In two recent posts I have discussed Keynes’s theory of interest and the natural rate of interest. My goal in both posts was not to give my own view of the correct way to think about what determines interest rates, but to identify and highlight problems with Keynes’s liquidity-preference theory of interest, and with the concept of a natural rate of interest. The main point that I wanted to make about Keynes’s liquidity-preference theory was that although Keynes thought that he was explaining – or perhaps, explicating — the rate of interest, his theory was nothing more than an explanation of why, typically, the nominal pecuniary yield on holding cash is less than the nominal yield on holding real assets, the difference in yield being attributable to the liquidity services derived from holding a maximally liquid asset rather than holding an imperfectly liquid asset. Unfortunately, Keynes imagined that by identifying and explaining the liquidity premium on cash, he had thereby explained the real yield on holding physical capital assets; he did nothing of the kind, as the marvelous exposition of the theory of own rates of interest in chapter 17 of the *General Theory* unwittingly demonstrates.

For expository purposes, I followed Keynes in contrasting his liquidity-preference theory with what he called the classical theory of interest, which he identified with Alfred Marshall, in which the rate of interest is supposed to be the rate that equilibrates saving and investment. I criticized Keynes for attributing this theory to Marshall rather than to Irving Fisher, which was, I am now inclined to think, a mistake on my part, because I doubt, based on a quick examination of Fisher’s two great books *The Rate of Interest* and *The Theory of Interest*, that he ever asserted that the rate of interest is determined by equilibrating savings and investment. (I actually don’t know if Marshall did or did make such an assertion.) But I think it’s clear that Fisher did not formulate his theory in terms of equating investment and savings via adjustments in the rate of interest rate. Fisher, I think, did agree (but I can’t quote a passage to this effect) that savings and investment are equal in equilibrium, but his analysis of the determination of the rate of interest was not undertaken in terms of equalizing two flows, i.e., savings and investment. Instead the analysis was carried out in terms of individual or household decisions about how much to consume out of current and expected future income, and in terms of decisions by business firms about how much available resources to devote to producing output for current consumption versus producing for future consumption. Fisher showed (in Walrasian fashion) that there are exactly enough equations in his system to solve for all the independent variables, so that his system had a solution. (That Walrasian argument of counting equations and unknowns is mathematically flawed, but later work by my cousin Abraham Wald and subsequently by Arrow, Debreu and McKenzie showed that Fisher’s claim could, under some more or less plausible assumptions, be proved in a mathematically rigorous way.)

Maybe it was Knut Wicksell who in his discussions of the determination of the rate of interest argued that the rate of interest is responsible for equalizing savings and investment, but that was not how Fisher understood what the rate of interest is all about. The Wicksellian notion that the equilibrium rate of interest equalizes savings and investment was thus a misunderstanding of the Fisherian theory, and it would be a worthwhile endeavor to trace the genesis and subsequent development of this misunderstanding to the point that Keynes and his contemporaries could have thought that they were giving an accurate representation of what orthodox theory asserted when they claimed that according to orthodox theory the rate of interest is what ensures equality between savings and investment.

This mistaken doctrine was formalized as the loanable-funds theory of interest – I believe that Dennis Robertson is usually credited with originating this term — in which savings is represented as the supply of loanable funds and investment is represented as the demand for loanable funds, with the rate of interest serving as a sort of price that is determined in Marshallian fashion by the intersection of the two schedules. Somehow it became accepted that the loanable-funds doctrine is the orthodox theory of interest determination, but it is clear from Fisher and from standard expositions of the neoclassical theory of interest which are of course simply extensions of Fisher’s work) that the loanable-funds theory is mistaken and misguided at a very basic level. (At this point, I should credit George Blackford for his comments on my post about Keynes’s theory of the rate of interest for helping me realize that it is not possible to make any sense out of the loanable-funds theory even though I am not sure that we agree on exactly why the loanable funds theory doesn’t make sense. Not that I had espoused the loanable-funds theory, but I did not fully appreciate its incoherence.)

Why do I say that the loanable-funds theory is mistaken and incoherent? Simply because it is fundamentally inconsistent with the essential properties of general-equilibrium analysis. In general-equilibrium analysis, interest rates emerge not as a separate subset of prices determined in a corresponding subset of markets; they emerge from the intertemporal relationships between and across all asset markets and asset prices. To view the rate of interest as being determined in a separate market for loanable funds as if the rate of interest were not being simultaneously determined in all asset markets is a complete misunderstanding of the theory of intertemporal general equilibrium.

Here’s how Fisher put over a century ago in *The Rate of Interest:*

We thus need to distinguish between interest in terms of money and interest in terms of goods. The first thought suggested by this fact is that the rate of interest in money is “nominal” and that in goods “real.” But this distinction is not sufficient, for no two forms of goods maintain or are expected to maintain, a constant price ratio toward each other.

There are therefore just as many rates of interest in goods as there are forms of goods diverging in value.(p. 84, Fisher’s emphasis).

So a quarter of a century before Sraffa supposedly introduced the idea of own rates of interest in his 1932 review of Hayek’s *Prices and Production*, Fisher had done so in his first classic treatise on interest, which reproduced the own-rate analysis in his 1896 monograph *Appreciation and Interest*. While crediting Sraffa for introducing the concept of own rates of interest, Keynes, in chapter 17, simply — and brilliantly extends the basics of Fisher’s own-rate analysis, incorporating the idea of liquidity preference and silently correcting Sraffa insofar as his analysis departed from Fisher’s.

Christopher Bliss in his own classic treatise on the theory of interest, expands upon Fisher’s point.

According to equilibrium theory – according indeed to any theory of economic action which relates firms’ decisions to prospective profit and households’ decisions to budget-constrained searches for the most preferred combination of goods – it is prices which play the fundamental role. This is because prices provide the weights to be attached to the possible amendments to their net supply plans which the actors have implicitly rejected in deciding upon their choices. In an intertemporal economy it is then, naturally, present-value prices which play the fundamental role. Although this argument is mounted here on the basis of a consideration of an economy with forward markets in intertemporal equilibrium, it in no way depends on this particular foundation. As has been remarked, if forward markets are not in operation the economic actors have no choice but to substitute their “guesses” for the firm quotations of the forward markets. This will make a big difference, since full intertemporal equilibrium is not likely to be achieved unless there is a mechanism to check and correct for inconsistency in plans and expectations. But the forces that pull economic decisions one way or another are present-value prices . . . be they guesses or firm quotations. (pp. 55-56)

Changes in time preference therefore cause immediate changes in the present value prices of assets thereby causing corresponding changes in own rates of interest. Changes in own rates of interest constrain the rates of interest charged on money loans; changes in asset valuations and interest rates induce changes in production, consumption plans and the rate at which new assets are produced and capital accumulated. The notion that there is ever a separate market for loanable funds in which the rate of interest is somehow determined, and savings and investment are somehow equilibrated is simply inconsistent with the basic Fisherian theory of the rate of interest.

Just as Nick Rowe argues that there is no single market in which the exchange value of money (medium of account) is determined, because money is exchanged for goods in all markets, there can be no single market in which the rate of interest is determined because the value of every asset depends on the rate of interest at which the expected income or service-flow derived from the asset is discounted. The determination of the rate of interest can’t be confined to a single market.