Loanable Funds – The History of a Bad idea

Loanable Funds – the idea that financial ‘intermediaries’ such as banks take ‘savings’ of currency and then lend to borrowers is an outdated concept of modern money creation.  But how did it originate?  It seems to have been outdated even in the 18th Century when Adam Smith wrote given the wave of banking innovation that had swept from Italy across France, the Netherlands and Scotland.

Adam Smith took many of his ideas from Turgot and the Physiocrats, including his concept of capital accumulation, savings and investment.  We need to put aside any conception of Tugot’s views from Bohm-Bawerk – who tended to charicature most thinkers who might have anticipated him, and misrepresented Turgot’s theory as a narrow productivity -‘fructification’ theory, and go back to the source material.

Turgot’s view of interest was a considerable step forward from earlier thinkers such as Hume.  Hume correctly deduced that the rate of profits and rate of interest must be the same but assumed the causation went of profits to interest – neglecting how interest enters into price and hence profits.  The focus was on demand (derived from factor returns) for goods translating into a demand for money given a fixed quantity of specie. Turgot expanded the analysis to include supply of loans to advance capital.

‘The price of money is regulated like the price of all other merchandice – by the balance of money at the market with demand for it’ (1793:51)

Note the generality and modernity of this statement.  Supply and demand for money, not supply and demand for loanable funds.  Turgots mistake was his narrow focus on what could supply that money.

At the time Turgot wrote the money market in France had contracted to a loanable funds market supplied through notaries.  The Mississipi Bubble had led to a collapse in credit based on fractional reserve lending, money creation at the stroke of a pen.

Therefore Turgot developed a conception of savings of what we would now term loanable funds for investment purposes.

Schumpeter, and endogenous money theorist, criticised this

 ‘The theory was swallowed hook line and sinker, it was if John Law had never existed’. (1954:325)

John Law of course developing theories of fractional reserve lending leading to endogenous money creation.

Schumpeter was slightly unfair.  Turgot’s theory rested on the supply and demand of money, then he set out a mechanism for money (loanable funds) accurate to the circumstances in France of when he was writing only.

As modern historian Antoin Murphey writes Turgot’s theory was stuck in an 18th Century time warp and reflected his own prejudices against finance capital and in favour of prudence, prejudices carried forward by Adam Smith.

Overall though Turgots ideas were very advanced and even included the first rudimentary characterization of markets in dynamic equilibrium –

‘like two liquors of unequal gravity – that communicate with each other through a reversed siphon’ 1793:58

The irony is that most of the problems of modern economics can be traced to two errors in interpreting Turgot.

-Firstly adopting his specific (loanable funds) rather than his more general model of interest.

-Secondly adopting a model of static equilibrium rather than one of prices being regulated by pressure of flows from stocks

Further Reading

Adam Smith – Wealth of Nations

Turgot – Reflextions

Schumpeter- History of Economic Analysis

The Genesis of Macroeconomics – Antoin Murphy

John Law – Oevres Complete du John Law

Hume – Treatey on Money

Bohm Bawerk – Capital and Interest

3 thoughts on “Loanable Funds – The History of a Bad idea

  1. Yes loanable funds is old, old hat, and dynamic equilibrium is the correct direction of research, but economics is still groping around in the dark mostly because its still fraught with conventional “wisdom” instead of applying actual Wisdom to the economy and finance.

    Wisdom is the act and the result of integrating a bothness/duality. So you have to consider and include both the bothness and then do the integration before you can have a complete understanding. For instance finance is about money and economics is about cost, both of which have their own dynamic and both of which ARE dynamic in and of themselves. The continuous injection of money into the economy makes it dynamic and if someone can tell me when cost is not a factor in economics I will back off it being not only a dynamic factor, but the most deeply embedded one at that. So combining/integrating the two might just be the place to look for enlightening data. Money being basically accounting as Steve Keen and others have recently come to understand is a good start, although they are still stuck in the surface analysis of only stocks and flows of money and mistakenly have excluded Cost as a dynamic factor because they (mistakenly) think of it as non-dynamic. So integrate accounting and cost and you get cost accounting…and there is where you will find the datums whose economic relationships reveal the most deeply embedded source of disequilibrium in the economy namely that the rate of flow of total costs always tends to exceed the rate of flow of individual incomes.

    All economists are basically nascent Social Crediters.

  2. Loanable funds is a valid idea in the sense that if one person is going to borrow and spend some money, then someone else has save and abstain from spending money assuming constant GDP. I.e. the latter saver supplies the borrower with funds.

    In contrast, assuming GDP is expanding, that will almost certainly be accompanied by an increase in the total lending. To that extent, there is no need for the expansion in the total amount loaned to “come from anywhere”. That is, banks can just credit freshly created money to the accounts of borrowers A, B & C.That money will end up in the accounts of X, Y & Z. Some of the latter will simply save the new money so that won’t contribute the GDP expansion. And some will spend it, so that WILL CONTRIBUTE to GDP expansion.

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