Saturday, August 18, 2012

The difference between Keynes and Hayek

Gene Callahan and Jonathan Catalan have weighed in. Gene agrees with me that the real difference is in the way they thought about interest rates, and he suggests that which was right is an empirical question and may vary from time to time. Jonathan thinks that a potentially more important difference is between the Ricardo effect and the multiplier (I'm not sure why these are being contrasted with one another, personally).

But most of Jonathan's post is about interest rates again. If I'm reading him right, I think he's suggesting that the interest rate theories are not a "crucial difference" because they ultimately provide you the same conclusion. He writes:

"If the classical loanable funds theory is correct, the aggregate demand for factors of production equals exactly the amount of money saved. If Keynes’ liquidity preference theory is correct, there runs the chance that the rate of interest won’t accurately reflect society’s time preference. In both cases, the prices of the factors of production should reflect the nature of the rate of interest.
In other words, even if the rate of interest is higher than what it should be given society’s time preference, the prices of the factors of production will reflect total aggregate demand for them. That is, the prices of the means of production would be lower than they would be if the rate of interest were lower. We can roughly conceive of this as an equilibrium ratio between the prices of producers’ goods, the rate of interest, and expectations of future income."

I think this is right. You could talk about both theories with an AD-AS graph (just ask Roger Garrison!). This is a good point to make because it speaks to my initial reaction to Gene's post. Gene wrote:

"And they were both partially correct: the interest rate is influenced by both of these factors. So here is where we must get empirical: To the extent that the interest rate is determined by liquidity preference, to that extent Keynes was correct. To the extent the interest rate is determined by the supply and demand for loanable funds, Hayek was correct."*

But what is the empirical test??? We don't have data on liquitiy preference schedules (although presumably we could come up with something). For me, the real testable difference comes back to Wicksell. Both Hayek and Keynes are heavily influenced by Knut Wicksell, specifically the idea that there is a "cumulative process" (and Keynes and Hayek both have thoughts on what that cumulative process is... and perhaps this is what Jonathan was thinking about when discussing the multiplier and the Ricardo effect together) that are set off when the interest rate departs from some "natural rate".

But this works differently for Keynes and Hayek. Keynes suggests that the departure from the natural rate comes during the crash, either because of changes in the interest rate or MEC or both. Before the crash (aside from perhaps some asset bubbles that might induce the panic), the economy is operating normally. For Hayek the interest rate goes below the natural rate before the crash. That sets of an unsustainable cumulative process that ultimately has to end because of the irreversibility of capital investments, the distortions set off by the Ricardo and Cantillon effects, and revisions in entrepreneurs understanding of what's going on.

So here's the heart of all that: what is the empirical test we could do that Gene suggests we do?

If we had a good estimate of the natural rate, we could compare it to the interest rate over the business cycle and assess the strong and weak points of each description of reality.

So why do I think interest rate theory is so important? Because Keynes's liquidity preference theory and the whole constellation of observations about financial markets in the General Theory provides us with a reason to think that the interest rate is higher than the natural rate during the downturn. It motivates the whole description of what we observe.

I am thinking about all these things right now, and Gene and Jonathan should both be prepared to be pestered for thoughts on a draft in a couple months.

* I actually don't hold a pure liquidity preference theory myself (and I wonder if Keynes really would have if he thought about it). So in that sense I'm in between Gene's two poles to begin with. When a person saves rather than consumes, that is obviously informed by their time preference. So even if the marginal decision between keeping money liquid and putting it at interest is primarily a liquidity preference decision, the size of the pool of liquid assets influences the ultimate decision and the size of that pool is clearly determined by time preference! In addition, financial institutions that pay interest are going to be informed by the demand for loanable funds, which is going to be determined by firms' internal rate of return. So yes - interest is definitely the price for parting with liquidity. But the amount of liquid funds available and the demand for the liquid funds put at interest are both determined by time preference. A pure liquidity theory seems far less important to me than the simple fact that liquidity preference is in there at all, introducing a "loose joint".


  1. Out of curiosity Daniel, what of Knut Wicksell have you read? I own a copy of his Value, Capital and Rent, but I have yet to read it.

    As for the "draft" that you are referring to...are you talking about your Critical Review article that criticises Austrian Business Cycle Theory?

    As for interest rates and Keynes...Keynes does talk about an "optimum" rate of interest, or something along those lines. Unless I'm mistaken, Keynes seems to suggest that there are multiple equilibria in an economy, and there are multiple rates of interest for different situations that affect the economy.

    As for Keynes's theory of liquidity preference...keep in mind that Keynes's theory of liquidity preference actually goes back to his views in A Treatise on Probability. There's a remark by Keynes to a correspondent in Volume XXVIIII of the CWJMK that indicates that the "weight of evidence" is tied to uncertainty.

    On another note, Keynes talks about

  2. *On another note, Keynes talks about expected prices and expected profits, if I'm not wrong. It's the expected price and the expected profit that drives the enterpreneur. (Yes, the entrepreneur is featured in the GT folks. Schumpeter and Keynes would have agreed on financial markets and investment fluctuations in the business cycle, but Schumpeter chose to downplay his disagreements with the rest of the Classics.)

    1. Unless Keynes changed his mind after writing "A Treatise on Probability", he would not have talked of an expected price or profit in precise numerical terms, although he may have talked about expected price ranges or expected ranges of profits.

    2. Min: Have you read the TP? He does talk about expected profits and expected prices. Dr. Michael Emmett Brady has articles on this in Australia's History of Economics Review. Just dig through the HETSA archives or look up "Michael Emmett Brady" on Google Scholar.

    3. Yes, I have read "A Treatise on Probability". Since for Keynes probabilities are not necessarily numbers, even though they are bounded by numbers, if he talks about expected profits and prices he does not mean numbers, except under special circumstances.

    4. For Keynes, probabilities are interval estimates. That means that numbers can be used. Read CMarcello Basili and Carlo Zappia's 2009 article in the Journal of Economic Psychology or Dr. Michael Emmett Brady's paper with Rogerio Arthmar, please. Keynes's interval estimate approach to probability is more than an ordinal approach. See the following links.

  3. The debate about the older theories of interest vs the liquidity preference theory is confused by the different intentions of those involved. The marginalist economists were intending to complete their long-run overall economic theory and in the case of Bohm-Bawerk intended to attack the foundations of Marxism. In the 20s and 30s economists turned their thoughts towards macroeconomics and the business cycle. The desire to get to those end-points have shifted and warped the interest rate debate.

    Starting with the old theories.... Bohm-Bawerk discusses what Marxists call the "average rate of profit". He talks about the returns to capital in general. There are capital goods, businesses, property, land and debt. All of these earn returns and as such all compete with each other as investments. Some earn more and some earn less. That deviation from the average is determined by skill in investing, risk taken and duration. But, we can say that apart from that noise there is an average. This average is the subject of the old theories of interest. The theories that involve a savings-investment market make sense here.

    Keynes' liquidity preference theory is a different, it's a theory of two specific portions of the total capital market - liquid money and less liquid bonds. It's about the market rate of interest on low risk bonds (and that can be expanded to include some savings accounts), and the related rate on business loans. Keynes thought these parts of the market were very important (I agree) so he created a theory to zero in on them.

    1. Would you say that Dr. Michael Emmett Brady's observation on the connections between Keynes's weight of evidence and probability theory in the TP and liquidity preference theory in the GT have no merit, Current?

    2. I haven't read that Brady on that.

      I agree that uncertainty about the future heavily affects the liquidity preference of the general public and of investors.

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  5. Daniel, your discussion errs for it elevates form over substance.

    It suffers from errors like those committed by gold bugs who do not understand that gold is not money by reason of any rule of economics but that, in context, a written appraisal of a piece of real estate can be, under certain conditions, so like money that its effect is the same as money.

    No economy requires interest to operate. Loans and interest can be replaced by future contracts promising to share in future profits. We have loans and interest solely because some transactions are more efficient, in a Coasian sense, if we structure the transaction as a loan paying interest as opposed to more elaborate contracts with promises of parts of future profits.

    This makes your assertion that "the aggregate demand for factors of production equals exactly the amount of money saved" false. I don't have to have any money to induce someone to provide me goods or services, based on future promises. Money, as I showed several weeks ago with the story of Don Trump I building the First Pyramid comes afterward, once discovery that future promises can be made assignable.

    By now you should have learned that insight comes from simplification. Searching for the natural rate of interest is a meaningless exercise.

    What economists should be searching for are simple keys to creating confidence that future promises will be performed and future expectations meet. Keynes saw that there could be circumstances where confidence could be maintained or created only by the government, if at all. Hayek has no insights on this fundamental problem (no surprise).

    There is a further error in you post and that is that there is something called saving that can be identified. There is not.

    Consider a simple example: un-mined gold. What if its costs $100 to mine gold but fearful hoarders will make contracts with future promises to pay $1000 an ounce, if mined. Is newly mined gold a "saving." If the hoarders re-nege on their promises before they become due, what has happened to savings? The gold has been mined and is out of the ground.

  6. That the Hayekian view would be that interest rates are too low before the crash is pretty obvious as clearly this is a central tenet of ABCT. I can also see how liquidity preference theory would be consistent with the view that a sudden drop in demand for investment funds might not be met by a sufficiently large drop in interest rates (or it might even lead to a rise in interest rates if liquidity preference increased simultaaneously) and lead to a recession. However didn't Keynes also talk of a liquidity trap where interest rates during a recession would hit the zero-bound ?

    However I think most Austrians would also predict relatively high interest rates during the ensuing recession if the banking system was unhampered and the rates set by the market. This would be because the pool of savings has shrunk during the ABCT-type boom and because lenders would likely be more risk adverse (there liquidity preference has indeed increased). Such high interest rates would be part of the recovery process as the economy rebuilds the savings pool, and re-allocates this smaller amount to the appropriate areas of investment required to rebuild the structure of the economy.

    Which leads to the key difference in my opinion between the Keynesian and Hayekian view of interest rates. Keynesian would see an important element in the recovery would be to lower interest rates by increasing the money supply , while Austrians (leaving aside the tricky issues of monetary disequilibrium) would see such artificial lowering as actually slowing down the recovery by leading to further mis-allocations of resources.

    Separate point: As central bank manipulations of interest rates has been the main monetary tool for the last 50 years it is hard to see how an empirical study would lead one to any conclusions on whether loanable funds or liquidity preference theory is true. As in the short term the CB creates whatever money is needed to maintain the interest rate - one assumes that LP would be the model most closely manifested, but that would just be a creation of CB policy.

    1. A very simple thought experiment shows how entirely wrong this discussion happens to be.

      Keen has shown that the rise in private debt to GDP ratio was the underlying cause of the Lesser Depression (with Oil prices increases being the trigger).

      Properly, the "fiscal" side of government ought to regulate the level of private debt (example: 20% down payment for a home loan or higher bank capital requirements). However, on this score on government is entirely broken.

      This forces one to ask, What should the Fed have done to counteract the rising levels of private debt?

      The Fed could not raise interest rates, for after all we had just lost a War to Ben Laden on 9/11 and were about to go War in Iraq and Afghanistan. Under these circumstances, what the Fed should have done was "print money" reducing private debt with inflation.

      In sum, we are here, today, because the Fed did not let asset prices rise faster than private debt was rising post 9/11

      here is the chart

      this chart, BTW, also answers Noah's question why the economy broke in the early 1970s. notice that private debt passed 100% of GDP in 1970.


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