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Keynes on stock markets

Hector McNeill

Given the frenzy in stock market valuations resulting from quantitative easing's misdirection of money into assets and stock buy backs. Share values have risen sharply without any relationship to investment, productivity, prospects and other fundamentals.

This article has been re-posted and it reflects on the views of John Maynard Keynes on the stock market.

The tussle between enterprise & speculation

John Maynard Keynes, in his book, "The General Theory of Employment, Interest and Money" 1 reviewed the role of speculation in stock markets in Chapter 12 under the title of, "The State of Long-Term Expectation". He used the term speculation for "... the activity of forecasting the psychology of the market" and the term, enterprise for the, "... activity of forecasting the prospective yield of assets over their whole life." On this basis he stated that it was by no means always the case that speculation predominates over enterprise.

New York
Given the current cat and mouse situation of policy planners taking actions in the field of macro economic policy and stock markets reacting in either an enterprise or speculative mode so that market gains after a decision become market losses a few days later. Keynes states that with the improved functioning of investment markets he considered speculation to increase. For example in what he called, "one of the greatest investment markets in the world, namely, New York", the influence of speculation is enormous.

Betting against the average opinion

Keynes commented upon an American phenomenon easily observable today over seventy years after Keynes published these observations. It is the undue interest of Americans in discovering what average opinion believes average opinion to be 2. He considers this national weakness to find is clearest expression in the stock market. The issue of concern is that Keynes reports it be rare for investment to be made for income but rather in the hope of capital appreciation. In other words the investor attaches his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation. This is speculative activity. With a steady flow of enterprise investment speculation can have insignificant effects and indeed helps sustain liquidity within the markets at higher rates. However, Keynes considers the position to become serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism.

Speculative assets hurting enterprise

In terms of the current banking crisis the enterprise sector cannot access needed funds through financial intermediaries and banks because of the portfolio asset holdings which are highly speculative in the form of asset-based derivatives or sub-prime products. The degree of speculation can be judged from the number of associated variables which tend to move in concert and potentially in the wrong direction 3.

Keynes, writing in 1936, questioned the ease of access to stock markets

Keynes considered the speculative nature of the stock market to be a scarcely avoidable outcome of our having successfully organised "liquid" investment markets. He observes that it is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And he suggests that perhaps the same is true of Stock Exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is, compared with Wall Street to the average American, inaccessible and very expensive. Speaking about the pre-liberalization period of the London markets Keynes states that, "the jobber's "turn", the high brokerage charges and the heavy transfer tax payable to the Exchequer, which attended dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market (although the practice of fortnightly accounts operates the other way) to rule out a large proportion of the transactions characteristic of Wall Street.

Keynes suggests that, "The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States."

Seventy years later
Keynesian growth.....

Robin Matthews published a 1968 paper in the Economic Journal on why Britain had full employment since the war. In this he argued that far from injecting demand into the system, governments in the so-called "Golden Age of Keynesianism" had persistently run large current account surpluses, instead of the budget deficits that would have been the expected manifestation of a Keynesian stimulus. From this he inferred that fiscal policy had been not only deflationary, but strongly so in the post-war period, therefore something other than Keynesian fiscal policy must have been responsible. The answer, he felt, lay in demand arising out of wartime destruction and an unusually prolonged private sector investment boom.

Source: Daily Telegraph, 2010.

Keynes wrote these words in 1936 and since then there has been a disastrous war, a development of a welfare state and imposition of high rates of taxation but at the same time the purchasing power of the average Briton has increased remarkably. Indeed, much of the policy used to achieve this was assumed to ride upon concepts and relationships identified and described by Keynes. There is evidence that this, in reality, is not true in that Robin Matthews completed an analysis on UK growth since the war until the mid 1960s to show that in a period of impressive growth Keynesian policies were not applied (see box on right). In any case, this system fell apart under a strain created by massive rises in the prices of essential economic inputs (petroleum) in the 1970s and 1980s (slumpflation). The problem was that Keynesian policy variables have no traction 4 and are not based on microeconomic imperatives. So the time taken for essential adjustments in enterprise based upon reallocations of inputs away from high priced items and investment in appropriate technology was almost wholly a supply side private sector initiative. This should not be confused with what became known as supply side economics that emerged in the 1970s/1980s.

In the light of the New York Stock Exchange crash in 1929, Keynes' observations on the impact of a more restrictive access to UK stocks as being considered to be a potential benefit, reflected the general status quo of the relatively and generally low real per capita incomes in the United Kingdom at that time.

Today the issue does not seem to be liquidity as such creating speculative surges but rather the imperfect information used by policy makers, medium term investors and speculators. On the basis of the poorly-conceived macroeconomic policy of quantitative easing (QE) those within the management of larger corporations and with access to the very low interest rate funds have gained control over the rises in share prices through share buy backs. This form of lower risk speculation has been an exercise in outsmarting the policy makers. This assumes, of course, that this was not the intent of policy-makers. However, the latest declarations concerning "prosperity growth" and a "successful economy" suggest that policy-makers now favour this type of "growth". Since something like 40% to 50% of constituents have faced declines in their real incomes and purchasing power the notions of a share-owning democracy has lost any relevance for the majority.

Such appeals to "shared prosperity" and the talk of a "new era of opportunities" for the people of this country, it would be appropriate for the government to explain why the current macroeconomic policy continues to encourage an exclusive form of accumulation of wealth of a very select and well-defined set of constituents. Although Keynes considered the stock market to approximate the workings of a casino, in the current circumstances the "speculative wave" is a driven directly by government policy (QE) at the expense of the rest of the constituency. As a result the risks associated with stock market dealing have been externalised to the general public facing increasingly precarious circumstances and declining real incomes. Clearly, under these circumstances, government policy is resulting in a declining ability of the population to share in the "growth" generated by QE.

1 "Chapter 12. The State of Long-Term Expectation" in "The General Theory of Employment, Interest and Money", Keynes J. M., Harcourt, Brace & Co., 1936.

2 This notion of the theoretical consensus on targeting the average condition also applies to KM macroeconomic policy indicators. See:"Slumpflation, the policy-induced crisis", Real Incomes, March 2008, here.

3 The sensitivity of outcomes on asset-based derivatives in the sub-prime markets upon multiple related variables is described in "Slumpflation, the policy-induced crisis", Real Incomes, March 2008, here

4 Traction is the degree to which policy instruments can isolate policy targets and move them in a predictable fashion as well as far as necessary from the standpoint of the judgement of the economic constituency and electorate. This concept is described in more detail in "Slumpflation, the policy-induced crisis", Real Incomes, March 2008, here.

Updated: 19th April, 2008

28th January, 2020.