Loanable funds – 75 years later

by Severin Reissl

The recent discussion I had about Keynes’ article The Process of Capital Formation with Phil Pilkington (he wrote an excellent post about the paper) reminded me of a conversation I had with one of my lecturers some time ago. For a reason I cannot remember we were talking about saving and investment, and I voiced some criticism of the savings-cause/finance-investment view. She actually agreed with most of what I said (although she evidently believed that I was not saying anything new – a common attitude of the mainstream when confronted with criticism), and I ended up recommending a great working paper by Fabian Lindner of the Macroeconomic Policy Institute in Düsseldorf which debunks these notions quite skilfully.

Yet I remain puzzled about why, then, this same lecturer is prepared to keep teaching models that happily accept this erroneous view. Keynes, in the article mentioned above, is able to strike a quite critical blow to the loanable funds theory in the simplest terms possible. That was in 1939, and a lot has happened since then to complete the theory’s intellectual collapse (but, unfortunately, not its abandonment). 75 years later, I am confronted on my Macroeconomics module with the Solow model of economic growth. Now, there is a truckload of stuff that is wrong with this model and concepts related to it (reliance on the marginal productivity theory of income distribution; all the problems related to “growth accounting” and the “Solow residual” as analysed by Felipe & McCombie …), but what I want to focus on is that this model tells me that poor countries will become rich if they save more. The savings rate is a key determinant of an economy’s “steady state” level of income in this model, and the savings-investment identity is clearly presented to mean that a higher savings rate will cause more investment and hence growth. Yet this idea is just as false in the “long run” as it is in the “short run”. In fact, the distinction between short run and long run is particularly unhelpful in this context. The long run is itself just the result of a series of short runs and its character is determined by these. Therefore, if the paradox of thrift holds in the short run, there is no sense in saying that somehow, saving still magically causes investment and growth in the long run.  The trick is achieved by assuming that full employment prevails at any point in the Solow model, which amounts to assuming away the paradox of thrift altogether, at all points in (logical) time.

“[…] if households cut their consumption expenses by a certain amount because they plan to increase their financial net worth (believing in accordance with loanable funds theory that higher financial saving meant higher investment), corporations would immediately and mechanically see their revenues and profits from the sale of consumption goods fall by the same amount. […] As is rather obvious, there is no ex ante certainty that corporations, seeing their sales drop, will maintain their previous level of expenses – as loanable funds theory would like us to believe – or even increase their production of investment goods. Further, it is neither certain nor likely ex ante that firms would now borrow and increase their future debt service in the face of lower profits” (Lindner, 2012)

By assuming full employment at any point, we are assuming exactly this type of counterintuitive behaviour from agents in our model. It still does not mean that saving causes investment, but rather that we are imposing that there will always be sufficient outlays to maintain full employment at any desired rate of saving. Keynes reminds us in Chapter 21 of the General Theory that we use models “to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking “. And this is precisely what the Solow model does not do, by assuming away the complications pointed out through simply imposing full employment at all times.

I believe that this is an enormously important thing to point out. I am quite convinced that even many mainstream economists would agree with the analysis above, yet the Solow model is still being taught and, along with some other common culprits, contributes to forcing these erroneous views into students’ heads. The saving-causes/finances-investment view has a massive superficial appeal, because it is something we can metaphorically relate to our own lives. A big part of the problem is that, in my experience, the terms “investment” and particularly “saving” are notoriously liable to being ill-defined in economics courses. The crucial distinction between how they are used in everyday parlance and what they mean in an aggregate/national accounting sense is seldom pointed out. Indeed, the confusion is being encouraged, whether intentionally or not, by the way concepts such as the Solow model are presented. I would urge any student to read Lindner’s paper to get a grip on this distinction.

Since I am planning further posts on this blog, I should say that although I am an officer of Glasgow University Real World Economics Society, the views expressed in my posts do not necessarily represent the views of the society (although of course I hope that they do). Once this blog gets going properly (hopefully after our AGM), there will likely be posts from other members as well, and it will be used as a forum for expression of many different points of view.

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