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Speculation
and
Economic
Stability
such speculative activity would be attended by a loss, and not a gain; and
such speculators would be speedily eliminated. Only the speculator with
better than average foresight can hope to remain permanently in the market.
And this implies that the effect of speculative activity must be price-stabilising,
and in the above sense, wholly beneficial.
This argument, however, implies a state of affairs where speculative
demand or supply amount only to a small proportion of total demand or
supply, so that speculative activity, while it can influence the magnitude of the
price-change, cannot at any time change the direction of the price-change. If
this condition is not satisfied, the argument breaks down. It still remains true
that the speculator, in order to be permanently successful, must possess better
than average foresight. But it will be quite sufficient for him to forecast
correctly (or more correctly) the degree of foresight of other speculators, rather
than the future course of the underlyingnon-speculative factors in the market.,
If the proportionof speculative transactionsin the total is large, it may become,
in fact, more profitable for the individual speculator to concentrate on forecasting the psychology of other speculators, rather than the trend of the
non-speculative elements. In such circumstances, even if speculation as a
whole is attended by a net loss, rather than a net gain, this will not prove,
even in the long-run, self-corrective. For the losses of a floating population of
unsuccessful speculators will be sufficient to maintain permanently a small
body of successful speculators; and the existence of this body of successful
speculators will be a sufficient attraction to secure a permanent supply of this
floating population. So long as the speculators differ in their own degree of
foresight, and so long as they are numerous, they need not prove successful in
forecasting events outside; they can live on each other.
But the traditional theory can also be criticised from another point of
view. It ignored the effect of speculation on the general level of activity-or
rather, it concentrated its attention on price-stability and assumed (implicitly
perhaps, rather than explicitly) that if speculation can be shown to exert a
stabilising influence upon price, it will ipsofacto have a stabilising influence on
activity. This, however, will only be true under certain special assumptions
regarding monetary management which are certainly not fulfilled in the real
world. In the absence of those assumptions,as will be shown below, speculation,
in so far as it succeeds in eliminating price fluctuations will, in many cases,
generate fluctuations in the level of incomes. Its stabilising influence on price
will be accompanied by a de-stabilising influence on activity. Hence the
question of the effect of speculation on price-stability and its effect on the
stability of employment ought to be treated, not as part of the same problem,
but as separate problems.
In the subsequent sections of this paper we shall deal first with the conditions under which speculation can take place, secondly, with the effect of
speculation on price-stability, and finally, with the influence of speculation on
economic stability in general.
1 Cf. Keynes. General Theory, ch. 12 on " Long Term Expectations."
" We have reached the
third degree [in the share markets] where we devote our intelligences to anticipating what average
opinion expects average opinion to be." (p. I56.)
have a yield, qua stocks, by enabling the producer to lay hands on them the
moment they are wanted and thus saving the cost and trouble of ordering
frequent deliveries, or of waiting for deliveries.' But the important difference
is that with this latter category, the amount of stock which can be thus
" useful " is, in given circumstances,strictly limited; their marginalyield falls
sharply with an increase in stock above " requirements" and may rise very
sharply with a reduction of stocks below " requirements."2When redundant
stocks exist, the marginal yield is zero.3 With the other category of goods,
items of fixed capital, the yield declines much more slowly with an increase in
stock, and it is normally always positive. Hence as we defined " speculative
stocks" as the excess of stocks over normal requirements (i.e. that part of
stocks which is only held in the expectation of a price-rise and would not be
held otherwise) we may say that with working-capital-goods (Verbrauchsgiiter)
carrying costs are likely to be positive, when speculative stocks are positive,
and negative when they are negative; with fixed-capital-goods (Gebraucchsgiiter), carrying costs are normally negative, irrespective of whether " speculative stocks" are positive or negative.
It would follow from this that fixed-capital-goodslike machinesorbuildings,
whose carrying cost is negative and invariant with respect to the size of
speculative stocks, ought to be much better objects of speculation than rawmaterials, whose carrying costs are so variable. The reason why they are not,
is because the condition of high standardisation,necessary for a perfect market,
is not satisfied, and hence the lag between buying price and selling price is
large. It is not that machines, etc., by being used, become " second-hand,"
and thereby lose value, since the depreciation due to use is already allowed
for in calculating their net yield. The reason is that all second-handmachines
are to some extent de-standardised; it is very difficult to conceive a perfect
market in such objects.4,5 The same lack of standardisation accounts for the
comparative absence of speculation in land and buildings.
This explains, I think, why in the real world there are only two classes
of assets which satisfy the conditions necessary for large-scalespeculation. The
first consists of certain raw-materials,dealt in at organisedproduce exchanges.
1 There is, of course, in addition, the stock of goods in the course of production (goods in
process) which depends on the length of the production process, but with this we are not here
concerned (since they are not standardised).
2 This, as we shall see below, is equally true of stocks of money, as of other commodities.
a Mr. Keynes, in the Treatise on Money, uses the term " working capital " for stocks which
have a positive yield, and " liquid capital " for those which have a zero yield. (Vol. II, pp.I30.)
4 I.e. the seller of a second-hand machine must not only allow for a reduction of value due to
depreciation, but also an extra loss due to the fact that he is selling the machine and not buying it.
5 Mr. Keynes, in certain parts of the General Theory, appears to use the term " liquidity " in
a sense which comes very close to our concept of " perfect marketability "; i.e. goods which can
be sold at any time for the same price, or nearly the same price, at which they can be bought. Yet
it is obvious that this attribute of goods is not the same thing as what Mr. Keynes really wants to
mean by " liquidity." Certain gilt-edged securities can be bought on the Stock Exchange at a
price which is only a small fraction higher than the price at which they can be sold; on this
definition, therefore, they would have to be regarded as highly liquid assets. In fact it is very
difficult to find satisfactory definition of what constitutes " liquidity "-a difficulty, I think,
which is inherent in the concept itself. As will be argued below, what appears to be the result of
a preference for " liquidity " may be explained as the consequence of certain speculative activities
in which " liquidity preference " in any positive sense, plays a very small part.
premium by r (all these are marginal terms) the current price, expected price
and forward price by CP, EP, and FP respectively, the following relations
must always be satisfied:
EP-CP=i+c+r
FP-CP=i+c,
hence FP=EP-r
If speculative stocks are zero, i.e. EP=CP, then -c=i+r, i.e. the negative
of carrying cost must be equal to the sum of interest cost and risk premium,
and since i and r are always positive, the carrying cost must be negative, i.e.
the yield must exceed the sum of storage cost and primary depreciationby the
required amount. In that case FP=CP-r, the forward price must fall short
of the current price by an amount which Mr. Keynes calls " normal backwardation.1
The above theory of the forwardmarket, which is taken from Mr. Keynes'
Treatiseon Money, is subject, however, to a certain qualification.2 The proposition that the forwardprice must fall short of the expected price by the amount
of the marginal risk premium, so that if the current price is expected to-remain
unchanged, the forwardprice must be below the spot price, is only necessarily
true if the " hedgers " are forward sellers and not forward buyers, and- the
" speculators "3 being forward buyers, are not current holders of stock. This
is probably true in the majority of markets; in the case of certain industrial
raw materials, however, where the outside buyers are contractors with given
orders for some period ahead, the " hedgers " may be predominantly forward
buyers, and the " speculators " spot buyers and forward sellers. Now the
" carrying cost " for these speculators may be higher than the carrying costs
for the market generally. This is because the yield of stocks of raw materials
(which in our definition is included in net carrying cost) consists of " convenience," the possibility of making use of them the moment they are wanted,
and this convenience is largely lost if the stock held is already sold forward.
Hence in markets of this type, there are two " carrying costs ": (i) those of
ordinary holders, which consist of the costs or storage and wastage, minus the
yield; (ii) those of forwardspeculators which consist of costs of storage and
wastage only.
Taking this into account, a generalisedtheory of the forwardmarket might
be set out as follows. If we write q for the marginal yield and c' for marginal
carrying costs proper, so that c = c'-q,
EP-CP
i+c'-q+r
In markets where the " hedgers" are forward sellers, or where the yield
consists of a money return which is not affected by forwardselling,
FP-CP
i+c'-q,
hence FP = EP-r
").
In markets where the " hedgers " are forwardbuyers and where the yield
consists of " convenience,"
FP-CP = i + c', hence FP = EP-r + q
Hence in such markets the forwardprice can exceed the expected price by
the amount by which the marginal yield to ordinary holders exceeds the
marginal risk premium. When redundant stocks exist (q=O) the forward
price must be below the expected price, in all cases.'
5. The elasticity of speculative stocks may be defined as the proportionate
change in the amount of speculative stocks held as a result of a given percentage
change in the differencebetween the current price and the expected price. This
elasticity will obviously depend on the variations in the terms i, c, and r, which
are associated with a change in speculative stocks, in other words on the
elasticity of marginal interest cost, marginal carrying cost, and the marginal
risk premium, with respect to a change in speculative commitments.
Of these three factors the marginal interest cost, as we have seen, may be
subject to discontinuousvariation if the " marginal speculator,"in a particular
market turns from a lender of money into a borrower,or vice versa, but apart
from this its elasticity is likely to be fairly high, if not infinite.2 The marginal
risk premium is normally rising, and its elasticity probably differs greatly
between different markets. The more numerous are speculators in a particular
market, and the more steady the price on the basis of past experience,3 the
higher this elasticity is likely to be. Finally, the marginal carrying cost, as we
have seen, can be assumed to be constant in the case of securities, while it will
rise sharply (at any rate over a certain range) in the case of raw materials and
primary products. Hence, taking all factors together, the elasticity of speculative stocks is likely to be much higher in the case of long-term securities than
in the case of raw-materials.
The higher the elasticity of speculative stocks, the greater the dependence
of the current price on the expected price. In the limiting case when this
elasticity is infinite, the current price may be said to be entirely determinedby
the expected price; changes in the conditions of non-speculative demand or
supply can then have no direct influence on the current price at all (since
1 In the case of bonds and shares, where the yield is a money return which is independent
of forward sale, the forward price ought always to be below the expected price. In the forward
transactions of the London Stock Exchange, however, the yield is credited to the forward buyer
(and not to the forward seller, who actually holds the stock), hence the forward price is equal to
the current price plus interest cost and there is a " contango," (Since in this case c'=O,
FP=EP-r+q=
CP?+i) " Backwardation" can only arise on the Stock Exchange if a fall in
price is expected, and this expected fall, on account of a shortage of stock for immediate delivery
which is known to be purely temporary, cannot be adequately reflected in the current price (e.g.
in the case of transatlantic stocks, when arbitrageurs run out of stock and have to wait for fresh
supplies to be sent across the Atlantic). It is always a sign, therefore, of the current price not
being in equilibrium in relation to the expected price.
2 In certain markets-such
as the market for long term bonds-the lending rate is normally
always relevant, and not the borrowing rate. In this case the elasticity of interest cost can be
taken as infinite.
3 In other words, the elasticity of the marginal risk premium is likely to vary inversely with
the amount of the risk premium. When the risk premium is low, its elasticity is also likely to be
high. Cf. ?IO, p.I5 below.
speculative stocks will immediately be so adjusted as to leave the price unchanged); any change in the current price must be the result of a change in
price-expectations.'
-e (X-I)
Since e cannot be negative, the expression is negative or positive according
as q is greater or less than I.
7. It is not possible, however, to express the behaviour of expectations at
any given moment in terms of a single elasticity. For what this elasticity will
be, on a particular day, will depend on the magnitude of the price-change on
that day, the price-history of previous days, and on whether the price expectation refers to next day, next month, or next year. This elasticity is thus likely
to be both large and small, at the same time, accordingas the price-changehas
been large or small, and accordingas the expectation refers to the near future
or the more distant future. It will vary, moreover, with the cause of the pricechange. For it is permissible to assume that in most markets speculators
regard price-changes merely as indicators of certain forces at work, and that
they attempt to form some idea as to the nature of these forces before adjusting
their expectations. A given change in price will react differently on speculators' expectations accordingas they regardit as the result of speculative forces,
or of " outside" demand or " outside " supply and so on.
If any generalisation can be made it is that expectations are likely to be
less elastic as regards the more distant future than as regards the near future,
and as regards larger changes in price than as regards smaller changes. These
two factors moreover are not independent of each other. For the expectations
as regards the more distant future are likely to be more and more influenced
by the speculators' idea as to the " normal price "-this " normal price " is
determined by different factors in different markets, but as we shall see below,
it is likely to function in most-and the largerthe deviation of the currentprtce
from the normal, the longermust the period be which speculatorsexpectto elapse
S
Io
The following owes much to Hicks, Value and Capital, pp. 270-2.
This period of adjustment varies, I believe, for different commodities from six months to
anything up to two years, though it is likely to be between six and twelve months in the majority
of cases. The case of rubber and tin, where the period is several years, is exceptional. But in
these last two cases, the short-period elasticity (through more or less intensive " tapping " or
" plucking ") is considerable.
8 For it is the level of money wages which governs money supply prices if the elasticity of
supply is high.
II
I2
I939, p. 350.
Industrial crops, such as cotton, have shown inthe past more violent price-fluctuationthan
e.ither foodstuffs or industrial raw-materials.
3 Valueand Capital,pp. I45. Cf. also Pigou, Industrial Fluctuations,pp. 230-2.
2
I3
Hence,
(I + RI)10
(i+R2)9
(i+R2)9
(I +rl)
(I+r2)(I+r3)
(i +r2)
i
* * (I+,0)
* * * (i+rIO)
Thus the expected long-term rate will exceed the current long-term rate if the current shortterm rate is below its expected average, and vice versa. (Cf. Hicks, op. cit., p. I52; also Hicks,
"Mr. Hawtrey on Bank Rate and the Long-Term Rate of Interest," Manchester School, I939.)
2 The current short rate is not dependent on the expected short rates, simply because the lifetime of short-term bills is much too short for expectations to have much influence. The expected
rate on bills next year can have no influence on determining the rate on a three-months' bill to-day;
while the expected rates for the next three months are very largely determined by the current rate.
It is only in exceptional circumstances that the market expects a definite change in the short-term
discount rates within the next few months. It is just because the elasticity of expectations for
very short periods is generally so near to unity, that the short-term interest market is largely
non-speculative.
Similarly, a change in the long-term rate (either the current or the expected rate) cannot
react back on the short-term rate except perhaps indirectly by causing a change in the level of
income and, hence, in the demand for cash. For, supposing the change in the long rate causes
speculators to sell long-term investments, this could only affect the short rate if they substituted
the holding of cash for the holding of long-term bonds; it cannot affect the short rate if the
substitution takes place in favour of short-term investments other than cash (savings deposits,
etc.). But there is no reason to expect, in normal circumstances at any rate, that the substitution
will be in favour of cash. "Idle balances"-i.e. that part of short-term holdings which the owner
does not require for transaction purposes-can be kept in forms such as savings deposits, which
offer the same advantages as cash (as far as the preservation of capital value is concerned) and
yield a return in addition. It is only when the short rate is so low that investment in savings
14
at all (or only to a very minor extent) but only on the current demand for
cash balances (for transaction purposes) and the current supply. And since
the elasticity of supply of cash with respect to the short-term rate, is normally
much larger than the elasticity of demand, the current short-term rate can be
treated simply as a datum, determined by the policy of the central bank.'
How is this related to Mr. Keynes' theory of the long-term rate of interest
being determined by liquidity-preference? It leads to much the same result
(i.e. that the rate, in the short period, is not determined by savings and investment) but the route by which it is reached is rather different. The insensitiveness of the long-term rate to " outside " influences (i.e. the supply and demand
for " savings ") is not due to any " liquidity premium " attached to money or
short-termbills; in fact, the notion of a " liquidity premium " appearsentirely
absent. It may be objected that it is merely replacedby the notion of a marginal
risk premium, and that Mr. Keynes' " liquidity premium" on the holding of
short-term assets is merely the negativeof our marginal risk premium on the
holding of long-term bonds. But in this case, the peculiar behaviour of the
long-term interest rate is certainly not explained by the existence of this riskpremium.2 For let us suppose that subjective expectations are quite certain,
so that this risk premium is completely absent. In this case the current
deposits is no longer considered worth while (see footnote below) that there can be a net substitution in favour of cash; but precisely in those circumstances the elasticity of substitution between
cash and savings deposits is likely to be so high that this cannot have any appreciable effect on
the short-term rate.
Thus, while the current short rate does determine the relation between the current long
rate and the expected long rate, this is not true the other way round.
1 The nature of the equilibrium in the short-term interest
market is shown in the accompanying diagram, wherethequantity
D
of cash is measured along Ox, the short-term interest rate along y
Oy. DD and SS stand for the demand and supply of money,
respectively. The demand curve is drawn on the assumption
that the volume of money transactions (i.e. the level of income)
is given. This demand curve is inelastic, since the marginal yield
\
of money declines fairly rapidly with an increase in the proportion
of the stock to turnover. Below a certain point (g) the demand
curve becomes elastic, however, since the holding of short-term
assets tother than money is always connected with some risk
q
q
(and, perhaps, inconvenience), and individuals will not invest
is
than
the
\
rate
lower
necessary
short term if the short-term
compensation for this. There is a certain minimum, therefore,
below which the short-term rate cannot fall, though this
X
(The dotted line shows
minimum might be very low.
what the demand curve would be if this risk were entirely
absent.) Hence, when the short-term rate is very low, it can be said to be determined by the
risk premium attaching to the holding of the safest short-term asset; otherwise it is determined
by the supply-price of money (i.e. banking policy) and changes in the short-term rate are best
regarded as due to shifts in this supply price. (The elasticity of the supply of money in a modem
bankingsystemis ensured partlyby the open market operations of the central bank, partly by the
commercial banks not holding to a strict reserve ratio in the face of fluctuation in the demand for
loans, and partly it is a consequence of the fact that under present banking practices a switch-over
from current deposits to savings deposits automatically reduces the amount of deposit money in
existence, and vice versa.)
2 Moreover, the long-term rate is never equal to this risk premium (or liquidity premium);
this only accounts for the difference between the long-term rate and the expected average of
short-term rates. Professor Hicks has calculated this risk premium to have been about I per cent
in Great Britain before the last war, and 2 per cent after the war (Manchester School, Vol. X,
No. I, p. 3I).
I5
i6
x7
i8
we shall assume that the monetary authorities maintain the short-term rate
of interest constant. In the last section we shall deal with the question of how
far the instabilities due to speculation can be counteracted if a different monetary policy is adopted.
I3. Before proceeding further we must introduce the distinction between
income goods " and " capital goods." There are certain categories of goods
though we must remember that in our case, it is not the character or the
destination of the goods which is at the basis of the distinction but simply
whether spontaneous changes in the amount of money spent on them imply
simultaneous changes in the total amount of expenditure or not.
I4. In the case of " income-goods " a change in speculative stocks, which
has a stabilising effect on price must exert a destabilising influence on the
level of economic activity, irrespective of whether the change was due to a
change in the conditions of demand or supply. For an increase in the demand
(a shift in the outside demand curve to the right) by causing a reduction in
speculative stocks, also entails a reduction in the level of incomes, since the
increase in the demand is associated with a reduction in the amount spent,
and thus of incomes earned, in the production of other things, without any
compensating increase in incomes earned in the particular commodity in
question. Conversely, a reduction in demand will involve an increase in the
level of incomes, for the same reason. An increase in supply on the other hand
(a shift in the outside supply curve to the right) will involve an increase in
speculative stocks and thus an increase in the level of incomes; a reduction
in supply a reduction in incomes. None of these changes in incomes could
have taken place in the absence of speculation; and the extent of the change
in incomes, following upon a given shift in supply or demand, will be the
1 Income saved is also spent on something in so far as it is spent on the purchase of securities
or other income-yielding assets. What we are assuming here, therefore, is that there is no attempt
to " hoard "; that changes in the disposition of incomes between the different lines of expenditure
do not involve changes in the demand for money.
2 This is the meaning of the word " spontaneous " in the above definition. If there is a change
in the amount spent as a result of a change in the level of incomes, there need not be, of course,
any reduction in the amount spent on other things.
I9
2o
2I
Equalisation Fund, the price of foreign exchange, and, hence, the price of
imported goods, behave in much the same manner as the prices of goods
stabilised by speculation. Hence, in addition to the "savings-investment
multiplier" there exists a "foreign trade multiplier," and the operation of
the latter must weaken the price-stabilising forces operating in the former
(and vice versa).
This can be best elucidated by an example. Let us suppose that for the
community as a whole, 25 per cent of additional income is saved, and that there
is an increase in the rate of long-term investment (financed through the sale
of securities) by L'million per week. This will immediately increase incomes
in the investment good industries by LI million and savings by ?250,000.
Thus, while in the first " week " the investment market was required to
furnish the whole of the additional expenditure of L'million out of its speculative funds, in the second week it only has to furnish three-quarters of that
amount; one quarter will be furnished through the additional savings.' If
we suppose that all the income which is not saved is spent on home-produced
goods, there will be a further increasein incomes by 750,000 in the second week,
and 562,500 in the third week, and so on.2 Similarly, the outside demand for
securities will expand by I87,500 in the third week, I40,625 in the fourth week,
and so on. As a result, after a certain number of " weeks," total incomes will
have expanded by ?4 millions per week, and total savings by L'million; the
outside demand for securities will ultimately have increased in the same rate
as the outside supply. The size of speculative commitments has increased, of
course, duringthis process,but this increasewill come to a halt once the increase
in outside demand has caught up with the increase in the rate of supply;
the contribution which the speculative resources of the market have to make
is limited. Provided that the total required increase in the size of speculative
stocks is not too large relatively to the resources of the market (i.e. provided
it does not impair the degree of price-stabilising influence) there will be no
pressure on the price of securities (i.e. no tendency for the rate of interest to
rise) either in the long run, or in the short run.
Let us suppose now, however, that not three-quarters,but only a half of
the marginal income is spent on home-producedgoods; and while 25 per cent
is saved, another 25 per cent is spent on additional imports. In that case the
" multiplier " will not be 4, but only 2 ; the ultimate increase in incomes,
following upon a Li million increase in the rate of investment, will be ?2
millions (per week) and of savings ?500,000. Hence, even after incomes have
been fully adjusted to the change in the level of investment the rate of outside
demand for securities will have only increased by one-half of the increase in
the rate of supply; if the rate of interest is to remain unchanged, speculators
will have to furnish ?500,000 per week, indefinitely.
It is true that in this case the increasein speculative stocks in the securities
market is attended by a decrease in stocks (of gold and foreign exchange) in
1 On the assumption, of course, that all increase in " genuine savings " is directed at the
purchase of long-term assets.
2 Abstracting from any involuntary reduction in stocks in the hands of retailers and wholesalers, which is purely temporary; this will merely delay adjustment, not prevent it.
22
(where S is the
mdY
nbtdY
marginal propensity to save). This, as we have seen, need not be the case.3
1 There will be an initial increase in the demand for short-term funds with the increase in
incomes; but provided this demand is satisfied by the banking system, no further contribution
is required to keep the short-term rate stable. The continuous increase in the short-term indebtedness of the speculators in securities will be exactly offset by the decrease in the short-term
borrowings of the foreign exchange market.
2 " The Ex-Ante Theory of the Rate of Interest," Economic Journal, December, I937,
p. 669.
3 Mr. Keynes' own proof of this proposition is that there must " always be exactly enough
ex-post saving to take up the ex-post investment and so release the finance which the latter had
been previously employing" (ibid., p. 669). Ex-post investment and ex-post saving will always
be equal if " ex-post investment " is so defined as to include consequential changes in stocks (in
our example, foreign exchange balances). But in order that the funds released through the reduction in stocks should be available for the finance of long-term investment somebody must perform
23
24
25
term credit.' But he argues that it is the business of the monetary authorities
to counteract such tendencies by appropriateadjustments of the bank rate.
There are, of course, serious practical difficulties confronting a policy of
this kind; the difficulty of determiningthe correct timing and the appropriate
magnitude of the changes that are required. For if the changes in the bank rate
are incorrectly timed, or if they are greater than necessary, the instrument of
the bank rate becomes a source of further instability and not a stabiliser.
But apart from these practical difficulties, there are also certain theoretical
limitations to the extent to which stability can be secured by monetary policy;
and the remaining part of this paper may be devoted to a discussion of some
of these limitations.
20. The instrument of the bank rate operates through its effect on the
amount of stocks held of commodities in general. Hence, if any particular
market becomes a source of inflation (i.e. begins to accumulate stocks) it is
never possible to eliminate the source of the disturbance directlythrough the
changes in the short-termrate; all that can be achieved is to offset the accumulation of stocks in the one market by enforcing a reduction in stocks held in
all the other markets. There is, of course, always some rate of interest which,
if enforced, would be sufficient to stop the inflationary tendency emanating
from any particular market. But unless this rate of interest is confined to
lenders and borrowers in that particular market, its effect would be clearly
deflationary; for in addition to preventing the accumulation of stocks in the
" inflationary" market, it would involve a decumulation of stocks in all the
others. Hence, the " appropriate" short-term rate (the one which leaves the
level of incomes unchanged) is one which balances the accumulation of stocks
by a decumulation elsewhere; not one which prevents it.
The effect of any change in the short rate of interest on activity is purely
temporary. It operates by causing an adjustment in the size of stocks to the
new interest rate; once stocks have been adjusted to the new rate, its effect
is exhausted. A 6 per cent bank rate, provided it has been in operation long
enough is no more " deflationary " than a 4 per cent rate or a 2 per cent rate
(apart from its effect on the long-term rate, which we shall discuss below).
It is not the absolute level of the short-term rate, therefore, but its change
from some previous level which acts as a stimulant (or the reverse). Hence,
if a particular market becomes the source of an inflationary tendency, and
continues to do so, even after the effect of the rise in the bank rate has exhausted
itself, a furtherrise in the bank rate becomesnecessary,and so on. An expanding
or contracting tendency in the level of incomes may not be counteracted,
therefore, by a single change of the bank rate, but only by a series of changes.
2I. The instrument of the bank rate is subject, moreover, to a great
constitutional weakness: it cannot operate equally freely in both directions.
It should always be possible to stop an expansion of activity by a rise in the
short-term rate of interest, whatever the strength of the forces of expansion.
1 Capital and Employment, p. 66. A Ce-nturyof Bank Rate, p. 38. He still regards the fluctuations in short-term investment as the prime mover of the Trade Cycle, and the inflationary (or
deflationary) influences emanating from the capital market as subsidiary. But he would concede,
I think, that this need not necessarily be the case.
:z6
As Mr. Hawtrey says: "If a rate of, say, 6 per cent were found to be negligible,
the rate could be raised indefinitely. No one would regard a rate of 6o per cent
as negligible." 1 But it is not equally possible to prevent a contraction of
activity through a reduction in the rate. For the rate can never be below zero ;
and as we have seen, there is a certain level, above zero, at which the power of
the monetary authorities to determine the rate (by varying the quantity of
money) ceases to function.2 In order that the bank rate mechanism should be
efficacious in the downward direction, as well as in the upward direction, its
averagelevel must be kept high so as to leave sufficient " elbow room " for
reductions, as well as increases. For if, after a period of stable activity, a
deflationary process develops, it is much easier to counteract it by monetary
measures if the short-term rate stood previously at IO per cent or 6 per cent
than if it stood at 4 per cent or 3 per cent. The effectiveness of a reduction
in the bank rate from 4 per cent to 2 per cent is no greater than that of a
reduction from IO per cent to 8 per cent; and so far, CentralBanks have never
found it practicable to reduce the officialrate of discount below 2 per cent.
We have seen above, that as far as the short-term rate of interest is concerned, it is the change in the rate and not its absolute level, which has an
influence on activity. Hence, if the average long-run level of the short-term
rate is kept at io per cent this is no more detrimental to activity than if the
average rate is 3 per cent. This is not so, however, when the effect on the longterm rate is taken into account. In the short period, as we have seen, changes
in the short-term rate have only a minor effect on the long-term rate, because
the latter depends on the averageof short-termrates expected over a long period
in the future,3 and this average is but little affected by the changes in the
current rate. But if the monetary authorities, in their long-period policy,
regulate the short-term rate in such a way as to keep its average level high,
then it is this average level which will come to be regardedas the " long period
normal " and thus govern the level of the long-term rate. If over considerable
periods in the past the monetary authorities varied the bank rate between
2 per cent and IO per cent and maintained it on the average at 6 per cent
(thus allowing for a 4 per cent elbow room in each direction) the long-term
rate will settle at a level which is above6 per cent.4 This in turn, by restricting
long-term investment, will have a considerably depressingeffect on the average
level of activity.
'A Century of Bank Rate, p. I95.
2 Cf. the diagram on p.
When the rate falls below the point g the demand for
I4 above.
cash balances becomes elastic and this makes further reductions in the rate difficult or impossible.
It is only when the short-term rate is at this point that " idle balances," in the sense of idle cash
balances, really exist; and it is only then that the short-term rate reflects " liquidity preference,"
in any significant sense. (When the rate is above this level, the marginal demand price for cash
is determined by the marginal yield of money-stocks in terms of convenience, and not by the risk
premium attached to alternative forms of investment.)
3 We need not suppose, of course, that people have any definite expectation as to what the
short-term rate is going to be at any particular date in the future, other than the immediate future.
If the theory depended on there being such a definite expectation, it would clearly be wrong.
But all that is necessary to suppose is that people have certain ideas as to what constitutes the
" normal" level of the short-term rate of interest, and that they consider deviations from this
normal level as temporary. Their idea as to the normal is based, of course, on past experience,
and reflects the average level which ruled over some period in the past.
' Ignoring the lag between the official discount rate and the market rates.
27
In the long run; therefore, the monetary authorities are not free to vary
the short-term rate as they like; if they want to maintain activity at a satisfactory level, they must keep the mean level of the short-term rate sufficiently
low so as to secure a long-term rate which permits a sufficient amount of longterm investment. Alternatively, if they want to secure stability by means of
monetary policy, they must allow the average level of employment to fall to
a low enough level to permit the mean level of the short-term rate to be sufficiently high. Thus the two main aims of monetary policy, to secure a satisfactory level of incomes, and to secure stability of incomes, may prove incompatible: the one may only be achieved by sacrificingthe other.
Assuming that the monetary authorities regard the achievement of a
satisfactory level of activity as their paramount consideration,we must expect
the bank rate mechanism, as an instrument of economic policy, to become
increasingly ineffectual. As real incomes increase, savings rise, and the available investment opportunities become smaller, the bank rate, though still
available for dealing with an occasional boom, becomes more and more ineffective as a safeguard against the ravages of deflation.
Mr. Hawtrey is well aware of this constitutional weakness of the bank
rate mechanism; and he calls the state of affairs where the mechanism is put
out of action through the bank rate having reached its minimum level, a
" credit deadlock." But he is too much inclined, I think, to attribute the
emergence of a " credit deadlock " to past mistakes in banking policy-to the
Central Bank not having lowered the rate sufficiently soon, or sufficiently
suddenly-rather than to the inherent causes connected with the long-term
rate.' If Professor Hicks' calculations are right,2 and 2 per cent is now to be
regarded as the necessary marginal risk premium by which the current longterm rate exceeds the average savings deposit rate, then a 3 per cent rate on
Consols presupposes a i per cent average on deposits; and a i per cent rate
on deposits is perilouslynear its absolute minimumlevel. If " full employment "
requires a long-term rate which is below 3 per cent, and this is what the
monetary authorities aim at, the "credit deadlock" becomes a more or less
permanent state of affairs.
In a world of perpetual or semi-perpetualcredit deadlock, stability cannot
be achieved by monetary policy (in the sense in which this term is ordinarily
understood); nor can fluctuations in the level of activity be regarded as a
" purely monetary phenomenon." For in those circumstancesmonetary factors
can neither be said to have caused the fluctuations, nor have they the power
to prevent them.
London.
NICHOLAsKALDOR.
1 This is because he is sceptical of any influence of the short-term rate on the long-term rate
(either the current short rate or the average of past short rates) and regards the two rates as
independently determined. But it is difficult to see how the long-term rate can remain below the
short-term rate, once the prevailing level of the short-term rate comes to be accepted as " normal."
The supply of long-term funds comes from savers, and why should savers place any money in
long-term investments if they expect a higher return on savings deposits ?
2 Manchester School, Vol. X, N. I, p. 3I.