XXVIII. Differences Between Interest Rates: Conclusions and Outlook

CHAPTER XXVIII DIFFERENCES BETWEEN INTEREST RA'l'ES: CONCLUSIONS AND OUTLOOK THERE is one more complex of problems which, in a work so largely concerned with the question of the rate of interest, must be briefly considered, although its system atic study falls outside the scope of this Dlllerences between book. I refer to the problem of the rela-Interest rates (and rates or prollt) a tionship between the various rates of monetary problem interest and profit, and the causes of the differences in their height. We have of course already seen that in so far as rates of interest earned over periods of different lengths are concerned, there is, even apart from monetary influences, no reason why they should be the same in a non-stationary economic system. But we have so far had little to say about the way in which we should expect these various rates to differ. The main reason for this is that this problem, unlike that of the existence, and the long-run movements of the rate of profit, is very definitely a problem which belongs more to the field of monetary theory or economic dynamics generally than to the field of general equilibrium analysis to which this book has been mainly confined. We can here do little to contribute to its solution, and what attention we can give to it in this final chapter will be concerned mainly with showing what is the proper field of application of that" liquidity preference analysis" which we could not place among the primary factors that determine the height or the move ment of the rate of profit or (except in the very short run) the rate of interest.

Even in the last two chapters, when we were already considering the significance of monetary influences, we 397 398 The Money Rate of Interest PT. IV disregarded the possibility that there might be a differ ence between the various interest rates or between the rates of interest and the marginal rates of profit on various -connected with dif ference. of liquidity attaching to various Income-bearing assels w blcb wore so far dis regarded types of investment. This procedure was justified, because we had in effect assumed that there were only two sharply divided types of assets, money on the one hand and real capital goods on the other. Money was implicitly assumed to be one homogeneous group of assets which possessed the attribute of liquidity to so much greater an extent than anything else that the holding of money could be regarded as practically the sole means of satisfying the desire for liquidity or for providing against uncertainty. All investments proper, on the other hand, whether they took the form of the lending of money or of the purchase of commodities or services to be employed for gain, were regarded as equally illiquid and risky, so that the returns expected from those various investments would tend towards equality (subject to the qualifications necessary if this statement is to apply to a non-stationary equilibrium: see p. 167 above). Although the return on the use of any particular kind of resource in terms of itself might be different for different kinds of resources, the returns on the investment of different resources over any given period would have to be the same if all were measured in terms of anyone given unit.

\Ve have found that, under these circumstances, liquidity preference possessed little significance beyond providing an explanation as to why some assets would earn no interest (or perhaps a lower rate of interest than others), but that it certainly did not explain either the level of the rates of interest (except under most unlikely conditions) or the direction in which they would move. It appeared at most to describe one of the cost factors (i.e. of the "alternative uses" of funds) which had to be taken into account in determining the rate of return on investment. In other words, it provided an CR. xxvm Different Interest Rates 399 explanation of why people withheld some funds that might be invested (or invested at a higher rate of return). But it clearly did not explain even the size of the total supply of funds which at any moment would be available for investment (which depends also on the rate of saving), and it had therefore to be regarded as altogether insufficient to explain why there was a positive return on investment at all, or what its actual height would be.

We have also found that even in the short run during which liquidity preference, and changes in liquidity pre ference, may have a predominant influence in determining the rate of interest (and the marginal rate of profit), the latter will be related only in an indirect manner to those price differences (the" rate of profit ") which express the true scarcity of capital and regulate the proportional amount of capital that will be used in pI:oduction. And the indirect influence which the monetary forces, acting on the rate of interest, will have in that way will be directly opposite to that commonly supposed. A reduc tion of the rate of interest in consequence of changes in liquidity preference will tend to bring about an increase in price differences and the rate of profit (not the marginal rate of profit), and will thus lead to a reduction in the proportional amount of investment, and vice versa.

We shall now see that if we consider the effects of changes in liquidity preference further, and if we take account of the fact that, because of differences in the liquidity of different types of assets, the Changes In liquidity marginal rate of profit and the rate of pr.feren •• may cau •• divergent movements interest not only need not be identical but of rate of Interest and may actually move in opposite directions, marginal rat. of proDt the connection between the money rate of interest and the profitability of investment becomes even looser than we have sO far assumed. It is clear that in real life there is no such sharp division between one single kind of money on the one hand, and a mass of income-bearing assets, all equally illiquid, on the other. In the first place 400 The Money Rate of Interest PT. IV there are of course further alternatives to investment in real assets which we have not yet considered, in the shape of all the various" securities" (claims to money), so:rp.e at least of which must be regarded as so highly liquid as to form very close substitutes for money, while others will be more nearly akin to the less liquid types of real assets.

And the real assets will also differ greatly with respect to the possibility of disposing of them rapidly and without great loss, if this should become unexpectedly necessary. There is in fact a long and practically continuous range over which the various types of assets can be grouped according to the degrees of liquidity which they possess and the risk attaching to them. It is not possible here to enter into any more detailed analysis of the meaning of liquidity and the problem of the relation of this concept to that of risk. This is most Tb I f definitely a subject belonging to economic e mean ng 0 liquidity and Its re-dynamics, and little could be gained by iatioD to risk • f f h' I scratchmg on the sur ace 0 t IS prob em when no really systematic inquiry can be undertaken. Much work on these problems has been done in recent years and a great deal more remains to be done for the theory of the subject to be deemed satisfactory.! All that we shall mention here is that neither risk nor liquidity can be adequately expressed as simple, one dimensional magnitudes, since they are both of the nature of probabilities which can be sufficiently described only in terms of the properties of a frequency distribution. This means that, strictly speaking, it is not possibJe to arrange the various assets in a simple linear order according to the liquidity or the risk attaching to them, and that some multi-dimensional arrangement would have to be used instead.

For our purposes, however, we must be satisfied with 1 In addition to the work of Mr. Keynes, various articles by Pro· fessor Hicks and Dr. Hawtrey, and, at an earlier date, F. Lavington, are of special importance in this connection.

CH. XXVTII Different Interest Rates 401 some more rough and common-sense concept of liquidity, without making an attempt at exact classification. If in this rough sense we classify the various assets according to their liquidity, we shall have, at one end of the scale, investments which promise a very high rate of return, but which require that funds be irrevocably committed to a particular use for a long time, so that in the meantime there will be no possibility of diverting them to other purposes which in consequence of a change in conditions may then appear more attractive. At the other end of the scale we shall have pure money, which, while yielding no direct return, because of its universal acceptability puts the holder in the position of being immediately able to take advantage of any newly appearing opportunities for investment. And between these two extremes we shall have to range the great majority of assets, capital goods and securities, so that the decreasing magnitude of the return will be balanced in each case by a correspond ingly greater capacity of the assets for being" liquidated"

at short notice, i.e. a greater or smaller chance that, in case of an unforeseen change, it will be possible to preserve at least a high proportion of their present value by turning these assets to other uses. l ~-'or our purposes all this means that, for assets possessing different degrees of liquidity, we shall at any moment have not one uniform rate of return but a long series of different rates of return, ranging Effects of changes in from some positive figure down to zero ~~~a::::t II~;:!Y :~ and perhaps even negative figures (in cases assetswhere a payment is made for the safe-keeping of money, 1 The difference between the risk attaching to holding a particular asset and its liquidity is mainly that risk may refer merely to a loss that may be incurred although the date when the asset in question will have to be sold (or otherwise used) is definitely known beforehand, while liquidity stresses the extra loss (or rather absence of danger of this particular kind of loss) which may be incurred because the asset may have to be disposed of at a date which cannot be foreseen, and at very short notice.

27 402 The Money Rate of Interest PT. IV etc.). This would not make very much difference to our whole argument up to this point, if we could assume that the grouping of various types of assets according to their liquidity, and therefore the relations between the rates of return from the different types of assets, were con stant. But this is of course very far from being so. In changing conditions the views people will hold about the relative liquidity of different types of assets will also change; and this will cause modifications in the working of the prices mechanism very similar to those which we have seen will occur in consequence of changes in the rate of money expenditure. In fact we shall see that the effects of changes in liquidity preference in the narrower sense in which we have so far used the term, that. is, as referring solely to changes in the preference for holding money on the one hand and any other kinds of asset on the other, is only one special case of a much wider category; and that where there is no sharp separation between one perfectly liquid asset, money, and the mass of all the other equally illiquid assets, it becomes im possible either to draw any sharp distinction between monetary changes (changes in the quantity of money or its" velocity of circulation ") and changes in the relative liquidity attached to any group of assets, or to make a clear distinction between changes in the quantity of money and changes in its velocity of circulation.

If assets which are expected to bring a lower return are held, because of their greater liquidity, in preference to others which promise a higher rate of return, a reduct t tion in this liquidity preference will have - similar 0 ellec s 01 changes In quan-effects very similar to a rise in the investtlty 01 money ment demand schedule. This is so for several reasons. Firstly, because the amounts that will be invested at any given rate of interest will increase. Secondly, since, in general, investments for longer periods are likely to be less liquid than investments for shorter periods, the former will be increased relatively more than OR. XXVIII Different Interest Rates 403 the latter. Thirdly, because any increase in the liquidity of a particular asset will make it capable of acting to some extent as a substitute for money or at least for some other more liquid asset. Thus it will decrease the demand for these more liquid assets, and this effect, via the fall in the price of, or the rise in the rate of return on, these more liquid assets, will gradually work upwards in the scale of liquidity till it reaches the most perfectly liquid kind of asset, money. In this way, every increase in the liquidity attached to any sort of asset will tend to bring about an increase in the supply of investible money funds; and similarly any decrease in the liquidity attached to any particular type of asset is likely to increase the demand for money and to decreaS'C the supply of investible money funds.

How this operates can be aptly illustrated if we con sider a more particular case. Incidentally, this case will also show how, under conditions where we have to deal with an almost continuous range of assets which possess various degrees of liquidity almost imperceptibly shading into each other, it becomes impossible to draw any sharp distinction between the effects of changes in the quantity of money and changes in its velocity of circulation, or, what is the same thing, in the proportional size of the liquidity reserve people will want to hold compared to their transactions. The case we shall consider is that of some form of readily transferable short-term debt, e.g. treasury bills, which we suppose suddenly to acquire the reputation of being more liquid than it was previously. It is irrelevant for our purpose what the particular circumstances are, whether an increase in the credit of the debtor, the issue of a new particularly convenient type of security, increased confidence in the stability of interest rates, or any other factor which makes a security more widely acceptable, and thus provides an income-yielding asset which is con fidently expected to be readily convertible into money at any time and at a practically unchanged price. It is clear 404 The Money Rate of Interest PT. IV that the availability of this new alternative for holding reserves in a highly liquid form will lead to the substitu tion of some of the assets concerned for other more liquid assets, and particularly for money. This means that some of the money which before was held as a liquidity reserve will now be invested .and that, with the increase in the supply of, and the fall in the return on, the more liquid types of assets, there will be a general shift of investments in the' direction of less liquid assets.

If we assume this kind of change to occur, not with respect to some security but (in a country where the use of cheques is still somewhat limited) with respect to bank deposits, it is at once evident that it would It Is often dlmcult to decide whether a par-be equally legitimate to describe what tlcular change Is bet-happens either as an increase in the ter treated as a change In the liquidity of an quantity of money or as an. increase in the asset or as a change In the quantity of velocity of circulation of the unchanged money quantity of money . We can either say that bank deposits have now become money (or at least money substitutes having in all respects the same significance as money), or we can say that the availability of close substitutes for money makes it possible to economise money and to hold less real money in propor tion to any given volume of transactions, that is, to increase the velocity of circulation of money. Indeed, K" Wicksell, as is well known, preferred to treat increases in bank credit, not as increases of the quantity of money but as increases of what he called the" virtual velocity of circulation " of the basic money.1 The same reasons which make it impossible in this particular case to distinguish clearly between ~"hat are changes in the quantity of money and changes in its velocity of circulation apply, however, equally well to all other cases where the relative liquidity of various types of assets is changed; and they make it exceedingly difficult, if not impossible, to distinguish between the 1 Lectures on Political Economy, vol. ii, pp. 67 et seq.

CR. XXVIII Different Interest Rates 405 effects of what may properly be regarded as monetary changes in the narrower sense of the term, and thE) exactly similar effects of changes in the relative liquidity of various real assets which have nothing to do with any change in anything which can properly be called money. Resources may be withdrawn from investment, or from more profitable investments, not because people desire to use them in the current production of consumers' goods, but because they want to hold assets of a more liquid character, which need not be money or securities, but may, according to the circumstances, be anything from raw materials or certain storable foodstuffs to postage stamps or jewellery or works of art. And, similarly, fewer con sumers' goods may be produced, not because people want to make definite provision for an increased output of consumers' goods in the more distant future, but because they desire for the time being to convert part of their resources into what they regard as the safest and most adaptable forms.l Any such change in the relative preferences for assets possessing different degrees of liquidity will involve a change in the rate of return earned on these types of assets. We must therefore recognise that the various rates of interest and profit, which we find in a developed capital market, will be subject to all sorts of autonomous changes which will have no connection with changes in the profitability of investment or changes in the rate of saving. In consequence, the movement of interest rates in the narrower sense may sometimes take a direction opposite to that of the marginal rates of profit on real investment, and thus a given change in interest rates may be accompanied by a change in real investment which is the reverse of what we usually associate with a 1 The reason why the effect of such a change is similar to that of monetary changes proper is, of course, that in these cases too we have to deal with a sort of indirect exchange, only the medium which is kept as a store of value is not money but may be anything which in the circumstances seems to be specially suitable for the purpose.

406 The Money Rate of Interest PT. IV rise or fall of interest rates. If, for instance, a spontaneous change in liquidity preference leads to a shifting of funds from real investment to the holding of gilt-edged securities, the fall in interest rates proper will be accompanied by a rise in marginal rates of profit and will indicate that real investment is being curtailed. Similarly, a rise in money rates of interest may be accompanied by a fall in marginal rates of profit and may be merely a symptom of the fact that real investment is now regarded as relatively more attractive, with the result not only that no real' invest ment which was formerly profitable will become unprofit able on account of the rise in the rate of interest, but that some new real investments will now be undertaken which were not undertaken at the lower rate of interest. We cannot here further follow up the causes which make the connection between the money rate of interest and the factors which directly govern the profitability of investment even more loose and distant than we have already seen to be the case under the more favourable assumptions of the last chapter. We must be satisfied with having shown not only that the movement of money rates will be determined to a large extent by factors other than those which determine the profitability of investment, but also that the influences which changes in the money rates of interest do exert on the profitability of investment· will often be the opposite from what we are led to expect if we identify these money rates with the" rate ofinterest "

of pure theory. To give a brief summary of the main results, we may say that changes in money rates will have the effects commonly assumed only if and in so far as they correspond to real changes and serve merely to bring about changes made necessary by the real situation. If, however, interest rates are affected either by spon taneous monetary changes (changes in liquidity prefer ence or changes in the supply of resources of different degrees of liquidity) or induced monetary changes (changes in the relative demand for assets of various liquidities CR. XXVIII Different Interest Rates 407 due to changes in their returns, the liquidity preferences for, as owell as the supplies of, these assets being given), these monetary influences on the rates of interest will set up forces which will work in a direction opposite to their immediate effect through interest rates. Thus in the short run money may prevent real changes from showing their effect, and may even cause real changes for which there is no justification in the underlying real position. In the long run, however, it will always merely accentuate the change it has at first prevented, or will bring about changes which are the opposite of the impact effects. \Ve have already referred before to this self-reversing char acter of monetary changes. In the real world, of course, all changes must work through this monetary mechanism, which frequently delays adaptation and will often be the source of spontaneous disturbances. Money is of course never " neutral " in the sense of being merely an instru ment or servant: it always exercises some positive influ ence on the course of events. It would not be difficult to show how this role of money is bound to lead to con stant fluctuations of economic activity, even if we had never heard of the existence of such fluctuations. And the theory of fluctuations largely consists, of course, of a study of 0 the interaction between the monetary and the real factors.

This, however, is outside our present task. That task has been to bring out the importance of the real factors, which in contemporary discussion are increasingly dis regarded. But even without further continuing the discussion of the role money plays iIi this connection, we are certainly entitled to conclude from what we have already shown that the extent to which we can hope to shape events at will by controlling money are much more limited, that the scope of monetary policy is much more restricted, than is to-day widely believed. We cannot, as some writers seem to think, do more or less what we please with the economic system by playing on the 408 The Money Rate of Interest FT. IV monetary instrument. In every situation there will in fact always be only one monetary policy which will not have a disequHibrating effect and therefore eventually reverse its short-term influence. That it will always be exceedingly difficult, if not impossible, to know exactly what this policy is does not alter the fact that we cannot hope even to approach this ideal policy unless we under stand not only the monetary but also, what are even more important, the real factors that are at work. There is little ground for believing that a. system with the modern complex credit structure will ever work smoothly without some deliberate control of the monetary mechanism, since money by its very nature constitutes a kind of loose joint in the self-equilibrating apparatus of the price mechanism which is bound to impede its working - the more so the greater is the play in the loose joint. But the existence of such a loose joint is no justification for concentrating attention on that loose joint and disregarding the rest of the mechanism, and still less for making the greatest possible use of the short-lived freedom from economic necessity which the existence of this loose joint permits.

On the contrary, the aim of any successful monetary policy must be to reduce as far as possible this slack in the self-correcting forces of the price mechanism, and to make adaptation more prompt so as to reduce the necessity for a later, more violent, reaction. For this, however, an understanding of the underlying real forces is even more important than an understanding of the monetary surface, just because this surface does not merely hide but often also disrupts the underlying mechanism in the most unexpected fashion. All this is not to deny that in the very short run the scope of monetary policy is very wide indeed. But the problem is not so much what we can do, but what we ought to do in the short run, and on this point a most harmful doctrine has gained ground in the last few years which can only be explained by a complete neglect - or complete lack CR. XXVIII Different Interest Rates 409 of understanding - of the real forces at work. A policy has been advocated which at any moment aims at the maximum short-run effect of monetary policy, com pletely disregarding the fact that what is best in the short run may be extremely detrimental in the long run, because the indirect and slower effects of the short-run policy of the present shape the conditions, and limit the freedom, of the short-run policy of to-morrow and the day after.

I cannot help regarding the increasing concentration on short-run effects - which in this context amounts to the same thing as a concentration on purely monetary factors - not only as a serious and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave menace to our civilisation. To the under standing of the forces which determine the day-to-day changes of business, the economist has probably little to contribute that the man of affairs does not know better. It used, however, to be regarded as the duty and the privilege of the economist to study and to stress the long effects which are apt to be hidden to the untrained eye, and to leave the concern about the more immediate effects to the practical man, who in any event would see only the latter and nothing else. The aim and effect of two hundred years of continuous development of economic thought have essentially been to lead us away from, and " behind ", the more superficial monetary mechanism and to bring out the real forces which guide long-run develop ment. I do not wish to deny that the preoccupation with the "real" as distinguished from the monetary aspects of the problems may sometimes have gone too far. But this can be no excuse for the present tendencies which have already gone far towards taking us back to the prjOl-scientific stage of economics, when the whole working of the prige mechanism was not yet understood, and only the problems of the impact of a varying money stream on a supply of goods and services with given prices 410 The Money Rate of Interest PT. IV aroused interest. It is not surprising that Mr. Keynes finds his views anticipated by the mercantilist writers and gifted amateurs: concern with the surface pheno mena has always marked the first stage of the scientific approach to our subject. But it is alarming to see that after we have once gone through the process of developing a systematic account of those forces which in the long run determine prices and production, we are now called upon to scrap it, in order to replace it by the short-sighted philosophy of the business man raised to the dignity of a science. Are we not even told that, "since in the long run we are all dead", policy should be guided entirely by short-run considerations? I fear that these believers in the principle of apres nous le deluge may get what they have bargained for sooner than they wish.

APPENDICES APPENDIX I . TIME PREFERENCE AND PRODUCTIVITY THE treatment in Chapters XVII and XVIII of the role of psychic elements in the determination of the rate of interest differs from the classical discussion of the same questions as we find it in the writings of Bohm-Bawerk and his School in three main points. Fir8tly, it stresses from the outset that there is not one single significant rate of " time preference" (at least for any given person), but that this rate of time preference itself varies with the changes in the relative size of the present and future income for which provision is made. If the concept of the single rate of time preference is to have any meaning, it must therefore be confined to that rate which would prevail if provision for incomes of equal magnitude were made for present and future. Secondly, time preference involves no "perspective undervaluation", no "psychic discount" of the" true" future value, but is simply a descrip tion of the relative values that will be attached to present and future commodities under different conditions. And, thirdly, time preference is a subordinate factor compared with the productivity of investment in determining the rate of interest, since it operates only by way of determining the rate of saving and the rate of capital accumulation, and hence the productivity of investment. In the short run, it merely adapts itself to the given marginal productivity of investment.