Exorcising animal spirits out of Keynes<\/b><\/p>\n
Paul Jorion, Stewardship of finance<\/i> chair, Vrije Universiteit Brussel<\/p>\n
To be published in a forthcoming issue of the European Journal of Social Theory<\/em>:\u00a0special issue on “Rethinking Capitalism”, 2014<\/p>\n Might be referred to as “European Journal of Social Theory <\/em>(forthcoming): http:\/\/www.pauljorion.com\/blog_en\/?p=1229″<\/p>\n Abstract<\/span>:<\/p>\n 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 \u2018psychological mechanisms\u2019. It is claimed here that interest rates set at the level defined by the marginal yield of capital<\/i>, a hypothesis Keynes envisaged cursorily but only to assert it leading to \u2018circular reasoning\u2019.<\/p>\n 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<\/i>, power balance between involved parties is shown to be at the core of a fitting explanation.<\/p>\n <\/p>\n 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.<\/p>\n Such range of eclecticism explains the peculiarity of Keynes\u2019 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\u2019s 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<\/i> 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.<\/p>\n Reading Keynes with hindsight in the second decade of the 21st<\/sup> 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: \u2018I hit on what I now think to be the true explanation. The resulting theory, whether right or wrong, is exceedingly simple\u2026\u2019 (Keynes 1937b; CW XIV: 212-13).<\/p>\n \u2018\u2026 Whether right or wrong\u2026\u2019 as if \u2013 Keynes seems to say \u2013 anyone would really care which is the case.<\/p>\n Are missing however from such a bulky but disorganised toolbox, facts of a historical or sociological nature and kindred modes of explanation.<\/p>\n Robert Skidelsky, the author of Maynard Keynes\u2019 monumental biography, has aptly characterised such shortcomings:<\/p>\n \u2018Theology and economics have always been closely connected in the Anglo-Saxon tradition. What has been missing is history and sociology. The General Theory<\/i> is no exception. The psychological \u2018propensities\u2019 are data. They are the equipment which \u2018agents\u2019 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<\/i> of the great depression\u2019 (Skidelsky 1992: 543).<\/p>\n Indeed whenever Keynes\u2019 demonstration flounders the reader is being advised that some \u2018psychological mechanism\u2019 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\u2019 so-called \u2018animal spirits\u2019 accounting for our human propensity when faced with uncertainty for doing rather than abstaining from doing, or in Keynes\u2019s own terms: \u2018\u2026 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\u2019 (Keynes <\/i>1936: 161). Or, in another famous example: that of the beauty contest:<\/p>\n \u2018It 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.\u2019 (Keynes 1936: 156).<\/p>\n Things are much simpler though than what we\u2019re asked here to believe as the steps are: 1) assessing one\u2019s own opinion; 2) assessing how typical it is, i.e. guessing where it locates on the distribution of views compared to the \u2018modal\u2019 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 \u2018fourth, fifth and higher degrees\u2019 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 \u2018such matters are utterly complex\u2019; Keynes can\u2019t always help resorting to those clever tricks used by bankers when addressing customers.<\/p>\n 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 \u2018conventionality\u2019, 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.<\/p>\n Or, as Keynes expressed it in the National Debt Enquiry <\/i>of 1945: \u2018What 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\u2019 (Keynes 1945 CW XXVII: 391; as quoted by Tily 2007: 199).<\/p>\n Here in The General Theory<\/i>: \u2018It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon\u2019 (Keynes 1936: 203). Keynes had written earlier in that same book that<\/p>\n \u2018The essence of this convention \u2014 though it does not, of course, work out quite so simply \u2014 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\u2019 (ibid. 152).<\/p>\n <\/p>\n Keynes, the man<\/span><\/p>\n Keynes\u2019 works are very much the point wherefrom to start all over again despite his approach\u2019s 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 \u2018psychological mechanisms\u2019. 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\u2019s words, a zoon politikon<\/i> fundamentally, a social animal, a part of an organised whole, understandable in these terms only.<\/p>\n 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 \u2018Newton, the man\u2019, the \u2018last of the magicians\u2019 as were the terms he used when conjuring the eminent physicist and Master of the Mint:<\/p>\n \u2018I 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\u00a0 \u2018So happy in his conjectures,\u2019 said De Morgan, \u2018as to seem to know more than he could possibly have any means of proving.\u2019 The proofs, for what they are worth, were as I have said, dressed up afterwards \u2013 they were not the instrument of discovery\u2019 (Keynes 1946: 365).<\/p>\n 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 \u2013 because here is where there lies for us today most to learn \u2013 I will focus on this particular topic.<\/p>\n <\/p>\n Interest as a share of newly created wealth <\/span><\/p>\n The historical example of the economic arrangement known as sharecropping<\/i> offers a straightforward illustration of the issues here at hand. It will therefore be used as a template for clarifying\u00a0from inception such issues.<\/p>\n With sharecropping we\u2019re dealing with a two stakeholders\u2019 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).<\/p>\n 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.<\/p>\n 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\u2019s say \u2018fifty-fifty\u2019, are determined by the power balance extant between the parties brought together within the sharecropping contract.<\/p>\n The share rewarding the advance in capital is called, if it is to be paid in money instead of in kind, \u2018interest\u2019. In the contemporary variety of sharecropping that constitutes the publicly traded company, the share in earnings rewarding the advance in capital is called \u2018dividends\u2019 (Americans say \u2018stock\u2019 instead of \u2018share\u2019 but the essence of the contract is identical: a share in the returns of a productive venture).<\/p>\n 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\u2019s original contribution wrote:\u00a0 \u2018\u2026 the rate of interest is the price of time\u2019 (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\u2019s 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.<\/p>\n 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.<\/p>\n The share of the capitalist is conventionally called \u2018marginal yield of capital\u2019, \u2018marginal\u2019 as the most unfavourable circumstances for benefiting from such a share set a floor to expectations. The \u2018marginal yield of capital\u2019 is a type of profit: it is the capitalist\u2019s (literally understood as the provider of capital) form of profit.<\/p>\n 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\u2019 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\u2019 consistent advocacy of \u2018cheap money\u2019, of a state-enforced policy of low interest rates, in order to keep at bay the \u2018landlord-rentier\u2019 and give the \u2018sharecropper-entrepreneur\u2019 a chance of earning a decent living.<\/p>\n <\/p>\n How is the interest rate determined? <\/span><\/p>\n I will not start from Keynes\u2019s own explanation of how the interest rate gets determined but from principles, getting in steps to where Keynes himself stood on the subject.<\/p>\n An interest rate defines as a percentage of the loan amount the periodic remuneration of a loan\u2019s 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\u2019s start from basics before refining our approach.<\/p>\n Let\u2019s 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 \u2018coupon\u2019. There are several ways for setting the coupon<\/i> of a bond issued by a nation, I\u2019m referring here to the so-called \u2018French\u2019 auction method.<\/p>\n Let\u2019s say the grand duchy of Gerolstein aims at borrowing 100 million. Each would-be lender, each properly so called \u2018capitalist\u2019, 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n A is prepared to lend 20 @ 2.5%. Total bid amount: 20 million<\/p>\n B is prepared to lend 50 @ 2.75%. Total bid amount: 70 million<\/p>\n C is prepared to lend 75 @ 3%. Total bid amount: 145 million<\/p>\n There is no need to further proceed as the bond\u2019s 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.<\/p>\n 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.<\/p>\n Would-be lenders, \u2018capitalists\u2019, 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n <\/p>\n Risk premium<\/span><\/p>\n 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.<\/p>\n 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<\/i> as a profit for the lender.<\/p>\n 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<\/i>: 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 \u2018the poor pay more\u2019 encapsulates adequately (see Jorion 1999).<\/p>\n 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.<\/p>\n 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 \u2018purity\u2019 of the interest rate which the absence of a credit premium allows, sovereign debt\u2019s coupons of various maturities act as benchmarks in the absence of any concern for refunding of loan amount or payment of interest cash flows.<\/p>\n <\/p>\n How does the lender determine what interest rate to demand?<\/span><\/p>\n 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?<\/p>\n My claim is that these bids had as a basis the \u2018marginal yield of capital\u2019 we’ve encountered before, which I defined at the time as \u2018the 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\u2019 as part of a productive process.<\/p>\n Why would it be so? Because in today\u2019s 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.<\/p>\n 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.<\/p>\n 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<\/i> what we nowadays call \u2018consumer credit\u2019 while it tolerated interest being paid in economic arrangements of a sharecropping<\/i> 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 \u2018credit to households has at long last been restored!\u2019<\/p>\n 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.<\/p>\n \u2018One naturally began by supposing that the rate of interest must be determined in some sense by productivity \u2013 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\u00a0theory, whether right or wrong, is exceedingly simple \u2013 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 \u2013 i.e. of wealth-holders \u2013 equalises the attractions of holding idle cash and of holding the loan.\u2019\u00a0(Keynes 1937b; CW XIV: 212-213).<\/p>\n Are the twenty kernels in a head found in the crop, as compared to the one seed which was originally planted, \u2018circular reasoning\u2019? Is the notion that interest consists of a share in the surplus of nineteen kernels harvested in the productive process, \u2018circular reasoning\u2019? 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<\/i> or stock<\/i> giving rights to dividends as a share in a company’s earnings being an instance of the ordinary scheme?<\/p>\n 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?<\/p>\n <\/p>\n