The Loanable Funds Fallacy in Retrospect

The theory of liquidity preference is probably the single most controversial of the core constituents of John Maynard Keynes’s General Theory (1936). Keynes presents liquidity preference theory as a “liquidity [preference] theory of interest,” a theory that is supposed to fill the vacuum left by what he regarded as the flawed “classical [savings] theory of interest.” Keynes refers to that theory (and, effectively, to its loanable funds cousin) as a “nonsense theory” that, according to him, involves “formal error.” The objective of this article is to trace the evolution of the “liquidity [preference] theory of interest” from the Treatise on Money (published in 1930) to The General Theory, thereby illustrating that Keynes’s Treatise disequilibrium analysis already proves that what was to become loanable funds theory later on is, indeed, logically inconsistent.

The argument proceeds as follows. Section 1 summarizes the analytical apparatus of Keynes’s Treatise on Money, focusing particularly on the “excess-bearish factor,” while section 2 applies the Treatise disequilibrium analysis to a “rise in thrift” in order to illustrate the “loanable funds fallacy.” Sections 3 and 4 discuss the criticisms leveled against the Treatise by Dennis Robertson and Ralph Hawtrey respectively. I argue that Robertson’s criticism, which is directed mainly at the excess-bearish factor, made no impression on Keynes, who correctly identifies a flaw—the loanable funds fallacy—in Robertson’s argument. This is also reflected in the fact that the substance of the theory of liquidity preference does not change at all between the two books. Hawtrey’s criticism, by contrast, is then shown as providing one of the main influences that led Keynes on to The General Theory. I discuss the final product, the “liquidity [preference] theory of interest” of The General Theory, in section 5 and argue that it is not only the role of the theory of liquidity preference that changes between the two books, but also its exposition, in particular with respect to Keynes’s treatment of the banking system. This issue, which is related to the methodological changes in the type of disequilibrium analysis employed in the two books, is taken up in section 6. Section 7 concludes the analysis by briefly indicating the various directions that the notorious liquidity-preference-versus-loanable-funds (LP-LF) debate took from The General Theory onward.

1. A Treatise on Money and the Early Version of the Theory of Liquidity Preference

Keynes became rather disenchanted with the core analytical apparatus of the Treatise on Money subsequent to its publication in October 1930. He states his reasons in the preface to The General Theory: “My lack of emancipation from preconceived ideas showed itself in what now seems to me to be the outstanding fault of the theoretical parts of that work (namely, Books III and IV), that I failed to deal thoroughly with the effects of changes in the level of output” (Keynes [1936] 1973a, xxii). Keynes was to repair this defect successfully in The General Theory, but at the time of writing the Treatise Keynes still believed that the theory of short-period supply was outside the scope of monetary theory.

In the Treatise on Money, Keynes sets out to analyze the various factors that affect the price level, an approach that is much in line with the quantity theory view of the scope of monetary theory. A number of points are important here. First, although Keynes is still operating within the quantity theory perspective on the scope of monetary theory, he is highly dissatisfied with the usual forms of the quantity theory, which, he says, merely establish “identities or statical equations” that are altogether useless for the causal analysis of the credit cycle. In his view it is important to treat the problem “dynamically.” The real task of monetary theory, he argues, is to analyze “the different elements involved, in such a manner as to exhibit the causal process by which the price level is determined, and...