Thread by @GeorgeSelgin

Thread: Actually, there is something worse than even the most naive loanable funds intermediary view of what ordinary banks are about, to wit: still more naive Post-Keynesian and MMT alternatives.

https://twitter.com/robert19pearson/status/1429474470125838345

Commercial banks fund their loans and investments in one of two ways: using their own capital, or using funds borrowed from others. To the extent that they reply on borrowed funds, they are in fact credit (loanable funds) intermediaries.

Now for the provisos: the funds relied upon needn't consist of primary (that is, non-borrowed) deposits. They can consist of wholesale funds, funds borrowed from a central bank, or funds secured from other sources.

The borrowing needn't precede the lending: banks may negotiate loans and seek funding for them afterwards.

That a loan initially takes the form of a deposit credit doesn't mean that the credit itself "funds" the loan, except in a superficial sense. Borrowers borrow to spend; and in drawing on credit balances, they initiate a clearing and settlement process.

That sequence ultimately results in clearing debits against the lending bank equal to the loans it grants. The debits are either offset against dues from other banks, or settled by means of a reserve transfer.

Because net debits are a function of loans, and rise pari-passu with them, ceteris paribus, it follows that a commercial bank's ability to lend is constrained by its ability to borrow: unlike a central bank, it cannot create net settlement media, that is, reserves.

Any theory that suggests that commercial banks are just as capable of creating the funds they lend "out of thin air" as central banks are is itself far more naive than the credit-intermediary view.

Because central banks are one source of commercial bank loan funds, and because at any moment they supply funds at some target interest rate, some theorists insist that banks are not the supply of credit is endogenous in a sense that contradicts the intermediation view.

In their view, banks can make loans willy-nilly, always knowing that the funds are available at the going CB policy rate. Hence they are not constrained in any meaningful way by the available supply of private savings. Hence the LF theory is wrong.

But while a CB's funds-supply schedule may be regarded as "horizontally given" at any moment, it remains so only so long as the CB can achieve its macro. objectives by keeping it there.

If, for example, a CB seeks to maintain a stable price level, a rising price level will cause it to raise its rate setting. It isn't true, therefore, that CB's passively accommodate commercial bank lending.

Moreover, if we step back to consider the behavior of _real_ as opposed to nominal magnitudes, we can see how the loanable funds theory ultimately proves valid no matter what policies a CB pursues.

Suppose, for example, that an accommodative CB allows prices to rise. That means that the nominal amount of bank lending has grown independently of savings voluntarily surrendered to commercial banks: nominal bank lending generates nominal bank funding, not the other way 'round.

But the very fact that prices rise in consequence means that the _real_ value of loans is constrained by the extent of real (voluntary) savings directed toward the banking system, that is, the real demand for commercial bank deposits. Real savings governs real bank lending.

These facts aren't contradicted by the possibility that prices start out below their equilibrium levels, as in a recession, so that monetary expansion doesn't result in inflation. Bank lending has then ipso-facto fallen short of voluntary savings.

Nominal credit expansion in this case allows real lending by commercial banks to "catch up" with real lending _to_ commercial banks, without resort to the painful and wasteful alternative of deflation.

Like the whole of _The General Theory_, Keynes' "liquidity preference" theory takes a below-equilibrium P for granted. So, low and behold! It appears that investment "causes" real saving, and that interest is the price, not of loan funds, but of "liquidity."

But this is just one of many reasons why the title of Keynes's famous work is also its most misleading feature. His isn't a "general" theory: it's a "special" theory; and the loanable funds theory is the general counterpart of the Keynes' s special liquidity preference theory.

Both Post-Keynesian economics and MMT share this characteristic of GT Keynesianism, with its conflation of the determinants of real equilibrium magnitudes with those of nominal magnitudes.

Mr. Pearson's profile epigram, "the government doesn't borrow our savings in order to run a deficit, it runs a deficit so that we can have savings," is a case in point. In the context of a recession (P>P*), the statement is valid enough. Otherwise it is perfectly misleading.

So, give me that old-time loanable funds theory. Yes: it must be treated with caution; and certainly it must not be allowed to serve as an argument against accommodative monetary or fiscal policies when a recession threatens. But it is still a sound _general_ theory.