Critical Review
    vol. 8, no. 3 (Summer) 1994, pp. 451-460
     

    High Interest, Low Demand, and Keynes: Rejoinder to Hill and Felix

    Roger W. Garrison
     

    Both Greg Hill(1) and David Felix(2) call attention to the liquidity-preference theory of interest in their discussions of Keynes's General Theory, Meltzer's interpretation, and my review article. Both draw from Keynes's Chapter 13, "The General Theory of the Rate of Interest," which argues that interest is "the reward for parting with liquidity," (3) or "the compensation received for parting with liquidity for a specified period of time, that is, for not hoarding." (4) Interestingly, this critical aspect of Keynes's analytical framework is highlighted by the two commentators for radically different reasons. Hill restates the liquidity-preference theory and defends it on his way to arguing that the market has no mechanism to govern the rate of investment--and that government should step in and fill the void or, at least, lead the way; Felix points to a single sentence that captures the essence of the liquidity-preference theory and offers it as conclusive evidence that Keynes's views on interest-rate determination are "nonsensical" and that "his pure theory is the purest piffle." Both commentators hint that I have misread or not read Keynes.

    High Interest
    Keynes's liquidity-preference theory of interest, which was the focus of the earliest critical analysis, follows almost trivially from his idiosyncratic way of framing the issue. Individuals earn incomes, which permit them to buy goods and interest-earning assets and to hold money. Keynes formulates his theory by imposing a particular sequence on the income-earner's decision process:
     

      The psychological time-preferences of an individual require two distinct sets of decisions to carry them out completely. The first is concerned with that aspect of time-preference which I have called the 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. ¶ But this decision having been made, there is a further decision which awaits him, namely, in what form [i.e., interest-earning assets or money] he will hold the command over future consumption which he has reserved ... [emphasis altered].(5)
       
    For Keynes, the decisions about how much to spend, how much to put at interest, and how much to hold liquid are made seriatim. And the particular sequence posited seems to suggest a liquidity-preference theory of interest. Dennis Robertson noted this strange manner of theorizing early on: "Such loose phrases as that interest is not the reward for not-spending but the reward for not-hoarding seem to argue a curious inhibition against visualizing more than two margins at once."(6) Robertson's own argument was that if we do allow ourselves to visualize three margins simultaneously, we can see that Keynes's liquidity-preference approach and the more conventional loanable-funds (or time-preference) approach are largely if not wholly complementary. Although "time-preferences" are mentioned twice in the quoted passage, they get completely dissociated from the rate of interest by a preliminary and allegedly interest-independent decision about present consumption, which leaves for a subsequent decision one option that pays interest and one that does not. The fact that Keynes failed to realize that the seemingly revolutionary character of the liquidity-preference theory hinged critically upon an arbitrary and somewhat contrived notion about the sequence of decisions lends some support to Felix's characterization of Keynes's pure theory.
            An implicit acceptance of Keynes's two-margins-at-a-time formulation underlies Hill's restatement of Keynes's argument: "the person who sets a portion of her income aside, holding it in the form of money, earns no interest at all, even though she postpones the consumption of her wealth. Interest earnings cannot, then, be explained as the reward for deferred consumption" (7) A different argument would result, however, from focusing on a different pair of margins: if she were to part with liquidity in order to increase current consumption, she would earn no interest by so doing. Must we not conclude, then, that interest earnings cannot be explained as the reward for parting with liquidity? Clearly, if we allow for adjustments at all margins, the choice of any one of the three options (goods, interest-earning assets, or money) entails the foregoing of the other two.
            Outside the context of Keynesian theorizing (in which the relevant second choice is between money, narrowly defined, and a perpetual, or at least long-term, interest-earning asset) it can easily be seen that parting with liquidity is neither necessary nor sufficient for earning interest. Trading liquidity for consumption goods, as indicated above, demonstrates the insufficiency. Trading money for Treasury bills demonstrates the non-necessity. If the T-bill rate is the reward for parting with the liquidity differential separating money from T-bills, while the spread between T-bills and the market rate of interest is the reward for a more dramatic parting with liquidity, then we have an extremely skewed and curious reward structure. (8) Further, Keynes's willingness to define money broadly as well as narrowly works against his theory of interest. It may sometimes be convenient, as Keynes suggests, to include time deposits and even Treasury bills and other short-term debt instruments in our concept of money. (9) But what happens to the liquidity-preference theory when we can have our money and earn interest too?
            Pre-Keynesian economists felt themselves justified in treating the trade-off between present consumption and deferred consumption as fundamental. This trade-off is pervasive even in barter economies. Ends achievable today may be sacrificed in favor of means that will not achieve ends until much later. Robinson Crusoe as well as members of primitive trading societies make choices that imply a comparison of values over time. These intertemporal value comparisons can be summarily described in terms of a rate of interest. The introduction of a medium of exchange facilitates trade by creating the option of trading for nothing-in-particular, which can then be traded--either immediately or sometime later--for a specific object of value. The use of money adds a new dimension to economic decisionmaking and to economic theorizing, but to take the rate of interest as reflecting the price of nothing-in-particular--or the reward for parting with it--is to mistake the facilitator for the more fundamental objects of exchange.
            My exposition of "Keynesian Splenetics" departs from textbook Keynesianism and from Meltzer's "different" interpretation by incorporating the hard-drawn liquidity-preference theory. I take Keynes as claiming that the interest rate is determined by monetary factors alone.(10) It can influence--but cannot directly be influenced by--the rest of the economy. The supply and demand for money determine the current equilibrium rate of interest; the supply of money is set by the central bank; and the demand for money depends (exclusively) upon anticipated changes in the interest rate. Keynes's rate of interest is completely severed (in one direction) from the real economy, as Hill correctly notes and as was emphasized early on by Robertson: "The interest rate is what it is because it is expected to become other than what it is ... ."(11)
            Hill indicates that "it is hard to follow Garrison in imagining the interest rate being reduced to zero."(12) It is not necessary, however, that he follow me; he need only follow Keynes from his prescriptions of policy to his recommendations for reform. In the short run, the central bank can influence the rate of interest by manipulating the supply of money. Conventional wisdom about what constitutes a "normal" rate of interest governs speculation about likely movements in the interest rate and hence determines the current demand for money. Given these demand considerations, an increase in the money supply will--within limits--put downward pressure on the interest rate. As a general policy prescription, the central bank should provide whatever amount of money may be required to fully satisfy people's propensity to hoard, so that their hoarding will not drive up the interest rate and discourage investment.
            While policy is implemented through money-supply adjustments, reform is based on considerations of money demand. In the long run, a comprehensive socialization of investment can reduce risks, according to Keynes, and hence can reduce the so-called normal rate of interest. In this way the "rest of the economy" does influence the interest rate. It has become standard fare in textbooks that an extremely interest-elastic demand for money (the liquidity trap) may put a strict lower limit on reducing the interest rate (meaning the equilibrium rate, given a conventional wisdom about the normal rate). Monetary expansion may push the interest rate down to its liquidity-trap level without stimulating enough investment to fully employ the economy's labor force. But the Keynes of Chapter 24 holds out hope for fundamental reform that can reduce both the normal rate of interest and the marginal efficiency of capital virtually to zero within one or two generations. In an earlier chapter, the time frame is stated as a single generation. (13)
            With zero as the supposed ideal, any positive rate of interest, whether attributable to expectations that the interest rate will rise toward its normal level or to the socially unnecessary risks that are reflected in the normal rate itself, must be judged as "too high." But the belief that a zero rate of interest is possible flies in the face of the time-preference theory, which holds that values lying in the future are systematically discounted. Robertson's judgment that the liquidity-preference and time-preference approaches are complementary cannot be extended to Keynes's Chapter 24 or to the passages in earlier chapters that anticipate this final chapter.
            One difficulty in reading and interpreting Keynes stems from his intermingling propositions that have immediate implications for policy with propositions which presuppose fundamental reform. Meltzer's book helped me overcome this difficulty by highlighting the distinction between what is commonly called Keynesian Hydraulics, in which monetary and fiscal policies inject spending flows and stem leakages within the existing institutional setting, and what I have called Keynesian Splenetics, in which reforms that make the investment sector more public-minded change the setting.

    Low Demand
    Both Hill and Felix point to another aspect of Keynes's theory, namely, the supposed waning of spending propensities as wealth increases, as critical to interpreting his message. As people earn higher incomes and accumulate wealth, their spending does not increase proportionally. The increasing gap between spending and earning works as a drag on the economy. Each year investment spending needs to rise in order to turn the increased savings into more income but is likely to fall in anticipation of a still further weakening of consumption demand. According to Hill, "Keynes reasoned that a redistribution of wealth would increase the propensity to spend and, therefore, the inducement to invest"(14) This aspect of Keynesian theory is offered as evidence that "it is the economic analysis which produces the social vision and not the other way around." Felix characterizes the notion of spending waning with wealth as an "unproven ... proposition"(15) and argues elsewhere that the supposed relationship between spending propensities and wealth levels was no more than an assumption and that modern empirical research reveals a lack of supporting evidence.(16)
            The general notion that the economy is beset by demand deficiencies--whether or not these deficiencies are believed to increase proportionally or only absolutely with income--has given scope to alternative interpretations of Keynes's central message. Is the widespread unemployment of labor and of other resources ultimately attributable to the mispricing of these factors of production--and to a corresponding mispricing in product markets? Or does the deficiency persist even when the economy is in equilibrium (in the sense of market clearing) in both factor and product markets? Keynes's willingness to state the problem by comparing the business of pyramid building in Ancient Egypt to the business of railway construction in modern England suggests that his theory did not hinge on the difference between equilibrium and disequilibrium. "Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York." (17) They are twice as good not because pyramid markets clear while railway markets do not but because two--or twenty--can be ordered up from on high independent of any waning of consumption propensities. The ultimate solution to the problem of demand deficiencies, then, is not to be found in policies that encourage wage and price flexibility or even in monetary and fiscal policies that add to total demand. The ultimate solution, in Keynes's final reckoning, is reform in the direction of a command economy. This is the general thrust of Keynesian Splenetics.
            Hill finesses the critical question about the nature of demand deficiency. Whether the spending gap is conceived as a disequilibrium or an equilibrium phenomenon, Hill sees a vital role for government in leading the business community back to full employment. During a slump, an individual firm that expands its own operations would be doing more good for society than would be reflected in its own profits. But, expecting modest profits at best and fearing losses in the event that no general economic expansion develops, each individual firm is unlikely to expand. The role for government, then, according to Hill, is one of converting some of the largest firms to public ownership and allowing those firms' decisions to be based on the benefits to society as a whole. Alternatively, the government could orchestrate the expansion of privately owned firms through some sort of indicative planning. Envisioning such roles for government entails a dramatic departure from the fiscal and monetary policies associated with the Keynesian Hydraulics of modern textbooks, but Keynes himself provides clear supporting text: "I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of general social advantage, taking an ever greater responsibility for directly organizing investment ... .(18) There is not much distance between Hill's (and Keynes's) idea of government as bellwether or sheepdog and Keynes's hint in Chapter 24 of a comprehensive socialization of investment.
     
    Instincts and Visions
    Finally, let me comment on Keynes's wisdom, as judged by Felix, in seeing the darker side of the socialist development. Felix quotes from the first paragraph of a letter to F. A. Hayek in which Keynes praises Hayek's Road to Serfdom: "morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement with it, but in a deeply moved agreement."(19) A critical difference between Keynes's and Hayek's thinking, however, is revealed in the two final paragraphs: "Moderate planning will be safe if those carrying it out are rightly orientated in their own minds and hearts to the moral issue ... . Dangerous acts can be done safely in a community which thinks and feels rightly, which would be the way to hell if they were executed by those who think and feel wrongly." (20) In sharp contrast to Hayek, Keynes was an elitist. He believed that the agencies of government would--or should--be populated by an elite who take the long view, who act with a eye toward social advantage, and who respect the rights and liberties of those over whom they have power. Hayek hoped for institutions that would uphold the rule of law--that would protect people's rights and liberties no matter which particular individuals populate the agencies of government. Felix uses this letter to Hayek to suggest that Keynes was "true in instinct and realistically in equilibrium with economics and politics"; I see the letter as clear evidence of the difference between Keynes and Hayek in terms of their contrasting visions of the macroeconomy and of the potential for government to compensate for the market's perceived shortcomings.
            I do not intend to suggest, as Hill hints that I may, that having a pre-analytic vision about economic relationships is, in and of itself, a corrupting influence on the analytics. I do suggest, following Meltzer and Schumpeter, that a difference in vision, e.g., as between Keynes and Hayek, is more fundamental than differences in analytics. According to Schumpeter, "analytic effort is of necessity preceded by a preanalytic cognitive act [which he calls a vision] that supplies the raw material for the analytic effort." (21) Schumpeter cites Keynes as the most telling example of intellectual development illustrating his point. He argues that the Keynesian "vision, as yet analytically unarmed," was clearly present in Keynes's 1919 book The Economic Consequences of the Peace.(22) In my judgment, Meltzer's book contributes importantly toward substantiating Schumpeter's methodological views.
            Can Keynes's General Theory be seen as a collection of mutually reinforcing and jointly supportable propositions about the functioning of a market system and about the implied policy prescriptions and needed reform? After more than a half-century of debate, it is difficult to answer this question in the affirmative. There are too many loose arguments, too many inconsistencies, and too much scope for interpretation. There is some textual evidence to weigh in favor of each of the many competing interpretations. But Meltzer has come the closest, in my judgment, to producing the proverbial smoking gun--in the form of Keynes's social philosophy. His interpretation, which maximizes the fit between Keynes's macroeconomic theories and his early beliefs, gets high marks as a plausible interpretation having a substantial basis in the text. Assessing the economy's performance under actual as compared to ideal circumstances, as Meltzer does, or comparing capitalism-as-it-is with socialism-as-it-has-never-been, as I do, captures much of both the substance and the spirit of Keynes's book. My own interpretation differs from Meltzer's largely in its being less complimentary to Keynes. I can readily accept Hill's summary of my review article, according to which I have added a critical dimension to Meltzer's analysis by arguing that Keynes's vision is so utopian as to weaken his case against allowing markets to work.(23) But this difference aside, I find Meltzer's interpretation more plausible and truer to Keynes than any of those that have gained wider acceptance.

    Notes:

    *Roger W. Garrison, Department of Economics, Auburn University, Auburn, AL 36849, telephone (205) 844-2920, telefax (205) 844-4016, wishes to thank Thomas J. McQuade and Leland B. Yeager for their helpful comments.

    1.. Greg Hill, "Misreading Keynes: Reply to Garrison," Critical Review, vol.8, no. 3 (Summer 1994), 441-46.

    2. David Felix, "Interpreting Keynesian Instinct and Keynesian Theory: Reply to Garrison," Critical Review, vol.8, no. 3 (Summer 1994), 447-49.

    3. Quoted by Felix from John Maynard Keynes, The General Theory of Employment, Interest, and Money (London: Macmillan, 1936), 167.

    4. Reported by Hill with citation to Keynes, General Theory 166-67.

    5. Keynes, General Theory, 166.

    6. Dennis H. Robertson et al., "Alternative Theories of the Rate of Interest," Economic Journal, 42 (September 1937), 431.

    7. Hill, 3-4.

    8. I leave aside the question of whether a market price (of liquidity, credit, labor, or goods and services) is usefully thought of as a reward. Is the price of a movie ticket the theater owner's reward for allowing a patron to watch a movie? Hayek argues, in effect, against conceiving the wage rate as the reward for parting with leisure. "Reward" implies a meritorious act, which parting with leisure (or liquidity) does not necessarily entail. His arguments apply with greater force, in my judgment, to the interest rate. See Friedrich A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960), Chapter 6.

    9. Keynes, General Theory, 167, n. 1.

    10. Roger W. Garrison, "Keynesian Splenetics: From Social Philosophy to Macroeconomics," Critical Review 6, no. 4 (Fall 1993), 483.

    11. Robertson, "Alternative Theories," 433.

    12. Hill, 5-6.

    13. Keynes's General Theory contains several passages in which a zero marginal efficiency of capital in equilibrium (which implies a zero rate of interest, too) is taken to be an attainable goal: "a properly run community ... ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation" (220). "If I am right in supposing it to be comparatively easy to make capital-goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism" (221). And: "only experience can show ... how far it is safe to stimulate the average propensity to consume, without forgoing our aim of depriving capital of its scarcity-value within one or two generations" (377).

    14. Hill, 5.

    15. Felix, 2.

    16. David Felix, "Consuming Our Way to Greater Well-Being: Theory and History," Critical Review 3, nos. 2-4 (Summer-Fall 1989) 589-99.

    17. Keynes, General Theory, 131.

    18. 18. Ibid., 164.

    19. Quoted by Felix from John Maynard Keynes, Collected Writings (London: Macmillan, 1971-1983), 27:385-88.

    20. John Maynard Keynes, Collected Writings (London: Macmillan, 1971-1983), 27:385-88.

    21. Joseph A. Schumpeter, History of Economic Analysis (New York: Oxford University Press, 1954) 41.

    22. Ibid. 42.

    23. Hill, Abstract.