Friday, July 25, 2014

Liquidity Preference and the Zero-Lower Bound versus the Liquidity Trap

Philip Pilkington has two excellent posts here:
Philip Pilkington, “Financial Markets in Keynesian Macroeconomic Theory 101,” Fixing the Economists, July 24, 2014.

Philip Pilkington, “Paul Krugman Does Not Understand the Liquidity Trap,’” Fixing the Economists, July 23, 2014.
The first deals with liquidity preference and the definition of “cash” as understood in financial market theory.

The second discusses the difference between the zero-lower bound versus the “liquidity trap” as defined by Keynes and the New Keynesians.

This is what Keynes had to say in the General Theory about the liquidity trap:
“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest” (Keynes 1964 [1936]: 207).
Keynes said that he knew “of no example of … [sc. the liquidity trap] hitherto.”

Paul Davidson explains the old neoclassical synthesis view of the liquidity trap:
“…Old Keynesians claimed that, at some low, but positive, interest rate, the demand curve for speculative money balances becomes infinitely elastic (horizontal). This horizontal segment of the speculative demand curve was designated the liquidity trap by Old Keynesians such as Paul Samuelson and James Tobin. These mainstream Old Keynesians made the liquidity trap the hallmark of what Samuelson labeled Neoclassical Synthesis Keynesianism. If the economy is enmeshed in the liquidity trap, then Old Keynesians argued that the Monetary Authority is powerless to lower the rate of interest to stimulate the economy no matter how much the central bank exogenously increased the supply of money. This view of the impotence of monetary policy was succinctly summarized in the motto ‘you can’t push on a string.’ The liquidity trap implied that monetary policy would be powerless to stimulate the economy if it fell into recession. These Old Keynesians, therefore, proclaimed that deficit spending fiscal policy was the only policy action available to pull an economy out of a recession. This faith in deficit spending as the only solution for recession became the policy theme for ‘Keynesians’, even though Keynes's speculative motive analysis denies the existence of a ‘liquidity trap’....

In the decade after the Second World War, econometricians searched in vain to demonstrate the existence of a liquidity trap (that is, a horizontal segment of the speculative demand for money) where monetary policy could not affect the interest rate.” (Davidson 2002: 95).
It seems that the liquidity trap as defined by Keynes is not something that an economy actually experiences.

There seems to be some confusion here.

If we go back to the crucial passage:
“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest” (Keynes 1964 [1936]: 207).
Some questions:
(1) what did Keynes mean by the “interest rate”? Did he mean the base rate, or the yield on long term debt, or interest rates in the broadest sense to include the base rate and yields on short and long term debt?

(2) what did Keynes mean by “cash”? Did he mean, as it apparently does in modern financial market theory,
(1) physical currency, such notes and coins in circulation;
(2) demand deposit and demand deposit-like accounts (checking accounts, transactions accounts, savings accounts);
(3) short-term, liquid money market funds, and
(4) short-term, liquid government bills/bonds?
Further Reading
Philip Pilkington, “What is a Liquidity Trap?,” Fixing the Economists, July 4, 2013.

BIBLIOGRAPHY
Davidson, P. 2002. Financial Markets, Money, and the Real World. Edward Elgar, Cheltenham.

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.

Thursday, July 24, 2014

Mutuum versus Bailment in Banking

From an early 19th century treatise on bailment law:
“In ordinary cases of deposits of money with banking corporations, or bankers, the transaction amounts to a mere loan or mutuum, and the bank is to restore, not the same money, but an equivalent sum, whenever it is demanded. But persons are sometimes in the habit of making, what is called, a special deposit of money or bills in a bank, where the specific money, as silver or gold coin, or bills, are to be restored, and not an equivalent. In such cases the transaction is a genuine deposit; and the banking company has no authority to use the money so deposited, but is bound to return it in individuo to the party.” (Story 1832: 66).
The two legal contracts here are as follows:
(1) mutuum (sometimes called faenus/fenus when interest was part of the contract [Buckland 1925: 273]) or loan for consumption, in which ownership of the thing lent is transferred from creditor to debtor, and only something of the same quality, type and quantity is repaid.

(2) depositum regulare or bailment (and also called special deposit), in which a person retains ownership of the thing given to another person for safekeeping.
These legal concepts go right back to ancient Roman law and were known in the Middle Ages.

Fractional reserve banking normally involves the mutuum contract (and a variant on the mutuum called the “irregular deposit” or depositum irregulare) and, when banking on fractional reserves became important in medieval and early modern Europe, this was the primary contract used between bankers and their clients, not that of bailment (even though no doubt such bailment contracts were made too).

This is confirmed by the evidence of some of the earliest British goldsmiths’ notes.

These must be understood as IOUs or negotiable credit/debt instruments payable on demand (though sometimes with receipt of the initial amount left with the banker), with the statement “I promise to repay upon demand ...,” which explicitly demonstrates to us that these were IOUs or debt records, not certificates of bailment (Selgin 2011: 11).

An early example of a goldsmiths note is one issued by the London banker Feild Whorwood in 1654. This is both a receipt for the sum delivered to the banker (but not a certificate of bailment) and, without any doubt, a promissory note:
“Recd [i.e., received], ye [the] 16th [December] 1654 of Sam Tofte the some [sum] of Twenty five pounds w[hi]ch I promise to repay upon Demand I say R[eceived]
P[er] me*
Feild Whorwood
interest of both £2-05-0.” (Melton 1986: 101).

* = by me.
The nature of the contract entered into by Sam Tofte (the holder of the bank account) and the banker Feild Whorwood is made perfectly clear to us by the words of the banker: “I promise to repay upon Demand ....”

This was a receipt of money to the banker given by Sam Tofte as a loan or mutuum, and one re-payable on demand, with interest. It was no bailment contract.

The idea that the earliest goldsmiths were only engaged in bailment and that fractional reserve banking simply arose by fraud is not supported by the historical evidence.

BIBLIOGRAPHY
Buckland, W. W. 1925. A Manual of Roman Private Law. Cambridge University Press, Cambridge.

Melton, Frank T. 1986. Sir Robert Clayton and the Origins of English Deposit Banking, 1658–1685. Cambridge University Press, Cambridge.

Selgin, G. “Those Dishonest Goldsmiths,” revised January 20, 2011
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589709

Story, Joseph. 1832. Commentaries on the Law of Bailments, with Illustrations from the Civil and the Foreign Law. Hilliard and Brown, Cambridge.