Chapter 15
THE PSYCHOLOGICAL AND BUSINESS INCENTIVES TO LIQUIDITY
I
We must now develop in more detail the analysis 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;¾for
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 accumulated
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 analysis 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
can¾equally well, and, perhaps,
better¾consider the individual's
aggregate demand for money in given circumstances as a single
decision, though the composite result of a number of different
motives.
In analysing the motives, however, it is still convenient to
classify them under certain headings, the first of which broadly
corresponds to the former classification 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 classified 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 disbursement. 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 disbursement. 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 passes.
(iii) The Precautionary-motive. To provide
for contingencies requiring sudden expenditure and for unforeseen
opportunities of advantageous purchases, and also to hold an
asset 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 asset, 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
quantity of money.
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. But it is by playing on the
speculative-motive that monetary management (or, in the absence
of management, chance changes in the quantity 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
circumstances 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 quantity 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 circumstances or expectations will
not be capable of causing any displacement of money whatever;¾it 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 circumstances 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 circumstances 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 circumstances or expectations
will cause some realignment in individual holdings of money;¾since, 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 associated 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';¾which 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 analysis, 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 associated 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;¾in 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
assets 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 assumed 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) = ¾¾ = 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 classes and on the effective cost of
holding idle cash. Nevertheless, if we have a short period of
time in view and can safely assume 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 quantitative relation to a given rate of
interest of r;¾what 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
associated 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 quantities 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;¾particularly 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 associated,
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 association 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
movement¾up 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;¾the 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
quantity 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 analysis will only be useful and significant
in so far as there is some specially direct or purposive
connection between changes in the quantity 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 assets 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
quantity 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
quantity of money would be the amount which can find a home in
the possession of individuals who¾after
taking account of all relevant circumstances¾prefer
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;¾though 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
quantity 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 circumstances. 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 kind¾a 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
passu. 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;¾a
bank may have to charge its customers 1½ to 2 per cent., even if
the pure rate of interest to the lender is nil.
IV
At the cost of anticipating 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 quantity 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 hoard (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 quantity, O, and the price, P, of
current output, we have Y = OP,
and, therefore, MV = OP;
which is much the same as the quantity theory of money in its
traditional form.
For the purposes of the real world it is a great fault in the
quantity 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
assumptions that there is no propensity to hoard 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 quantity of
money.