Money, a substitute for confidence? Vaughan to Keynes and beyond

American Journal of Economics and Sociology, The, April, 1999 by Franz Ritzmann

I

Risk, Uncertainty, and Money

Since the times of aristotle, three cardinal functions are usually attributed to money: Money as a measure of value, money as a means of exchange, and money as a store of value. While the first two functions are usually regarded as very useful, the latter often arouses suspicion, if not plain condemnation. Accumulating barren money for its own sake is, according to Aristotle and his medieval followers, is the essence of "chrematistics," i.e., of insatiable greed for boundless wealth. It is definitely against nature as well. Karl Marx, with an explicit reference to Aristotle, stigmatized the abuse of trading commodities for mere money-making as alienation of money becoming capital by his famous formula of capitalistic exploitation: G-W-G'. In 1936, John Maynard Keynes wrote: "Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity."(2)

Despite innumerable denouncements of hoarding as foolish and destructive, people of all times continued to hoard money, whenever they found it appropriate to do so. This raises the question about the appropriateness of hoarding. It is easy to understand that money by spending gets the utility of the commodities it buys, and, moreover, that it may reduce costs of transactions and information in trade. Money "is none of the wheels of trade; It is the oil which renders the motion of the wheels more smooth and easy."(3) What, however, is the usefulness of money not spent, but hoarded?

The oldest answer to that question refers to intertemporal optimization: Liquid assets bridge the gap between present income and future spending. But if money bears no interest and if there exists at the same time a market for earning liquid assets, "why should anyone outside a lunatic asylum wish to use money as a store of wealth?"(4)

The reason lies in the uncertainty of the future, against which money may offer some kind of insurance. In a stochastic world money can reduce measurable risks, even if it will never be spent. To this property, although recognized very early, it must have been difficult to give a precise meaning, since its formal analysis started rather late. Two strands of thought developed: one in a flow and the other in a stock approach. Flow models - which originated with Edgeworth (1888) and were rediscovered by Orr and Mellon (1961) - determine the optimal volume of precautionary balances by weighing its opportunity costs against the expected value of illiquidity costs due to the stochastic flows of payments. The stock approach, suggested first by Hicks (1935) and formalized by Markowitz (1952) and Tobin (1958), treats money as an instrument to reduce the expected variance of stochastically fluctuating asset prices. Both approaches, cash management as well as portfolio selection, are based on objective or subjective known probabilities, allowing thus the reduction of multivalued into bi-valued (mean, variance) expectations.

Besides uncertain expectations of future price movements or money flows, we may distinguish a third kind of uncertainty: distrust of the willingness or the ability of the trading partners to observe commercial rules, or even of the rules themselves. Especially in the latter case, it may not be possible to compute objective or subjective probabilities - or, if they could so, they may be irrelevant to economic decisions. Since Knight (1921), we got accustomed to call the consciousness of such a situation "pure uncertainty," well distinguished from measurable and insurable "risk."

Risk is managed by various traditional techniques: insurance, substitution by certainty-equivalents, maximin-strategies, observance of "expert" advice, holdings of conventionally "reasonable" reserves (including money) for emergency, etc. With pure uncertainty, however, the situation turns dramatic. Since the frame of reference for forming expectations has lost its reliability, confidence in expectations themselves vanishes, and the degree of uncertainty jumps up vigorously. In economic affairs, however, it hardly happens that all expectations lose their significance at once; some, at least, still rest to be trusted in. One of them is the belief in the exceptional and transitory nature of such a disturbing situation, which implies cautious waiting as an appropriate strategy. Another one is the common conviction that even in a general crisis of confidence, some fundamental market rules will still survive, that, whatever happens, some kind of money (e.g., gold or silver) will always be accepted by the anonymous market. If you distrust your partner, you will insist on cash; if you distrust your bank, you will dissolve your account; if you distrust the central bank and the government, you will change your notes for precious metals. A breakdown of the state of confidence, therefore, is likely to increase the demand for liquid assets and especially for "safe" money as a reliable means to make waiting possible. In the following, I try to trace the development of this theory from its origin to the present.