The Errors in Liquidity Preferences

By: Frank_Hollenbeck

The theoretical construct of Keynes’s monetary view of the world is known as the liquidity preferences theory of money. This theory is the foundation of many macroeconomic models and stands in stark contrast to the classical view of interest rates, the loanable funds theorem.

Much of Keynes’ work, including this theory, disproportionately elevated the importance of holding cash as a key economic variable. Income can be consumed, saved or held in cash. Consumption is for personal satisfaction. Saving is a transfer of claims on goods and services from consumers to investors. Holding cash, or hoarding, is the equivalent of stuffing money in your mattress.

Keynes’ liquidity preference theory of money is structured around this desire to hold cash. According to this theory, the demand for money is a demand to hold cash, for transaction, precautionary and speculative reasons. The key relationship is the speculative motive to hold cash. It is the only relationship that links the desire to hold cash to interest rates.

Normally, when interest rates go up, bond prices go down and vice versa.

According to Keynes, when interest rates rise, the public will hold less cash and purchase bonds, or increase their savings, expecting interest rates to drop. If interest rates fall, the public will want to hold more cash and fewer bonds, saving less, presuming interest rates will eventually rise again. The locus of relationship points between the interest rate and the demand to hold cash gives us the demand curve for money. The equilibrium interest rate is then established where the supply of money equals the demand to hold cash. This money market equilibrium establishes the exclusive link between the money supply and nominal income (the Cambridge equation).

There are at least two major problems with this theory. When interest rates rise, the theory assumes the public switches exclusively from holding cash to savings: there is no switching from consumption to either savings or holding cash. The same is true when rates fall, the public switches from savings to holding cash, while consumption is left out of the picture. Interest rates only affect the choice between savings and holding cash, nothing else. Consumption is held constant. Of course, this goes against sound economic analysis which views interest rates as the price of the time preference of consumption. It is also totally inconsistent with the loanable funds theory of interest rates.

The second, even greater, problem is the logic underlying expectations of future interest rates. One of Keynes’ important contributions to economic theory was to highlight the importance of expectations in the economic decision process. Although his explanation of expected future interest rates may have been novel in the 1930’s, it is totally outmoded today. His followers seem to be totally ignorant of advances in other fields.

When investors expect interest rates to fall, they will fall immediately, and when investors expect them to rise, they will rise immediately. Expectations have been incorporate into current interest rates so that future interest rates follow a random walk and are not influenced by current expectations. The Keynesian logic that justified a switching between savings and holding cash does not exist. There is no speculative demand to hold cash, and, therefore, no relationship between the interest rate and this desire to hold cash. There is no money market equilibrium, and therefore no exclusive link between the money supply and nominal income.

The feeble attempts found in most textbooks to theoretically justify a relationship by invoking the opportunity cost of money was resolutely crushed by the leading Keynesian, James Tobin,

Nearly two decades of drawing downward sloping liquidity preference curves in textbooks and on classroom blackboards should not blind us to the basic implausibility of the behavior they describe. Why should anyone hold the non-interest bearing obligations of the government instead of its interest bearing obligations? The apparent irrationality of holding cash is the same, moreover, whether the interest rate is 6 %, 3 % or ½ of 1%.

The logic of Keynes’s theory is turned on its head, and the theory should have been, a long time ago, thrown onto the trash heap of ill-conceived economic ideas. The same should have occurred to its derivatives, the liquidity trap (as defined by Keynes), and economic models such as the IS-LM (a Krugman favourite) or AD-AS models built on a foundation of liquidity preferences. A large part of what is written in macroeconomic textbooks today should be discarded. When you foundation is false, anything built on top of it is also incorrect.

The correct definition of a “liquidity trap” is when the central banks provide liquidity but cannot find any takers. In other words, it can bring a horse to water but cannot make him drink. Today, banks have few creditworthy customers who want to borrow even at a zero lower bound. The public is still deleveraging and has little appetite for more debt, and businesses are keenly aware of the price distortions, such as interest rates, of current monetary policy. They are also keenly aware that the malinvesments of the boom years have not been cleared off because the FED has allowed banks to “extend and pretend”.

The real damage of this theory, however, is in its policy prescriptions. Economists, today, use a simplified version of the original quantity theory of money- the Cambridge equation. This version is also obtained from liquidity preferences. This has led central banks to singularly focus on consumer prices. They should, however, have been more concerned with the relationship between money and all prices. The original quantity theory of money related money to all transactions, not just nominal income. Prices in the original quantity theory of money theory were on anything money could buy, consumer goods, stocks, bonds, stamps, land etc.

It is now becoming more and more evident that if the central bank had used a correct measure of inflation, including the rise in asset prices, it would have realized in the 1920’s and between 2001 and 2007 that its monetary policy was too easy for too long, creating massive (defined correctly) inflation (mostly increases in asset prices). The central bank was looking at a grouping of healthy trees while the forest was burning around it. Obviously, we have learned nothing from history. Even today, a tame CPI is not reflecting the disastrous inflationary effects on asset prices, a direct consequence of ultra-loose monetary policy.

Unfortunately Keynes theories gave politicians the intellectual firepower to continue to implement socialist policies which had previously been ridiculed by such heavyweights as Ricardo, Bastiat, or Mill. It is time to shed the intellectual shackles of Keynesian economics, turn the clocks back, and reset economics on the solid theoretical foundations of its past.

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.

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