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8.10 Keynesian Uncertainty, Money and Explicit Money Contracts

Individuals in the real world must decide whether past experience provides a

useful guide to the future. Should one presume that economic processes are

uniform and consistent so that events are determined, either by ergodic

stochastic processes or at least by specified and completely ordered prospects?

Can the agent completely dismiss any fear of tragedy during the time

between choice and outcome? Does the agent believe he or she is ignorant

regarding the future? No rule can be specified in advance regarding how

individuals decide whether they are in an objective, a subjective, or a true

uncertainty environment. However, their perception will make a difference to

their behaviour.

Keynes laid great stress on the distinction between uncertainty and probability,

especially in relation to decisions involving the accumulation of wealth

and the possession of liquidity. The essence of his General Theory involves

liquidity preferences and animal spirits dominating real expenditure choices.

Money plays a unique role in ‘ruling the roost’ among all assets (Keynes,

1936, p. 223) and it is non-neutral in both the short and long run (Keynes,

1973a, pp. 408–11). These claims, as Keynes made clear in his 1937 restatement

(Keynes, 1973b, pp. 112, 114) of where he saw his general theory ‘most

clearly departing from previous theory’, rested on the clear distinction between

the ‘probability calculus’ and conditions of uncertainty when ‘there is

no scientific basis to form any calculable probability whatever. We simply do

not know.’

Liquidity and animal spirits are the driving forces behind Keynes’s analysis

of long-period underemployment equilibrium, even in a world of flexible

prices. Neither objective nor subjective probabilities suffice to understand the

role of non-neutral money and monetary policy in Keynes’s underemployment

equilibrium analysis. It is not surprising, therefore, that unemployment

still plagues most twenty-first-century economies, since most economists still

formulate policy guidelines which are only applicable to a limited domain

where agents choose ‘as if’ they had specific and completely ordered knowledge

about the future outcomes of their actions.

In Davidson (1978, 1982), I have shown that the existence of the societal

institution of legally enforceable forward contracts denominated in nominal

(not real!) terms creates a monetary environment that is not neutral, even in

the long run. These legal arrangements permit agents to protect themselves to

some extent against the unpredictable consequences of current decisions to

commit real resources towards production and investment activities of long

duration. Legal enforcement of fixed money contracts permits each party in a

contract to have sensible expectations that if the other party does not fulfil its

contractual obligation, the injured party is entitled to just compensation and

hence will not suffer a pecuniary loss. Tobin (1985, pp. 108–9) has written

that the existence of money ‘has always been an awkward problem for neoclassical

general equilibrium theory … [and] the alleged neutrality of money

… The application of this neutrality proposition to actual real world monetary

policies is a prime example of the fallacy of misplaced concreteness.’

Tobin then associates Keynes’s rejection of money neutrality presumption

with Keynes’s emphasis on ‘the essential unpredictability, even in a

probabilistic sense’ of the future (Tobin, 1985, pp. 112–13).

The social institution of money and the law of fixed money contracts

enables entrepreneurs and households to form sensible expectations regarding

cash flows (but not necessarily real outcomes) over time and hence cope

with the otherwise unknowable future. Contractual obligations fixed in

nominal terms provide assurance to the contracting parties that despite

uncertainty, they can at least determine future consequences in terms of

cash flows. Entering into fixed purchase and hiring contracts of long duration

limits nominal liabilities to what the entrepreneur believes his or her

liquidity position (often buttressed by credit commitments from a banker)

can survive. Entrepreneurs feeling the animal urge to action in the face of

uncertainty will not make any significant decisions involving real resource

commitments until they are sure of their liquidity position, so that they can

meet their contractual (transaction demand) cash outlays. Fixed forward

money contracts allow entrepreneurs (and households) to find an efficient

sequence for the use of and payment for resources in time-consuming

production and exchange processes.

Money, in an entrepreneur economy, is defined as the ‘means of contractual

settlement’. This implies that in the Post Keynesian monetary theory, the

civil law of contracts determines what is money in any law-abiding society.

In the first page of text in his Treatise on Money, Keynes (1930a, Vol. 1, p. 3)

reminds us that money comes into existence in association with contracts!

The possession of money, or any liquid asset (Davidson, 1982, p. 34), provides

liquidity (a liquid asset is one that is resaleable for money on a

well-organized, orderly spot market). Liquidity is defined as the ability to

meet one’s nominal contractual obligations when they come due. In an uncertain

world where liabilities are specified in terms of money, the holding of

money is a valuable choice (Keynes, 1936, pp. 236–7). Further, the banking

system’s ability to create ‘real bills’ to provide the liquidity to finance increases

in production flows is an essential expansionary element in the

operation of a (non-neutral) money production economy. If tight money

policies prevent some entrepreneurs from obtaining sufficient additional bank

money commitments at reasonable pecuniary cost, when managers (in the

aggregate) wish to expand their production flows (and the liquidity preference

of the public is unchanged), then some entrepreneurs will not be able to

meet their potential additional contractual payroll and materials-purchase

obligations before the additional output is produced and then profitably sold.

Accordingly, without the creation of additional bank money, entrepreneurs

will not be willing to sign additional hiring and material supply contracts and

long-run employment growth is stymied, even when entrepreneurs feel that

future effective demand is sufficient to warrant expansion. A shortage of

money can hold up the expansion of real output, despite expected profits!

Liquid assets also provide a safe haven for not committing one’s monetary

claims on resources when the threat of uncertainty becomes great, as in

Keynes’s discussion of precautionary and speculative motives. Keynes (1936)

claimed that the attribute of liquidity is only associated with durables that

possess ‘essential properties so that they are neither readily produced by

labour in the private sector nor easily substitutable, for liquidity purposes,

with goods produced by labour’.

When agents’ fear of the uncertain future increases their aggregate demand

for ‘waiting’ (even in the long run), agents will divert their earned income

claims from the purchase of the current products of industry to demanding

additional liquidity. Consequently, effective demand for labour in the private

sector declines. Only in an unpredictable (non-ergodic) environment does it

make sense to defer expenditures in this way, as opposed to spending all one’s

earnings on the various products of industry being traded in free markets.

This liquidity argument may appear to be similar to the view of general

equilibrium theorists like Grandmont and Laroque (1976), who stress an

option demand for money. However, in their model and many others, money

has an option value only because of very unrealistic assumptions elsewhere

in the model. For example, Grandmont and Laroque (1976) assume that (i) all

producible goods are non-storable; (ii) no financial system exists, which

means no borrowing and no spot markets for reselling securities; and (iii) fiat

money is the only durable and hence the only possible store of value which

can be carried over to the future. Of course, if durable producible and productive

goods existed (as they do in the real world) and outcomes associated with

holding producible durables were completely orderable, flexible spot and

forward prices would reflect the multiperiod consumption plans of individuals

and no ‘optimizing’ agent would hold fiat money as a store of value. Say’s

Law would be applicable, and the nominal quantity of money would be

neutral. Hence Grandmont and Laroque can achieve ‘temporary’ Keynesian

equilibrium via an option demand for money to hold over time only under the

most inane of circumstances. By contrast, Keynes allowed the demand to

hold money as a long-run store of value to coexist with the existence of

productive durables.

Another approach to liquidity is that of Kreps, whose analysis of ‘waiting’

(Kreps, 1988, p. 142) presumes that at some earlier future date each agent

will receive ‘information about which state prevails’ at a later future pay-off

date. Accordingly, waiting to receive information is only a short-run phenomenon;

long-run waiting behaviour is not optimal in the Kreps analysis –

unless the information is never received! The option to wait is normally

associated with a ‘preference for flexibility’ until sufficient information is

obtained. Although Kreps does not draw this implication, his framework

implies that if agents never receive the needed information and thus remain in

a state of true uncertainty, they will wait forever.

Keynes (1936, p. 210), on the other hand, insisted that decisions not to buy

products – to save – did ‘not necessitate a decision to have dinner or to buy a

pair of boots a week hence or a year hence or to consume any specified thing

at any specified date … It is not a substitution of future consumption demand

for current consumption demand – it is a net diminution of such demand.’ In

other words, neither Kreps’s waiting option nor the Grandmont and Laroque

option demand for money explain Keynes’s argument that there may be no

intertemporal substitution. In the long run, people may still want to stay

liquid and hence a long-run unemployment equilibrium can exist.

This argument has empirical support. Danziger et al. (1982–3, p. 210)

analysed microdata on consumption and incomes of the elderly and have

shown that ‘the elderly do not dissave to finance their consumption at retirement

… they spend less on consumption goods and services (save significantly

more) than the non-elderly at all levels of income. Moreover, the oldest of the

elderly save the most at given levels of income.’ These facts suggest that as

life becomes more truly uncertain with age, the elderly ‘wait’ more without

making a decision to spend their earned claims on resources. This behaviour

is irrational according to the life cycle hypothesis, inconsistent with the

Grandmont–Laroque option demand for waiting, and not compatible with

Kreps’s ‘waiting’ – unless one is willing to admit that even in the long run

‘information about which state will prevail’ may not exist, and these economic

decisions are made under a state of Keynesian uncertainty.

Probabilistic analysis of waiting and option value recognize only a need to

postpone spending over time. However, only Keynesian uncertainty provides

a basis for a long-run demand for liquidity and the possibility of long-run

underemployment equilibrium.