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Keynes on stock markets

Hector McNeill

Given the frenzy in stock market valuations resulting from quantiative 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 macroeconomic policy and stock markets reacting in either an enterprise or speculative mode so that market gains after a decison 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 Keyens reports it be 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 liqudity 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 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

Keynes wrote these words in 1936 and since then there has been a disastrous war, a development of a welfare state and impositon 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 rode upon concepts and relationships identified and described by Keynes. This system fell apart under a strain created by massive rises in essential economic inputs (petroleum). The problem was that Keynesian policy variables have no traction 4 and 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 private sector initiative. 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 per capita low real 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 this basis speculation continues to be an exercise in outsmarting the policy makers while medium term investors can become caught up in trying to manage failing portfolio values. However, the prevailing force becomes the one whose decisions are based upon better quality information. With better information, and in particular more reliable asset rating covering all related variables which deterine performance of derivatives, speculation could even fall as a proportion of total trading while medium term investors could perform better. Under such conditions making stocks more accessible will no doubt be associated with some additional speculation but not to the degree of frustrating the main thrust of national enterprise.

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 concensus 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 in "Slumpflation, the policy-induced crisis", Real Incomes, March 2008, here.

Updated: 19th April, 2008