Does Saving Increase the Supply of Credit? A Critique of Loanable Funds Theory

The paper presents a critique of loanable funds theory by using simple accounting relationships. It is shown that many economists identify saving and the credit supply by interpreting the macroeconomic saving-investment identity as a budget constraint. According to that interpretation, more saving through lower consumption (and government spending) leads to a higher supply of credit and thus more funds to be invested by firms for investment. The paper shows that proponents of this theory commit accounting fallacies or need very strong and somewhat peculiar assumptions for their theory to hold. In the first step, the concepts of \saving" and \credit" will be clearly distinguished using simple accounting. It will be shown that credit is not limited by anybody's saving and that no one has to abstain from consumption in order for a credit to be provided. Also, it will be shown that financial saving (an increase in net financial assets) through a reduction in expenses reduces other economic units' ability to spend and save. The identification of saving and the provision of credit is likely to stem from the invalid application of neoclassical growth models to a monetary economy. In those models, there are either only tangible assets, so that no coordination failures in financial saving can occur, or in those models real goods are lent and borrowed, not money.