Interest Rates and Animal Spirits: A Response to JW Mason

JW Mason has an interesting post on the interest rate over at his Slackwire blog. In it he basically tries to resuscitate Keynes’ theory of liquidity preference as that which determines the interest rate on various assets. I think that he does rather a good job given that this is his goal but from the moment I looked into this debate over a year ago I was always bothered by what was going on.

First let us start with the conclusion that Mason comes to when considering the theory of the interest rate that Keynes lays out in the General Theory,

If we take a more realistic view of credit markets, we come to the same conclusion: the yield on a credit instrument (call this the “credit interest rate”) has no relationship to the intertemporal substitution rate of theory (call this the “intertemporal interest rate.”)

Mason gives the example of the mortgage market. He points out, quite rightly, that when a bank loan is made there is no intertemporal substitution on either the side of the bank or on the side of the borrower. What he means by that is that neither the bank nor the borrower must forgo consumption in the present for consumption in the future. So, he asks, what then explains the amount of loans outstanding? He answers as such,

Buying a house makes you less liquid — it means you have less flexibility if you decide you’d like to move elsewhere, or if you need to reduce your housing costs because of unexpected fall in income or rise in other expenses. You also have a higher debt-income ratio, which may make it harder for you to borrow in the future. The loan also makes the bank less liquid — since its asset-capital ratio is now higher, there are more states of the world in which a fall in income would require it to sell assets or issue new liabilities to meet its scheduled commitments, which might be costly or, in a crisis, impossible. So the volume of mortgages rises until the excess of housing service value over debt service costs make taking out a mortgage just worth the incremental illiquidity for the marginal household, and where the excess of mortgage yield over funding costs makes issuing a new mortgage just worth the incremental illiquidity for the marginal bank.

So, again we’re back to Keynes: the interest rate is based on liquidity preference. Now, this looks all neat and tidy doesn’t it? Well, I would argue it isn’t. Let’s wind this back a little bit, shall we?

Okay, so why do economic actors require liquidity? Well, according to Keynes’ theory it is a buffer against uncertainty. Economic actors do not have access to crystal balls — that is, they do not know what is going to happen in the future — so they keep cash on hand in case anything bad and unforeseen happens in the future.

The same is basically true of Mason’s reformulation of Keynes’ liquidity preference theory. The purchase of a house ties the buyer down in a market that is by no means perfectly liquid, while the extension of the loan also places the bank in a less liquid position.

Now, this all sounds good, right? Well, not really. You see the operative word here is ‘uncertainty’. In order for this theory to work we must fully recognise that economic actors operate in an environment of uncertainty. But earlier on in the piece Mason laid out what determines an interest rate as such,

The yield of the bond — the thing that in conventional usage we call the “interest rate” — depends on the risk of the bond, the expected price change of the bond, and the liquidity premium of money compared with the bond. (My Emphasis)

You see those three sections of the sentences I highlight? Well, are they not one and the same thing? After all, isn’t the risk of the bond and the expected future price of the bond inherently tied up with the liquidity premium of money compared with that of a bond?

I do not raise this issue simply to be pedantic. No, I believe it contains within it an important oversight: namely, that these is no such thing as “risk” on the bond in the sense of a given objective probability that people hold inside their heads. If there were then the notion of a liquidity premium on money would be meaningless. Why? Because, again, liquidity is something we desire only in the face of an uncertain future. If we assume that bonds have objective probabilities then there is no uncertain future and there is no need for liquidity preference. Whereas if we assume that the future is uncertain and that liquidity preference is real then there is no such thing as “risk on a bond”.

This makes the whole issue far simpler and also paints the dividing line between the mainstream and the heterodox theory much more clearly: either there is uncertainty, in which case “risk” cannot be measured and so interest rates are subject to “animal spirits”, or there is no uncertainty and interest rates merely reflect intertemporal substitution. There really is no point in talking about liquidity premium and the risk on a bond as the very existence of the former is predicated on the non-existence of the latter.

What’s more, as I’ve argued extensively before, most New Keynesian economists today think that financial markets — i.e. those in which interest rates are set — are subject to animal spirits. This, as I’ve pointed out in the above linked to post, means that any theory of a natural rate of interest is inconsistent with their belief in behavioral finance and economics because the natural rate of interest theory requires that interest rates across the economy are set to line up savings and investment perfectly and thus must incorporate all information about the future perfectly.