This phrase comes from the cotton industry and dates back as far as the 1780s, when the industrial revolution made mass production of textiles possible for the first time. Huge mills sprang up to take advantage of the new technology (and cheap labour), but it was difficult to keep all the machines running properly. Any machine that broke down or produced defective cloth was said to have a screw loose somewhere. (source)
How it evolved to the meaning of someone who is unstable is unclear. No research I did traced the evolution.
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