Re: Uncertainty and Liquidity Preference

[Paul Davidson <pdavidson@xxxxxxx>]

At 10:32 AM 7/13/99 -0300, David very correctly noted:

>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.


As Kreynes continually pointed out, his wa anattempt to escape from old
modes of thought.  Weight was oner of these concepts that -- in my view --
does not help clarify things


>>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).


That's where "animal spirits" comes in.  An animated entrepreneurs has
great confidence in his expectations -- even though the likelihood of his
expectations turning out wrong can be quite high.

The question David raises is does it make any sense to attempt a
quantitative measure of animal spirits -- if not ordinal than at least
cardinal??  My reply is there is little to be gained and much to be lost in
that such an attempt opens a back door for thoe who wish to put a
quantitative measuring device (normalized so the the complete set of
possible outcomes eqwuals unit) to "degrees of animal spirits or degress of
confidence.

the decision to undertake an investment project o or other such positive
actiion is a "go-no go" decision not one of degrees of go!! Hence either
one has sufficient animal spirits to act  or one does not.  If you have
more than enough animal spirits that does not change the fact that you will
take action, if you have marginally less or a great deal less that does not
change your no go decision.

>>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].

Thus the liquidity premium is the crux -- If on average the entrepreneurs
have less confidence -- then they will have a higher liquidity premium --
and the no go decision will be undertaken.

In an economy that fears the future -- in David's taxonomy  has a lower
degree of confidence or weight -- there will be a greater desire to be
liquid -- and hence the rate of interest (the liquidity premium on money
will be, ceteris paribus, higher.

Under this interpretation even weight or degrees of confidence is not a
multiplicative modifier of expectations -- it is an offset  or opportunity
cost so to speak!

>>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".

Note this is consistent with my above argument that "weight" to the extent
Keynes could salvage something from his past conceptual baggage was
associted with people's desire to remain liquid, i.e., with the demand for
liquidity and not with the expectations associated with a future stream of
quasi-rents.

>
>Paul: all this was written by the mature Keynes.

David, for someone less interested in History of Economic Thought than
theory -- you have all the quotations correct.

my approach to Keynes is that one should not take his words as the Ten
Commandments written in stone.  Keynes. like all us poor motrals was human
and fallible, even though he was a genius.

What I try to get from Keynes is not a parrot-like repetition of his words
-- but a logical development of his analytical work -- which as he readily
admitted he had not seen all the ramifications.  There are many parts of
the GT that Keynes was inconsistent with other parts (still not having shed
all of his classical skin) -- and there are even parts which clearly are in
eror with his theoretical framework or where he made a simple mathematiccal
mistake (see for example, the equations in Chapter 20).  For the most part
these glitches and inconsistencies are in unimportant nooks and cranies.
The important thing is not to unthinkingly parrot  a particular sentence of
Keynes-- but to use that part of his exposition that is logically
consistent with the axioms that he based his GT upon.


 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.

For the most part capital goods are ILLIQUID , i.e., they are not
resaleable in a well-organized and orderly spot market (see chapter 4 of my
POST KEYNESIAN MACROECONOMIC THEORY). Therefore there is no nice continuous
margin between liquid assets and nonliquid real capital goods, i.e., the
elasticity of substitution (an essential property of money and all liquid
assets as Keynes developed in Chapter 17) is zero or negligible.  This
essential property is necessary to break Say's Law-- and those interested
in the argument can see the debate between myself and Milton Friedman in
the 1972 JPE or in the book developed from this JPE issue on MILTON
FRIEDMAN'S MONETARY FRAMEWORK: A DEBATE WITH HIS CRITICS (1974) edited by
R. J. Gordon.

Also see my distincition between Fully liquid, liquid, and liquid assets in
my PKMT. This taxonomic distinction was suggested to me by Sir John Hicks
when he read a draft of a paper I was preparing.

The inclusion of
>capital goods implies the inclusion of the type of uncertainty
>Ted was
>talking about, doesn't it?

BUT DAVID here is where Chip is correct, Ted has confounded the discussion
of the expected future stream of quasi rents (the undiscounted MEC) with
the lchoice of liquidity vehicles to store claims.

> 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".
>

Exactly my point, the fear of the future -- your "weight" determines the
interest rate one must pay to induce money holders to give up their fully
liquid asset known as money.


Paul
Paul Davidson
Holly Chair of Excellence in Political Economy
Editor, JOURNAL OF POST KEYNESIAN ECONOMICS [JPKE]
Economics Department -- 523 SMC
University of Tennessee
Knoxville, Tennessee 37996-0550
email: Pdavidson@xxxxxxx;   phone: (423)974-4221;    fax: (423) 974-4601
http://econ.bus.utk.edu/Davidson.html