Chapter 14, Liquidity Preference
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
and how much he will reserve in some form of command over future consumption, page 166.
This decision having been made, the individual must then decide, in what form he will hold
the command over future consumption, page 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
Mises' 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.
Page 166.
Keynes goes on,
It should be obvious that the rate of interest cannot be a return to saving or waiting as
Much. 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
of Liquidity is a measure of the unwillingness of those who possess money to part with their
liquid control over it, pages 166 through 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.
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
But as a serious explanation for the market prices of commodities, I do not believe it would have any advantages over the purchase of tomatoes.
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
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 1.
The transactions motive, i.e. the need for cash for the current transaction of personal
and Business Exchanges, the precautionary motive, i.e. the desire for security as the
future cash equivalent of a certain proportion of total resources, and the speculative motive,
i.e. the object of securing profit from knowing better than the market what the market will
will bring forth, page 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.
Page 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, pages 196 through 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 a 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 or not 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.
Money, it is well known, serves two principal purposes.
By acting as a money of account, it facilitates exchanges without its being necessary that
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.
Pages 186 through 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?
Page 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.
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
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.
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
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,
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 as 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
He would have had to confine his theory to pocketbook cash and under-the-matress 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
and 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, page 189.
This is to throw out cavalierly not only Marshall but practically all the classical and neoclassical
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.
Menzians 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 12 years before Keynes's theory was even published.
The following passage is from page 133 of Mises's 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
And 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 naivete.
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
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
Hicks 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.
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
Newt Wicksow 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
for the next chapter.