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Keynes and Bernanke on Bubbles and Manias: Blame the Free Market
Jan. 6, 2010
In 1936, John Maynard Keynes' book appeared: The General Theory of Employment, Interest, and Money. It changed the world. It justified in the name of economic theory what governments had been doing since 1932: running deficits and creating fiat money. Keynes' ideas took over. Today, they are dominant. The 30-year break, 1978-2008 -- Chicago School, rational expectations, efficient market theory -- is over. Academic economists, like Dorothy in Kansas, ran for the Keynesian storm cellar. Unlike Dorothy, they made it. No trip to Oz for them!
In chapter 12, he contrasts enterprise with speculation. This is conceptually incorrect. Both rely on accurate forecasting. Both rely on transferring assets to a specific market position. He made speculators sound like gamblers. They aren't. The emotions may be the same, but the economics are different.
A speculator operates in an uncertain market that reflects life's uncertainties. A gambler bets on the outcome of a game -- a game that is rigged for the house. The game follows the law of averages. Markets have no comparably reliable laws.
Speculators provide insight into how assets should be priced to maximize profit. This information is vital to enterprisers.
Keynes understood none of this.
If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise.
GAMBLING IS NOT SPECULATING
Keynes' distinction between speculation and enterprise is conceptually flawed. Both the speculator and the enterpriser seek to predict asset prices in the future. The speculator must take into consideration supply and demand for capital. The enterpriser must consider prices set by futures markets. Each needs the other's specialization.
As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase.
He offers no reason to believe this. If it is true, it has to do with specialization of production and reduced cost of entry. But speculation is inescapable in enterprise and capital markets. Men seek for forecast future prices, because profit and loss are calculated in prices.
In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market.
In any market, forecasters must pay attention to what other forecasters think and do. This includes assessing psychology. The goal is to buy low and sell high. What others think about the future is a major factor in predicting future prices.
It is rare, one is told, for an American to invest, as many Englishmen still do, "for income"; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator.
How does a wise investor assess the appropriate price to pay for an expected stream of income? Does he look at the interest rate? Yes; this discounts the value of that expected stream. How about the likelihood of the stream's drying up? Of course. This is another uncertainty to consider. What about the purchasing power of the currency? Yes, indeed. Should he assume that none of this will change after he buys? Of course not. Then should he consider "a favourable change in the conventional basis of valuation." That is what the market pays investors to do accurately. Keynes dismissed this as mere speculation. But forecasting unexpected changes that affect future prices is the heart of investing. Speculation is central to investing.
What will be the bottom line, to use the language of accounting, as every speculator should? Will the sales price be higher than the purchase price in purchasing power? A capital market operates in terms of prices. This is why economic calculation is possible. Without economic calculation in a money economy, modern society would collapse. The division of labor would contract. Most of us would starve. Keynes berated speculation. We should praise it.
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 capital development of a country is nothing like a casino, except insofar as people want to buy low and sell high. Capital has to do with the real world with all its uncertainties. A casino has to do with risk: statistically calculable returns on investment over many bets and many years. Speculation is not a game played for itself. Gambling is.
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 directed towards a different object.
On the contrary, a developed market that raises trillions of dollars in capital, providing second-by-second assessments of investors' best guesses, is an enormous achievement. It ranks among the most important achievements in man's history. Without capital, we would starve.
KEYNES, THE GENTLEMAN SPECULATOR
Keynes was a successful speculator. He made a fortune for himself and his university, Cambridge. This began as early as 1905. But he made his money in Britain's stock market. That was a market for gentlemen. The upstarts across the Atlantic were not gentlemen.
These tendencies are a scarcely avoidable outcome of our having successfully organised "liquid" investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is, compared with Wall Street to the average American, inaccessible and very expensive. The jobber's "turn", the high brokerage charges and the heavy transfer tax payable to the Exchequer, which attend dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market (although the practice of fortnightly accounts operates the other way) to rule out a large proportion of the transactions characteristic of Wall Street.
Keynes called for restricted entry into markets. Keep the unwashed speculators out. Make capital markets a club of English gentlemen. What might do this? A transfer tax.
The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.
Keynes was an elitist -- the consummate English snob. He resented grubby Americans, who could make fortunes when cultured British gentlemen could not. He therefore resented the American stock exchange. There was altogether too much freedom associated with it in 1936 -- and it had been much worse in the 1920s. He and his disciples have dedicated their careers to this crucial elitist task.
CENTRAL BANK POLICIES, 1920-29
He did not mention the secret meetings between the head of the New York Federal Reserve Bank and the head of the Bank of England in the 1920s. Rothbard told the story about these meetings in his 1963 book, America's Great Depression. Establishment economists have ignored this ever since.
On Norman's appointment as Governor during the War, Strong hastened to promise him his services. In 1920, Norman began taking annual trips to America to visit Strong, and Strong took periodic trips to visit Europe. All of these consultations were kept highly secret and were always camouflaged as "visiting with friends," "taking a vacation," and "courtesy visits." The Bank of England gave Strong a desk and a private secretary for these occasions, as did the Bank of France and the German Reichsbank. These consultations were not reported to the Federal Reserve Board in Washington. Furthermore, the New York Bank and the Bank of England kept in close touch via weekly exchange of private cables (p. 144).
Benjamin Strong did what his intimate friend Montagu Norman asked him to do in 1925, when England went back on the gold standard at a price for gold far lower for pounds than the free market would have established. The pound was overvalued. Gresham's law would soon persuade speculastors to sell pounds and buy dollars. Norman knew this.
Strong lowered the rate of interest by inflating money, so that the Bank of England would not suffer an outflow gold to the upstart Americans, who were paying a higher rate of interest for capital until FED policy changed. This ignited the American stock market bubble, 1926-29. The bubble broke because Strong died in 1928, and the FED tightened money. The FED quit bailing out Norman and his gentlemen peers. England threw in the towel in 1931. It went off the gold standard.
Keynes blamed the gold standard. He blamed the American stock market. He did not blame the Federal Reserve System and the Bank of England. His disciples have continued to follow his lead.
BERNANKE ON BUBBLES
For all their talk about the benefits of capital markets, Keynesian economists do not trust them. They want to regulate them and tax them. No better example can be found that Ben Bernanke's speech on Sunday, January 3, to the American Economic Association. This is America's organization of academic economists. He was speaking to the guild as the most famous member of the guild.
What we need, he said, is more regulation. Greenspan's monetary policy was not the cause of the bubble, he insisted. It was lack of regulation. We need more regulation.
That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs.
Then what of monetary policy? An afterthought.
However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks--proceeding cautiously and always keeping in mind the inherent difficulties of that approach.
Then what of economic cause and effect? What has Bernanke learned? Not much. He admitted this in his closing words.
Clearly, we still have much to learn about how best to make monetary policy and to meet threats to financial stability in this new era. Maintaining flexibility and an open mind will be essential for successful policymaking as we feel our way forward.
It is blind man's bluff.
The FED is now keeping the federal funds rate at 0% to 0.25%. It is inflating like mad to do this, as the adjusted monetary base indicates. Has this anything to do with bubbles? Not in Bernanke's view -- no more than it did under Greenspan.
The bubbles are caused by inflationary central bank policies, Ludwig von Mises argued. These lead to market manias -- what Keynes called the casino mentality. Keynes and his disciples have always blamed free markets for bubbles and manias. They have never seriously challenged regulation, central bank inflation, and "too big to fail." When push came to shove in the capital markets, non-Keynesian economists praised Bernanke and Paulson for their bailouts of September and October 2008. Only the Austrian School economists protested.
What will be the result? More bubbles, more manias, and more misdirected resources.