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Keynes on Investment

Jamal Munshi, Sonoma State University, 1995

All rights reserved

In chapters 12 and 13 of “The general theory of employment, interest,

and money”, John Maynard Keynes lays out his theory of the
determinants of returns from holding risky assets (stock) and those of
holding debt (bonds) and vents his disgust for speculative trading in
financial assets.

To a rational investor, asset valuation should be based only on the present

value of the best projections of the future cash flows, adjusted for risk,
that the investor believes will be generated by the asset. As such, capital
investment is a long term decision based on long term projections and

However, by allowing the stock market to value the stock of the firm,
this ideal goes wrong, says Keynes, because most investors are from the
"ignorant masses" and they tend to buy stock only for short term capital
gains rather than for long term income.

Keynes eschews "playing the market" which he likens to a "feeding

frenzy". He despises what he calls the "animal instincts" of stock market
investors to gamble. He feels that investors are simply trying to out-
guess and out-wit each other rather than attempting to project and
compute the cold mathematics of future cash flows and associated risks.

He says that the valuation of capital assets thus established is "absurd"

because the stock market has become a forum for speculation rather
than one of enterprise; although he admits in passing that the liquidity
and the outlet for our animal instincts provided by the market are
necessary for capital formation.

He homes in on speculation as the problem. Speculation is evil according

to Keynes. He says that speculation causes undue and irrational
fluctuations in both the stock market and the bond market and these
fluctuations do not reflect real changes in economic variables.
The speculation and excess volatility syndrome of the stock market thus
also affects the debt market as they are turned into casino-like venues
for speculators instead of being the rational arenas of the economic man
who through his liquidity preference, propensity to consume, and
propensity to save, would make all of his equations come out right.

Mankind apparently is too stupid to follow his prescribed behavior and

investors too dumb to make his equations work. It is likely that he saw
himself not simply as an observer of economic behavior but as a physician
who is required to prescribe economic behavior.

Although our view of capital markets has changed since 1935, Keynes was,
of course, a giant in his time and his wisdom still influences economic and
financial thought. However, it helps to understand that his work was
largely part of the overall response of economists to the 1929 crash and
the ensuing depression.

It must have seemed at the time that the system of free enterprise that
we inherited from the Dutch and the British Dissenters and their
Industrial Revolution may not be viable; that capitalism had failed; just as
it seemed after the fall of the Soviet Union that communism has failed.
And it was Keynes' work more than any other ideology that delivered us
from at least the psychological depression of the times. In the midst of
all the wringing of hands and gnashing of teeth, he stood tall and said
that capitalism had not failed and prescribed a cure for the depression.
It was a very uplifting piece of work.

Although Keynes' discussion of market mechanism was not necessary to

his general theory he felt compelled to write about it anyway because no
economic work of his time was deemed complete without an 'explanation'
for the crash. Chapters 12 and 13 should be read in this light.

The legacy of the crash was to make the market into the whipping boy
explaining away the depression as an artifact of market structure that
can be fixed and therefore not a fundamental failure of capitalist
economics. Keynes' strong language in this regard can be forgiven on this
score. We believe today that the market is, on the aggregate, rational
and an efficient aggregator of information and provider of liquidity going
so far as to provide additional mechanisms for speculators to provide
information and liquidity to markets. We do not question market valuation
and investor behavior. We only seek to understand them.