“The ghost of John Maynard Keynes…has returned to haunt us”, commented Martin Wolf (2008) in the wake of the global financial crisis, suggesting that the lessons from the father of macroeconomics were the best way to understand the crisis and to return the world economy to health.
In fact, the severity of the crisis persuaded several scholars to re-evaluate Keynes’ teachings, which had for decades disappeared from mainstream economic theory and practice. And, if in the March 2008 annual meeting of the American Economic Association economists were still skeptical to the idea of fighting recessions with fiscal stimuli, only a few months later, at the January 2009 meeting, virtually everyone was supportive of such measures (Uchitelle 2009).
Yet, while the economics profession found renewed interest in Keynes’ demand management policy, it failed to recognize Keynes’ liquidity preference theory (LPT) as the fundamental explanation of why a capitalist economy can feature permanent involuntary unemployment, and how effective can monetary and fiscal policies be in driving the economic recovery.
Keynes’ analysis undermined productivity and thrift as the foundations of the neoclassical theory of the rate of interest. Recognizing the centrality of uncertainty –not just measurable risk – for all economic decisions, LPT viewed the interest rate not as the reward for patience, or abstinence, as in neoclassical theory, but as the compensation for agents parting with liquidity, and thus as a measure of their unwillingness to dispossess themselves of their control over liquidity in an uncertain world. At any time the interest rates must be such that the general public’s desire to hold liquid assets rather than other assets ceases at the margin, given the amount of liquidity available in the economy (Keynes (1971-89), Vol. 7, 167).
For Keynes, the determination of the rate of interest does not derive from saving decisions, but from the degree of liquidity that agents prefer their savings to have. These preferences concern the stock of savings (wealth), not the flows of saving, and the interest rate is determined by the demand for and supply of assets into which wealth can be placed, not by the supply of and demand for (flows of) saving – as in the neoclassical loanable fund theory that today still underpins mainstream (neo-Wicksellian) macroeconomic modeling (Woodford 2003). In this regard, it is important to understand LPT in broad terms, and to not identify it exclusively with the demand for money. The LPT concerns the demand for assets of various degrees of liquidity, and the rate of interest depends on both the demand for and supplies of assets across this whole spectrum.
Accordingly, future interest rates on financial assets are determined by market valuations as influenced by mass psychology and by the extent to which this reflects back on agent liquidity preferences. For LPT, the interest rate is a conventional phenomenon, whose value is largely governed by the prevailing view as to what its value is expected to be, and which may permanently settle at levels that are chronically too high to ensure full employment.
Thus, there is not a unique (‘natural’) level of interest allowing the system to automatically adjust to the unique (‘natural’) full-employment equilibrium, but rather any level of interest that happens to satisfy the conventions held in financial markets at any time (Bibow 2005). Turning the neoclassical vision upside down, LPT showed that it is the real sphere of the economy that has to accommodate itself to whatever interest level the financial system might come up with.
LPT and monetary policy
By removing thrift and productivity as real anchors of the interest rate, LPT left the latter at the mercy of people’s conventional beliefs. Yet precisely the conventional nature of the rate of interest, as encapsulated in LPT, paved the way for recognizing the central role of expectations for economic policy making. In the presence of the fundamental indeterminacy of macroeconomic equilibrium – in the context of a multitude of possible equilibria – the active management of expectations through monetary policy (in conjunction with the use of the short-term policy rates) became the key central bank tool to influence beliefs (and interest rates) and hence to steer the economy towards its optimal (full-employment, low-inflation) equilibrium.
In Keynes’ view, policy effectiveness largely depends on the credibility of the actions undertaken and the institutions undertaking them. Today, one would add communication to the policy toolbox required for central banks to be able to guide market expectations consistently with policy objectives. Far from being neutral, money can be used to drive real activity and accumulation to their socially optimal levels.
The question is whether central banks can always succeed in such task. Keynes believed that if the authorities conduct measured policy and pursue it consistently, conveying to the markets that they know what they’re doing and that they are confident about their purposes, they can shape agent expectations as desired (Aspromourgos 2006).
Keynes also saw the possibility of extreme situations – like an obstinate persistence of a slump – where the economy features increased uncertainty, depressed financial sentiment, and heterogeneous expectations. For which cases, he advised that central banks take recourse to ‘extraordinary methods’, such as carrying out open-market operations in long-term securities. It sounds very much like ‘unconventional’ (central bank’s balance sheet) policies ante litteram (Bossone 2013a,b).
Would there be limits to such policies?
Keynes repeatedly referred to the possibility of some absolute floor impeding the full downward adjustment of interest rates (although he wasn’t sure about the concrete relevance of such possibility), due to uncertainty causing investors to move into liquidity. A limit would eventually be reached where selling pressure due to securities holders moving into liquidity fully offsets the upward price pressure due to open-market operations. At that point, the central bank loses effective control: the system is in a liquidity trap. Keynes, in fact, indicated that this condition might arise at any level of the interest rate that is considered to be ‘fairly safe’ (and not necessarily at the zero lower bound). Thus, there is correspondingly a multiplicity of liquidity traps. This problem would not arise if the authorities managed to shift the state of expectations in the desired direction, or so it was thought.
Is monetary policy, alone, sufficiently effective to ensure this result?
Experience with the global financial crisis of 2007-09 and the subsequent debt crisis in Europe has shown the severe limitations of monetary policy. After a short period, when governments in most advanced economies used the fiscal lever (in concurrence with virtually unlimited provision of central bank liquidity) as a stopgap to the risk of financial meltdown, the monetary authorities were then left with the task of helping the economy out of recession at the same time that fiscal policy turned conservative again for fears of excessive public debt creation. As monetary authorities in each country responded to circumstances, the general outcome of their actions was that it took extremely long for them to let the economy on the path to recovery as well as to actually achieve recovery.
LPT explains this outcome by pointing that even though unconventional policies may succeed in cutting rates, liquidity preference driven by pessimistic expectations can be so strong and persistent as to make rate cuts insufficient, or ineffective, to induce agent preferences to shift from liquidity to consumption and investment. In fact, given the importance of people’s conventional beliefs, even if additional interest rate reductions were possible, they might signal further economic weakening and fuel even more depressed market sentiments, rather than encourage demand.
What central banks can achieve through the continuing expansion of their balance sheet, and the adoption of forward guidance policies, is to slowly change pessimistic expectations by signaling an obstinate determination to backstop recession and fight deflation (Bossone 2017). People eventually learn; however, this is a very indirect and time-consuming policy strategy since the money injected into the economy through open-market operations does not reach those who can most readily spend it. On the other hand, experience shows that where negative policy interest rates were adopted to stimulate aggregate demand, the transmission channels did not work as expected, as high liquidity preference actually froze them out, and results were overall unsatisfactory (Jobst and Lin 2016).
Monetary and fiscal policy
Liquidity traps are where fiscal policy can achieve the largest bang for the buck, especially if coordinated with monetary policy. In the aftermath of the Great Recession, several mainstream economists (most notably Krugman 2016, and Delong and Summers 2012) emphasized the use of fiscal policy as the best way out of liquidity traps. A few others broke the taboo and recommended such measures as the monetary financing of fiscal deficits (Bernanke 2002, 2017; Caballero 2010; Turner 2013, 2015) or the public distribution of central bank money (Blyth and Lonergan 2014, Muellbauer 2014).
Here, Friedman (1969) and his ‘helicopter money’ concept are a more pertinent reference than Keynes. Yet Keynes’ LPT and income multiplier analysis provide a powerful rationale for using monetary and fiscal policy jointly, with a view to maximizing their impact on aggregate demand by minimizing the effect of pessimistic expectations on liquidity preference (Bossone 2017). By implication, the central bank and treasury should coordinate their action so as to:
- enable government to finance new spending, tax reduction or social welfare programs specifically tailored to activate the highest income multipliers possible, without issuing new debt (which is especially useful for countries with a highly constrained fiscal space), or
- distribute money directly to the people, without having to rely on bank credit channels when neither banks nor the public wish to lend and borrow, respectively.
Such joint uses of monetary and fiscal policy amount to a “free lunch” (Bossone (2016) and always work (Buiter 2014), but they have never been attempted, probably for failing to understand that strong and persistent liquidity preference:
- freezes the normal operation of a monetary production economy – the object of Keynes’ theory – and
- requires monetary and fiscal policy coordination as the only strategy to intervene on aggregate demand directly (and with no debt implications) and to change expectations rapidly by showing visible output and employment gains.
The crisis events that have plagued the advanced economies over the last decade have brought to a resurgence of the macroeconomics of John Maynard Keynes. Other than possibly being short-lived, such resurgence has in fact been less intellectually engaging than any serious process of reevaluation should appropriately demand. A less than careful re-reading of Keynes’ thought revolution has caused many of those who have recently sympathized with it to miss the critical role of his liquidity preference theory to explain why capitalist economies can be trapped into underemployment equilibria and to point to how monetary and fiscal policies can be used to restore their health.
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 Keynes (1971-89), Vol. 7, 203-204. Interestingly, Lansing (2017) estimates a strongly negative correlation between the ‘natural’ (‘r-star’) interest rate and an index of macroeconomic uncertainty.
 It is the rate of interest on liquidity that “rules the roost” by setting “the standard to which the marginal efficiency of a capital-asset must attain if it is to be newly produced.” (Keynes (1971-89), Vol. 7, 222.)
 Keynes noted:
“In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest…I believed this to be a development and clarification of Wicksell’s ‘natural rate of interest’…
I had, however, overlooked the fact that in any given society there is…a different natural rate of interest for each hypothetical level of employment…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 no longer of the opinion that the concept of a ‘natural’ rate of interest…has anything very useful or significant to contribute to our analysis…
If there is any such rate of interest…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.” (Keynes (1971-89), Vol. 7, 242-3)
 See for instance Keynes (1971-89), Vol. 6, 334.
 Keynes (1971-89), Vol. 7, 207.
 By Krugman’s (2015) recognition, this line of thinking draws more on Sir John Hicks’ reinterpretation of Keynes than on Keynes’ original theory. See also Boianovsky (2004).
 On monetary fiscal coordination see, Bossone (2015) and Balls et al (2016).