Thursday, July 14, 2011

Murphy's on a roll on interest rates

A very good post from Bob Murphy continuing the assault on Wenzel. I wanted to highlight this point specifically:

"The standard (and obvious) explanation for the yield curve invokes the desire for liquidity. I’m guessing Wenzel will come back and say something like, “Short rates might move in the future, so that’s why the yield curve can be upward or downward sloping.” But my point is, even if we expected the short rate to stay constant for the next ten years, a desire for liquidity would cause the yield curve to be upward sloping. If you roll your money over 10 times, you are less exposed to a sudden (and unexpected) move in interest rates than if your money is “stuck” in a ten-year bond. If for some reason your plans change, and you need to spend your money before the originally planned ten years, and if interest rates have risen in the meantime, you will take less of a hit if you have been rolling your money over in one-year bonds, than if it’s still sitting in (say) a 60%-matured 10-year bond."

This point that Bob makes is precisely the connection between uncertainty about the future and liquidity preference that Keynes makes, and I thought that was worth pointing out. In chapter 13 Keynes writes:

"At this point, however, let us turn back and consider why such a thing as liquidity-preference exists. In this connection we can usefully employ the ancient distinction between the use of money for the transaction of current business and its use as a store of wealth. As regards the first of these two uses, it is obvious that up to a point it is worth while to sacrifice a certain amount of interest for the convenience of liquidity. But, given that the rate of interest is never negative, why should anyone prefer to hold his wealth in a form which yields little or no interest to holding it in a form which yields interest (assuming, of course, at this stage, that the risk of default is the same in respect of a bank balance as of a bond)? A full explanation is complex and must wait for Chapter 15. There is, however, a necessary condition failing which the existence of a liquidity-preference for money as a means of holding wealth could not exist.

This necessary condition is the existence of uncertainty as to the future of the rate of interest, i.e. as to the complex of rates of interest for varying maturities which will rule at future dates. For if the rates of interest ruling at all future times could be foreseen with certainty, all future rates of interest could be inferred from the present rates of interest for debts of different maturities, which would be adjusted to the knowledge of the future rates.
For example, if 1dr is the value in the present year 1 of £1 deferred r years and it is known that ndr will be the value in the year n of £1 deferred r years from that date, we have

ndr = ndn+r / 1dn ;

whence it follows that the rate at which any debt can be turned into cash n years hence is given by two out of the complex of current rates of interest. If the current rate of interest is positive for debts of every maturity, it must always be more advantageous to purchase a debt than to hold cash as a store of wealth.

If, on the contrary, the future rate of interest is uncertain we cannot safely infer that ndr will prove to be equal to 1dn+r/1dn when the time comes. Thus if a need for liquid cash may conceivably arise before the expiry of n years, there is a risk of a loss being incurred in purchasing a long-term debt and subsequently turning it into cash, as compared with holding cash. The actuarial profit or mathematical expectation of gain calculated in accordance with the existing probabilities — if it can be so calculated, which is doubtful — must be sufficient to compensate for the risk of disappointment.

There is, moreover, a further ground for liquidity-preference which results from the existence of uncertainty as to the future of the rate of interest, provided that there is an organised market for dealing in debts. For different people will estimate the prospects differently and anyone who differs from the predominant opinion as expressed in market quotations may have a good reason for keeping liquid resources in order to profit, if he is right, from its turning out in due course that the 1drs were in a mistaken relationship to one another.

This is closely analogous to what we have already discussed at some length in connection with the marginal efficiency of capital. Just as we found that the marginal efficiency of capital is fixed, not by the “best” opinion, but by the market valuation as determined by mass psychology, so also expectations as to the future of the rate of interest as fixed by mass psychology have their reactions on liquidity-preference; — but with this addition that the individual, who believes that future rates of interest will be above the rates assumed by the market, has a reason for keeping actual liquid cash, whilst the individual who differs from the market in the other direction will have a motive for borrowing money for short periods in order to purchase debts of longer term. The market price will be fixed at the point at which the sales of the “bears” and the purchases of the “bulls” are balanced."

This passage, which actually comes right after the Chapter 13 passage that Bob quoted earlier, was one of those lightbulb moments for me when I first read the book. OK, now I'm convinced that this fall I need to:

1. Reread the General Theory, and
2. Read Bob's dissertation

1 comment:

  1. I really couldn't figure the criticisms of, effectively, liquidity preference coming from Wenzel (and various of his commentators). They seemed to me to so obviously miss the point that I almost felt that I was missing something obvious.

    I would love to know what Wenzel makes of the convenience yield that underpins commodity markets...


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