Re: Uncertainty and Liquidity Preference

[chip poirot <csp@xxxxxxx>]

Ted Winslow wrote:

> Chip, Paul, John, David:
>
> My question isn't about liquidity preference in general.  It's about the
> rationality of holding money as a way of dealing with the fundamental
> uncertainty of the long run future yields of capital assets, i.e. the Qs in
> Keynes's definition of the marginal efficiency of capital. Keynes claims
> these are fundamentally uncertain in the sense that they are usually
> unknowable i.e. "about these matters there is no scientific basis on which
> to form any calculable probability whatever.  We simply do not know."

First, if I understand what you are getting at correctly, you are mixing the
concepts of MEC and liquidity preference. The MEC is, as I understand, the
expected NPV of one additional unit of investment in physical capital and is
partially determined by the cost of money (the rate of interest on borrowing
money or the cost of raising capital in financial markets).

If I want to start a business today, I have a rough idea of the NPV of buying a
steel mill. I also know the cost of borrowing. What I do not kow is if the U.S.
will ban cheap imports of Russian steel, if the U.S. will initiate a new cold
war with China, etc. If my memory serves me correctly when Keynes writes about
uncertainty he gives the sense in which a new war in Europe is uncertain as an
example. Today I may be optimistic so I buy the steel plant. Or, I could be
pessimistic not buy the steel plant. If I am pessimistic enough, you cannot
loan me money even at negative real interest rates to get me to buy the steel
plant.

If I choose not to invest in fixed capital, I can choose among varying
financial forms of capital.

The concept of liquidity preference has to do with the choice of holding
interest bearing financial assets (of various levels of risk) vs. holding
non-interest bearing cash. Today, a lot of this distinction is absent. However,
I can choose assets with various possible returns and various levels of
perceived risks. As I noted in a previous post, this is both subjective and
objective. Even academics like us make these choices-should you put additional
contributions into CREF (and get the tax and presumably higher rate of return)
or should you save money in home equity, or just hold it in a passbook savings
account. It all depends on your subjective expectations about forseeable
scenarios.

All this is a long winded way of saying that yes, given that your expectation
formation is "sensible", it is "sensible" to react to perceived levels of risk
in different ways, even if you think there is an outside probability that
nuclear reactors will melt down at midnight on December 31.