Lesson 3 of 7
Saving meeting investment
The loanable funds market drawn once. What is on each side, what the rate is supposed to clear, and the three things this picture leaves out.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Loanable funds is one market with a price. Supply is what people decline to consume, demand is what producers want for projects, and the rate is what clears it.
- In this tradition a market cleared only by real saving settles at something near the natural rate, because both sides are made of the same real resources.
- Bank credit is a second source of supply that is not made of anybody's abstention. That is the single fact the next four lessons turn on.
Wicksell needed a market for his two rates to be rates in. This is it, drawn once, plainly, so the later lessons can move things around on it.
One market, two possible sources of supply
- 1Households defer consumptionReal goods left unbought this period
- 2Banks create depositsClaims created by lending, with no abstention behind them
- 3Loanable fundsBoth arrive as money, and look identical here
- 4Producers borrowProjects started, resources bid away from other uses
The supply side
Somebody has income and does not spend all of it on consumption. The unspent part is lent, directly or through an intermediary, and it is available to whoever will pay for it.
The important thing about this source is what stands behind it. If a household declines to buy goods this period, those goods are not bought, and the labour and materials that would have gone into replacing them are free for something else. The loan is a claim on resources that genuinely exist and are genuinely unclaimed.
The demand side
Producers want funds for projects. Which projects are worth starting depends on what the funds cost, and the ordering matters: at any rate, the projects taken up are the ones that clear it, and a lower rate brings in projects that did not before.
Mises puts the ordering sharply in The Theory of Money and Credit. Capital is always invested in the shortest available roundabout processes first, because those yield the most, so any new roundabout process that gets started must be more roundabout than the ones already running.
What the rate is doing
Clearing. At the rate that empties the market, the quantity producers want equals the quantity savers offer, and the marginal project taken up is the last one worth the wait at that price.
Wicksell's natural rate is what this market would settle at with the money stripped out, which is why his definition speaks of lending in kind. If the only supply in the market is real saving, the money rate and the natural rate are answers to the same question.
The second source of supply
They stop being answers to the same question as soon as a bank can add to supply without anyone abstaining. The previous course posted the entries: a loan asset and a deposit liability created together, with the earlier depositor's claim untouched.
Those funds arrive in this market as money, indistinguishable from the money a saver lent. The rate falls. Projects are started. But the goods a saver would have left unbought were never left unbought, because there was no saver.
That asymmetry is the whole of the next three lessons.
Three things this picture hides
It shows one rate, when the previous lesson argued there may be many. It shows funds as a homogeneous quantity, when what is really being bid for is specific labour, specific materials and specific machines. And it is drawn as a snapshot, when everything in the two courses that follow is about a sequence in time.
Use it as a bookkeeping device for who is supplying what, and stop there.
Check yourself
What stands behind the supply of funds when it comes from saving?
- A promise by the borrower to repay
- Goods that were not bought, and the labour and materials free as a result
- The bank's capital
Show the answer
Answer: B.
Abstention releases real resources. That is what makes saving-financed supply different from the second source, and the difference is the subject of lessons five and six.On Mises's ordering, what must be true of any newly started roundabout process?
- It must be shorter than the ones already running
- It must be more roundabout, because the shortest and most productive ones are taken up first
- It must use no machinery
Show the answer
Answer: B.
He argues that capital is always invested in the shortest available roundabout processes because they yield the greatest returns, so only longer ones remain.What does the diagram deliberately hide?
- The identity of the borrower
- That funds are not homogeneous: what is bid for is specific labour, materials and machines, and the picture is a snapshot of a sequence
- The existence of banks
Show the answer
Answer: B.
It is a bookkeeping device for who supplies what. Heterogeneity and time are exactly what the structure course and the boom course put back in.Sources
- Mises, The Theory of Money and Credit, German original 1912, English translation by Batson 1934, part three, chapter 5, section 4, on the limit to the natural rate set by the productivity of the marginal lengthening, and on capital being invested in the shortest available roundabout processes first.
- Wicksell, Interest and Prices, English translation 1936, chapter 8, for the market this rate is supposed to clear and for lending in kind as the reference case.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The dollar figures in the example are round invented numbers chosen so the change can be seen. No market is described.
- Loanable funds is one way to draw the determination of interest and it is contested. Keynes's liquidity preference account puts the rate somewhere else entirely, and that disagreement is taken up in the course on rival theories later in this track.