Liquidity Preference and Monetary Economies

Fernando J. Cardim de Carvalho

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317560807
• Edition: 1
• Topic: Commerce
• Subtopic: Commerce Général

The 2008 international crisis has revived the interest in Keynes's theories and, in particular, on Minsky's models of financial fragility. The core proposition of these theories is that money plays an essential role in modern economies, which is usually neglected in other approaches. This is Keynes's liquidity preference theory, which is also the foundation for Minsky's model, a theory that has been largely forgotten in recent years.

This book looks at liquidity preference theory and its most important problems, showing how one should understand the role of money in modern monetary economies. It develops Keynes's and Minsky's financial view of money, relating it to the process of capital accumulation, the determination of effective demand and the theory of output, and employment as a whole.

Building on the author's significant body of work in the field, this book delves into a broad range of topics allowing the general reader to understand propositions that have been mistreated in the literature including Keynes and the concept of monetary production economy; uncertainty, expectations and money; short and long period; liquidity preference theory as a theory of asset pricing under uncertainty; asset prices and capital accumulation; Keynes's version of the principle of effective demand; and the role of macroeconomic policy. It will be essential reading for all students and scholars of Post-Keynesian economics.

1 Introduction

Liquidity preference in monetary economies

In 1933, halfway between the publication of A Treatise on Money and The General Theory of Employment, Interest and Money (hereafter the GT), Keynes announced that he was working on a new conceptual framework to describe the dynamics of modern economies. He confessed to be dissatisfied with the way some essential problems were treated by the theories that were dominant at the time (and still are) and despaired of the possibility of reforming them. He reckoned that progress could only be made if those theories were replaced.

Experienced practitioners of any academic discipline know how difficult and painful such an endeavor is. Contrary to what is sometimes assumed, realism alone is not a sufficient reason to propose new fundamental concepts the content of which will be foreign to other practitioners. One has to face misunderstandings and the resistance of other practitioners whose careers were built relying on the development of established ideas, both solid obstacles to conceptual revolutions in any field. Many would-be revolutionaries are aware of how time- and effort-consuming persuading academic colleagues may be and, worst of all, that all the effort may end up being in vain.

The practical value of realism itself can be difficult to ascertain anyway. Fully realistic models, after all, can be impossibly complex to handle while simplistic renditions of a given situation may sometimes yield some valuable insights. The dilemma may be even worse for people like Keynes, whose prestige in the academic and political worlds had been built on a creative exploration of the boundaries of the period’s economic “orthodoxy.” To turn against one’s church, apostasy, is always a worse crime than that of being a born atheist. Besides, Keynes was never a “pure” economist. He was intent on persuasion, publicly arguing out policies to improve the lives of actual people (and, also, of course, strengthening the international standing of Great Britain). Becoming a heretic may be intellectually amusing for some but Keynes not only knew the costs of heresy, but he also respected his forebears. In the early 1930s it was obvious he was led to seek new ways to understand the workings of modern economies by necessity rather than by pleasure.¹

Keynes’s stated reason to seek to establish new conceptual foundations for economic theory was the need to deal properly with the properties of money in modern economies and the implications of such a treatment to the understanding of how such economies actually operate. In A Treatise on Money, Keynes arrived at an impasse when he proposed that monetary factors affected the amount of investment an economy would spend on. Keynes had always accepted the Quantity Theory of Money² (hereafter QTM) as a theory of the long run impacts of changes in monetary policy on real and monetary variables. In the Treatise itself, his belief on the QTM was reaffirmed. But the QTM was based on a view of money as a mere means of payment, a vehicle for the purchase of the commodities individual agents wanted. Money was neutral because the choice of vehicles was, very reasonably, supposed to be independent of the choice of commodities to be bought with those vehicles. Once it changed hands in settlement of a market transaction, the role of money in the process was ended, leaving no permanent or durable mark on what happened afterwards. Only “real” factors mattered to determine the “real” choices of consumers and investors.

The Treatise, however, suggested that monetary factors actually did leave a durable mark on the “real” economic process. Affecting the amount of investment, monetary factors had an impact on the quantity of real capital accumulated in a given period, a central determinant of long-run configurations in practically all economic theories one can think of. But “classical” economic theory³, of which the QTM was a fundamental pillar, was built on the idea that these effects did not exist. Keynes’s first attempt to deal with such a dilemma was to circumvent it. In the Tract on Monetary Reform, Keynes wrote his famous dictum “in the long run we are all dead” to support his simultaneous attempts to give a substantive role to money in the short run while forgetting all about it in the long run. After the publication of the Treatise this view was no longer tenable. Examining where the dilemma was rooted, Keynes realized that it was in the very foundations of the dominant theories of the time. “Classical” economics, the theories that became dominant in Great Britain in the last decades of the nineteenth century, was based on a Robinson-Crusoe-concept of economy. An individual, solitary in an island lost somewhere in the middle of the ocean, has to decide how to survive under semi-wild conditions.⁴ Crusoe had to choose between hunting and fishing, which gave different prizes since they yielded diverse levels of satisfaction, but demanded different amounts of effort. Moreover, he could postpone consumption while preparing better hunting and fishing instruments, illustrating how capital accumulation resulted from the interaction between Crusoe’s intertemporal preferences and the production transformation possibilities opened by his technical knowledge and availability of instruments. A modern economy was assumed to be an immensely more complicated Crusoe-type economy, but not really of a different nature. In fact, in the same year the GT) was published, 1936, Roy Harrod’s book The Trade Cycle came out, where this most typical phenomenon of modern industrial economies, the business cycle, was explained by reference to a modified Crusoe-type economy.

In the orthodox economist’s reading of Defoe’s text, Robinson Crusoe made choices between goods, by relating the satisfaction each class of goods offered to him against the effort needed to get them (his “budget constraint”). Following the same logic of behavior, he made choices as to how much capital he would produce and accumulate. Modern investors and consumers were supposed to behave according to the same logic. Crusoe economies, however, lacked money since there was no one else for Crusoe to deal with.⁵ Therefore, there was no way money could be an essential factor in this type of economy, affecting consumption and investment choices. This was the conclusion Keynes seems to have finally arrived at, once the Treatise was published and was severely criticized by friends and foes alike.

Monetary economies

In 1933 Keynes gave few details of what the new conceptual framework would look like, but he informed readers what kind of result he expected from its use. He called the new framework a monetary production economy. Its main feature was to rely on the proposition that “real” variables were no longer sufficient to describe either short or long period equilibrium positions of the economy, in contrast to what he called the cooperative economies of classical economics, where monetary forces did not affect real equilibrium positions. Money, therefore, was no longer neutral in monetary production economies, not even in the long period, in the sense that

… the course of events cannot be predicted, either in the long period or in the short, without a knowledge of the behavior of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.

(CW 13: 409)⁶

It is very important to stress, but also to clarify, this statement. For Keynes, the distinctive factor of a modern economy was that money played an essential role in it. To understand this role, it was necessary to identify and redefine the very foundations of the approach shared by dominant theories since they were all (or most) based on the idea that money is a late addition to the model, a qualification to be considered after everything essential to its workings had been identified and understood, as is done in a Crusoe-type economy. Keynes defended the idea that the results he wanted to stress could not be obtained by adding money to a fully structured “real” model, after its basic dynamics had already been determined.⁷ To show why money was not neutral in the short as in the long period was proposed by Keynes to be the core of the theory of a monetary production economy.

Once the goal had been clearly established, the next step was to identify the fundamental features of existing modern economies that allowed money not to be neutral. Keynes’s search for the elements that supported the non-neutrality of money was not systematic though, and it is not clear whether it could be.⁸ It is also unclear if one could formulate the fundamental model in a simple and elegant way as is possible in the Crusoe tradition. But Keynes and those of his followers that pursued the same goal were able to outline which should be the essential traits of a monetary production economy, capable of guaranteeing the desired non-neutrality of money.

It should be made clear, perhaps, at the outset, that a theory of a monetary production economy is historically, or more precisely perhaps institutionally specific. Keynes followed Marshall’s footsteps in understanding economics as an evolutionary discipline rejecting the radical ahistoricism proposed by Walras. Naturally, every economy faces the same fundamental problem of transforming natural resources into consumable output. Nevertheless, the way the economic activity is structured in order to solve that fundamental problem differs from one historical period to another, and from a type of social organization to another. One cannot elucidate how these economies work based only on “fundamental” notions. Keynes looked for a theory to explain the workings of modern economies, which he postulated to be structurally different from other types of economies, be those of the past, or those modern ones which were organized on different bases (such as the Soviet economy, contemporary to Keynes).

But Keynes would also develop an important methodological innovation. In the search for understanding the behavior of modern economies, Keynes would constantly move between two angles of approach. On the one hand, Keynes would ask himself what the individual decision-maker sees and how he or she processes the information received into the formation of expectations, how uncertainty is perceived and felt, and so on. Of course, he was not the only analyst taking this stand. Austrian economists also tried it, and Neo-Austrian economists proceed with this methodology. Keynes’s novelty was to combine it with the Classical Political Economy, which was later followed by neoclassical equilibrium theorists, bird’s eye view of the economy. In this angle of approach, the economist sees the economy as a deus ex machina, an outsider capable of seeing the whole picture at the same time, able, thus, to see how individuals interact, the extent to which such interactions constrain individual actions and confirm or negate expectations, etc. In other words, Keynes synthesizes the two methods of looking through the two alternative lenses, as an insider and as an outsider. Classical Political Economists tended to describe the great trends marking the development of capitalist economies. These trends were assumed to prevail no matter what individual agents thought or wanted. Radical individualists considered this nonsense, arguing that masses or social groups did not take decisions, individuals did. Keynes used both angles: the outsider view allows him to describe significant interactions between individual agents and the material and other constraints they face; the insider view allows him to see how individual decisions may shape these interactions and eventually change those constraints. For Keynes, there are no laws that impose themselves independently of the way individuals perceive constraints and set their goals. At the same time, individuals are not those absolute metaphysical entities, lost in time and space postulated by radical individualists. In the end, Keynes’s method, fully utilized in the GT, is to begin with individuals, to ask himself what they see, what are they capable of understanding, how they feel their own limitations when making economic decisions, and then aggregate it all into theory of social interactions that shape collective behaviors.

In his attempts to name such an economy, Keynes tried some other denominations than monetary production economy. The terms entrepreneurial economy, monetary economy and money wage economy were also tried.⁹ In this book we will use most frequently the term entrepreneurial economy, not only for shortness but also because it does focus attention right away on one of the fundamental features of the type of economy Keynes tried to define.

The most evident feature of an entrepreneurial economy is that its operation is led by firms. Firms tend to be a shadowy figure in modern economics. Conventional microeconomic theory usually reduces them to production functions, arguably a description of their “technical” side: a firm is the conduit through which inputs are transformed into outputs. Its “goal” is to maximize profits so that its owners can maximize their satisfaction by consuming a higher income than they would earn if each one tried to produce alone. Industrial organization studies, on the other hand, offer a more nuanced perspective of firms’s motives and behaviors, but this is rarely integrated into “pure” theory.

Keynes never showed much interest in microeconomics one way or the other. Most of the time, Marshall’s lessons in The Principles of Economics seemed to offer all he needed to know about firms. Nevertheless, when outlining his alternative to the Crusoe model of classical economics, the existence of firms and their central role in organizing production and capital accumulation seemed to mark the most fundamental difference between an economy describable through the production and consumption choices faced by a solitary individual and a modern economy, that is, an entrepreneurial economy. In his search for the key to understand why money is essential to the operation of a modern economy, Keynes, probably to his own surprise, got very close to Marx. Both thought that a capitalist firm is not a technical specification of how production is carried out, but a particular type of entity which pursues its own goals, which should not be confused with the goals of its owners or of its managers. Keynes approached the modern firm considering it an individual, defined by the particular object of its preferences: the control of wealth as such. As people demand specific consumption goods and are satisfied by their consumption, firms are proposed to demand wealth and to be satisfied with their accumulation. An important point of contrast between consumers and firms is that consumers increase their level of satisfaction when they can get hold of a varied basket of goods, while firms are not supposed to seek variety, because, again, it is wealth as such that they seek, in its most general form available.

The most general form of wealth in a market economy is money, which represents power to command a share of the incomes created in that economy at any time. Borrowing an expression from Marx, one can say that money is the general form of wealth, in contrast to the particular forms of wealth represented by stocks of specific goods which can only be expected to command social incomes if there is a solvable demand for those goods at a given particular moment.

The references to Marx are not gratuitous. They were, in fact, suggested by Keynes himself (CW 29: 81). When trying to clarify the nature and role of the firm in an entrepreneurial economy he appealed to Marx’s well-known scheme of commodity circulation in a capitalist economy. Marx described it through a simple formula: M→ C→ M′, where M is the amount of money invested in the purchase of labor force and means of production at the beginning of the production cycle, C are the commodities produced during the cycle and M′ is the surplus-value-added amount of money (M′ > M) obtained at the end of the cycle, after the sale of output. Money is the beginning and the end of the process. Keynes borrows the idea stating that

The firm is dealing throughout in terms of sums of money. It has no object in the world except to end up with more money than it started with. This is the essential characteristic of an entrepreneur economy.

(CW 29: 89)

Firms are not supposed to accumulate money wealth because of money illusion, that is, the inability to distinguish “real” wealth from a pile of paper. They do so because the ability to sell a firm’s output in the market means the social validation of that firm’s activity. A firm may be very productive, employ state-of-the-art production methods and still fail if it is not able to sell its production for money. In Keynes’s entrepreneurial economy approach, wha...