Appendix 2: The perplexing chapter17 of The General Theory7

Minsky argued that Keynes "dug deeper - but not clearly" into the crises tendencies of modern capitalism in chapter 17 and that the chapter's secular stagnation arguments were "obscure" because the general equi­librium model presented there brought the reader "back into the world of the classical economy" and away from the endogenous instability stressed in chapters 2, 3, 5, 12-15, 19, and 22 of The General Theory and in Keynes's defense of The General Theory in the QJE in 1937 (Minsky 1975, p.

High-unemployment long-run equilibrium 193 so he did not have to rely solely on the validity of the arguments in this chapter to defend this assertion.

The chapter opens with this question:

It seems, then, that the rate of interest on money plays a peculiar part in setting a limit to the level of employment, since it sets a standard to which the marginal efficiency of a capital-asset must attain if it is to be newly produced... It is natural to enquire wherein the peculi­arity of money lies as distinct from other assets. Until we answer [this] question, the full significance of our theory will not be clear. The money-rate of interest - we remind the reader - is nothing more than the percentage excess of a sum of money contracted for forward delivery, e.g. a year hence.

(CW 7, p. 222, emphasis in original)

Keynes identifies three types of assets that can be used to store wealth: capital investment goods, durable "consumption goods" such as housing, and "money." He focused on three attributes of assets that determine their annual yields in terms of their own values, or their "own­rates of interest," or their marginal efficiencies: (1) their "yield or output q measured in terms of themselves"; (2) the wastage or carrying cost of holding assets "irrespective of their being used to produce a yield," called c; and (3) "the power of disposal over an asset during a period," denoted l, which is called its "liquidity premium" (CW 7, pp. 225-226).

The key to Keynes's argument in the chapter is that while real assets have a higher net yield (q-c) than money, money earns a substantial "liquidity premium" while the real assets do not. The liquidity premium is defined as:

the power of disposal over an asset during a period [which] may offer a potential convenience or security, which are not equal for assets of different kinds. There is, so to speak, nothing to show for this at the end of the period in the shape of output; yet it is something for which people are willing to pay something. The amount (measured in terms of itself) which they are willing to pay for the potential conveni­ence or security given by this power of disposal (exclusive of the yield [q] or carrying cost [c] attaching to the asset), we shall call its liquidity premium l.

(CW 7, p. 226)

Liquidity, or the "power of disposal" of an asset, is, surprisingly, not defined here, but it is typically understood to be the ability to sell an asset quickly with a low transaction cost and without a significant capital loss. In the absence of inflation, money is the ultimate liquid asset because it cannot suffer a nominal capital loss. The real assets considered here are

potentially quite illiquid.

Minsky argued that the last sentence in the quote immediately above should begin: "The amount [in foregone cash flows]..." Risky assets have higher cash flows over the long run than safe assets. Their "ease of disposal" and the "certainty of [their] sale price" can be quite volatile over the business cycle, but they should not be volatile in a long-term equilibrium state.

If an asset is liquid the cash flow in the form of interest and profits per dollar [q] of market value will be smaller than if the asset is illiquid. The visible rate of return on an asset will vary inversely with the quality of the market for the asset or with the time to maturity, or with other measures of the ease of disposal and the certainty of its sale price.

(Minsky 1975, pp. 81-82)

The "liquidity premium" used here appears to be closely related to the concept of "liquidity preference" that is the centerpiece of the theory of the determination of the long-term interest rate discussed in chapter15 of The General Theory. The conclusion of that chapter is that fluctuations in expected capital gains or losses in the bond market, along with investor ignorance in a world of Keynesian uncertainty about the likelihood of unforeseeable future needs to raise cash quickly, cause investors to switch their preferences from holding mostly "money" to mostly long-term bonds and back as the pessimism of financial market downturns is replaced by the optimism of booms.⁹ The theory of liquidity preference of chapter 15 does not transfer smoothly into a static long-term equilibrium model precisely because interest rate instability is powered by the volatility of expectations of future asset prices and the confidence with which investors hold these expectations.

Keynes does discuss the influence of short- to intermediate-term expectations in chapter 17. "To determine the relationships between the expected returns on different types of assets which are consistent with equi­librium, we must also know what the changes in relative values during the year are expected to be" (CW 7, p. 227, emphasis added). Keynes does not

High-unemployment long-run equilibrium 195 tell us here whether these are the psychologically complex "Keynesian" expectations stressed in the rest of the book. If they are not - if the expected yields are the truth about the future - then no one needs to hold money as an asset as an insurance policy against unpredictable outcomes. If the future is assumed to be representable by pre-given and stationary probability distributions, as in the classical theory and modern "rational expectations" models, all risk can presumably be hedged. On the other hand, if the future is unknowable and expectations are conventionally and behaviorally constructed as in the rest of the book, there will be a liquidity preference for money that keeps the interest rate high, especially at times of economic and financial instability.

The kernel of Keynes's thesis in chapter 17 is that "money... has special characteristics which lead to its own-rate of interest. being more reluc­tant to fall as the stock of assets in general increases than the own-rates of interest of other assets" in the long run (CW 7, p. 229). He calls attention to two main "peculiarities" in the money rate of interest that limit its long­term decline.

The first characteristic is that, under existing institutional and political conditions, the money supply is relatively inflexible or the elasticity of supply is low with respect to changes in demand for money. There are two reasons for this. One is that the central bank is committed to maintaining that level of supply needed to keep the exchange rate relatively stable; another is that Britain cannot mine gold domestically whenever there is a rising demand for gold. Keynes could have added the fact that the policy of the Bank of England reflected the interests of the rentier class and the big banks, and thus would be likely to keep a tight rein on the money supply to sustain high interest rates even when Britain was not on the gold standard.

Therefore, as the demand to hold money as an asset grows over time, unless the supply of money is deliberately increased by the central bank, the excess demand can only be eliminated by a rising interest rate. By way of contrast, as the supplies of real assets grow over time, Keynes believed, there will be a decline in their marginal efficiencies or own-rates of interest. These facts led Keynes to the conclusion that the interest rate is unlikely to fall as fast as the value of (q-c) for capital goods and consumer durables such as housing over the long run, causing the gap between current invest­ment and saving at full-capacity output to grow over time.

The first characteristic which tends toward the above conclusion is the fact that money has, both in the long and in the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority. Now, in the case of assets having an elasticity of produc­tion, the reason why we assumed their own-rate of interest to decline was because we assumed the stock of them to increase as the result of

a higher rate of output. In the case of money, however - postponing for the moment, our consideration of the effect of [deflation] or of a deliberate increase by the monetary authority - the supply is fixed.

(CW 7, p. 230, emphasis added)

Keynes makes clear that this particular cause of an excessively high interest rate in the short and the long run could be eliminated by a central bank committed to the goal of sustained full employment. The prime objective of such a central bank would be to increase the money supply by enough to allow the interest rate to fall to zero as the mec on real assets falls to zero under the relentless growth of public and semi-public investment. Capital controls would obviously be needed to accomplish this goal.

Unemployment develops, that is to say, because people want the moon; - men cannot be employed when the object of their desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily chocked off. There is no remedy but to per­suade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control.

(CW 7, p. 235)¹⁰

In other words, elimination of this problem required that the central bank be nationalized and its main objective changed from defense of rentier income to the pursuit of sustained full employment. The Bank of England had been owned by its private shareholders and was strongly influenced by their interests from its founding in 1694. It was finally nationalized by the Labour Party in 1946.

Keynes commented that land rent shares with the interest rate the property that rising demand elicits no increase in supply. To distin­guish between the two, Keynes introduced a "second condition" that differentiated between them.

The second differentia of money is that it has an elasticity of substitu­tion equal, or nearly equal, to zero, which means that as the exchange value of money rises there is no tendency to substitute some other factor for it... This follows from the peculiarity of money that its utility is solely derived from its exchange-value, so that the two rise and fall pari passu, with the result that as the exchange value rises there is no motive or tendency, as in the case of rent-factors, to substi­tute some other factor for it.

(CW 7, p. 231, emphasis in original)

If the price or exchange value of housing or of capital goods rises, ceteris paribus, the demand for these assets will fall. But if a drop in the price level causes the exchange value of money to rise, the demand to hold money

High-unemployment long-run equilibrium 197 as an asset will not fall, so there is no reason to exchange money for real assets. Indeed, in an era of deflation - an ongoing process of price decline expected to continue into the future rather than a once-and-for-all change in the price level - there will be a strong incentive to sell real assets and hold more money. Deflation causes "capital gains" in the purchasing power of money.¹¹ Recall that Britain experienced a serious process of deflation from the early 1920s through much of the 1930s,

On other hand, deflation will reduce the demand for money to make transactions, and this will increase the stock of money available to buy bonds, which will reduce the interest rate.

Since there are forces operating on the interest rate in both directions:

It is not possible to dispute on purely theoretical grounds that this reac­tion might be capable of allowing an adequate decline in the money­rate of interest. There are, however, several reasons, which taken in combination are of a compelling force, why in an economy of the type to which we are accustomed it is very probable that the money-rate of interest will often prove reluctant to decline adequately.

(CW 7, p. 232)

Keynes offered four reasons why the interest rate was likely to rise in a deflation. First, anticipating an argument made in chapter 19, Keynes states that "If the effect [of falling prices] is to produce an expectation of a further fall, the [negative] reaction on the marginal efficiency of capital may offset the decline in the rate of interest" caused by lower transactions balances (CW 7, p. 232). If businesses and households expect an ongoing process of deflation to continue, they will postpone purchases today in anticipation of lower prices next period, which will reduce AD and employment today and fuel further deflation. This argument is quite reasonable but is spe­cifically about disequilibrium processes and thus does not seem suitable for inclusion in a long-term equilibrium model.

Second, wages are downwardly "sticky in terms of money" (CW 7, p. 232). If they were not, "this might often tend to create an expectation of a further fall in wages with unfavourable reactions on the marginal effi­ciency of capital," as explained in the previous paragraph (CW 7, p. 232). This helps protect the economy from the potential for high unemployment to trigger a destructive deflationary spiral. Keynes devotes considerable space in The General Theory, especially in chapters 2 and 19, to a defense of his belief that downward wage rigidity created by strong labor unions is a necessary condition for avoiding disastrous deflation under conditions of sustained high unemployment - the inverse of the classical position.

The third reason as to why the interest rate cannot fall as far as the own-rates on real assets, Keynes said, "is the most fundamental consid­eration in this context, namely, the characteristics of money which satisfy liquidity-preference" (CW 7, p. 233).

For, in certain circumstances such as will often occur, [liquidity pref­erence] will cause the rate of interest to be insensitive, particularly below a certain figure, even to a substantial increase in the quantity of money in proportion to other forms of wealth. In other words, beyond a certain point money's yield from liquidity does not fall in response to an increase in its quantity to anything approaching the extent to which the yield from other types of assets fall when their quantity is comparably increased.

(CW 7, p. 233, emphasis added)

This argument is presumably intended as a longer-term variant of the famous "liquidity trap" discussed in chapter 15 on "Incentives to Liquidity." The liquidity trap is a condition in which increases in the money supply elicit no decline in the interest rate because it is already so low that the reward for holding risky bonds relative to riskless money in the form of the interest rate is negligible, and expectations of a future cap­ital loss on bond-holding become almost universal.

There is the possibility... that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.

(CW 7, p. 207)

Keynes used US financial markets in the early 1930s as an example of this kind of phenomenon: "In the United States at certain dates there was. a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms" (CW 7, pp.207-208).

Keynes also pointed out there would be an important upside to a liquidity trap in the Liberal Socialist economy he desired. It would allow a Board of National Investment to borrow extensive funds to finance public investment at an exceptionally low rate of interest. "Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow [to finance public investment] through the banking system on an unlimited scale at a nominal rate of interest" (CW 7, p. 207).

In his 1937 defense of The General Theory in the QJE (Keynes 1937), Keynes famously asked of the classical theory, which assumed a static equilibrium in which the (stochastic) future would look like the present until an exogenous shock to the system took place: what possible motive could people have for holding money as a store of value in long-term equi­librium? His answer was that the existence of a demand for money as an

High-unemployment long-run equilibrium 199 asset requires radical or Keynesian uncertainty about future states of the economy. Since expectations and the confidence with which they are held are endogenously restless, the "equilibrium" Keynes refers to in the last sentence can, logically, only be a temporary or moving equilibrium and not a long-term static equilibrium. In chapter15, Keynes said:

In a static society or in a society in which for any other reason no one feels any uncertainty about the future rates of interest, the liquidity function [or demand to hold money as an asset function], or the pro­pensity to hoard function (as we might term it), will always be zero in equilibrium.

(CW 7, pp. 208-209)

Liquidity preference to hold money as an asset is a positive function of our sense of the unpredictability of future non-money asset prices. Even if we were to think of the future as identical to the present in the sense that outcomes would be random draws from a stationary probability function, the sense of uncertainty would be at its nadir in static equilibrium and all risk could be hedged.

Fourth, Keynes argued that "the fact that contracts are fixed, and [money] wages [and therefore prices] are usually somewhat stable, in terms of money unquestionably plays a large part in attracting to money so high a liquidity-premium" (CW 7, p. 236). Both factors - that contracts are written in terms of money (rather than real assets such as, say, wheat) and that money wages are usually stable so that prices are usually stable - certainly help to make money an attractive store of wealth, even though its yield is small. In Britain, there had been sub­stantial price stability over most of the nineteenth century and defla­tion over most of the interwar years, which made money an even more attractive store of wealth. This presumably put upward pressure on the long-term interest rate.

Summary

In my opinion, chapter 17 does contain a number of interesting arguments in support of the main proposition of the chapter that interest rates are unlikely to fall fast enough or far enough to keep investment spending at a level consistent with full employment as the mec and the mpc fall over time. In this important sense, the chapter is a success. However, I also believe that a substantial part of the liquidity premium on money is attrib­utable to ever-changing short-term and long-term expectations that, upon occasion, can become wildly unstable - see chapters 12 and 15. This phe­nomenon simply cannot be integrated comfortably into a long-term asset equilibrium model.