Published in Economica in February 1935 (V2. No. 5, pp. 1-19), this paper presents an effort to reformulate the theory of money in terms of standard value theory. That is, it begins with the position that "...the relative value of two commodities depends upon their relative marginal utility..." (p. 2). He then provides this detailed justification for his approach (pp. 2-3):
And, as he points out (p. 3), one can read the development of liquidity preference theory in The General Theory as compatible with a choice theory approach (p. 3):
It was tried by Wicksell, and
though it led to int-eresting results, it did not lead to a marginal utility
theory of money. It was tried by Mises, and led to the conclusion that money is
a ghost of gold-because, so it appeared, money as such has no marginal
utility., The suggestion has a history, and its history is not encouraging.
This would be enough to frighten one off, were it not for two things.
Both in the theory of value and in the theory of money there- have been
developments in the twenty or thirty years
since Wicksell and Mises wrote. And these developments have considerably
reduced the barriers that blocked their way. In the theory of value, the work
of Pareto, Wicksteed, and their successors, has broadened and deepened our
whole conception of marginal utility.
We now realise that the marginal utility analysis is nothing else than a
general theory of choice, which is applicable whenever the choice is between
alternatives that are capable of quantitative expression. Now money is
obviously capable of quantitative expression, and therefore the objection that
money has no marginal utility must be wrong. People do choose to have money
rather than other things, and therefore, in the relevant sense, money must have
a marginal utility.
It emerges when Mr. Keynes begins to talk about the price-level of investment goods; when he shows that this price-level depends upon the relative preference of the investor-to hold bank-deposits or to hold securities. Here at last we have something which to a value theorist looks sensible and interesting! Here at last we have a choice at the margin! And Mr. Keynes goes on to put substance into our X, by his doctrine that the relative preference depends upon the " bearishness " or " bullishness " of the public, upon their relative desire for liquidity or profit.
What strikes me as I read his development of this point is the extent to which he actually anticipates the development of prospect theory (Richard Thaler and daniel Kahneman) in this passage (pp. 7-9):
Note that in these examples, the expected value of the return on an investment does not change, only the distributionof that value changes. If this is sufficient to cause people to hold more money (and less of financial assets), then the utility or value assigned to the risk of loss (or of a smaller gain) must be greater than the utility or value of the potential of a larger gain. And that is one of the major tenets of prospect theory.
Hicks then notes (pp. 9-10) that this assymetric risk can be dealt with by diversification (writing as he does before the advent of index funds, he suggests that risk diversificiation is much more difficult and expensive for small investors, and will be limited even for large investors). He suggests that one reason for the desire to hold money (a non-interest-earning asset), then, is the relative cost of holding interest earnings assets in a risk-reducing, diversified form. And (pp. 10-11)<
Where risk is present, the
particular expectation of a riskless situation is replaced by a band of
possibilities, each of which is considered more or less probable…
If, therefore, our individual, instead of knowing (or thinking he knows) that
he will not want his ₤100 till June 1st, becomes afflicted by increased
uncertainty; that is to say, while still thinking that June 1st is the most
likely date, he now thinks that it will be very possible that he will want it
before, although it is also very possible that he will not want it till after ;
what will be the effect on his conduct ?...With uncertainty introduced in the
way we have described, the investment now offers a chance of larger gain, but
it is offset by an equal chance of equivalent loss. In this situation, I think
we are justified in assuming that he will become less willing to under- take
If this is so, uncertainty of the period for which money is free will
ordinarily act as a deterrent to investment. It should be observed that
uncertainty may be increased, either by a change in objective facts on which
estimates are based, or in the psychology of the individual, if his temperament
changes in such a way as to make him less inclined to bear risks.
To turn now to the other uncertainty-uncertainty of the yield of investment.
Here again we have a penumbra; and here again we seem to be justified in
assuming that spreading of the penumbra, increased dispersion of the
possibilities of yield, will ordinarily be a deterrent to investment. Indeed,
without assuming this to be the normal case, it would be impossible to explain
some of the most obvious of the observed facts of the capital market. This sort
of risk, therefore, will ordinarily be
another factor tending to increase the demand for money…
So far the effect of risk seems fairly simple; an increase in the risk of
investment will act like a fall in the expected rate of net yield; an increase
in the uncertainty of future out- payments will act like a shortening of the
time which is expected to elapse before those out-payments; and all will
ordinarily tend to increase the demand for money...
One lesson here is that if safe assets are insufficiently available, the most likely response is that money holdings will increase, perhaps in unexpected quantities. Indeed, following the recent financial crisis, money (defined as M2) holdings has been growing at an average annual rate of 6.7% per year, well above its pre-crisis rate.
More on this larer, as I move through the analysis (this is one short, dense article.)
The appearance of such safe
investments will act as a substitute for money in one of its uses, and
therefore diminish the demand for money.
This particular function is performed, in a modern com- munity, not only by
banks, but also by insurance companies, investment trusts, and, to a certain
(perhaps small) extent, even by large concerns of other kinds, through their
prior charges. And, of course, to a very large extent indeed, it is performed
by government stock of various kinds.
Banks are simply the extreme case of this phenomenon they are enabled to go
further than other concerns in the creation of money substitutes, because the
security of their promises to pay is accepted generally enough for it to be
possible to make payments in those promises. Bank deposits are, therefore,
enabled to substitute money still further, because the cost of investment is
reduced by a general belief in the absence of risk.