Bob Wenzel on Bob Murphy on Liquidity Preference

Bob Wenzel criticizes Bob Murphy for drawing an objective conclusion regardless of the ideological fallout that it might inspire (which is absolutely not to say that everyone who took issue with Bob Murphy was being ideological about it... but you could sense him bracing himself in the original post).

I left this response on Wenzel's blog - nothing revolutionary, but hopefully helpful:

"You seem to be confusing "liquidity" with "cash in your wallet". Liquidity for Keynes is simply the control over funds to use as a medium of exchange.

You can save $1,000 in your mattress for ten years, you can save $1,000 in a savings account for ten years, you can save $1,000 in a 2 year CD for ten years (rolling it over four times), you can save $1,000 in a 5 year CD for ten years (rolling it over once), or you can save $1,000 in a 10 year CD for ten years.

In each case your time preference is to forgo $1,000 in the present and use it ten years from now. However, your liquidity preference varies in each case.

Holding time preference constant, we still have a variance in the interest rate that people are willing to accept.

That's the liquidity preference theory of interest. That's all it is. It shouldn't be all that controversial. People should be able to identify this in their own lives - think about how much you keep in a savings account vs. how much you tie up in other accounts. Usually it's not because the amount you keep in savings is expected to be used any more imminently than what you keep in a CD or something else. Sometimes people have a specific imminent purchase in mind, but often it's intended to sit and earn interest for the same amount of time. You just trade off the interest rate against how accessible you want those funds. If you need less accessibility you tie it up in a higher interest rate account for the exact same time span that you're expecting to leave the money in savings. It's precisely the uncertainty of those expectations that causes us to keep money liquid. If we were certain, we'd put it all in a high interest account for precisely the time period that is consistent with our time preference."

One of the things that bothers me about the way people talk about liquidity preference is when they refer to it as "hoarding". Hoarding implies that mattress-stuffing caused the Great Depression. This is silly, of course. Certain sorts of money holding can be more liquid than others, and so an increase in liquidity preference can shift the composition of money holdings to be relatively more liquid across the board without a discernable increase in cash holdings.

I think it's also fair to give Bob Murphy a voice here. This is his comment on Wenzel's post:

"I was going to make a Darth Vader joke, but this is actually an important issue and 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 $5x52 = $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?"