Re: Uncertainty and Liquidity Preference

["David Dequech" <dequech@xxxxxxxxxxxxxx>]

Regarding this thread, it is useful to distinguish between theory and
history of thought (in particular Keynes's thought). I personally am more
interested in theory (and in using Keynes's and other people's insights to
develop better theories). Thus, I will focus on what I think we should say
about uncertainty, liquidity preference and rationality rather than on what
Keynes said about this.

Ted argues that uncertainty of the fundamental kind isn't capable of degree
and, from this premise, which may be accepted or not, he rightly deduces
that
variations in uncertainty cannot be used to explain variations in liquidity
preference.
Even without questioning that premise, one can argue that there is a
rationale for liquidity preference under this type of uncertainty. In my
opinion, Paul's reply to Ted provides part of the answer, by presenting a
view of the nature of liquidity preference. The other part has to do with
something that hasn't been mentioned in the recent postings, namely the
*motives* for liquidity preference. In particular, the motive that would be
present even if fundamental uncertainty didn't admit of degrees is the
precautionary one. Incidentally, this motive has been mentioned in the
literature by several Post Keynesians, Paul included.
Depending on what I call in my recent JPKE article the willingness to face
uncertainty, or uncertainty aversion, the awareness of uncertainty would
justify the holding of some liquid assets (which are not reduced to money),
for the decision-maker to at least in part protect himself/herself against
undesired unforeseen circumstances. The connection with Paul's reply lies,
for example, in the fact that these circumstances may affect the
decision-maker's ability to honour his commitments.

Now, if we can speak of degrees of uncertainty, then additional motives
would exist which vary with what I called uncertainty perception. In
particular, if fundamental uncertainty may vary over time and if the
perception of such uncertainty has any rational basis, then people may
rationally wait for fundamental uncertainty to be reduced so that they can
form expectations with greater confidence. In my scheme of analysis,
confidence, which Keynes relates to the liquidity premium of money (see the
passage of the 1937 QJE article quoted by Ted), depends both on uncertainty
perception and on uncertainty aversion.

I don't claim that this is what Keynes said. Regarding Keynes's view on
these matters, and particularly on the connection between confidence and the
liquidity premium, one has to look not only at the QJE passage quoted by
Ted,
but also at chapter 17 of the GT and a 1938 letter to Townshend in volume
XXIX of Keynes's Collected Writings. In both places, Keynes connects the
liquidity premium with the notion of weight he presented in A Treatise on
Probability. This connection has also been noted by people like O'Donnell,
Carabelli and Runde.

Cheers,
David Dequech