Tuesday, April 26, 2011

Keynes didn't have an "idle resources theory of the interest rate"

He had a "liquidity preference theory of the interest rate", and I think I typically try to talk about liquidity preference on here, rather than idle resources. Not a big deal in every day discussions about it, but it's an important distinction to keep in mind.

"Idle resources" have come up in online discussions of Landsburg's piece on taxes, and they have recently been highlighted by "Lord Keynes" in a critique of Jonathan's mises.org piece on government spending. "Lord Keynes" focuses on the idea that people don't want to work when they are unemployed - a point I agree with him on. He also highlights another particularly problematic statement of Jonathan's where he says that (1.) government is a disequilibrium force, and (2.) government pursues less preferred ends. Both of these could be true, but I don't think Jonathan has any warrant to suggest that they have to be true.

Anyway, what caught my attention was the use of these terms "idle resources". It gives us the image of machines that aren't being used or factories that are shuttered, or people that do not have jobs. These things are real problems, but it's important to remember that idleness need not be so dichotomous. Idleness of resources can emerge when the same resource is being used, but it is kept more liquid than it normally would. Let's say depositors at a bank shift their funds from two year CDs to six month CDs because they are concerned about the prospect of imminent job loss and want to keep some savings liquid. Those deposits are going to be more idle when the bank turns around to use them. Stuffing mattresses with bills and "hoarding" is how we talk about these idle resources, but of course "hoarding" is only the most extreme case of idle resources. Economic actors need not increase their cash on hand at all to have idleness. Keynes's key point was that it is on this margin between leaving resources relatively more or less liquid that the interest rate is determined. When firms make investment decisions they compare the marginal efficiency of capital - the discount rate that would be required for a project to provide net benefits - and determine whether the marginal efficiency of capital exceeds the interest rate or not. If the marginal efficiency of capital exceeds the interest rate, then all interest earnings from putting funds at interest would be discounted and the firm would make a net loss. If the interest rate exceeds the marginal efficiency of capital then more present value earnings are to be had in putting funds at interest, and investments are not made. The idleness of resources is determined by the interest rate and liquidity preference.

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