Saturday, 24 March 2012

Excerpts from the General Theory by Keynes

I've been reading the General Theory by Keynes due to the "policy chapter" (working title) of my PhD thesis. I had only read chapter 12 before but now that I'm working my way properly through book IV of the GT (chapters 11 to 18 on The Inducement to Invest) I realise what sort of genius Keynes was. Here are some excerpts, only from chapters 11 and 12 (I don't have much time and the number of quotes would grow quickly if I would include chapters 13-18, especially from chapter 13 where the liquidity-preference theory of rate of interest is introduced):

Chapter 11 - The Marginal Efficiency of Capital
"The most important confusion concerning the meaning and the significance of the marginal efficiency of capital has ensued on the failure to see that it depends on the prospective yield of capital, and not merely on its current yield."

"It is important to understand the dependency of the marginal efficiency of capital of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle."

"The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake in regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between today and tomorrow... The fact that assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality."

Chapter 12 - The State of Long-Term Expectations
"It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. 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 out 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 the future, modified only to the extent that we have more or less definite reasons for expecting a change.

The state of long-term expectations, upon which our decisions are based, does not solely depend, therefore, on the most probable forecast we can make. It also depends on the confidence with which we make this forecast - on how highly we rate the likelihood of our best forecast turning out quite wrong."

"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; or even five years hence."

Factor no. 4 of how we form the expectations of the future and on what they are based on deserves to be quoted at full length. Keynes's own italics are still there but my emphasises are underlined:

"(4) But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgement and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator 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 with foreseeing changes in 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 it “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 behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. 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.

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 organised 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. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day 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.

This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it 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 long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

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 that each competitor has to pick, not those faces which he himself finds prettiest, but those which 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. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

If the reader interjects 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 investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day 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; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. 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, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally 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. For it is in the essence  of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. 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. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

"We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance."

And today's economic theory?
What I must admit finding amazing is that all that is written here above doesn't take a genius to write (although Keynes certainly was). I cannot help to feel that the meaning of the text here above can be agreed to be in some sense true by any commonly intelligent human being. That same human being would at the same time quite likely to be able to convey the meaning of this text to another person, maybe not using those exact words but conveying its meaning and feeling all the same. This is truly nothing more than common sense.

Nevertheless, today's economic theory is nothing of this sort. Just as an example, uncertainty about the future does not exist in today's ruling macroeconomic theory. It is disturbing how far away from the real world the ruling paradigm of economic theory is.

And is it any wonder, seeing today's ruling economics theory where the sensible economics of Keynes is completely and patently ignored with fully informed economic agents who take decisions based on "rational" expectations where there is no uncertainty about the future course of events, that we are in a world of economic mess?


  1. Gunnar Tómasson24 March 2012 at 19:01

    Many years ago, a young Egyptian colleague at the IMF stopped by my office after I had circulated a piece on "analytical economics" - a term by which I distinguished the approach of my piece from the mushy mainstream concept thereof.

    My colleague brought me a piece of paper and said that my approach seemed to exemplify the concept of "The Theory of Economics" as Keynes had defined it as Editor of the Cambridge Economic Handbook in 1922. This is what Keynes wrote then:

    "The Theory of Economics does not furnish a body of settled conclusions immediately applicable to a policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions."

    This concept of "The Theory of Economics" was in the tradition of John Stuart Mill and, further back, of Quesnay-Adam Smith-Jean Baptiste Say-Jeremy Bentham. In the 20th century, the concept was summarized by Joseph Schumpeter's statement that "economics is a branch of logic".

    Here is Wikipedia's introductory comments on my young Egyptian colleague:

    Dr. Mohamed A. El-Erian, born August 19, 1958, is the CEO and co-CIO of PIMCO, a global investment management firm and one of the world’s largest bond investors with approximately US$1.35 trillion of assets under management as of September 30, 2011

  2. Excellent quotes...I would say that the spiritual heart of the General Theory is in Chapter 12 of the book. But the technical heart of the General Theory is in Book V - Chapters 19, Appendix to Chapter 19, Chapter 20, and Chapter 21. The last two contain an elasticity analysis.

    Out of curiosity Dr. Margeirsson, have you ever heard of a fellow by the name of Michael Emmett Brady? You might be interested in reading a few of his articles...

  3. Thanks for the comments. Gunnar, loved your story on El-Erian! This truly is a small world.

    I hadn't seen the work of Brady but it looks very interesting to me. Thanks so much for the links, the papers are certainly on my to-read list. His books on Keynes and probability look very interesting as well!

    And as much as I liked being titled "Dr.", I feel I must correct you; I'm not there yet, but that will hopefully change soon.