Brad de Long, Professor of Economics, University of California, Berkeley, has a blog on ‘natural rates of interest’: Cracking the Hard Shell of the Macroeconomic Knut: “Keynesian”, “Friedmanite”, and “Wicksellian” Epistemes in Macroeconomics.
In commenting on the debate around the ‘natural rate’ DeLong writes:
“Keynes devoted a great deal of effort to knocking down the natural rate of interest…” Indeed he did Keynes saw the natural rate of interest as part of a wrong loanable-funds theory of interest rates: that, given the level of spending Y, supply-and-demand for bonds determined the interest rate. Keynes thought that people must reject that wrong theory before they could adopt what he saw as the right, liquidity-preference, theory of interest rates: that, given the level of spending Y and the speculative demand for money S, supply-and-demand for money determined the interest rate.
“I think Keynes was wrong. I think Keynes made an analytical mistake.
“Hicks (1937) established that Keynes was wrong when he believed that you had to choose. You don’t. Because spending Y is not given but is rather jointly determined with the interest rate, you can do both. Indeed, you have to do both. Liquidity-preference without loanable-funds is just one blade of the scissors: it cannot tell you what the interest rate is. And loanable-funds without liquidity-preference is just the other blade of the scissors: it, too, cannot tell you what the interest rate is. You need both.
“More important, however, in thinking about our present concern with the natural (“neutral”) (“equilibrium”) real rate of interest is knowledge of the historical path by which we arrived at our current intellectual situation.”
In denying liquidity preference, DeLong denies Keynes.
According to conventional wisdom Keynes’s economics was reproduced in a more accessible and tractable form as ‘Keynesian Economics’ by John Hicks and Alvin Hansen.
A chink in the armour that has generally been avoided in textbooks is that Hicks had simply rejected Keynes’s liquidity preference theory.
He put forward convoluted arguments that liquidity preference could basically be set aside and replaced by the loanable funds interpretation that underpinned IS-LM.
Keynes himself rejected these arguments as ‘fundamental heresy’. Generations of post-Keynesian economists subsequently did likewise.
The revival of debates around the rate of interest is inevitably and justly drawing attention to this sleight of hand. In Bradford DeLong’s piece he seeks to defend ‘Keynesians’ by re-asserting the Hicks formula.
Apart from ignoring the rival arguments, he also does not recognise the high stakes of this sleight of hand.
As repeatedly argued on our site Policy Research in Macroeconomics (PRIME) (see e.g. here: ‘An Appeal to the Bank of England: The ‘rate of interest’ has not been low”), liquidity preference was the cornerstone of the General Theory. The possibilities for prosperity and stability turned on the ability of the authorities to take control and reduce the long rate of interest, an action permitted by liquidity preference but not by loanable funds.
And with these policy conclusions recognised, the immense implications of the denial of liquidity preference are revealed. This must be understood. On this basis, ‘Keynesian economics’ is an entirely different theory to Keynes’s own.