From the boardroom to the financial gambling casino: how the long-term expectations that determine capital investment became unstable and confidence in expectations evaporated in the 1930s

In chapter 11, Keynes created a theory in which, given the interest rate, investment in capital goods depended on the long-term profit expectations of business firms as reflected in the mec.

Keynes explained how this structural change came to pass.

In former times, when enterprises were mainly owned by those who undertook them or by their friends and associates, investment depended upon a sufficient supply of individuals of sanguine tem­perament and constructive impulses who embarked on business as a way of life, not relying on a precise calculation of prospective profit.

(CW 7, p. 150)

In the nineteenth century, most firms were owned by founders and their families and friends, but by the interwar period, many large firms had gone public as the founding families cashed out their illiquid stock of real capital by selling ownership of the firm on the stock market. The assumed replacement of the management of the firm by investors in the stock market as the site of the determination of the mec required a rethinking by Keynes of the theory of capital investment.

Family-owned and -operated firms were committed to the long-term growth of the firm primarily because this made possible the long-term repro­duction of the economic and social status of the family.

Keynes stressed the importance of this change in liquidity in his explan­ation of the instability of the period.⁴ An asset is liquid if it can be sold quickly with a small transaction cost without the sale causing a significant drop in the price of the asset. Physical capital can be highly illiquid. Once put in a specific place, with a specific technology, and integrated into an existing production system, the resale of the asset may take a substantial period of time and can result in a substantial capital loss. If the firm is forced to sell plant or equipment when business in the industry is bad and the demand for capital goods has collapsed, the sale will result in a large capital loss for the firm.

Family-owned firms did not consider selling their factories in eco­nomic downturns or buying factories for the purpose of reselling them a short time later for capital gains. They were not short-term speculators. "Decisions to invest in private business of the old-fashioned type were, however, decisions that were irrevocable, not only for the community as a whole, but also for the individual" (CW 7, p. 150). This limited the vola­tility of capital investment over time.

On the other hand, a shareholder owns a piece of paper he or she can buy or sell at a moment's notice at a small transaction cost. In the unstable stock markets of the late 1920s and 1930s, speculators operated - often with borrowed money - on very short-term horizons, seeking quick capital gains when prices were rising, while quickly selling to avoid short-term

Chapter 12 of The General Theory 249 capital losses when prices were falling.

Why was Keynes so focused on the properties of the stock market in a chapter devoted to long-term expectations as they affect the mec and the level of investment spending? It is because in this chapter Keynes argues that a rise in a firm's stock price is tantamount to an increase in its mec, and it therefore creates an increase in the demand for capital goods. If, then, the stock market is an insane gambling casino, investment spending will be exceptionally volatile and thus exceptionally risky: over the long run there will be too little investment, and what investment there is will not be efficiently allocated.

With the separation between ownership and management that prevails today and with the development of organised investment [i.e. stock] markets, a new factor of great importance has entered in, which some­times facilitates investment but sometimes adds greatly to the instability of the system. In the absence of security markets there is no object in fre­quently attempting to revalue a [capital] investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revive his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week.

(CW 7, p. 150-151, emphasis added)

[T]he daily revaluations of the Stock Exchange, though they are pri­marily transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current invest­ment. 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.⁵

(CW 7, p.

He repeated this assertion in chapter22.

I have shown above (Chapter 12) that, although the private [stock market] investor is seldom himself responsible for new [capital] investment, nevertheless, the entrepreneurs, who are directly respon­sible, will find it financially advantageous, and often unavoidable, to fall in with the ideas of the market, even though they themselves are better instructed.

(CW 7, p. 316)

Some distinguished Modern Keynesians followed Keynes's lead in this. James Tobin wrote that his famous "q" theory of investment, in which investment is determined by the ratio of the financial market value of the firm to its reproduction cost, was inspired by chapter 12.6 Hyman Minsky also flirted with theory q, but he was not consistent about this (Minsky 1975).

This thesis is consistent with Keynes's methodological tenet that the dynamics of capitalist economies are informed by their historically specific institutional and behavioral foundations. In this case, the tenet suggests that the impact of changes in stock prices on capital investment depends on historically and institutionally specific conditions. Keynes himself said that the proposition that the mec was set in the stock market rather than the boardroom was not true in the pre-WWI era. I argued (Crotty 1990) that Keynes's assertion that stock price behavior, not man­agerial discretion, determined investment spending was not correct in the period of the dominance of the "managerial firm" in the USA and else­where. This historical dynamic is described in detail by the business his­torian Alfred Chandler (Chandler 1990). On the other hand, as explained in Crotty (2005), the relation between stock prices and capital investment was altered by the emergence of the hostile takeover movement of the 1980s and the "shareholder-value" movement in the 1990s. In the first case, hostile takeovers forced management to pursue the objectives of their attackers even though they did not share them and in fact resisted most takeovers - which is why they were called hostile.

Keynes then asked a question whose answer has a major impact on the determination of the mec: what is the character of the expectations that move stock prices and - at least in this historical period and especially in the USA - alter capital investment spending?

Early in the chapter, he offered one psychologically based convention that led to the conclusion that long-term expectations would be formed by extrapolation from fairly recent trends, which would make them pro­cyclical and therefore potentially destabilizing. This convention centers on

Chapter 12 of The General Theory 251 the assumption that people have more confidence in short-term than long­term expectations, or alternatively, that long-term expectations are based mostly or only on the behavior of the recent past.

It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain.⁷ It is reasonable, there­fore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long term expectations; our usual practice being to take the existing situ­ation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.

(CW 7, p. 148)

Taken by itself, this statement suggests that the mec of a factory with an expected life of two decades will be primarily determined by forecasts of the state of the economy, say, two or three years in the future, with the years beyond that being behaviorally irrelevant. Though the profit yielded by this factory in the last 17-18 years of its expected life are more important to the determination of the mec than that generated in the first 2-3 years, the firm, Keynes suggested, has little confidence in its ability to forecast beyond the first few years - "our knowledge is vague and scanty" - and therefore does not put much weight on the out years. But it does believe it can forecast the coming few years with reasonable confidence by extrapo­lating economic trends over the last couple of years. Therefore, the mec calculation will be disproportionately influenced by performance in the past few years rather than by long-term trends.

Keynes returned to this question immediately after he argued that the mec was set in the volatile stock market and not in corporate boardrooms. In the first paragraph that followed this argument, he asked: "How then are these highly significant daily, even hourly, revaluations of existing [capital] investments carried out in practice?" (CW 7, p. 151). He answered his own question as follows:

In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention - though of course it does not work out quite so simply - lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reason to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience this is most unlikely.

(CW 7, p. 152, emphasis in original)

Keynes seems to be saying that if you want to forecast stock prices in a period like the 1930s, in which they were enormously volatile, the best you can do is to extrapolate price movements from the very recent past: long­term trends cannot help with this task. Keynes said that the speculators that determined stock prices in the era only needed to forecast prices "three months or a year hence" to ply their trade (CW 7, p. 155). This can lead to alternating waves of buying and selling.

Moreover, when stock price movements are volatile and thus difficult to predict with any accuracy, agents will lose confidence in their ability to forecast accurately. The US economy was in a disastrous situation in the first half of the 1930s because expected long-term profit rates on capital investment as seen from the boardroom were dismal and financial markets were incredibly unstable, a situation that created an extreme lack of con­fidence in the ability of investors to predict future security prices. This caused a huge decline in the mec in Keynes's model. We repeat here a comment Keynes made about the utter loss of investors' confidence in their ability to predict stock price movements in the USA in 1930. He said he discussed the state of the stock market with:

all sorts of people [in America], but found no-one who even thought his opinion 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 course of the credit cycle itself, the case is hopeless.

(CW 20, p. 586)

Keynes paid particular attention to the almost unlimited instability of conventionally generated expectations in what he called "abnormal times."

A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of sudden fluctuations of opinion due to factors that do not really matter much to the prospective yield; since there will be no strong roots to hold it steady.⁸ In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.

(CW 7, p. 154)

Financial markets are thus potentially very unstable because the future is unknowable, which makes investors inevitably "ignorant" of the future

Chapter 12 of The General Theory 253 and dependent upon psychological mechanisms to guide their decisions. Volatile expectations are "unreasoning" yet "legitimate" because the infor­mation needed to make assuredly optimal decisions does not exist. There are no knowable future fundamentals to guide investor choice. "It is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment" (CW 7, p. 153).

Keynes is here asserting that secular stagnation and casino financial markets are related in that the propensity of financial markets to create excessive capital investment instability is part of the explanation of secular stagna­tion. Investment is insufficient to sustain full employment in part because it is so potentially unstable that it makes the future states of the economy more unpredictable than they otherwise would be. This makes the invest­ment decision riskier than it otherwise would be. We might say that finan­cial market instability lowers the risk-adjusted mec, or, more accurately, it lowers confidence in the truth content of the mec.

Keynes went on to list a series of factors "which accentuate this precar­iousness" of the mec that is largely determined in the stock market. They include the following:

As a result of the gradual increase in the proportion of equity in the community's aggregate investment which is owned by persons who do not manage and have no special knowledge of the circumstances, either actual or perspective, of the business in question, the element of real knowledge in the valuation of investments by those who own them or are contemplating purchasing them has seriously declined.. 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.

(CW 7, pp. 153-154)

Keynes explained why the stock market is a short-term speculative gambling casino in which professional investors cannot form long-term expectations of corporate profits, which, in turn, determine market prices.

It happens, however, that the energies and the skill of the professional investor and speculators are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but in forecasting the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys if "for keeps," but with what the market will value it at, under the influence of mass

psychology, three months or a year hence. Moreover, this behavior is.. an inevitable outcome of an investment market organized along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify 30, if you also believe that the market will value it at 20 three months or a year hence.

Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organized with a view to so-called "liquidity"...

The battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of investment over a long term of years. can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long­term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs - a pastime in which he is the victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.

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 each competitor has to pick, not the faces who he himself finds prettiest, but those who 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. We have reached the [point] where we devote our intelligence to anticipating what average opinion expects the average opinion to be.

(CW 7, pp. 154-156)

Keynes then replies to a hypothetical reader who argues that "there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pas­time, continues to purchase [financial] investments on the best long-term expectations he can frame" (CW 7, p. 156). He says that there are some investors of this type, but several factors limit their influence on security pricing.

Investment based on genuine long-term expectations is so difficult to­day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks that he who tries to

Chapter 12 of The General Theory 255 guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes... It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; human nature desires quick results, there is a peculiar zest in making money quickly.

(CW 7, p. 157)

Keynes then lists two reasons why the buy-and-hold long-term investor may bear a heavier risk than the short-term speculator. First, there is the balance sheet or financial fragility problem resulting from the fact that the long-term investor must be able to bear substantial capital losses in a market collapse whereas the speculator can cut his or her losses by selling early in the downturn. An "investor who proposes to ignore near-term [downward] market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money" (CW 7, p. 157).

Second, Keynes tells us that a manager of investment funds has an asymmetric incentive structure that induces him to join the crowd in the midst of a market bubble of some duration even if he knows the bubble will eventually collapse. If he fails to shift his clients' funds into hot stocks, he will soon lose his clients to his competitors, but if he follows the crowd in its herd behavior, his clients will not blame him when the boom turns into a bust because everyone will have suffered the same losses. If "in the short run [in the boom] he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better to fail with the crowd than to succeed unconventionally" (CW 7, pp.157-158).

Keynes was well aware that much of the frantic speculation of the period in the USA was heavily funded by short-term margin loans from banks and from brokers who borrowed from banks. Therefore, he said, a theory of stock price determination must incorporate a theory of margin lending by financial institutions. If either the demand to hold stocks falters or the market providing margin credit seizes up, a collapse in stock prices and capital investment spending will follow. Once this collapse takes place, even a sharp drop in interest rates on margin loans will not be able to revive the stock market and capital investment.

So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them,

sometimes described as the state of credit. A collapse in the price of equities, which has disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about its collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.

(CW 7, p. 158, emphasis in original)

So, capital investment depends on the mec, which depends on the stock market and on the long-term interest rate. Stock prices (and therefore the mec) depend in part on short-term interest rates on margin borrowing by speculators. And, of course, stock prices depend on capital invest­ment because the level of investment affects current and expected future profit rates. Long-term interest rates also depend to some extent on cap­ital investment, which is partially funded by new bond issues. Finally, the response of AD to problems originating in the real or financial sectors depends on the degree of financial fragility in both sectors. Economic per­formance in this period thus depended crucially on the behavior of stock markets, bond markets, and the market providing margin loans to stock and bond speculators, markets that Keynes characterized as insane gam­bling casinos. And all of this was taking place in the context of extreme financial fragility.

Thus, extreme stock market, capital investment, and employment vola­tility are the:

inevitable result of investment markets organized with a view to so- called "liquidity." 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.

(CW 7, p. 155)

Keynes defined speculation as "the activity of forecasting the [short­term] psychology of the market" and enterprise as "the activity of forecasting the prospective yield of [real] assets over their whole life" (CW 7, p. 158). For markets to be economically functional, he said, the capital investment decision must be guided by enterprise, not speculation. But as market liquidity increases, "the risk of the predominance of specula­tion [also] increases" (CW 7, p. 159). The higher the market liquidity, the greater the proportion of short-term speculators in the market and the greater the potential volatility of capital investment spending.

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. 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 - which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact otherwise engaged.

(CW 7, p. 159)

Keynes concluded that the disastrous consequences of speculation on investment and employment "are a scarcely avoidable outcome of our having successfully organized 'liquid' [financial] investment markets" (CW 7, p. 159).

Keynes's most important policy proposal to resolve the dilemma created by highly liquid financial markets, offered in the exit paragraph of chapter 12, will not come as a surprise to readers of this book. The state will have to directly control and/or guide the majority of large-scale capital investment in the country to achieve the goal of sustained full employment.

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; 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 described above, will be too great to be offset by any practicable changes in the rate of interest. (CW 7, p. 164, emphasis added)

Keynes's analysis in chapter 12 of the destabilizing effects of volatile and speculative financial markets on the mec, and therefore on capital invest­ment, complement his analysis of the destabilizing effects of bond markets in chapters 13-15. Both help accelerate economic expansions, pushing them to unsustainable levels, and as Keynes described in chapter 22 on business cycles, if conditions are right, both can also turn real-sector downturns into deep recessions and financial market downturns into dev­astating crashes. He believed that the disequilibrium properties of finan­cial markets that always help restore full-employment equilibrium in the face of negative AD shocks as embodied in classical theory were ideology disguised as theory. In the real world, the "insane" financial markets of his time (and of any time in which largely unregulated financial markets play a dominant role in the economy) can propagate and strengthen negative aggravate demand shocks and initiate economic instability endogenously.