What are the criticisms of the liquidity preference theory?

Answer 1

The General Theory of Keynes is not a cohesive or integrated book in the matter of guidance as to what we should do in the sphere of interest. His broad approach is to identify the areas of its exploitative manifestations. He spells out fifteen reasons1 why it should be abolished, the most important of which are that unemployment must persist as long as interest stays,2 and that the remedy for inflation is also to lower the rate of interest3. Though this may perhaps be the most revolutionary contribution of Keynes, it so seriously threatens some of the fundamental postulates of economics that post-Keynesian economics has preferred to completely neglect this main thread which runs through the General Theory, and reaches its most unequivocal expression in his last chapter significantly entitled 'Concluding Notes on the Social Philosophy Towards Which the General Theory Might Lead', Section II pages 374-377.

A second posture which recurs in the book is one of doubt whether institutional and psychological factors will allow interest to fall to a level at which full employment can be attained. He therefore feels forced to regard a 'technical minimum' of around two percent as necessary.4

His third concern related to the issue of interest is the shortage of capital resources. He ponders over the reason as to why the world is 'so poor as it is in accumulated capital assets', and reaches the conclusion that it can be explained 'neither by the improvident propensities of mankind, nor even by the destruction of war, but by the high liquidity premium ... attaching to money'.5 This is the mental background, the intellectual concern, which gives birth to the concept of liquidity preference. On account of this concept, we reach the stage where a low rate of interest, say two percent, 'leaves more to fear than to hope'.6

What was the hope and what is the fear? The hope was that with every reduction of interest rate, the hazard of enterprise will fall and its profitability will rise, leading to expansion and deepening of all varieties of investment, with the consequence of going a long distance towards reducing unemployment, when interest falls to its 'technical minimum' of two percent.

Now what is the fear? The fear is that interest 'being the reward for parting with liquidity',7 at such a low rate of interest people may like to keep their saving uninvested. This being precisely the time for investment why should people like to keep their savings in a liquid form? He gives three considerations which may persuade them to stay liquid. He names them transactions motive, precautionary motive and speculative motive. Due to these considerations, the fear is that long before reducing interest to zero, even at two percent interest 'liquidity preference may become virtually absolute in the sense that almost every one prefers cash to holding a debt which yields so low a rate of interest'.8

If it could be established that at low rate of interest, people will literally prefer 'cash to holding a debt which yields so low a rate of interest', the theory will stand proved and the purpose of the theory fulfilled in explaining why the world is so short in capital resources. But that involves proving that people at two percent interest will start keeping their savings inside their mattresses or their pillows or create hidden hollows in the wall or under the floor to stack them. However much Keynes may have erred in the formulation of this theory, he stopped short of relying on the absurd conclusion of his logic. He therefore resiles from this preposterous position by first replacing the word 'money' in the place of liquid savings, and including 'time deposits with banks and, occasionally even such instruments as (e.g.) treasury bills'9 in his definition of liquid savings.

Now this is no ordinary twist of logic. This amounts to pulling out the entire foundation of the theory, after which the superstructure of the theory has no place to go to except falling flat. Once liquid saving goes to a bank, however much it may remain liquid for the depositor, it becomes a part of the social money stream, from which the borrowers can borrow, within the limits prescribed by the statutory reserve. As soon as savings are out of mattresses and pillows and into time deposits and treasury bills these cease to be a case in which people prefer 'cash to holding a debt which yields so low a rate of interest'.10 They have already unequivocally indicated their preference for 'holding a debt' to 'holding cash' and in so doing repudiated the theory.

How then do we explain the scarcity of capital, which Keynes wanted to elucidate with the help of this theory? The real point of contraction of capital resources is not the liquidity of saving but the bank reserve, which has nothing to do with the three motives spelled out by Keynes. It is this bank reserve, and this alone, which is a self-contrived arrangement for scarcity of capital. It is not the logic of Keynes remarkably bearing the stamp in this case of having been 'confounded by the touch of the Evil One'11 but the bias of economics which forces it to accord acceptance to this theory.12 It is the same bias which has compelled economics to give acceptance to every other theory of interest as well, although every one is as devoid of logic and of empirical support as liquidity preference theory happens to be.

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