Wednesday, March 28, 2012

A phenomenon that loanable funds theory can't explain

Mainstream economists believe that since for every buyer there is a seller, they take this logic to the notion of bank lending, and assume that for every borrower, there is a lender, with banks just bringing them together. And they further assume that when a borrower needs to increase his consumption, a lender needs to curtail his, to provide the necessary funds.

Paul Krugman recently asks:  "If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and I’m not sure what. I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand."

This image of lending is outdated, and does not explain why banks trip over themselves to provide lines of credit to creditworthy customers. Just imagine, you have all those banks that have issued you credit cards, with varying line amounts, whether you actually asked for the card or not. Why did they do it? Because they have tons of unlent funds that they have to lend out? What good is it to them if you don't use your card, if they've already issued you one? They've given you an open commitment to provide you up to your line limit, but it's your option whether to you use it, not use it, partially use it, or use it then pay it down quickly.  

If you don't use it, the bank doesn't earn interest from you. If they did secure loanable funds prior to you drawing your line, then what happens to the poor schmuck who provided that loanable fund? No interest income for him. Is there really a schmuck standing ready to not consume by the exact amount that you draw your line with, month after month, and stands ready to forego his interest income once you pay it back?  Did the bank promise him something in order to secure his funds? If the loanable funds theory of banking is correct, then credit cards have got to be the most uneconomical bank product ever invented.  Any banker worth his salt will push to sell you an actual loan rather than a miserable line of credit.  As far as the logic of loanable funds theory is concerned,  it's a losing proposition for any bank. So why do banks provide this product, often to people who don't even want it? Does the loanable funds theory have an explanation for this?

Krugman tries to explain why banks do it: "As I (and I think many other economists) see it, banks are a clever but somewhat dangerous form of financial intermediary, one that exploits the law of large numbers to offer a better tradeoff between liquidity and returns, but does so at the cost of taking on very high leverage, with all the risks that entails.The super-high leverage of banks, and the role of bank deposits as a key form of liquid assets, means that banks broadly defined are usually central players in financial crises. But that’s a quantitative thing, not a qualitative thing."

Banks risking insolvency for an uncertain income stream? Does the loanable funds theory have an explanation for this?