The General Theory of Employment, Interest and Money Part 6

The General Theory of Employment, Interest and Money Part 6

THE CLa.s.sICAL THEORY OF THE RATE OF.

INTEREST.

I.

What is the cla.s.sical theory of the rate of interest? It is something upon which we have all been brought up and which we have accepted without much reserve until recently. Yet I find it difficult to state it precisely or to discover an explicit account of it in the leading treatises of the modern cla.s.sical school.

It is fairly clear, however, that this tradition has regarded the rate of interest as the factor which brings the demand for investment and the willingness to save into equilibrium with one another. Investment represents the demand for investible resources and saving represents the supply, whilst the rate of interest is the 'price' of investible resources at which the two are equated. Just as the price of a commodity is necessarily fixed at that point where the demand for it is equal to the supply, so the rate of interest necessarily comes to rest under the play of market forces at the point where the amount of investment at that rate of interest is equal to the amount of saving at that rate.

The above is not to be found in Marshall's Principles in so many words. Yet his theory seems to be this, and it is what I myself was brought up on and what I taught for many years to others. Take, for example, the following pa.s.sage from his Principles: 'Interest, being the price paid for the use of capital in any market, tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming at that rate'. Or again in Professor Ca.s.sel's Nature and Necessity of Interest it is explained that investment const.i.tutes the 'demand for waiting' and saving the 'supply of waiting', whilst interest is a 'price' which serves, it is implied, to equate the two, though here again I have not found actual words to quote. Chapter vi of Professor Carver's Distribution of Wealth clearly envisages interest as the factor which brings into equilibrium the marginal disutility of waiting with the marginal productivity of capital. Sir Alfred Flux (Economic Principles, p. 95) writes: 'If there is justice in the contentions of our general discussion, it must be admitted that an automatic adjustment takes place between saving and the opportunities for employing capital profitably. . . Saving will not have exceeded its possibilities of usefulness. . . so long as the rate of net interest is in excess of zero.' Professor Taussig (Principles, vol. ii. p. 29) draws a supply curve of saving and a demand curve representing 'the diminishing productiveness of the several instalments of capital', having previously stated (p.20) that 'the rate of interest settles at a point where the marginal productivity of capital suffices to bring out the marginal instalment of saving'. Walras, in Appendix I (III) of his elements d'economie pure, where he deals with 'l'echange d'epargnes contre capitaux neufs', argues expressly that, corresponding to each possible rate of interest, there is a sum which individuals will save and also a sum which they will invest in new capital a.s.sets, that these two aggregates tend to equality with one another, and that the rate of interest is the variable which brings them to equality; so that the rate of interest is fixed at the point where saving, which represents the supply of new capital, is equal to the demand for it. Thus he is strictly in the cla.s.sical tradition.

Certainly the ordinary man?banker, civil servant or politician?brought up on the traditional theory, and the trained economist also, has carried away with him the idea that whenever an individual performs an act of saving he has done something which automatically brings down the rate of interest, that this automatically stimulates the output of capital, and that the fall in the rate of interest is just so much as is necessary to stimulate the output of capital to an extent which is equal to the increment of saving; and, further, that this is a self-regulatory process of adjustment which takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority. Similarly?and this is an even more general belief, even to-day?each additional act of investment will necessarily raise the rate of interest, if it is not offset by a change in the readiness to save.

Now the a.n.a.lysis of the previous chapters will have made it plain that this account of the matter must be erroneous. In tracing to its source the reason for the difference of opinion, let us, however, begin with the matters which are agreed.

Unlike the neo-cla.s.sical school, who believe that saving and investment can be actually unequal, the cla.s.sical school proper has accepted the view that they are equal. Marshall, for example, surely believed, although he did not expressly say so, that aggregate saving and aggregate investment are necessarily equal. Indeed, most members of the cla.s.sical school carried this belief much too far; since they held that every act of increased saving by an individual necessarily brings into existence a corresponding act of increased investment. Nor is there any material difference, relevant in this context, between my schedule of the marginal efficiency of capital or investment demand-schedule and the demand curve for capital contemplated by some of the cla.s.sical writers who have been quoted above.

When we come to the propensity to consume and its corollary the propensity to save, we are nearer to a difference of opinion, owing to the emphasis which they have placed on the influence of the rate of interest on the propensity to save. But they would, presumably, not wish to deny that the level of income also has an important influence on the amount saved; whilst I, for my part, would not deny that the rate of interest may perhaps have an influence (though perhaps not of the kind which they suppose) on the amount saved out of a given income. All these points of agreement can be summed up in a proposition which the cla.s.sical school would accept and I should not dispute; namely, that, if the level of income is a.s.sumed to be given, we can infer that the current rate of interest must lie at the point where the demand curve for capital corresponding to different rates of interest cuts the curve of the amounts saved out of the given income corresponding to different rates of interest.

But this is the point at which definite error creeps into the cla.s.sical theory. If the cla.s.sical school merely inferred from the above proposition that, given the demand curve for capital and the influence of changes in the rate of interest on the readiness to save out of given incomes, the level of income and the rate of interest must be uniquely correlated, there would be nothing to quarrel with. Moreover, this proposition would lead naturally to another proposition which embodies an important truth; namely, that, if the rate of interest is given as well as the demand curve for capital and the influence of the rate of interest on the readiness to save out of given levels of income, the level of income must be the factor which brings the amount saved to equality with the amount invested. But, in fact, the cla.s.sical theory not merely neglects the influence of changes in the level of income, but involves formal error.

For the cla.s.sical theory, as can be seen from the above quotations, a.s.sumes that it can then proceed to consider the effect on the rate of interest of (e.g.) a shift in the demand curve for capital, without abating or modifying its a.s.sumption as to the amount of the given income out of which the savings are to be made. The independent variables of the cla.s.sical theory of the rate of interest are the demand curve for capital and the influence of the rate of interest on the amount saved out of a given income; and when (e.g.) the demand curve for capital shifts, the new rate of interest, according to this theory, is given by the point of intersection between the new demand curve for capital and the curve relating the rate of interest to the amounts which will be saved out of the given income. The cla.s.sical theory of the rate of interest seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the a.s.sumption that income is constant is inconsistent with the a.s.sumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the a.s.sumption of a given income breaks down. The position could only be saved by some complicated a.s.sumption providing for an automatic change in the wage-unit of an amount just sufficient in its effect on liquidity-preference to establish a rate of interest which would just offset the supposed shift, so as to leave output at the same level as before. In fact, there is no hint to be found in the above writers as to the necessity for any such a.s.sumption; at the best it would be plausible only in relation to long-period equilibrium and could not form the basis of a short-period theory; and there is no ground for supposing it to hold even in the long- period. In truth, the cla.s.sical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

The above can be ill.u.s.trated by a diagram as follows:

In this diagram the amount of investment (or saving) I is measured vertically, and the rate of interest r horizontally. X1X1' is the first position of the investment demand-schedule, and X2X2' is a second position of this curve. The curve Y1 relates the amounts saved out of an income Y1 to various levels of the rate of interest, the curves Y2, Y3, etc., being the corresponding curves for levels of income Y2, Y3, etc. Let us suppose that the curve Y1 is the Y-curve consistent with an investment demand-schedule X1X1' and a rate of interest r1. Now if the investment demand-schedule shifts from X1X1' to X2X2', income will, in general, shift also. But the above diagram does not contain enough data to tell us what its new value will be; and, therefore, not knowing which is the appropriate Y-curve, we do not know at what point the new investment demand-schedule will cut it. If, however, we introduce the state of liquidity-preference and the quant.i.ty of money and these between them tell us that the rate of interest is r2, then the whole position becomes determinate. For the Y-curve which intersects X2X2' at the point vertically above r2, namely, the curve Y2, will be the appropriate curve. Thus the X-curve and the Y- curves tell us nothing about the rate of interest. They only tell us what income will be, if from some other source we can say what the rate of interest is. If nothing has happened to the state of liquidity- preference and the quant.i.ty of money, so that the rate of interest is unchanged, then the curve Y2' which intersects the new investment demand-schedule vertically below the point where the curve Y1 intersected the old investment demand-schedule will be the appropriate Y-curve, and Y2' will be the new level of income.

Thus the functions used by the cla.s.sical theory, namely, the response of investment and the response of the amount saved out of a given income to change in the rate of interest, do not furnish material for a theory of the rate of interest; but they could be used to tell us what the level of income will be, given (from some other source) the rate of interest; and, alternatively, what the rate of interest will have to be, if the level of income is to be maintained at a given figure (e.g. the level corresponding to full employment). The mistake originates from regarding interest as the reward for waiting as such, instead of as the reward for not-h.o.a.rding; just as the rates of return on loans or investments involving different degrees of risk, are quite properly regarded as the reward, not of waiting as such, but of running the risk. There is, in truth, no sharp line between these and the so-called 'pure' rate of interest, all of them being the reward for running the risk of uncertainty of one kind or another. Only ln the event of money being used solely for transactions and never as a store of value, would a different theory become appropriate.

There are, however, two familiar points which might, perhaps, have warned the cla.s.sical school that something was wrong. In the first place, it has been agreed, at any rate since the publication of Professor Ca.s.sel's Nature and Necessity of Interest, that it is not certain that the sum saved out of a given income necessarily increases when the rate of interest is increased; whereas no one doubts that the investment demand-schedule falls with a rising rate of interest. But if the Y-curves and the X-curves both fall as the rate of interest rises, there is no guarantee that a given Y-curve will intersect a given X-curve anywhere at all. This suggests that it cannot be the Y-curve and the X-curve alone which determine the rate of interest.

In the second place, it has been usual to suppose that an increase in the quant.i.ty of money has a tendency to reduce the rate of interest, at any rate in the first instance and in the short period. Yet no reason has been given why a change in the quant.i.ty of money should affect either the investment demand-schedule or the readiness to save out of a given income. Thus the cla.s.sical school have had quite a different theory of the rate of interest in volume I dealing with the theory of value from what they have had in volume II dealing with the theory of money. They have seemed undisturbed by the conflict and have made no attempt, so far as I know, to build a bridge between the two theories. The cla.s.sical school proper, that is to say; since it is the attempt to build a bridge on the part of the neo- cla.s.sical school which has led to the worst muddles of all. For the latter have inferred that there must be two sources of supply to meet the investment demand-schedule; namely, savings proper, which are the savings dealt with by the cla.s.sical school, plus the sum made available by any increase in the quant.i.ty of money (this being balanced by some species of levy on the public, called 'forced saving' or the like).

This leads on to the idea that there is a 'natural' or 'neutral' or equilibrium' rate of interest, namely, that rate of interest which equates investment to cla.s.sical savings proper without any addition from 'forced savings'; and finally to what, a.s.suming they are on the right track at the start, is the most obvious solution of all, namely, that, if the quant.i.ty of money could only be kept constant in all circ.u.mstances, none of these complications would arise, since the evils supposed to result from the supposed excess of investment over savings proper would cease to be possible. But at this point we are in deep water. 'The wild duck has dived down to the bottom?as deep as she can get?and bitten fast hold of the weed and tangle and all the rubbish that is down there, and it would need an extraordinarily clever dog to dive after and fish her up again.'

Thus the traditional a.n.a.lysis is faulty because it has failed to isolate correctly the independent variables of the system. Saving and investment are the determinates of the system, not the determinants. They are the twin results of the system's determinants, namely, the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest. These determinants are, indeed, themselves complex and each is capable of being affected by prospective changes in the others. But they remain independent in the sense that their values cannot be inferred from one another. The traditional a.n.a.lysis has been aware that saving depends on income but it has overlooked the fact that income depends on investment, in such fashion that, when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment.

Nor are those theories more successful which attempt to make the rate of interest depend on 'the marginal efficiency of capital'. It is true that in equilibrium the rate of interest will be equal to the marginal efficiency of capital, since it will be profitable to increase (or decrease) the current scale of investment until the point of equality has been reached. But to make this into a theory of the rate of interest or to derive the rate of interest from it involves a circular argument, as Marshall discovered after he had got half-way into giving an account of the rate of interest along these lines. For the 'marginal efficiency of capital' partly depends on the scale of current investment, and we must already know the rate of interest before we can calculate what this scale will be. The significant conclusion is that the output of new investment will be pushed to the point at which the marginal efficiency of capital becomes equal to the rate of interest; and what the schedule of the marginal efficiency of capital tells us, is, not what the rate of interest is, but the point to which the output of new investment will be pushed, given the rate of interest.

The reader will readily appreciate that the problem here under discussion is a matter of the most fundamental theoretical significance and of overwhelming practical importance. For the economic principle, on which the practical advice of economists has been almost invariably based, has a.s.sumed, in effect, that, cet. par., a decrease in spending will tend to lower the rate of interest and an increase in investment to raise it. But if what these two quant.i.ties determine is, not the rate of interest, but the aggregate volume of employment, then our outlook on the mechanism of the economic system will be profoundly changed. A decreased readiness to spend will be looked on in quite a different light If, instead of being regarded as a factor which will, cet. par., increase investment, it is seen as a factor which will, cet. par., diminish employment.

Appendix to Chapter 14 APPENDIX ON THE RATE OF INTEREST IN MARSHALL'S PRINCIPLES OF ECONOMICS,.

RICARDO'S PRINCIPLES OF POLITICAL ECONOMY, AND ELSEWHERE.

I.

There is no consecutive discussion of the rate of interest in the works of Marshall, Edgeworth or Professor Pigou,?nothing more than a few obiter dicta. Apart from the pa.s.sage already quoted above (p. 139) the only important clues to Marshall's position on the rate of interest are to be found in his Principles of Economics (6th edn.), Book VI. p. 534 and p. 593, the gist of which is given by the following quotations: 'Interest, being the price paid for the use of capital in any market, tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming there at that rate. If the market, which we are considering, is a small one?say a single town, or a single trade in a progressive country?an increased demand for capital in it will be promptly met by an increased supply drawn from surrounding districts or trades. But if we are considering the whole world, or even the whole of a large country, as one market for capital, we cannot regard the aggregate supply of it as altered quickly and to a considerable extent by a change in the rate of interest. For the general fund of capital is the product of labour and waiting; and the extra work, and the extra waiting, to which a rise in the rate of interest would act as an incentive, would not quickly amount to much, as compared with the work and waiting, of which the total existing stock of capital is the result. An extensive increase in the demand for capital in general will therefore be met for a time not so much by an increase of supply, as by a rise in the rate of interest; which will cause capital to withdraw itself partially from those uses in which its marginal utility is lowest. It is only slowly and gradually that the rise in the rate of interest will increase the total stock of capital' (p.534).

'It cannot be repeated too often that the phrase "the rate of interest" is applicable to old investments of capital only in a very limited sense. For instance, we may perhaps estimate that a trade capital of some seven thousand millions is invested in the different trades of this country at about 3 per cent net interest.

But such a method of speaking, though convenient and justifiable for many purposes, is not accurate.

What ought to be said is that, taking the rate of net interest on the investments of new capital in each of those trades [i.e. on marginal investments] to be about 3 per cent; then the aggregate net income rendered by the whole of the trade-capital invested in the various trades is such that, if capitalised at 33 years' purchase (that is, on the basis of interest at 3 per cent), it would amount to some seven thousand million pounds. For the value of the capital already invested in improving land or erecting a building, in making a railway or a machine, is the aggregate discounted value of its estimated future net incomes [or quasi-rents]; and if its prospective income-yielding power should diminish, its value would fall accordingly and would be the capitalised value of that smaller income after allowing for depreciation'

(p.593).

In his Economics of Welfare (3rd edn.), p. 163, Professor Pigou writes: 'The nature of the service of "waiting" has been much misunderstood. Sometimes it has been supposed to consist in the provision of money, sometimes in the provision of time, and, on both suppositions, it has been argued that no contribution whatever is made by it to the dividend. Neither supposition is correct. "Waiting" simply means postponing consumption which a person has power to enjoy immediately, thus allowing resources, which might have been destroyed, to a.s.sume the form of production instruments. The unit of "waiting" is, therefore, the use of a given quant.i.ty of resources ?for example, labour or machinery?for a given time. . . In more general terms we may say that the unit of waiting is a year- value-unit, or, in the simpler, if less accurate, language of Dr Ca.s.sel, a year-pound. . . A caution may be added against the common view that the amount of capital acc.u.mulated in any year is necessarily equal to the amount of "savings" made in it. This is not so, even when savings are interpreted to mean net savings, thus eliminating the savings of one man that are lent to increase the consumption of another, and when temporary acc.u.mulations of unused claims upon services in the form of bank-money are ignored; for many savings which are meant to become capital in fact fail of their purpose through misdirection into wasteful uses.'

Professor Pigou's only significant reference to what determines the rate of interest is, I think, to be found in his Industrial Fluctuations (1st edn.), pp. 251?3, where he controverts the view that the rate of interest, being determined by the general conditions of demand and supply of real capital, lies outside the central or any other bank's control. Against this view he argues that: 'When bankers create more credit for business men, they make, in their interest, subject to the explanations given in chapter xiii. of part i., a forced levy of real things from the public, thus increasing the stream of real capital available for them, and causing a fall in the real rate of interest on long and short loans alike. It is true, in short, that the bankers' rate for money is bound by a mechanical tie to the real rate of interest on long loans; but it is not true that this real rate is determined by conditions wholly outside bankers' control.'

My running comments on the above have been made in the footnotes. The perplexity which I find in Marshall's account of the matter is fundamentally due, I think, to the incursion of the concept 'interest', which belongs to a monetary economy, into a treatise which takes no account of money. 'Interest' has really no business to turn up at all in Marshall's Principles of Economics,?it belongs to another branch of the subject.

Professor Pigou, conformably with his other tacit a.s.sumptions, leads us (in his Economics of Welfare) to infer that the unit of waiting is the same as the unit of current investment and that the reward of waiting is quasi-rent, and practically never mentions interest, which is as it should be. Nevertheless these writers are not dealing with a non-monetary economy (if there is such a thing). They quite clearly presume that money is used and that there is a banking system. Moreover, the rate of interest scarcely plays a larger part in Professor Pigou's Industrial Fluctuations (which is mainly a study of fluctuations in the marginal efficiency of capital) or in his Theory of Unemployment (which is mainly a study of what determines changes in the volume of employment, a.s.suming that there is no involuntary unemployment) than in his Economics of Welfare.

II.

The following from his Principles of Political Economy (p. 511) puts the substance of Ricardo's theory of the rate of interest: 'The interest of money is not regulated by the rate at which the Bank will lend, whether it be 5, 3 or 2 per cent., but by the rate of profit which can be made by the employment of capital, and which is totally independent of the quant.i.ty or of the value of money. Whether the Bank lent one million, ten millions, or a hundred millions, they would not permanently alter the market rate of interest; they would alter only the value of the money which they thus issued. In one case, ten or twenty times more money might be required to carry on the same business than what might be required in the other. The applications to the Bank for money, then, depend on the comparison between the rate of profits that may be made by the employment of it, and the rate at which they are willing to lend it. If they charge less than the market rate of interest, there is no amount of money which they might not lend;?if they charge more than that rate, none but spendthrifts and prodigals would be found to borrow of them.'

This is so clear-cut that it affords a better starting-point for a discussion than the phrases of later writers who, without really departing from the essence of the Ricardian doctrine, are nevertheless sufficiently uncomfortable about it to seek refuge in haziness. The above is, of course, as always with Ricardo, to be interpreted as a long-period doctrine, with the emphasis on the word 'permanently' half-way through the pa.s.sage; and it is interesting to consider the a.s.sumptions required to validate it.

Once again the a.s.sumption required is the usual cla.s.sical a.s.sumption, that there is always full employment; so that, a.s.suming no change in the supply curve of labour in terms of product, there is only one possible level of employment in long-period equilibrium. On this a.s.sumption with the usual ceteris paribus, i.e. no change in psychological propensities and expectations other than those arising out of a change in the quant.i.ty of money, the Ricardian theory is valid, in the sense that on these suppositions there is only one rate of interest which will be compatible with full employment in the long period. Ricardo and his successors overlook the fact that even in the long period the volume of employment is not necessarily full but is capable of varying, and that to every banking policy there corresponds a different long-period level of employment; so that there are a number of positions of long- period equilibrium corresponding to different conceivable interest policies on the part of the monetary authority. If Ricardo had been content to present his argument solely as applying to any given quant.i.ty of money created by the monetary authority, it would still have been correct on the a.s.sumption of flexible money- wages. If, that is to say, Ricardo had argued that it would make no permanent alteration to the rate of interest whether the quant.i.ty of money was fixed by the monetary authority at ten millions or at a hundred millions, his conclusion would hold. But if by the policy of the monetary authority we mean the terms on which it will increase or decrease the quant.i.ty of money, i.e. the rate of interest at which it will, either by a change in the volume of discounts or by open-market operations, increase or decrease its a.s.sets?which is what Ricardo expressly does mean in the above quotation?then it is not the case either that the policy of the monetary authority is nugatory or that only one policy is compatible with long-period equilibrium; though in the extreme case where money-wages are a.s.sumed to fall without limit in face of involuntary unemployment through a futile compet.i.tion for employment between the unemployed labourers, there will, it is true, be only two possible long-period positions?full employment and the level of employment corresponding to the rate of interest at which liquidity- preference becomes absolute (in the event of this being less than full employment). a.s.suming flexible money-wages, the quant.i.ty of money as such is, indeed, nugatory in the long period; but the terms on which the monetary authority will change the quant.i.ty of money enters as a real determinant into the economic scheme.

It is worth adding that the concluding sentences of the quotation suggest that Ricardo was overlooking the possible changes in the marginal efficiency of capital according to the amount invested. But this again can be interpreted as another example of his greater internal consistency compared with his successors. For if the quant.i.ty of employment and the psychological propensities of the community are taken as given, there is in fact only one possible rate of acc.u.mulation of capital and, consequently, only one possible value for the marginal efficiency of capital. Ricardo offers us the supreme intellectual achievement, unattainable by weaker spirits, of adopting a hypothetical world remote from experience as though it were the world of experience and then living in it consistently. With most of his successors common sense cannot help breaking in?with injury to their logical consistency.

III.

A peculiar theory of the rate of interest has been propounded by Professor von Mises and adopted from him by Professor Hayek and also, I think, by Professor Robbins; namely, that changes in the rate of interest can be identified with changes in the relative price levels of consumption-goods and capital- goods It is not clear how this conclusion is reached. But the argument seems to run as follows. By a somewhat drastic simplification the marginal efficiency of capital is taken as measured by the ratio of the supply price of new consumers' goods to the supply price of new producers' goods. This is then identified with the rate of interest. The fact is called to notice that a fall in the rate of interest is favourable to investment. Ergo, a fall in the ratio of the price of consumers' goods to the price of producer's goods is favourable to investment.

By this means a link is established between tncreased saving by an individual and increased aggregate investment. For it is common gound that increased individual saving will cause a fall in the price of consumers' goods, and, quite possibly, a greater fall than in the price of producers' goods; hence, according to the above reasoning, it means a reduction in the rate of interest which will stimulate investment. But, of course, a lowering of the marginal efficiency of particular capital a.s.sets, and hence a lowering of the schedule of the marginal efficiency of capital in general, has exactly the opposite effect to what the above argument a.s.sumes. For investment is stimulated either by a raising of the schedule of the marginal efficiency or by a lowering of the rate of interest. As a result of confusing the marginal efficiency of capital with the rate of interest, Professor von Mises and his disciples have got their conclusions exactly the wrong way round. A good example of a confusion along these lines is given by the following pa.s.sage by Professor Alvin Hansen: 'It has been suggested by some economists that the net effect of reduced spending will be a lower price level of consumers' goods than would otherwise have been the case, and that, in consequence, the stimulus to investment in fixed capital would thereby tend to be minimised. This view is, however, incorrect and is based on a confusion of the effect on capital formation of (i) higher or lower prices of consumers' goods, and (2) a change in the rate of interest. It is true that in consequence of the decreased spending and increased saving, consumers' prices would be low relative to the prices of producers' goods. But this, in effect, means a lower rate of interest, and a lower rate of interest stimulates an expansion of capital investment in fields which at higher rates would be unprofitable.'

Chapter 15.

THE PSYCHOLOGICAL AND BUSINESS INCENTIVES.

TO LIQUIDITY.

I.

We must now develop in more detail the a.n.a.lysis of the motives to liquidity-preference which were introduced in a preliminary way in chapter 13. The subject is substantially the same as that which has been sometimes discussed under the heading of the demand for money. It is also closely connected with what is called the income-velocity of money;?for the income-velocity of money merely measures what proportion of their incomes the public chooses to hold in cash, so that an increased income-velocity of money may be a symptom of a decreased liquidity-preference. It is not the same thing, however, since it is in respect of his stock of acc.u.mulated savings, rather than of his income, that the individual can exercise his choice between liquidity and illiquidity. And, anyhow, the term 'income-velocity of money'

carries with it the misleading suggestion of a presumption in favour of the demand for money as a whole being proportional, or having some determinate relation, to income, whereas this presumption should apply, as we shall see, only to a portion of the public's cash holdings; with the result that it overlooks the part played by the rate of interest.

In my Treatise on Money I studied the total demand for money under the headings of income-deposits, business-deposits, and savings-deposits, and I need not repeat here the a.n.a.lysis which I gave in chapter 3 of that book. Money held for each of the three purposes forms, nevertheless, a single pool, which the holder is under no necessity to segregate into three water-tight compartments; for they need not be sharply divided even in his own mind, and the same sum can be held primarily for one purpose and secondarily for another. Thus we can?equally well, and, perhaps, better?consider the individual's aggregate demand for money in given circ.u.mstances as a single decision, though the composite result of a number of different motives.

In a.n.a.lysing the motives, however, it is still convenient to cla.s.sify them under certain headings, the first of which broadly corresponds to the former cla.s.sification of income-deposits and business-deposits, and the two latter to that of savings-deposits. These I have briefly introduced in chapter 13 under the headings of the transactions-motive, which can be further cla.s.sified as the income-motive and the business-motive, the precautionary-motive and the speculative-motive.

(i) The Income-motive. One reason for holding cash is to bridge the interval between the receipt of income and its disburs.e.m.e.nt. The strength of this motive in inducing a decision to hold a given aggregate of cash will chiefly depend on the amount of income and the normal length of the interval between its receipt and its disburs.e.m.e.nt. It is in this connection that the concept of the income-velocity of money is strictly appropriate.

(ii) The Business-motive. Similarly, cash is held to bridge the interval between the time of incurring business costs and that of the receipt of the sale-proceeds; cash held by dealers to bridge the interval between purchase and realisation being included under this heading. The strength of this demand will chiefly depend on the value of current output (and hence on current income), and on the number of hands through which output pa.s.ses.

(iii) The Precautionary-motive. To provide for contingencies requiring sudden expenditure and for unforeseen opportunities of advantageous purchases, and also to hold an a.s.set of which the value is fixed in terms of money to meet a subsequent liability fixed in terms of money, are further motives for holding cash.

The strength of all these three types of motive will partly depend on the cheapness and the reliability of methods of obtaining cash, when it is required, by some form of temporary borrowing, in particular by overdraft or its equivalent. For there is no necessity to hold idle cash to bridge over intervals if it can be obtained without difficulty at the moment when it is actually required. Their strength will also depend on what we may term the relative cost of holding cash. If the cash can only be retained by forgoing the purchase of a profitable a.s.set, this increases the cost and thus weakens the motive towards holding a given amount of cash. If deposit interest is earned or if bank charges are avoided by holding cash, this decreases the cost and strengthens the motive. It may be, however, that this is likely to be a minor factor except where large changes in the cost of holding cash are in question.

(iv) There remains the Speculative-motive. This needs a more detailed examination than the others, both because it is less well understood and because it is particularly important in transmitting the effects of a change in the quant.i.ty of money.

In normal circ.u.mstances the amount of money required to satisfy the transactions-motive and the precautionary-motive is mainly a resultant of the general activity of the economic system and of the level of money-income. But it is by playing on the speculative-motive that monetary management (or, in the absence of management, chance changes in the quant.i.ty of money) is brought to bear on the economic system. For the demand for money to satisfy the former motives is generally irresponsive to any influence except the actual occurrence of a change in the general economic activity and the level of incomes; whereas experience indicates that the aggregate demand for money to satisfy the speculative-motive usually shows a continuous response to gradual changes in the rate of interest, i.e. there is a continuous curve relating changes in the demand for money to satisfy the speculative motive and changes in the rate of interest as given by changes in the prices of bonds and debts of various maturities.

Indeed, if this were not so, 'open market operations' would be impracticable. I have said that experience indicates the continuous relationship stated above, because in normal circ.u.mstances the banking system is in fact always able to purchase (or sell) bonds in exchange for cash by bidding the price of bonds up (or down) in the market by a modest amount; and the larger the quant.i.ty of cash which they seek to create (or cancel) by purchasing (or selling) bonds and debts, the greater must be the fall (or rise) in the rate of interest. Where, however, (as in the United States, 1933?1934) open-market operations have been limited to the purchase of very short-dated securities, the effect may, of course, be mainly confined to the very short-term rate of interest and have but little reaction on the much more important long-term rates of interest.

In dealing with the speculative-motive it is, however, important to distinguish between the changes in the rate of interest which are due to changes in the supply of money available to satisfy the speculative- motive, without there having been any change in the liquidity function, and those which are primarily due to changes in expectation affecting the liquidity function itself. Open-market Operations may, indeed, influence the rate of interest through both channels; since they may not only change the volume of money, but may also give rise to changed expectations concerning the future policy of the central bank or of the government. Changes in the liquidity function itself; due to a change in the news which causes revision of expectations, will often be discontinuous, and will, therefore, give rise to a corresponding discontinuity of change in the rate of interest. Only, indeed, in so far as the change in the news is differently interpreted by different individuals or affects individual lnterests differently will there be room for any increased activity of dealing in the bond market. If the change in the news affects the judgment and the requirements of everyone in precisely the same way, the rate of interest (as indicated by the prices of bonds and debts) will be adjusted forthwith to the new situation without any market transactions being necessary.

Thus, in the simplest case, where everyone is similar and similarly placed, a change in circ.u.mstances or expectations will not be capable of causing any displacement of money whatever;?it will simply change the rate of interest in whatever degree is necessary to offset the desire of each individual, felt at the previous rate, to change his holding of cash in response to the new circ.u.mstances or expectations; and, since everyone will change his ideas as to the rate which would induce him to alter his holdings of cash in the same degree, no transactions will result. To each set of circ.u.mstances and expectations there will correspond an appropriate rate of interest, and there will never be any question of anyone changing his usual holdings of cash.

In general, however, a change in circ.u.mstances or expectations will cause some realignment in individual holdings of money;?since, in fact, a change will influence the ideas of different individuals differently by reasons partly of differences in environment and the reason for which money is held and partly of differences in knowledge and interpretation of the new situation. Thus the new equilibrium rate of interest will be a.s.sociated with a redistribution of money-holdings. Nevertheless it is the change in the rate of interest, rather than the redistribution of cash, which deserves our main attention. The latter is incidental to individual differences, whereas the essential phenomenon is that which occurs in the simplest case. Moreover, even in the general case, the shift in the rate of interest is usually the most prominent part of the reaction to a change in the news. The movement in bond-prices is, as the newspapers are accustomed to say, 'out of all proportion to the activity of dealing';?which is as it should be, in view of individuals being much more similar than they are dissimilar in their reaction to news.

II.

Whilst the amount of cash which an individual decides to hold to satisfy the transactions-motive and the precautionary-motive is not entirely independent of what he is holding to satisfy the speculative-motive, it is a safe first approximation to regard the amounts of these two sets of cash-holdings as being largely independent of one another. Let us, therefore, for the purposes of our further a.n.a.lysis, break up our problem in this way. Let the amount of cash held to satisfy the transactions- and precautionary-motives be M1, and the amount held to satisfy the speculative-motive be M2. Corresponding to these two compartments of cash, we then have two liquidity functions L1 and L2. L1 mainly depends on the level of income, whilst L2 mainly depends on the relation between the current rate of interest and the state of expectation. Thus M = M1 + M2 = L1(Y) + L2(r), where L1 is the liquidity function corresponding to an income Y, which determines M1, and L2 is the liquidity function of the rate of interest r, which determines M2. It follows that there are three matters to investigate: (i) the relation of changes in M to Y and r, (ii) what determines the shape of L1, (iii) what determines the shape of L2.

(i) The relation of changes in M to Y and r depends, in the first instance, on the way in which changes in M come about. Suppose that M consists of gold coins and that changes in M can only result from increased returns to the activities of gold-miners who belong to the economic system under examination. In this case changes in M are, in the first instance, directly a.s.sociated with changes in Y, since the new gold accrues as someone's income. Exactly the same conditions hold if changes in M are due to the government printing money wherewith to meet its current expenditure;?in this case also the new money accrues as someone's income. The new level of income, however, will not continue sufficiently high for the requirements of M1 to absorb the whole of the increase in M; and some portion of the money will seek an outlet in buying securities or other a.s.sets until r has fallen so as to bring about an increase in the magnitude of M2 and at the same time to stimulate a rise in Y to such an extent that the new money is absorbed either in M2 or in the M1 which corresponds to the rise in Y caused by the fall in r. Thus at one remove this case comes to the same thing as the alternative case, where the new money can only be issued in the first instance by a relaxation of the conditions of credit by the banking system, so as to induce someone to sell the banks a debt or a bond in exchange for the new cash.

It will, therefore, be safe for us to take the latter case as typical. A change in M can be a.s.sumed to operate by changing r, and a change in r will lead to a new equilibrium partly by changing M2 and partly by changing Y and therefore M1. The division of the increment of cash between M1 and M2 in the new position of equilibrium will depend on the responses of investment to a reduction in the rate of interest and of income to an increase in investment. Since Y partly depends on r, it follows that a given change in M has to cause a sufficient change in r for the resultant changes in M1 and M2 respectively to add up to the given change in M.

(ii) It is not always made clear whether the income-velocity of money is defined as the ratio of Y to M or as the ratio of Y to M1. I propose, however, to take it in the latter sense. Thus if V is the income- velocity of money, Y.

L1(Y) = ?? = M1.

V.

There is, of course, no reason for supposing that V is constant. Its value will depend on the character of banking and industrial organisation, on social habits, on the distribution of income between different cla.s.ses and on the effective cost of holding idle cash. Nevertheless, if we have a short period of time in view and can safely a.s.sume no material change in any of these factors, we can treat V as nearly enough constant.

(iii) Finally there is the question of the relation between M2 and r. We have seen in chapter 13 that uncertainty as to the future course of the rate of interest is the sole intelligible explanation of the type of liquidity-preference L2 which leads to the holding of cash M2. It follows that a given M2 will not have a definite quant.i.tative relation to a given rate of interest of r;?what matters is not the absolute level of r but the degree of its divergence from what is considered a fairly safe level of r, having regard to those calculations of probability which are being relied on. Nevertheless, there are two reasons for expecting that, in any given state of expectation, a fall in r will be a.s.sociated with an increase in M2. In the first place, if the general view as to what is a safe level of r is unchanged, every fall in r reduces the market rate relatively to the 'safe' rate and therefore increases the risk of illiquidity; and, in the second place, every fall in r reduces the current earnings from illiquidity, which are available as a sort of insurance premium to offset the risk of loss on capital account, by an amount equal to the difference between the squares of the old rate of interest and the new. For example, if the rate of interest on a long-term debt is 4 per cent, it is preferable to sacrifice liquidity unless on a balance of probabilities it is feared that the long-term rate of interest may rise faster than by 4 per cent of itself per annum, i.e. by an amount greater than 0.16 per cent per annum. If, however, the rate of interest is already as low as 2 per cent, the running yield will only offset a rise in it of as little as 0.04 per cent per annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of interest to a very low level. Unless reasons are believed to exist why future experience will be very different from past experience, a long-term rate of interest of (say) 2 per cent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.

It is evident, then, that the rate of interest is a highly psychological phenomenon. We shall find, indeed, in Book V that it cannot be in equilibrium at a level below the rate which corresponds to full employment; because at such a level a state of true inflation will be produced, with the result that M1 will absorb ever-increasing quant.i.ties of cash. But at a level above the rate which corresponds to full employment, the long-term market-rate of interest will depend, not only on the current policy of the monetary authority, but also on market expectations concerning its future policy. The short-term rate of interest is easily controlled by the monetary authority, both because it is not difficult to produce a conviction that its policy will not greatly change in the very near future, and also because the possible loss is small compared with the running yield (unless it is approaching vanishing point). But the long- term rate may be more recalcitrant when once it has fallen to a level which, on the basis of past experience and present expectations of future monetary policy, is considered 'unsafe' by representative opinion. For example, in a country linked to an international gold standard, a rate of interest lower than prevails elsewhere will be viewed with a justifiable lack of confidence; yet a domestic rate of interest dragged up to a parity with the highest rate (highest after allowing for risk) prevailing in any country belonging to the international system may be much higher than is consistent with domestic full employment.

Thus a monetary policy which strikes public opinion as being experimental in character or easily liable to change may fail in its objective of greatly reducing the long-term rate of interest, because M2 may tend to increase almost without limit in response to a reduction of r below a certain figure. The same policy, on the other hand, may prove easily successful if it appeals to public opinion as being reasonable and practicable and in the public interest, rooted in strong conviction, and promoted by an authority unlikely to be superseded.

It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing society to fluctuations for all kinds of reasons round the expected normal. In particular, when M1 is increasing faster than M, the rate of interest will rise, and vice versa. But it may fluctuate for decades about a level which is chronically too high for full employment;?particularly if it is the prevailing opinion that the rate of interest is self- adjusting, so that the level established by convention is thought to be rooted in objective grounds much stronger than convention, the failure of employment to attain an optimum level being in no way a.s.sociated, in the minds either of the public or of authority, with the prevalence of an inappropriate range of rates of interest.

The difficulties in the way of maintaining effective demand at a level high enough to provide full employment, which ensue from the a.s.sociation of a conventional and fairly stable long-term rate of interest with a fickle and highly unstable marginal efficiency of capital, should be, by now, obvious to the reader.

Such comfort as we can fairly take from more encouraging reflections must be drawn from the hope that, precisely because the convention is not rooted in secure knowledge, it will not be always unduly resistant to a modest measure of persistence and consistency of purpose by the monetary authority.

Public opinion can be fairly rapidly accustomed to a modest fall in the rate of interest and the conventional expectation of the future may be modified accordingly; thus preparing the way for a further movement?up to a point. The fall in the long-term rate of interest in Great Britain after her departure from the gold standard provides an interesting example of this;?the major movements were effected by a series of discontinuous jumps, as the liquidity function of the public, having become accustomed to each successive reduction, became ready to respond to some new incentive in the news or in the policy of the authorities.

III.

We can sum up the above in the proposition that in any given state of expectation there is in the minds of the public a certain potentiality towards holding cash beyond what is required by the transactions- motive or the precautionary-motive, which will realise itself in actual cash-holdings in a degree which depends on the terms on which the monetary authority is willing to create cash. It is this potentiality which is summed up in the liquidity function L2. Corresponding to the quant.i.ty of money created by the monetary authority, there will, therefore, be cet. par. a determlnate rate of interest or, more strictly, a determinate complex of rates of interest for debts of different maturities. The same thing, however, would be true of any other factor in the economic system taken separately. Thus this particular a.n.a.lysis will only be useful and significant in so far as there is some specially direct or purposive connection between changes in the quant.i.ty of money and changes in the rate of interest. Our reason for supposing that there is such a special connection arises from the fact that, broadly speaking, the banking system and the monetary authority are dealers in money and debts and not in a.s.sets or consumables.

If the monetary authority were prepared to deal both ways on specified terms in debts of all maturities, and even more so if it were prepared to deal in debts of varying degrees of risk, the relationship between the complex of rates of interest and the quant.i.ty of money would be direct. The complex of rates of interest would simply be an expression of the terms on which the banking system is prepared to acquire or part with debts; and the quant.i.ty of money would be the amount which can find a home in the possession of individuals who?after taking account of all relevant circ.u.mstances?prefer the control of liquid cash to parting with it in exchange for a debt on the terms indicated by the market rate of interest.

Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management.

To-day, however, in actual practice, the extent to which the price of debts as fixed by the banking system is 'effective' in the market, in the sense that it governs the actual market-price, varies in different systems. Sometimes the price is more effective in one direction than in the other; that is to say, the banking system may undertake to purchase debts at a certain price but not necessarily to sell them at a figure near enough to its buying-price to represent no more than a dealer's turn, though there is no reason why the price should not be made effective both ways with the aid of open-market operations.

There is also the more important qualification which arises out of the monetary authority not being, as a rule, an equally willing dealer in debts of all maturities. The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect reactions from the price of short-term debts;?though here again there is no reason why they need do so. Where these qualifications operate, the directness of the relation between the rate of interest and the quant.i.ty of money is correspondingly modified. In Great Britain the field of deliberate control appears to be widening. But in applying this theory in any particular case allowance must be made for the special characteristics of the method actually employed by the monetary authority.

If the monetary authority deals only in short-term debts, we have to consider what influence the price, actual and prospective, of short-term debts exercises on debts of longer maturity.

Thus there are certain limitations on the ability of the monetary authority to establish any given complex of rates of interest for debts of different terms and risks, which can be summed up as follows: (1) There are those limitations which arise out of the monetary authority's own practices in limiting its willingness to deal to debts of a particular type.

(2) There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.

(3) The most striking examples of a complete breakdown of stability in the rate of interest, due to the liquidity function flattening out in one direction or the other, have occurred in very abnormal circ.u.mstances. In Russia and Central Europe after the war a currency crisis or flight from the currency was experienced, when no one could be induced to retain holdings either of money or of debts on any terms whatever, and even a high and rising rate of interest was unable to keep pace with the marginal efficiency of capital (especially of stocks of liquid goods) under the influence of the expectation of an ever greater fall in the value of money; whilst in the United States at certain dates in 1932 there was a crisis of the opposite kind?a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms.

(4) There is, finally, the difficulty discussed in section IV of chapter 11, p. 144, in the way of bringing the effective rate of interest below a certain figure, which may prove important in an era of low interest- rates; namely the intermediate costs of bringing the borrower and the ultimate lender together, and the allowance for risk, especially for moral risk, which the lender requires over and above the pure rate of interest. As the pure rate of interest declines it does not follow that the allowances for expense and risk decline pari pa.s.su. Thus the rate of interest which the typical borrower has to pay may decline more slowly than the pure rate of interest, and may be incapable of being brought, by the methods of the existing banking and financial organisation, below a certain minimum figure. This is particularly important if the estimation of moral risk is appreciable. For where the risk is due to doubt in the mind of the lender concerning the honesty of the borrower, there is nothing in the mind of a borrower who does not intend to be dishonest to offset the resultant higher charge. It is also important in the case of short- term loans (e.g. bank loans) where the expenses are heavy;?a bank may have to charge its customers 1 to 2 per cent., even if the pure rate of interest to the lender is nil.

IV.

At the cost of antic.i.p.ating what is more properly the subject of chapter 21 below it may be interesting briefly at this stage to indicate the relationship of the above to the quant.i.ty theory of money.

In a static society or in a society in which for any other reason no one feels any uncertainty about the future rates of interest, the liquidity function L2, or the propensity to h.o.a.rd (as we might term it), will always be zero in equilibrium. Hence in equilibrium M2 = 0 and M = M1; so that any change in M will cause the rate of interest to fluctuate until income reaches a level at which the change in M1 is equal to the supposed change in M. Now M1 V = Y, where V is the income-velocity of money as defined above and Y is the aggregate income. Thus if it is practicable to measure the quant.i.ty, O, and the price, P, of current output, we have Y = OP, and, therefore, MV = OP; which is much the same as the quant.i.ty theory of money in its traditional form.

For the purposes of the real world it is a great fault in the quant.i.ty theory that it does not distinguish between changes in prices which are a function of changes in output, and those which are a function of changes in the wage-unit. The explanation of this omission is, perhaps, to be found in the a.s.sumptions that there is no propensity to h.o.a.rd and that there is always full employment. For in this case, O being constant and M2 being zero, it follows, if we can take V also as constant, that both the wage-unit and the price-level will be directly proportional to the quant.i.ty of money.

Chapter 16.

SUNDRY OBSERVATIONS ON THE NATURE OF.