John Hicks Liquidity - Sequential Choice

John Hicks Liquidity and Sequential Choice

In the area of monetary theory (perhaps more than any other area) Hicks has again attempted to extend and refine Keynes's analysis. He notes that Keynes's concentration on money and bonds (in the General Theory at least) had left a lot to be done. His recent contributions have concentrated on Keynes's motives for holding money, on the 'true' meaning of liquidity and on the sort of minimum financial structure that must be posited once Keynes's narrow money-bonds model is abandoned. All three are interrelated, e.g. the attempt to make headway with the liquidity concept dictates a certain type of .financial structure.

In the Two Triads (1967, Chaps. 1-3) Hicks ingeniously links together the transactions, precautionary and speculative motives with the three main functions of money - medium of exchange, store of value and measure of value. However, although his analysis was not entirely sound in this respect (see Harris, 1969) there is one part of the analysis to which he continues to hold, i.e. he insists that the transactions demand is not a voluntary demand to hold money - 'It is the money that is needed to circulate a certain quantity of goods at a particular level of prices'. The portfolio approach, which attempts to explain this demand in terms of voluntary choice theory, is therefore rejected by Hicks.
Moreover, the simple version of the portfolio theory is also rejected as a viable explanation of the other parts of Keynes's demand for money - the precautionary and speculative motives. Hicks rejects the portfolio approach because it is not sufficiently 'in time' and therefore does not adequately come to grips with the concept of liquidity.

For Hicks liquidity is concerned with the spectrum of (more or less liquid) assets. Liquidity preference is not concerned solely with the demand for money but with the movement along this spectrum of assets. The portfolio approach (for which Hicks had laid the foundations back in 1935) deals with a single choice -between what is known and what is unknown but where the latter is reduced to a probability. However, in Hicks's analysis liquidity is a property of a sequence of choices. The distinction is not simply between the known and the unknown but between what is known now and those things that may become known in the near future (with the passage of time). '[Liquidity] is concerned with the passage from the unknown to the known - with the knowledge that if we wait we can have more knowledge' (1973, pp. 38-9).

This point can be elaborated in terms of two decision points -Hicks calls them 'Christmas' and 'Easter'. A decision must first be made (say) at 'Christmas' on the basis of the possible eventualities as seen at that date; but only one of these will actually occur. However, between 'Christmas' and 'Easter' some of these possible eventualities will be ruled out by subsequent events. Choice at 'Easter' then depends crucially on which particular eventualities survive. Therefore it 'becomes relevant to the "Christmas" choice whether it carries with it a wide or a narrow band of "Easter" alternatives - whether, that is to say, the choice admits of flexibility' (Hicks, 1973, p. 41). Hicks insists that this extra dimension of risk bearing over time is ignored in the standard portfolio approach.

The flexibility referred to in this context should be seen in a market context, i.e. the ease with which it is possible to buy or sell existing assets. When transactors become 'locked-in' to their current holding of assets - because selling them would incur a capital loss - their flexibility of action is correspondingly reduced. Therefore a liquid asset is one that can be sold at short notice without loss - if an asset is not liquid, sale at short notice will often involve a loss in comparison with the price that could be obtained by waiting. Many assets, such as real capital assets, are very illiquid because there are few markets on which to resell them; other assets, such as bonds, are also illiquid because, although they are easily marketable, their price is highly unstable and therefore a quick sale may involve a loss. Holding imperfectly liquid assets therefore narrows the band of opportunities available at 'Easter'. However, it is outside the financial sector that the full implications of liquidity are likely to be found since the assets of the industrial sector are much more illiquid than those held by financial firms. This has important implications for the sort of financial structure with which economic models should be concerned.

For Hicks, the general concept of liquidity is concerned with the balance sheet of the decision maker -its liabilities and assets. For financial firms both their liabilities and assets are financial but for industrial firms only their liabilities are financial-their assets are real, and since there are few markets on which such assets can be sold, the concept of liquidity for industrial firms is much more problematic. However, at the boundary between the financial sector and the industrial sector that liquidity considerations are vital. Thus if the industrial sector can expand its holdings of real assets (i.e. the capital stock) without seriously impairing its liquidity, then an expansion is more likely to take place. Liquidity in this sense is a vital ingredient of economic growth (Hicks, 1979a, Chap. VII).