Fixing the Economists Article of the Week

by Philip Pilkington

In Keynes’ General Theory is is famously stated that the demand for money relies on three distinct functions. These are: the transactions demand for money; the precautionary demand for money; and the speculative demand for money.

Or, more formally:

M = Mt + Mp + Ms

In that work Keynes — as he regularly did in his monetary theories — laid rather a lot of emphasis on the speculative demand for money and not a great deal of emphasis on the precautionary demand for money. In chapter 13 of his General Theory he wrote,

It may illustrate the argument to point out that, if the liquidity-preferences due to the transactions-motive and the precautionary-motive are assumed to absorb a quantity 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 quantity of money, less this quantity, 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 quantity 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 quantity 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. (My Emphasis)

I have quoted that passage at length because readers of Keynes will note that it ties in with his earlier work A Treatise on Money through its mention of ‘bulls’ and ‘bears’. In that work too Keynes viewed the money markets as inherently speculative in nature. As can be seen from the highlighted part of the above quote he thought that the other components of the demand for money — namely, Mt and Mp — were not subject to changes in the rate of interest. Indeed, Keynes seems to leave aside these aspects of money demand and focus instead on the speculative motive.

Roy Harrod spends quite a good deal of his book Money arguing against this. Harrod claims that the precautionary demand for money is often far more important than the speculative demand. He also argues that the precautionary demand is just as sensitive to changes in the environment as the speculative demand. In the book he notes two distinct actions in the money market that are undertaken in line with the precautionary motive and have substantial effects on various aspects of these markets. These are: covering and hedging.

Harrod’s main example is taken from a situation when the exchange rate is expected to shift but I think that we could also find purely domestic instances of the same phenomena. Covering is the action taken by businesses — typically large businesses — that they should be able to ‘cover’ all their known future commitments as soon as they are entered into. These businesses then seek advice from professional financial advisers, often economists, who keep an eye on developing trends. If, for example, the financial advisers think that a currency which their clients receive in exchange for exports is going to decline in value they may advise companies to sell this currency in the future market.

Hedging is very similar. It has to do with the fact that companies and individuals hold financial assets from various different countries. If, for example, foreigners own a lot of sterling assets and their financial advisers believe that the sterling might decline they will likely hedge against this decline . They would do this, again, by selling the sterling in the forward market in equal amount to the amount of sterling assets that they hold. That way, if the sterling does decline the profit that they make on the forward sale will balance out with the losses they make on their assets.

Again, Harrod’s examples have to do with currencies but similar processes take place with respect to domestic issues such as inflation. Harrod argues that these processes make up far more of financial market activity than simple speculation. Of course, both speculation and precaution are both due to the existence of Keynesian or Knightian uncertainty in these markets but Harrod and Keynes are perfectly correct to delineate between them. But I do want to emphasise that the reason for their existence is identical to that of speculation: the future is not a mirror of the past and so many financial transactions are taken, not with given measurable numerical probabilities in mind (when these are given they are faked to give management the illusion of control), but rather in the face of true uncertainty.

This is not to say that Harrod thinks that speculation never plays a large role. He gives the example of Britain after the war when the Chancellor of the Exchequer Dr. Dalton insisted on holding interest rates down despite the likely upsurge of inflationary pressure. Many in the financial markets held money back from the stock market in the expectation that Dalton would be forced to raise interest rates, the market would decline and they could pick up stocks at bargain prices. Nevertheless, Harrod sees the precautionary motive as more important generally speaking than the speculative motive.

I think that Harrod is indeed correct. The financial architecture is taken up a very good deal of the time with precautionary rather than speculative ebbs and flows of capital. Indeed, this is how the capital markets generally advertise themselves; they portray themselves not as speculators, but as insulating their clients from the uncertainties of the real world. This, of course, is propaganda and a great deal of speculation does take place. But I think that Harrod is basically correct in that the bulk of the activity that causes interest rates and other financial variables to respond to uncertainty in line with Keynes’ liquidity preference theory are due to the precautionary rather than the speculative motive. He is also correct to point out that talk of ‘speculation’ any time, for example, exchange rates become unstable might be misleading. He writes,

The overemphasis of speculation, as against precaution, has been instanced in an entirely different field, by the frequent reference to ‘speculation’ against sterling or dollar in recent periods. Doubtless there was some speculation in these cases, but this was probably of minor importance compared with the vast movement of funds, due to the precautionary motive. (p173)

I too, like Keynes, am somewhat guilty of this oversight. In my working theory of assets prices I focus almost entirely on speculation. I very rarely mention that the price dynamics that I describe might be due to precaution in the face of uncertainty rather than speculation pure and simple. But this is really just a question of emphasis. As I noted above, both the speculative and the precautionary demand for money are motivated by the existence of uncertainty and so any framework that can deal with one can deal with the other. Both also give rise to self-fulfilling dynamics in which, when the markets begin to believe something, this something has a very good chance of coming true simply because this belief exists. This is what Soros calls ‘reflexivity’ and it is a key component of Keynes’ financial theories. That said, when I do revise my theory of asset pricing (which is currently in somewhat ill health) in the coming months and years I will give far more consideration to the precautionary as opposed to the speculative motive.