America's "insane" financial markets and the global economic crisis

Keynes's two-volume Treatise on Money was written during the stock market boom in the USA in the late 1920s and published on December 1930 (CW 5 and 6, 1930), shortly after the US stock market entered the early stages of its collapse.

In the Treatise, Keynes described security-price cycles in terms of the balance between the optimistic expectations of "bulls" and the pessimistic expectations of "bears." His theory of financial market cycles emphasizes

Keynes on “insane” financial markets 137 that the endogeneity of security-price expectations leads to the high volatility of stock and bond changes.

We typically enter a financial boom, he said, when economic conditions are improving rapidly and most investors have confident expectations that this will continue. In Keynes's words, in the upswing there is a " 'bull' market with a consensus of opinion" (CW 5, p. 226). But as security prices continue to rise, some cautious investors will come to expect that the bull market has run its course, inducing them to sell some risky long­term securities and hold the receipts as "money" -savings accounts and Treasury bills. Keynes argued:

as soon as the price of securities have risen high enough, relatively to the short-term rate of interest, to occasion a difference of opinion as to the prospects, a "bear" position will develop, and some people will begin to increase their savings deposits...

(CW 21, p. 229)

If underlying economic conditions deteriorate, so that performance disappoints the expectations of many investors, a downturn in security prices will begin. We now have a " 'bear ' market with a division of opinion" (CW 21, p. 226). Finally, when pessimistic expectations spread widely, we enter a '"bear' market with a consensus of opinion" (CW 21, p. 226). Now everyone wants to sell long-term securities and hold the money they receive in the form of cash or short-term financial assets that cannot suffer a nominal loss of value. In terms used in The General Theory, "liquidity preference" has spiked. Security prices may fall rapidly. Thus, to a limited extent, the Treatise anticipated the emphasis on the potential for extreme financial instability in The General Theory.

However, the theory of security-price volatility in the Treatise had a major flaw that would be corrected in The General Theory. It assumed that financial cycles take place around fixed equilibrium income and output levels. This limits the potential amplitude of stock- and bond-price fluctuations. You cannot get a near-total collapse in stock prices such as occurred in the USA in the early 1930s in the fixed-equilibrium model of the Treatise. But you can, as we will see, in The General Theory, where changes in expectations will cause changes in security prices, equilib­rium income, and corporate profits that lead to further changes in security expectations, and so on.

Keynes's seeming lack of serious attention to financial-market instability as a potential threat to US economic progress in the 1920s ended with the collapse of the US stock market in the fall of 1929. At the end of May 1931,

Keynes left on his first visit to America since 1917.

Keynes returned from the USA on July 18, 1931, with the American economy on a downhill slide, US security prices in an uneven process of collapse, the banking system in a state of crisis, and the unemployment rate skyrocketing - it rose from 4 percent in 1929 to 15 percent in 1931 on its way to a 1933 peak of 25 percent. Meanwhile, the rate of unemployment among all workers in Britain doubled between 1929 and 1931, rising from 8.0 to 16.4 percent. It peaked at 17.0 percent in 1932 (Garside 1990, p. 5).¹

By the end of his trip, Keynes had come to believe that America was in a catastrophic condition. All of his previous hopes for a US-led global recovery had evaporated. His belief that British prosperity could only be restored by a revolutionary change in her economic system such as the one described in BIF was strongly reinforced, as was his belief that Britain needed much greater independence from the global economy - what he would refer to in 1933 as greater "national self-sufficiency."

Rather than looking at Keynes's comments in the early 1930s in chrono­logical order, we will first present excerpts from his statements about the destructive character of the process of price deflation that was cur­rently greatly exacerbating the ongoing global economic crisis. We will then examine the stark transformation that took place in Keynes's understanding of the nature and condition of US financial markets. After explaining why Keynes came to believe, for the first time, that the US had now entered a period of secular stagnation, we end with a few of his observations concerning the dire situation in the global economy.

Keynes's views in the early 1930s might be summarized as follows: the UK and now perhaps the USA and much of the world economy had entered an era of long-term or secular economic stagnation.

New investment during the previous five years [1924-1929] had been, indeed, on so enormous a scale in the aggregate that the pro­spective yield on further additions was, coolly considered, falling rapidly. Correct foresight would have brought down the marginal efficiency of capital [or expected profit rate on new capital goods] to an unprecedentedly low figure; so that the "boom" could not have continued on a sound basis except with a very low long-term rate of interest.

Keynes on “insane” financial markets 139 This fall in the incentive to invest was reinforced by the outbreak of finan­cial crises in America and elsewhere - though not in Britain. The financial crisis was the result of a number of factors. The main problem was massive overborrowing that led to weakening balance sheets in both financial and nonfinancial corporations. In the USA, there was excessive borrowing in agriculture, in real estate, in residential and business construction, and for stock and bond market speculation. A large volume of foreign funds had flooded into New York City to get in on the great financial market boom there, which ratcheted up the likelihood that a financial crisis origin­ating in the USA would quickly spread around the globe. This left the US economy in a state of extreme financially fragility. Governments in Europe were also heavily overindebted. Britain's staggering war debt was mostly domestically held, but there were massive cross-border loans resulting from war finance and the reparations imposed on the losers of the war by the winners in the Treaty of Versailles. The entire global financial system had become incredibly fragile.

By the early 1930s, balance sheets in real-sector and financial firms in the USA and elsewhere showed that the value of assets was either not much higher than the value of liabilities or, in many cases, even lower than the value of liabilities, so that anything that caused interest rates to rise (and bond prices to fall) or the value of the real or financial assets used as collateral for loans to fall could trigger a financial crisis capable of spreading across countries through highly integrated national finan­cial markets. The "Great Crash" in US securities markets that began in late 1929 provided the trigger. It created falling financial security prices, rising interest rates - especially real or deflation-adjusted interest rates - and a collapse in the supply of credit in the face of a wave of margin calls, defaults, and bankruptcies. As output and income began to decline, deflation spread to the real sector - profit rates and investment spending plummeted and unemployment exploded. The real-sector collapse exacerbated the financial crisis and vice versa in a kind of economic dance of death. Interconnected international financial and real-sector markets spread the devastation almost everywhere. A massive deflation of goods and financial market prices spread rapidly around the world, threatening to destroy national economies.

The global economy had thus entered a disastrous downward dis­equilibrium process that demonstrated that Keynes's fear of the impact of deflation in a fragile "regime of money contract" was well-founded. But even Keynes was shocked to see how quickly the destructive self­reinforcing dynamics of the global crisis were proceeding.

Keynes gave two lectures at the New School for Social Research in New York in June, where he stressed the urgent need to first stop the current deflationary spiral, then reflate the global economy. He argued, as he had before, that deflation was an economically, politically, and socially dangerous process, one that violated basic norms of social justice.

Deflation was dangerous in part because, in the UK at least, "the social resistance to a drastic downward readjustment of salaries and wages [will] be an ugly and dangerous thing." Keynes referred to the conven­tional belief that wage deflation would "present comparatively little dif­ficulty in a country such as the United States where economic rigidity has not yet set in." He disagreed with this proposition: "I find it difficult to believe this" (CW 20, p.

Keynes had long argued that deflation is particularly dangerous in a fragile "regime of money contract" because, as prices fall, "we increase proportionately the burden of monetary indebtedness" (CW 20, p. 545). He focused on the condition of balance sheets in a globally integrated financial system as a crucial indicator of the potential dangers caused by a period of serious deflation. In a general deflation, the value of the col­lateral relied on by lenders evaporates, threatening both lender and bor­rower with default. Keynes said that if this deflationary disequilibrium process proceeds far enough in a heavily indebted environment, it can become a threat to the entire financial system and indeed the entire eco­nomic and social order.

For the burden of monetary indebtedness in the world is already so heavy that any material addition would render it intolerable. The burden takes different forms in different countries. In my own country it is the national debt for the purposes of War which bulks largest. In Germany it is the weight of reparation payments fixed in terms of money. For creditor and debtor countries there is the risk... of general default. In the United States the main problem would be, I suppose, the mortgages of farmers and loans on real estate generally.

(CW 20, p. 546)

The truth is that the financial structure of the United States is no more able than the rest of the world to support so terrific a change in the value of money. The vast growth of bank deposits and bonded indebtedness in that country interposes a money contract between the real asset on the one hand and the ultimate owner of wealth on the other. A depreciation of the money value of the real asset, sufficient to cause [bank safety] margins to run off, necessarily tends to burst up the whole structure of money contract, particularly those short-term contracts represented by bank deposits.

(CW 20, p. 571)

In a letter written from the USA to his friend Hubert Henderson in June 1931, Keynes expressed shock at the extreme vulnerability of the US banking system. The crash in stock and bond prices after late 1929 exposed securities markets as speculative gambling casinos whose instability contributed to the collapse of capital investment. But Keynes had not fully appreciated before his trip to America the degree of rot that existed in the heart of America's financial markets - its banks. "I had most underestimated before I came... the position of many banks in the country" (CW 20, p. 556). It was not just securities markets, but the entire financial system that was on the verge of destruction.³ The threat of a financial collapse in the USA was a threat to the global finan­cial system. It is not surprising, therefore, that Keynes went on to argue in The General Theory that financial markets were the Achilles' heel of modern capitalism.

US banks had lent heavily to farmers, to land speculators, for resi­dential and commercial real estate and construction, to financial market speculators - and to each other. They had significant investments in bonds that had collapsed in value and had borrowed heavily from their depositors, including those who lived outside the USA. The ongoing deflation in so many real and financial markets had left the balance sheets of many banks in near-disastrous condition.

A large number of banks had recently failed and thousands of others were in a perilously fragile condition. Keynes observed:

there is great unrest amongst depositors. There is a possibility at any moment of bank runs breaking out in different parts of the country, similar to what was lately experienced in Chicago. The consequence is that depositors not infrequently take their money out in cash and keep it in a safe deposit box. This means that the banks in their turn are extraordinarily nervous, even those that are perfectly solvent, since they never know when they may have to support a run from their depositors. Accordingly they have an absolute mania for liquidity. They put pressure on their customers to repay loans, since loans and advances are non-liquid in an emergency. Generally speaking, they turn all the assets they can into a fairly liquid form and in some cases keep an abnormally large amount of till money. As long as this men­tality exists on the part of depositors and banks, and it is obvious that in the circumstances it is entirely intelligible, since many banks are in fact not safe, whilst the members of the general public cannot tell which the dangerous ones are, it overshadows the whole situation⁴. It is the weakness of the banking system all over the country which primarily stands in the way of the usual remedy, cheap and abundant credit, failing to take effect. It will be difficult to make much progress until there is a challenge to this mentality.

(CW 20, pp. 556-557, emphasis added) Note Keynes's emphasis on the "absolute mania for liquidity" - the intense pressure to trade every kind of marketable asset, real or financial, to get the cash needed to pay debts and to avoid additional capital loss. This mania found its reflection in the intense focus on "liquidity preference" as a behavior toward risk in the relevant chapters on financial markets in The General Theory.

Keynes focused on the fact that the condition of balance sheets was a major cause of the economic chaos of the era. For Keynes, balance sheets matter! I emphasize this because, for reasons that are not clear to me, Keynes discussed but did not adequately stress the centrality of balance sheet conditions in his analysis of the crisis tendencies of modern capitalism in The General Theory, though he does refer to the importance of balance sheets in his analysis of disequilibrium dynamics in chapters 19 and 22. This lack of adequate emphasis may have led most modern "Keynesian" economists to assume that Minsky added this dimension to Keynes's ana­lysis of the destructive dynamics of capitalist economies. Nothing could be further from the truth.

Another serious problem was that long-term interest rates in the USA were very high just when the actual and the expected rates of profit on capital investment had been dramatically reduced. "In the light of past experience, the rate of interest in the U.S. is, it seems to me, absurdly, incredibly high - sufficient by itself to explain the slump in which we are labouring" (CW 20, p. 552). Keynes then addressed the question of what the effect on output and employment might be if the interest rate were to be substantially reduced. His answer was that low interest rates alone could not increase industrial capital investment in such depressed conditions. But this was not a devastating problem because, as Keynes said over and over again, manufacturing investment is not large relative to other kinds of investment such as in infrastructure, real estate, and public utilities: "Manufacturing enterprise [alone] is never capable of absorbing any large proportion of current saving" (CW 20, p. 553). But low interest rates would help stimulate investment in buildings, transport, and public utilities, the kind of investments that he believed should be controlled by public and semi-public entities.

Keynes returned to these themes in a lecture on July 1, 1931. He addressed the question of why long-term interest rates did not fall even though the Fed had substantially cut short-term rates. Adjusted for defla­tion and for increased risk as reflected in bond ratings, long-term interest rates had risen dramatically - the opposite of what classical theory (and Modern Keynesian theory) predicted would happen when unemployment was high. Keynes tells us that the "morbid psychology" of financial institutions is a big part of the problem. They are caught in a situation in which the deflationary process has caused their net worth to evaporate to the point where they are forced to sell all risky assets. This pushes interest rates up and bond prices down, which makes the situation even more dangerous.

There is a certain point where almost everybody in charge of funds reaches the stage of what I call "abnormal psychology." In an ordinary way, any kind of financial institution has a certain cushion of some kind, reserves and margins, and is prepared to run reasonable risks, prepared to be sensible on the evidence, but when these margins run down to a certain point they get into a state of mind where they are not prepared to run... any risk at all, because they have got to the end of their margins. If they would run any risk at all, and it was to go wrong, they would be in a horrid situation, and. they get into a state of mind where they won't run [even] a sound risk. That morbid psych­ology, though quite intelligible and natural, is a tremendous obstacle to a right development of affairs when it exists. There is an element of that morbid psychology present today; there are financial institutions and individuals who want to safeguard against any possible future loss, and are therefore unwilling to run sound risks.

(CW 20, p. 537, emphasis added)

Keynes also learned a great deal about the "abnormal psychology" of financial market investors while in America. He mentioned that he discussed the state of the stock market with

all sorts of people, but found no- one who even thought their opinion [about the future path of stock prices] was worth two-pence. When the elements of bluff and skilled market-manipulation and mass psychology and pure chance are added to the intrinsic difficul­ties of forecasting the courses of the credit cycle itself, the case is hopeless.

(CW 20, p. 586)

This discovery had a profound effect on Keynes's evolving theory of "insane" financial markets. In the language of chapter 12 of The General Theory, this "hopeless" feeling will be described as a complete loss of "confidence" by investors in their ability to generate useful forecasts of future stock-price movements to guide their behavior in the market. In chapter 12, Keynes will argue that such a loss of "confidence" by investors will lead to extreme volatility in security prices, a condition he refers to as "abnormal times."

A conventional valuation [of security prices] which is established as the outcome of the mass psychology of a large number of [unavoid­ably] ignorant individuals is likely to change violently as the result of a sudden fluctuation of opinion. since there will be no strong roots of conviction to hold it steady.

Many investors were not willing to buy or hold long-term securities under these conditions and others bought or sold securities as their optimism about future prices rose and fell in cycles.

Keynes began a lecture in Germany in January 1932 with an acknow­ledgment that the most immediate threat to the global economy was now a financial crisis, not the industrial slump he had pointed to only a year earlier.

The immediate problem for which the world needs a solution today is essentially different from the problem a year ago. Then it was a question of how we could lift ourselves out of the acute slump into which we had fallen and raise the volume of production and employ­ment back towards a normal level. But today the primary problem is how to avoid a far-reaching financial crisis... Can we prevent an almost complete collapse of the financial structure of modern capitalism?. [N]o one is likely to dispute that the avoidance of financial collapse, rather than the stimulation of industrial activity is not the front-rank problem. (CW 21, p. 39, emphasis added)

The world was now witnessing one of the greatest deflations in the price of real and financial assets in the modern era. As early as May 1930, Keynes had written: "Apart from the [immediate post-WWI] slump of 1921, one can go back seventy years without finding anything equal to it" (CW 20, p. 346). The average annual rate of deflation in the US con­sumer price index from December 1929 to June 1933 was 8.3 percent. In the quotation immediately below (from January 1932), note again that Keynes believed that Britain was probably the only major nation not involved in the financial panic because it did not have a casino financial system.

[T]he immediate causes of the financial panic [are found in] a cata­strophic fall in the money value not only of commodities but of prac­tically every kind of asset - a fall which has proceeded to a point at which the assets, held against money debts of every kind including bank deposits, no longer have a realizable value in money equal to the amount of the debt. The "margins" as we call them, upon which confidence in the maintenance of which the debt and credit structure of the modern world depends, have "run off." The assets of banks in very many countries - perhaps in all countries with the probable excep­tion of Great Britain - are no longer equal, conservatively valued, to their liabilities to their depositors. Debtors of all kinds no longer have assets equal in value to the fixed money charges for which they have made themselves liable. Few governments still have revenues equal to the fixed money charges for which they have made themselves liable.

(CW 21, p. 39, emphasis added)

Keynes went on to explain yet again how the outbreak of crisis in a financially fragile system with precarious balance sheets can trigger destructive disequilibrium dynamics. Note his stress on the "competitive panic" to get liquid. In The General Theory, Keynes observed that in the USA in 1932 "there was a financial crisis or crises of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms" (CW 7, pp. 207-208).

Moreover, a collapse of this kind feeds on itself. We are now in the phase where the risk of carrying assets with borrowed money is so great that there is a competitive panic to get liquid. And each indi­vidual who succeeds in getting more liquid forces down the price of assets in the process of getting liquid, with the result that the margins of other individuals are impaired and their courage undermined. And so the process continues. It is, perhaps, in the US that it has proceeded to the most incredible lengths. But that country only offers an example, extreme owing to the psychology of its people, of a state of affairs which exists in some degree almost everywhere.

(CW 21, p. 40)

The destructive disequilibrium dynamics also involved national governments; it induced them to adopt beggar-thy-neighbor trade policies. The gold standard made the situation worse. Keynes, of course, supported managed trade and capital controls to minimize these problems.

The competitive struggle for liquidity has now extended beyond indi­viduals and institutions to nations and to governments, each of which tries to make its international balance sheet more liquid by restricting imports and stimulating exports by every possible means, the success of each one in this direction meaning the defeat of someone else. Moreover every country tries to stop capital development within its own borders for fear of the effect on its international balance. Yet it will be successful in its object only in so far as its progress towards negation is greater than that of its neighbours.

(CW 21, p. 40)

In an article published in The Economic Journal in September 1932, Keynes unleased a ferocious attack in the strongest possible language on the structure and performance of US financial markets. He argued they were short-term-oriented, speculative, "insane gambling" casinos subject to extreme instability, and that they were causing economic devastation around the world. This is the Schumpeterian "pre-analytic vision" that inspired Keynes's analysis of US financial markets in The General Theory. He argued that US financial markets were: dominated by insane gambling to get in at the bottom, just as they were dominated in the boom by insane gambling to get out at the top. If one is offered $20 for the price of $10, it may be foolish to refuse; but it may not seem so, if the $20 is on offer for $8 a week later. Yet positions of this kind - games of musical chairs in which all the players but one will fail to get a seat - which are not based, and do not even pretend to be based, on intrinsic values and long views, change suddenly... I do not so much refer to the fact, though it is truly remarkable, that the paper value of all the railways and public utilities, after having fallen to one tenth of what it had been two years previously, has then proceeded to double itself within five weeks. For this is no more than a vivid illustration of the disadvantages of running a country's development and enterprise as a bye-product of a casino.

(CW 21, pp. 120-21, emphasis added)

This language used here - about games of "musical chairs" and the "disadvantages of running a country's development and enterprise as a bye-product of a casino" - reappeared in chapter 12's analysis of the instability of stock market prices and the destructive effects of this instability on capital investment. In chapter12, Keynes concluded:

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 whirlwind 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.

(CW 7, p. 159)