“Loanable Funds Theory” of Banking is Wrong

The typical economics textbook describes banking as a process where people deposit money and then the bank looks for good opportunities to loan those funds out. This “Loanable Funds Theory” implies that banks will not even look for good loans if they don’t have that amount of money in deposits to loan out. That might be true under a banking system with a 100 percent reserve requirement, but our system of banking maintains a reserve requirement closer to 10 percent. A realistic theory of how a bank decides to make a loan doesn’t actually correspond to the Loanable Funds Theory. In fact, the process is somewhat the opposite. Banks first look for good loan opportunities, and if they find one, they check to see if they have enough excess reserves. Often a bank will have enough excess reserves to make the loan if it meets its risk-reward criteria. The bank creates a deposit account for the person or entity taking out the loan. The deposit account is created “out of thin air” as a result of the decision to create the loan, and not the other way around. This means that the bank is creating money. However, if the bank is already at its reserve requirement limit and needs more reserves to make the loan, it will increase the interest rate on savings and certificates of deposit to attract more money to satisfy the reserve requirement. Banks can also borrow money from each other or from the Federal Reserve Bank where the largest banks have accounts.

My wife and I have certificates of deposit (CDs) that we need to renew from time to time. We are in a metropolitan area with lots of banks. The interest rate offered on CDs can sometimes differ greatly from one branch to another of the same bank. Instead of going to bankrate.com and moving our money around over the internet, as we did when we lived in an area with fewer banks, we often find a bank locally with a CD interest rate that is at least as good as the best rate on bankrate.com. Typically the interest rates offered on CDs at most of the banks in our area are quite low. Most banks still have adequate excess reserves, or have not located any good additional loan opportunities offering a good enough risk-reward ratio to satisfy them. Consequently, most banks are not trying hard to attract more money and are happy to provide a very low interest rate on CDs to all those people who don’t check the interest rates on CDs and just let their CDs roll over at whatever rate the bank sets. After all, why would a bank want to pay to borrow money from you that it doesn’t need? Increasing costs without any corresponding increase in revenues makes no sense.

But even though the vast majority of banks offer a very low rate of return on CDs, there will often be one or two banks which offer rates that are three or four times the typical CD interest rate. Sometimes this is because those high-interest-rate banks have found some really good loan opportunity and are already at their reserve requirement limit. Sometimes a bank has gotten into trouble with loans that have defaulted. Fortunately for us the Federal Deposit Insurance Corporation (FDIC) covers us up to a specified maximum amount in case the bank goes bankrupt. What this all boils down to is that it really pays to check the interest rates each time your CDs become due. Be sure to ask if the bank is offering any CD “specials” which might be for an odd period such as for 11 months or 13 months.

The Loanable Funds Theory of banking is wrong. That theory tells us that banks wait for deposits and then loan out only that money that has already been deposited with them. But under fractional reserve banking, banks do not have to wait for enough deposit money to cover the full amount of the loan. In reality, under the current system of fractional reserve banking, banks can offer loans even if they don’t have enough money in deposits to cover those loans as long as they meet the fractional reserve requirement. Banks make loans when those loans offer a good risk-reward opportunity.

This has important implications for our economic system overall. When savers cannot get a good return on their savings, they often turn to the stock market or the bond market. But corporations often pay out dividends and engage in share buybacks precisely because they cannot find new profitable investment opportunities. Financial investments in collateralized debt obligations, credit default swaps, mortgage-backed securities, and other financial derivatives are not the same as direct investments in physical and intellectual capital. A bank may know more about the local economy and the reliability of the entity taking out the loan than reflected in the basic statistics used to securitize that loan. The temptation then is for a bank to make riskier loans than it would if it were to hold on to that loan instead of selling it off as part of a mortgage-backed security.

What this all boils down to is that the financial economy where money is traded has become more and more separated from the real economy. Money flowing into the New York financial markets is not guaranteed to end up in an expansion of our economy. Over time more and more of that money just goes around and around in the New York financial markets without ever making it out to the real economy. The velocity of money in the financial markets speeds up as second-by-second trading is replaced by nanosecond-by-nanosecond trading, while the velocity of money in the real economy slows as interest rates fall, our population ages, and income inequality becomes more extreme. All this has important implications for the effectiveness of monetary policy, which is a topic for a future blog post.

For a great YouTube video on why the “Loanable Funds Theory” is wrong go to this link: https://www.youtube.com/watch?v=OgsEyM82oCE&t=785s

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Disequilibrium Economics and Adam Smith’s Two Invisible Hands

In competitive markets with sufficient elasticity, equilibrium is established and maintained relatively easily. Consumer demand and supply respond quickly to the mantra: “The solution to high prices is high prices; and the solution to low prices is low prices.” Obviously, the point is that in the face of high prices, consumers cut back demand and suppliers increase supply to bring down prices. Conversely, in the face of low prices, consumers increase demand and suppliers cut back supply to raise prices. We achieve equilibrium quickly and efficiently.

Except this doesn’t work very well or very quickly in the financial markets and in the economy overall. The problem is that traditional equilibrium economics assumes rational, independent decision makers with full information and sufficient mental energy to compute and re-compute their optimal behavior in complex situations that can quickly change and invoke emotional responses. Contagion effects in financial markets can drive prices dramatically higher in irrational exuberance as higher prices cause people to jump in and follow the crowd to purchase even more in the face of those higher prices instead of less. Conversely, a downward price spiral can be hard to stop when fear overtakes hope and prices fall precipitously. Dan Ariely’s book “Predictably Irrational” reveals a problem that economists have tried to ignore and marketers have profited by exploiting. An irrational herd effect can quickly overwhelm market participants to leave markets in disequilibrium for an extended period. It is hard to understand why economists have taken so long to catch on to consumer irrationality when the people in marketing have understood consumer irrationality and have been exploiting it for hundreds of years.

Moreover, too many people confuse optimal microeconomic behavior with optimal macroeconomic outcomes. The aggregate economy does not converge toward equilibrium when microeconomic incentives do not lead to the intended desirable macroeconomic effects. The classic example is the paradox of thrift where during a recession, when people see friends and neighbors losing their jobs, they try to save a larger share of their earnings in case they might lose their jobs, but the total amount of savings falls because the drop in spending causes more cutbacks in working hours and jobs as consumer demand and prices fall causing businesses to cut back production of goods and services. The microeconomic incentive to save more leads to less total savings at the macroeconomic level. My spending contributing to your earnings and your spending contributing to my earnings can sometimes lead to greater disequilibrium instead of a convergence toward an overall equilibrium for the economy as a whole.

It would be nice to have a world that even in primitive times would have allowed individuals to compete freely and fairly with perfect competition resulting in a natural, efficient and dynamic equilibrium being established in every market. But that is far from reality. In most primitive and many modern societies, the big guy gets what he wants. The equal opportunity and competitive environment is not the natural state. Far from it. It takes a strong and active government to enforce freedom with equal opportunity and competitive markets. In his book “The Myth of Capitalism” Jonathan Tepper has revealed the surprising extent of reduced competition and increased concentration in most major industries in the United States.

For example, consider the market for eyeglasses. Glass and plastic should be very cheap. After all, we throw a lot of glass and plastic into recycling bins every week. But instead of two or three dollars, eyeglasses typically cost about one-hundred and thirty dollars or more. In reality eyeglass manufacturing is basically a duopoly with only two eyeglass manufacturers dominating the market. In the eyeglass market, Adam Smith’s first invisible hand of competition has been suppressed by Adam Smith’s second invisible hand of market power where he said: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the publick, or in some contrivance to raise prices.”

Moreover, government can interfere with freedom and competition by imposing patents, copyrights and licensing requirements, among other restrictions such as child labor laws and government sponsored monopolies. Sometimes government intervention is good in solving problems that the free market is incapable of solving on its own. At other times, government intervention can create problems or make problems worse, so it is important to distinguish between good government intervention and bad government intervention. With limited mental energy, we have a natural tendency to think in all-or-nothing terms, but reality requires careful analysis to devise effective and efficient policies to fix free market problems without introducing significant other inadvertent difficulties. For a better understanding of the role of government in our economy see Mariana Mazzucato’s three books: “The Entrepreneurial State,” “The Value of Everything,” and “Mission Economy.”

Adam Smith’s explicit invisible hand of competition suggested that we just need to focus on maximizing our own personal utility function or profits, and others will benefit from our self-centered behavior. But Adam Smith wrote implicitly about a second invisible hand where competitors conspired together to block competition and exploit consumers. While the invisible hand of competition led to lower prices with a focus on quality, the second invisible hand led to higher prices with less concern for quality. Assuming that the first invisible hand will always dominate is naive at best. The rules and regulations set by government play an important role in determining the balance of power between these two invisible hands.

Distorted Money Flow Creates Chronic Disequilibrium in our Economy

January 7 – 9  is the American Economic Association Conference with 115,000 economists attending virtually where I present a rough draft of my new book in a poster session, followed later by a presentation at the Midwest Economics Association meeting in Minneapolis. Instead of emailing you my 70+ page research paper, I am providing below the content of the PowerPoint slides that summarize the paper.  

 “The Public Banking Act ” Should Allow for Individual Federal Reserve CBDC Bank Accounts (“FedAccounts”) To Transform Monetary Policy.  Adjusting interest rates on Wall Street is ineffective in stimulating and too brutal in slowing the economy, but injecting stimulus money and adjusting interest rates on small individual consumer Federal Reserve bank accounts could impact consumer demand more effectively and more immediately.  Note the author’s  proposal for stopping inflation using “FedAccounts” at: https://www.youtube.com/watch?v=nnMT7DVyK0g This follows from the money flow paradigm in the author’s book “Optimal Money Flow” which also considers the case of deflation where aggregate demand is inadequate to match aggregate supply which is summarized on YouTube at: https://www.youtube.com/watch?v=-hqBD3ZEhIM  

Digital Currency Threat => Will Central Banks lose control of money?  Banks creating their own money caused bank panics that continued even after adopting a common currency (dollars).  Wide use of private digital currencies could cause excessive volatility, tax avoidance, and criminal activities. Central Banks need to create their own digital currencies.

STOP  INFLATION without causing a RECESSION. The supply-side tool of raising interest rates in New York financial markets causes layoffs as businesses cut back. Don’t trash the economy to stop inflation. A demand-side tool can be created to stop inflation more effectively and more efficiently.  

Control demand to avoid economic downturns. NYC financial markets already have more money than can be put to work. Lowering interest rates further and supplying more money is just “pushing on a string.” A demand-side tool can be created to stimulate economy more directly using much less money. 

Velocity of Money Falls => Milton Friedman  M V = P Q  inflation always a monetary phenomenon with V (velocity) constant, and P (prices) constant only if M (quantity of money) rises at same rate as Q (economic output) rises. But V falls as population ages. And V falls as economic inequality increases. To keep Q growing at full employment, M must rise faster than V is falling so P can be constant.

Adam Smith =>  Two  Invisible  Hands: 1. Economic competition (lower prices). 2. Economic concentration (higher prices). USA economy has become less competitive with greater oligopoly and monopoly (as well as oligopsony and monopsony) power. See Jonathan Tepper’s book: “The Myth of Capitalism” about the dramatic drop in competition in the USA economy.

Pure Profits at Zero Marginal Cost => The explosion of information on the Internet has produced a commodity with essentially zero marginal cost. For example, with premium access you can gain access to extra information that already exists but only requires changing a zero to a one in computer code for you to access, which is done automatically when you make your payment for premium access. See book by Jeremy Rifkin: The Zero Marginal Cost Society. New York: St. Martin’s Press, 1014.

Profits rise as labor and capital shares fall => Barkai (2020) calculated the capital costs for the U.S. non-financial corporate sector over the period 1984 to 2014 and found that while labor’s share has dropped by 11 percent, the share of real capital has declined 22 percent with a corresponding increase in pure profits. Barkai, Simcha. “Declining Labor and Capital Shares.” The Journal of Finance, 75(5), pp. 2421-2463. 2020.  https://doi.org/10.1111/jofi.12909 

Distorted Money Flow => extreme wealth inequality leads to instability. Most of the money flows to the already wealthy who put it into the New York financial markets (stocks and bonds). The money flow has become so distorted the middle class can no longer afford to buy back the value it creates. Individuals go deep into debt while the government runs large deficits to keep the economy from sliding into recession. However, recently a combination of a large stimulus and COVID related supply shortages temporarily disrupted this chronic problem of inadequate demand relative to extensive global supply.

Disequilibrium Economics => Hyman Minsky explained that while most markets for well-defined goods and services move toward equilibrium, the economy as a whole and especially the financial markets are prone to swing between an upward irrational exuberance and a downward recessionary spiral. As John Maynard Keynes said: “In the long run we are all dead. Economists set themselves too easy, too useless a task if, in tempestuous seasons, they can only tell us that when the storm is long past the ocean is flat again.”

Darwinian Natural Selection Paradox => As countries reach about $6,000 per capita, birth rates drop like a rock, eventually falling below the 2.1 replacement rate. Wealthy and well-educated countries and families have fewer and fewer children in recent decades. Instead of success in education and wealth breeding bigger populations, human populations fall dramatically. As world population shrinks to zero, last one remember to “turn off the lights.”

Private and Public Debt => Decline of unions and Citizens United’s one dollar = one vote cuts workers’ real pay. Middle class unable to buy back the value of the goods and services it produces. Low pay and low interest rates drive people on Main Street deep into debt as more and more money flows to Wall Street. Government debt needed to fill in for the money flow going to Wall Street to maintain full employment.

Financial vs. real economy => Money flow to wealthy goes mainly into stock and bond markets on Wall Street driving down interest rates and inflating stock prices. Large amount of money not used for real investment (physical and intellectual) but goes into financial investments (dividends and stock buybacks). Consequently, the middle class is unable to purchase the value of the goods and services it is capable of producing at full employment.

Money Flow Paradigm => George Cooper in “Fixing Economics” identified key problem of too much money flowing to Wall Street and not enough money flowing to Main Street. Government sets the rules and regulations, and provides the money for free enterprise system. Government investment in common property resources is key to economic efficiency and growth. See Mariana Mazzucato’s 3 books: The Entrepreneurial State, The Value of Everything, and Mission Economy. 

The Age of Oversupply => Globalization and the collapse of communism. Cheap labor makes large quantities of high quality products available at very low prices and leads to deflation in prices of goods and services when demand is inadequate relative to enormous global supply. Read Daniel Alpert’s book: “The Age of Oversupply.”

Policy Driven Excess Supply => Chinese take resources and work hard to make products for USA in return for pieces of paper with George Washington’s picture on it. To keep Chinese products inexpensive for USA and Chinese workers employed, China collects USA dollars and buys U.S. Treasury securities in New York financial markets instead of driving down value of dollar in foreign exchange markets.

Antithesis of Say’s Law => population growth > food supply  reversed!!! Global supply exceeds demand when too much money flows to Wall Street and too little money left on Main Street. Supply-side economics replaced with demand-side economics. “Supply creates its own demand” replaced with “Demand creates it own supply.”

Distorted Money Flow => extreme wealth inequality leads to instability. To understand how “Distorted Money Flow” can become “Optimal Money Flow” visit the following website: https://optimal-money-flow.website/  For more information on the author visit the author’s public website at: https://sites.nd.edu/lawrence-c-marsh/home/ 

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Please provide your insights and comments on “Distorted Money Flow Creates Chronic Disequilibrium in our Economy” by scrolling down to the bottom of this page and writing your comments in the textbox “Comment.”
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Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone
You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh with no charge for shipping and handling.  

To sign up for this free monthly Money Flow Newsletter =>  click here.

Money Flow Dynamics in a Disequilibrium Economy

Static equilibrium analysis is insufficient for understanding and controlling our economy. Our economy does not transition smoothly from one well-defined equilibrium to another. Rather we experience periods of dynamic disequilibrium which require more careful analysis.

Moreover, the nature of the USA economy has changed fundamentally since the nineteen eighties. Earlier the economy was occasionally subject to bouts of strong consumer demand and constrained supply that led to excessive inflation. This was countered with tighter fiscal policy and higher interest rates in monetary policy which sometimes produced recession. The challenge was to keep inflation in check while providing enough stimulus to maintain full employment. During that period the Phillips curve with its trade-off between inflation and unemployment was a useful device for understanding the policy challenge. But this relationship has fundamentally changed in recent decades.

Many authors have documented our transition to extreme income and wealth inequality. Both pay-to-play politics and advances in technology have greatly increased the return to capital relative to labor. What has been less discussed and understood is how this has contributed to a disequilibrium state where consumer demand is constrained while money has piled up in financial markets driving up stock and bond prices while depressing interest rates. Money is readily available for investment but investment opportunities are limited. Investing in an additional production line doesn’t make sense if you are unable to sell all of the product from your first production line. A combination of rapid and extensive automation and massive global supply has overwhelmed consumer demand and driven prices down or at least greatly constrained potential price increases. Inflation has fallen below and stayed below our monetary policy target of two percent.

One aspect of this situation has proven to be especially important. The very low interest rates has discouraged savings and encouraged consumer debt. Little or no savings has greatly contributed to economic instability. Consumers have taken on massive amounts of debt in the form of mortgage debt, credit card debt, home equity debt, student loan debt and, in conjunction with our aging population, medical and health related debt. In fact, in our current state of economic disequilibrium the middle class can no longer afford to buy back the value of the goods and services it is creating.

With virtually no savings, members of the middle class are operating paycheck to paycheck with no safety net. This turns income and wealth inequality into inherent economic instability. Any accident or unanticipated medical issue, not to mention job loss, could mean a sudden drop in consumption of ordinary goods and services.

To compensate for what would otherwise be a shortfall in consumer demand, the Federal government has stepped in with unpaid-for tax cuts and increased expenditures that have substantially increased the Federal debt. The proponents of new monetary theory who generally dismiss the importance of this ever increasing national debt have implicitly understood the growing and essential role of the Federal government in supplementing the otherwise inadequate consumer demand.

But it is monetary policy that is partially to blame for this situation. The practice of buying Treasury securities in the New York financial markets has greatly contributed to stock and bond price bubbles, but, more importantly, to lower interest rates and the over-indebtedness of the middle class. In this way, with the help of the mathematics of compound interest, monetary policy exacerbates income and wealth inequality by making the rich even richer (higher stock and bond prices) and the middle class poorer (deeper in debt).

Forthcoming book “Optimal Money Flow” proposes creating “My America” Federal Reserve smartphone bank accounts for everyone with a Social Security number. When the economy slows, money can be injected directly into these accounts to avoid recession. This would be much more effective in reviving the economy and require much less money than the enormous amount of money given to Wall Street bankers, which is a waste of time when consumer demand is inadequate to justify adding another line of production when companies can’t sell all they are producing with their first line of production. Instead, Wall Street bankers just buy more stocks and bonds. Giving the money directly to consumers makes much more sense.

The author has agreed to forgo his book royalties so that the full purchase price ($24.95) will go into the student scholarship fund when purchased through Avila University Press at the link: https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh