Re: Uncertainty and Liquidity Preference

["John M. Legge" <jlegge@xxxxxxxxxx>]

Ted,

for a microeconomic explanation of liquidity preference you could look up Dixit and Pindyck's "Investment Under Uncertainty" or Dixit's JEP paper "Investment and Hysteresis". (NB: Michael Perelman considers Dixit's work derivative, so you could chase Michael or Dixit's references for more original source readings.)

"Fundamental" uncertainty does not rule out inertia (today is still the best predictor of tomorrow's conditions) but it implies non-stationarity (the standard deviation of a prediction increases without limit as the time from the last empirical data point increases).  Dixit uses a geometric random walk to illustrate this and to derive some analytic solutions, but a random walk is not the only nonstationary model by any means.

Cash gives the holder the option to invest now or to wait for something better to turn up: this "real options" theory of investment is now everywhere in the business literature, even getting a small run in Business Week.  Prospective investments, to attract a rational investor, must not merely offer a better return than cash or short term deposits, but this return must be sufficiently attractive to "buy out" the option value associated with holding cash.

Expressed as hurdle rates, the rational investor offered an uncertain investment will demand two, three or even more than the current cash rate.

In anecdotal rather than analytic terms it becomes easy to see how a spirit of general pessimism leading to low forecasts of returns to investment could encourage holders of cash to go on holding it, which would reinforce the depressed forward outlook through the workings of Keynes' investment multiplier. Optimistic forward projections, if widely held, would have the opposite effect.  In either case, expectations are self-reinforcing in the short and medium term, which is all that concerns living men and women,

JML





----- Original Message (part)-----
From: Ted Winslow <winslow@xxxxxxxx>
To: POST-KEYNESIAN THOUGHT <pkt@xxxxxxxxxxxxxxxx>
Sent: Monday, 12 July 1999 9:53
Subject: Re: Uncertainty and Liquidity Preference


>
>
> I've read you too Paul.  I'll read you again more carefully.  My
> recollection is that you don't answer the question either, however.  The
> reference to Chap. 16 of the GT doesn't help me.
>
> I don't think Keynes treats liquidity preference as a rational way of
> dealing with fundamental uncertainty.  Like conventional forecasting
> practices, liquidity preference in this context is a way of avoiding the
> anxiety provoked by _consciousness_ of fundamental uncertainty.
> Conventional forecasting practices work by suppressing this consciousness;
> they enable us to "hide from ourselves how little we foresee."
>
> The "feeling about money" that enables anxiety to be avoided by holding
> money is, like these forecasting practices, "itself conventional or
> instinctive" but "operates, so to speak, at a deeper level of our
> motivation". "It takes charge at the moments when the higher, more
> precarious conventions have weakened.  The possession of actual money lulls
> our disquietude; and the premium which we require to make us part with
> money is the measure of the degree of our disquietude."  (XIV, p. 116)
>
> Fundamental uncertainty is invariant; what varies is _consciousness_ of
> fundamental uncertainty.  For the psychological reason just pointed to,
> liquidity preference varies with this consciousness.
>
> The discussion in Chap. 16 is fully consistent with this.  It treats the
> marginal efficiency of capital as the product of conventional forecasting
> practices, i.e. as the outcome of practices associated not with rational
> "faith" in the "optimistic hypothesis" but with an irrational need to "hide
> from ourselves how little we foresee."  Thus "the expectation of future
> consumption is so largely based on current experience of present
> consumption that a reduction in the latter is likely to depress the former,
> with the result that the act of saving will not merely depress the price of
> consumption-goods and leave the marginal efficiency of existing capital
> unaffected, but may actually tend to depress the latter also". (VII, p. 210)
>
> Another difficulty with basing an interpretation of the relation between
> uncertainty and liquidity preference on the premise that individuals are
> always fully conscious of fundamental uncertainty and act rationally in
> relation to it is raised by Keynes's claim in Chap. 16 that an "absurd"
> idea about the effect of increased saving on investment - Say's law - is
> "almost universal".  Moreover, "it is of this fallacy ['that current
> investment is promoted by individual saving to the same extent as present
> consumption is diminished'] that it is most difficult to disabuse men's
> minds."  (VII, p. 211-2)  Why would sensible people be "most difficult to
> disabuse" of an "absurd" idea?
>
> Ted
>
>
>
>
>
> Ted Winslow                          E-MAIL: WINSLOW@xxxxxxxx
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>