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– the idea that financial ‘intermediaries’ such as banks take ‘savings’ of currency and then lend to borrowers is an outdated concept of modern money creation.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 It seems to have been outdated even in the 18th Century when Adam Smith wrote given the wave of banking innovation that had swept from Italy across France, the Netherlands and Scotland.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