Archive for the 'liquidity preference' Category

Irving Fisher Demolishes the Loanable-Funds Theory of Interest

In some recent posts (here, here and here) I have discussed the inappropriate application of partial-equilibrium analysis (aka supply-demand analysis) when the conditions under which the ceteris paribus assumption underlying partial-equilibrium analysis are not satisfied. The two examples of inappropriate application of partial equilibrium analysis I have mentioned were: 1) drawing a supply curve of labor and demand curve for labor to explain aggregate unemployment in the economy, and 2) drawing a supply curve of loanable funds and a demand curve for loanable funds to explain the rate of interest. In neither case can one assume that a change in the wage of labor or in the rate of interest can occur without at the same time causing the demand curve and the supply curve to shift from their original position to a new one. Because of the feedback effects from a change in the wage or a change in the rate of interest inevitably cause the demand and supply curves to shift, the standard supply-and-demand analysis breaks down in the face of such feedback effects.

I pointed out that while Keynes correctly observed that demand-and-supply analysis of the labor market was inappropriate, it is puzzling that it did not occur to him that demand-and-supply analysis could not be used to explain the rate of interest.

Keynes explained the rate of interest as a measure of the liquidity premium commanded by holders of money for parting with liquidity when lending money to a borrower. That view is sometimes contrasted with Fisher’s explanation of the rate interest as a measure of the productivity of capital in shifting output from the present to the future and the time preference of individuals for consuming in the present rather waiting to consume in the future. Sometimes the Fisherian theory of the rate of interest is juxtaposed with the Keynesian theory by contrasting the liquidity preference theory with a loanable-funds theory. But that contrast between liquidity preference and loanable funds misrepresents Fisher’s view, because a loanable funds theory is also an inappropriate misapplication of partial-equilibrium analysis when general-equilibrium anlaysis is required.

I recently came upon a passage from Fisher’s classic 1907 treatise, The Rate of Interest: Its Nature, Determination and Relation to Economic Phenomena, which explicitly rejects supply-demand analysis of the market for loanable funds as a useful way of explaining the rate of interest. Here is how Fisher made that fundamental point.

If a modern business man is asked what determines the rate of interest, he may usually be expected to answer, “the supply and demand of loanable money.” But “supply and demand” is a phrase which has been too often into service to cover up difficult problems. Even economists have been prone to employ it to describe economic causation which they could not unravel. It was once wittily remarked of the early writers on economic problems, “Catch a parrot and teach him to say ‘supply and demand,’ and you have an excellent economist.” Prices, wages, rent, interest, and profits were thought to be fully “explained” by this glib phrase. It is true that every ratio of exchange is due to the resultant of causes operating on the buyer and seller, and we may classify these as “demand” and supply.” But this fact does not relieve us of the necessity of examining specifically the two sets of causes, including utility in its effect on demand, and cost in its effect on supply. Consequently, when we say that the rate of interest is due to the supply and demand of “capital” or of “money” or of “loans,” we are very far from having an adequate explanation. It is true that when merchants seek to discount bills at a bank in large numbers and for large amounts, the rate of interest will tend to be low. But we must inquire for what purposes and from what causes merchants thus apply to a bank for the discount of loans and others supply the bank with the funds to be loaned. The real problem is: What causes make the demand for loans and what causes make the supply? This question is not answered by the summary “supply and demand” theory. The explanation is not simply that those who have little capital demand them. In fact, the contrary is often the case. The depositors in savings banks are the lenders, and they are usually poor, whereas those to whom the savings bank in turn lends the funds are relatively rich. (pp. 6-7)

Keynes on the Theory of the Rate of Interest

I have been writing recently about Keynes and his theory of the rate of interest (here, here, here, and here). Perhaps unjustly – but perhaps not — I attribute to him a theory in which the rate of interest is determined exclusively by monetary forces: the interaction of the liquidity preference of the public with the policy of the monetary authorities. In other words, the rate of interest, at least as an approximation, can be modeled in terms of a single market for holding money, the demand to hold money reflecting the liquidity preference of the public and the stock of money being directly controlled by the monetary authority. Because liquidity preference is a function of the rate of interest, the rate of interest adjusts until the stock of money made available by the monetary authority is held willingly by the public.

I have been struggling with Keynes’s liquidity preference theory of interest, which evidently led him to deny the Fisher effect, thus denying that there is a margin of substitution between holding money and holding real assets, because he explicitly recognizes in Chapter 17 of the General Theory that there is a margin of substitution between money and real assets, the expected net returns from holding all assets (including expected appreciation and the net service flows generated by the assets) being equal in equilibrium. And it was that logic which led Keynes to one of his most important pre-General Theory contributions — the covered-interest-arbitrage theorem in chapter 3 of his Tract on Monetary Reform. The equality of expected returns on all assets was the key to Irving Fisher’s 1896 derivation of the Fisher Effect in Appreciation and Interest, restated in 1907 in The Rate of Interest, and in 1930 in The Theory of Interest.

Fisher never asserted that there is complete adjustment of nominal interest rates to expected inflation, actually providing empirical evidence that the adjustment of nominal rates to inflation was only partial, but he did show that in equilibrium a difference in the expected rate of appreciation between alternative assets must correspond to differences in the rates of interest on loans contracted in terms of the two assets. Now there is a difference between the static relationship between the interest rates for two loans contracted in terms of two different assets and a dynamic adjustment in time to a change in the expected rate of appreciation or depreciation of a given asset. The dynamic adjustment does not necessarily coincide with the static relationship.

It is also interesting, as I pointed out in a recent post, that when criticizing the orthodox theory of the rate of interest in the General Theory, Keynes focused not on Fisher, but on his teacher Alfred Marshall as the authoritative representative of the orthodox theory of interest, criticizing Fisher only for the Fisher effect. Keynes reserved is comprehensive criticism for Marshall, attributing to Marshall the notion that rate of interest adjusts to equalize savings and investment. Keynes acknowledged that he could not find textual support in Marshall’s writings for this idea, merely citing his own prior belief that the rate of interest performs that function, consequently attributing a similar belief to Marshall. But even if Marshall did mistakenly believe that the rate of interest adjusts to equalize savings and investment, it does not follow that the orthodox theory of interest is wrong; it just means that Marshall had a defective understanding of the theory. Just because most physicists in the 18th century believed in the phlogiston theory of fire does not prove that classical physics was wrong; it only means that classical physicists had an imperfect understanding of the theory. And if Keynes wanted to establish the content of the most authoritative version of the orthodox theory of interest, he should have been citing Fisher not Marshall.

That is why I wanted to have a look at a not very well known paper by Keynes called “The Theory of the Rate of Interest,” written for a 1937 festschrift in honor of Irving Fisher, The Lessons of Monetary Experience. Keynes began the paper with the following footnote attached to the title acknowledging Fisher as the outstanding authority on the orthodox theory of interest.

I have thought it suitable to offer a short note on this subject in honor of Irving Fisher, since his earliest [presumably Appreciation and Interest, Fisher’s doctoral dissertation] and latest [presumably The Theory of Interest] have been concerned with it, and since during the whole of the thirty years that I have been studying economics he has been the outstanding authority on this problem. (p. 145)

The paper is mostly devoted to spelling out and discussing six propositions that Keynes believes distill the essentials of the orthodox theory of interest. The first four of these propositions Keynes regards as unassailable, but the last two, he maintains, reflect very special, empirically false, assumptions. He therefore replaces them with two substitute propositions, whose implications differ radically from those of orthodox theory. Here are the first four propositions.

1 Interest on money means precisely what the books on arithmetic say it means. . . . [I]t is simply the premium obtainable on current cash over deferred cash, so that it measures the marginal preference . . . for holding cash in hand over cash for deferred delivery. No one would pay this premium unless the possession of cash served some purpose, i.e., has some efficiency. Thus, we can conveniently say that interest on money measures the marginal efficiency of money in terms of itself as a unit.

2 Money is not peculiar in having a marginal efficiency measured in terms of itself. . . . [N]ormally capital assets of all kinds have a positive marginal efficiency measured in terms of themselves. If we know the relation between the present and expected prices of an asset in terms of money we can convert the measure of its marginal efficiency into a measure of its marginal efficiency in terms of money by means of a formula which I have given in my General Theory, p. 227.

3 The effort to obtain the best advantage from the possession of wealth will set up a tendency for capital assets to exchange in equilibrium, at values proportional to their marginal efficiencies in terms of a common unit. . . . [I]f r is the money rate of interest . . . and y is the marginal efficiency of a capital asset A in terms of money, then A will exchange in terms of money at a price such as to make y = r.

4 If the demand price of our capital asset A . . . is not less than its replacement cost, new investment in A will take place, the scale of such investment depending on the capacity available for the production of A, i.e., on its elasticity of supply, and on the rate at which y, its marginal efficiency, declines as the amount of new investment in A increases. At a scale of new investment at which the marginal cost of producing A is equal to its demand price as above, we have a position of equilibrium. Thus the price system resulting from the relationships between the marginal efficiencies of different capital assets including money, measured in terms of a common unit, determines the aggregate rate of investment. (p. 145-46)

Keynes sums up the import of his first four propositions as follows:

These proposition are not . . . inconsistent with the orthodox theory . . . or open to doubt. They establish that relative prices . . . and the scale of output move until the marginal efficiencies of all kinds of assets are equal when measured in a common unit and . . . that the marginal efficiency of capital is equal to the rate of interest. But they tell us nothing as to the forces which determine what this common level of marginal efficiency will tend to be. It is when we proceed to this further discussion that my argument diverges from the orthodox argument.

Here is how Keynes describes the divergence between the orthodox theory and his theory:

[T]he orthodox theory maintains that the forces which determine the common value of the marginal efficiency of various assets are independent of money, which has . . . no autonomous influence, and that prices move until the marginal efficiency of money, i.e., the rate of interest, falls into line with the common value of the marginal efficiency of other assets as determined by other forces. My theory . . . maintains that this is a special case and that over a wide range of possible cases almost the opposite is true, namely, that the marginal efficiency of money is determined by forces partly appropriate to itself, and that prices move until the marginal efficiency of other assets fall into line with the rate of interest. (p. 147)

I find Keynes’s description of the difference between the orthodox theory and his own both insightful and problematic. Keynes notes correctly that the orthodox theory, abstracting from all monetary influences, treats the rate of interest as a rate of intertemporal exchange, applicable to exchange between any asset today and any asset in the future, adjusted for differences in rates of appreciation, and in net service flows, across assets. So Keynes was right: the orthodox theory is a special case, corresponding to the special assumptions required for full intertemporal equilibrium. And Keynes was right to emphasize the limitations of the orthodox theory.

But while drawing a sharp contrast between his theory and the orthodox theory (“over a wide range of possible cases almost the opposite is true”), Keynes, to qualify his disagreement, deploys the italicized (by me) weasel words, but without explaining how his seemingly flat rejection of the orthodox theory requires qualification. It is certainly reasonable to say “that the marginal efficiency of capital is determined by forces partly appropriate to itself.” But I don’t see how it follows from that premise “that prices move until the marginal efficiency of other assets fall into line with the rate of interest.” Equilibrium is reached when marginal efficiencies (adjusted for differences in expected rates of appreciation and in net services flows) of all assets are equal, but rejecting the orthodox notion that the marginal efficiency of money adjusts to the common marginal efficiency of all other assets does not establish that the causality is reversed: that the marginal efficiencies of all non-money assets must adjust to whatever the marginal efficiency of money happens to be. The reverse causality also seems like a special case; the general case, it would seem, would be one in which causality could operate, depending on circumstances, in either direction or both directions. An argument about the direction of causality would have been appropriate, but none is made. Keynes just moves on to propositions 5 and 6.

5 The marginal efficiency of money in terms of itself has the peculiarity that it is independent of its quantity. . . . This is a consequence of the Quantity Theory of Money . . . Thus, unless we import considerations from outside, the money rate of interest is indeterminate, for the demand schedule for money is a function solely of its supply [sic, presumably Keynes meant to say “quantity”]. Nevertheless, a determinate value for r can be derived from the condition that the value of an asset A, of which the marginal efficiency in terms of money is y, must be such that y = r. For provided that we know the scale of investment, we know y and the value of A, and hence we can deduce r. In other words, the rate of interest depends on the marginal efficiency of capital assets other than money. This must, however, be supplemented by another proposition; for it requires that we should already know the scale of investment. (p. 147-48)

I pause here, because I am confused. Keynes alludes to the proposition that the neutrality of money implies that any nominal interest rate is compatible with any real interest rate provided that the rate of inflation is correctly anticipated, though without articulating the proposition correctly. Despite getting off to a shaky start with a sloppy allusion to the Fisher effect, Keynes is right in observing that the neutrality of money and the independence of the real rate of interest from monetary factors are extreme assumptions. Given that monetary neutrality is consistent with any nominal interest rate, Keynes then tries to show how the orthodox theory pins down the nominal interest rate. And his attempt does not seem successful; he asserts that the money rate of interest can be deduced from the marginal efficiency of some capital asset A in terms of money. But that marginal efficiency cannot be deduced without knowledge, or an expectation, of the future value of the asset. Instead of couching his analysis in terms of the current and (expected) future values of the asset, i.e., instead of following Fisher’s 1896 own-rate analysis, Keynes brings up the scale of investment in A: “This must . . . be supplemented by another proposition; for it requires that we should already know the scale of investment.” Aside from not knowing what “this” and “it” are referring to, I don’t understand how the scale of investment is relevant to a determination of the marginal efficiency of the capital asset in question.

Now for Keynes’s final proposition:

6 The scale of investment will not reach its equilibrium level until the point is reached at which the elasticity of supply of output as a whole has fallen to zero. (p. 148)

The puzzle only deepens here because proposition 5 is referring to the scale of investment in a particular asset A while proposition 6 seems to be referring to the scale of investment in the aggregate. It is neither a necessary nor a sufficient condition for an equilibrium scale of investment in a particular capital asset to obtain that the elasticity of supply of output as a whole be zero. So the connection between propositions 5 and 6 seems tenuous and superficial. Does Keynes mean to say that, according to orthodox theory, the equality of advantage to asset holders between different kinds of assets cannot be achieved unless the elasticity of supply for output as a whole is zero? Keynes then offers a synthetic restatement of orthodox theory.

The equilibrium rate of aggregate investment, corresponding to the level of output for a further increase in which the elasticity of supply is zero, depends on the readiness of the public to save. But this in turn depends on the rate of interest. Thus for each level of the rate of interest we have a given quantity of saving. This quantity of saving determines the scale of investment. The scale of investment settles the marginal efficiency of capital, to which the rate of interest must be equal. Our system is therefore determinate. To each possible value of the rate of interest there corresponds a given volume of saving; and to each possible value of the marginal efficiency of capital there corresponds a given volume of investment. Now the rate of interest and the marginal efficiency of capital must be equal. Thus the position of equilibrium is given by that common value of the rate of interest and of the marginal efficiency of capital at which saving determined by the former is equal to the investment determined by the latter. (Id.)

This restatement of orthodox theory is remarkably disconnected from the six propositions that Keynes has just identified as the bedrock of the orthodox theory of interest. The word “saving” or “save” is not even mentioned in any of Keynes’s six propositions, so the notion that the orthodox theory asserts that the rate of interest adjusts to equalize saving and investment is inconsistent with his own rendering of the orthodox theory. The rhetorical point that Keynes seems to be making in the form of a strictly analytical discussion is that the orthodox theory held that the equilibrium of an economic system occurs at the rate of interest that equalizes savings and investment at a level of output and income consistent with full employment. Where Keynes was misguided was in characterizing the mechanism by which this equilibrium is reached as an adjustment in the nominal rate of interest. A full equilibrium is achieved by way of a vector of prices (and expected prices) consistent with equilibrium, the rate of interest being implicit in the intertemporal structure of a price vector. Keynes was working with a simplistic misconception of what the rate of interest actually represents and how it affects economic activity.

In place of propositions 5 and 6, which Keynes dismisses as special factual assumptions, he proposes two alternative propositions:

5* The marginal efficiency of money in terms of itself is . . . a function of its quantity (though not of its quantity alone), just as in the case of capital assets.

6* Aggregate investment may reach its equilibrium rate under proposition (4) above, before the elasticity of supply of output as a whole has fallen to zero. (Id.)

So in substituting 5* for 5, all Keynes did was discard a proposition that few if any economists — certainly not Fisher — upholding the orthodox theory ever would have accepted as a factual assertion. The two paragraphs that Keynes devotes to refuting proposition 5 can be safely ignored at almost zero cost. Turning to proposition 6, Keynes restates it as follows:

A zero elasticity of supply for output as a whole means that an increase of demand in terms of money will lead to no change in output; that is to say, prices will rise in the same proportion as the money demand [i.e., nominal aggregate demand, not the demand to hold money] rises. Inflation will have no effect on output or employment, but only on prices. (pp. 149-50)

So, propositions 5 and 6 turn out to be equivalent assertions that money is neutral. Having devoted two separate propositions to identify the orthodox theory of interest with the idea that money is neutral, Keynes spells out the lessons he draws from his reconstruction of the orthodox theory of the rate of interest.

If I am right, the orthodox theory is wholly inapplicable to such problems as those of unemployment and the trade cycle, or, indeed, to any of the day-to-day problems of ordinary life. Nevertheless it is often in fact applied to such problems. . . .

It leads to considerable difficulties to regard the marginal efficiency of money as wholly different in character from the marginal efficiency of other assets. Equilibrium requires . . . that the prices of different kinds of assets measured in the same unit move until their marginal efficiencies measured in that unit are equal. But if the marginal efficiency of money in terms of itself is always equal to the marginal efficiency of other assets, irrespective of the price of the latter, the whole price system in terms of money becomes indeterminate. (150-52)

Keynes is attacking a strawman here, because, even given the extreme assumptions about the neutrality of money that hardly anyone – and certainly not Fisher – accepted as factual, the equality between the marginal efficiency of money and the marginal efficiency of other assets is an equilibrium condition, not an identity, so the charge of indeterminacy is mistaken, as Keynes himself unwittingly acknowledges thereafter.

It is the elements of elasticity (a) in the desire to hold inactive balances and (b) in the supply of output as a whole, which permits a reasonable measure of stability in prices. If these elasticities are zero there is a necessity for the whole body of prices and wages to respond immediately to every change in the quantity of money. (p. 152)

So Keynes is acknowledging that the whole price system in terms of money in not indeterminate, just excessively volatile. But let’s hear him out.

This assumes a state of affairs very different from that in which we live. For the two elasticities named above are highly characteristic of the real world; and the assumption that both of them are zero assumes away three-quarters of the problems in which we are interested. (Id.)

Undoubtedly true, but neither Fisher nor most other economists who accepted the orthodox theory of the rate of interest believed either that money is always neutral or that we live in a world of perpetually full employment. Nor did Keynes show that the theoretical resources of orthodox theory were insufficient to analyze situations of less than full employment. The most obvious example of such an analysis, of course, is one in which a restrictive monetary policy, by creating an excess demand for money, raises the liquidity premium, causing the marginal efficiency of money to exceed the marginal efficiency of other assets, in which case asset prices must fall to restore the equality between the marginal efficiencies of assets and of money.

In principle, the adjustment might be relatively smooth, but if the fall of asset prices triggers bankruptcies or other forms of financial distress, and if the increase in interest rates affects spending flows, the fall in asset prices and in spending flows may become cumulative causing a general downward spiral in income and output. Such an analysis is entirely compatible with orthodox theory even if the orthodox theory, in its emphasis on equilibrium, seems very far removed from the messy dynamic adjustment associated with a sudden increase in liquidity preference.

Thinking about Interest and Irving Fisher

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.

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.

Liquidity Trap or Credit Deadlock

In earlier posts in my series about Hawtrey and Keynes, I’ve mentioned the close connection between Hawtrey’s concept of a “credit deadlock” and the better-known Keynesian concept of a “liquidity trap,” a term actually coined by J. R. Hicks in his classic paper summarizing the Keynesian system by way of the IS-LM model. As I’ve previously noted, the two concepts, though similar, are not identical, a characteristic of much of their work on money and business cycles. Their ideas, often very similar, almost always differ in some important way, often leading to sharply different policy implications. Keynes recognized the similarities in their thinking, acknowledging his intellectual debt to Hawtrey several times, but, on occasion, Keynes could not contain his frustration and exasperation with what he felt was Hawtrey’s obstinate refusal to see what he was driving at.

In this post, commenter GDF asked me about the credit deadlock and the liquidity trap:

Would you mind explaining your thoughts apropos of differences between Hawtrey’s credit deadlock theory and Keynes’ liquidity trap. It seems to me that modern liquidity trapists like Krugman, Woodford etc. have more in common with Hawtrey than Keynes in the sense that they deal with low money demand elasticity w.r.t. the short rate rather than high money demand elasticity w.r.t. the long rate.

To which I answered:

My view is that credit deadlock refers to a situation of extreme entrepreneurial pessimism, which I would associate with negative real rates of interest. Keynes’s liquidity trap occurs at positive real rates of interest (not the zero lower bound) because bear bond speculators will not allow the long-term rate to fall below some lower threshold because of the risk of suffering a capital loss on long-term bonds once the interest rate rises. Hawtrey did not think much of this argument.

Subsequently in this post, commenter Rob Rawlings suggested that I write about the credit deadlock and provided a link to a draft of a paper by Roger Sandilands, “Hawtreyan ‘Credit Deadlock’ or Keynesian ‘Liquidity Trap’? Lessons for Japan from the Great Depression” (eventually published as the final chapter in the volume David Laidler’s Contributions to Economics, edited by Robert Leeson, an outstanding collection of papers celebrating one of the greatest economists of our time). In our recent exchange of emails about Hawtrey, Laidler also drew my attention to Sandilands’s paper.

Sandilands’s paper covers an extremely wide range of topics in both the history of economics (mainly about Hawtrey and especially the largely forgotten Laughlin Currie), the history of the Great Depression, and the chronic Japanese deflation and slowdown since the early 1990s. But for this post, the relevant point from Sandilands’s paper is the lengthy quotation with which he concludes from Laidler’s paper, “Woodford and Wicksell on Interest and Prices: The Place of the Pure Credit Economy in the Theory of Monetary Policy.”

To begin with, a “liquidity trap” is a state of affairs in which the demnd for money becomes perfectly elastic with respect to a long rate of interest at some low positive level of the latter. Until the policy of “quantitative easing” was begun in 2001, the ratio of the Japanese money stock to national income, whether money was measured by the base, M1, or any broader aggregate, rose slowly at best, and it was short, not long, rates of interest that were essentially zero. Given these facts, it is hard to see what the empirical basis for the diagnosis of a liquidity trap could have been. On the other hand, and again before 2001, the empirical evidence gave no reason to reject the hypothesis that a quite separate and distinct phenomenon was at work, namely a Hawtreyan “credit deadlock”. Here the problem is not a high elasticity of the economy’s demand for money with respect to the long rate of interest, but a low elasticity of its demand for bank credit with respect to the short rate, which inhibits the borrowing that is a necessary prerequisite for money creation. The solution to a credit deadlock, as Hawtrey pointed out, is vigorous open market operations to bring about increases in the monetary base, and therefore the supply of chequable deposits, that mere manipulation of short term interest rates is usually sufficient to accomplish in less depressed times.

Now the conditions for a liquidity trap might indeed have existed in Japan in the 1990s. Until the credit deadlock affecting its monetary system was broken by quantitative easing in 2001 . . . it was impossible to know this. As it has happened, however, the subsequent vigorous up-turn of the Japanese economy that began in 2002 and is still proceeding is beginning to suggest that there was no liquidity trap at work in that economy. If further evidence bears out this conclusion, a serious policy error was made in the 1990s, and that error was based on a theory of monetary policy that treats the short interest rate as the central bank’s only tool, and characterizes the transmission mechanism as working solely through the influence of interest rates on aggregate demand.

That theory provided no means for Japanese policy makers to distinguish between a liquidity trap, which is a possible feature of the demand for money function, and a credit deadlock which is a characteristic of the money supply process, or for them to entertain the possibility that variations in the money supply might affect aggregate demand by channels over and above any effect on market rates of interest. It was therefore a dangerously defective guide to the conduct of monetary policy in Japan, as it is in any depressed economy.

Laidler is making two important points in this quotation. First, he is distinguishing, a bit more fully than I did in my reply above to GDF, between a credit deadlock and a liquidity trap. The liquidity trap is a property of the demand for money, premised on an empirical hypothesis of Keynes about the existence of bear speculators (afraid of taking capital losses once the long-term rate rises to its normal level) willing to hold unlimited amounts of money rather than long-term bonds, once long-term rates approach some low, but positive, level. But under Keynes’s analysis, there would be no reason why the banking system would not supply the amount of money demanded by bear speculators. In Hawtrey’s credit deadlock, however, the problem is not that the demand to hold money becomes perfectly elastic when the long-term rate reaches some low level, but that, because entrepreneurial expectations are so pessimistic, banks cannot find borrowers to lend to, even if short-term rates fall to zero. Keynes and Hawtrey were positing different causal mechanisms, Keynes focusing on the demand to hold money, Hawtrey on the supply of bank money. (I would note parenthetically that Laidler is leaving out an important distinction between the zero rate at which the central bank is lending to banks and the positive rate — sufficient to cover intermediation costs – at which banks will lend to their customers. The lack of borrowing at the zero lower bound is at least partly a reflection of a disintermediation process that occurs when there is insufficient loan demand to make intermediation by commercial banks profitable.)

Laidler’s second point is an empirical judgment about the Japanese experience in the 1990s and early 2000s. He argues that the relative success of quantitative easing in Japan in the early 2000s shows that Japan was suffering not from a liquidity trap, but from a credit deadlock. That quantitative easing succeeded in Japan after years of stagnation and slow monetary growth suggests to Laidler that the problem in the 1990s was not a liquidity trap, but a credit deadlock. If there was a liquidity trap, why did the unlimited demand to hold cash on the part of bear speculators not elicit a huge increase in the Japanese money supply? In fact, the Japanese money supply increased only modestly in the 1990s. The Japanese recovery in the early 200s coincided with a rapid increase in the money supply in response to open-market purchases by the Bank of Japan.  Quantitative easing worked not through a reduction of interest rates, but through the portfolio effects of increasing the quantity of cash balances in the economy, causing an increase in spending as a way of reducing unwanted cash balances.

How, then, on Laidler’s account, can we explain the feebleness of the US recovery from the 2007-09 downturn, notwithstanding the massive increase in the US monetary base? One possible answer, of course, is that the stimulative effects of increasing the monetary base have been sterilized by the Fed’s policy of paying interest on reserves. The other answer is that increasing the monetary base in a state of credit deadlock can stimulate a recovery only by changing expectations. However, long-term expectations, as reflected in the long-term real interest rates implicit in TIPS spreads, seem to have become more pessimistic since quantitative easing began in 2009. In this context, a passage, quoted by Sandilands, from the 1950 edition of Hawtrey’s Currency and Credit seems highly relevant.

If the banks fail to stimulate short-term borrowing, they can create credit by themselves buying securities in the investment market. The market will seek to use the resources thus placed in it, and it will become more favourable to new flotations and sales of securities. But even so and expansion of the flow of money is not ensured. If the money created is to move and to swell the consumers’ income, the favourable market must evoke additional capital outlay. That is likely to take time and conceivably capital outlay may fail to respond. A deficiency of demand for consumable goods reacts on capital outlay, for when the existing capacity of industries is underemployed, there is little demand for capital outlay to extend capacity. . .

The deadlock then is complete, and, unless it is to continue unbroken till some fortuitous circumstance restarts activity, recourse must be had to directly inflationary expedients, such as government expenditures far in excess of revenue, or a deliberate depreciation of the foreign exchange value of the money unit.


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.

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