Keynes s theory of liquidity preference and his debt management and monetary policies

Transcription

1 Cambridge Journal of Economics Advance Access published January 4, 2006 Cambridge Journal of Economics 2005, 1 of 14 doi: /cje/bei104 Keynes s theory of liquidity preference and his debt management and monetary policies Geoff Tily* This paper seeks to bolster the view that Keynes was a monetary economist concerned primarily with monetary and not fiscal policy. His most fundamental policy conclusion for national economies was that the authorities could control the long-term rate of interest and should do so to promote investment, growth and employment. Keynes s theory of liquidity preference is presented as a theory of money as a store of value that leads to this fundamental policy conclusion. The theory is then applied to explain the debt management, monetary and international financial policies that were adopted in World War II. Key words: Keynes, Keynesians, Liquidity preference, Long-term rate of interest, Debt management policy JEL classifications: B22, E12, E43, E50 1. Introduction Many economists have long recognised that the Keynesian economists betrayed Keynes s economic theory; this paper argues that they betrayed Keynes s policy conclusions as well. For the whole of his life, Keynes was primarily concerned with monetary not fiscal policy. Beginning by rejecting and seeking to replace the gold standard, ultimately he developed domestic and international policies that would facilitate the setting of appropriate cheap rates of interest across the spectrum of liquidity. These policies developed alongside the evolution of an increasingly sophisticated theory of how a free market monetary economy actually operated. The General Theory of Employment, Interest and Money (Keynes, 1973A) was the culmination of this theoretical enquiry. The paper begins with a contextual overview of the evolution of Keynes s monetary policies and theory. In Section 3, his critical theoretical contribution the theory of liquidity preference is examined. Even in the most sophisticated modern literature, the full power of this theory remains lost. While the role of expectations and uncertainty in the determination of the rate of interest has been restored by Chick (1983), this restoration has not led to a recognition that expectations can be managed and the rate of interest brought under control. Sections 4 and 5 then look at the practical policies that effect this Manuscript received 19 April 2004; final version received 28 June Address for correspondence: 12 Copthorne Ave., London SW12 OJZ; geoff.tily@ons.gov.uk * My thanks go to Victoria Chick, without whom, for all sorts of reasons, I would not have got far. She cannot be held responsible for the destination. Ó The Author Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved.

2 2 of 14 G. Tily control: first, debt management policy and, second, monetary policy. 1 In setting out the discussion this way, an alternative approach to the longstanding theoretical concern about the compatibility between liquidity preference and endogenous money is proposed. Section 6 briefly addresses the international environment that Keynes saw as necessary to these domestic policies. Lastly, Section 7 appeals to the practical success of these policies in bringing the rate of interest under control as evidence of the validity of Keynes s theory, and argues that the high rates of interest that have prevailed for the last quarter of a century are a consequence of the gradual abandoning of Keynes s policies. Considerations of space mean that a number of important issues have been left aside; the two most important are perhaps the precedents to the present discussion and the relevance of the discussion to policy today. In very loose terms, I see the work in the tradition of monetary economics that originates with Richard Kahn and Joan Robinson, and was pursued by Paul Davidson, John Kenneth Galbraith, Nicholas Kaldor, Leon Keyserling, Abba Lerner, Hyman Minsky and Sidney Weintraub. There are important differences in the theoretical approach and policy emphasis of all these scholars which merit fuller exploration at a later date; but all of them have in common a rejection of the Keynesian model and an emphasis on the monetary nature of Keynes s economics. In terms of more recent literature, I see a close relation with Smithin s (e.g., 1996) policy arguments concerning the importance of interest rate policy, 2 and theoretical contributions concerning the compatibility of endogenous money and liquidity preference (e.g., Dow, 1996; Bibow, 1998; 2001; Chick and Dow, 2002). 3 The question of the relevance of Keynes s monetary policy conclusions today requires a full discussion of the implications of liquidity preference for wider macroeconomic activity. Certainly, one cannot attempt to understand today s world without the liquidity preference theory of interest. But it is compelling to reject the feasibility of his practical policies, given the great differences in the international and domestic financial environments to those which set the backdrop to Keynes s policies. 1 I am using monetary policy to mean the policy managed (but not necessarily specified) by the central bank with regard to the volume and price of credit creation and the associated practical mechanisms. 2 For example: though Keynes and many of the early Keynesian writers did not make much distinction between real and nominal interest rates, Smithin and Wolf (1993, p. 373) have argued that, in contemporary conditions Keynesian policies should generally be associated with attempts to bring about low real rate of interest on financial instruments. Although this point may not be stressed in the standard textbooks, it can none the less be argued that this is the interpretation which is most consistent with Keynes s own writing. It is supported, for example, by Kaldor (1986, p. xxi), and at the other end of the professional spectrum by Meltzer (1988), in a book-length study (Smithin, 1996, p. 57). His references to Kaldor and Meltzer lead to the following: The appearance of Keynes s General Theory in 1936 gave the [UK] cheap money policy [in the first half of the 1930s] its theoretical underpinning. The policy of low interest rates was maintained throughout the war the Government borrowed enormous sums, at very low interest rates, not only on shortterm but also in medium and long-term paper, without the slightest difficulty... (Kaldor, 1986, p. xxi), and He [Keynes] favoured policies to reduce interest rates to the level at which investment would absorb saving at full employment. That rate, he believed, would bring interest rates to zero in a generation. This is the correct interpretation, I believe, of Keynes s statements favouring lower interest rates (Meltzer, 1988, p. 280). 3 I am inclined to agree with the suggestion of one of my referees that ongoing debates among post- Keynesians are to some extent at cross-purposes. Horizontalists have tended to give more emphasis to interest rate policy, but their theory of the long rate as determined by expectations of the short rate misleads when it comes to practical policy and is therefore revealed to be in error. As the structuralists recognise, liquidity preference is the relevant theory of interest. But they have not followed the theory through to the debt management conclusions that Keynes drew. It should also be noted that economic historians have not entirely neglected Keynes s monetary policy. Moggridge and Howson s (1974) Keynes on Monetary policy, portrayed an intermediate Keynes who was not only interested in fiscal policy, but also held important views on monetary policy. However, neither Howson nor Moggridge have subsequently been evangelical. This intermediate Keynes does not obviously emerge from Moggridge s (1992) biography. Similarly, while Howson has gone on to a number of very detailed studies of monetary policy in the Keynes period, her work does not give front place to Keynes s role.

3 Keynes s theory of liquidity preference 3 of 14 Yet Keynes had equally sought that backdrop as complementary and indeed necessary to his policies. The feasibility of his policies ultimately rests on the feasibility of constructing a contemporary institutional environment that is in accord with those policies. 2. The General Theory: policy and theoretical context Keynes was a monetary economist concerned with monetary reform. He sought to build policy and an institutional structure for the management of domestic and international currency that was relevant for a bank money system. Between 1909 and 1931, his policy preoccupation was international. He recognised the gold standard as a barbarous relic of a commodity money world. Suffice to say it took others much longer to reach the same conclusion. But as the Great Depression unfolded, countries abandoned gold and implemented the exchange management techniques that he had consistently advocated in all his contributions to the economic policy debate (Keynes, 1971A, 1971B, 1971C, 1971D). The actual advent of exchange management permitted the monetary policy appropriate to domestic conditions that had previously been precluded by the constraints of gold. But Keynes s own analysis of what that appropriate domestic policy should be had developed as he worked out his Treatise. At the end of Chapter 37, he asserted, for the first time, his fundamental diagnosis of the cause of the Economic Problem: I am writing these concluding lines in the midst of the world-wide slump of Thus I am lured on to the rash course of giving an opinion on contemporary events which are too near to be visible distinctly; namely, my view of the root causes of what has happened, which is as follows. The most striking change in the investment factors of the post-war world compared with the pre-war world is to be found in the high level of the market-rate of interest. (Keynes, 1971D, p. 377) As Harrod (1972, p. 469) puts it, [h]e had become convinced that the time was ripe for a large and permanent reduction [of interest rates] throughout the world. This was to be the basis of all his future thinking on economic policy. For the next 15 years, Keynes advocated and developed the domestic policies that would permit and affect such a reduction. From a theoretical perspective, Keynes quickly came to see that the analysis of the Treatise was inadequate. Up to this point, he had maintained an underlying position that was essentially classical. Crudely put: the best that could be achieved was to rectify an inappropriate monetary policy. In the context of the discussion here, despite the emergence of the concept of liquidity preference (as the state of bearishness ), he held to a underlying theory of interest as follows: Thus the natural rate of interest is the rate at which saving and the value of investment are exactly balanced, so that the price level of output as a whole exactly corresponds to the money rate of efficiency earnings from the factors of production (Keynes, 1971C, p. 139). With The General Theory, he departed from this theory of interest and with it from his underlying classical position. A little over a year in advance of the publication of his new book, Keynes foreshadowed what he had identified as the specific flaw of the classical theory in the 21 November 1934 edition of The Listener: There is, I am convinced, a fatal flaw in that part of the orthodox reasoning which deals with the theory of what determines the level of effective demand and the volume of aggregate employment; the flaw being largely due to the failure of the classical doctrine to develop a satisfactory theory of the rate of interest. (Keynes, 1973B, p. 489)

4 4 of 14 G. Tily The General Theory offered the theory of liquidity preference as a satisfactory theory of interest. This theory involved a change in perspective from Keynes s earlier analysis that was underpinned by a treatment of credit and hence money as a means of exchange. The critical innovation of The General Theory was to base the theory of interest on an analysis of money as a store of value. Keynes argued that: the current rate of interest depends, as we have seen, not on the strength of the desire to hold wealth, but on the strengths of the desire to hold it in liquid and illiquid forms respectively, coupled with the amount of the supply of wealth in the one form relatively to the supply of it in the other (Keynes, 1973A, p. 213). Nor was the rate of interest the reward for saving or for issuing credit. Mirroring his policy initiatives of the time, his theory almost exclusively emphasised long rates. Nevertheless, contrary to most received wisdom, this theory and his earlier theories of credit were complementary and together offered a fuller explanation of the nature of money and interest in a monetary economy. The General Theory, intentionally, was not a policy manual. While Keynes made a number of public statements concerning monetary policy in the years after 1936, no such manual was forthcoming. But a complete record of the techniques that he developed has been available through his evidence to an internal HM Treasury enquiry. At the National Debt Enquiry (NDE) in April/May 1945, Keynes set out the practical mechanisms that experience, and wartime experience in particular, had proved effective in bringing interest rates under control. (The enquiry arose as the Coalition Government in Britain began to look to economic policy measures after the end of the war, the specific issue being reduction of the post-war burden of debt interest on the immense debt accumulated throughout the war.) The discussion is documented through the reproduction of Keynes s speaking notes for the meetings and his summary minute of policy proposals in Collected Writings (Keynes, 1980C, 1980D) and in the official minutes and papers held on file at The National Archives. 1 The Report of the enquiry has very recently been published by Professor G. C. Peden (2004). Much of the practical analysis in this paper draws on this crucial and largely ignored material. 3. The theory of liquidity preference in The General Theory On the opening page of The General Theory, Keynes stated his purpose as deal[ing] with difficult questions of theory, and only in the second place with the applications of this theory to practice. It is a great and tragic flaw of his book that Keynes appears to have taken this practical policy as given. The first substantial statement of policy comes on the last page of Chapter 12, The State of Long-Term Expectation, the page before he begins discussing the theory of the rate of interest: [o]nly experience, however, can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment (Keynes, 1973A, p. 164). He was writing not for us but for an audience familiar with his preoccupation with interest rates. His theoretical exposition of liquidity preference and the logic of his presentation are nevertheless strongly motivated by practical policy considerations. The following summary of his discussion is presented with a view to revealing and restoring the critical interplay between theory and policy. Keynes s discussion of interest rate theory begins in Chapter 13, where he introduces the concept of liquidity preference from the perspective of store of value considerations. The rate of interest is first defined as the price which equilibrates the desire to hold wealth in 1 Minutes of the meetings can be found on T160/1408, T230/94 and T230/95; the report is on T230/95.

5 Keynes s theory of liquidity preference 5 of 14 the form of cash with the available quantity of cash (Keynes, 1973A, p. 167). Explaining the paradoxical decision to hold wealth in an interest free form is the existence of uncertainty as to the future rate of interest, i.e., as to the complex of rates of interest for varying maturities which will rule at future dates (Keynes, 1973A, p. 168). The uncertainty of the future cash value of a holding of bonds is the critical explanation for holding wealth as money, i.e., for liquidity. Keynes then introduces the transactions, precautionary and speculative motives, and, following a brief discussion, characterises the schedule of liquidity-preference as a smooth curve which shows the rate of interest falling as the quantity of money is increased (Keynes, 1973A, p. 171). Critical to this derivation is the role of expectations as to the future of the rate of interest as fixed by mass psychology (Keynes, 1973A, p. 170). This is the relevant point to note the Keynesian bastardisation of Keynes s interest theory. As Chick (1983, ch. 10 and Appendix) has emphasised, the Keynesian liquidity preference function is wrongly derived as portfolio choice in the face of risk rather than precautionary and speculative behaviour in the face of uncertainty. Moreover, as one of a number of simultaneous equations, the Keynesian liquidity preference function has detracted from the fact that Keynes s schedule is simply a demand schedule that shifts according to the mass psychology of the public. It is set against a supply of money (to be defined later) that is under the authorities control (although the presentation is not straightforward: Keynes sets the supply of money against the rate of interest on bonds). Without this perspective, Keynes s critical practical point is meaningless: If, however, we are tempted to assert 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 quantity 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 quantity of money;... (Keynes, 1973A, p. 173) Attempting to manage the rate of interest by shifting the supply of money will not work if a shift in demand acts in the opposite direction. Chapter 15 turns to an explanation of the nature of these shifts to liquidity preference that are fundamental to a policy aimed at control of interest (it follows a chapter-length digression on the classical theory of interest). Through a more detailed examination of the motives for holding money, Keynes explains how shifts in demand are caused by changes in expectation: Changes in the liquidity function itself, due to a change in the news which causes revision of expectations, will often be discontinuous, and will, therefore, give rise to a corresponding discontinuity of change in the rate of interest (Keynes, 1973A, pp ). For reasons of emphasis rather than elaboration, Figure 1 illustrates how a change in the state of expectation from e 0 to e 1 can lead to a reduction in the rate of interest from r 0 to r 1 without any necessary change in the supply of money. Keynes then goes on to expose more fully the critical link between present interest rates and expectations of interest rates into the future. 1 The discussion leads to the essential conclusion of the theory of liquidity preference: It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing 1 His discussion introduces the notion of a safe rate. Chick (1983, pp ) offers a fuller exposition (although she uses the terminology normal rather than safe ).

6 6 of 14 G. Tily Fig. 1. A change in expectations. society to fluctuations for all kinds of reasons round the expected normal. (Keynes, 1973A, p. 203; emphasis in original) Following from this, public confidence was essential to the success of any practical policy; and he cited the British experience after leaving gold: The fall in the long-term rate of interest in Great Britain after her departure from the gold standard provides an interesting example of this; the major movements were effected by a series of discontinuous jumps, as the liquidity function of the public, having become accustomed to each successive reduction, became ready to respond to some new incentive in the news or in the policy of the authorities. (Keynes, 1973A, p. 204) Keynes s policy therefore has two dimensions: managing money and managing expectations. However, such policies remained, in part, theoretical abstractions. Only at the end of the discussion did he turn to debt management policy: Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management. (Keynes, 1973A, p. 206) But he had in mind a more formal and broader application of policies with which the British authorities were already experimenting and that he had advocated throughout the 1930s. ( In Great Britain the field of deliberate control appears to be widening, Keynes, 1973A, p. 206.) Apart from the lack of a matter-of-fact statement of policy, a second issue that has caused immense difficulties with the interpretation of Keynes s theory of interest concerns the nature of money itself. Again this reflects stated intent: whilst it is found that money enters into the economic scheme in an essential and peculiar manner, technical monetary detail fails into the background (Keynes, 1973A, p. xxi). His only real definition is set in general terms (in a footnote): [W]e can draw the line between money and debts at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for three months one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. It is often convenient in practice to include in money time-deposits with banks and, occasionally, even such instruments as (e.g.) treasury bills.

7 Keynes s theory of liquidity preference 7 of 14 As a rule, I shall, as in my Treatise on Money, assume that money is co-extensive with bank deposits. (Keynes, 1973A, p. 167, n. 1) In my view, the relevant definition of money changes according to the analytical perspective in a more substantial way than Keynes suggested. The unending confusion about the inadequacy of Keynes s treatment of credit in The General Theory (as well as the compatibility of liquidity preference and endogenous money) rests in his not having delineated sufficiently clearly between means of exchange and store of value considerations. From the perspective here, Keynes s inclusion of transactions (and later finance) demand(s) is, at first sight, at odds with a theory of money as a store of value. That said, there is no a priori reason to assume that his new theory of money as a store of value should be incompatible with previous theories of credit money surely quite the opposite. The resolution I propose here is to apply liquidity preference as a concept separately to both store of value and means of exchange considerations. The following two sections do so in the specific context of practical policy: first debt management and second monetary policy Debt management policy Debt management policy concerns the supply of the financial assets that are the borrowing instruments of government. Any supply is set against a demand, primarily on the part of financial institutions but that reflects the wealth of the household sector. Applied to this market, liquidity preference theory sets the interest rate on illiquid assets bonds against the supply of liquid assets bills. In this context, money is defined as Government bills. In his notes for the NDE, Keynes explained that the ability to set the rate of interest on bonds turned on abandoning the policy known as the funding complex : the authorities traditional preference for long-term debt (which was known as the funds ): Now the authorities are only fettered in their policy if they themselves have a counter-liquidity preference. If they are indifferent about funding they can make both the short and long-term whatever they like, or rather whatever they feel to be right having regard to possibilities of under and over-employment and other social reasons. If, however, they are not indifferent their motivation comes into play. Historically the authorities have always determined the rate at their own sweet will and have been influenced almost entirely by balance of trade reasons and their own counter-liquidity preference.... Authorities make rate what they like by allowing the public to be as liquid as they wish. Suppose Tr y [Treasury] say half the debt must be more than 25 years off or floating debt must not exceed xmn then it is the public which set the rate of interest. If they require a great inducement to become so illiquid, then rates have to be higher. However it is a vicious circle, dear money provokes expectation of dearer money. It is the technique of the tap issue that has done the trick. Thus it is only if the Tr y get rid of the Funding Complex that cheaper money is possible. (Keynes, 1980C, pp ) Keynes contrasts two situations. Under the funding complex (F), the authorities were concerned to limit the issue of bills. In Figure 2, in a given state of liquidity preference L(e), with the supply of bills set at M F, rate of interest r F followed as a consequence. Conversely, the policy of the tap issue (T) allowed the public to choose between bonds and bills 1 This treatment follows from the suggestions of my referees, for which I am obviously immensely grateful.

8 8 of 14 G. Tily Fig. 2. Debt management policy. according to their own preferences. 1 In Figure 2, r T could be set if the public demand for liquid assets M T was met by the authorities. In practice, the policy of the tap issue required changes to the issue policy for both bills and bonds. The issue of bills to meet public demand required a change in attitude towards the floating debt; this is discussed in the next section. For bonds, rates of interest and maturities were announced but no limits were set to the cash amount of any issue. The tap of any bond was held open so that individuals and institutions could purchase when and to whatever quantities they desired (a notice read subscriptions will be received on Tuesday, 25th June, 1940, and thereafter until further notice... ). The method was first introduced for the June 1940 wartime issue of 2½% medium-term bonds (known as National War Bonds), and then for the next issue of 3% long-term bonds (known as Savings Bonds) (Howson, 1988, p. 252). Keynes s debt management policy also led to the offering of a wider range of bonds. Before the gradual development of Keynes s policies, the authorities tended to offer only very long-term securities and a limited number of Treasury bills. In his NDE notes, and again following wartime experience, Keynes argued that the Government should offer two fixed-maturity bonds and a perpetuity: (c)... 5 year Exchequer Bonds at 1½ per cent and 10 year Bonds at 2 per cent on tap, a new series to be started annually; (d) 3 per cent Savings Bonds on tap, a new series to be started annually, with an option to the Treasury to repay after 10 years and with, preferably, no final maturity (or, if necessary, a fixed latest date of repayment 35 years hence); (Keynes, 1980D, p. 399) The purpose of this arrangement was to cater for medium-term as well as longer-term savings requirements. The facilities further relieved pressure arising from the desire to hold precautionary holdings of wealth as money, and served to create a more balanced portfolio of asset holdings. 1 Attention should be drawn to the differing meanings of tap issue used by Keynes and used later by R. S. Sayers, the UK banking historian. In the 1967 edition of his Modern Banking, Sayers (p. 55) uses the terminology to explain a mechanism whereby the authorities issued Treasury bills to Government departments that have funds in hand, and to certain overseas monetary authorities, with the rates unknown and irrelevant to the discount market. With the widespread acceptance of Sayers s terminology, it seems that the original notion of the tap which is of course very different and much more important has been lost.

9 Keynes argued that, for the longer-term debt, the option of early redemption safeguards a future liberty of action (Keynes, 1980D, p. 400). This reflected his views on (perhaps very) long-term trends in interest rates. From the macroeconomic perspective, the notion of diminishing returns to capital means that the yield on aggregate capital expenditure will fall over time. With the rate of interest governing the volume of capital expenditure as of course it does a monetary policy aimed at stable and high employment would therefore have to be managed at not only low but also falling rates of interest. From the debt management perspective, this meant that terms on any long bond issued would not be superseded by terms on a later issue. It was therefore desirable to avoid, to as great an extent as possible, the situation where previous higher-interest bonds remained in the market as new lower-interest bonds were issued. Overall, his minute of recommendations looked to mechanisms that preserved the maximum degree of flexibility and freedom for future policy (Keynes, 1980D, p. 397). Diminishing returns to capital also provided a component of the apparatus for cheap money policy that was important from the perspective of expectations. With recognition that the long-term rate of interest would move in line with the yield on capital, the public would come to understand that future movements to the long-term rate of interest would only be in the downward direction and, hence, that any existing terms would not be improved on. 5. Monetary policy Keynes s theory of liquidity preference 9 of 14 While a number of discussions touched on various practical points, Keynes made no full and formal statement of his monetary policy and the associated theory as he did for debt management policy. However, several years before the NDE, the Committee on Economic Information did set out what amounts to a fairly fundamental statement of principles in its February 1937 Report: [I]t may be much more possible and desirable for the financial authorities to exercise adequate control over the supply of credit without recourse to the manipulations of short-term rates which are traditionally associated with this objective We attach far greater importance to the effect of credit policy on long-term interest rates, as expressed by the yield on Government securities... (The National Archives, CAB 58/22) The basic principle was that it was more important to set the discount rate in line with the broader spectrum of rates that the authorities sought to establish than to retain its use for short-term credit control. From the general theoretical perspective, what seems to have been overlooked by Keynes s critics is that the mechanisms that allow the authorities to set the discount rate follow liquidity preference reasoning. The key mechanism is the supply of liquidity in the form of cash. Commercial banks require cash to support aggregate deposits (and hence credit) according to standard cash-ratio considerations. The central bank uses its monopoly over cash issue to set rates through discounting arrangements. Certain eligible assets traditionally short-term government debt are reserved at the central bank in exchange for cash at the required discount rate. As Keynes had observed in the Treatise it is characteristic of modern systems that the central bank is ready to buy for money at a stipulated rate of discount any quantity of securities of certain approved types (Keynes, 1971D, p. 189). In this way, the central bank supplies liquidity or money in the form of cash in order to manage the interest rate that underpins short-term bank lending.

10 10 of 14 G. Tily Liquidity preference considerations underpin the setting of interest rates on bank lending whether or not the discount rate is used as an active instrument of monetary policy. With active use ruled out, the authorities quantitative regulation of the basis of credit (CAB 58/22) could instead be affected through control over the issue of eligible assets. By tightening the supply of bills to banks, the authorities could, in theory, restrict the issue of credit. The necessity of such action should depend on the cause if known of an increased demand for credit and whether that demand might be inflationary; even then, this demand might be better addressed more directly (e.g., with taxes). In general, Keynes advised an accommodative stance. There is no inconsistency between liquidity preference theory and the use of money as a means of exchange, so long as the theory is applied to the eligible assets and cash that underpin the generation of bank money, rather than regarded as a theory of an exogenous supply of bank money itself. Keynes s theory permits interest rates to respond to the authorities policy with regard to the supply of bills and cash to banks. Again World War II led to further development of practical policies. Sayers notes that the discounting procedure of the Bank of England was formalised as the open back door, to which the discount houses could resort...[and] turn Treasury Bills into cash at the fixed discount rate of 1 per cent (Sayers, 1956, p. 223). The most substantial development, however, picked up on the inter-relation between the level of government borrowing and the ability of banks to extend credit. With Keynes advising that the great increase in expenditure for the war effort should be financed in the first place by borrowing from banks, doing so by issuing Treasury bills would have had the paradoxical side-effect of effecting an even larger increase in the banks ability to extend credit. The authorities therefore developed the Treasury Deposit Receipt, described by Howson as follows: The introduction in July 1940 of Treasury Deposit Receipts (TDRs), by which the major banks were obliged to lend directly to government, added a new instrument to the floating debt, enabling the authorities to borrow on short term without either increasing the Treasury bill issue or having recourse to Ways and Means Advances. Of longer maturity (six months) than threemonth Treasury bills and non-marketable, TDRs were less liquid than Treasury bills and carried a slightly higher interest rate (1 1/8 %). This wartime expedient [1] was, as Sayers put it, concocted...[so as] not to disturb the customary relationship [between banks, discount houses, and the Bank of England] and customary ratios of the peacetime [banking] system, but it was nonetheless seen as a revolution in fiscal policy, at least in Labour Party circles... (Howson, 1988, pp ) From the monetary policy perspective, the critical point was that banks were unable to trade in or reserve TDRs to support an expansion of credit. In this way, policy addressed the concern of monetising government debt and potentially causing inflation by breaking the direct link between floating debt and credit creation. Furthermore, control of credit was also aided by other aspects of wartime economic policy. Most importantly, aggregate demand was dominated by government expenditure, which should have been more easily regulated than other sources of demand. In addition, consumer demand was implicitly controlled by higher and well-thought-out taxation policies, and investment was potentially controlled by the Capital Issues Committee s management of the new issues market. 2 Outside banking mechanisms, the concern that an increase in the floating debt must be inflationary arises from a misunderstanding of the nature of such increases. 1 This is misleading, TDRs were an integral part of the plan for post-war monetary policy. 2 Although Sayers (1956, p. 167) notes it was not of major importance in its ostensible purposes of controlling the use of real resources.

11 Keynes s theory of liquidity preference 11 of 14 Keynes s debt management policies involved accommodating wealth holders preferences for short-term debt, but these increases were due to savings not spending considerations and therefore were not inflationary. The NDE Report summed up: The dangerous character of this type of debt [floating debt] disappears if there are adequate understandings with the financial world (including, it may be, appropriate regulations for continuing into the future the system of Treasury Deposit Receipts) to ensure the continuous holding of a large, and even increasing, floating debt in all circumstances. (NDE Report, para. 23) The rates on the floating debt completed the full term structure of interest rates that the authorities sought to establish. During the war, Treasury bills carried interest of 1% and TDRs, as above, 1 1/8%. In this way the authorities continued to reward liquidity with non-negligible interest rates. The discount rate was merely set in line with these short rates. As seen, during the war it was 1% the same as the rate on Treasury bills. Keynes s NDE proposals looked to reductions in the rate of interest on both Treasury bills and TDRs of ½%. The NDE discussions did not refer specifically to the discount rate; but his proposal for Bank rate was as follows: (a) Bank rate to be reduced to 1 per cent and to govern the rate payable on overseas money in the hands of the Bank of England, so that this rate would remain unchanged. (Keynes, 1980D, p. 399) It may be that this also reflected a proposed formal acknowledgement of the wartime 1% discount rate. Finally the notion that the discount rate should remain unchanged merits additional emphasis. Keynes s original policy concern was that the gold standard led to a monetary policy stance that was inappropriate to the domestic economy. With the advent of currency management in 1932, the discount rate was freed to focus on the domestic role. In his early work, Keynes envisaged aiming policy at price stability. But with the advent of the cheap money policy, the discount rate was abandoned as an instrument of active monetary policy management. At the NDE, Keynes simply affirmed this as the appropriate state-of-affairs for the post-war era. The ultimate monetary governor of the level of aggregate demand was the long-term not the short-term rate of interest. In sum, all these practical measures demonstrate both a complete understanding of means-of-exchange considerations on Keynes s part as well as the compatibility of his theoretical depiction of the economy and its operation in practice. 6. International financial policies Keynes s domestic initiatives emerged against a foreign exchange regime for which he had provided the intellectual justification. The over-riding consideration was that exchange policy should not interfere with domestic policy. While wartime initiatives were facilitated by fuller exchange and capital controls, Keynes also looked to more formal international mechanisms after the war. The details of these proposals are highly important aspects of Keynes s overall practical policy, yet have been almost entirely ignored in the context of facilitating domestic policy autonomy. There is obviously insufficient space for an adequate treatment here. But two overriding principles can be stated using Keynes s own words. For asset markets, Keynes required capital control: You overlook the most fundamental long-run theoretical reason. Freedom of capital movements is an essential part of the old laissez-faire system and assumes that it is right and desirable to have an equalisation of interest rates in all parts of the world. It assumes, that is to say, that if the rate of

12 12 of 14 G. Tily interest which promotes full employment in Great Britain is lower than the appropriate rate in Australia, there is no reason why this should not be allowed to lead to a situation in which the whole of British savings are invested in Australia, subject only to different estimations of risk, until the equilibrium rate in Australia has been brought down to the British rate. In my view the whole management of the domestic economy depends upon being free to have the appropriate rate of interest without reference to the rates prevailing elsewhere in the world. Capital control is a corollary to this. Both for this reason and for the political reasons given above, my own belief is that the Americans will be wise in their own interest to accept this conception, even though its immediate applicability in their case is not so clear. (Keynes, 1980B, p. 149) For exchange markets, Keynes developed his Clearing Union; the essential mechanism was outlined in a letter to the Governor of the Bank of England: The essence of the scheme is very simple indeed. It is the extension to the international field of the essential principles of banking by which, when one chap wants to leave his resources idle, those resources are not therefore withdrawn from circulation but are made available to another chap who is prepared to use them and to make this possible without the former losing his liquidity and his right to employ his own resources as soon as he chooses to do so. Just as the domestic situation was transmogrified in the eighteenth and nineteenth centuries by the discovery and adoption of the principles of local banking, so (I believe) it is only by extending these same principles to the international field that we can cure the manifest evils of the international economy as it existed between the two wars, after London had lost the position which had allowed her before 1914 to do much the same thing off her own bat. (Keynes, 1980A, pp. 98 9) Article VI of the Bretton Woods Agreement permitted member countries to put into place, or keep in place, capital controls. 1 On exchange policy, the Agreement fell far short of Keynes s ideal. 7. Outcome The theory of liquidity preference is strongly supported by the results of practical experience. The first ad hoc efforts to reduce interest rates from 1932 were, in the great part, successful. Long-term government rates were reduced from 4½ to 3%. The success of the more formal World War II approach is encapsulated by the notion of the 3% war. One of the highest-ever increases in government expenditure was facilitated by low rates of interest; the fact that massive borrowing did not cause high rates of interest decisively refutes classical theory. While some have argued that the termination of the post-war Labour Government s cheaper money policy (between 1945 and 1947) refuted the feasibility of cheap money policy, Howson (1993, p. 152) has rightly argued that Keynes would not have supported the specific manner in which the policy was implemented after his death. Moreover, the Labour Government was successful in preserving low interest rates throughout the remainder of the 1940s. Monetary policy did not lead to high inflation, which returned only with the increase in government expenditure required for the Korean War. When the Conservative Government took office in 1951, the cheap money policy was terminated. The discount rate was re-employed as a counter-inflationary measure, and the tap issue and TDRs were discontinued. Nevertheless, the real long-term interest rate on 1 Today, the post-keynesian position is also associated with capital control. However, the argument is not put in the context of domestic interest rate policy. A good example is Paul Davidson s justification, published quite recently in The Guardian: (1) to prevent a lack of global effective demand due to nations oversaving liquid foreign reserves (2) to induce the surplus nation to contribute to resolving the import export imbalance, since the surplus nation has the economic wherewithal and is in the better economic position and (3) to encourage debtor nations to work their way out of debt rather than await handouts or bailouts, or to default on their international obligations (Davidson, 2003).

13 government bonds (with real meaning inflation-adjusted) was preserved at a low level throughout the whole of the so-called golden age between 1950 and The sharp tightening of monetary policy and full financial liberalisation at the start of the 1980s led to a sharp rise in the long-term rate of interest, and high rates have persisted ever since. Domestic and international policies have now moved about as far away from Keynes s policies as it is possible to go. Capital controls have been removed and laissez-faire has been the dominant exchange rate principle with only animal spirits constraining the supply of international liquidity to meet current account deficits. Bank rate aimed at inflation is the central instrument and mechanism of monetary policy. An independent agency now has responsibility for the issue of government debt and the share of government debt issued as Treasury bills is minimal (and has been since the 1970s). I have deliberately not addressed the consequence of these higher rates. I am concerned only to argue that they are an artefact of changes in institutional environment and policy, not of natural forces. Similarly, the desirability of low rates is also a matter for another day. As noted in the introduction, their feasibility rests on the feasibility of fundamental change to the present institutional environment, i.e., of a reversal of financial liberalisation. 8. Conclusion I have argued that the primary concern of a genuine Keynesian policy was to manage interest rates. This policy conclusion follows from the theory of liquidity preference. Keynes s central theoretical innovation demonstrated that the reward for parting with liquidity depended to a great extent on expectations that could be managed by the authorities. His practical experience led to the development of a full and formal debt management and monetary policy framework that, set within an international environment that permitted such domestic action, would allow the authorities full control over interest rates across the whole spectrum of liquidity. Despite irrefutable practical evidence of the validity of this theory of interest, the specific proposals that Keynes set out at the NDE have never been adhered to in full. Over time, and without due debate, the associated practical mechanisms were dismantled and the rate of interest abandoned to vested interests. Along with the Clearing Union, Keynes s debt management and monetary proposals are a legacy for the world that has been lost. This loss is the real legacy of Keynesian economics. Bibliography Keynes s theory of liquidity preference 13 of 14 Bibow, J On Keynesian theories of liquidity preference, Manchester School, vol. 66, Bibow, J The loanable funds fallacy: exercises in the analysis of disequilibrium, Cambridge Journal of Economics, vol. 25, Chick, V Macroeconomics After Keynes, Oxford, Philip Allan Chick, V. and Dow, S. C Monetary policy with endogenous money and liquidity preference: a non-dualistic treatment, Journal of Post Keynesian Economics, vol. 24, Davidson, P Debtor nations need a financial system that allows them to work their way to prosperity, The Guardian, 1 December Dow, S. C Horizontalism: a critique, Cambridge Journal of Economics, vol. 20, Harrod, Roy 1952 [1972]. The Life of John Maynard Keynes, Harmondsworth, Pelican Howson, S Cheap money and debt management in Britain , in Cottrell, P. L. and Moggridge, D. E. (eds), Money and Power: Essays in Honour of L. S. Pressnell, Basingstoke, Macmillan Howson, S British Monetary Policy , Oxford, Oxford University Press

14 14 of 14 G. Tily Kaldor, N [1986]. The Scourge of Monetarism, Oxford, Oxford University Press Keynes, J. M. 1971A. Indian Currency and Finance. Collected Writings, Vol. I, London, Macmillan for the Royal Economics Society Keynes, J. M. 1971B. A Tract on Monetary Reform. Collected Writings, Vol. IV, London, Macmillan for the Royal Economics Society Keynes, J. M. 1971C. A Treatise on Money. 1. The Pure Theory of Money. Collected Writings, Vol. V, London, Macmillan for the Royal Economics Society Keynes, J. M. 1971D. A Treatise on Money. 2. The Applied Theory of Money. Collected Writings, Vol. VI, London, Macmillan for the Royal Economics Society Keynes, J. M. 1973A. The General Theory of Employment, Interest and Money. Collected Writings, Vol. VII, London, Macmillan for the Royal Economics Society Keynes, J. M. 1973B. Poverty in plenty: is the economic system self-adjusting? (November 1934), The General Theory and After; Part I Preparation. Collected Writings, Vol. XIII, pp , London, Macmillan for the Royal Economics Society Keynes, J. M. 1980A. Proposal for an international currency union, letter to M. Norman, 19 Dec. 1941, Activities Shaping the Post-War World: the Clearing Union. Collected Writings, Vol. XXV, pp , London, Macmillan for the Royal Economics Society Keynes, J. M. 1980B. Your memorandum on forthcoming US conversations, letter to R. F. Harrod, 19 April 1942, Activities Shaping the Post-War World: the Clearing Union. Collected Writings, Vol. XXV, pp , London, Macmillan for the Royal Economics Society Keynes, J. M. 1980C. National Debt Enquiry: Lord Keynes notes, Activities : Shaping the Post-War World: Employment and Commodities. Collected Writings, Vol. XXVII, pp , London, Macmillan for the Royal Economics Society Keynes, J. M. 1980D. National Debt Enquiry: Summary by Lord Keynes of his proposals, Activities : Shaping the Post-War World: Employment and Commodities. Collected Writings, Vol. XXVII, pp , London, Macmillan for the Royal Economics Society Meltzer, A. H Keynes s Monetary Theory: A Different Interpretation, Cambridge, Cambridge University Press Moggridge, D. E John Maynard Keynes: An Economist s Biography, London and New York, Routledge Moggridge, D. E. and Howson, S Keynes on monetary policy, , Oxford Economic Papers, vol. 26, Peden, G. C. (ed.) Keynes and His Critics: Treasury Responses to the Keynesian Revolution , Oxford, Oxford University Press for the British Academy Sayers, R. S Financial Policy: , London, Her Majesty s Stationary Office and Longmans, Green Sayers, R. S Modern Banking, 7th edn, Oxford, Oxford University Press Smithin, J. N Macroeconomic Policy and the Future of Capitalism, Cheltenham, Edward Elgar Smithin, J. N. and Wolf, B. M What would be a Keynesian approach to currency and exchange rate issues? Review of Political Economy, vol. 5,