Re: Uncertainty and Liquidity Preference

["David Dequech" <dequech@xxxxxxxxxxxxxx>]

Dear Paul, Ted and others,

Although I'm more interested in theory, here are some comments pertaining to
the history of (Keynes's) thought.
While Ted admits that Keynes connected weight and liquidity preference on
some occasions, but not when dealing with fundamental uncertainty, Paul
seems to deny any connection whatsoever between A Treatise on Probability
(based on a fellowship dissertation) and Keynes's later writings.

I'd like to quote a few passages from Keynes's writings that strongly
suggest that Keynes did establish some connections between his early work on
probability and his later writings. Please note, Paul, that doesn't mean
that there is a strict continuity in Keynes's writings. He may have kept
some notions from the TP while abandoning others. I'm sure that Ted knows
these quotations, and would just like to call his attentions to the context
in which they appear: at least some of these passages seem to refer to the
type of uncertainty involved in decisions about buying capital goods.

>From The General Theory, p. 148:
"It would be foolish, in forming our expectations, to attach great weight to
matters which are very uncertain[1]".
Footnote 1 reads: 'By "very uncertain" I do not mean the same thing as very
improbable". Cf. my Treatise on Probability, chap. 6, on "The weight of
Arguments".
On the same page, when referring to confidence, Keynes refers to "how highly
we rate the likelihood of our best forecast turning out quite wrong". If one
reads the TP on weight, one can see that there clearly is a connection
between confidence and weight (but see my 1999 JPKE article for the argument
that weight is not the same as confidence).

All this is in chapter 12, on "The state of Long-Term Expectation".

>From The General Theory, p. 240:
'The owners of wealth will then weigh the lack of "liquidity" of different
capital equipments in the above sense as a medium in which to hold wealth
against the best available actuarial estimate of their prospective yields
after allowing for risk. The liquidity-premium, it will observed, is partly
similar to the risk-premium, but partly different; - the difference
corresponding to the difference between the best estimates we can make of
the probabilities and the confidence with which we make them [1].
Footnote [1] reads: "Cf. the footnote to p. 148 above".
The footnote to p. 148 is the one I quoted above.
P. 240 is in chapter 17.

>From a 1938 letter to Hugh Townshend, on p. 293 of volume XXIX of Keynes's
Collected Writings:
"As regards my remarks in my General Theory, have you taken account of what
I say at page 240, as well as what I say at page 148, which is the passage I
think you previously quoted. I am rather inclined to associate risk premium
with probability strictly speaking, and liquidity premium with what in my
Treatise on Probability I called 'weight'". ... A liquidity premium ... is a
payment ... for an increased sense of comfort and confidence during the
period".

Paul: all this was written by the mature Keynes. Ted: The liquidity premium,
as I understand it, is an important element of the choice between assets of
different degrees of liquidity, including capital goods. The inclusion of
capital goods implies the inclusion of the type of uncertainty Ted was
talking about, doesn't it? And isn't the connection that appears in the
above quotations between weight, confidence and the liquidity premium useful
to understand the connection between confidence and liquidity premium that
appears in the passage Ted quoted from the 1937 QJE article? After all, in
that passage Keynes argued that "partly on reasonable and partly on
instinctive grounds, our desire to hold money as a store of wealth is a
barometer of the degree of our distrust of our own calculations and
conventions regarding the future".

In addition, please note that in one of the quotations above Keynes used the
phrase "VERY uncertain" (emphasis added), which suggests that he saw the
uncertainty involved in the state of long-term expectation as a matter of
degrees.

To conclude, I suggest we use Keynes's insights to improve our theories. If
Keynes is at times unclear or confusing, we should try to build theories
that are not.

Hope you find this useful. Cheers,
David Dequech