Appendix 2: The "dilemma" created by a liquid stock market
Keynes raised an important question in this chapter: why are financial investors willing to buy and hold risky equity securities whose price behavior at times is volatile and unpredictable? There are two parts to Keynes's answer.
The first is implicit in his theory of conventional expectations and confidence formation, a behavioral theory that implies that agents' perceptions of market risk will be low in periods of stable security prices and even lower during market booms when confidently held expectations of rising prices become widespread. In ebullient markets, agents come to believe that stocks are not really risky investments. This is a core building block of Minsky's theory of the endogenous creation of financial fragility.The second answer is that investors will only agree to buy and hold risky long-term stocks because the high liquidity of the stock market allows them to convince themselves that in the event that stock prices unexpectedly begin to decline, they can exit the market before prices fall very far. This makes potentially high-risk investment in stocks appear to be relatively safe, which stimulates stock purchases. It therefore contributes to the propensity to generate market bubbles, and the longer and stronger the bubble, the more likely it is to be followed by a serious crash. Keynes concluded that the liquidity properties of lightly regulated modern stock markets helped create the insane gambling casinos of the era.
Keynes suggested that conventionally constituted expectations are held with substantial confidence during periods of relatively stable trends in security prices. Yet there are many examples in the historical record when such expectations have been disastrously misleading to investors. Investors are never sure that a market crash will not occur over the intermediate to long run. Because they cannot totally erase their fear that another market crash could happen, investors are hesitant to commit their money to risky long-term securities unless financial markets are extremely liquid so that these securities can be sold at a moment's notice when problems first develop.
In my view, Keynes should have made this property of investor psychology historically specific. For example, it seems reasonable for the 1930s, but not for the stock market boom in the USA in the late 1920s. Historically, substantial stock market booms over long periods have been accompanied by a widely accepted belief that "this time is different." When financial asset prices rise fast enough for long enough, market analysts, financial economists, financial firms, politicians, and others will always find or create reasons to believe that today's financial markets are not subject to the imperfections that led previous booms to self-destruct. Many of those insisting that "this time is different" will believe in the dream they are propagating. In the stock market boom in the USA from 1984 through 2000, it was the short-term behavior of stock prices that was thought to be
Chapter 12 of The General Theory 261 unpredictable: "don't sell on the dips" became the conventional wisdom. It became widely believed that as long as investors held on to their stocks during the short periods of downward price movement that inevitably occur during any long-term boom, they were bound to receive large capital gains on their stock holdings. Optimism about longer-term market prospects facilitated the longevity of that boom.
If investors can count on the fact that stocks can be sold quickly and with a low transaction cost in liquid markets, and if most investors rely on conventional expectations and confidence formation at least over the short run, they will normally be happy to buy and hold stocks until a serious downturn actually begins to develop.
An investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For assuming the convention holds, it is only these changes which can affect the value of his investment, and he need not lose any sleep merely because he has not any notion what his investment will be worth ten years hence.
(CW 7, pp. 152-153, emphasis in original)
That is, investors believe that outcomes beyond a short- to intermediaterun future are not relevant to their portfolio investment decisions as long as markets remain highly liquid. If, as Keynes claimed, the likelihood that significant unexpected negative events that will substantially affect stock prices over the course of a few weeks is legitimately considered to be "unlikely to be very large" and investors can sell their stock in an instant at little cost, they may come to believe that aggressive investment strategies that would be extremely risky if the securities had to be held over a longer period are in fact relatively safe.
Investment becomes reasonably "safe" for the individual over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown of the convention and on his therefore having an opportunity to revise his judgment and change his investment position before there has been time for much to happen. (CW 7, p. 153)
Of course, if all investors actually do try to exit the market simultaneously when prices drop, all but the quickest to act will suffer large capital losses. What is sensible for the individual investor can be disastrous for the investing class. Keynes made the implicit assumption here that agents are not fully conscious of the collective illogic of their position, though he rejected that assumption elsewhere in the book.
Without the assumed "insurance" against large losses provided by high liquidity, investors would be far less willing to hold a large part of their wealth in the form of stocks and average stock prices would be much lower, as would the mec - and Tobin's q. Moreover, the demand to hold long-term bonds would also decline, driving up interest rates. As a result, capital investment itself would be much lower, ceteris paribus.
If capital investment is strongly influenced by stock prices, as Keynes says it is in chapters 12 and 22, then a highly liquid stock market is a necessary (though certainly not sufficient) condition for there to be extended periods of high stock prices and high investment.
And, as Keynes stressed in chapter 13 and 15, as long as investors have the option to hold their wealth in the form of risk-free "money," they cannot be induced to hold risky bonds unless they believe that they can sell them at a moment's notice at a negligible transaction cost. This results in what Keynes twice refers to as a "dilemma" in the chapter. Under existing institutional arrangements, highly liquid markets for stocks and bonds are required to provide adequate funds at moderate cost to finance high levels of capital investment. Yet the liquidity of these securities contributed to the great instability of stock and bond markets in the era, leading investors to buy in the booms, often on credit, and to dump their holdings in the downturn. This leads to unstable capital investment spending that creates unstable employment and income. High liquidity also leads to inadequate average investment spending, which creates high secular unemployment, because it reduces the level of the capital stock below what it would have been otherwise, thereby reducing employment opportunities.