Interest Rates
The impacts of interest rates:
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Interest rates play a major role in the investment demand-schedule. Keynes advocates
government "monetary policy directed at influencing the rate of interest." However, he
believes that the other factors that influence the investment demand-schedule are too
powerful for such "monetary policy" alone to achieve levels of investment sufficient to
maintain full employment.
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Keynes argues that it is impossible to determine the rate of interest just from investment
demand and savings supply.
There is a well recognized relationship between investment demand and interest rates.
According to classical economic theory, interest rates sensitively adjust to allocate all
available funds for investment purposes.
With the growth of consumer credit - already a recognized factor in the 1920s -
investment demand is not the only major use of funds available for loans. The fact that
interest rates allocate available funds not just for various investment purposes but for
consumption purposes as well is omitted by Keynes. The availability at low interest rates
of abundant funds has to influence the propensity to consume.
Keynes attacks the classical view. He argues that it is impossible to determine the rate of
interest just from investment demand and savings supply.
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Keynes assumes that people part from their savings only if offered an interest return.
Thus, the interest offered counters a "liquidity preference" to hold wealth in the form of
immediately usable but sterile cash.
Keynes uses the term "liquidity preference" for those who prefer to keep significant
sums in the sterile form of cash. Keynes assumes that people part from their savings only
if offered an interest return. Thus, the interest offered counters a "liquidity preference" to
hold wealth in the form of immediately usable but sterile cash.
"Thus, the rate of interest at any time, being the reward for parting with liquidity, is a
measure of the unwillingness of those who possess money to part with their liquid control
over it. The rate of interest is not the 'price' which brings into equilibrium the demand for
resources to invest with the readiness to abstain from present consumption."
This is, in fact, a correct view of matters where financial intermediaries are unavailable
or unreliable - as in undeveloped nations or - during the Great Depression - even in the
U.S. It is also true when - for any reason - profits are so scarce that there is no
inducement to borrow at any interest rate - as during the Great Depression.
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However, in developed nations with reliable banking systems, Keynes' "liquidity
preference" disappears. It is then safer and more convenient to deposit cash in banks than
in mattresses, even with little or no interest on offer. Except during the depths of already
existing depressions, banks and other financial intermediaries have no trouble
immediately circulating ALL savings through the money markets if not through direct
lending.
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In developed nations, idle hoards don't cause depressions. Depressions cause idle
hoards.
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However, interest rates WILL determine - along with various risk factors - whether
funds available for loan will be drawn into domestic markets from abroad - or will flow
abroad to take advantage of better opportunities in foreign markets. Artificially low
interest rates will cause capital flight.
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Keynes provides some simplistic mathematical equations explaining "liquidity
preference" - all of it inapplicable to capitalist economics except when - for other reasons
- there has been a breakdown in the financial system. Even then, interest rates won't
eliminate or reduce "liquidity preference." Only the elimination of the factors that
undermined the reliability of the financial system and the functioning of the economy
will reduce or eliminate "liquidity preference." This involves analysis and reform of
fundamentals. Government deficits and manipulation of money and interest don't solve
fundamental problems.
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It is to the great credit of Keynes and his followers that - when given the authority and
opportunity after WW-II - they took steps needed to end the trade war. With
commendable U.S. leadership, steps were taken to facilitate international trade, and war
debts from both world wars were substantially written off. Wouldst that it had all been
done two decades earlier.
There are three general reasons for holding cash identified by Keynes. Cash is held for
transactions, safety, and speculation purposes. Monetary expansion may not always
reduce interest rates, and interest rate reductions may not always stimulate economic
recovery. Keynes recognizes many of the factors that may get in the way.
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However, Keynes asserts that the level of income is the key factor that determines if
savings will equal investment, and that this belief is what separates him from the classical
view. Classical theory asserts that interest rates will automatically equate net savings with
investment (which except during the depths of depression does indeed happen).
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Keynes here discusses the supply and demand for savings as if investment returns were
the only reason for savings. However, as elsewhere recognized by Keynes, savings
depend on many factors other than interest and investment yields. Interest rates - or more
precisely, the complex of interest rates - allocate accumulated savings between various
investment uses and periods
Only if banks are less secure than mattresses - and thus themselves constitute an
investment risk - are yields essential to draw savings into the financial system.
Yet, Keynes' whole discussion of "classical theory" assumes that it depends on how
interest rates induce savings. (This may have been true when early capitalist economic
systems had archaic financial systems, but for economic systems with modern financial
systems, it is an obvious straw man - a nonsense theory.) He correctly notes that savings
do not in fact necessarily increase when interest rates increase - but the investment
demand-schedule does in fact fall. Thus, the two lines need not intersect at all. Some
other factors indeed must be involved.
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Keynes thus easily slays this straw man. He correctly notes that many interrelated
factors such as money, incomes, savings rates, and consumption rates, impact interest and
investment.
Keynes is here still theorizing about a closed system - unconcerned with international
money flows.
In the Keynesian world of dysfunctional financial systems (as indeed existed in 1935 in
the midst of the Great Depression), reduced spending that increased savings indeed did
not reduce interest rates - which were already as low as they could go. In such a world, it
did indeed reduce employment instead, since there existed almost no profit-inducement to
borrow even at minimal interest rates.
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It is probably the nature of his times that led Keynes astray, since he clearly understood
money - as can be seen from the following paragraph.
"The strength of all [transactions and reserve motives for holding cash] will depend on
the cheapness and the reliability of methods of obtaining cash, when it is required, by
some form of temporary borrowing, in particular by overdraft or its equivalent. For there
is no necessity to hold idle cash to bridge over intervals if it can be obtained without
difficulty at the moment when it is actually required. Their strength will also depend on
what we may term the relative cost of holding cash. If the cash can only be retained by
forgoing the purchase of a profitable asset, this increases the cost and thus weakens the
motive towards holding a given amount of cash. If deposit interest is earned or if bank
charges are avoided by holding cash, this decreases the cost and strengthens the motive. It
may be, however, that this is a minor factor except where large changes in the cost of
holding cash are in question."
Clearly, in the midst of the Great Depression, money on deposit in banks is viewed by
Keynes as sitting idle - as the equivalent of "holding cash" - since there is little profit
inducement for regular or overnight borrowing of such funds. Today, credit cards and
lines of credit substitute for cash reserves, large and small.
A relatively small monetary effort may be all that is required to move interest rates up or
down as desired, because speculators will quickly enter to move the market in the
expected direction, and they will arbitrage subsequent interest rate fluctuations on the
basis of the expected rate.
Speculation will affect any "monetary policy" that is designed to change or control
interest rates. The cash needs for transactions and reserve purposes are fairly constant,
but speculation rises and falls like passing waves, in sensitive response to expectations
based on a wide variety of factors.
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Thus, a relatively small monetary effort may be all that is required to move interest rates
up or down as desired, because speculators will quickly enter to move the market in the
expected direction, and they will arbitrage subsequent interest rate fluctuations on the
basis of the expected rate.
However - in the nature of markets - to maintain a desired level of interest rates below
the market rate will inevitably require an increasing rate of monetary expansion over
time.
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Moreover, interest rates are the time cost of money. They dictate investment patterns.
They also influence saving and consumption patterns. By fiddling with interest rates,
Keynesian "monetary policy" inevitably sends erroneous signals and screws up the
economy. A substantial period of artificially low interest rates MUST leave an economic
system increasingly unbalanced. Thus, the Keynesian effort to provide short term
stability MUST create increasing instability over time. Ultimately, this instability will
increase to levels that will prove unmanageable.
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But these are long run factors, while Keynes is still here analyzing short run
phenomena.
In his usual style, Keynes offers a mathematical model to trace the relationships of
monetary policy and expectations. These relationships depend on cash holdings, M, and
liquidity preferences, L, for purposes of transactions and reserves, M1, and speculation,
M2, and their related liquidity functions, L1 and L2, which are determined by income, Y,
and interest rates, r. Aside from M, none of these factors are precisely determinable, as
Keynes candidly notes, (and even M has more than a few ambiguities). Nevertheless, he
proceeds to explain the general impacts of monetary policy in these broad, ill defined
terms.
"A change in M [the money supply] can be assumed to operate by changing r [interest
rates], and a change in r [interest rates] will lead to a new equilibrium partly by changing
M2 [reserves held for speculation], and partly by changing Y [income] and therefore M1
[transactions and ordinary contingency reserves]."
A whole variety of factors apply to this calculation, Keynes notes, such as the financial
and industrial characteristics of the economy, social habits, income inequality, and " the
effective cost of holding cash." However, for short period calculations, they can all be
treated as constants.
This is the key to the Keynesian remedies of monetary expansion and budgetary deficits.
By concentrating only on immediate results - and in a system substantially closed to
international trade - the fact that these "policies" can be no more than temporary
palliatives with inevitable unpleasant long term impacts can be ignored.
If bonds are traded on public markets, market liquidity should reduce long term
opportunity risks to a series of short term opportunity risks, and thus facilitate the raising
of debt capital.
The impacts of interest rate changes are perceptively analyzed by Keynes. He
especially notes the impacts of interest rates that are artificially pushed below market
rates. He calls market rates "safe" rates.
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Long term interest rates - properly viewed as the most significant for the economy -
must offer an adequate return to balance a variety of risks that include opportunity risks
as well as risks of default. Something like 2%, then, is viewed as about as low as long
term rates can go. However, if the securities are traded on public markets, market
liquidity should reduce long term opportunity risks to a series of short term opportunity
risks, and thus facilitate the raising of debt capital.
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The conclusion of this analysis is that short term rates are "easily controlled by the
monetary authority" because it is easier to produce a conviction of both policy
consistency and success in the short run. Bringing long term rates down below natural
market rates will be more difficult - even if market rates are too high to produce full
employment.
By concentrating only on short term impacts, Keynes provides an intellectual excuse for
the ancient political vice of monetizing debt. That's why the politicians hire only
Keynesian economists - and they become the "authoritative voices" that provide people
with authoritative misinformation on economic matters.