Chapter 17
THE ESSENTIAL PROPERTIES OF INTEREST AND MONEY
I
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. That
this should be so, is, at first sight, most perplexing. It is
natural to enquire wherein the peculiarity of money lies as
distinct from other assets, whether it is only money which has a
rate of interest, and what would happen in a non-monetary
economy. Until we have answered these questions, the full
significance of our theory will not be clear.
The money-rate of interest¾we may
remind the reader¾is nothing more
than the percentage excess of a sum of money contracted for
forward delivery, e.g. a year hence, over what we may call the
'spot' or cash price of the sum thus contracted for forward
delivery. It would seem, therefore, that for every kind of
capital-asset there must be an analogue of the rate of interest
on money. For there is a definite quantity of (e.g.) wheat to be
delivered a year hence which has the same exchange value to-day
as 100 quarters of wheat for 'spot' delivery. If the former
quantity is 105 quarters, we may say that the wheat-rate of
interest is 5 per cent per annum; and if jt is 95 quarters, that
it is minus 5 per cent per annum. Thus for every durable
commodity we have a rate of interest in terms of itself;¾a wheat-rate of interest, a copper-rate of interest, a
house-rate of interest, even a steel-plant-rate of interest.
The difference between the 'future' and 'spot' contracts for a
commodity, such as wheat, which are quoted in the market, bears a
definite relation to the wheat-rate of interest, but, since the
future contract is quoted in terms of money for forward delivery
and not in terms of wheat for spot delivery, it also brings in
the money-rate of interest. The exact relationship is as follows:
Let us suppose that the spot price of wheat is £100 per 100
quarters, that the price of the 'future' contract for wheat for
delivery a year hence is £107 per 100 quarters, and that the
money-rate of interest is 5 per cent; what is the wheat-rate of
interest? £100 spot will buy £105 for forward delivery, and
£105 for forward delivery will buy
105/107 × 100 ( = 98) quarters for
forward delivery. Alternatively £100 spot will buy 100 quarters
of wheat for spot delivery. Thus 100 quarters of wheat for spot
delivery will buy 98 quarters for forward delivery. It follows
that the wheat-rate of interest is minus 2 per cent per
annum.
It follows from this that there is no reason why their rates
of interest should be the same for different commodities,¾why the wheat-rate of interest should be
equal to the copper-rate of interest. For the relation between
the 'spot' and 'future' contracts, as quoted in the market, is
notoriously different for different commodities. This, we shall
find, will lead us to the clue we are seeking. For it may be that
it is the greatest of the own-rates of interest (as we may
call them) which rules the roost (because it is the greatest of
these rates that the marginal efficiency of a capital-asset must
attain if it is to be newly produced); and that there are reasons
why it is the money-rate of interest which is often the greatest
(because, as we shall find, certain forces, which operate to reduce the own-rates of interest of
other assets, do not operate in the case of money).
It may be added that, just as there are differing
commodity-rates of interest at any time, so also exchange dealers
are familiar with the fact that the rate of interest is not even
the same in terms of two different moneys, e.g. sterling and
dollars. For here also the difference between the 'spot' and
'future' contracts for a foreign money in terms of sterling are
not, as a rule, the same for different foreign moneys.
Now each of these commodity standards offers us the same
facility as money for measuring the marginal efficiency of
capital. For we can take any commodity we choose, e.g. wheat;
calculate the wheat-value of the prospective yields of any
capital asset; and the rate of discount which makes the present
value of this series of wheat annuities equal to the present
supply price of the asset in terms of wheat gives us the marginal
efficiency of the asset in terms of wheat. If no change is
expected in the relative value of two alternative standards, then
the marginal efficiency of a capital-asset will be the same in
whichever of the two standards it is measured, since the
numerator and denominator of the fraction which leads up to the
marginal efficiency will be changed in the same proportion. If,
however, one of the alternative standards is expected to change
in value in terms of the other, the marginal efficiencies of
capital-assets will be changed by the same percentage, according
to which standard they are measured in. To illustrate this let us
take the simplest case where wheat, one of the alternative
standards, is expected to appreciate at a steady rate of a per
cent per annum in terms of money; the marginal efficiency of an
asset, which is x per cent in terms of money, will then be
x - a per cent
in terms of wheat. Since the marginal efficiencies of all
capital-assets will be altered by the same amount, it follows
that their order of magnitude will be the same irrespective of
the standard which is selected.
If there were some composite commodity which could be regarded
strictly speaking as representative, we could regard the rate of
interest and the marginal efficiency of capital in terms of this
commodity as being, in a sense, uniquely the rate of
interest and the marginal efficiency of capital. But there
are, of course, the same obstacles in the way of this as there
are to setting up a unique standard of value.
So far, therefore, the money-rate of interest has no
uniqueness compared with other rates of interest, but is on
precisely the same footing. Wherein, then, lies the peculiarity
of the money-rate of interest which gives it the predominating
practical importance attributed to it in the preceding chapters?
Why should the volume of output and employment be more intimately
bound up with the money-rate of interest than with the wheat-rate
of interest or the house-rate of interest?
II
Let us consider what the various commodity-rates of interest
over a period of (say) a year are likely to be for different
types of assets. Since we are taking each commodity in turn as
the standard, the returns on each commodity must be reckoned in
this context as being measured in terms of itself.
There are three attributes which different types of assets
possess in different degrees; namely, as follows:
(i) Some assets produce a yield or output q,
measured in terms of themselves, by assisting some process of
production or supplying services to a consumer.
(ii) Most assets, except money, suffer some wastage
or involve some cost through the mere passage of time (apart from
any change in their relative value), irrespective of their being
used to produce a yield; i.e. they involve a carrying cost c
measured in terms of themselves. It does not matter for our
present purpose exactly where we draw the line between the costs which we
deduct before calculating q and those which we include in c,
since in what follows we shall be exclusively concerned with q - c.
(iii) Finally, the power of disposal over an asset
during a period may offer a potential convenience or security,
which is not equal for assets of different kinds, though the
assets themselves are of equal initial value. 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 ready
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 yield or carrying
cost attaching to the asset), we shall call its liquidity-premium
l.
It follows that the total return expected from the ownership
of an asset over a period is equal to its yield minus its
carrying cost plus its liquidity-premium, i.e. to q - c + l. That
is to say, q - c + l
is the own-rate of interest of any commodity, where q, c
and l are measured in terms of itself as the standard.
It is characteristic of instrumental capital (e.g. a machine)
or of consumption capital (e.g. a house) which is in use, that
its yield should normally exceed its carrying cost, whilst its
liquidity-premium is probably negligible; of a stock of liquid
goods or of surplus laid-up instrumental or consumption capital
that it should incur a carrying cost in terms of itself without
any yield to set off against it, the liquidity-premium in this
case also being usually negligible as soon as stocks exceed a
moderate level, though capable of being sigmficant in special
circumstances; and of money that its yield is nil and its
carrying cost negligible, but its liquidity-premium substantial.
Different commodities may, indeed, have differing degrees of
liquidity-premium amongst themselves, and money may incur some
degree of carrying costs, e.g. for safe custody. But it is an essential difference between money and
all (or most) other assets that in the case of money its
liquidity-premium much exceeds its carrying cost, whereas in the
case of other assets their carrying cost much exceeds their
liquidity-premium. Let us, for purposes of illustration, assume
that on houses the yield is q1 and the carrying
cost and liquidity-premium negligible; that on wheat the carrying
cost is c2 and the yield and liquidity-premium
negligible; and that on money the liquidity-premium is l3
and the yield and carrying cost negligible. That is to say, q1
is the house-rate of interest, - c2
the wheat-rate of interest, and l3 the
money-rate of interest.
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. Taking money (which need only be a money
of account for this purpose, and we could equally well take
wheat) as our standard of measurement, let the expected
percentage appreciation (or depreciation) of houses be a1
and of wheat a2. q1, - c2 and l3
we have called the own-rates of interest of houses, wheat and
money in terms of themselves as the standard of value; i.e. q1
is the house-rate of interest in terms of houses, - c2 is the
wheat-rate of interest in terms of wheat, and l3
is the money-rate of interest in terms of money. It will also be
useful to call a1 + q1,
a2 - c2
and l3, which stand for the same quantities
reduced to money as the standard of value, the house-rate of
money-interest, the wheat-rate of money-interest and the
money-rate of money-interest respectively. With this notation it
is easy to see that the demand of wealth-owners will be directed
to houses, to wheat or to money, according as a1 + q1
or a2 - c2
or l3 is greatest. Thus in equilibrium the
demand-prices of houses and wheat in terms of money will be such
that there is nothing to choose in the way of advantage between
the alternatives;¾i.e. a1 + q1,
a2 - c2
and l3 will be equal. The choice of the
standard of value will make no difference to this result because
a shift from one standard to another will change all the terms
equally, i.e. by an amount equal to the expected rate of
appreciation (or depreciation) of the new standard in terms of
the old.
Now those assets of which the normal supply-price is less than
the demand-price will be newly produced; and these will be those
assets of which the marginal efficiency would be greater (on the
basis of their normal supply-price) than the rate of interest
(both being measured in the same standard of value whatever it
is). As the stock of the assets, which begin by having a marginal
efficiency at least equal to the rate of interest, is increased,
their marginal efficiency (for reasons, sufficiently obvious,
already given) tends to fall. Thus a point will come at which it
no longer pays to produce them, unless the rate of interest
falls pari passu. When there is no asset of which the
marginal efficiency reaches the rate of interest, the further
production of capital-assets will come to a standstill.
Let us suppose (as a mere hypothesis at this stage of the
argument) that there is some asset (e.g. money) of which the rate
of interest is fixed (or declines more slowly as output increases
than does any other commodity's rate of interest); how is the
position adjusted? Since a1 + q1,
a2 - c2
and l3 are necessarily equal, and since l3
by hypothesis is either fixed or falling more slowly than q1
or - c2, it
follows that a1 and a2 must
be rising. In other words, the present money-price of every
commodity other than money tends to fall relatively to its
expected future price. Hence, if q1 and - c2 continue to
fall, a point comes at which it is not profitable to produce any
of the commodities, unless the cost of production at some future
date is expected to rise above the present cost by an amount
which will cover the cost of carrying a stock produced now to the
date of the prospective higher price.
It is now apparent that our previous statement to the effect
that it is the money-rate of interest which sets a limit to the
rate of output, is not strictly correct. We should have said that
it is that asset's rate of interest which declines most slowly as
the stock of assets in general increases, which eventually knocks
out the profitable production of each of the others,¾except in the contingency, just mentioned,
of a special relationship between the present and prospective
costs of production. As output increases, own-rates of interest
decline to levels at which one asset after another falls below
the standard of profitable production;¾until,
finally, one or more own-rates of interest remain at a level
which is above that of the marginal efficiency of any asset
whatever.
If by money we mean the standard of value, it is clear
that it is not necessarily the money-rate of interest which makes
the trouble. We could not get out of our difficulties (as some
have supposed) merely by decreeing that wheat or houses shall be
the standard of value instead of gold or sterling. For, it now
appears that the same difficulties will ensue if there continues
to exist any asset of which the own-rate of interest is
reluctant to decline as output increases. It may be, for example,
that gold will continue to fill this r6le in a country which has
gone over to an inconvertible paper standard.
III
In attributing, therefore, a peculiar significance to the
money-rate of interest, we have been tacitly assuming that the
kind of money to which we are accustomed has some special
characteristics which lead to its own-rate of interest in terms
of itself as standard being more reluctant to fall as the stock
of assets in general increases than the own-rates of interest of
any other assets in terms of themselves. Is this assumption
justified? Reflection shows, I think, that the following
peculiarities, which commonly characterise money as we know it, are capable of
justifying it. To the extent that the established standard of
value has these peculiarities, the summary statement, that it is
the money-rate of interest which is the significant rate of
interest, will hold good.
(i) The first characteristic which tends towards
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;¾elasticity of production meaning, in this context, the response of the quantity of labour
applied to producing it to a rise in the quantity of labour which
a unit of it will command. Money, that is to say, cannot be
readily produced;¾labour cannot be
turned on at will by entrepreneurs to produce money in increasing
quantities as its price rises in terms of the wage-unit. In the
case of an inconvertible managed currency this condition is
strictly satisfied. But in the case of a gold-standard currency
it is also approximately so, in the sense that the maximum
proportional addition to the quantity of labour which can be thus
employed is very small, except indeed in a country of which
gold-mining is the major industry.
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, however¾postponing, for the moment, our
consideration of the effects of reducing the wage-unit or of a
deliberate increase in its supply by the monetary authority¾the supply is fixed. Thus the
characteristic that money cannot be readily produced by labour
gives at once some prima facie presumption for the view
that its own-rate of interest will be relatively reluctant to
fall; whereas if money could be grown like a crop or manufactured like a motor-car, depressions would be avoided or mitigated
because, if the price of other assets was tending to fall in
terms of money, more labour would be diverted into the production
of money;¾as we see to be the case in
gold-mining countries, though for the world as a whole the
maximum diversion in this way is almost negligible.
(ii) Obviously, however, the above condition is
satisfied, not only by money, but by all pure rent-factors, the
production of which is completely inelastic. A second condition,
therefore, is required to distinguish money from other rent
elements.
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;¾except, perhaps, to some trifling extent,
where the money-commodity is also used in manufacture or the
arts. This follows from the peculiarity of money that irs 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 of money rises there is no motive or tendency, as in the
case of rent-factors, to substitute some other factor for it.
Thus, not only is it impossible to turn more labour on to
producing money when its labour-price rises, but money is a
bottomless sink for purchasing power, when the demand for it
increases, since there is no value for it at which demand is
diverted¾as in the case of other
rent-factors¾so as to slop over into
a demand for other things.
The only qualification to this arises when the rise in the
value of money leads to uncertainty as to the future maintenance
of this rise; in which event, a1 and a2
are increased, which is tantamount to an increase in the
commodity-rates of money-interest and is, therefore, stimulating
to the output of other assets.
(iii) Thirdly, we must consider whether these conclusions are upset by the fact that, even though the quantity
of money cannot be increased by diverting labour into pro4ucing
it, nevertheless an assumption that its effective supply is
rigidly fixed would be inaccurate. In particular, a reduction of
the wage-unit will release cash from its other uses for the
satisfaction of the liquidity-motive; whilst, in addition to
this, as money-values fall, the stock of money will bear a higher
proportion to the total wealth of the community.
It is not possible to dispute on purely theoretical grounds
that this reaction might be capable of allowing an adequate
decline in the money-rate of interest. There are, however,
several reasons, which taken in combination are of 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:
(a) We have to allow, first of all, for
the reactions of a fall in the wage-unit on the marginal
efficiencies of other assets in terms of money;¾for it is the difference between
these and the money-rate of interest with which we are concerned.
If the effect of the fall in the wage-unit is to produce an
expectation that it will subsequently rise again, the result will
be wholly favourable. If, on the contrary, the effect is to
produce an expectation of a further fall, the reaction on the
marginal efficiency of capital may offset the decline in the rate
of interest.
(b) The fact that wages tend to be sticky
in terms of money, the money-wage being more stable than the real
wage, tends to limit the readiness of the wage-unit to fall in
terms of money. Moreover, if this were not so, the position might
be worse rather than better; because, if money-wages were to fall
easily, this might often tend to create an expectation of a
further fall with unfavourable reactions on the marginal
efficiency of capital.
Furthermore, if wages were to be fixed in terms of some other
commodity, e.g. wheat, it is improbable that they would continue
to be sticky. It is because of money's other characteristics¾those, especially, which make it liquid¾that wages, when fixed in terms of it,
tend to be sticky.
(c) Thirdly, we come to what is the most
fundamental consideration in this context, namely, the
characteristics of money which satisfy liquidity-preference. For,
in certain circumstances such as will often occur, these 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 falls
when their quantity is comparably increased.
In this connection the low (or negligible) carrying-costs of
money play an essential part. For if its carrying costs were
material, they would offset the effect of expectations as to the
prospective value of money at future dates. The readiness of the
public to increase their stock of money in response to a
comparatively small stimulus is due to the advantages of
liquidity (real or supposed) having no offset to contend with in
the shape of carrying-costs mounting steeply with the lapse of
time. In the case of a commodity other than money a modest stock
of it may offer some convenience to users of the commodity. But
even though a larger stock might have some attractions as
representing a store of wealth of stable value, this would be
offset by its carrying-costs in the shape of storage, wastage,
etc.
Hence, after a certain point is reached, there is necessarily
a loss in holding a greater stock.
In the case of money, however, this, as we have seen, is not
so,¾and for a variety of reasons,
namely, those which constitute money as being, in the estimation
of the public, par excellence 'liquid'. Thus those
reformers, who look for a remedy by creating artificial
carrying-costs for money through the device of requiring
legal-tender currency to be periodically stamped at a prescribed
cost in order to retain its quality as money, or in analogous
ways, have been on the right track; and the practical value of
their proposals deserves consideration.
The significance of the money-rate of interest arises,
therefore, out of the combination of the characteristics that,
through the working of the liquidity-motive, this rate of
interest may be somewhat unresponsive to a change in the
proportion which the quantity of money bears to other forms of
wealth measured in money, and that money has (or may have) zero
(or negligible) elasticities both of production and of
substitution. The first condition means that demand may be
predominantly directed to money, the second that when this occurs
labour cannot be employed in producing more money, and the third
that there is no mitigation at any point through some other
factor being capable, if it is sufficiently cheap, of doing
money's duty equally well. The only relief¾apart
from changes in the marginal efficiency of capital¾can come (so long as the propensity
towards liquidity is unchanged) from an increase in the quantity
of money, or¾which is formally the
same thing¾a rise in the value of
money which enables a given quantity to provide increased
money-services.
Thus a rise in the money-rate of interest retards the output
of all the objects of which the production is elastic without
being capable of stimulating the output of money (the production
of which is, by hypothesis, perfectly inelastic). The money-rate of interest, by setting
the pace for all the other commodity-rates of interest, holds
back investment in the production of these other commodities
without being capable of stimulating investment for the
production of money, which by hypothesis cannot be produced.
Moreover, owing to the elasticity of demand for liquid cash in
terms of debts, a small change in the conditions governing this
demand may not much alter the money-rate of interest, whilst
(apart from official action) it is also impracticable, owing to
the inelasticity of the production of money, for natural forces
to bring the money-rate of interest down by affecting the supply
side. In the case of an ordinary commodity, the inelasticity of
the demand for liquid stocks of it would enable small changes on
the demand side to bring its rate of interest up or down with a
rush, whilst the elasticity of its supply would also tend to
prevent a high premium on spot over forward delivery. Thus with
other commodities left to themselves, 'natural forces,' i.e. the
ordinary forces of the market, would tend to bring their rate of
interest down until the emergence of full employment had brought
about for commodities generally the inelasticity of supply which
we have postulated as a normal characteristic of money. Thus in
the absence of money and in the absence¾we
must, of course, also suppose¾of any
other commodity with the assumed characteristics of money, the
rates of interest would only reach equilibrium when there is full
employment. Unemployment develops, that is to say, because people
want the moon;¾men cannot be employed
when the object of desire (i.e. money) is something which cannot
be produced and the demand for which cannot be readily choked
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.
It is interesting to notice that the characteristic which has been traditionally supposed to render gold
especially suitable for use as the standard of value, namely, its
inelasticity of supply, turns out to be precisely the
characteristic which is at the bottom of the trouble.
Our conclusion can be stated in the most general form (taking
the propensity to consume as given) as follows. No further
increase in the rate of investment is possible when the greatest
amongst the own-rates of own-interest of all available assets is
equal to the greatest amongst the marginal efficiencies of all
assets, measured in terms of the asset whose own-rate of
own-interest is greatest.
In a position of full employment this condition is necessarily
satisfied. But it may also be satisfied before full employment is
reached, if there exists some asset, having zero (or relatively
small) elasticities of production and substitution,
whose rate of interest declines more closely, as output
increases, than the marginal efficiencies of capital-assets
measured in terms of it.
IV
We have shown above that for a commodity to be the standard of
value is not a sufficient condition for that commodity's rate of
interest to be the significant rate of interest. It is, however,
interesting to consider how far those characteristics of money as
we know it, which make the money-rate of interest the significant
rate, are bound up with money being the standard in which debts
and wages are usually fixed. The matter requires consideration
under two aspects.
In the first place, the fact that contracts are fixed, and
wages are usually somewhat stable, in terms of money
unquestionably plays a large part in attracting to money so high
a liquidity-premium. The convenience of holding assets in the same standard as that in which
future liabilities may fall due and in a standard in terms of
which the future cost of living is expected to be relatively
stable, is obvious. At the same time the expectation of relative
stability in the future money-cost of output might not be
entertained with much confidence if the standard of value were a
commodity with a high elasticity of production. Moreover, the low
carrying-costs of money as we know it play quite as large a part
as a high liquidity-premium in making the money-rate of interest
the significant rate. For what matters is the difference between
the liquidity-premium and the carrying-costs; and in the case of
most commodities, other than such assets as gold and silver and
bank-notes, the carrying-costs are at least as high as the
liquidity-premium ordinarily attaching to the standard in which
contracts and wages are fixed, so that, even if the
liquidity-premium now attaching to (e.g.) sterling-money were to
be transferred to(e.g.) wheat, the wheat-rate of interest would
still be unlikely to rise above zero. It remains the case,
therefore, that, whilst the fact of contracts and wages being
fixed in terms of money considerably enhances the significance of
the money-rate of interest, this circumstance is, nevertheless,
probably insufficient by itself to produce the observed
characteristics of the money-rate of interest.
The second point to be considered is more subtle. The normal
expectation that the value of output will be more stable in terms
of money than in terms of any other commodity, depends of course,
not on wages being arranged in terms of money, but on wages being
relatively sticky in terms of money. What, then, would the
position be if wages were expected to be more sticky (i.e. more
stable) in terms of some one or more commodities other than
money, than in terms of money itself? Such an expectation
requires, not only that the costs of the commodity in question
are expected to be relatively constant in terms of the wage-unit
for a greater or smaller scale of output both in the short and in
the long period, but also that any surplus over the current
demand at cost-price can be taken into stock without cost, i.e.
that its liquidity-premium exceeds its carrying-costs (for,
otherwise, since there is no hope of profit from a higher price,
the carrying of a stock must necessarily involve a loss). If a
commodity can be found to satisfy these conditions, then,
assuredly, it might be set up as a rival to money. Thus it is not
logically impossible that there should be a commodity in terms of
which the value of output is expected to be more stable than in
terms of money. But it does not seem probable that any such
commodity exists.
I conclude, therefore, that the commodity, in terms of which
wages are expected to be most sticky, cannot be one whose
elasticity of production is not least, and for which the excess
of carrying-costs over liquidity-premium is not least. In other
words, the expectation of a relative stickiness of wages in terms
of money is a corollary of the excess of liquidity-premium over
carrying-costs being greater for money than for any other asset.
Thus we see that the various characteristics, which combine to
make the money-rate of interest significant, interact with one
another in a cumulative fashion. The fact that money has low
elasticities of production and substitution and low
carrying-costs tends to raise the expectation that money-wages
will be relatively stable; and this expectation enhances money's
liquidity-premium and prevents the exceptional correlation
between the money-rate of interest and the marginal efficiencies
of other assets which might, if it could exist, rob the
money-rate of interest of its sting.
Professor Pigou (with others) has been accustomed to assume
that there is a presumption in favour of real wages being more
stable than money-wages. But this could only be the case if there
were a presumption in favour of stability of employment. Moreover, there is also the
difficulty that wage-goods have a high carrying-cost. If, indeed,
some attempt were made to stabilise real wages by fixing wages in
terms of wage-goods, the effect could only be to cause a violent
oscillation of money-prices. For every small fluctuation in the
propensity to consume and the inducement to invest would cause
money-prices to rush violently between zero and infinity. That
money-wages should be more stable than real wages is a condition
of the system possessing inherent stability. Thus the attribution
of relative stability to real wages is not merely a mistake in
fact and experience. It is also a mistake in logic, if we are
supposing that the system in view is stable, in the sense that
small changes in the propensity to consume and the inducement to
invest do not produce violent effects on prices.
V
As a footnote to the above, it may be worth emphasising what
has been already stated above, namely, that 'liquidity' and
'carrying-costs' are both a matter of degree; and that it is only
in having the former high relatively to the latter that the
peculiarity of 'money' consists.
Consider, for example, an economy in which there is no asset
for which the liquidity-premium is always in excess of the
carrying-costs; which is the best definition I can give of a
so-called 'non-monetary' economy. There exists nothing, that is
to say, but particular consumables and particular capital
equipments more or less differentiated according to the character
of the consumables which they can yield up, or assist to yield
up, over a greater or a shorter period of time; all of which,
unlike cash, deteriorate or involve expense, if they are kept in
stock, to a value in excess of any liquidity-premium which may
attach to them.
In such an economy capital equipments will differ from one
another (a) in the variety of the consumables in the
production of which they are capable of assisting, (b) in
the stability of value of their output (in the sense in which the
value of bread is more stable through time than the value of
fashionable novelties), and (c) in the rapidity with which
the wealth embodied in them can become 'liquid', in the sense of
producing output, the proceeds of which can be re-embodied if
desired in quite a different form.
The owners of wealth will then weigh the lack of 'liquidity'
of different capital equipments in the above sense as a medium in
which to hold wealth against the best available actuarial
estimate of their prospective yields after allowing for risk. The
liquidity-premium, it will be observed, is partly similar to the
risk-premium, but partly different;¾the
difference corresponding to the difference between the best
estimates we can make of probabilities and the confidence with
which we make them.
When we were dealing, in earlier chapters, with the estimation of
prospective yield, we did not enter into detail as to how the
estimation is made: and to avoid complicating the argument, we
did not distinguish differences in liquidity from differences in
risk proper. It is evident, however, that in calculating the
own-rate of interest we must allow for both.
There is, clearly, no absolute standard of 'liquidity' but
merely a scale of liquidity¾a varying
premium of which account has to be taken, in addition to the
yield of use and the carrying-costs, in estimating the
comparative attractions of holding different forms of wealth. The
conception of what contributes to 'liquidity' is a partly vague
one, changing from time to time and depending on social practices
and institutions. The order of preference in the minds of owners
of wealth in which at any given time they express their feelings
about liquidity is, however, definite and is all we require for our analysis of the behaviour of the economic system.
It may be that in certain historic environments the possession
of land has been characterised by a high liquidity-premium in the
minds of owners of wealth; and since land resembles money in that
its elasticities of production and substitution may be very
low,
it is conceivable that there have been occasions in history in
which the desire to hold land has played the same rôle in
keeping up the rate of interest at too high a level which money
has played in recent times. It is difficult to trace this
influence quantitatively owing to the absence of a forward price
for land in terms of itself which is strictly comparable with the
rate of interest on a money debt. We have, however, something
which has, at times, been closely analogous, in the shape of high
rates of interest on mortgages.
The high rates of interest from mortgages on land, often
exceeding the probable net yield from cultivating the land, have
been a familiar feature of many agricultural economies. Usury
laws have been directed primarily against encumbrances of this
character. And rightly so. For in earlier social organisation
where long-term bonds in the modern sense were non-existent, the
competition of a high interest-rate on mortgages may well have
had the same effect in retarding the growth of wealth from
current investment in newly produced capital-assets, as high
interest rates on long-term debts have had in more recent times.
That the world after several millennia of steady individual
saving, is so poor as it is in accumulated capital-assets, is to
be explained, in my opinion, neither by the improvident
propensities of mankind, nor even by the destruction of war, but
by the high liquidity-premiums formerly attaching to the
ownership of land and now attaching to money. I differ in this
from the older view as expressed by Marshall with an unusual
dogmatic force in his Principles of Economics,
p. 581:
Everyone is aware that the accumulation of wealth is held
in check, and the rate of interest so far sustained, by the
preference which the great mass of humanity have for present
over deferred gratifications, or, in other words, by their
unwillingness to 'wait'.
VI
In my Treatise on Money I defined what purported to be
a unique rate of interest, which I called the natural rate of
interest¾namely, the rate of interest
which, in the terminology of my Treatise, preserved
equality between the rate of saving (as there defined) and the
rate of investment. I believed this to be a development and
clarification of Wicksell's 'natural rate of interest', which
was, according to him, the rate which would preserve the
stability of some, not quite clearly specified, price-level.
I had, however, overlooked the fact that in any given society
there is, on this definition, a different natural rate of
interest for each hypothetical level of employment. And,
similarly, for every rate of interest there is a level of
employment for which that rate is the 'natural' rate, in the
sense that the system will be in equilibrium with that rate of
interest and that level of employment. Thus it was a mistake to
speak of the natural rate of interest or to suggest that
the above definition would yield a unique value for the rate of
interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system
could be in equilibrium with less than full employment.
I am now no longer of the opinion that the concept of a
'natural' rate of interest, which previously seemed to me a most
promising idea, has anything very useful or significant to
contribute to our analysis. It is merely the rate of interest
which will preserve the status quo; and, in general, we
have no predominant interest in the status quo as such.
If there is any such rate of interest, which is unique and
significant, it must be the rate which we might term the neutral
rate of interest,
namely, the natural rate in the above sense which is consistent
with full employment, given the other parameters of the
system; though this rate might be better described, perhaps, as
the optimum rate.
The neutral rate of interest can be more strictly defined as
the rate of interest which prevails in equilibrium when output
and employment are such that the elasticity of employment as a
whole is zero.
The above gives us, once again, the answer to the question as
to what tacit assumption is required to make sense of the
classical theory of the rate of interest. This theory assumes
either that the actual rate of interest is always equal to the
neutral rate of interest in the sense in which we have just
defined the latter, or alternatively that the actual rate of
interest is always equal to the rate of interest which will
maintain employment at some specified constant level. If the
traditional theory is thus interpreted, there is little or
nothing in its practical conclusions to which we need take
exception. The classical theory assumes that the banking
authority or natural forces cause the market-rate of interest to satisfy one or other of the above conditions; and it
investigates what laws will govern the application and rewards of
the community's productive resources subject to this assumption.
With this limitation in force, the volume of output depends
solely on the assumed constant level of employment in conjunction
with the current equipment and technique; and we are safely
ensconced in a Ricardian world.