The General Theory of Employment, Interest and Money Part 5

IV.

Two types of risk affect the volume of investment which have not commonly been distinguished, but which it is important to distinguish. The first is the entrepreneur's or borrower's risk and arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes. If a man is venturing his own money, this is the only risk which is relevant.

But where a system of borrowing and lending exists, by which I mean the ranting of loans with a margin of real or personal security, a second type of risk is relevant which we may call the lender's risk. This may be due either to moral hazard, i.e. voluntary default or other means of escape, possibly lawful, from the fulfilment of the obligation, or to the possible insufficiency of the margin of security, i.e.

involuntary default due to the disappointment of expectation. A third source of risk might be added, namely, a possible adverse change in the value of the monetary standard which renders a money-loan to this extent less secure than a real a.s.set; though all or most of this should be already reflected, and therefore absorbed, in the price of durable real a.s.sets.

Now the first type of risk is, in a sense, a real social cost, though susceptible to diminution by averaging as well as by an increased accuracy of foresight. The second, however, is a pure addition to the cost of investment which would not exist if the borrower and lender were the same person. Moreover, it involves in part a duplication of a proportion of the entrepreneur's risk, which is added twice to the pure rate of interest to give the minimum prospective yield which will induce the investment. For if a venture is a risky one, the borrower will require a wider margin between his expectation of yield and the rate of interest at which he will think it worth his while to borrow; whilst the very same reason will lead the lender to require a wider margin between what he charges and the pure rate of interest in order to induce him to lend (except where the borrower is so strong and wealthy that he is in a position to offer an exceptional margin of security). The hope of a very favourable outcome, which may balance the risk in the mind of the borrower, is not available to solace the lender.

This duplication of allowance for a portion of the risk has not hitherto been emphasised, so far as I am aware; but it may be important in certain circ.u.mstances. During a boom the popular estimation of the magnitude of both these risks, both borrower's risk and lender's risk, is apt to become unusually and imprudently low.

V The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake of regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between to- day and to-morrow. Even the rate of interest is, virtually, a current phenomenon; and if we reduce the marginal efficiency of capital to the same status, we cut ourselves off from taking any direct account of the influence of the future in our a.n.a.lysis of the existing equilibrium.

The fact that the a.s.sumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality. But the introduction of the concepts of user cost and of the marginal efficiency of capital, as defined above, will have the effect, I think, of bringing it back to reality, whilst reducing to a minimum the necessary degree of adaptation.

It is by reason of the existence of durable equipment that the economic future is linked to the present. It is, therefore, consonant with, and agreeable to, our broad principles of thought, that the expectation of the future should affect the present through the demand price for durable equipment.

Chapter 12.

THE STATE OF LONG-TERM EXPECTATION.

I.

We have seen in the previous chapter that the scale of investment depends on the relation between the rate of interest and the schedule of the marginal efficiency of capital corresponding to different scales of current investment, whilst the marginal efficiency of capital depends on the relation between the supply price of a capital-a.s.set and its prospective yield. In this chapter we shall consider in more detail some of the factors which determine the prospective yield of an a.s.set.

The considerations upon which expectations of prospective yields are based are partly existing facts which we can a.s.sume to be known more or less for certain, and partly future events which can only be forecasted with more or less confidence. Amongst the first may be mentioned the existing stock of various types of capital-a.s.sets and of capital-a.s.sets in general and the strength of the existing consumers' demand for goods which require for their efficient production a relatively larger a.s.sistance from capital. Amongst the latter are future changes in the type and quant.i.ty of the stock of capital-a.s.sets and in the tastes of the consumer, the strength of effective demand from time to time during the life of the investment under consideration, and the changes in the wage-unit in terms of money which may occur during its life. We may sum up the state of psychological expectation which covers the latter as being the state of long-term expectation;?as distinguished from the short-term expectation upon the basis of which a producer estimates what he will get for a product when it is finished if he decides to begin producing it to-day with the existing plant, which we examined in chapter 5.

II.

It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.

The state of long-term expectation, upon which our decisions are based, does not solely depend, therefore, on the most probable forecast we can make. It also depends on the confidence with which we make this forecast?on how highly we rate the likelihood of our best forecast turning out quite wrong. If we expect large changes but are very uncertain as to what precise form these changes will take, then our confidence will be weak.

The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not a.n.a.lysed it carefully and have been content, as a rule, to discuss it in general terms. In particular it has not been made clear that its relevance to economic problems comes in through its important influence on the schedule of the marginal efficiency of capital.

There are not two separate factors affecting the rate of investment, namely, the schedule of the marginal efficiency of capital and the state of confidence. The state of confidence is relevant because it is one of the major factors determining the former, which is the same thing as the investment demand-schedule.

There is, however, not much to be said about the state of confidence a priori. Our conclusions must mainly depend upon the actual observation of markets and business psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book.

For convenience of exposition we shall a.s.sume in the following discussion of the state of confidence that there are no changes in the rate of interest; and we shall write, throughout the following sections, as if changes in the values of investments were solely due to changes in the expectation of their prospective yields and not at all to changes in the rate of interest at which these prospective yields are capitalised. The effect of changes in the rate of interest is, however, easily superimposed on the effect of changes in the state of confidence.

III.

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.

In former times, when enterprises were mainly owned by those who undertook them or by their friends and a.s.sociates, investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life, not really relying on a precise calculation of prospective profit. The affair was partly a lottery, though with the ultimate result largely governed by whether the abilities and character of the managers were above or below the average. Some would fail and some would succeed. But even after the event no one would know whether the average results in terms of the sums invested had exceeded, equalled or fallen short of the prevailing rate of interest; though, if we exclude the exploitation of natural resources and monopolies, it is probable that the actual average results of investments, even during periods of progress and prosperity, have disappointed the hopes which prompted them. Business men play a mixed game of skill and chance, the average results of which to the players are not known by those who take a hand. If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation.

Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to-day and with the development of organised investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system. In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and II in the morning and reconsider whether he should return to it later in the week. But the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain cla.s.ses of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice?

In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention?though it does not, of course, work out quite so simply?lies in a.s.suming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalise our behaviour by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the a.s.sumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities. We are a.s.suming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield.

Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.

For if there exist organised investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, a.s.suming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose hiS sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes reasonably 'safe' for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are 'fixed' for the community are thus made 'liquid' for the individual.

It has been, I am sure, on the basis of some such procedure as this that our leading investment markets have been developed. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment.

V.

Some of the factors which accentuate this precariousness may be briefly mentioned.

(1) As a result of the gradual increase in the proportion of the equity in the community's aggregate capital investment which is owned by persons who do not manage and have no special knowledge of the circ.u.mstances, either actual or prospective, of the business in question, the element of real knowledge in the valuation of investments by whose who own them or contemplate purchasing them has seriously declined.

(2) Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market. It is said, for example, that the shares of American companies which manufacture ice tend to sell at a higher price in summer when their profits are seasonally high than in winter when no one wants ice. The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.

(3) A conventional valuation which is established as the outcome of the ma.s.s psychology of a large number of ignorant individuals is liable to change violently as the result ofa sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to antic.i.p.ate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.

(4) But there is one feature in particular which deserves our attention. It might have been supposed that compet.i.tion between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it 'for keeps', but with what the market will value it at, under the influence of ma.s.s psychology, three months or a year hence.

Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

Thus the professional investor is forced to concern himself with the antic.i.p.ation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the ma.s.s psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called 'liquidity'. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment inst.i.tutions to concentrate their resources upon the holding of 'liquid' securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is 'to beat the gun', as the Americans so well express it, to outwit the crowd, and to pa.s.s the bad, or depreciating, half-crown to the other fellow.

This battle of wits to antic.i.p.ate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional;?it can be played by professionals amongst themselves.

Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs?a pastime in which he is victor who says Snap neither too soon nor too late, who pa.s.sed the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

Or, to change the metaphor slightly, professional investment may be likened to those newspaper compet.i.tions in which the compet.i.tors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the compet.i.tor whose choice most nearly corresponds to the average preferences of the compet.i.tors as a whole; so that each compet.i.tor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other compet.i.tors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to antic.i.p.ating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how thc crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable.

It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough;?human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.

Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money?a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long- term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. (5) So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly a.s.suming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending inst.i.tutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit.

But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both.

For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.

VI.

These considerations should not lie beyond the purview of the economist. But they must be relegated to their right perspective. If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of a.s.sets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, 'for income'; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an inst.i.tution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism?which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

These tendencies are a scarcely avoidable outcome of our having successfully organised 'liquid'

investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is, compared with Wall Street to the average American, inaccessible and very expensive. The jobber's 'turn', the high brokerage charges and the heavy transfer tax payable to the Exchequer, which attend dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market (although the practice of fortnightly accounts operates the other way) to rule out a large proportion of the trinsaction characteristic of Wall Street. The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.

The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is 'liquid' (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in h.o.a.rding or lending money, the alternative of purchasing actual capital a.s.sets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital a.s.sets and knows very little about them), except by organising markets wherein these a.s.sets can be easily realised for money.

The only radical cure for the crises of confidence which afflict the economic life of the modern world would be to allow the individual no choice between consuming his income and ordering the production of the specific capital-a.s.set which, even though it be on precarious evidence, impresses him as the most promising investment available to him. It might be that, at times when he was more than usually a.s.sailed by doubts concerning the future, he would turn in his perplexity towards more consumption and less new investment. But that would avoid the disastrous, c.u.mulative and far-reaching repercussions of its being open to him, when thus a.s.sailed by doubts, to spend his income neither on the one nor on the other.

Those who have emphasised the social dangers of the h.o.a.rding of money have, of course, had something similar to the above in mind. But they have overlooked the possibility that the phenomenon can occur without any change, or at least any commensurate change, in the h.o.a.rding of money.

VII.

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits?of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quant.i.tative benefits multiplied by quant.i.tative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;?though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;?it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

VIII.

There are, moreover, certain important factors which somewhat mitigate in practice the effects of our ignorance of the future. Owing to the operation of compound interest combined with the likelihood of obsolescence with the pa.s.sage of time, there are many individual investments of which the prospective yield is legitimately dominated by the returns of the comparatively near future. In the case of the most important cla.s.s of very long-term investments, namely buildings, the risk can be frequently transferred from the investor to the occupier, or at least shared between them, by means of long-term contracts, the risk being outweighed in the mind of the occupier by the advantages of continuity and security of tenure. In the case of another important cla.s.s of long-term investments, namely public utilities, a substantial proportion of the prospective yield is practically guaranteed by monopoly privileges coupled with the right to charge such rates as will provide a certain stipulated margin. Finally there is a growing cla.s.s of investments entered upon by, or at the risk of; public authorities, which are frankly influenced in making the investment by a general presumption of there being prospective social advantages from the investment, whatever its commercial yield may prove to be within a wide range, and without seeking to be satisfied that the mathematical expectation of the yield is at least equal to the current rate of interest,?though the rate which the public authority has to pay may still play a decisive part in determining the scale of investment operations which it can afford.

Thus after giving full weight to the importance of the influence of short-period changes in the state of long-term expectation as distinct from changes in the rate of interest, we are still ent.i.tled to return to the latter as exercising, at any rate, in normal circ.u.mstances, a great, though not a decisive, influence on the rate of investment. Only experience, however, can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment.

For my own part I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest.

Chapter 13.

THE GENERAL THEORY OF THE RATE OF INTEREST.

I.

We have shown in chapter 11 that, whilst there are forces causing the rate of investment to rise or fall so as to keep the marginal efficiency of capital equal to the rate of interest, yet the marginal efficiency of capital is, in itself; a different thing from the ruling rate of interest. The schedule of the marginal efficiency of capital may be said to govern the terms on which loanable funds are demanded for the purpose of new investment; whilst the rate of interest governs the terms on which funds are being currently supplied. To complete our theory, therefore, we need to know what determines the rate of interest.

In chapter 14 and its Appendix we shall consider the answers to this question which have been given hitherto. Broadly speaking, we shall find that they make the rate of interest to depend on the interaction of the schedule of the marginal efficiency of capital with the psychological propensity to save. But the notion that the rate of interest is the balancing factor which brings the demand for saving in the shape of new investment forthcoming at a iven rate of interest into equality with the supply of saving which results at that rate of interest from the community's psychological propensity to save, breaks down as soon as we perceive that it is impossible to deduce the rate of interest merely from a knowledge of these two factors. What, then, is our own answer to this question?

II.

The psychological time-preferences of an individual require two distinct sets of decisions to carry them out completely. The first is concerned with that aspect of time-preference which I have called the propensity to consume, which, operating under the influence of the various motives set forth in Book III, determines for each individual how much of his income he will consume and how much he will reserve in some form of command over future consumption. But this decision having been made, there is a further decision which awaits him, namely, in what form he will hold the command over future consumption which he has reserved, whether out of his current income or from previous savings. Does he want to hold it in the form of immediate, liquid command (i.e. in money or its equivalent)? Or is he prepared to part with immediate command for a specified or indefinite period, leaving it to future market conditions to determine on what terms he can, if necessary, convert deferred command over specific goods into immediate command over goods in general? In other words, what is the degree of his liquidity-preference?where an individual's liquidity-preference is given by a schedule of the amounts of his resources, valued in terms of money or of wage-units, which he will wish to retain in the form of money in different sets of circ.u.mstances?

We shall find that the mistake in the accepted theories of the rate of interest lies in their attempting to derive the rate of interest from the first of these two const.i.tuents of psychological time-preference to the neglect of the second; and it is this neglect which we must endeavour to repair.

It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man h.o.a.rds his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period. For the rate of interest is, in itself; nothing more than the inverse proportion between a sum of money and what can be obtained for parting with control over the money in exchange for a debt for a stated period of time.

Thus the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it. The rate of interest is not the 'price' which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption. It is the 'price' which equilibrates the desire to hold wealth in the form of cash with the available quant.i.ty of cash;?which implies that if the rate of interest were lower, i.e. if the reward for parting with cash were diminished, the aggregate amount of cash which the public would wish to hold would exceed the available supply, and that if the rate of interest were raised, there would be a surplus of cash which no one would be willing to hold. If this explanation is correct, the quant.i.ty of money is the other factor, which, in conjunction with liquidity-preference, determines the actual rate of interest in given circ.u.mstances. Liquidity-preference is a potentiality or functional tendency, which fixes the quant.i.ty of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quant.i.ty of money and L the function of liquidity- preference, we have M = L(r). This is where, and how, the quant.i.ty of money enters into the economic scheme.

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 (a.s.suming, 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 ln 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

1dn + r ndr = ???? ;

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 organlsed 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 1dr's were in a mistaken relationship to one another.

This is closely a.n.a.logous 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 ma.s.s psychology, so also expectations as to the future of the rate of interest as fixed by ma.s.s 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 a.s.sumed 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.

The three divisions of liquidity-preference which we have distinguished above may be defined as depending on (i) the transactions-motive, i.e. the need of cash for the current transaction of personal and business exchanges; (ii) the precautionary-motive, i.e. the desire for security as to the future cash equivalent of a certain proportion of total resources; and (iii) the speculative-motive, i.e. the object of securing profit from knowing better than the market what the future will bring forth. As when we were discussing the marginal efficiency of capital, the question of the desirability of having a highly organised market for dealing with debts presents us with a dilemma. For, in the absence of an organised market, liquidity-preference due to the precautionary-motive would be greatly increased; whereas the existence of an organised market gives an opportunity for wide fluctuations in liquidity-preference due to the speculative-motive.

It may ill.u.s.trate the argument to point out that, if the liquidity-preferences due to the transactions- motive and the precautionary-motive are a.s.sumed to absorb a quant.i.ty of cash which is not very sensitive to changes in the rate of interest as such and apart from its reactions on the level of income, so that the total quant.i.ty of money, less this quant.i.ty, is available for satisfying liquidity-preferences due to the speculative-motive, the rate of interest and the price of bonds have to be fixed at the level at which the desire on the part of certain individuals to hold cash (because at that level they feel 'bearish' of the future of bonds) is exactly equal to the amount of cash available for the speculative-motive. Thus each increase in the quant.i.ty of money must raise the price of bonds sufficiently to exceed the expectations of some 'bull' and so influence him to sell his bond for cash and join the 'bear' brigade. If, however, there is a negligible demand for cash from the speculative-motive except for a short transitional interval, an increase in the quant.i.ty of money will have to lower the rate of interest almost forthwith, in whatever degree is necessary to raise employment and the wage-unit sufficiently to cause the additional cash to be absorbed by the transactions-motive and the precautionary-motive.

As a rule, we can suppose that the schedule of liquidity-preference relating the quant.i.ty of money to the rate of interest is given by a smooth curve which shows the rate of interest falling as the quant.i.ty of money is increased. For there are several different causes all leading towards this result.

In the first place, as the rate of interest falls, it is likely, cet. par., that more money will be absorbed by liquidity-preferences due to the transactions-motive. For if the fall in the rate of interest increases the national income, the amount of money which it is convenient to keep for transactions will be increased more or less proportionately to the increase in income; whilst, at the same time, the cost of the convenience of plenty of ready cash in terms of loss of interest will be diminished. Unless we measure liquidity-preference in terms of wage-units rather than of money (which is convenient in some contexts), similar results follow if the increased employment ensuing on a fall in the rate of interest leads to an increase of wages, i.e. to an increase in the money value of the wage-unit. In the second place, every fall in the rate of interest may, as we have just seen, increase the quant.i.ty of cash which certain individuals will wish to hold because their views as to the future of the rate of interest differ from the market views.

Nevertheless, circ.u.mstances can develop in which even a large increase in the quant.i.ty of money may exert a comparatively small influence on the rate of interest. For a large increase in the quant.i.ty of money may cause so much uncertainty about the future that liquidity-preferences due to the precautionary-motive may be strengthened; whilst opinion about the future of the rate of interest may be so unanimous that a small change in present rates may cause a ma.s.s movement into cash. It is interesting that the stability of the system and its sensitiveness to changes in the quant.i.ty of money should be so dependent on the existence of a variety of opinion about what is uncertain. Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quant.i.ty of money, it is important that opinions should differ Thus this method of control is more precarious in the United States, where everyone tends to hold the same opinion at the same time, than in England where differences of opinion are more usual.

III.

We have now introduced money into our causal nexus for the first time, and we are able to catch a first glimpse of the way in which changes in the quant.i.ty of money work their way into the economic system. If, however, we are tempted to a.s.sert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip. For whilst an increase in the quant.i.ty of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quant.i.ty of money; and whilst a decline in the rate of interest may be expected, cet. par., to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of intere~t; and whilst an increase in the volume of investment may be expected, cet. par., to increase employment, this may not happen if the propensity to consume is falling off.

Finally, if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money. And when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quant.i.ty of money necessary to maintain a given rate of interest.

IV.

Whilst liquidity-preference due to the speculative-motive corresponds to what in my Treatise on Money I called 'the state of bearishness', it is by no means the same thing. For 'bearishness' is there defined as the functional relationship, not between the rate of interest (or price of debts) and the quant.i.ty of money, but between the price of a.s.sets and debts, taken together, and the quant.i.ty of money. This treatment, however, involved a confusion between results due to a change in the rate of interest and those due to a change in the schedule of the marginal efficiency of capital, which I hope I have here avoided.

VThe concept of h.o.a.rding may be regarded as a first approximation to the concept of liquidity- preference. Indeed if we were to subst.i.tute 'propensity to h.o.a.rd' for 'h.o.a.rding', it would come to substantially the same thing. But if we mean by 'h.o.a.rding' an actual increase in cash-holding, it is an incomplete idea?and seriously misleading if it causes us to think of 'h.o.a.rding' and 'not-h.o.a.rding' as simple alternatives. For the decision to h.o.a.rd is not taken absolutely or without regard to the advantages offered for parting with liquidity;?it results from a balancing of advantages, and we have, therefore, to know what lies in the other scale. Moreover it is impossible for the actual amount of h.o.a.rding to change as a result of decisions on the part of the public, so long as we mean by 'h.o.a.rding' the actual holding of cash. For the amount of h.o.a.rding must be equal to the quant.i.ty of money (or?on some definitions?to the quant.i.ty of money minus what is required to satisfy the transactions-motive); and the quant.i.ty of money is not determined by the public. All that the propensity of the public towards h.o.a.rding can achieve is to determine the rate of interest at which the aggregate desire to h.o.a.rd becomes equal to the available cash. The habit of overlooking the relation of the rate of interest to h.o.a.rding may be a part of the explanation why interest has been usually regarded as the reward of not-spending, whereas in fact it is the reward of not-h.o.a.rding.

Chapter 14.