Hawtrey v. Keynes on the General Theory and the Rate of Interest

Almost a year ago, I wrote a post briefly discussing Hawtrey’s 1936 review of the General Theory, originally circulated as a memorandum to Hawtrey’s Treasury colleagues, but included a year later in a volume of Hawtrey’s essays Capital and Employment. My post covered only the initial part of Hawtrey’s review criticizing Keynes’s argument that the rate of interest is a payment for the sacrifice of liquidity, not a reward for postponing consumption – the liquidity-preference theory of the rate of interest. After briefly quoting from Hawtrey’s criticism of Keynes, the post veered off in another direction, discussing the common view of Keynes and Hawtrey that an economy might suffer from high unemployment because the prevailing interest rate might be too high. In the General Theory Keynes theorized that the reason that the interest rate was too high to allow full employment might be that liquidity preference was so intense that the interest rate could not fall below a certain floor (liquidity trap). Hawtrey also believe that unemployment might result from an interest rate that was too high, but Hawtrey maintained that the most likely reason for such a situation was that the monetary authority was committed to an exchange-rate peg that, absent international cooperation, required an interest higher than the rate consistent with full employment. In this post I want to come back and look more closely at Hawtrey’s review of the General Theory and also at Keynes’s response to Hawtrey in a 1937 paper (“Alternative Theories of the Rate of Interest”) and at Hawtrey’s rejoinder to that response.

Keynes’s argument for his liquidity-preference theory of interest was a strange one. It had two parts. First, in contrast to the old orthodox theory, the saving-investment equilibrium is achieved by variations of income, not by variations in the rate of interest. Second – and this is where the strangeness really comes in — the rate of interest has an essential nature or meaning. That essential meaning, according to Keynes, is not a rate of exchange between cash in the present and cash in the future, but the sacrifice of liquidity accepted by a lender in forgoing money in the present in exchange for money in the future. For Keynes the existence of a margin between the liquidity of cash and the rate of interest is the essence of what interest is all about. Although Hawtrey thought that the idea of liquidity preference was an important contribution to monetary theory, he rejected the idea that liquidity preference is the essence of interest. Instead, he viewed liquidity preference as an independent constraint that might prevent the interest rate, determined, in part, by other forces, from falling to a level as low as it might otherwise.

Let’s have a look at Keynes’s argument that liquidity preference is what determines the rate of interest. Keynes begins Chapter 7 of the General Theory with the following statement:

In the previous chapter saving and investment have been so defined that they are necessarily equal in amount, being, for the community as a whole, merely different aspect of the same thing.

Because savings and investment (in the aggregate) are merely different names for the same thing, both equaling the unconsumed portion of total income, Keynes argued that any theory of interest — in particular what Keynes called the classical or orthodox theory of interest — in which the rate of interest is that rate at which savings and investment are equal is futile and circular. How can the rate of interest be said to equilibrate savings and investment, when savings and investment are necessarily equal? The function of the rate of interest, Keynes concluded, must be determined by something other than equilibrating savings and investment.

To find what it is that the rate of interest is equilibrating, Keynes undertook a brilliant analysis of own rates of interest in chapter 13 of the General Theory. Corresponding to every commodity or asset that can be held into the future, there is an own rate of interest which corresponds to the rate at which a unit of the asset can be exchanged today for a unit in the future. The money rate of interest is simply the own rate of interest in terms of money. In equilibrium, the expected net rate of return, including the service flow or the physical yield of the asset, storage costs, and expected appreciation or depreciation, must be equalized. Keynes believed that money, because it provides liquidity services, must be associated with a liquidity premium, and that this liquidity premium implied that the rate of return from holding money (exclusive of its liquidity services) had to be correspondingly less than the expected net rate of return on holding other assets. For some reason, Keynes concluded that it was the liquidity premium that explained why the own rate of interest on real assets had to be positive. The rate of interest, Keynes asserted, was not the reward for foregoing consumption, i.e., carrying an asset forward from the current period to the next period; it is the reward for foregoing liquidity. But that is clearly false. The liquidity premium explains why there is a difference between the rate of return from holding a real asset that provides no liquidity services and the rate of return from holding money. It does not explain what the equilibrium expected net rate of return from holding any asset is what it is. Somehow Keynes missed that obvious distinction.

Equally as puzzling is that Keynes also argued that there is an economic mechanism operating to ensure the equality of savings and investment, just as there is an economic mechanism (namely price adjustment) operating to ensure the equality of aggregate purchases and sales. Just as price adjusts to equilibrate purchases and sales, income adjusts to equilibrate savings and investment.

Keynes argued himself into a corner, and in his review of the General Theory, Hawtrey caught him there and pummeled him.

The identity of saving and investment may be compared to the identity of two sides of an account.

Identity so established does not prove anything. The idea that a tendency for saving and investment so defined to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system; it can only strain Keynes’s vocabulary.

Thus, Keynes’s premise that it is income, not the rate of interest, which equilibrates saving and investment was based on a logical misconception. Now to be sure, Keynes was correct in pointing out that variations in income also affect saving and investment. But that just means that income, savings, investment, the demand for money and the supply of money and the rate of interest are simultaneously determined in a macroeconomic model, a model that cannot be partitioned in such a way investment and saving depend exclusively on income and are completely independent of the rate of interest. Whatever the shortcomings of the Hicksian IS-LM model, it at least recognized that the variables in the model are simultaneously, not sequentially, determined. That Keynes, who was a highly competent and skilled mathematician, author of one of the most important works ever written on probability theory, seems to have been oblivious to this simple distinction is hugely perplexing.

In 1937, a year after publishing the General Theory, Keynes wrote an article “Alternative Theories of the Rate of Interest” in which he defended his liquidity-preference theory of interest against the alternative theories of interest of Ohlin, Robertson, and Hawtrey in which the rate of interest was conceived as the price of credit. Responding to Hawtrey’s criticism of his attempt to define aggregate investment and aggregate savings as different aspects of the same thing while also using their equality as an equilibrium condition that determines what the equilibrium level of income is, Keynes returned again to a comparison between the identity of investment and savings and the identity of purchases and sales:

Aggregate saving and aggregate investment . . . are necessarily equal in the same way in which the aggregate purchases of anything on the market are equal to the aggregate sales. But this does not mean that “buying” and “selling” are identical terms, and that the laws of supply and demand are meaningless.

Keynes went on to explain the relationship between his view that saving and investment are equilibrated by income and his view of what determines the rate of interest.

[T]he . . . novelty lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments which lead up to this initial conclusion are independent of my subsequent theory of the rate of interest, and in fact I reached it before I had reached the latter theory. But the result of it was to leave the rate of interest in the air. If the rate of interest in not determined by saving and investment in the same way in which price is determined by supply and demand, how is it determined? One naturally began by supposing that the rate of interest must be determined in some sense by productivity – that it was, perhaps, simply the monetary equivalent of the marginal efficiency of capital, the latter being independently fixed by physical and technical considerations in conjunction with expected demand. It was only when this line of approach led repeatedly to what seemed to be circular reasoning, that I hit on what I now think to be the true explanation. The resulting theory, whether right or wrong, is exceedingly simply – namely, that the rate of interest on a loan of given quality and maturity has to be established at the level which, in the opinion of those who have the opportunity of choice – i.e., of wealth-holders – equalises the attractions of holding idle cash and of holding the loan. It would be true to say that this by itself does not carry us very far. But it gives us firm and intelligible ground from which to proceed.

The concluding sentence seems to convey some intuition on Keynes’s part of how inadequate his liquidity-preference theory is as a theory of the rate of interest. But if he had thought the matter through to the bottom, he could not have claimed even that much for it.

Here is Hawtrey’s response to Keynes’s attempt to defend his position.

The part of Mr. Keynes’ article . . . which refers to my book Capital and Employment is concerned mainly with questions of terminology. He finds fault with my statement that he has defined saving and investment as “two different names for the same thing.” He himself describes them as being “for the community as a whole, merely different aspects of the same thing ” . . . . If, as I suppose, we both mean the same thing by the same thing, the distinction is rather a fine one. In Capital and Employment . . . I point out that the identity of . . . saving and investment . . . “is not a purely verbal proposition: it is an arithmetical identity, comparable to two sides of an account.”

Something very like that seems to be in Mr. Keynes’ mind when he compares the relation between saving and investment to that between purchases and sales. Purchases and sales are necessarily equal, but “this does not mean that buying and selling are identical terms, and that the laws of supply and demand are meaningless.”

Purchases and sales are also “different aspects of the same thing.” And surely, if demand were defined to mean purchases and supply to mean sales, any proposition about economic forces tending to make demand and supply equal, or about their equality being a condition of equilibrium, or indeed a condition of anything whatever, would be nonsense.

“The theory of the rate of interest which prevailed before 1914,” Mr. Keynes writes, “regarded it as the factor which ensured equality between saving and investment,” and he claims therefore that, “in maintaining the equality of saving and investment,” he is “returning to old-fashioned orthodoxy.” That is not so. Old-fashioned orthodoxy never held that saving and investment could not be unequal; it held that their inequality, when it did occur, was inconsistent with equilibrium. If they are defined as “different aspects of the same thing,” how can it possibly be “the level of incomes which ensures equality between saving and investment”? Whatever the level of incomes may be, and however great the disequilibrium, the condition that saving and investment must be equal is always identically satisfied.

While it is widely recognized that Hawtrey showed that Keynes’s attempt to define investment and savings as different aspects of the same thing and as a condition of equilibrium was untenable (a criticism made by others like Haberler and Robertson as well), the fallacy committed by Keynes was not a fatal one, though the fallacy has not been entirely extirpated from textbook expositions of the basic Keynesian model. Unfortunately, the related fallacy underlying Keynes’s attempt to transform his liquidity-preference theory of the demand for money into a full-fledged theory of the rate of interest was not as easily exposed. In his review, Hawtrey discussed various limitations of Keynes’s own-rate analysis, but, unless I have missed it, he failed to see the fallacy in supposing that liquidity premium on money explains the equilibrium net return from holding assets, which is what the real (or natural) rate of interest corresponds to in the analytical framework of chapter 13 of the General Theory.


16 Responses to “Hawtrey v. Keynes on the General Theory and the Rate of Interest”

  1. 1 Bob Storgenson March 13, 2014 at 4:31 pm

    It sounds as if Keynes and the others were tripping over the vocabulary and the abstract concepts in more than one way.

    I am constantly amazed at the technical aspects in some fields of study that always seem to draw people in deeper and deeper until they are like Trekkies arguing about Klingon mating rituals, forgetting or losing their ability to keep things in a proper perspective, i.e. trying to force reality into the model even when it doesn’t fit or work as conceived, forgetting all the other variables in a sort of tunnel vision, or things like that.

    As far as I’m concerned, interest isn’t caused by everyone suddenly realizing that a formula needs to be followed to determine the rate.
    That is too surreal.

    No, I think interest is caused, in the end, by nothing but greed and ignorance.
    Liquidity, in my useless opinion, has nothing to do with what rate some greedy lender will charge.
    They can be cash-rich or poor and still lend the money at a rate they want, no reason, formula, or logic required.
    Just greed and ignorance.
    Their supply of money is virtually endless, since they can use future lending needs as a basis for acquiring more cash, but the end user never has that option.

    That’s another reason to deny people equal access to credit.
    They need someone at the end of the chain even though it’s all imaginary and there’s no reason why there has to be a chain set up that way.
    It’s all arbitrary with terminology that does not always label the right things in the right way to help confuse things further.

    If I didn’t know any better I’d say some of those people were being confusing and confused on purpose, lest the proletariat realize what a large fraud the whole mess is and how it’s been deliberately set up to drain them of every penny.
    Yeah, couldn’t possibly be the case. Right.


  2. 2 cantillonblog March 13, 2014 at 5:35 pm

    Hi David.

    I hope you’re well.

    It has been approaching twenty years since I last looked at these questions, but in the end, is it not the case that the General Theory must be seen as in fact a rather special theory developed to suit the particular conditions of the time, and to be rhetorically persuasive in this context. It’s notable that it is a very unclear piece of work in relation to Keynes’s other work and usually I have observed in life that when writing is unclear it reflects either genuine confusion on the part of the writer, or in part an attempt to deceive. Who may know what the balance was here.

    But writing as both a student and practitioner of financial markets, I think that in particular, in depression type conditions, the only thing that matters is liquidity. Time preference is neither here nor there when compared to that most powerful force in the universe: necessity.

    We saw this in credit market (US corporate bonds) pricing in Nov 2008 – Mar 2009. According to personal correspondence at that time with Gerard Minack at Morgan Stanley (I am not a credit specialist), markets priced in a worse default scenario than the 1930s. It is well known that price makes news, and certainly there were many headlines speaking of armageddon ahead. But I don’t believe that was actually what market participants believed – the pricing reflected the fact that people needed to sell, and that was the price at which the market would clear.

    At that time, time preference was completely irrelevant for market pricing.

    Because the episode of fear passed quickly in financial markets (although we Pigou’s giant remains quite tall when it comes to the real economy), the direct impact on savings and investment was somewhat limited. (When I say quickly, I mean that global wealth peaked in July 2008, and bottomed Jan 2009).

    But imagine these stressed levels had persisted for years. In that case one could understand the relevance of a conception of the interest rate as being determined primarily by liquidity preference, and also that income adjusted to equilibrate planned savings and investment.

    Keynes doesn’t make the proper distinctions between different regimes, and different kinds of interest rate. Perhaps that suited his rhetorical purpose.


  3. 3 andrew lainton March 14, 2014 at 1:40 am

    David, good article on a key and sadly today little studied aspect of economic theory. …But Keynes is sometimes wrong (including on liquidity preference for reasons you state succinctly) but he was never stupid and never missed the obvious. The key theoretical break with ‘classical’ thinking, including Keyne’s own in the Theory of Money was from the influence of Khan, and the discovery of the investment multiplier. Keynes realised that if Khan was right that the ‘classical’ theory of investment was wrong, and if that was wrong so was the classical theories of interest and unemployment. Keynes may not have joined the dots – as the new theory was so revolutionary he had to make marshallian comparative static simplifications to make it understandable and tractible to other economists, but approach was the sign of his genius not of him making an oversight.

    On the S=I ‘identity’ (so called). Only true exposte. Its not an accounting identity in the sense of being true at every moment in time. Rather it is the result of the Kahn formula of how disequilibrium forces must create income, how then liquidity acts as a ‘buffer’ stock and how investment can only come from this non liquid income flow (including credit on the basis of future income). The only person who properly undertood this I think was Kaldor who did the math in process analysis terms of why and how the khan multiplier theory had to be true and why S must equal I in ‘the long run’. Imagine an economy in such long run equilibrium. Then the only shift in interest rates can come only from shifts in the liquidity premium as S=I. It does not by itself explain the baseline rate of interest, it is imcomplete as a total theory of interest as Bohm-Bawerk might have put it, but Keynes purpose was to explain what happened when teh economy is not in equilibrium and how this could lead to prolonged – theoretically potentially permanent, periods of partial equilibrium,with high unemployment. This is where I think Keynes was coming from. Roger Falmer.holds a similar interpretation.

    Sorry would explain more but big tender deadline today.


  4. 4 JKH March 14, 2014 at 4:36 am

    “If they are defined as “different aspects of the same thing,” how can it possibly be “the level of incomes which ensures equality between saving and investment”? Whatever the level of incomes may be, and however great the disequilibrium, the condition that saving and investment must be equal is always identically satisfied.”

    That’s the question I would have.

    If he had said – the level of incomes determines the level of saving and investment (somehow) – that would be more understandable. But that it should determine the outcome of an equality between the two seems contradictory. S = I (globally) should hold at any moment in time simply due to double entry bookkeeping combined with consistent definitions for S and I (e.g. inventory investment adjustments).

    I’ve always found the IS curve in ISLM to be weird for this reason.


  5. 5 David Glasner March 14, 2014 at 9:58 am

    Bob, Not every borrower is as desperate as you suggest. A lot of borrowers have a lot of choices. Why do you assume that it is the most desperate borrower rather than the marginal borrower whose demand determines the rate of interest? Oh, and can you please explain to me why real interest rates have been negative for the past 5 years?

    cantillonblog, Obviously there is a lot of context that one would want to take into account in trying to reconstruct how Keynes arrived at his theory. But in the end Keynes’s theory has to be able withstand scrutiny on its own. I agree that in a market environment in which uncertainty is so overwhelming that no one is willing to commit to any long-term capital investment, the standard analysis of how the rate of interest is determined does not apply. But we need a better framework for that analysis than the one Keynes provided, which is not to say that Keynes has nothing to teach us, just that we can’t assume that it’s all in Keynes.

    Andrew, You have given us a lot to think about, but I need more help in working through your discussion of savings and investment. Do you have some handy references for me to consult?

    JKH, The best discussion of all this is by R.G. Lipsey “The Foundations of the theory of national income: an analysis of some fundamental errors,” originally published in Essays in Honour of Lord Robbins (1972).


  6. 6 am March 14, 2014 at 11:49 am

    What would happen in the world if interest was made illegal and making it illegal was strictly enforced so that it did not happen.

    Where would that leave the banking sector for starters.

    What would happen to inflation.


  7. 7 greghill1000 March 14, 2014 at 8:06 pm

    Hi David,

    Fascinating post with some intriguing comments and enlightening replies, but, that said, I disagree with the thrust of it. I don’t think you’ve reached the deepest layer of Keynes’ thinking about the rate of interest, viz. its interconnection with Keynes’ distinctive understanding of “the choice set.”

    If Keynes thought the rate of interest had “an essential nature or meaning,” as you indicate, then it was that the rate of interest is a measure of our “disquietude.” Money and its close relatives are a refuge from the unknown, a store of value that isn’t subject to tomorrow’s news and doesn’t have to be converted into a means of payment at an unknown price, especially in the event everything goes haywire. If the supply of money is held constant, then an increase in the degree of our “disquietude” will push the rate of interest higher and bond prices lower until all outstanding bonds find willing holders.

    If I grasp your point of view, it is that the rate of interest is “a rate of exchange between cash in the present and cash in the future.” This formulation works for T-Bills and CDs, but not for longer-term bonds the future value of which is unknown.

    You criticize Keynes for not recognizing that “income, savings, investment, the demand for money and the supply of money and the rate of interest are simultaneously determined in a macroeconomic model.” Keynes did write quite a bit about the interconnections among the other macro variables you mention (in both the Treatise and the GT), but he rejected the view that these values are all “simultaneously determined” (just as, I believe, he’d reject rational expectations and competitive equilibrium as the best building blocks of a macro theory that explains real world around us).

    I suspect that Keynes’ theory might be more appealing to you if, as you, yourself, suggest, Keynes’ had a wider conceptual vocabulary, say, one that included ex ante and ex post.


  8. 8 andrew lainton March 15, 2014 at 12:23 am

    David, thats a tough one as after chewing the cud on this issue in discussions with others Im not sure the papers on this have even been written yet. Last year I wrote a (sketchy) paper http://andrewlainton.wordpress.com/2013/07/26/a-simple-post-keynesian-alternative-to-is-lm/ trying to replace the IS icurve with a one which was much more ‘hawtryian’ in its approach towards money, and afterwards released that Keynes was well ahead of us all on the issue of liquidity preference and it needed to be redone (not yet even started).

    On the I=S identity. Much recent work on monetary identities has been done by the Fields institute on Montreal (a mathematical research institution) with professor Matheus Grasselli collaborating with Steve Keen – a book is currently being written. Recasts economics maths using lebesque integration, implying that Says Law and Walras law equations need to be rewritten, suspect it will have quite an impact when finally out if it is understood! . You can get a simple flavour of this here
    http://www.youtube.com/watch?feature=player_embedded&v=qL-GUcJY4Mo#t=1130 and here, http://www.youtube.com/watch?v=_qcXR5P3rck&feature=plcp and Nick Rowe of all people coming to the same conclusion. http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/08/what-steve-keen-is-maybe-trying-to-say.html

    On Kahns influence on Keyes and the Circus – huge literature Im sure you know well. For example http://w3.uniroma1.it/marcuzzo/pdf/CollaborationKKGeneralTheory.pdf
    I dont think this has got the issue of savings, the multiplier and S I disequilibrium sorted out though which is where Kaldor comes in.

    Kaldor – he wrote half a dozen key papers on this theme. The main ones relating to the multiplier and the revolving fund of finance argument are summed up in this paper https://researcharchive.lincoln.ac.nz/bitstream/10182/1039/3/cd_dp_8.pdf

    Kaldors disequilibrium savings and growth models see Kaldor 1950 Essays in Value and Disatribution and many subsequent papers and books.

    And of course Pasinetti’s subsequent refinements.

    Om partial/general EQ and unemployment see http://andrewlainton.wordpress.com/2014/01/27/general-equilibrium-and-people-production-factories/ and http://rogerfarmerblog.blogspot.ae/2014/01/old-keynesian-economics-and-equilibrium.html but I would not go as far as you or flamer on the simultaneity issue, as people clearly have to earn a budget before it becomes a budget constraint – the point made above.

    The problem is pulling all of this together in a coherent framework. There was a flurry of activity in this field in the 1970s, then Lucas came along and until very recently nothing, as economics was led by him up a blind ally.


  9. 9 HJC March 16, 2014 at 8:05 pm

    One of the problems that Keynes ran into was that S equals I ex post over any time-frame, no matter how small. So his multiplier concept, which was supposed to explain where the required savings for equality are generated, didn’t really seem to work fast enough. But the basic idea was that income would adjust so that the desired level of savings matched that which was created by the actual level of investment. Unfortunately the interest rate determined by liquidity preference may be too high to ensure enough investment for full employment.

    Andrew, I am intrigued as to how Lebesgue integrals would useful in relation to Say’s or Walras’ Laws. Do you know of any papers (not videos)?


  10. 10 Michael Gill March 17, 2014 at 1:27 am

    In the case of the equality of savings and investment in the General Theory model, as Andrew Lainton points out above, a buffer is provided by liquidity, that is of money doing its job of enabling individual decision makers to decide separately on savings and investment without having to meet up and arrange individual contracts, in the same way that a barter economy would require individuals to meet up to exchange goods. The economy will however constantly be evolving towards identity, but of course never actually getting there, as things move on. Keynes was only claiming identity in a static model. This argument could have been his counter to HJC’s reference to a concern that the multiplier doesn’t work fast enough. It doesn’t need to, as liquidity will take the strain.

    It may therefore be the case that in some sense Keynes was overstating the strength of the link between the savings and investment, but his purpose, as HJC says, was to develop the direction of causality. In the General Theory he separately describes savings as both a “determinate” of the system, and alternatively as “a residual”. It may be that, in specifying national income from the perspective of the entrepreneur, he wished to emphasise that in his model it is entrepreneurial decisions over the maintenance of capital asset positions that drives what the level of savings must therefore also be.

    This point was reinforced by his suggestion that this issue be thought of in terms of the decision to consume (or not to consume) rather than to save, because consumption, like investment is a “determinant” of the system rather than a determinate.

    On a personal note as a first time contributor here, I am delighted, being an occasional and amateur observer of the history of economic thought, to have come across this highly informative blog. I look forward to catching up on some previous material.


  11. 11 Tom Brown March 17, 2014 at 1:31 am

    Lebesque integration… I haven’t seen that since grad school, and it’s come up three times now w/in the past week!… plus I saw this pi-day anti-pi rant that touches on the idea behind it:


  12. 12 andrew lainton March 17, 2014 at 8:42 pm

    HJC, its to do with how Lebesque integration can cope with the issue of ‘discontinuous’ creation of assets (including money and QE) ex nilio. using it you can see that ex ante and ex post identities need not be the same rather like a computer coding S=S+x type equations become possible. It explains why Basil Morre got it wrong about the multiplier, why MMTrs used to be wrong about credit creation and demand (though the key figures seem to have been converted to the new math approach following the fields institute seminar last year). Using the Cathedoris Theorum ANY formula using conventional integration can be converted to Lebesque. It also gets over all of the hang ups over continuous and discontinous time form equations. You simply use continuous time for everything in a consistent double entry framework.
    The problem is its like 1936 in terms of monetary theory. Lots of new ideas but the papers not written up yet and all the connections not made, so have to be expressed verbally. I have a diagram somewhere on my website inn a debate woth Pontus Rendall on this issue which explains the monetary issue rather well – http://andrewlainton.wordpress.com/2012/12/06/some-notes-on-pontus-rendahls-review-of-keensian-economics/.


  13. 13 HJC March 18, 2014 at 3:17 am

    Thanks Andrew that’s plenty to be looking at for now.


  14. 14 Shahid March 19, 2014 at 12:51 pm


    A fascinating description of highly intellectual debate between two greats of economic history. But to realize that the world once saw such debates in plain English without the use of over-the-top math and econometric’s makes me a bit sad because we rarely see debates of such caliber and clarity nowadays (and in plain English, there for the understanding of everybody).

    Before i state my thoughts, i have a simple query in mind. Rate of Interest is an important component of today’s economic activity, but how did ‘interest’ arise in the first place? What’s the history of this concept, and can this history help us understand today’s nature of interest, its role and its movements? In this regard, i am reminded of one of your blogs that concerned the rise of ‘money’. That was also a truly informative blog with lot’s of historical insights, and the implication of those insights for today’s nature of money. Is there literature out there that can help one understand the evolution of interest? I am sure that if one analyses these aspects of history, we could be in for some really interesting stuff on this subject.

    To be honest i’ve done a bit of reading (historical) on this stuff from various sources. Here’s what i understand about the formation of ‘interest’. Ever since the days of recorded history of humanity, our exchanges have had an element of interest in it. That ‘interest’ was mainly in the form of price one had to pay for getting possession of something valuable. Why get something valuable. Well the obvious answer was to fulfill the immediate ‘needs’. But a further, and more deserving candidate in this regard, was that there was a realization that a possession that was valuable because it could be used to create even more value, which in turn enhanced the quantity of possessions. For example, in the Babylonian/Assyrian periods, its common to come across the example of an ox (or two) being exchanged for much larger quantity of other goods. Why? Because ox were more valuable (partly due to scarcity),were worth it since they could be used to till land and realize produce from it, which only added to valuable possessions. Therefore, there was an implicit ‘interest’ (or price) to pay for getting an Ox. And this also kind of debunks the myth of many who believe that no interest were to be found in barter exchanges. It’s just that at that time, nobody put a percentage or mathematical number on it. Otherwise, there was definitely a price to pay for getting one’s hand on a valuable possession. That price was ‘interest’. In this particular story, the rise of interest has more to with ‘needs’ and a wish to accumulate more.

    But there have also been reality ‘checks’, one’s that have led to variations in rate of interest since known human history. These take two forms: obligations (a person has to pay back more than what he got) and constraints/uncertainty (i got the Ox, but what if the output is destroyed or turns out to be bad? Naturally, i won’t be able to get my hands on more).

    Let’s now jump to the present (sorry for leaving out the period in between. But this just ain’t the place for a longer discussion). David mentioned negative real interest rates in the last five years. Now think in terms of what i stated above. Paper notes (and its substitutes) are a valuable possession (they provide liquidity,and can be used to create more wealth, primarily in the form of investment). So why,despite almost zero nominal interest rate, people just don’t grasp them and make use of them to create more wealth? Well, the same ‘checks’. Individuals still have needs, but majority of Americans are in debt (an obligation to pay). Moreover, in lieu of the sluggish economic growth and job market, there is uncertainty on the part of consumer (why should i take on more debt when i am already indebted with an uncertain future) and producers (why should i invest more when there is so much uncertainty and probability of deflation). Therefore, there is little demand for a valuable asset like money, which would explain the very low nominal interest rates.

    Perhaps readers will find my discussion a bit aside form the topic. But my point is that to understand what Keynes what Keynes and Hawtrey were arguing about, it’s essential to understand interest, its nature, its role and why a disequilibrium may ensue due to its variations?. Aside from income or returns from other assets, i believe one has to look at the psychological basis of decision making of various actors in the economy to understand the complex relationship between the mentioned variables in David’s articles. I believe Keynes termed them as ‘animal spirits’, but he never got around to properly using them as a probable explanation for interest, S and I, disequilibrium, etc.

    And oh, i also wanted to engage in some intellectual debate, the kind that went on between Keynes and Hawtrey :-). Hope i don’t bore the reader.


  15. 15 Blue Aurora March 28, 2014 at 7:03 pm

    Since you mentioned A Treatise on Probability, David Glasner…I don’t think J.M. Keynes was “oblivious” of the point you made, sir. I think that J.M. Keynes clearly recognised that John R. Hicks’s IS/LM model was a flawed simple model, but acquiesced with it because it was half-right.

    But since we are also on the subject of the rate of interest…have you read Stephen F. LeRoy’s article in the Fall 1983 edition of History of Political Economy? It demonstrates how nuanced and sophisticated J.M. Keynes’s concept of the Marginal Efficiency of Capital really is, once translated from English into mathematics. Perhaps it might help you understand things in The General Theory better.


    One last thing…wasn’t R.G. Hawtrey really fond of Chapter XVII of The General Theory? IIRC, he was. On that related note, I would like to remind you that Chapters XII to XVII of The General Theory all deal with the rate of interest and its impact upon investment in the economy as a whole. (There is also a footnote in Chapter XV of The General Theory which in turn refers to Chapter XXI – I believe you might find this to be helpful.)


  16. 16 Bob Storgenson April 3, 2014 at 10:44 pm

    Dave, I guess I didn’t inspire your imagination in the direction I was hoping for, but that’s okay, I don’t always express myself very well.
    Perhaps that is what happened here.

    Banks can get cash virtually interest free.
    Now show me the man on the street who can do the same thing.
    You say we all have the same choices as a bank?
    Really? We all have tons of choices?
    You can’t be serious.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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