Investment in the current period depends to a large extent about expectations about the future. Since capital equipment can last a long time, what entrepreneurs expect about the state of demand, production techniques, etc., some years in the future matters in the present. It is not just the expectations that matter, but the confidence with which those expectations are held. Uncertainty can make entrepreneurs hold back as much as do negative expectations held with some certainty.
This is an interesting chapter because while expectations and confidence are obviously of major importance, they are difficult to formalise.
There is, however, not much to be said about the state of confidence a priori. Our conclusions must mainly depend upon the actual observation of markets and business psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book. [p. 149]
No-one can pretend to predict economic conditions five or ten years down the track. But firms do have to make decisions now that have a major impact on the fixed capital they will be stuck with at that point in time. Keynes makes a very interesting point about how financial change has modified how investors deal with uncertainty. Back in the day, when enterprises were run by the individuals who owned them, this was very much a lottery and “investment depended on a sufficient supply of individuals who embarked on business as a way of life, not really relying on a precise calculation of prospective profit.” [p. 150]
But with the dispersal of ownership through the sharemarket, individuals can rearrange their risks over time; they are not stuck with what they invested in. Changing prospects for a firm, or an industry, are reflected in their share prices, and those share prices affect the cost of capital to that firm or industry – because when those involved in the enterprise or similar ones, the price they can get for new shares depends on the price of the existing ones. So a high share price has an equivalent effect to a low interest rate, with the difference that it is localised to a firm or industry. Share prices will be related to the supply price and marginal efficiency of capital goods in the industry.
For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. [p. 151]
Because the future is unknowable, entrepreneurs and financial investors work with a convention: “assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” [p. 152] Of course, the one thing we can be certain of is that the existing state of affairs is not going to continue indefinitely. But the best we can do is assume that current market valuations of assets are a correct guide to the future.
(Incidentally, Keynes mocks an idea that is later at the core of rational expectations theory:
Nor can we rationalise our behaviour by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities. [p. 152])
The advantage of the convention of assuming present market valuations are correct is that it gives stability to the economy, even if the assumption is wrong. Because investors can sell out if the convention changes, they only risk a small loss; they are not liable for the immense loss if the underlying capital asset turns out to be worthless in five or ten years. The risks are there for the community as a whole, but the potential losses are spread more widely across the economy: “Investments which are ‘fixed’ for the community are thus made ‘liquid’ for the individual.” [p. 153]
However, there are drawbacks to this system. First, because the ultimate owners (shareholders) are removed from the day-to-day business of the firm, their knowledge of the real conditions of the firm and the industry are impaired. Second, minor and unimportant changes in profitability may have an exaggerated effect on the share price. Third, because market conventions are formed by a mass of agents who are ignorant of the real business conditions of the underlying firms, the conventions have no strong roots and may fluctuate violently for no rational reason.
Fourth – and Keynes discusses this at length – professional, well-informed investors’ arbitrage activities (where they buy what seems undervalued and sell what seems overvalued) will not be a stabilising force. This is because they make their judgements on what is over- or under-valued based not on some ‘fundamentals’ (as we call them these days) but based on trying to second-guess what the herd will do next. Investors with long time horizons are likely to be pushed out by those with shorter horizons. This is another patch of great stinging writing, including one the best-known Keynes quotes:
Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks is the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees. [p. 156]
Fifth, Keynes notes that a high state of confidence on the part of investors is a necessary but not sufficient condition for a boom. Also necessary is the confidence of those who lend to the investors and to the entrepreneurs. A collapse on the sharemarket may be induced by a fall in the confidence of lenders, and a sudden lack of availability of funds, rather than that of speculators themselves. Of course this is very familiar to us in late 2007.
Really, this whole section is brilliant and worth reading in the original, full of bites like: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” [p. 158] The point is quite ambiguous though. Keynes is having the most fun when he is unleashing his righteousness against speculation. There is a conventional element of moralising in this. But also a serious point – that there is no such thing as ‘liquidity’ for society as a whole, and the fact that individual investors can sell out of positions at a moment’s notice still leaves the underlying assets in existence, in somebody’s hands. Again we have a case where functionality for the individual is dysfunctional for the whole (or, if you prefer to think about individuals, for most individuals). But before this tirade started, Keynes was explaining how the tradeability of ownership shares had brought more stability to capitalism, had induced investment because it lowered the risks to the investor. It appears that capitalism can’t live with financial markets, and can’t live without them. Somebody else we know might call this a contradiction.
Another famous quote:
Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. [p. 159]
This has a more specific meaning in context, because Keynes has just defined ‘speculation’ as “the activity of forecasting the psychology of the market” and ‘enterprise’ as “the activity of forecasting the prospective yield of assets over their whole life”. [p. 158] Keynes is disputing the idea that the sharemarket allocates funds for investment to where a rational (but not prescient) person would allocate funds if they were interested in maximum profitability over the whole economy in the long run. (Since Keynes believes in the (neo)classical theory of distribution this may be the same as saying that such a rational allocator would be directing funds where they would have the highest pay-off for society as a whole – but this does not follow if you don’t accept that theory of distribution.) The goal of short-term capital gains warps the allocation of capital for long-term productive ends.
But again Keynes is led back to the paradox that the sharemarket improves the liquidity of investments for individual investors, and therefore facilitates investment. Instability is built into developed capitalism. The only thing that could prevent it, he writes in a cryptic comment, would be if individuals were not able to hold any savings in the form of money – either they would have to consume income immediately, or they would have to invest in some specific physical capital asset. How this would work is left unclear. Money and finance, it seems, are for Keynes capitalism’s original sin. But capitalism had to eat the fruit and leave the garden and hence is condemned to waves of instability.
Finally, Keynes concludes that in fact investment is driven more by ‘animal spirits’ of optimism and adventure rather than rational calculation. This is probably a good thing, but the side-effect is that irrational lack of confidence is also possible, say from “fear of a Labour Government or a New Deal”. The rest of the community depends on the “nerves and hysteria and even the digestions and reactions to the weather” of investors. [p. 162]
Consequently, Keynes thinks the rate of interest will be swamped by swings in expectations as a determinant of investment, and therefore monetary policy will be less effective. Hence, investment is likely to be more surely undertaken by the State. Keynes seems careful not to say whether or not he thinks this is a good thing, and gives no indication of the form this will take:
I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have decided above, will be too great to be offset by any practicable changes in the rate of interest. [p. 164]