Exorcising animal spirits out of Keynes, by Paul Jorion

Exorcising animal spirits out of Keynes

Paul Jorion, Stewardship of finance chair, Vrije Universiteit Brussel

To be published in a forthcoming issue of the European Journal of Social Theory: special issue on “Rethinking Capitalism”, 2014

Might be referred to as “European Journal of Social Theory (forthcoming): http://www.pauljorion.com/blog_en/?p=1229″


Torn between the duties associated with the capacities of academic, banker and statesman, Maynard Keynes was in a constant hurry. He glossed over the missing parts of the economic theories he devised by referring to various unfathomable ‘psychological mechanisms’. It is claimed here that interest rates set at the level defined by the marginal yield of capital, a hypothesis Keynes envisaged cursorily but only to assert it leading to ‘circular reasoning’.

Keynes never considered the power balance between lenders and borrowers to be relevant in setting the level of market rates. However, resorting here as a blueprint to the economic arrangement known as sharecropping, power balance between involved parties is shown to be at the core of a fitting explanation.


By training, Maynard Keynes was no economist. His formal training was as a mathematician. His was also a strong background in philosophy, with an initial acquaintance which had been granted him during his days as a schoolboy at Eton, then in the most conducive environment for philosophy which is Cambridge University. Of course he became an expert in economics but not any differently than he would become over the years an expert in banking or in government.

Such range of eclecticism explains the peculiarity of Keynes’ approach to economics: with its one foot in economic theory proper and the other in the much wider field of culture taken as a whole. It explains also why we need to get back to Keynes’s contribution to economics whenever looms as is the case currently a feeling of urgency due to something having gone awfully wrong in economic thinking. What better example of a major mishap than the incapacity of economists to forecast the subprime crisis (with only a handful of exceptions among them), then, once it had broken out, to come up with a set of plausible and feasible suggestions as to how finance should be mended.

Reading Keynes with hindsight in the second decade of the 21st century, there is one thing especially striking in his theorising: an unsettling combination of mechanisms of various types called up for explanatory purposes, hinting at that Keynes knew with a higher degree of accuracy what he meant to persuade us of than he ever knew how to perform the task convincingly, rummaging instead in his very untidy toolbox, however universal this might have been, and brandishing then for the world to see whatever he came up with. Not that he was at all unaware of such legerdemain, as can be read here in one instance: ‘I hit on what I now think to be the true explanation. The resulting theory, whether right or wrong, is exceedingly simple…’ (Keynes 1937b; CW XIV: 212-13).

‘… Whether right or wrong…’ as if – Keynes seems to say – anyone would really care which is the case.

Are missing however from such a bulky but disorganised toolbox, facts of a historical or sociological nature and kindred modes of explanation.

Robert Skidelsky, the author of Maynard Keynes’ monumental biography, has aptly characterised such shortcomings:

‘Theology and economics have always been closely connected in the Anglo-Saxon tradition. What has been missing is history and sociology. The General Theory is no exception. The psychological ‘propensities’ are data. They are the equipment which ‘agents’ bring to their decisions. Their roots in events or social systems are unexplored. There is no mention of the Great War, political and currency disorders, the changing balance between capital and labour, all of which might plausibly be called causes of the great depression’ (Skidelsky 1992: 543).

Indeed whenever Keynes’ demonstration flounders the reader is being advised that some ‘psychological mechanism’ within the financial actors is most likely at work here, the precise nature of which is most often then left in the dark when not wilfully relegated to the shade of the fully unknowable. The most blatant example of this being of course Keynes’ so-called ‘animal spirits’ accounting for our human propensity when faced with uncertainty for doing rather than abstaining from doing, or in Keynes’s own terms: ‘… 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 quantitative benefits multiplied by quantitative probabilities’ (Keynes 1936: 161). Or, in another famous example: that of the beauty contest:

‘It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.’ (Keynes 1936: 156).

Things are much simpler though than what we’re asked here to believe as the steps are: 1) assessing one’s own opinion; 2) assessing how typical it is, i.e. guessing where it locates on the distribution of views compared to the ‘modal’ view (the most represented view); 3) from our assessment of how distant our opinion is from the most represented, determining what the most represented is. What these ‘fourth, fifth and higher degrees’ could possibly be Keynes leaves in the dark, and no wonder: they are in truth nothing more than a rhetorical device aiming at convincing us that ‘such matters are utterly complex’; Keynes can’t always help resorting to those clever tricks used by bankers when addressing customers.

An alternative for a psychological mechanism being postulated before being deemed unfathomable is when its operation dissolves into triviality as with price expectation which is not even determined as the product of a psychological mechanism but through ‘conventionality’, i.e. due to the psyche having gone blank, having recoiled from processing at all the input information at hand and regurgitating it then so to speak in its prime condition.

Or, as Keynes expressed it in the National Debt Enquiry of 1945: ‘What determines the return the individual requires to surrender his liquidity for a long or short period? In practice, of course, what some stockbroker who knows nothing about it advises him, or convention based on old dead ideas or past irrelevant experience’ (Keynes 1945 CW XXVII: 391; as quoted by Tily 2007: 199).

Here in The General Theory: ‘It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon’ (Keynes 1936: 203). Keynes had written earlier in that same book that

‘The essence of this convention — though it does not, of course, work out quite so simply — lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change’ (ibid. 152).


Keynes, the man

Keynes’ works are very much the point wherefrom to start all over again despite his approach’s shortcomings which have become increasingly self-evident since by his death in 1946 he put a full stop to any improvements he could have complemented it with. It is my view also that Keynes has helped us with any required refurbishing by marking the location where an uplift is needed by precisely postulating the presence there of such so-called ‘psychological mechanisms’. There is indeed where lurks a want, where lies a weakness in reasoning and where an addendum can strategically be brought in, the nature of which Skidelsky has aptly defined as historical or sociological, taking into account the essence of the human race of being not only endowed with a psyche but being also, in Aristotle’s words, a zoon politikon fundamentally, a social animal, a part of an organised whole, understandable in these terms only.

Skidelsky has aptly observed that Keynes’s method proceeds in two steps: he first clarifies the policy point he wishes to make and then comes up with some theoretical argument to prove it. Not surprisingly then, this is a quality Keynes admired in others. Thus when he wrote about ‘Newton, the man’, the ‘last of the magicians’ as were the terms he used when conjuring the eminent physicist and Master of the Mint:

‘I believe that Newton could hold a problem in his mind for hours and days and weeks until it surrendered to him its secret. Then being a supreme mathematical technician he could dress it up, how you will, for purposes of exposition, but it was his intuition which was pre-eminently extraordinary  ‘So happy in his conjectures,’ said De Morgan, ‘as to seem to know more than he could possibly have any means of proving.’ The proofs, for what they are worth, were as I have said, dressed up afterwards – they were not the instrument of discovery’ (Keynes 1946: 365).

Theory as a rhetorical afterthought is nowhere more noticeable in Keynes than when he talks about the determination of the interest rate. This is why – because here is where there lies for us today most to learn – I will focus on this particular topic.


Interest as a share of newly created wealth

The historical example of the economic arrangement known as sharecropping offers a straightforward illustration of the issues here at hand. It will therefore be used as a template for clarifying from inception such issues.

With sharecropping we’re dealing with a two stakeholders’ set-up: the owner of the land (of the fishing boat, of the plant, and so on) and the sharecropper properly so called: the peasant (the deckhand, the piecework worker, and so on).

Due to advances of different natures having been corralled to allow a productive process, a surplus is being generated. For instance, out of one seed a head of wheat will grow. The surplus obtained is then shared between both providers of the advances, the landlord and the sharecropper, according to terms reflecting the power balance defining their mutual relationship. With such power balance, each party is weakened or strengthened according to there being high or low competition in its own midst: many land owners with fallow land facing few would-be sharecroppers with their labour force on offer or, conversely: few land owners for many would-be sharecroppers.

One seed is being planted. Advances have been made: the landlord has advanced the land, the sharecropper has advanced his own labour (if any day labourers have been hired, they in turn have advanced their own labour while the sharecropper himself provided supervision for this). Nature has contributed what is required for the metamorphosis of a single seed into a head of wheat: nutrients in the soil, sunrays and raindrops. All those who made advances are entitled to a share in the surplus which arose as the outgrowth from the one seed initially planted into the twenty or so kernels which are to be found in the head. The exact terms of the share distribution, let’s say ‘fifty-fifty’, are determined by the power balance extant between the parties brought together within the sharecropping contract.

The share rewarding the advance in capital is called, if it is to be paid in money instead of in kind, ‘interest’. In the contemporary variety of sharecropping that constitutes the publicly traded company, the share in earnings rewarding the advance in capital is called ‘dividends’ (Americans say ‘stock’ instead of ‘share’ but the essence of the contract is identical: a share in the returns of a productive venture).

John Hicks, Nobel prize in economics for 1972, an early commentator of Keynes and the author of a set of linear equations mistakenly supposed to summarise Keynes’s original contribution wrote:  ‘… the rate of interest is the price of time’ (as quoted by Tily 2007: 217) but this is a misleading definition of what the rate of interest is in truth: what time is the gauge of is the generosity of nature, the sunrays, the raindrops, the nutrients in the soil, or the riches buried in the ground which gets extracted through man’s industry but only as long as it lay there beforehand, combined with hard work. The rate of interest is what share of the windfall offered by the planet through its constant ebullition combined with labour gets allocated to the one source which provided advances in cash. The size of that share is determined by the power balance between all parties involved in the productive process.

In other terms, interest is the part of the surplus which the capitalist, the provider of capital, manages to obtain for himself or herself as a reward for the advances he or she has made. The share obtained by capital is the price to be paid for cash resources which were missing where they were needed and this definition not only applies to productive processes, as with the illustration I gave of agricultural sharecropping, but also as the occasion arises, to the distributive processes of a market economy or even to consumptive processes.

The share of the capitalist is conventionally called ‘marginal yield of capital’, ‘marginal’ as the most unfavourable circumstances for benefiting from such a share set a floor to expectations. The ‘marginal yield of capital’ is a type of profit: it is the capitalist’s (literally understood as the provider of capital) form of profit.

Starting from circumstances where two parties are facing each other where one needs resources which it has no direct access to while the other has at its disposal resources which it can do without for a time, derives a new situation where the party which could spare monies to begin with is rewarded with interest cash flows, meaning that the resources at its disposal have grown by the time the loan reaches maturity, i.e. gets refunded. These additional interest cash flows feed thus as an intrinsic part of the capitalist system an engine for concentrating wealth into an ever reduced number of hands, even if the borrower manages also to get for himself or herself in the process a share in the wealth newly created. As it was Keynes’ merit to underline, for the borrower to manage getting for himself a share in the surplus created through the loan amount having been used as advances, depends at how high a level the interest rate gets set; the lower this rate, the more likely that the borrower manages to secure for himself too a share in the newly created wealth. Hence Keynes’ consistent advocacy of ‘cheap money’, of a state-enforced policy of low interest rates, in order to keep at bay the ‘landlord-rentier’ and give the ‘sharecropper-entrepreneur’ a chance of earning a decent living.


How is the interest rate determined?

I will not start from Keynes’s own explanation of how the interest rate gets determined but from principles, getting in steps to where Keynes himself stood on the subject.

An interest rate defines as a percentage of the loan amount the periodic remuneration of a loan’s lender by the borrower. It is supposedly, as we have seen, a share in the new wealth that this loan has made it possible to generate. How are interest rates set? Let’s start from basics before refining our approach.

Let’s take as an initial illustration the setting of the interest rate of a sovereign bond, meaning what fraction of the loan amount a state will pay on a yearly basis as a fee to its lender or lenders. The term used for the interest rate when talking of debt instruments or bonds is ‘coupon’. There are several ways for setting the coupon of a bond issued by a nation, I’m referring here to the so-called ‘French’ auction method.

Let’s say the grand duchy of Gerolstein aims at borrowing 100 million. Each would-be lender, each properly so called ‘capitalist’, each holder of capital, comes up with an offer made out of two bits of information: a quote for a loan amount and a quote for the interest rate or coupon whereat that specific loan amount would be lent by him.

Would-be lender A is prepared to lend Gerolstein 20 million at a rate of 2.5%; would-be lender B is prepared to lend the grand duchy 50 million at a rate of 2.75%; C is prepared to lend 75 million at 3%; lender D requires 3.25% for the 50 million she is prepared to lend.

Once all bids have been recorded, the following procedure is followed: bids are ranked according to interest rate level, starting from bottom with the bid having the lowest rate attached to it; the loan amounts attached to the individual bids are added on the way up.

A is prepared to lend 20 @ 2.5%. Total bid amount: 20 million

B is prepared to lend 50 @ 2.75%. Total bid amount: 70 million

C is prepared to lend 75 @ 3%. Total bid amount: 145 million

There is no need to further proceed as the bond’s issuance amount has by now been reached. Too bad for bank D which was prepared to lend Gerolstein 50 million at a 3.25% coupon level.

As the loan amount expected by the issuing state was reached at the 3% interest rate level, such will indeed be the coupon attached to the bond. Otherwise said, the coupon is set so as to clear the offer. Would-be lender C is the one who made it possible that the offer got cleared by providing the final 30 million needed to top the 70 million bid by A and B together at a lower coupon level. As far as the supply side is concerned, bank C sees only 30 million cleared out of the 75 she was prepared to lend; this is the price to be paid by her for having demanded an interest rate as high as the one which ends up on the cusp and whereat the bond’s coupon sets.

Would-be lenders, ‘capitalists’, aim at obtaining the highest possible yield for a particular level of credit risk, i.e. risk of not seeing the principal, the loan amount, being refunded, and the promised interest cash flows not materialising. If risk increases, a credit risk premium gets comprised in the rate demanded by capitalists for lending, and this principle applies right across for all debt instruments, whether one is talking of corporate debt, consumer credit or sovereign debt.

When in the auction demand is lower than supply, i.e. the total sum of bids fails to clear it, the power balance favours the lenders and they are in a position to dictate the rate terms, as long that is as they are aware that such is the case. Otherwise, as in the illustration given, the power balance is unfavourable to them as competition to lend prevails. Here once again, as with sharecropping, we’re dealing with circumstances where a power balance prevails between the parties involved and the strength of each of them is determined by the degree of competition observable in its midst.

It is generally assumed that supply and demand meet on a continuum and economists are in the habit of representing neighbouring configurations as developing along smooth curves. Nothing could be further from the truth as such is hardly ever the case: a discontinuity does exist most often. With a case as discussed here, a jump will occur between the coupon levels obtained when the offer is cleared because of a high demand and when, due to poor demand, it is not. In the former case, competition between bidders will significantly lower the interest rates quoted for fear of being outbidden, while in the latter no pressure is exerted by any bidder on any other as all will in any case get served and the rates quoted are likely to be significantly higher.

We’re dealing thus here with two entirely different set-ups: no continuum will be observed, but a jump instead, for the coupon levels obtained for circumstances where demand is higher than supply and where demand is lower than supply.


Risk premium

I mentioned earlier that if a risk exists that the principal, the loan amount, is not refunded, or that the interest cash flows are not being paid as promised, a credit risk premium gets comprised in the rate demanded by capitalists for lending, acting as an insurance premium covering the sums at risk.

A risk premium covers for the lender the risk of unexpected credit events over the period elapsing between the time when a promise was made and the time when it got fulfilled. If the supposedly risk-prone borrower ends up paying back and made all timely payments, the risk premium accrues in fine as a profit for the lender.

Because of the absence of any time-lag between engagement and delivery in spot transactions, such as a sale, no risk premium is here involved. The sole risk for the buyer in a sale is in the ask: the price requested by the seller. According to Aristotle, the fair price on a spot transaction is the one which maintains the social order unperturbed: the one such that once the transaction has taken place the social standing of buyer and seller is the exact same as before it occurred; a state of affair which the formula ‘the poor pay more’ encapsulates adequately (see Jorion 1999).

If a credit risk exists, a risk premium will be demanded by the lender as one of the components of the interest rate being charged. The risk premium represents therefore an incompressible part of the interest rate and it sets a floor, a lower bound, to the coupon level; it can be observed that inflation expectations do not act that way: nothing prevents a debt instrument from being issued with a coupon below the expected inflation level.

In ordinary times sovereign debt is assumed to be paid back and interest payments are supposed to be made at the periodicity contractually agreed upon. There is no need therefore for would-be lenders to include a credit premium in the coupon demanded by them. Because of the ‘purity’ of the interest rate which the absence of a credit premium allows, sovereign debt’s coupons of various maturities act as benchmarks in the absence of any concern for refunding of loan amount or payment of interest cash flows.


How does the lender determine what interest rate to demand?

Thinking again of our earlier hypothetical example of the grand duchy of Gerolstein issuing a bond, we saw how the coupon was ultimately set from various bids made by several banks but what was not discussed is the basis chosen for those 2.5% to 3.25% bids by the banks. These interest rates did not materialise out of thin air: their level had been determined elsewhere but in what manner? How did the bidders define the interest rate level associated with their bid?

My claim is that these bids had as a basis the ‘marginal yield of capital’ we’ve encountered before, which I defined at the time as ‘the part of the surplus which the capitalist, the provider of capital, manages to obtain for himself or herself as a reward for the advances he or she has made’ as part of a productive process.

Why would it be so? Because in today’s world there is but a single market for capital: capitalists are free to lend wherever they wish and the benchmark for what obtains is the share an overall power balance allows them to acquire of the windfall deriving from the generosity of planet Earth under the shape of sunrays, raindrops, nutrients in the soil, oil, ore, etc. combined with labour.

For any same maturity: any same length of time the money has been lent, and at the same credit risk level, interest rates set at the same figure, which is the marginal yield of capital over a period of that duration.

Consumer credit, i.e. credit obtained for a consumptive goal, does not generate surplus and interest cash flows to be paid cannot be drawn off in this instance as a share of newly created wealth. This is why the Church prohibited under the name of usury what we nowadays call ‘consumer credit’ while it tolerated interest being paid in economic arrangements of a sharecropping nature where the interest cash flows represent a share in wealth newly created through the loan having been used as advances. But as said before, as the capitalist has alternative uses for his capital, the yield on consumptive loans aligns on that of productive loans since they are not only tolerated nowadays as we know but even highly praised: the end of a recession is hailed with clamour that ‘credit to households has at long last been restored!’

Where does Keynes stand on this issue? He does envisage as an option my proposition of interest rates being determined by the marginal yield of capital but only to dismiss it out of hand. Let’s examine his reasoning.

‘One naturally began by supposing that the rate of interest must be determined in some sense by productivity – that it was, perhaps, simply the monetary equivalent of the marginal efficiency of capital, the latter being independently fixed by physical and technical considerations in conjunction with the expected demand. It was only when this line of approach led repeatedly to what seemed to be circular reasoning, that I hit on what I now think to be the true explanation. The resulting theory, whether right or wrong, is exceedingly simple – namely, that the rate of interest on a loan of given quality and maturity has to be established at the level which, in the opinion of those who have the opportunity of choice – i.e. of wealth-holders – equalises the attractions of holding idle cash and of holding the loan.’ (Keynes 1937b; CW XIV: 212-213).

Are the twenty kernels in a head found in the crop, as compared to the one seed which was originally planted, ‘circular reasoning’? Is the notion that interest consists of a share in the surplus of nineteen kernels harvested in the productive process, ‘circular reasoning’? Indeed no surplus gets generated in a loan allocated through consumer credit, I said why it was an anomaly and that our forefathers were aware of this. But what about a share or stock giving rights to dividends as a share in a company’s earnings being an instance of the ordinary scheme?

So if the marginal return on capital fails to qualify as a benchmark for interest rates, what does? What is Keynes’ own approach on the issue?


A parenthesis on money

To understand Keynes’ explanation of interest rates in terms of liquidity preference one needs first a good grasp of the nature of money.

Aristotle held a representation of money and monetary mechanisms still shared by us today. Aristotle acknowledged money three functions: as a means of transaction, as a store of value and as a unit of account. This is still the way money is defined in current textbooks of economics.

Aristotle distinguished ten ‘categories’, which are perspectives we adopt when envisaging objects in the world; these categories appear in a sentence as either its subject or its predicate. Money’s three functions mentioned above refer to money when examined in the light of two of Aristotle’s ten ‘categories’: as a quality or as a quantity.

‘Means of transaction’ and ‘store of value’ refer to money looked at in terms of its quality. Qualities come according to Aristotle, in two modes: either in actu or in potentia, either in the actuality of something or as a potential for the same thing.

Money as a means of transaction is used in actu; as a store of value it is looked at in potentia: for what it could actually be, i.e. as a means of transaction. Money in its capacity of unit of account is envisaged in the perspective of quantity.

This being said, money can still be envisaged in the light of other Aristotelian categories, location for instance. Money can be in the possession of a physical person or of a moral person (a state, a firm, etc.), it can be held also by a commercial or an investment bank, or by a central bank. Money can be considered also according to the category of substance: as coins, banknotes, digital traces on a computer’s hard disk, as precious metal, etc.

Before moving away from Aristotle, let’s ponder on one of money’s remarkable properties.

There is a famous distinction assigned to Aristotle which he in truth never made: the contrast between ‘usage value’ and ‘exchange value’. The whole passage of the Nicomachean Ethics where this distinction was supposedly made by him does not even contain a word meaning ‘value’, the closest one gets to such thing is a word meaning ‘as measured by price’[1]. What Aristotle actually says is that there are for anything likely to be priced, two possible usages: its usage proper of being used as to its purpose, i.e. being worn at one’s feet for a pair of shoes, and being used in exchange, i.e. in the case of a pair of shoes, being exchanged for something else, e.g. for a couple of guitar lessons. Now what is remarkable with money is that these two possible usages coalesce: the purpose of money is of being exchanged and what should be called the proper usage of money is thus that it is being used in exchange. Money is the only entity whereof the two possible usages, proper and in view of exchange, are one and the same.


Liquidity preference

What is liquidity preference? It is the acknowledgement of a possible transition between money as a store of value (in potentia) and as a means for transaction (in actu), the market interest rate being according to Keynes the materialisation of the level where this transition occurs.

What is being meant by this?

Here is what Keynes wrote in The General Theory of Employment, Interest, and Money:

‘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 circumstances?

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 constituents of psychological time-preference to the neglect of the second; and it is this neglect which we must endeavour to repair.’ (Keynes 1936: 166).

Let’s note that two hypotheses are presented for the mechanism that sets interest rates: the first is powered by an individual’s propensity to consume, the second reflects the degree of his liquidity-preference. Keynes states that the first of these two hypotheses is the one held by ‘the accepted theories of the rate of interest’ while it is the second which should have been preferred. Let’s note also that to Keynes, the interest rate setting mechanism can only lie in one of two ‘psychological time-preferences of an individual’. No question here of interest cash-flows being a share in newly created wealth, the proportion of which being determined by a power balance between lender and borrower, no: what sets the interest rate is one out of two possible representations in the mind of an individual, and that individual is the lender.

Let’s imagine that a capitalist (would-be lender) has a certain amount of money at his or her disposal that he or she considers lending. He or she is prepared to lend for five years at the 3.2% level but no less. How did he or she come up with that figure? It is the outcome, says Keynes, of expectations by that person of coming financial and economic circumstances and in particular of the future level of interest rates, as impacted for instance by views about prospective inflation. Now the person in question, if he or she has strong views about prospective interest rates, is most likely a sophisticated investor since we’ve seen that according to Keynes the ordinary person holds a ‘conventional’, unimaginative, view of interest rates and their figure in the future, i.e. that they’re most likely to remain as they are now.

Why hoard instead of lending as there is no benefit whatever to it compared to lending which brings a reward? Here is what Keynes has to say:

‘… partly on reasonable and partly on instinctive grounds, our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. […] The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude’ (Keynes 1937a: 116).

Let’s say that an individual decides to lend according to whether or not the current market rate is higher or lower than 3.2%. But that’s precisely not the way Keynes sees it as there is for him no market rate distinct from the market’s overall threshold for liquidity preference. Keynes claims that the rate sets according to the overall picture emerging from financial actors determining their own individual liquidity preference threshold level.

In other words, in Keynes’s opinion, the market rate is the price to be paid to a would-be lender so that he’s prepared to relinquish liquidity preference. A different way to express the same is saying that the market rate as determined by liquidity preference is the price required by a capitalist for holding a debt acknowledgement instead of cash. Still another way would be to say that the market interest rate is the rate level whereat the holder of capital is prepared to transition monies in his possession from store of value to means for transaction.

Those three formulations seem at first sight to be informative but they turn out to be trivial as far as forecast is concerned and might well amount to the kind of pure circular reasoning which Keynes was himself decrying when dismissing the ‘marginal yield of capital’ hypothesis: nothing tells how that particular level is arrived at and if one takes in earnest two suggestions from Keynes in chapter 12 of the General Theory, the ‘beauty contest’ and ‘animal spirits’, it is fair to say that the determination of the precise level is unknowable. I’ve already quoted a brief passage from the ‘beauty contest’ argument but here it is in its full development:

‘Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, 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 anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees’ (Keynes 1936: 156).

… and even if one doubts that there is anything like those ‘fourth, fifth and higher degrees’, as I said earlier is my case, it remains quite difficult to guess accurately who will be the winner, unless one’s own judgment is ‘modal’, the most well-represented, from the beginning and one is aware of the fact.

The ‘animal spirits’ hypothesis refers to a different type of unknowability as it suggests deeds might be entirely disconnected from any rational decision process such as that assumed under the ‘beauty contest’ hypothesis. Let’s read the passage in full:

‘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 quantitative benefits multiplied by quantitative 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’ (Keynes 1936: 161-162).

Combined together, the ‘beauty contest’ and ‘animal spirits’ hypotheses constitute the ultimate black-box as to men’s decisions and causal relationship then between decisions made and actual conduct, with the implication that the liquidity preference approach to rates’ determination amounts to saying that market rates are set through a particular mechanism the nature of which can be fairly accurately described but the precise working and outcomes of which are unknowable.

By contrast, the hypothesis of the market rates being set by the marginal yield of capital is assessable. The fact that it is assessable is of course no proof that it is true but its plausibility means that in order to be dismissed, more is required than the somewhat rash statement that ‘this line of approach led repeatedly to what seemed to be circular reasoning’, as Keynes says. The marginal yield of capital is not some fancy of the imagination as would be an idiosyncratic synthesis of representations of rates to come in one’s own mind and in the mind of an indefinite number of other people using various methods to come up with a figure, but, as I said earlier, it is the actual yield of productive process all over the globe: the share which capital obtains for itself out of the windfall which planet Earth delivers as sunrays, raindrops, nutrients in the soil, coal, oil, ore, etc. whenever advances under the shape of energy, tools, machinery, labour are being provided.


Keynes own incidental refutation of preference liquidity as setting interest rates

Now, quite interestingly, Keynes has incidentally offered his own refutation of the liquidity preference determination of the rate of interest and nowhere else than in the very same General Theory where the hypothesis was originally stated. Let’s see indeed how can be achieved the ‘euthanasia of the rentier’ which is Keynes’ method for bringing about a smooth transition to socialism, as described in chapter 24, entitled ‘Concluding notes on the social philosophy towards which the general theory might lead’:

‘Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. Interest to-day rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant’ (Keynes 1936: 375-6).

‘The owner of capital can obtain interest because capital is scarce’, says Keynes. If capital ceased to be scarce, if it became abundant, interest would cease to be reaped, and that would mean the euthanasia of the rentier. It seems fair to assume that Keynes was postulating here a monotonic function where the more abundant the capital, the lower the need to pay interest. And this supposes that the rate of interest is set by the intrinsic abundance or scarcity of capital rather than by some representation held in the mind by the would-be-lender, or ‘capitalist’ as he calls him here, about his or her preference for liquidity.

But aren’t we talking here precisely of the rate of interest as of something ‘being independently fixed by physical and technical considerations in conjunction with the expected demand’ which Keynes was mentioning in his ‘Alternative theories of the rate of interest’ article of 1937, only to dismiss at the time the very idea? I.e. aren’t we talking of Keynes’ own ‘marginal efficiency of capital’ which he rejected as a possible determinant for the interest rate level on the grounds that it ‘led repeatedly to what seemed to be circular reasoning’?

Haven’t we come full circle with these observations by Keynes on the euthanasia of the rentier and how to achieve the task? Back in fact to the sharecropping set-up which I initially presented, where the power balance between lender and borrower depends on the scarcity of capital under the shape of land. A high competition between land owners means that they will need to satisfy themselves with a lower share in the newly created wealth than if there were conversely a high competition between would-be sharecroppers.

As long as at least two parties contribute the advances needed to bring about a productive process, the fact that some new wealth ends up having been generated, benefiting from nature’s windfall which man takes advantage of, justifies fully that they are both rewarded with a share of it.

If need arises for capital as advances of cash in a productive process and a surplus happens to be created, there is no justification for it not being rewarded by a share of that surplus and in the absence of credit risk and therefore of a credit risk premium being encompassed in the coupon, the interest rate will not drop to zero: it would only drop to zero if production failed and no wealth got created at the end of the day.

Within a productive process where wealth has indeed been generated beyond the advances which were gathered together and where a share was in capital which will be rewarded as interest, there will be a positive part of the interest rate representing the marginal yield of capital. That part of the interest rate would only vanish if there were no interest payments at all and this will only be the case if the producer has no need for capital, i.e. if he or she has full access to the entirety of resources required by the productive process. Otherwise it makes perfect sense that a share is being paid for the advances which were made.

Getting back now to Keynes’ point: it is not true that the interest rate will get reduced to a vanishing point where it assimilates with the risk premium component (and depreciation says Keynes) if capital gets abundant: as long as capital is needed, it can get rewarded with a share of newly created wealth if any, even if that share can indeed be small if capital is abundant. It is not by eliminating the scarcity of capital that the rate gets lowered to a vanishing point but by removing altogether the need for capital. The rate drops as resources required as advances in the productive process are present instead of absent and need not therefore to be borrowed, drawing the attention to the fact that the word ‘capital’ is not – as usually assumed – a synonym for ‘resources’ but refers only to resources envisioned as missing at the very location where they are needed; this is the – some have called it ‘unexpected’ – definition I set forth for ‘capital’ in my book Le capitalisme à l’agonie: ‘capital refers to resources missing where they are needed in a productive, distributive or consumptive economic process’ (Jorion 2011: 30).

On the contrary, and this was precisely the point underlying the medieval notion of usury, there can be no justification for interest payments if the loan is no part of a productive process where new wealth gets created. This applies especially to consumer credit or revolving sovereign debt, the function whereof is to fulfil a need and not to act as advances in a productive process.

We are left thus with the inescapable conclusion that the mechanism underlying Keynes’ ‘euthanasia of the rentier’ entails that the rate of interest is nothing but the marginal yield of capital. The rate of interest gets lowered indeed by eliminating the scarcity of capital which can only mean that interest cash flows amount to a share in newly created wealth.


What are we then left with when talking about liquidity preference?

Keynes’ notion that interest rate levels are set by liquidity preference didn’t fare well over the years. It survives to my knowledge under only two guises in economic theory: first, to underline an asymmetry between lenders and borrowers in terms of preference for a loan’s ‘maturity’ (duration), with an entailment of this for the level where the interest rates will set; the second is the occurrence of a ‘liquidity trap’ when market rates drop very low.

The ‘liquidity preference theory’ according to Hull assumes the following:

‘This argues that forward rates should always be higher than expected future spot interest rates. The basic assumption underlying the theory is that investors prefer to preserve their liquidity and invest funds for short periods of time. Borrowers, on the other hand, usually prefer to borrow at fixed rates for long periods of time.

In practice, in order to match depositors with borrowers and avoid interest rate risk, financial intermediaries raise long-term interest rates relative to expected future short-term interest rates’ (Hull 1993: 87-88).

One notices that this ‘liquidity preference theory’ entails that it is not only the lender’s requirements which determine at what level the interest rate will set but that the level results also from a compromise between lender and borrower, a view in tune with the one I personally derive from using the traditional economic arrangement that is sharecropping as the blueprint allowing to analyse interest mechanisms, where the existing power balance between the parties involved decides in a tug-of-war of the ensuing interest rate level.

According to Tily, the concept of the ‘liquidity trap’ was born in 1937 out of a concession to Keynes by his dear foe Dennis Robertson (1890-1963) when the latter wrote:

‘And I’m prepared, too, with Mr. Hawtrey and Mr. Hicks, to concede to Mr. Keynes that so-called ‘liquidity’ considerations might in certain conditions set a limit to the practicable fall in the long-term rate of interest, …’ (Tily 2007: 113).

A ‘liquidity trap’ reveals itself when market rate levels for various maturities drop so low that candidate investors would rather hoard than lend. The notion is self-evident: it underlines that market rates may get located lower than overall liquidity preference thresholds and not simply lower than investor-specific thresholds: that the overall, global, liquidity preference thresholds might occasionally set at a higher level than the market rates. This excludes necessarily the option that overall liquidity preference thresholds determine market rates in all circumstances.

The notion of liquidity trap has been the royal path for Keynes’ view of liquidity preference becoming familiar even if the liquidity trap is foreign to Keynes’ own thinking and clearly irreconcilable with his opinion that the investors’ liquidity preference sets the interest rate.

What is then the precise relationship between market rates and liquidity preference?

Liquidity preference is inescapably no more than a marginal phenomenon: its range of intervention is unlikely to extend far out of scope of the first two percentage points of interest rate. What liquidity preference does is setting a threshold between hoarding on the one hand and lending on the other: liquidity preference sets a bound in the mathematical sense of the term.

Keynes imagined he was seeing in liquidity preference the crucial factor in the function determining the level of market interest rates. The role of liquidity preference is in truth of a different nature: it sets a bound. Liquidity preference acts as a bound just as the subsistence level of the buyer sets a ceiling, an upper bound, to the price staple commodities are allowed to reach, while subsistence level of the seller sets a floor, a lower bound, to these prices. Subsistence is no ‘factor’, it sets bounds for buyer and seller, nor is it ‘psychological’: it is harshly objective.

The liquidity preference bound sets the level where a transition occurs between the use of money as a store of value and as a means of transaction. It determines a decision to either hoard (maintain the monies as store of value: money in potentia) or to lend (shift the monies to their use as a means for transaction: money in actu). But that bound can only play its role within a landscape of fluctuating values for market rates. And what determines these market rates I claim personally to be the marginal yield of capital.


With liquidity preference Keynes made come to light a major lower bound on interest rates. His understanding of the market rates’ mechanism however was not sufficiently elucidated that he mistook a bound on the value of the interest level with the main factor in the function establishing it.
Looking at how interest rates are effectively set in a productive environment as defining a share in newly created wealth, it has been possible to offer a proper definition of the function that sets that part of an interest rate distinct from its risk premium component and to identify it with the marginal yield of capital, the outcome of labour combined with the windfall which nature generously grants us.

Mixing objective factors reflecting the circumstances of the world outside with the possible impact on the world of representations brewed up in people’s minds, Keynes produced an untidy model of how market rates get generated. Prices and rates reflect the power balance between the parties involved, deriving from a tug-of-war between buyers and sellers, borrowers and lenders, rather than from one party or other’s simpleminded representations of what is going on, however elaborate the construction of these representation might have been. It takes two to tango, in financial matters just as well as in the rest of the world.





Hull, John C., Options, Futures, and other Derivative Securities, Englewood Cliffs: Prentice-Hall 1993

Jorion, Paul, ‘Aristotle’s Theory of Price Revisited’, Dialectical Anthropology, 1999, Vol. 23, N° 3, 247-80

Jorion, Paul, Le capitalisme à l’agonie, Paris: Fayard 2011

Keynes, John Maynard, A Treatise on Probability, London: Macmillan 1921

Keynes, John Maynard, The General Theory of Employment, Interest and Money, London: Macmillan 1936

Keynes, John Maynard, ‘The General Theory of Employment’, February 1937a in Collected Works XIV, Cambridge : Cambridge University Press, 109-23

Keynes, John Maynard, ‘Alternative Theories of the Rate of Interest’, June 1937b in Collected Works XIV, Cambridge : Cambridge University Press, 201-15

Keynes, John Maynard, ‘Newton, the man’, 1943 in Essays in Biography, London: Palgrave Macmillan 2007: 363-74

Skidelsky, Robert, John Maynard Keynes. The Economist as Saviour 1920-1937, London: Macmillan 1992

Piron, Sylvain, ‘Albert le Grand et le concept de valeur’, I Beni di questo mondo. Teorie etico-economiche nel laboratorio dell’Europa medievale, R. Lambertini, L. Sileo (eds.) 2010: 131-56

Tily, Geoff, Keynes Betrayed, The General Theory, the Rate of Interest and ‘Keynesian’ Economics, London: Palgrave Macmillan 2007


Paul Jorion is holder of the Chair ‘Stewardship of Finance’ at the Vrije Universiteit Brussel, he is also a columnist at the daily Le Monde. He is a Doctor in the Social Sciences from the Free University Brussels. He holds MAs in sociology and social anthropology. He’s lectured at the universities of Brussels, Cambridge, Paris VIII and at the University of California at Irvine. He was at one time a United Nations Officer (FAO), working on development projects in Africa. Paul Jorion worked in the American banking industry as a pricing specialist from 1998 to 2007.





[1] The mistranslation is due to Scholastic Albert the Great (?–1280) ; see on this Piron 2011.

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