XIII. Expectations and Speculation

Chapter XIII

EXPECTATION AND SPECULATION

1. The State of Confidence

Keynes’s Chapter 12, “The State of Long-Term Expectation,” is crowded with confusions. It is one of those chapters in which Keynes revels in pure satire and ends by believing his own paradoxes. All this is in the tradition of Bernard Mandeville, Bernard Shaw, and Lytton Strachey rather than of serious economics. But as passages from this chapter are often quoted with delighted approval by those who wish to rationalize their antipathy to the system of free enterprise and free markets, it is worth examining them in some detail.

First we must notice that here the definition of “the marginal efficiency of capital” undergoes what B. M. Anderson called one of its many “metamorphoses,” and that causes and effects are arbitrarily selected:

The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analyzed it carefully and have been content, as a rule, to discuss it in general terms. In particular it has not been made clear that its relevance to economic problems comes in through its important influence on the schedule of the marginal efficiency of capital. There are not two separate factors affecting the rate of investment, namely, the schedule of the marginal efficiency of capital and the state of confidence. The state of confidence is relevant because it is one of the major factors determining the former, which is the same thing as the investment demand-schedule (pp. 148-149).

We saw that, in his original definition of the marginal efficiency of capital (pp. 135-136), Keynes tied it up with the yield of specific capital instruments or assets, and particularly with the expected yield of newly produced assets. But here it is broadened out to mean business profits generally, or rather, expectations concerning business profits generally.

It is hard to see why the “relevance to economic problems” of “the state of confidence” should come in only “through its important influence on the schedule of the marginal efficiency of capital”—particularly if the latter phrase refers merely to the specific yield of new capital assets. For the “state of confidence” refers to all future expectations—including the future prices of consumption as well as capital goods, the future of wage-rates, of foreign trade, of the likelihood of war or peace, of a change of political administration, of a Supreme Court decision, etc. Why should “the marginal efficiency of capital” be singled out as the sole factor which makes the state of confidence “relevant” to “economic problems”? It is true, of course, that if “the schedule of the marginal efficiency of capital” is identified with “the investment demand-schedule,” it becomes very important. But employment may increase without a rise in new investment, or disproportionately to new investment, as a result of a rise in the state of confidence or a (relative) fall of wage-rates.

2. Fictions About the Stock Market

But Chapter 12 is chiefly an essay in satire. And in order to patronize the behavior of enterpreneurs and to ridicule the behavior of speculators Keynes finds it necessary to patronize and ridicule the human race in general:

If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing. (My italics, pp. 149-150.)

It is true, of course (and this seems to be mainly what Keynes is saying) that with regard to the future we can never act on the basis of certainty. We are not certain that an earthquake will not destroy our house next week. We are not even certain that the sun will rise tomorrow. We are forced to act on the basis of probabilities. But to admit that our knowledge of the future of an investment necessarily contains elements of uncertainty is far different from saying that it amounts to little or “nothing.”

Keynes’s trick in this chapter is to mix plausible statements with implausible statements, hoping that the latter will seem to follow from the former. “It is probable,” he declares, “that the actual average results of investments, even during periods of progress and prosperity, have disappointed the hopes which prompted them” (p. 150). It is probable. “If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation” (p. 150). This is possible, but it is hard to say whether it is probable. It is not easy to imagine precisely what would happen if human nature and human motives were entirely different from what they are.

But then Keynes begins to expatiate upon all the dire consequences which follow from “the separation between ownership and management which prevails today” (p. 150), and all the evils which follow from the opportunities which organized stock markets give to the individual to revise his commitments. He does this by creating a number of fictions. One is that people know nothing about the future, and chronically guess wildly. Another is that those who buy and sell shares on the market are ignorant of the companies in whose shares they deal, and that only the “professional entrepreneur” has “genuine” knowledge. Still another fiction is that professional speculators are not concerned with the real prospective yields of investments, but merely with their ability to pass shares on at a higher price to “gulls” among the public, or even to gulls among themselves! Expectation comes to mean expectations regarding expectations: “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be” (p. 156).

In this chapter Keynes is still satirizing the New York stock market of 1928 and 1929. Today, of course, it is not hard to see in retrospect that optimism then went to excessive lengths. Hindsight is always clearer than foresight; and Keynes seems to be preening himself on how much better his hindsight of 1936 is than the foresight of the speculative community of 1929. But was Keynes sure enough of his ground in early 1929 to sound a clarion warning, or to sell short and make a killing (and incidentally confer a social benefit by helping to mitigate excessive optimism)? Apparently not; but he explains that there were certain difficulties. Before we go into his further rhetoric, however, it may be advisable here to make a simple point. Whenever men are allowed liberty, and freedom of choice, they will make mistakes. Liberty is not a guarantee of omniscience. But neither are the mistakes of free men a valid excuse to take away their liberty, and impose government controls in its stead, on the ground that all wisdom and disinterestedness resides in the people who are going to do the controlling.

I have pointed out before that Keynes disdains to offer serious statistical evidence for statements that could easily be supported or disproved by available statistics. For example:

Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market. It is said, for example, that the shares of American companies which manufacture ice tend to sell at a higher price in summer when their profits are seaonably high than in winter when no one wants ice. The recurrence of a bank holiday may raise the market valuation of the British railway system by several million pounds (pp. 153-154).

Let us take these statements as they occur. Contrary to Keynes’s first assertion, what nearly always surprises daily market commentators and outside observers is how little attention the market usually pays to non-significant day-today fluctuations in profits. A strike in the steel industry may be front-page news in every newspaper in the country, but shares of steel companies may not go down at all, or only by a tiny fraction. On the day that the strike is settled, however, and the whole country is breathing an audible sigh of relief, the steel stocks may go down. This is always ridiculed in letters to the editor as “illogical”; but it may happen because, though operations are being resumed, the higher wage-cost involved in the settlement may be regarded as threatening a reduction of profits in the long-term.

Notice how Keynes’s second assertion above begins. “It is said.” Is such hearsay Keynes’s notion of evidence? Apparently it is; for he offers nothing else. In these days of electric refrigerators, his illustration of ice-manufacturing companies may seem obsolescent; but I have succeeded in digging up two American ice companies, and I print in Appendix B¹ the high, low, and average prices for each of them in the mid-winter period January-February for each of the twenty-five years from 1932 to 1956, inclusive, compared with the high, low, and average prices of the same shares in the mid-summer period July-August, as registered on the New York Stock Exchange. In the final column the July-August average is presented as a percentage of the January-February average.

What do these comparisons show? They show that the shares of the American Ice Co. averaged higher in summer than in winter in fourteen of these twenty-five years, but actually averaged lower in summer than in winter for nine of them. The shares of City Products Co. (formerly City Ice & Fuel Co.) averaged higher in summer than in winter in twelve of those years, but lower in summer than in winter for nine of them. Out of fifty cases, in short, the shares of these companies sold higher in summer than in winter only twenty-six times—about as often as a penny might come heads instead of tails in fifty throws.

The results here, it may be said, are inconclusive because summer ice companies were usually also in the winter fuel business. This is true; but it merely emphasizes the frivolous and apocryphal nature of Keynes’s undocumented illustration.

Keynes’s third assertion, about bank holidays, lends itself more easily to statistical verification or disproof. In Appendix C² I present a table comparing the closing bid-and-asked prices of the Southern Railway Company’s deferred ordinary shares on two specific days out of every year for the twenty-five years from 1923 to 1947, inclusive. The Southern Railway Co. has been chosen because it was one of the “Four Main Line Railway Companies” and did not have dividends falling due in August. The twenty-five years from 1923 to 1947 were chosen because amalgamation of the British Railways took effect as from the first of January, 1922, when the “Four Main Line Railway Companies” came into being, and because nationalization of the principal railway undertakings was effected on the first of January, 1948, when they were vested in the British Transport Commission and shareholders received compensation by way of a fixed interest stock (guaranteed as to principal and interest by the British Treasury), and its market prices were not therefore influenced by earnings.

Now the most famous English Bank Holiday (which bears that specific name) is the one that falls on the first Monday in August. This is the one most likely to show the effect of Bank Holidays on the quotations of British Railways. Therefore the table in Appendix C compares the closing bid-and-asked prices of Southern Railway shares on the last business day in February (chosen as being furthest away from the August Bank Holiday and also reasonably away from the Christmas-New Year holidays) with the closing bid-and-asked prices on the first business day after the August Bank Holiday.

And what do the results show? Comparing the price on each of the two days, we find that in only seven of the twenty-five years was the price of these railway shares higher on the day after the August Bank Holiday than on the last day of February, whereas in eighteen of the twenty-five years it was actually lower right after the August Bank Holiday.³

From Keynes’s point of view this is simply bad luck. On the mere law of averages, assuming that the Bank Holiday did not affect the value of railway shares one way or the other, Southern Railway shares should have been higher at Bank Holiday time about as often as they were lower. I attach no significance to the fact that the result turns out to be exactly the reverse of that of Keynes’s unsupported statement. But the actual comparison is a good lesson against making sarcastic gibes at the expense of the speculative community on the basis of unconfirmed and, as it may turn out, quite false information.

Keynes next attacks professional speculators: “They are concerned,” he writes, “not with what an investment is really worth to a man who buys it ‘for keeps,’ but with what the market will value it at, under the influence of mass psychology, three months or a year hence” (p. 155). And this behavior is an “inevitable result” of the mere freedom to buy and sell securities: “For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence” (p. 155).

Such reasoning on the part of a professional speculator is of course possible, but it is preposterous to regard it as usual. It assumes a speculator saying to himself something like this: “I know from my own sources of information that this stock I can buy now for 25 is really worth 30, on the basis of what it is going to earn; but I have a hunch that some apparently bad news is going to break within the next few months, and though I know that this will not adversely affect the real value of this stock, other people, who constitute the majority, will be foolish enough to be influenced by this news, and therefore they will push the quotation of this stock down to 20, even though more people by that time will know as I do that the stock is really worth 30 on the basis of yield,” etc., etc.

It is a byword in Wall Street that people who turn this number of mental somersaults to arrive at a conclusion quickly go broke. Contrary to what Keynes supposes, it is the speculators who try to figure what the real future values of stocks are going to be who are most likely to come out best in the long run. Many seasoned speculators got out of the market in 1928, for the sound reason that stocks were selling too high in relation to existing or likely earnings. Then, seeing the market still going up, some of them decided to jump in again, on the assumption that “the others” were not only crazy, but could be safely counted upon to go still crazier. It was the speculators who threw away their own sensible calculations, in a cynical effort to beat the mob psychology, who got caught.

But Keynes is firmly convinced of the opposite: “Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave” (p. 157). Keynes apparently believes this precisely because it is so implausible.

It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.... If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy (pp. 157-158).

To one who, like the present writer, spent many years writing daily on the stock market for New York newspapers, the foregoing sounds suspiciously familiar. It sounds like a man who once gave investment advice that turned out to be wrong, and who is looking for an alibi. It is the system that made the mistake, not he. The stock he recommended should in all logic have gone up to 108, even though it never did.... But such suspicions are unworthy, and I shall return to the merits of the argument.

3. Gambling, Speculation, Enterprise

What is it that Keynes is trying to prove? He is trying to prove that “liquidity” is wicked; that the freedom of people to buy and sell securities in accordance with their own judgment ought not to be allowed; and that their money ought to be taken from them and “invested” by bureaucrats, omniscient and beneficent by definition:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole (p. 155).

It is true that there is no such thing as liquidity of investment for the community as a whole. (But only if this means the world community. The British, for example, can relieve a crisis by selling their American shares. Any individual country can sell or buy gold or dollars, etc.) But even if we grant that there is no such thing as liquidity of investment for the world considered as one big community, this does not mean that “liquidity” cannot still be of considerable advantage to individual countries, individual banks, individual corporations, or individual persons—and therefore of advantage to the community as a whole.

On the same kind of reasoning as he used in this instance, Keynes could have argued that fire insurance is worthless because someone must bear the loss of the fire. It is true that someone must bear the loss; but the whole purpose of insurance is to distribute and diffuse the loss. And this is what “liquidity” also serves to do. It is easy to see how much good can come, and it is difficult to see how much harm can come, from allowing an individual to sell his securities to others. Others are not forced to buy them. They buy them only at a price that they regard as advantageous to themselves; and they may turn out to be better judges than the seller.

This is why there is no point to Keynes’s complaint that: “The actual, private object of the most skilled investment today is ‘to beat the gun,’ as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow” (p. 155). This is a peculiarly unfortunate image for Keynes, the advocate of government spending, deficit financing, and inflation, to have used. For if the half-crown is depreciating, it is depreciating because the politicians are printing too much money, and if the half-crown can be passed on, despite the other fellow’s unwillingness to take it, it is because the politicians have made it legal tender. Keynes forgets that what he is describing is not merely the purpose of stock-market speculation, but the purpose of enterprise as well. For the entrepreneurs who make the greatest profits will be the minority who first and best anticipate the wants of consumers, who, if Keynes wishes to put it that way, ‘beat the gun’ as compared with the majority of their competitors.

Keynes once derided economists who worried about results “in the long run.” “In the long run,” he said cynically, “we are all dead.” It is amusing to find the same man complaining here that long-run considerations are minimized because “human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate” (p. 157). But for Keynes, any stick was apparently good enough to beat the capitalist system with.

In attacking “speculation” in Wall Street, Keynes forgets that all enterprise, all human activity, inextricably involves speculation, for the simple reason that the future is never certain, never completely revealed to us. Who is a greater speculator than the farmer? He must speculate on the fertility of the acreage he rents or buys; on the amount and distribution of rainfall over the coming crop season; on the amount of pests and blight; on the final size of his crop; on the best day to sow and the best day to harvest and his ability to get help on those days. And finally he must speculate on what the price of his crop is going to be when he markets it (or at what day or price to sell for future delivery). And even in deciding how much acreage to plant to wheat or corn or peanuts, he must guess what other farmers are going to plant, and how much they are going to harvest. It is one speculation after another. And he and every entrepreneur in every line must act in relation to some guess regarding the actions of other entrepreneurs.

When all this is kept in mind, Keynes’s attack on “speculation” begins to look pretty silly. His contrast between “speculation” and “enterprise” is false. If he is merely attacking bad speculation, then it is bad by definition. But intelligent speculation, as economists and market analysts have pointed out over and over, mitigates fluctuations, broadens markets, and increases production of the types of goods that consumers are most likely to want. Intelligent speculation is an indispensable and inherent part of intelligent production.

But Keynes deplores human freedom; he seems to deplore practically all the financial progress of the last two centuries:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes a 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 (p. 159).

This tirade, which treats speculation as merely a synonym for gambling, reflects the prejudices of the man in the street. The difference between gambling and speculation is clear: in gambling, the risks are arbitrarily invented or created; in speculation, the risks already exist, and somebody has to bear them.

In gambling one man wins $1,000 and another loses it, depending on whether a ball falls into an odd or even number on a roulette wheel or on which horse comes in first on a race track. But the wheel could be spun and the race could be run without the betting, without either losses or gains. The world would probably be richer rather than poorer if gambling casinos and race tracks did not exist at all.

But it is not so with the great organized exchanges, either for commodities or for securities. If these did not exist, the farmer who raises wheat would have to speculate on the future price of wheat. But as they do exist, the farmer or miller who does not wish to assume this risk can “hedge,” so passing the risk on to a professional speculator. Similarly, a corporation manager who knows how to make air conditioners, but does not wish personally to assume all the financial risks involved from the vicissitudes of competition and of changing market conditions for air conditioners, may offer stock on the market and let investors and professional speculators assume those financial risks. Thus each job is done by a specialist in that job, and is therefore likely to be better done than if either the producer or the speculator tried to do both jobs.

The market, consisting of human beings, unable to foresee the future with certainty, will make mistakes—and some of them in retrospect will look like incredible mistakes. Yet Wall Street, notwithstanding its academic and political detractors, can be claimed as one of the outstanding triumphs of “laissez-faire” capitalism. The results speak for themselves. The United States has achieved the greatest volume of investment, the greatest capitalistic development, the greatest volume of production, the greatest economy of manpower, the highest standard of living that the world has ever known. And it has been able to do this in an important degree precisely because of the help rendered by the marvelous financial organization centered in Wall Street and not in spite of it. Surely it should have struck Keynes and his followers as worthy of notice that the country with the greatest “gambling casinos” and the greatest “liquidity” was also the country with the world’s greatest capital development and the highest average standard of living!

But Keynes carries his hostility to freedom to the point where he suggests “the introduction of a substantial Government transfer tax on all transactions” as “the most serviceable reform available” (p. 160). Continuing, he declares: “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” (p. 160).

He draws back from this totalitarian suggestion for a moment, only to work himself up again: “So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive” (p. 160). “The only radical cure for the crises of confidence... would be to allow the individual no choice [my italics] between consuming his income and ordering the production of [a] specific capital-asset” (p. 161). For people don’t know what they are doing anyway. “Most, probably, of our decisions to do something positive... can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus” (pp. 161-162). Free private investment depends upon “the nerves and hysteria and even the digestions” of private investors (p. 162), on “whim or sentiment or chance” (p. 163).

And what is all this leading up to? The denouement comes in the final paragraph of the chapter:

For my own part I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. 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 organizing investment (p. 164).

So there you have it. The people who have earned money are too shortsighted, hysterical, rapacious, and idiotic to be trusted to invest it themselves. The money must be seized from them by the politicians, who will invest it with almost perfect foresight and complete disinterestedness (as illustrated, for example, by the economic planners of Soviet Russia). For people who are risking their own money will of course risk it foolishly and recklessly, whereas politicians and bureaucrats who are risking other people’s money will do so only with the greatest care and after long and profound study. Naturally the businessmen who have earned money have shown that they have no foresight; but the politicians who haven’t earned the money will exhibit almost perfect foresight. The businessmen who are seeking to make cheaper and better than their competitors the goods that consumers wish, and whose success depends upon the degree to which they satisfy consumers, will of course have no concern for “the general social advantage”; but the politicians who keep themselves in power by conciliating pressure groups will of course have only concern for “the general social advantage.” They will not dissipate the money for harebrained peanut schemes in East Africa; or for crop supports that keep submarginal farmers in business and submarginal acreage in cultivation; or to build showy dams and hydroelectric plants that cannot pay their way but can swing votes in the districts where they are built; or to set up Reconstruction Finance Corporations or Small Business Administrations to make loans to projects in which nobody will risk his own money. There will never be even a hint of bribery, or corruption, or the gift of a mink coat to a minor official by the beneficiary of the loan....

This is the glorious vista that Keynes unveils. This is “the new economics.”

¹ See p. 445.

² See p. 447.

³ Though the figures are not shown in Appendix C (p. 447), I found that the results were exactly the same if the day chosen for comparison was the last business day before the August Bank Holiday.