Journal of Post Keynesian Economics

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On the nature and role of financial systems in

Keynes’s entrepreneurial economies

Fernando J. Cardim de Carvalho

To cite this article: Fernando J. Cardim de Carvalho (2016) On the nature and role of financial
systems in Keynes’s entrepreneurial economies, Journal of Post Keynesian Economics, 39:3,
287-307, DOI: 10.1080/01603477.2016.1190282

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JOURNAL OF POST KEYNESIAN ECONOMICS
2016, VOL. 39, NO. 3, 287–307
http://dx.doi.org/10.1080/01603477.2016.1190282

On the nature and role of financial systems in Keynes’s

entrepreneurial economies
Fernando J. Cardim de Carvalho

ABSTRACT KEYWORDS
In his debate with Bertil Ohlin, Keynes observed that Entrepreneurial economies;
entrepreneurs, when deciding to invest, have to be sure they financial systems; Keynes’s
will access the amount of finance necessary to initiate the economics; liquidity
preference
investment process and that they will be able, when the time
comes, to fund their debts in ways that are adequate to the JEL CLASSIFICATIONS:
profile of assets they are purchasing. In this statement, Keynes E02; E12; E44
outlines the functions of financial systems in Entrepreneurial
Economies, the type of economies he hypothesizes we live in. In
entrepreneurial economies, investing firms have to be able to
get hold of the necessary amount of means of payment
required to purchase or order investment goods and to build
balance sheets where in- and outflows of cash are broadly
matched within reasonable margins of safety. This means that
financial systems’ primary role in Keynesian economics is not to
allocate savings or capital but to allocate liquidity and to allow
investors to build liquid balance sheets. The article develops this
proposition, presenting Keynes’s basic concepts on the matter
and showing how modern financial systems perform their role.

In a paper published in 1937, one of his only three replies to the critics of The
General Theory of Employment, Interest and Money (hereafter GT), Keynes sta-
ted that the book presented two main theoretical innovations. One of them was
the twin concepts of propensity to consume and the consumption multiplier,
which Keynes stated to be essential to refute Say’s law. The other sprang from
the role of money in modern capitalism (Moggridge, 1973, pp. 109–123).
Keynes’s own words, however, did not seem to have caused too much of an
impression on most of his readers. Some among his best-known followers,
which Paul Samuelson christened the neoclassical synthesis (NCS),
interpreted the GT as a fiscalist manifesto. In their view, Keynes had given
new fancy names to old concepts (e.g., calling money demand “liquidity
preference”), but only the concept of liquidity trap, a situation in which
monetary policy was powerless to influence aggregate demand behavior,
was considered to be a true innovation.1
Fernando J. Cardim de Carvalho is a senior research scholar, Levy Economics Institute of Bard College and emeritus
professor of economics at the Institute of Economics, Federal University of Rio de Janeiro (Brazil). The author thanks,
without implicating, Jan Kregel for his observations on an earlier version of the article and an anonymous referee.
Financial support from the National Research Council (CNPq) is gratefully acknowledged.
1
It was, of course, the dominance of the NCS among macroeconomists for many years that allowed Milton Friedman
later to lead the monetarist counterrevolution with the motto “Money Matters!”.
© 2016 Taylor & Francis
288 F. J. CARDIM DE CARVALHO

Important nonorthodox economists among Keynes’s followers, however, also

considered his emphasis on the role of money misguided. Kaldor (1985)
explained it as a result of Keynes’s lingering attachment to the obsolete theories
he learned as a student. Others before him, such as Abba Lerner (1949) and
John Hicks in 1937, considered that Keynes’s effort to distinguish his liquidity
preference theory, with its emphasis on money, from Bertil Ohlin’s and others’
loanable funds theories, which emphasize credit, was a mistake, stating that both
theories are in fact complementary, a view that became widely shared.
The debate between Keynes and Ohlin is our starting point in this article.2
It began when Ohlin criticized Keynes’s theory of determination of the inter-
est rate by the interaction between supply of and demand for money. Ohlin
introduced the arguments of the Stockholm School, heir to Wicksell’s views,3
according to which the interest rate was determined by the supply of and
demand for credit. In his reply, Keynes reaffirmed the theory outlined in
the GT. The discussion lasted for a few more rounds, including one that
was published in a different journal only some decades later (Ohlin, 1981).
Judging by the theoretical developments that followed it, one can hardly
escape the conclusion that Keynes was anything but successful in convincing
even friendly readers of the validity of his views.
Keynes’s difficulties in elaborating his arguments sprang from the innova-
tive nature of his approach to the relationship between money, credit, finance,
and saving. The theory he proposed was not only very complex but also, at
least to some extent, counterintuitive. Loanable funds theories, in contrast,
are based on two intuitive notions: (1) an interest rate is what you pay when
you borrow money, and (2) for somebody to lend money it is necessary first to
have earned it and refrained from spending it, that is, to have saved it. One
can develop the theory to deal with more complex situations, such as one
in which one lends indirectly to a borrower, through a financial intermediary.
It should thus be hardly surprising that the loanable funds approach pre-
vailed as it did. After influential authors such as John Hicks and Abba Lerner
argued that liquidity preference and loanable funds theories were not really
opposed, as Keynes had thought, no major obstacle remained to the complete
absorption of Keynesian theories into the loanable-theory family of
approaches.4 The Keynesian theory of the interest rate, and its macroeco-
nomic implications, was believed from that point onwards to consist in two
propositions. First, the loanable theory of determination of the interest rate
2
Keynes’s side of the debate is reproduced in volume 14 of his Collected Writings. Ohlin’s contributions were pub-
lished in the March, June, and September 1937 issues of the Economic Journal.
3
The Stockholm School included Scandinavian economists who modernized Wicksell’s theories, such as, notably, Erik
Lindahl, Gunnar Myrdal, and Bertil Ohlin.
4
Two examples should suffice to illustrate the point. Blinder (1989) contained a chapter intended to “take issue with
some fashionable views of why money has real effects, and to suggest a new theory, or rather resurrect an old one
—the loanable funds theory” (p. 17). Stiglitz and Greenwald (2003) state “the theory that we develop can be
thought of as a generalization of the loanable funds theory” (p. 45). In both cases, the authors were advancing
what they judged to be the ‘Keynesian’ view.
 JOURNAL OF POST KEYNESIAN ECONOMICS 289

by the interaction between supply and demand for credit. Secondly, the idea
that while ex post investment was always equal to ex post savings, it was the
difference between ex ante (or planned) investment and ex ante (or planned)
saving that really mattered in analyzing macroeconomic behavior. Nothing
could be more ironic, since Keynes had strenuously fought both propositions
in his exchange with Ohlin.
Particularly influential in the modified Keynesian macroeconomics was
Gurley and Shaw’s (1955) formulation where savers and investors were
redefined as surplus and deficit units, further concealing, whether the authors
intended it or not, the “classical”5 premises on which the approach actually
relied. Gurley and Shaw’s ideas were incorporated into Keynesian models
mainly by Tobin (1963). A whole body of financial systems theory was built
on these foundations to explain how financial institutions and markets could
improve the conditions under which resources were to be transferred from
surplus units (those with incomes that exceeded planned expenditures) to
deficit units (those planning to spend more than they earned).
In contrast to the “Keynesian” consensus just described, Keynes’s liquidity
preference theory of interest rates implied a completely different view of the
nature and role of financial systems. Financial institutions and markets do not
intermediate either capital, or savings or excess income over expenditures,6
either directly or indirectly. Financial systems in Keynes’s theory deal with
liquidity, and liquidity has nothing whatsoever to do with saving. This article
intends to discuss what this statement means and what it implies.

Fundamental concepts
Keynes got personally involved in just a few published theoretical debates in the
years that followed the publication of The General Theory. The most extended
exchange with his critics was the debate with Ohlin (which also included,
mostly indirectly, Robertson and Hawtrey among others) in the pages of the
Economic Journal in 1937. Ohlin objected to Keynes’s statement that the interest
rate was determined in the money market, proposing instead that the interest
rate was the price of credit. Keynes strongly rejected this view. In the attempt
to clarify his reasoning, he not only tried to rephrase some of his ideas but
he also ventured into areas that had not in fact been touched in the GT.
In a nutshell, Ohlin defended the “Stockholm School” view that the interest
rate was not the price of liquidity but the price of credit and therefore it was not
determined in the market for stocks of liquid wealth but in the market of credit
5
“Classical” in the sense used by Keynes in the GT.
6
Gurley and Shaw’s surplus and deficit units are not the same thing as savers and investors because the value of
savings that is spent on investment by savers themselves is included in the amount of savings but is not included
in Gurley and Shaw’s surplus. Surplus and deficits are defined in terms of external resources, that is, of what
remains after surplus units spend in consumption and investment, and deficit units need to spend in consumption
and investment.
290 F. J. CARDIM DE CARVALHO

flows instead. The demand for credit was assumed to represent mostly the needs
of those who wished to invest but did not possess the means to do it, while the
supply of credit was supposed to come from savers, either directly or through
financial intermediation using the deposits they made at the banks. Ohlin
accepted what he judged to be Keynes’s point in the GT about the necessary
equality between saving and investment, but defended the idea that only ex post
investment was necessarily equal to ex post saving. Intended investment, in con-
trast, was the source of the demand for credit, while the supply of credit resulted
from intended savings. Intended savings and investment were not necessarily
equal and, thus, the supply of credit was not necessarily equal to the demand
for credit. They were made equal by movements of the interest rate.
Keynes rejected Ohlin’s view of the role of intended savings right away. He
himself had tried previously to work with a concept of intended savings, in his
Treatise on Money, and failed. Based on his own attempts to work with those
ideas, Keynes objected to Ohlin that the concept of intended savings suffered
from two shortcomings: (1) it was not clear whether it meant the amount of sav-
ings someone wanted to make in the future or the proportion of expected income
one would save in the future;7 (2) while intended investment did cause prospec-
tive investors to act in the present moment in some definite and observable ways,
intended saving was just an intention, something somebody would wish to do in
the future, but that had no impact on the current supply of credit. One cannot
lend or deposit in the bank the savings one intends to make in the future.8
Having admitted that intended investment could have an impact on the
interest rate, Keynes proceeded to argue that this did not change the basic
argument of the GT in any essential way.9 The reason that no change in
liquidity preference theory was required was that intended investment did
not create a new demand for credit per se, as suggested by Ohlin. Instead,
7
Keynes tried unsuccessfully to work with the difference between actual and expected incomes in the Treatise by
considering the possibility of windfall profits and losses. The point may seem trivial at first sight, but it relates
to a larger concern, how to deal with expectations and, even trickier, how to deal with disappointed expectations.
8
“Now, ex-ante investment is an important, genuine phenomenon, inasmuch as decisions have to be taken and credit
or ‘finance’ provided well in advance of the actual process of investment; though the amount of the preliminary
credit demanded is not necessarily equal to the amount of investment which is projected. There is, however, no
such necessity for individuals to decide, contemporaneously with the investment-decisions of the entrepreneurs,
how much of their future income they are going to save. To begin with, they do not know what their incomes
are going to be, especially if they arise out of profit. But even if they form some preliminary opinion on the matter,
in the first place they are under no necessity to make a definite decision (as the investors have to do), in the second
place they do not make it at the same time, and in the third place they most undoubtedly do not, as a rule, deplete
their existing cash well ahead of their receiving the incomes out of which they propose to save, so as to oblige the
investors with ‘finance’ at the date when the latter require to be arranging it. Finally, even if they were prepared to
borrow against their prospective savings, additional cash could not become available in this way except as a result
of a change of banking policy. Surely nothing is more certain than that the credit or ‘finance’ required by ex-ante
investment is not mainly supplied by ex-ante saving” (Keynes, 1937b, pp. 663–664).
9
Keynes certainly did not convince Robertson, who saw in the demand for finance “a far longer stride back than he
yet realizes towards the orthodox view” (Robertson, 1988, p. 12). Hicks, in his famous 1937 article, “Mr Keynes and
the Classics,” had already concluded that Keynes had taken “a big step back to Marshallian orthodoxy” with the
simple recognition of the role of money as a means of payment (Hicks, 1967, p. 134). Robertson and Hicks appar-
ently shared the same view, that “Mr Keynes was so taken up with the fact that people sometimes acquire money
in order to hold it that he had apparently all but entirely forgotten the more familiar fact that they often acquire it
in order to use it” (Robertson, 1988, p. 12).
 JOURNAL OF POST KEYNESIAN ECONOMICS 291

it represented a new source of demand for money, to be dealt with by

introducing a fourth motive to demand money, the finance motive, in addition
to the transactions, precautionary and speculative motives described in the
GT: “an investment decision (Prof. Ohlin’s investment ex-ante) may
sometimes involve a temporary demand for money before it is carried out,
quite distinct from the demand for active balances which will arise as a result
of the investment activity whilst it is going on” (Keynes, 1937a, p. 246).
The finance motive to demand money created some additional pressure on
the pool of money available to circulate goods, services, and financial assets.
In itself, the finance motive shares the same nature of the transactions motive:
it refers to the amount of money one demands in advance of a purchase of a
good or service. If one intends to buy some commodity on a given date, one
has to get hold of the means of payment required to pay for that commodity
in advance of the moment to settle the deal. The transactions motive to get
hold of money described in the GT dealt with routine operations. It was
supposed to be determined mostly by institutional factors such as contractual
settlement dates, payroll payment dates, and so on.10 Investment, on the other
hand, is not a routine expenditure and would not follow the regular pattern
that the transactions motive was supposed to follow (described by a relatively
stable specific velocity of circulation). As a discretionary expenditure,
investment fluctuates in patterns that required a specific metric to describe.
That was why Keynes decided to propose a fourth motive to demand money.
Statistically, the distinction between the various motives to hold money is
expressed in the assignment of a specific velocity of circulation for each class
of operation.11 The finance motive to hold money was singled out because it
behaved in a different way in comparison with the other three motives.
Keynes therefore concluded that considering the influence of planned
(or intended or ex ante) investment on the interest rate could be done entirely
within the framework of his liquidity preference theory. Facing a new motive
to hold money, an economy’s supply of liquidity has to accommodate all
demands, wherever they come from. If the supply of money is not sufficient
to accommodate the demand for money to hold either in anticipation of
planned expenditures (for the transactions, speculative and finance motives)
or as an insurance against an uncertain future (the precautionary demand
for money), the interest rate will rise. The finance demand for money
improved the degree of fineness of the model, not its substance:
Now, a pressure to secure more finance than usual may easily affect the rate of
interest through its influence on the demand for money; and unless the banking

10
Keynes made the distinction between the finance motive and “the demand for active balances which will arise as a
result of the investment activity whilst it is going on,” which is precisely the increase in the transactions demand
for money induced by the investment activity.
11
One should note that using the velocity of circulation in this sense does not imply giving any causative influence
to this variable. It is an index describing a certain pattern of motion, not necessarily an explanatory variable.
292 F. J. CARDIM DE CARVALHO

system is prepared to augment the supply of money, lack of finance may prove an
important obstacle to more than a certain amount of investment decisions being on
the tapis at the same time. (Keynes, 1937a, p. 247)

The term finance, however, was misunderstood by Ohlin (and in fact by most
of Keynes’s readers). The most accepted meaning of “finance” among
economists and noneconomists alike refers to a debt-increasing operation
in which someone gets access to means of payment owned by somebody else.
Keynes, however, used the word with a different meaning. Calling attention to
the use of the term credit by Ohlin, Keynes observed:
Prof. Ohlin means by “credit” the total supply of loans from all sources. But other
writers mean by it the supply of bank loans. Now, although changes in the quantity
of bank loans may, subject to certain conditions, be equal to the changes in the
quantity of bank money, the resemblance of this also to my theory would be only
superficial. For it is concerned with changes in the demand for bank borrowing,
whereas I am concerned with changes in the demand for money; and those who
desire to hold money only overlap partially and temporarily with those who desire
to be in debt to the banks. (Keynes, 1937a, pp. 245–246, emphasis added)

Thus, the finance motive has to do with the use of money, not with the issuance
of debt, even if this particular class of money demand is to be satisfied by the
creation of money through credit creation by banks. Keynes’s point was rela-
tively simple: if somebody plans to spend money acquiring a class of goods
that happens to be called investment goods, this person has to get hold of
money in advance of this expenditure, just as it would be the case if one
wanted to buy candy or clothes. If monetary circulation cannot accommodate
these additional demands for money (regardless of whether to buy investment
goods or to buy candy), liquidity will be scarce and the interest rate will rise as
a result.12 We will explore this notion in the next section, but it seems that
Ohlin misinterpreted the meaning of finance in Keynes’s usage and seemed
to believe that Keynes’s term, finance, and his own term, credit, meant the
same thing: borrowing from banks.13 Because of this confusion, the focus
of the discussion changed from the ways planned investment could have an
impact on the interest rate to the conditions in which investment can be made
viable in financial terms.

12
The role of the interest rate in Keynes’s view is precisely to change prices of nonmonetary assets, that is, interest
rates, to make the demand for money equal to the supply of money: “The function of the rate of interest is to
modify the money-prices of other capital assets in such a way as to equalise the attraction of holding them
and of holding cash” (Keynes, 1937a, p. 250).
13
Keynes’s inability to stick to his own labeling may have helped to confuse Ohlin and others. At one point in the
debate, Keynes used the term credit to mean the demand for money: “In what follows I use the term “finance” to
mean the credit required in the interval between planning and execution” (Keynes, 1937b, p. 664n1, emphasis
added). In the same article, Keynes distinguishes between finance and funding needs as satisfied by “the markets
for new short-term loans and for new long-term issues” (ibid.). In other points, Keynes seems to conflate both
meanings of finance as in: “For ‘finance’ constitutes, as we have seen, an additional demand for liquid cash in
exchange for a deferred claim. It is, in the literal sense, a demand for money” (Keynes, 1937a, p. 248). In this state-
ment we have finance in the meanings of both demand for money and issuance of debt.
 JOURNAL OF POST KEYNESIAN ECONOMICS 293

To dispel the confusion, Keynes wrote one of his most-often quoted, if

somewhat cryptic, passages: “The entrepreneur when he decides to invest
has to be satisfied on two points: firstly, that he can obtain sufficient short-
term finance during the period of producing the investment; and secondly,
that he can eventually fund his short-term obligations by a long-term issue
on satisfactory conditions” (Keynes, 1937b, p. 664).
In other words, an entrepreneur has two problems to solve: (1) how to get
hold of money to make the intended expenditure, and (2) how to properly
structure his liabilities, or, more, generally, his balance sheet. In the
interpretation offered in this article, these are not sequential problems, as
some authors have interpreted them, but in fact two different questions: the
first deals with money circulation, how to accommodate a new use for
money-in-circulation, and the second is what we could call, in modern terms,
a corporate finance problem, how to structure one’s balance sheet between
assets and liabilities to minimize financial costs and risks. Finance and funding
are therefore not different steps in the same process, they are different
concepts describing specific dimensions of the same decision.

Finance
As narrated by Keynes, the first problem the entrepreneur has to deal with after
deciding to invest is to get hold of the necessary amount of means of payment to
be able to acquire or order investment goods. According to Keynes, this is a
monetary problem, that is, a question of how to accommodate the finance
demand for money. Borrowing from banks is, of course, one possible source,
but it is not credit provision per se that makes it possible to satisfy that demand.
Rather, what is needed is to make deposits available to entrepreneurs to
accommodate their needs for liquidity. Keynes stressed that it is money that
matters, not savings. Money could be obtained from banks, by borrowing,
but also through the use of existing deposits resulting, for instance, from cash
receipts from past sales, from the liquidation of other assets, or from the
placement of stocks or debt securities in the securities markets.14
Selling securities should nevertheless cause a fall in securities prices,
however small, and, thus, a rise in interest rates. Since savings are equal to
investments, current securities prices, as explained in chapter 17 of the GT,
should be those determined by the interaction between the supply of securities
issued to fund, totally or most probably in part, realized investments and the
demand for securities by savers out of the increase in their incomes caused by
those very investments, and by financial intermediaries, given their liquidity
14
“Occasionally he may be in a position to use his own resources or to make his long-term issue at once; but this
makes no difference to the amount of ‘finance’ which has to be found by the market as a whole, but only to the
channel through which it reaches the entrepreneur and to the probability that some part of it may be found by
the release of cash on the part of himself or the rest of the public” (Keynes, 1937b, p. 664).
294 F. J. CARDIM DE CARVALHO

preferences. If one tried to place additional securities in advance of

investments, and thus before the increase of income and savings generated
by the investment expenditure, an excess supply of securities would emerge,
depressing their prices.15 Thus, there are really only two sources for satisfying
the finance demand for money without putting any pressure on the interest
rate: (1) existing deposits generated by, for instance, past cash receipts, and kept
idle; or (2) borrowing from banks.16 In any case, satisfying the finance demand
for money does not imply anything different from satisfying any other demand
for money, either for transactions, precaution, or speculation. Like the other
three motives to demand money, the finance motive also works as if the
amount of money in circulation was a revolving fund. To repeat once again,
money demand refers to money held in advance of an intended purchase
(whether the purchase of goods and services or of financial assets or of invest-
ment goods). The demand for money is extinguished when the time comes to
conclude the process by actually making the purchase and paying for it. When
money is spent (and, therefore, when money demand for that reason becomes
zero), that amount of means of payment becomes available to be held by some-
body else in advance of some other purchase. It works like a revolving fund,
where money spent can now be used by somebody else to make a purchase
as long as the value of the latter is the same as the value of the former.17
Keynes’s fundamental conclusion about the role of finance, in the particular
sense he gave to the word, is thus that it is a monetary circulation problem, having
nothing whatsoever to do with saving, or even with whether the economy is
growing or not. In a growing economy the pressure on liquidity rises but does
not change the nature of the problem or the ways in which the problem is solved:
The demand for liquidity can be divided between what we may call the active
demand which depends on the actual and planned scales of activity, and the inactive
15
One could think, however, that this impact on interest rates could be avoided or minimized by having these
securities absorbed by financial institutions financing their purchases with deposits created by banks.
16
Why would borrowing from banks not push the interest rate up? Kregel (1992) argues, based on some of Keynes’s
early writings on bank behavior, that banks would use inactive deposits, deposits held temporarily by income
earners before a final decision is made whether to buy consumption goods or assets. Banks would see an opport-
unity to transform these temporarily inactive deposits into active balances by lending them to satisfy short-term
borrowers. The interest rate would not rise because the opportunity cost of these deposits for banks would be
zero.
17
The use of the expression revolving fund of finance by Keynes added to the already deep misunderstanding that
characterized his exchange with Ohlin (see Keynes, 1937b, p. 666). Since Ohlin (and Robertson) understood finance
to mean borrowing from banks, the idea of a revolving fund of finance being replenished by the mere act of
spending seemed absurd since debts created by borrowing would only be extinguished when those debts were
liquidated. If one thinks of resources available to make loans, banks could not make new loans until the first bor-
rower had settled the debts incurred with them. But Keynes was actually talking about money circulation. One
takes money out of circulation to hold until a purchase is made and money comes back into active circulation.
This works as if it were a revolving fund of finance, but it is not itself a revolving fund. If one remembers the
meaning of finance in Keynes’s works, the statement is simple, almost trivial. If one takes finance to mean
borrowing, it is certainly impossible to see how anybody could make such silly mistake as the one attributed
to Keynes. In fact, only the disbelief that Keynes could have made a mistake like that can explain Asimakopulos’s
attempt to explain the operation of a revolving fund of credit (not of finance in Keynes’s sense) through special
assumptions about the consumption multiplier (see Asimakopulos [1983, 1986], Kregel [1986], and Davidson
[1986]). Keynes proposed an analogy to clarify his argument, but ended up muddling even further the already
difficult dialogue he was sustaining with Ohlin.
 JOURNAL OF POST KEYNESIAN ECONOMICS 295

demand which depends on the state of confidence of the inactive holder of claims
and assets; whilst the supply depends on the terms on which the banks are prepared
to become more or less liquid …. The point remains, however, that the transition
from a lower to a higher scale of activity involves an increased demand for liquid
resources which cannot be met without a rise in the rate of interest, unless the banks
are ready to lend more cash or the rest of the public to release more cash at the
existing rate of interest. If there is no change in the liquidity position, the public
can save ex-ante and ex-post and ex-anything-else until they are blue in the face,
without alleviating the problem in the least—unless, indeed, the result of
their efforts is to lower the scale of activity to what it was before. (Keynes,
1937b, p. 668)18

Funding
The concept of funding, in contrast to the concept of finance, has to do with
the issuance of liabilities, or more precisely, with the building up of balance
sheets, that is, choosing assets and liabilities. If the investing firm is drawing
on retained profits maintained as demand deposits in the banking system, for
instance, the finance motive to demand money can be satisfied without bor-
rowing from banks. At the same time, its funding problem, that is, issuing
liabilities that minimize financial costs and risks for the firm, is also satisfied
since the firm draws on its own net worth. There is no reason, however, to
suppose that attractive investment opportunities, will be limited to the values
that can be spent without recourse to third parties’ resources.
Funding a project is mostly a question of matching assets and liabilities,
that is, accepting obligations that could ideally be settled with the revenues
expected to be generated by the assets one is acquiring. Keynes did not take
a direct interest in this matter but one of his followers, Hyman Minsky, did.
In fact, according to Minsky this is the main speculative bet an investor can
make: that the assets he buys will generate enough cash flow to service and
liquidate the liabilities issued to allow their purchase.19 Minsky extended
liquidity preference theory to include balance-sheet construction rather than
just asset choice, as Keynes did in the GT. Liquidity concerns arise in at least
two ways. On the one hand, an investor has to fulfill a liquidity condition in
being able to make contractually defined payments in the dates set in their
debt contracts. It is not enough to be solvent (i.e., to have assets the present
18
The frequent use of the expression credit-money by some Keynesian economists in this context, something one
does not find in Keynes’s works anyway, may also add to the confusion by stressing the credit-generating aspect
of the operation of the finance demand rather than the monetary circulation aspect. It is the lack of liquidity that
worried Keynes because in a monetary economy it is money that is required to purchase goods, not savings or
credit. Extending credit is one way to satisfy the demand for money but it is not the only one, even if it is the
more important. The problem at this point is not debt creation (and the related issues of solvency, cash in-
and outflows, etc.) but money creation so that the demand for money to hold in advance of investment expen-
ditures does not generate pressures on the existing pool of liquidity that would cause interest rates to rise.
19
“The fundamental speculative decision of a capitalist economy centers around how much, of the anticipated cash
flow from normal operations, a firm, household, or financial institution pledges for the payment of interest and
principal on liabilities” (Minsky, 1975, pp. 86–87).
296 F. J. CARDIM DE CARVALHO

value of which are at least equal to the present value of the liabilities in the
balance sheet), one has also to be liquid (i.e., to be able to make contractual
payments when they come due). Minsky’s point is that to deal properly with
the liquidity condition it is not sufficient to consider asset attributes, as
proposed by Keynes in chapter 17 of the GT, but it is also necessary to
examine the extent to which cash inflows generated by assets match cash
outflows established by liabilities issued to fund their purchase.20
But liquidity is also a concern for the investor in a more traditional sense.
The investor knows that the future is uncertain and that expectations about
future cash flows can be disappointed, so that holding liquid assets becomes
a way to ensure some fallback position in case things do take a turn for the
worse. In fact, the explicit consideration of liabilities strengthens Keynes’s
liquidity premium arguments in the GT, since the need to honor liabilities
becomes a strong reason to keep liquid reserves. In fact, as Minsky put it:
In a world with private debts denominated in money, money is a safe asset for meeting
such commitments. Money always has a ready market, for those units with
commitments to pay money engage in activities designed to obtain money. Money is
not an asset with an invariant value with respect to income, for the price level of current
output can change. Furthermore, the value of money in terms of other assets, including
real capital, is not invariant—the money price of real and financial assets can change.
Money is of invariant value only with respect to money contracts and payment
commitments denominated in money—regardless of whether these payment
commitments are due to debts, taxes, or current transactions. (Minsky, 1975, p. 72)21

Finally, Minsky also added an important argument to liquidity preference

theory when discussing funding problems, which is the core of his financial
fragility model: liquidity concerns change with the business cycle. Since
holding liquid assets is a defensive device against unexpected adverse events,
the less confident the investor feels about future successes, the higher his or
her demand for these devices will be. More generally, the less attractive or
the more obscure the future may appear to be, the stronger the concern with
margins of safety will be, that is, with maintaining some room for maneuver-
ing in case adverse developments take place.22
Again, it has nothing to do with saving or saving propensities. The concern
with funding is related to the way liabilities are structured, how they match

20
Minsky’s well-known taxonomy of portfolio profiles where he distinguishes between hedgers, speculators and
Ponzi investors is an attempt to typify funding strategies.
21
“In a world with borrowing and lending, it is sensible for anyone or any organization with payment commitments
to keep some money—the item in which its commitments are denominated—on hand as an insurance policy
against unfavorable contingencies …. The ability of an asset to yield cash when needed and with slight variation
in the amount is called its liquidity” (Minsky, 1986, p. 180). The relationship between money contracts and money
is, of course, the cornerstone of Davidson’s interpretation of Keynes’s theory. See Davidson (1978).
22
“The margins of safety can be identified by the payment commitments on liabilities relative to cash receipts, the
net worth or equity relative to indebtedness (the margin of stock market purchases), and the ratio of liabilities to
cash and liquid assets, that is, the ratio of payment commitments to assets that are superfluous to operations. The
size of the margins of safety determines whether a financial structure is fragile or robust and in turn reflects the
ability of units to absorb shortfalls of cash receipts without triggering a debt deflation (Minsky, 1986, pp. 79–80).
 JOURNAL OF POST KEYNESIAN ECONOMICS 297

assets, in terms of maturities and cash flows, and how margins of safety are
maintained. If one could for a moment imagine a modern capitalist economy
without a financial system, the answers to these concerns would depend on
expectations and liquidity preferences of ultimate borrowers and lenders. But
in a sophisticated capitalist economy, monetary and financial institutions determine
the way in which the funds required both for the ownership of items in the stock of
capital assets and for the production of new capital assets are obtained. In a
capitalist economy of the kind Keynes postulated, there are private portfolios,
real-capital assets are in essential details equivalent to speculative financial assets,
and banks, generically defined as institutions specializing in finance, are important.
(Minsky, 1975, p. 57)

In economies such as this, described by Minsky as fitting the Wall Street

Paradigm (in opposition to the Village Fair Paradigm theorized by neoclassical
economics): “the essential liquidity preference … is that of bankers and
businessmen, and the observable phenomena that indicate the state of liquidity
preference are the trends of business and banker balance sheets” (Minsky, 1982,
p. 74).
Minsky’s theory of portfolio choices can thus be seen as an extension of
Keynes’s liquidity preference theory to the case in which the asset buyer issues
liabilities of some type and the impacts this issuance may have on the beha-
vior of asset holders, perhaps to avoid getting into even more confusion in the
debate against loanable funds theorists who insisted on the importance of
credit, as opposed to Keynes’s emphasis on money. Once this confusion is
cleared, however, the way is open to the consideration of liabilities and a
new dimension of liquidity, the ability to pay debts when they come due, a
parallel, but related, concept to that of liquidity as convertibility into money,
the notion explicitly treated in the GT.

The meaning of liquidity

Liquidity is a very complex concept. In fact, under the same term one usually
refers to at least three different, albeit related, operations or aspects of operations.
The first meaning of liquidity refers to the marketability of different classes
of assets, that is, the facility with which the owner of a given asset can dispose
of it. Liquidity in this sense (which Brunnermeier and Pedersen [2009]
suggested callimg market liquidity) has two dimensions. An asset is more
or less liquid the more or less time is necessary to find a buyer for it. However,
one could think that anything can be sold very quickly if the seller does not
mind accepting a low enough price. This is obviously not what asset holders
have in mind when they evaluate the liquidity of an asset. One could argue
that liquid assets are those that can be sold at prices very close to the ones that
were paid for them. Again, the condition in itself is not enough to characterize
298 F. J. CARDIM DE CARVALHO

an asset as being liquid, since one could assume that if an asset holder is pre-
pared to wait indefinitely, the probability of finding a buyer that agrees with
his assessment of the value of the asset increases with time. Liquidity in the
sense of high marketability requires a combination of both characteristics:
the quicker an asset can be sold with a minimum loss of value, the more liquid
it is (Cardim de Carvalho, 1992). Liquid assets are those that can be sold easily
with a maximum degree of value conservation.
But to say that an asset is liquid in the sense of being easily marketable is
just to say that holding that asset is expected to allow its holder to access
means of payment without delay or significant loss. Liquidity in this sense
means convertibility into means of payment. There are, however, other ways
to access means of payment, and these other ways add other dimensions to
the concept of liquidity.
One can obviously access means of payment by borrowing. In this case, an
asset may be liquid because it is easy to sell without significant losses, as already
argued, or because it can be easily accepted as collateral by lenders.23 In general,
collateralizable assets have to be liquid in the first sense given above, since the
role of a collateral is to guarantee the lender against a failure by the borrower to
settle his debts. The lender is not necessarily interested in holding the asset.
Taking possession of a collateral is in many cases a sort of Plan B. Most lenders
will try to sell assets as quickly as possible. So liquid assets in the sense of easy
convertibility are also preferred to provide funding liquidity, although in certain
situations lenders can in fact reveal other preferences.24
A third meaning of liquidity is even more complex because it does not refer
to individual items, as the other two, but to whole balance sheets. Liquid
balance sheets are those that guarantee that the liquidity condition mentioned
previously is respected. Balance sheets may be liquid if cash inflows and
outflows are synchronized by matching maturities of assets and liabilities.
However, this may not be enough, since cash inflows are expected revenues
while most outflows are obligations defined in contracts. To allow for the
possibility of disappointment of expectations, a liquid balance sheet is built
embedding a margin of safety, that is, by restricting accepted obligations to
a fraction of expected revenues and/or by including in the asset side items that
can be sold or used as collateral if necessary. Therefore, if uncertainty was not
a consideration, liquid balance sheets could be built just by matching perfectly
inflows and outflows of cash established by assets and liabilities. But of course
taking into consideration not only that the future is uncertain, but that econ-
omic agents know that it is uncertain and take precautions to protect against
unpredicted and unpredictable future developments means that liquid balance
sheets have to include liquid assets in the senses identified above.
23
This is similar to what is called funding liquidity by Brunnermeier and Pedersen (2009).
24
It may happen, for instance, that in highly inflationary economies lenders prefer to accept inflation-proof assets
instead of more liquid alternatives that would provide weaker protection against rising prices.
 JOURNAL OF POST KEYNESIAN ECONOMICS 299

The role of financial systems

The fundamental proposition of this article is that financial contracts do not
deal with savings, they deal with liquidity. In this picture, financial transac-
tions enable agents with illiquid assets to trade them for liquid assets, or, as
Keynes put it, “‘finance’ constitutes … an additional demand for liquid cash
in exchange for a deferred claim. It is, in the literal sense, a demand for
money” (Keynes, 1937a, p. 248). Somebody, or most likely some entity, agrees
to go illiquid to allow the other party to become liquid.
Contrary to the alternative approach of Gurley and Shaw (1955), where
financial systems intermediate “excess” saving from surplus to deficit units,25
the role of financial systems in the provision of liquidity to spenders is not
confined to that of a mere intermediary between ultimate takers and ultimate
suppliers of liquidity. The ultimate source of liquidity, as Minsky stated, is the
government, not a private income earner.26 But liquidity can also be created
by other entities if they are able to create assets that are viewed as perfect or at
least very good substitutes for those assets that constitute “ultimate liquidity”
and for as long as they are recognized as such. Among the candidates to supply
these substitutes the most important are financial institutions.
Thus, financial systems intervene in the process of liquidity allocation
through three main channels.
First, in modern monetary economies, the main creator of liquidity is a
particular class of financial institutions: banks. Ultimate liquidity is created
by the government, as we just saw. Modern commercial banks, however,
are able to issue the most perfect substitute for government currency in the
form of demand deposits. Demand deposits are convertible into currency
on demand at fixed prices. Although it is a private liability in most cases (that
is, an obligation issued by private entities), some institutions were evolved to
ensure that convertibility (such as lenders of last resort and deposit insurance
schemes). As a result, the public believes that deposits can always be
exchanged at fixed prices for currency. As long as this belief is held by the
public, bank deposit liabilities will remain as perfect substitutes for currency.
In Keynes’s view, shared by Minsky and by Davidson, among others, one
can say that while currency’s liquidity is unconditional, private liabilities
are liquid only as long as the convertibility condition is assured.
Secure that depositors will seldom need or want to convert deposits into cur-
rency, banks were able to maintain only a small fraction of the value of their
deposit liabilities as currency reserves even before the emergence of lenders
of last resort. In fact, within wide limits, they can create deposit liabilities,
25
I am using the expression “excess” savings to mean savings that are not used by the saver himself to fund his own
investments, in accordance with the definition of surplus proposed by Gurley and Shaw (1955) explained before.
26
“The ultimately liquid assets of an economy consist of those assets whose nominal value is independent of the
functioning of the economy. For an enterprise economy, the ultimately liquid assets consist of the domestically
owned government debt outside government funds, Treasury currency, and specie” (Minsky, 1982, p. 9).
300 F. J. CARDIM DE CARVALHO

confident that practically nobody will actually try to cash them, and use these
liabilities to buy earning assets. For instance, when a firm needs working capi-
tal, it can apply for a bank loan. If the bank decides to offer the loan, it will buy
a debt contract issued by the firm paying for it with the issuance of a deposit.
The borrowing firm will then transfer this deposit to its suppliers, who will use
it to pay to their creditors, and so on. As long as the public trusts the convert-
ibility of demand deposits (and the institutions created to ensure it), banks can
literally buy earnings assets for nothing. Once created, deposits become part of
monetary circulation, being transferred from one party to another, in a revolv-
ing fund of the kind described by Keynes with respect to the finance demand
for money. In fact, as shown by Kregel (1998) banks can (and actually did) use
the creation of deposit liabilities even to build up their own capital.
When banks issue deposits to purchase assets (such as debt obligations by
firms borrowing working capital), they become relatively illiquid. In their bal-
ance sheets, banks will show demand liabilities but in the asset side they will
have debt contracts bought from firms, which cannot be liquidated before
their settlement dates without the risk of incurring losses. In general, banks
increase liquidity in the economy by trading liquid liabilities for illiquid assets.
Thus, the first way in which financial systems intervene in the process of
liquidity allocation is by creating deposits and by managing payment systems
where deposits circulate as means of payment. As we argued before, it is the idea
of circulation of deposits that inspired Keynes to compare it to a revolving fund
of finance. Commercial banks are the most important creators of liquidity in
this sense, but under some more stringent conditions, other currency substi-
tutes can be created by other entities, including nonfinancial institutions, or
through the creation of clearing mechanisms that can sustain partial monies.
In a growing economy, the “revolving fund of finance” (that is, of means of
payment) is no longer enough to support the expansion of output. If expan-
sion is led by investments, it is the finance motive that will first put pressure
on available liquidity, but even if it is just the case of an expansion of current
output, a similar pressure will arise, through the increase in the transactions
demand for money resulting from an expanding economy. In this case, as
Keynes observed, “the transition from a lower to a higher scale of activity
involves an increased demand for liquid resources which cannot be met with-
out a rise in the rate of interest, unless the banks are ready to lend more cash
or the rest of the public to release more cash at the existing rate of interest”
(Keynes, 1937b, p. 668).27
27
We are tangentially touching here a very important question for Keynesian economists, that is, the meaning and
degree of endogeneity of money in entrepreneurial economies. This subject has long divided Keynesian, and even
post Keynesian, economists, opposing so-called horizontalists, who propose that the money supply is fully
endogenous, resulting in a horizontal money supply curve in the interest rate/money quantity space, and the
“liquidity preference group,” for lack of a better term, which includes this author. One cannot explore the question
in this article, other than suggesting that while horizontalists usually emphasize constraints on the action of cen-
tral banks, the liquidity preference group tends to emphasize bank behavior. A more extended discussion of this
point may be found in Cardim de Carvalho (2015, chap. 4).
 JOURNAL OF POST KEYNESIAN ECONOMICS 301

The second channel through which financial systems affect the dynamics of
an entrepreneurial economy is liquidity transformation through financial
intermediation. A firm searching for funding for an investment project, for
example, can issue a debt liability on contractual terms that are compatible
with the characteristics of the assets it is buying to get the means of payment
it needs from the general public. However, the contractual terms that are
adequate to the firm’s expectations of prospective yields of the investment
might be attractive to only a small number of potential lenders. If that is
the case, the individuals who could make the loan will know that the debt
contract is illiquid, that is, that it may be hard to sell that debt contract to
others if the lender wants to. In this case, the firm would either have to pay
a premium to compensate the lender for the illiquidity of the debt contract or
accept contractual terms that would expose it to risks it does not want to run
or, finally, to give up the projected investment.
Financial intermediation is the situation in which a financial intermediary
buys the relatively illiquid debt contract issued by the firm, giving it access,
therefore, to means of payment, and issues itself a new, more liquid, liability
to be sold to individual lenders. In other words, the financial intermediary
transformed the illiquid debt contract issued by the firm into a more liquid
liability acceptable to individual lenders. The financial intermediary can
perform liquidity transformation because it can (1) absorb a large number
of individual debt contracts where idiosyncratic features that make them
illiquid may largely cancel each other; and (2) access banks for short-term
credit in case of need.28
Finally, the third channel through which financial systems intervene in the
finance/funding process described by Keynes is through the operation of
securities markets where firms issuing liabilities can place them directly with
individual lenders, although almost always with the help of specialized financial
institutions. However, to overcome the difficulties just mentioned regarding the
liquidity preferences of the general public, for direct placements to work it is often
necessary to create secondary markets for these contracts. Secondary markets
offer the possibility for the investor to change his portfolio if he so wishes by
transferring assets to third parties. As Davidson (2002) put it:
The good edge of the financial market sword is that the existence of financial mar-
kets makes real investments that are fixed for the community appear to be liquid for
the individual. This prospect of liquidity encourages today’s savers to transfer their
command of existing real resources to entrepreneur-investors who require funding
in order to command real resources in excess of what their own earned claims will
permit. (Davidson, 2002, p. 104)

28
If idiosyncratic elements cannot be canceled out or eliminated, a financial intermediary may not be able to per-
form this function and alternative ways to fund the investment may have to be found, such as, in some cases,
having public entities perform the intermediation. In some of these cases, the development of the derivatives mar-
ket, particularly through over-the-counter contracts, offered another solution.
302 F. J. CARDIM DE CARVALHO

Keynes explored this third channel explicitly in chapter 12 of the GT, when
discussing how stock exchanges, the best known among all modern secondary
markets for financial assets, can transform intrinsically illiquid capital assets
into liquid stocks for individual shareholders.
For secondary markets to exist, however, assets have to fulfill some
preconditions. According to Kaldor assets must exhibit four attributes for
what he called “perfect” markets to exist:29 “These attributes are: (1) the good
must be fully standardized, or capable of full standardization; (2) it must be an
article of general demand; (3) it must be durable; (4) it must be valuable in
proportion to bulk” (Kaldor, 1980, p. 20).
The reason for those requirements is that secondary markets are institu-
tions that are expensive to create and maintain. To be viable, their costs of
creation and maintenance have to be shared by a large number of participants.
Kaldor’s conditions can in fact be summarized by stating that, to be viable,
markets have to have a minimum density and a minimum degree of
permanence to allow them to reach a volume of operations large enough to
keep their per-operation maintenance costs low. Assets have to be designed
in such a way as to be attractive to as a large a number of potential traders
as possible, working with as little interruption as possible.
Paul Davidson refined Kaldor’s conditions to define liquid assets as those
“that are traded in well-organized, orderly spot markets” (Davidson, 1994, p.
49, emphasis added). An asset is not liquid if its prices are wildly volatile, even
if average prices are stable. Being liquid means to be convertible into money
quickly and at a minimum loss of value. If prices are too volatile, there can be
no assurance that they will not be at a very low point precisely when the
holder eventually wishes to sell it. Thus, density and permanence are neces-
sary but not sufficient conditions to ensure that an asset is liquid. As Davidson
put it, well-organized secondary markets are necessary to ensure liquidity, that
is, one needs a market in which price changes are limited by the action of
market makers, financial entities, or agents to which responsibility is given
to keep prices within given intervals. Market makers do it by “announc
[ing] a willingness to act as a residual buyer or seller to assure orderliness
if an abrupt disruptive change occurs on either the demand for supply side
of the market” (Davidson, 1994, p. 49). Dense and permanent markets ensure
that assets can be traded. The action of market makers ensures that prices are
stable within given limits.30

29
Kaldor’s reference to “perfect” markets is somewhat unfortunate because it suggests that “complete” markets and
an efficient auctioneer are the answers one needs to deal with illiquidity problems. Many financial deregulation
initiatives were actually justified on these grounds. Nothing would be lost if the analogy to “perfect” markets of
Walrasian microeconomics was dropped and secondary markets were analyzed exclusively in terms of material
and institutional characteristics.
30
As Jan Kregel reminds me, market makers, on the other hand, often operate with funds provided by the banking
system, exemplifying a peculiarity of the financial sector in comparison with other sectors of the economy: the
interrelationship of its participants.
 JOURNAL OF POST KEYNESIAN ECONOMICS 303

To consider financial innovations such as the development of securitization

and of derivatives markets does not require any change in this framework. In
fact, it is quite the opposite. Securitization and derivatives are specific
attempts explicitly developed to give liquidity to contracts that were
traditionally illiquid. Through securitization, credit contracts that are heavily
idiosyncratic (and therefore illiquid) are transformed into standardized
securities that can be traded in open markets. Derivatives, on the other hand,
and more particularly over-the-counter derivatives, offer through other means
the sort of protection to idiosyncratic contracts that secondary markets would
offer if these contracts could be standardized. It is the same ultimate motiv-
ation that explains the existence of these innovations, the need to protect
the liquidity of balance sheets in uncertain environments.
The three channels show that financial systems have little, if anything, to do
with allocating savings in Keynes’s view of how an entrepreneurial economy
operates. In fact, saving is not a variable in this approach. In the model
proposed in the GT, total savings is always equal to investment, ex ante invest-
ment and saving as much as ex post investment and saving. Therefore, there
cannot be a constraint on investment imposed by the lack of savings or by
imperfections in the mechanisms that allocate savings among investors. There
can be, in contrast, a liquidity constraint, and the role of the financial system is
to obviate constraints of this type, either by creating means of payment, or by
transforming illiquid into liquid liabilities, or finally, by creating and
organizing secondary markets in which liquid assets can be traded. There
are thus multiple functions to be performed by financial institutions and
markets, all of them related, however, to liquidity, not savings, allocation.

Foreign “capital” flows

The confusion between concepts of capital, finance, and liquidity is parti-
cularly acute in balance-of-payments analysis. Let us first quickly dispose of
the concept of foreign savings. The label clearly suggests a measure of the
foreign contribution to domestic capital accumulation, when it is nothing
of the kind. Being equal to the deficit in the current account, it is an account-
ing measure of the rest-of-the-world saving, since it is the excess of what it
sold to a country over what it bought from that same country. For the
economy exhibiting a current account deficit, it is foreign savings only in
the sense that its excess purchases had to be “financed” somehow (by getting
into debt or by selling assets or by drawing on foreign reserves).
One looks for “capital” flows, however, in the capital account of the balance
of payments. It comes through two channels: foreign direct investment and
portfolio investment. But what can one do with foreign “investments”?
Capital inflows are inflows of foreign currency. Foreign currency cannot be
used domestically until it is converted into the domestic currency. As such,
304 F. J. CARDIM DE CARVALHO

foreign currency can only be used to buy goods and services or assets in the
rest of the world. If a country does not need imported goods to that extent, the
liquidity that is obtained in foreign currency is largely useless. It certainly
cannot “finance,” for instance, an increase in investment with domestically
produced capital goods. For the same reason, it cannot finance fiscal deficits,
since what governments need when they spend more than they collect as taxes
are domestic revenues in domestic currency.
There is one indirect route in which foreign capital inflows can in fact con-
tribute to financing domestic investment or fiscal deficits by accommodating
portfolio preferences of domestic wealth holders. Let us suppose that domestic
wealth holders, for whatever reason, do not want to acquire securities issued
by their government to finance its deficits. Let us suppose further that foreign
wealth holders, in contrast, want to buy those securities. The operation may
then be completed by triangulation: domestic wealth holders would agree to
hold foreign assets instead of domestic assets, so they would willingly sell
domestic currency to foreign investors. The latter would use the domestic
currency they acquired to buy the securities issued by the domestic govern-
ment to finance its fiscal deficit. One could say then that foreign capital
inflows are financing fiscal deficits, although what they are really doing is
exchanging foreign for domestic liquid assets with domestic private wealth
holders. Triangulation did not increase the aggregate domestic ability to
“finance” fiscal deficits (or excess investment over domestic savings). What
was allowed was the portfolio accommodation that would not take place
otherwise. It had nothing to do with capital or savings transfer—it was
liquidity of portfolios that was affected.

The bad edge of the financial markets sword: Instability, volatility,

and crises
It is an essential proposition of Keynes’s theory that the adequate provision of
liquidity is essential for the efficacious operation of an entrepreneurial
economy. Liquid assets provide access to means of payment allowing firms,
households, and governments to purchase the goods and assets they desire
while giving them a measure of protection against adverse events that may
take place in the uncertain future. Nevertheless, the availability of liquid assets
is not an unmixed blessing. Paraphrasing Paul Davidson, there is a bad, as
well as a good, edge in the financial market sword.
As discussed in the section on the meaning of liquidity, an asset is liquid
when its holder can assume that it can be sold or offered as collateral without
significant delay or loss of value. Basically, this means that an asset is liquid
when it is safe to assume the existence of a reservation demand for that asset
at the current market price. The asset is deemed to be relatively scarce, in the
sense that its holder expects that it will not be difficult to find a buyer (or a
 JOURNAL OF POST KEYNESIAN ECONOMICS 305

lender who accepts it as collateral for a loan) for that asset, at fair prices, if he
decides to alienate it.
In sum, an asset is liquid when it is generally accepted that it can be trans-
ferred easily to third parties. It is straightforward to conclude that (1) liquidity
is not an intrinsic attribute of an asset, it relies on the expectation of positive
excess demand for that asset;31 and (2) liquidity may be a fleeting attribute,
disappearing very quickly when the expectation of prevalence of excess
demand is put in question by a sufficiently large number of asset holders.
Excessive reliance on the supposed liquidity of certain classes of assets (in
terms of both marketability and acceptance as collateral) was an essential
element of the 2007–8 financial meltdown in the U.S. financial system.
Moreover, the crisis also helped to make clear the importance of a second
characteristic of Keynes’s concept of liquidity: its hierarchical nature. In
normal times, when excess demands for some assets, and therefore convertibil-
ity into money, can be assumed, assets created by some segments of the private
sector tend to be accepted as perfect (or even superior, given the yields they
offer) substitutes to ultimately liquid assets. It becomes an accepted
convention that one can consider these assets as safe. However, when such a
convention is challenged, liquidity can disappear almost instantaneously, as
asset holders try to dump the doubtful assets and flee to the sources of ultimate
liquidity, that is assets issued by the state. The flight for quality thus initiated
can lead to a general process of debt deflation feeding a financial collapse.
As Lord Turner, head of the UK’s Financial Services Authority, has pro-
posed, it may be advisable to regulate private liquidity creation so to limit
the provision of liquidity to the amounts that are functional to support
macroeconomic prosperity without endangering financial stability (Turner,
2010). The extent to which an effort in this direction can be successful in
entrepreneurial economies characterized by the existence of sophisticated
diversified financial systems is a central concern in the economics of Keynes.

Conclusion
Keynes’s approach to the role of financial systems in monetary production econ-
omies is irreconcilable with Gurley and Shaw’s or any other version of loanable
funds theories that, all of them, postulate that saving and investment are the ulti-
mate determinants of supply of and demand for credit and argue that the role of
financial systems is to facilitate the interaction between savers and investors.
Liquidity is what allows individuals and entities to purchase goods, services,
and assets of all types. Liquidity is also what allows individuals and entities to
protect themselves, to some extent, against the uncertainties of the future. Of
31
Not even legal tender itself is intrinsically liquid, as one can learn from hyperinflationary situations where sellers
tend to prefer to suffer eventual legal penalties to selling goods in exchange for an instantaneously depreciating
currency.
306 F. J. CARDIM DE CARVALHO

course, liquidity is not an unmixed blessing. The same easiness that is offered
by a liquid asset to its holder to sell it responds to the increased possibility of
pursuing speculative strategies, feeding the volatility of markets, and
eventually causing major disruptions. Keynes expressed fears about such
developments in the GT at the same time that he acknowledged the positive
role of liquid markets. As he put it, in a lengthy quotation:
The spectacle of modern investment markets has sometimes moved me towards the
conclusion that to make the purchase of an investment permanent and indissoluble,
like marriage, except by reason of death or other grave cause, might be a useful
remedy for our contemporary evils. For this would force the investor to direct
his mind to the long-term prospects and to those only. But a little consideration
of this expedient brings us up against a dilemma, and shows us how the liquidity
of investment markets often facilitates, though it sometimes impedes, the course
of new investment. For the fact that each individual investor flatters himself that
his commitment is “liquid” (though this cannot be true for all investors collectively)
calms his nerves and makes him much more willing to run a risk. If individual
purchases of investments were rendered illiquid, this might seriously impede new
investment, so long as alternative ways in which to hold his savings are available
to the individual. This is the dilemma. So long as it is open to the individual to
employ his wealth in hoarding or lending money, the alternative or purchasing
actual capital assets cannot be rendered sufficiently attractive (especially to the
man who does not manage the capital assets and knows very little about them),
except by organizing markets wherein these assets can be easily realized for money.
(Keynes, 2007, pp. 160–161)

As with other essential arguments of Keynes’s economics, the liquidity

dilemma is intrinsic to the dynamics of a monetary economy. The same
financial structures that allow productive investment and capital accumu-
lation, and economic growth, to reach the levels characteristic of modern
capitalist economies are also those where fragilities are accumulated that
ultimately cause deep crises, such as the one that began in the U.S. economy
in 2007 and has since spread throughout most of the world.

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