The loanable funds doctrine is not totally invalid.

The loanable funds doctrine is the idea that banks simply connect borrowers and lenders. Nowadays, that is regarded as an over simple view of what banks do. However, a baby has been thrown out with the bathwater: the loanable funds idea is not totally invalid, and for the following reasons.

 The flaw in the loanable funds idea is that a bank (and more particularly the bank system as a whole) does not need deposits in order to make loans: that is, when a bank spots a credit worthy borrower, the bank can simply credit the account of the borrower, and regardless of how much money has been deposited at the bank.

However, an INDIVIDUAL bank can’t take that activity too far, else it runs out of reserves. Reason is that most of the money that a bank lends into existence will be deposited at other banks, and the latter will want “proper” central bank money, i.e. reserves, in exchange for the first bank’s “created out of thin air” funny money.

It is thus largely true to say of an INDIVIDUAL bank that the amount of lending it can do is dependent on how much is deposited at that bank. So to that extent the loanable fund idea is valid.

In contrast, there are no such constraints on the bank system AS A WHOLE. That is, if every bank expands the amount it lends out by the same percentage, no individual bank will run out of reserves. So to that extent, the loanable funds idea would seem to be INVALID. (And if the bank system as a whole runs short of reserves, the central bank has to supply more reserves if the central bank wants to keep control of interest rates.)

So it seems there are no constraints on the commercial bank system’s freedom to lend money into existence.

However it’s not quite that simple, and for the following reasons. When a loan is made, the relevant sum is deposited in the accounts of sundry depositors fairly soon after the loan is made: after all, there is no point in getting a loan and paying interest and/or other bank charges and then not making use of the loan.

Now suppose those “other depositors” want to use their newly acquired money AS MONEY rather than to make a longish term loan to anyone: that is suppose those depositors want to use their newly acquired wealth as day to day spending money. The relevant depositors would put their money in a CURRENT account rather than in a term or deposit account.

Now that’s a problem for the banks concerned and the problem has to do with maturity transformation. Maturity transformation (MT) is the process of borrowing short and lending long, which is one of the basic activities of banks. But MT is a risky activity if taken too far, and indeed hundreds of banks thru history have failed because they’ve taken the process too far.

So, suppose the bank system as a whole expands the amount it lends, and suppose that system has already taken MT as far as is prudent, and suppose the depositors whose stock of cash expands as a result of the new loans don’t want to see their money loaned on long term (i.e. assume they want to use that money as day to day spending money). In that scenario, banks have a problem: the problem is that there is a shortage of depositors who want their money loaned on long term.

Conclusion.

While the commercial bank system can certainly create money out of thin air and lend it out, it is nevertheless constrained by the extent to which recipients of that new money want their money loaned on. So to that extent, banks are in the business of connecting borrowers to lenders: the loanable funds doctrine has some validity.

Endnote.

The above ideas occurred to me as a result of an exchange of views with ClintBallinger. That’s the beauty of blogging: it forces you to think thru, and defend statements you make.