Murphy-Kuehn Tag-Team on Wenzel
I am apparently a double agent, because after my alliance with Brad DeLong, I now join forces with Daniel Kuehn to pin down Bob Wenzel in a merciless crossfire.
After I quoted what seemed to me to be an obvious argument in favor of Keynes’ view of interest, Bob Wenzel responded as a bull to a red Mises shirt. An excerpt:
Say what? Maybe Murphy sees something different in the obtuse writing style and sloppy terminology that Keynes uses in the other chapters of The General Theory, but I don’t. To me it is more of the same distortions and odd definitions. Let’s take a look at [Keynes’] use of the word “savings” in the above paragraph [that Murphy quoted with approval].
You can essentially do three things with money. 1. You can hold onto it as cash. 2. You can spend it on a consumption good or 3.you can loan it out and expect a return on your money.
Keynes uses “savings” to mean BOTH 1 and 3, simulataneously. It is this cross-definition that causes typical Keynesian confusion.
Yet as I pointed out in the comments, Wenzel is the one who’s forced to use weird definitions in order to salvage his worldview (and deny Keynes’). I illustrate with a simple example:
…I’m amused at how many people are high-fiving Wenzel here, when he is the one who is clearly using a weird, non-layman’s definition of “saving.”
15-year-old Johnny mows my lawn every week, and I pay him $20 each time. Every week, he spends $15 of it going to the movies with his friends, but he puts $5 in a piggy jar on his bureau.
After a year, he has accumulated $5×52 = $260 which he uses to buy a nice watch. Johnny says, “I’m sure glad I consumed less than my income all year, saving $5 per week. Then I used my accumulated savings to buy a watch. I deferred consumption all year in order to buy a nice good later on.”
Wenzel says, “What the heck are you talking about? Are you a Keynesian Johnny? You haven’t saved at all.”
Are you guys all comfortable with that? You don’t think Johnny was saving $5 per week?
To this, Wenzel wrote: “@Bob Murphy So Keynes was talking about kids piggy banks and Groupon discounts? Now it all make sense to me.”, which I think roughly translates as, “I unconditionally surrender on this point.”
Major Freedom had a more interesting attempt to answer me: “Bob Murphy: Yes, Johnny is actually delaying his consumption each week in the amount of $5. So his actions will affect market interest rates.”
Notice the clever bait and switch. Major Freedom doesn’t come right out and say, “Yes, Johnny is actually saving,” because that would be too obvious an endorsement of Keynes and a rejection of Wenzel. Instead he says, “Yes, Johnny is actually delaying his consumption…” So I repeat: Are Austrians now supposed to say that consuming less than your income is not necessarily saving? Is that how badly we hate Keynes, that we are going to mess with that definition?
Then, Major Freedom says, “So his actions will affect market interest rates.” But that’s not the issue. The question is, does a person saving in the form of increased cash balances earn interest? Well, not in the sense of a monetary rate of return. That’s what Keynes was saying, and Major Freedom is redefining the question to try to deny Keynes’ (obvious) point.
(If you want to get really saucy, you could say that if people are saving by accumulating larger nominal cash balances, then they could still earn a “real” rate of return if prices fall over time because of this. Then even the nominal interest rate of zero on cash, would translate into a positive real rate of interest.)
Anyway, Daniel Kuehn also had a really good point. I’m not going to quote it here, but let me paraphrase: Austrians argue that market interest rates are fundamentally about time preference, not about liquidity. Yet how then does the Austrian explain the yield curve? If I want to defer $1,000 in potential consumption today, to a point ten years from now, then time preference explains why I have to earn a positive interest rate. Fine.
But why should it matter how I save that money? For example, if I roll it over in 12 different one-year bonds, then I expect to earn less total interest than if I dump it into a 10-year bond at the outset. (I’m assuming an upward-sloping yield curve.) So why should that be the case? You can’t say, “Because other things equal, people prefer to consume today rather than 10 years from now.” That doesn’t explain why the series of 10 one-year bonds should give me (in expectation today) a lower rate of return over the next decade, than the single 10-year bond.
The standard (and obvious) explanation for the yield curve invokes the desire for liquidity. I’m guessing Wenzel will come back and say something like, “Short rates might move in the future, so that’s why the yield curve can be upward or downward sloping.” But my point is, even if we expected the short rate to stay constant for the next ten years, a desire for liquidity would cause the yield curve to be upward sloping. If you roll your money over 10 times, you are less exposed to a sudden (and unexpected) move in interest rates than if your money is “stuck” in a ten-year bond. If for some reason your plans change, and you need to spend your money before the originally planned ten years, and if interest rates have risen in the meantime, you will take less of a hit if you have been rolling your money over in one-year bonds, than if it’s still sitting in (say) a 60%-matured 10-year bond.
To be clear: The actual slope of the yield curve could be mostly due to expected changes in short rates over time. But even if we thought short rates would stay constant, I think most market participants would need to earn a higher rate of return on longer-dated bonds. There is no way to explain this just using time preference. (In fact, Rothbard in Man, Economy, and State did argue that the yield curve would be flat in the ERE. That’s true, but I think he missed the significance of that fact. Tomorrow I’ll post a paper where I criticize Rothbard’s arguments on this.)
Let me reassure libertarian readers that even if it turns out that “liquidity preference” has a lot to do with the money rate of interest, we aren’t forced to therefore support fiscal stimulus. “Keynesian” policy prescriptions do not at all follow from a “Keynesian” theory of interest by itself.
In all of the longer exposition of PTPT that I have read (apart from MES, waiting for Murphy’s course on that section), it seems like it is admitted that it is only an ERE phenomenon. What you seem to be saying is that
1. Saving may also take place due to uncertainty and
2. Uncertainty, being existent in a changing economy, contributes to the contribution of the interest rate.
But I have not seen any expositions of PTPT doubting this. Mises in Human Action seems to support this position.
I like this debate a lot. It exposes a lack of understanding on my part in this area and gives me something to focus on studying.
Dr. Murphy, maybe you could play Matt Damon’s roll in this clip and Wenzel can play Stellan Skarsgård’s roll. I might have to reverse the rolls if Wenzel blows you up with his comeback though.
http://www.youtube.com/watch?v=AqoSxVf4qTY
“To be clear: The actual slope of the yield curve could be mostly due to expected changes in short rates over time. But even if we thought short rates would stay constant, I think most market participants would need to earn a higher rate of return on longer-dated bonds. There is no way to explain this just using time preference.”
But… why not? Why can’t a good ten years from now diminish in value exponentially more than a good one year from now, and thus demand a much higher interest rate than waiting one year? Does time preference theory state that waiting ten years to consume *must* be 10x worse than waiting one year? Obviously, a person may choose 10 one-year bonds over the ten-year bond for the purposes of liquidity, but I don’t know why this would affect the formation of the respective interest rates. Investing in a one-year bond is deferring consumption for one year, and that’s what you get paid for. You may intend to roll this bond over ten times, deferring consumption for ten years, but the borrower doesn’t know that; he only knows you’re parting with this money for one year, and that’s the interest rate he’s willing to pay. If you want to offer him a ten-year loan, he’ll compensate you greater for waiting ten years.
P.S. I don’t know what I’m talking about, so maybe I’m missing some obvious point above. I suspect you (and Rothbard, apparently) understand PTPT better than I do.
I agree with you, for me 10 sequential one-year bonds don’t equate to 1 ten-year bond. At time zero in one case you are asking for someone to lend you money for 10 years, and in the other you’re asking for 1 year. Anyway, I know even less than you about the subject. 🙂
From my illiterate point of view I think it IS possible to define interest rates in terms of liquidity, but that would be a bit awkward definition. I don’t know how Keynes defined liquidity but for me it measures the ease at which you can trade a good in the market, and that itself doesn’t say anything about interests. You have to go one step further in your logic and introduce the time factor, and think well if it’s difficult to trade then I will have to wait some time to get the trade done. Then is when I can begin to see some relation between liquidity and interest rates.
For me it’s like adding an unnecessary layer to the concept of interest rates, I see more naturally define the interest rates directly trough time and waiting. But again, I have read none of the “magnum opus” of the big economists (just some of the Murphy’s ;)) and I may be speaking nonsense up to this point.
Yeah, I don’t mean to suggest that pure time preference is 100% right and liquidity preference is obviously wrong, only that Bob’s example looks very flawed. Liquidity preference nicely explains why money sitting in my Chase Money Market savings account seems to earn so little interest.
Don’t worry, you got the understanding down pat. You are saying in those few words what I am rather verbosely trying to say in many paragraphs.
Just so you know,
1. Mises explicitly said interest WAS NOT a price
2. You and Hülsmann have been addressed:
mises.org/journals/qjae/pdf/qjae8_3_5.pdf
mises.org/journals/scholar/cwik.pdf
The reason why I said “Yes, Johnny is actually delaying his consumption each week in the amount of $5” is not to engage in a sneaky bait and switch to avoid Keynes’ argument and be rescued by Wenzel. It is because Johnny’s saving of cash is affecting market interest rates through the effects of his changed consumption, not the saving in cash itself.
The reason this distinction is important is because depending on how one comes to hoard cash specifically, by either reducing one’s investment relative to one’s consumption, or reducing one’s consumption relative to investment, the direction of the changed interest rate will increase or decrease. It won’t just increase as per Keynes. In other words, an increased “liquidity preference” is related to interest rates, through how such increased hoarding came to be that changed the consumption / investment ratio (time preference).
In your example, Johnny is not an investor. He is only a consumer. So his consumption to investment ratio is infinity. He is spending 100% of his income on consumption, and 0% on investment. His time preference is therefore infinitely high, and so he earns zero interest. This is true even if Johnny hoard $5 in cash each week.
The reason why it is problematic for you to say that by hoarding $5 each week is “saving” is because there is no objective time frame to define a holding of cash as “saving.” You implicitly defined “saving” in your example as “hoarding a portion of one’s income, in cash, and do so for one year.”
But WHY one year? Depending on the time frame considered, we can say that Johnny is “saving” even if he spends all $20 each week. He would be “saving” from the time you paid him in cash, to the time he goes out and spends the money.
In your conceptual framework, your logic would force you conclude that Johnny is “saving” during the time period in between Johnny taking ownership of the $20 from you (say you hand him a $20 bill after he cuts your grass) and Johnny even making the decision to spend $15 of it in a consumer goods store! You can’t say “that’s not the “correct” time frame, because there IS no objective time frame that defines holding cash as “saving” and holding cash as “on the way to purchasing consumer goods.”
If the mere holding of cash for any time at all is classified as “saving” then EVERYONE who earns any money at all is “saving” almost all the time, even if they never invest and consume out of everything they earn! They would be “saving” for every infinitesimal moment in time that they do not spend money on consumption. In your conception then, they could only NOT save during the exact moments in time that they literally trade their money away by buying consumer goods.
Just because you selected a time period of one year of delayed consumption in your example, that doesn’t mean that all of a sudden NOW we should call it “saving” and now we should seek to connect interest rates with such cash holding and say “Neener neener Major_Freedom and Bob Wenzel, Johnny is clearly “saving” here and so you have to admit it that he is “saving” to be honest about liquidity preference and interest rates!!”
It seems your mindset is stuck in the Keynesian framework of treating the mere holding of cash for any length of time at all as “saving.” You see, Keynes’ fallacious economic worldview lead him to be so adamant about “spending” that if his mind even considered someone NOT spending for ANY length of time (he probably would have had an aneurysm if he ever learned that most people save 99.999999% of everything they earn over time, if the time periods selected are in between the receiving of money and the actual spending of money) then immediately he would believe that this is a dangerous “savings leakage.”
That is why I emphasized right off the bat that the crucial issue is not the holding of cash, but the delaying of one’s consumption. It was to connect changed interest rates with the changed consumption investment ratio. Since Johnny isn’t an investor, I had to invoke a 2 scenario example where his consumption pattern changes. Interest rates are determined by more than just one person. They are determined by a market process of exchange between individuals. So in order to know how ANYONE’S economic behavior will affect interest rates, we have to connect one’s behavior with other economic actors.
The Austrian conception of interest rates is superior because it doesn’t get confused by the holding of cash. You got confused because you want to treat cash hoarding as saving. Remember, in order for a commodity to even function as a money, it has to have value when it is held as cash for at least a positive amount of time. If a money didn’t have such a property, then it could not even be a money, because nobody would value holding money for ANY length of time at all. That means hyperinflation and rejection of the currency.
The issue, contrary to your claim, IS how Johnny’s behavior will affect interest rates. If you insist that we focus on Johnny not earning any money interest for “saving” $5 each week (he’s actually “saving” all $20 on his way home from your house after all), on the basis that this is what Keynes talked about and we should accept it and say yes Keynes was right about this, then SO WHAT? It is not interesting at all to ponder Johnny not earning money interest for “saving” $5. He’s also not earning money interest on his way home from your house, when he takes out the garbage, when he goes onto the internet, when he does ANYTHING AT ALL that is NOT the actual direct spending of money on consumption in an actual store, and not only that, but even as he is walking around in the store, and even as he moves his hands with his money in it towards the clerk’s outstretched hands, all throughout this he is “saving,” because he is not exactly spending! Well woopdeedoo!
You got confused because Keynes led you into believing that hoarding money IS saving, and so you tried to plaster that flawed conception into your example of cash hoarding for an entire year, just to really drive the point home. But such an extreme is the consequence of not getting the Austrian conception of interest, and trying to bait and switch others into believing that the mere holding of money is saving. Why is one year important? Why not one month? One day? One hour? One second?
It’s simply NOT the act of cash holding or hoarding that itself causes interest to come into existence. It is the selection of choosing between consumption and investment that does it. It’s time preference. The reason why I had to introduce a modified 2 scenario example that includes investors is precisely because interest as a phenomenon comes into existence because of the existence of investment and consumption. To see a change in interest, we have to identify the change in the consumption investment ratio.
An individual can consume and invest, or they can just consume. If they just consume, then strictly speaking, they are having no direct affect on interest rates. If everyone just consumed, then there would be no money interest at all. The way Johnny’s changed consumption pattern affects interest rates is how his actions affect investor behavior, and it is investors, strictly speaking, who bring interest into existence. It is not the consumers. If we are going to seek an explanation for WHY there is interest at all, then we have to consider investors and investment.
To really drive my point home, and to really make this as clear as possible, I will propose one last example. Suppose that everyone consumed 100% of their incomes. Suppose nobody invested anything, that is, nobody spent money for the purposes of making subsequent sales. They all spent ONLY to consume. If this took place, then MONEY interest as a phenomenon would simply not exist. Nobody is lending or borrowing after all. Nobody is acting as an investor.
Suppose that as people consume their money, the time periods, from the receiving of money income to the spending of money income, changed every which way and that. Some people spent money soon after they earned it, others spent money one hour after they earned it, others spent their money one day after they earned it, others spent money one week after they earned it, and little Johnny waited one whole year. Then imagine the waiting times changing. Imagine people wait as long as possible before they consume, then imagine them consuming almost immediately after earning money.
Here’s the question: Do any of these various consumption patterns in any way affect money interest rates? Would people’s “liquidity preference” differences generate different money interest rates? Absolutely not. The reason is because nobody is investing. There are no investors. Liquidity preferences are changing all over the place, but nothing is happening to money interest rates. People’s time preferences, in the narrow sense of valuing present goods more than future goods, are changing all over the place too, but again nothing is happening to money interest rates. Why? Because in this 100% consumption economy, time preference and liquidity preference become an inversely proportional dual concept. They become two sides of the same coin. To increase liquidity preference is to decrease time preference, and to decrease liquidity preference is to increase time preference.
Money interest rates come into existence only when there are investors, that is, when people start to spend for the purposes of making subsequent sales, which is an action other than consumption and other than mere waiting to consume by holding cash for a time. The investor’s investments bring money interest into existence, and time preference as manifested in the ratio between consumption and investment are what determine the height of interest rates. Liquidity preference has nothing to do with money interest and money interest rates.
If you want to define the action of waiting any positive length of time before consuming as “saving,” then whatever floats your boat. I’ll call Johnny walking home from your house with $20 in his hands as “saving.” You’ll call his waiting one year before spending $5×52 as “saving.” Big deal. We won’t be showing that liquidity preference determines interest rates. We’d only be taking one step forward towards finding out how such waiting indirectly affects interest rates by finding out if such waiting sets into motion a change in the investment consumption ratio in the rest of the economy. If waiting longer or shorter before consuming with one’s money does not affect any investment consumption ratio, that is, if liquidity preference rises or falls and no change in investment and consumption ratio takes place because of it, then it simply won’t affect money interest rates.
OK Major I agree you weren’t being sneaky–you are biting the bullet and saying Johnny isn’t really saving.
That’s fine, but 99% of the world, and all economics textbooks, disagree with that usage. For everyone else, saving is defined as income minus consumption.
So the oddball Misesian theory of interest has forced you to redefine what savings is.
That’s fine, but 99% of the world, and all economics textbooks, disagree with that usage. For everyone else, saving is defined as income minus consumption.
So the oddball Misesian theory of interest has forced you to redefine what savings is.
Yes, saving is typically defined in economics textbooks as income minus consumption, but whoever said typical economics textbooks are correct?
Income is a flow concept and consumption is a stock concept. They are incommensurable concepts. It leads to confusion because if you hold consumption in your mind, it doesn’t have a time dimension, and so you ignore the time dimension with income.
Will you really call the action of Johnny going from the front door of your house after he received the $20, to ONE STEP towards the sidewalk as “saving”? After all, he has in income, and yet he is not consuming. He is allegedly saving until he spends his money.
In this conception, the only way to not save money is to never accept any money at all.
The “oddball”-ness is actually on the mainstream conception of saving, not the Misesian theory.
Investment and consumption, THOSE are commensurable concepts. They are both stock concepts, and yet the ratio between them conveys a flow concept which then applies to interest rates, another flow concept.
The only way I will say Johnny is “saving” in your example is if he is purposefully investing in dollars, for the purposes of making subsequent sales, for example if little Johnny cut grass by day and traded FX by night. THEN I would say yes, he is saving by holding dollars.
But he is not holding dollars for the purposes of investment. He is holding them for the purposes of consumption, just a different length of time compared to the time walking to the front curb from your house.
I suppose then that “liquidity preference” might affect the exchange rates between various currencies, but that is not strictly money interest rates, so if the context is interest rates, it certainly isn’t liquidity preference.
I know I repeat myself on this point, but why don’t I earn interest when “parting with liquidity” when buying consumer goods, or burning the money, or giving it to charity?
I would not consider myself “redefining” saving, I just don’t hold the same flawed definition as most mainstream textbooks.
Also MF, are you really sure you want to say Johnny’s time preference is infinitely high? He is clearly trading away potential present consumption for future consumption (the watch). If he has infinitely high time preference, why isn’t he consuming the full $20 every week?
Yet another bit of evidence that you and Wenzel have the wrong take on this. Look at the odd corner into which you’ve painted yourself.
Also MF, are you really sure you want to say Johnny’s time preference is infinitely high?
If he doesn’t invest and all he does is consume, then in the Austrian conception, yes his time preference is infinitely high.
He is clearly trading away potential present consumption for future consumption (the watch). If he has infinitely high time preference, why isn’t he consuming the full $20 every week?
One week is not an objective time context! If the context is one year, then he is in fact consuming 100% of his earnings!
You can’t say that “the” time period that we can say aha, Johnny is saving in cash is one week or one year. These time periods are all completely arbitrary. If we select a time period of one second we would be forced to conclude that Johnny is saving 100% of his income, and consuming 0%. If we select a time period of one year we could be forced to conclude that Johnny is saving 0% of his income, and consuming 100%.
It is you that is being painted into an odd corner here. It is because you are comparing apples and oranges. “Income minus consumption” is a terribly muddled concept because income is a time concept, a flow concept, but consumption is timeless, it is a stock concept.
Thus, for the same individual, for the same set of actions from birth to death, their “saving” can either be 0%, 100%, or everything in between, depending on what time period is arbitrarily chosen.
Then there is the fact that under very rapid inflation, liquidity preference drops to zero, and yet interest rates skyrocket, and under modest inflation, interest rates are lower, directly counter the liquidity preference doctrine.
Then there is the fact that I “part with liquidity” when I buy consumer goods, and yet I don’t earn any money interest.
Add all this up and it is the liquidity preference theory that is bogus.
MF, you are contradicting yourself in this very response. You are saying we need to measure consumption in reference to a time interval–if we choose one day, then Johnny is saving, but if we choose one year, then he is not.
Then a few paragraphs later, you (falsely) state that consumption is a stock concept, not a flow concept.
Consumption is a flow concept. Anyone who is a bystander on this debate, look at how tangled Major Freedom has become. Income, saving, and consumption are flow concepts. The size of the cash balance is a stock concept.
I don’t know if anyone’s still following, but I whole-heartedly agree with you, Major, on your point about the indefiniteness of how long you have to hold on to cash before it’s “saving” or “hoarding”. I’ve had to make the exact same points with quasi-Keynesian economists (which includes quasi-monetarists). See in particular here for just one example.
To take it further, money would *be* vauable as money if you couldn’t “hoard” it in the time between when you receive and when you spend it. If every moment that you hold the money as cash is some kind of detrimental “leakage”, the only “correct” monetary system is one in which you have to decide what to buy the moment you receive money. But if you can do that, you don’t need money in the first place! You just work out some fancy tangle of barters!
That said, I do have to echo Bob’s comment about your reckoning of time preference on the part of Johnny.
Oops, second para should start, “… money wouldn’t be valuable …”
Silas, do you have any objections to my answer to MF, about analyzing Johnny in one-hour versus one-day increments? And how it all checks out, if you treat income, saving, and consumption as flow variables, while the cash balance is a stock concept? (And changes in the cash balance are equal to the differences between income and consumption over a given time interval?)
This is perfectly straightforward stuff. Mises spelled it out in the quotation I provided.
Two things to consider:
The liquidity of the yield curve generally decreases as you move out on the curve but not uniformly with time. An On-the-Run 10yr is further out on the curve than an Off-the-Run 10yr, yet is more liquid. In times of crisis you will see the spread widen as people demand liquidity.
The convexity of the curve (non-linear duration across the curve) indicates a premium in longer-dated treasuries not from liquidity but the assymetric (returns) relative to a particular move in rates.
As for Kuehn’s point, you paraphrased him as saying:
Austrians argue that market interest rates are fundamentally about time preference, not about liquidity. Yet how then does the Austrian explain the yield curve? If I want to defer $1,000 in potential consumption today, to a point ten years from now, then time preference explains why I have to earn a positive interest rate. Fine.
But why should it matter how I save that money? For example, if I roll it over in 12 different one-year bonds, then I expect to earn less total interest than if I dump it into a 10-year bond at the outset. (I’m assuming an upward-sloping yield curve.) So why should that be the case? You can’t say, “Because other things equal, people prefer to consume today rather than 10 years from now.” That doesn’t explain why the series of 10 one-year bonds should give me (in expectation today) a lower rate of return over the next decade, than the single 10-year bond.
The standard (and obvious) explanation for the yield curve invokes the desire for liquidity.
The reason why that is the case is because the upward sloping yield curve is not generated by people intending to roll over their investments. It is generated by people who intend to consume and invest differently from each other over different time scales. You cannot presume that everyone else is expecting to roll over their investments the way you described. Those who want to wait to consume for only one year are going to have to be rewarded more if you ask them to wait to consume for 10 years. It’s not because they are parting with liquidity longer, it’s because they are not consuming for longer.
If today I invested in a 1 year bond, then my time preference in this action will be higher relative to investing in a 10 year bond. Kuehn is treating the different annualized interest rates that typically exist (upward sloping) as the effect of different strengths in the desire to want money after 1 and 10 years. For example, “parting with liquidity” should bring them a greater reward for the 10 year investment wait relative to the 1 year investment wait. By itself, this seems plausible, but only because you are ignoring why there are 1, 2, 5, and 10 year bonds at all.
The reason why the 1 year typically has a lower annualized rate compared to the annualized 10 year is not because of “liquidity preference,” but because of a preference to consume sooner rather than later, which manifests itself, in a monetary economy, as “wanting money” sooner rather than later. People want money because they want to consume. You and Kuehn are just focusing on the desire to want money, and ignoring WHY people should want money at all. People want money in order to consume. If people did not care when they consumed, (which is impossible by the way, but for the sake of argument) then they wouldn’t ask for more annualized interest waiting for 10 years relative to the 1 year. In fact, they wouldn’t ask for any money interest at all, because to “part with liquidity” forever is to forever delay one’s consumption, and to forever delay one’s consumption is we just assumed people don’t care about. If you didn’t care when you consumed, then the 1 year and 10 year money interest rates would not be different. They would be the same, and they would be zero. If I didn’t have any time preference for consumption, then I could part with liquidity forever because I don’t need it to consume.
Yes, it seems very plausible to conclude that because merely waiting to consume longer by holding cash for longer doesn’t in itself generate interest rates (Johnny hoarding $5 per week for a year), that it is only when individuals “part with liquidity” does money interest come into existence. It seems almost too easy to not conclude this. The problem with this view however is, ironically enough, the same problem you say is wrong with the Austrian conception of saving. Just like you say that people can save other than through investment, but not earn any money interest, so too can I say that people can “part with liquidity” other than through investment, and not earn any money interest!
I “part with liquidity” when I buy consumer goods, do I not? Why don’t I earn money interest then? I “part with liquidity” when I burn money, why don’t I earn money interest? I “part with liquidity” when I donate it as charity, why don’t I earn money interest?
The fact is that the mere “parting with liquidity” is not why interest comes into existence. What brings interest into existence is the ratio between investment and consumption, which is the Austrian conception of time preference in a monetary exchange economy.
Hi Bob.
Here’s the way I think of it (today, anyway, as I feel my way through this stuff).
I think of time preference as a preferred pattern of consumption over time determined by an estimate of one’s own permanent income (as in the permanent income hypothesis). However, it’s also influenced by uncertainty over the future course of one’s own life so that, at the margin, there is a preference for earlier rather than later. One’s estimate of permanent income is constantly being reassessed and thus one’s pattern of preferred consumption is subject to ongoing change. Giving up liquidity is giving up the ability to costlessly modify your preferred future pattern at any point in time you choose, as circumstances warrant.. In other words, you agree to lock-in your planned pattern (or part of it) for a specified period of time. It is compensation for waiting enforced by contract rather than waiting solely of your own choosing. The same uncertainty that is the source of the preference for earlier rather than later is also the source of the need to be compensated for locking-in.
The requirement for compensation for a contractual shift of liquidity from saver to borrower/entrepreneur is thus itself an expression of time preference, or perhaps the potential for one’s time preference to be thwarted by previous contractual commitments. In more stable times in which regime uncertainty and government-induced policy risk is smaller, people are prepared to lock-in more of their plans (i.e., the demand for money as a portfolio asset is lowish).
The problem I have is that “liquidity preference” – to me – means time preference for money. I’d rather have my money in my hand today than letting somebody else hold onto it for however long. And, ceteris paribus, even assuming away uncertainty, the longer they want to hold onto it, the more I want in return… I ain’t getting younger.
Some of my comments in the Kuehn post try to synthesize what’s true in the time-preference theory of the interest rate, and what’s true in the liquidity-preference theory of the interest rate. If we start as the classical economists (and most Austrians) do in analyzing macroeconomic concerns, we start from simple premises to complex ones. We start from statics and then proceed carefully into dynamics. We don’t jump straight into dynamic banking policy to conclude, “Aha! It must be people’s desire to hold liquidity!”
Using my method (starting with Crusoe, going to barter, moving to a money economy, and introducing fractional reserve banking), we find that the time-preference theory is overwhelming responsible for the determination of the interest rate in a dynamic economy, and liquidity-preference, entrepreneurial uncertainty premium, risk premium, and price premium are all introduced later into the rate of interest as the economy becomes more complex – albeit to a smaller degree.
“The standard (and obvious) explanation for the yield curve invokes the desire for liquidity. ”
Perhaps there is another simple actuarial explanation for upward-sloping yield curves – longer loans are ever-so-slightly riskier because the longer the term, the more likely the loan recipient will die or become insolvent. Longer term loans essentially have an act-of-God premium built in because, no matter who the borrower is, a longer loan is always less likely to get paid back than a shorter one