I was recently discussing econometrics and Keynes’ critique of it with Severin Reissl, a particularly clever student currently attending the University of Glasgow who is critical of mainstream economics. (You can find some examples of his writing here in which I am quoted to criticise some of the assumptions in a mainstream macroeconomic textbook).
Anyway, I sent Reissl a copy of Keynes’ famous paper on econometrics entitled Professor Tinbergen’s Method and while we were discussing it Reissl pointed out the short piece that appeared below it. The paper, you see, was a book review published in The Economic Journal in 1939 and below it was another review by Keynes. This review was entitled The Process of Capital Formation and it dealt with an early statistical attempt to formalise the national accounts — something that Keynes would become deeply involved in during the war years and after.
I had never read the paper before but Reissl said that it contained within it a lucid critique of the loanable funds theory. I want to examine this here because I think it’s a very important point. By studying this paper I think that we can indeed understand better Keynes’ ideas about loanable funds.
The relevant discussion begins when Keynes discusses the savings/investment identity and clearly states that it is investment that drives savings, not savings that allow for investment. Using his typically brilliant ability for metaphor he writes,
For example, [the reader] might naturally suppose — for anything the Committee say to the contrary — that the right way to prepare for an increase of investment is to save more at an appropriately prior date. But the corollary shows that this is impossible. Saving at the prior date cannot be greater than the investment at that date. Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving. (p527 — My Emphasis)
Let us translate that into more formal terms before we move on. ‘Dishoarding’ would entail an increase in the velocity of money — as funds that were left dormant were reactivated they would begin the process of circulation. ‘Credit expansion’ while it clearly means some sort of borrowing is, at this moment in time, ambiguous and we shall deal with this point in a moment.
Keynes then goes on to show that funds that are invested add to savings and so, thinking that there is some pool of savings out of which investment is drawn is misleading because the money that is so invested is then added to the pool of savings. If there is £1m in savings in a country (assuming a closed economy) and £100,000 of these funds are invested then at the end of the period there will still be £1m in savings because the money invested will accrue as savings. This process is instantaneous because when I take the £100,000 and spend it on wages and investment goods that money is instantaneously credited to the bank accounts of workers and other capitalists where it then sits waiting to be spent as savings.
Or, as Keynes puts,
Prior saving has no more tendency to release funds available for subsequent investment than prior spending has. (pp572-573)
He then goes on to discuss the fact that what we are really dealing with when new investment is forthcoming is not the demand for savings but rather the demand for money. This ties in with his liquidity preference theory of the interest rate wherein the interest rate is determined as much by financial considerations — liquidity preference as a sort of ‘insurance’ against uncertainty — as by the considerations of the demand for money to finance investment.
At this point I think that Keynes has little to say that we can use today. The rest of the paper is written in a manner that implies that this quantity of money is somehow fixed at any moment in time. Thus, if the demand for money increases for any reason the interest rate should rise. This is the same assumption as the ISLM model with the upward-sloping LM curve. But as we now know, in a regime where the central bank targets the interest rate and not the quantity of money then the quantity of money will increase if there is any upward pressure on the interest rate.
While Keynes did indeed strike the first blow against the loanable funds theory in this review in that he got rid of the silly notion that investment out of savings ‘used up’ said savings, he nevertheless did not overturn it completely. That would have to wait for Robinson and Kaldor’s early formulations of the endogenous money theory.