matures. But it may be that mobilizing underutilized labor locally for useful and needed things will still require something that “works” like money, perhaps tax credits of the local tax authority. “Labor for money” is a pretty deeply ingrained mindset for us now. The idea of group efforts to produce community goods is increasingly alien to us.

      1. allcoppedout

        Expressed with more clarity than I can muster at the moment Samuel. In backstage university teaching conversations we would moan to each other that all we could do in our classes was teach a few sums and get the kids up to speed with economic and financial comment in the Guardian and NYT. In the university boardroom I don’t remember much economic-financial expertise beyond copying other similar institutions. And low and behold we have a lot of very similar universities all providing a very high cost and low quality product differentiated largely by prestige and the class/wealth of student entrants.

        We might do better to find out more about the price of fish than what Keynes meant, though I agree what Philip says below. In terms of something like methodological individualism we know more or less nothing on economic decision-making, whether of that choice moment for a shop-lifter on which products to rob, or Gordon Brown selling-off our gold reserves cheap.

  2. James Cole

    The gist of this appears to be “any savings set aside to add to investment can’t add to investment because it already was investment by the time it became savings.” Is this important from any perspective other than historical? It’s not entirely clear what theory he is refuting.

    1. Philip Pilkington

      Many macroeconomic theories today assume that investment is constrained by savings. The Solow Growth Model would be one such theory but I could think of many more.

      These theories implicitly assume that “savings” and “investment” refer to real resources in an economy operating at full employment. Keynes was trying to get us to stop thinking in these terms altogether. I think that he was correct to do so.

    2. Ben Johannson

      Also, loanable funds is frequently used by conservatives as an argument that government simply must cut spending or interest rates will skyrocket.

      As an aside, failure of interest rates to rise along with the deficit in 2009 was what first gave me the impression something was wrong with the dominant economic narrative.

  3. F. Beard

    The liabilities of the banking cartel AS A WHOLE are almost entirely virtual since the cartel has a default and morally bogus monopoly on the risk-free storage of and transactions with claims to fiat plus a fiat lender of last resort (the central bank) should it get into trouble meeting liabilities.

    Therefore “loanable funds” is absurd since the banking cartel can create vast liabilities it need never redeem or which it can redeem via a loan of new fiat from the central bank.

    The banks are thus legal counterfeiters.

    1. F. Beard

      Actually, the banking cartel is worse than moderate traditional counterfeiters because:

      1) The repayment of bank credit causes it to cease to exist – thus whipsawing the economy with price inflation and price deflation.
      2) The banks charge usury (any positive interest rate) for their legal counterfeit of fiat. In principle, this usury might not even exist in aggregate except as even more debt.

      But hey, it isn’t like there’s an ethical form of endogenous money except there is – shares in Equity (common stock).

  4. Jose

    Interesting article.
    However, by circumscribing early developments of the endogenous money theory to the works of Robinson and Kaldor the author (perhaps not intentionally) does a great injustice to one of the giants of economic thought, who anticipated that theory many decades before Keynes – Joseph Schumpeter.

  5. j gibbs

    All this accounting analysis is beside the point. Banks create whatever money is required by investment decisions of those owning collateral. Investment decisions are made by business according to perceived future demand and competitive necessity. Savers are interest takers, who must be satisfied with whatever returns are available. Today that return is zero.

  6. susan the other

    When Paul Craig Roberts posted recently that he had been the architect of Reagan’s supply side economics he explained that SS was meant to resolve stagflation – that early manifestation of what we now seem to be calling austerity – self imposed dysfunction. PCR said he saw SS as a way to stimulate the economy without inflating it, because the inflation side of the equation was far more worrisome than the stagnation side. And of course it was hijacked by Wall Street immediately with their productivity-profit tyranny, corporate raiding and off-shoring which did nothing to create employment but vastly enriched international corporations. Just so today – the Fed (perverting our economy in the name of Keynesianism) has funneled massive quantities of money to the banksters and Wall Street because it does not “inflate” the economy – it merely keeps asset prices high, and just like Reagan they are hoping for enough trickle-down to keep the country on life support. This is clearly a bad political reaction to an fiscal question. If economics were uncontaminated by hysterical politics about inflation it would be a good thing. Spend to accomplish our goals. But first we have to have some. Or the whole thing is going to spin out of control as per usual.

    1. TimR

      I don’t know if they care about trickle-down from QE, maybe they were/are just cleaning toxic assets off banks’ books. And using it as a psychological prop, to suggest they’re “doing something,” (even something excessive-seeming, since many people think the “money printing” is going to flood the economy and create runaway inflation). Also the asset inflation has a psychological boost on the public and markets, to counteract dismal numbers elsewhere. And the “cascade” of money from one asset class to another, as QE rolls through the market, is fun & games for financial types, to give them some bubbles to play around with. (Just speculation, I only dabble in this stuff.)

    2. Carla

      “Spend to accomplish our goals. But first we have to have some.”
      Perhaps even before that, we need to figure out how to be “we.”

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