Chapter XIV “LIQUIDITY PREFERENCE”

1. No “Liquidity” Without Saving

We now come to three chapters and an appendix that it seems most convenient to treat as a unit. These are the chapters in which Keynes unfolds his famous concept of “liquidity-preference” as an explanation (in fact as the sole explanation) of the rate of interest, and in which he dismisses the alleged “classical” theory of the rate of interest as altogether inadequate and mistaken. We shall first take up the concept of liquidity-preference, to find what is wrong with it, and then see to what extent, if any, Keynes’s criticisms of the “classical” theory of interest are warranted.

Just before he gets to his own explanation of the rate of interest, Keynes uses casually, and in passing, the phrase “the psychological time-preferences of an individual.” Except for the adjective “psychological,” which in this context is quite unnecessary, the concept of time-preference, as we shall see, is essential to any theory of interest. Though Keynes constantly uses this concept implicitly, he either ignores or repudiates it explicitly. But here I wish merely to call attention to the phrase itself, because it probably suggested to Keynes his own phrase “liquidity-preference” which, as we shall see, happens to be both unhelpful and inappropriate.

Let us begin with his definition. Keynes begins by admitting time-preference into his analysis under the name of “propensity to consume,” which “determines for each individual how much of his income he will consume and how much he will reserve in some form of command over future consumption” (p. 166). This decision having been made, the individual must then decide:

in what form he will hold the command over future consumption (p. 166). Does he want to hold it in the form of immediate, liquid command (i.e., in money or its equivalent)? Or is he prepared to part with immediate command for a specified or indefinite period, leaving it to future market conditions to determine on what terms he can, if necessary, convert deferred command over specific goods into immediate command over goods in general? In other words, what is the degree of his liquidity-preference—where an individual’s liquidity-preference is given by a schedule of the amounts of his resources, valued in terms of money or of wage-units, which he will wish to retain in the form of money in different sets of circumstances? (p. 166).

[Keynes goes on:] It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period.... Thus the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it. (My italics, pp. 166-167.)

There are several odd things about this passage. Keynes begins by denying what nobody of sense asserts. Of course the rate of interest is not a return merely for “saving or waiting as such.” But the saving or waiting is the necessary means to obtain the funds to be invested at interest.¹

Nor, on the other hand, is the rate of interest the “reward” for parting with liquidity. The economic system is not a Sunday school; its primary function is not to hand out rewards and punishments. Interest is paid, not because borrowers wish to “reward” lenders, but because borrowers expect to earn a return on their investment greater than the interest they pay for the borrowed funds. The lender is also free to invest his own funds directly rather than to lend them to someone else for investment; and the rate of interest that he is offered may often decide which of these two things he will do.

But let us, in order to look into the matter, provisionally accept Keynes’s definition that interest is “the reward for parting with liquidity”—in other words, for overcoming the individual’s “liquidity-preference.”

We may note in passing that it is rather odd that Keynes did not make the overcoming of “liquidity-preference” the explanation not only of the rate of interest, but of any price whatever. If you wish to sell me tomatoes, for example, you will have to offer them at a sufficiently low price to “reward” me for “parting with liquidity”—that is, parting with cash. Thus the price of tomatoes would have to be explained as the amount necessary to overcome the buyer’s “liquidity-preference” or “cash preference.” Perhaps this way of describing the matter might serve to make the man who is being induced to buy tomatoes look slightly ridiculous for preferring “liquidity” or cash, and if the purpose was ridicule of the purchaser’s mental processes, in needing to have an inducement to buy tomatoes, it might do well enough for that purpose. But as a serious explanation for the market prices of commodities, I do not believe it would have any advantages over the present more orthodox explanations of economists, and it is easy to see some very serious disadvantages. It is hardly an illuminating phrase. If I wish to hold cash rather than invest it at the moment, this may of course be called cash preference or liquidity-preference. But preference over what? If I am offered $20,000 for my house and turn the offer down, this could be described in Keynesian language as house-preference. But if I am offered $21,000 and take it, this would have to be called liquidity-preference. Yet it is merely the preference of $21,000 over $20,000. It is a little hard to see what advantage this Keynesian phrase has over orthodox economic terms.

2. Money is a Productive Asset

Now what are the motives for “liquidity-preference”? In separate chapters Keynes gives two different sets. In Chapter 13, “The General Theory of the Rate of Interest,” he tells us:

The three divisions of liquidity preference which we have distinguished above may be defined as depending on (i) the transactions-motive, i.e., the need for cash for the current transaction of personal and business exchanges; (ii) the precautionary motive, i.e., the desire for security as the future cash equivalent of a certain proportion of total resources; and (iii) the speculative motive, i.e., the object of securing profit from knowing better than the market what the market will bring forth (p. 170).

But in Chapter 15, “The Psychological and Business Incentives to Liquidity,” Keynes gives us a further breakdown of the “transactions-motive” into the “income-motive” and the “business-motive.”

Now the transactions-motive and the precautionary-motive Keynes seems to respect and almost to approve: “In normal circumstances 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” (p. 196). But the speculative-motive arouses his derision and anger. And also his reforming zeal: “It is by playing on the speculative-motive that monetary management... is brought to bear on the economic system” (pp. 196-197).

According to Keynes, holding cash for the “speculative-motive” is wicked. This is what the Monetary Authority must stop. It is Keynes’s usual trick of giving the dog a bad name as an excuse for shooting him. But it is a nice question whether those who hold cash because they distrust the prices of investments or of commodities are holding cash in order to speculate or in order not to speculate. They hold cash (beyond the needs of the transactions-motive) because they distrust the prices of investments or of durable consumption goods; they believe that the prices of investments and/or of durable consumption goods are going to fall, and they do not wish to be caught with these investments or durable goods on their hands. They are seeking, in short, not to speculate in investments or goods. They believe that next week, next month, or next year they will get them cheaper.

This may be called speculating in money, as Keynes calls it; or it may be called a refusal to speculate in stocks, bonds, houses, or automobiles. The real question to be asked about it, however, is not whether or not this is “speculation,” but whether it is wise or unwise speculation. It is usually most indulged in after a boom has cracked. The best way to prevent it is not to have a Monetary Authority so manipulate things as to force the purchase of investments or of goods, but to prevent an inflationary boom in the first place. However, I am anticipating.

Perhaps we may get a little more light on this subject if we turn for a moment from the General Theory to an answer made by Keynes in the Quarterly Journal of Economics (1937) to four discussions of his General Theory.²

Money, it is well known, serves two principal purposes. By acting as a money of account, it facilitates exchanges without its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence. In the second place, it is a store of wealth. So we are told, without a smile on the face (pp. 186-187).

This is an extraordinary perversion of classical doctrine. The most usual statement in the orthodox economic textbooks is that money serves first of all the function of a medium of exchange. And according to some economists, this function includes and subsumes all its other functions— such as “money of account,” “standard of value,” and “store of value”—which are merely the qualities of a satisfactory or ideal medium of exchange.

But to continue the quotation from Keynes that we had just started:

It is a store of wealth. So we are told without a smile on the face. But in the world of the classical economy, what an insane use to which to put it! For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit. Why should anyone outside a lunatic asylum wish to use money as a store of wealth? (p. 187).

Perhaps, with a little patience, we could have helped Keynes to understand. They wish or hope or believe that the thousand dollars they earn today will have at least as much purchasing power (whether in cash or as face value of a bond) a year from now or twenty years from now. They do not wish to have to become speculators. If “it is a recognized characteristic of money as a store of wealth that it is barren,” this “recognition” is mistaken, in spite of the fact that so many economists have been guilty of it. As W. H. Hutt has pointed out, money “is as productive as all other assets, and productive in exactly the same sense.” “The demand for money assets is a demand for productive resources.”³ Failure to recognize this is the source of one of Keynes’s greatest fallacies.

Before we go on to explain the theoretical reasons why Keynes’s liquidity-preference theory is wrong, we must first point out that it is clearly wrong. It goes directly contrary to the facts that it presumes to explain. If Keynes’s theory were right, then short-term interest rates would be highest precisely at the bottom of a depression, because they would have to be especially high then to overcome the individual’s reluctance to part with cash—to “reward” him for “parting with liquidity.” But it is precisely in a depression, when everything is dragging bottom, that short-term interest rates are lowest. And if Keynes’s liquidity-preference were right, short-term interest rates would be lowest in a recovery and at the peak of a boom, because confidence would be highest then, everybody would be wishing to invest in “things” rather than in money, and liquidity or cash preference would be so low that only a very small “reward” would be necessary to overcome it. But it is precisely in a recovery and at the peak of a boom that short-term interest rates are highest.⁴

It is true that in a depression many long-term bonds tend to sell at low capital figures (and therefore bear a high nominal interest yield), but this is entirely due, not to cash preference as such, but to diminished confidence in the continuation of the interest on these bonds and the safety of the principal. In the same way, in the early and middle stages of a recovery, many bonds will rise in price and the yield they bear will therefore decline. But this will not be the result of diminished cash preference, but simply the result of increased confidence in the continuance of the interest and the repayment of the principal.

It is true again that when a boom has just busted, then in the crisis of confidence short-term interest rates will rise and sometimes soar. But the common-sense explanation of this is not merely a rise in cash preference on the part of lenders, and a compensation for increased risks, but a greatly increased demand for loans on the part of borrowers to protect security margins, and to carry unsold and temporarily unsaleable inventories of finished goods.

3. Interest Is Not Purely Monetary

The reader will notice that in the paragraphs above I have frequently substituted the term “cash preference” for Keynes’s “liquidity-preference.” I do not think that either term is helpful or necessary; they throw considerably more confusion, and considerably less light, on the condition to be analyzed than the traditional terms that Keynes rejects. But as between the two, cash preference is much to be preferred to liquidity-preference, not only because it is less vague, but because it does not, like liquidity-preference, make Keynes’s doctrine self-contradictory. For if a man is holding his funds in the form of time-deposits or short-term Treasury bills, he is being paid interest on them; therefore he is getting interest and “liquidity” too. What becomes, then, of Keynes’s theory that interest is the “reward” for “parting with liquidity”?

Even if a man carries his liquid funds, not in the form of cash under the mattress, but in the form of a demand bank deposit, the bank is lending out, say, some four-fifths of this, and therefore in combination they are getting the better of both worlds. For he still has the “liquidity” and the bank has the interest. One of the most unrealistic aspects of his wholly unrealistic theory is Keynes’s singular blindness to the fact that banks lend out the great bulk of their demand deposit liabilities, put them to work, and draw interest on them. If Keynes had confined his “liquidity-preference” theory to a pure cash-preference theory, he would have had to confine his theory to pocketbook cash and under-the-mattress cash, plus the cash reserves of banks. For these are the only unused “hoards” in the system. And the great bulk even of these would have to be set down, even by Keynes, as cash kept for “the transactions-motive.”

Now Keynes’s theory of interest is a purely monetary theory. Keynes, in fact, ridicules all theories of interest that bring in “real” factors. His attack on Alfred Marshall’s theory is typical:

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 (p. 189).

This is to throw out cavalierly not only Marshall but practically all the “classical” and “neo-classical” economists —in fact, all the economists who have made any contribution to the subject since the Middle Ages. Interest, of course, is normally paid in money. But so is rent; so are profits; so are prices; and so are wages. They all, like interest, “belong to a monetary economy.” On this reasoning we would take no account of real factors whatever but throw the analysis of everything into the books devoted purely to money.

Keynesians might go on to object that interest is paid not only in money but for money; that in this sense the phenomenon of interest is “purely monetary,” and is merely to be explained in terms of the supply of, and demand for, loanable funds. This type of supply-and-demand theory, often met with in current economic textbooks, is not incorrect, but it is superficial and incomplete. When we go on to ask what in turn determines the supply of, and demand for, loanable funds, the explanation must be made largely in real terms. But Keynes explicitly denies the relevance of these real factors.

A sufficient judgment on Keynes’s theory of interest was pronounced by Ludwig von Mises at least twelve years before Keynes’s theory was even published. The following passage is from page 133 of Mises’ The Theory of Money and Credit. This book was published in the American edition (New York: Harcourt, Brace) in 1935. But this is a translation from the second German edition, published in 1924:

To one group of writers, the problem appeared to offer little difficulty. From the circumstance that it is possible for the banks to reduce the rate of interest in their bank-credit business down to the limit set by their working costs, these writers thought it permissible to deduce that credit can be granted gratuitously or, more correctly, almost gratuitously. In drawing this conclusion, their doctrine implicitly denies the existence of interest. It regards interest as compensation for the temporary relinquishing of money in the broader sense—a view, indeed, of insurpassable naiveté. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest hold an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy.

And this, in fact, is the judgment of other competent economists. Frank H. Knight writes:

The most essential fact is that there is no functional relation between the price level and any rate of interest. Consequently, no monetary change has any direct and permanent effect on the rate. On this point such writers as Keynes and [J. R.] Hicks fall into the simple methodological fallacy dealt with in the early part of this paper—confusion of the power to ‘disturb’ another value magnitude with a real functional connection of causality. Keynes bases his whole argument for the monetary theory of interest on the familiar fact that open-market operations can be effective. Hicks makes the error more palpable.... Hicks assumes without qualification or reservation a definite (inverse) functional relation between the quantity of money and the interest rate.

It is a depressing fact that at the present date in history there should be any occasion to point out to students that this position is mere man-in-the-street economics.⁵

It is true that interest is paid in money, and on a capital sum usually specified in money, and that therefore monetary factors have to be considered, especially when considering dynamic changes in the rate of interest. Keynes’s fallacy consists in assuming that because monetary factors can be shown to affect the rate of interest, “real” factors can safely be ignored or even denied.

Whatever is true in Keynes’s theory of interest was discovered long ago by the Swedish economist Knut Wicksell, and is fully taken account of in the works of Ludwig von Mises,. F. A. Hayek, and others.

But an account of the real factors which govern the rate of interest will be reserved for the next chapter.

¹ Jacob Viner has made this point neatly: “By analogous reasoning [Keynes] could deny that wages are the reward for labor, or that profit is the reward for risk-taking, because labor is sometimes done without anticipation or realization of a return, and men who assume financial risks have been known to incur losses as a result, instead of profits. Without saving there can be no liquidity to surrender. [My italics.]... The rate of interest is the return for saving without liquidity.” Quarterly Journal of Economics, LI (1936-1937), 157.

² Reprinted as Chapter XV in The New Economics, ed. by Seymour E. Harris, (New York: Alfred Knopf, 1952).

³ W. H. Hutt, “The Yield from Money Held,” On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises (Princeton: Van Nostrand, 1956), p. 197 and p. 216.

⁴ See Appendix D, p. 448.

⁵On the History and Method of Economics, (University of Chicago Press, 1956), p. 222.