The Loanable Funds Fallacy: Why the Economy Doesn’t Work Like Economists Think It Does

💣 The Loanable Funds Fallacy: Why the Economy Doesn’t Work Like Economists Think It Does

Mainstream economics has a comforting fairy tale at its core: that before anyone can borrow, someone else must first save. This idea is formalized in the loanable funds model, and it underpins much of modern macroeconomic thought, from the Chicago School to ECB policy memos.

It paints a world of order and thrift: savers forgo spending, banks collect those savings, and only then can others invest. It’s a Newtonian clockwork version of the economy. But it is empirically false, logically incoherent, and operationally useless.

Worse — it’s actively harmful. It misguides policy, misreads financial crises, and props up an entire scaffolding of broken assumptions: from crowding-out theory to natural interest rates to the fantasy of money neutrality.

This post is a long-form demolition of that myth.

🧩 What the Loanable Funds Model Claims

In the basic loanable funds story:

• People save by deferring consumption.
• Banks gather these savings and loan them out.
• The supply of savings and demand for loans determines the interest rate.
• Investment then follows.

It’s a nice supply-and-demand tale. Balanced, intuitive, moral even. But the simplicity is a trap.

🚫 Why It Doesn’t Work: A Summary of Fatal Problems

Before we dive into detail, here’s the executive summary of why loanable funds fails:

1. Banks don’t lend out savings — they create money endogenously through lending.
2. Spending drives income — not the reverse.
3. Trade is credit-based — not money-based.
4. Expectations shape the economy — not just past actions.
5. Saving doesn’t reduce purchasing power — it often increases it.
6. The model can’t handle asynchronous causality — and that’s how the real world operates.
7. Government finance doesn’t work this way either — and never has.

Let’s break it down.

🏦 How Banks Actually Operate: Lending vs Treasury

In the real world, commercial banks operate through two semi-autonomous departments:

1. The 

Lending Department

• Engages customers
• Assesses credit risk
• Builds loan proposals
• Drives business growth

2. The 

Treasury Department

• Manages liquidity
• Handles reserve requirements
• Deals with interbank payments
• Prices funding and liabilities

These two are linked by a cash buffer and a pricing mechanism. But they are not causally ordered. They operate asynchronously, in parallel, not in sequence.

Lending proposals take weeks to move through the pipeline. Treasury can arrange funding in days. The system is designed to deal with thousands of unpredictable transactions per day. It must be distributed and loosely coupled.

There is no strict “first you get deposits, then you make loans” causality. There is only forecasting, buffering, and real-time liquidity management.

And this, crucially, is how the entire monetary system works — including the government sector.

💰 Loans Create Deposits — Not the Other Way Around

When a bank approves a mortgage, it doesn’t check its deposit base or wait for someone to save. It creates the deposit simultaneously with the loan.

• Bank asset: The loan
• Bank liability: The deposit

This means the bank creates money — ex nihilo — subject only to regulatory and risk constraints. As the Bank of England, Bundesbank, and BIS have all confirmed: banks are not intermediaries of loanable funds. They are creators of money.

Which renders the loanable funds model completely backward.

🔄 Trade Is Always Credit Before Settlement

All economic transactions start with credit — explicit or implicit — and settle with money later:

• You buy groceries with a debit card: the store gives you goods before settlement.
• Businesses order inventory on net-30 terms.
• Governments spend before taxing.

Even in barter systems, the idea of immediate, symmetrical exchange is mythical. What drives trade is trust and time — not a stock of settled funds.

Money is the means of final settlement. It is not the precondition of trade.

🧠 Expectations Drive the Economy

The economy is not a mechanical contraption. It is a forward-looking, expectation-driven system.

When someone applies for a loan, they begin planning purchases. Sellers begin anticipating income. Prices begin to adjust. And banks start lining up funding.

Nothing has “happened” yet in monetary terms, but everything has already changed in behavioral terms.

This expectation feedback loop is a core causal driver of the modern economy — and the loanable funds model cannot represent it. Because it assumes all spending is driven by already-existing funds, and that causality only runs backward in time.

🧾 Saving Doesn’t Reduce Demand

Loanable funds relies on the idea that savings represent deferred consumption — a reduction in current purchasing power that “frees up” resources for others to use.

But in real life:

• Savings increase financial net worth.
• Time deposits and investments can be used as collateral.
• Wealth holders can access liquidity when needed.
• The financial system is built to keep wealth mobile.

So saving doesn’t reduce demand — and often increases expected future demand. The entire model rests on the false idea that only one person can spend at a time, which is nonsense in a system with credit and liquidity management.

📉 The “Wealth Effect” Contradicts Loanable Funds

Here’s the fatal irony.

Monetarists and New Keynesians love the “wealth effect” — the idea that if your house or stocks go up in value, you’ll feel richer and spend more.

But if spending is constrained by savings, and only happens after prior abstention, how can a paper gain in wealth increase demand?

You can’t have it both ways. Either:

• Wealth perception drives spending (which means funding doesn’t precede it), or
• Spending is strictly limited to past income/saving (in which case wealth effects don’t exist).

The mainstream tries to have both — and ends up with a contradiction.

🔁 Steve Keen and the Dynamics of Credit

Economist Steve Keen has shown that aggregate demand = income + change in private debt.

In other words:

• When private debt grows, spending increases.
• When it contracts, spending collapses.

Loanable funds can’t account for this, because it treats all lending as a transfer from one person to another — not as net new money creation.

This dynamic view explains why financial crises are so devastating: when the private sector deleverages, demand vanishes — and only government deficits can fill the gap.

🏛️ Governments Don’t Operate on Loanable Funds Logic

The government doesn’t “tax then spend.” It spends then taxes.

• Spending injects money into the economy.
• Taxes withdraw it back.
• Bond sales are used to drain reserves, not raise funds.

This is the consolidated Treasury/Central Bank view — long understood by insiders, ignored by most economists.

Just like a bank’s lending and treasury departments, government spending and funding operate asynchronously, via buffers and expectations. Not via a strict ordering.

🌐 Endogeneity Is Not a Bug. It’s the System.

Money creation is endogenous to the system — created by banks in response to demand, by governments through fiscal operations, and by the central bank through its monetary operations.

You cannot manage this system through fixed quantities, natural rates, or money supply targets.

You have to manage it through:

• Real-time price signals (interest rates)
• Buffer stocks (like the Job Guarantee)
• Automatic stabilizers
• Macroprudential tools

Trying to model an endogenous system as if it were exogenous is like flying a drone with a hammer.

📢 Final Thoughts: Let the Model Die

The loanable funds model survives because it flatters certain ideologies:

• That saving is moral.
• That government deficits are dangerous.
• That only private markets allocate capital “efficiently.”

But these are not truths — they are moral stories, dressed in mathematical language.

The truth is this:

The economy is a dynamic, credit-based, asynchronous, expectation-driven system.

To understand it, we need models that reflect reality, not fables. And we need policies that work with the grain of modern finance, not against it.

Until we bury the loanable funds model for good, we will keep making the same catastrophic mistakes — austerity, underinvestment, crisis misdiagnosis — over and over again.

Further reading:

• Steve Keen – Debunking Economics
• Bank of England – “Money Creation in the Modern Economy”
• BIS Working Papers on endogenous money
• Modern Monetary Theory (Kelton, Wray, Mitchell et al.)