Keynes was correct: A key theme from the early lectures

Richard Da Costa

Western University

History 2171B: “Greed is Good”: The History of Modern Capitalism

Dr. Peter Krats

February 15th, 2024

 Through the early lectures, one theme jumps out at me – our collective failure to learn

from our mistakes. Most economic busts that we have learned about so far stem from greed, and

yet consumers, producers, and governments alike have repeatedly allowed greed to cloud their

vision and cause them to act irrationally. This is the core reason behind the initial success of

Keynesian economic policy. Keynes created a new paradigm in which psychological principles

became part of economics. Keynes coined the term “animal spirits” to refer to emotional

mindsets, which the classical school of thought and its derivatives essentially ignored. (Akerlof

& Shiller, 2009) For over a century, economic theory completely failed to account for the role of

human emotion in economic decisions.

In fact, Adam Smith himself was one of the first proponents of rational choice

theory, which states that the consumer always uses logic in order to make the best

decision for himself. (Smith, 2002) However, this is directly contradictory to patterns that

we have seen in market bubbles, from the 1600s tulip bubble all the way through the

1929 stock market crash.

Even the best and brightest among us are not immune to the effects of greed –

Isaac Newton himself lost roughly twenty thousand pounds (equivalent to over 260

million pounds today) when he was swept up in the mania surrounding the South Sea

Company, a British enterprise that had no real long-term business plan, simply promising

large profits to its investors. Shares soared in the summer of that year, increasing nearly

tenfold, before crashing back down in the fall following legislation that restricted

corporate debt, killing investor confidence. If Newton, the man responsible for
discovering the laws of gravity, was unable to remain rational in the face of a financial

bubble, what hope does anyone have?

Yet every new bubble brings with it supremely self-confident investors and

market makers who think that they are different, that things will change, that they know

why past bubbles happened, and that they will not repeat the mistakes of those who came

before them. No two bubbles are exactly alike, it is true, but no matter the circumstances,

emotion leads people to make irrational choices.

A new sector, industry, or perhaps merely a new corporation starts to gain steam,

investors gain confidence, discount the possibility of a bust, keep pouring money in, then

some unforeseen circumstance comes along to flip that greed into fear and the house of

cards comes crashing down. Some come out ahead – generally “smart money,” the

powerful people in the know, tipped off as to whatever is coming to disrupt the bliss of a

bubble – but most are left worse off, often indebted and with their dream of wealth

snatched from their fingers.

And circumstances are oftentimes quite comparable: compare the South Sea

bubble to the larger (and longer lasting) 1920s stock market bubble. Both bubbles

involved individuals leveraging themselves far more than they rationally should have,

because they saw no future in which they lost their money. Returns were guaranteed by

those deemed to be market experts, despite no real underlying factors to back up their

assurances. Investors bought more than they could afford to buy, driving up prices, before
some extraneous condition or conditions create doubt and fear, causing a price drop.

When prices drop, those who bought on margin must sell their shares to cover their debts,

taking losses and lowering the price, which fuels more panic selling until the bubble has

well and truly burst.

What causes the crash always varies: it is easy to blame a sudden change – a

change in laws, a once proud corporation going under, some act of God – but in truth,

every crash was years in the making, with a confluence of factors having created the right

environment for a bubble to form. Time and time again, the pattern of corporations and

market insiders overpromising and underdelivering creates a paradigm of unrealistic

optimism that is quickly dashed by the slightest resistance. The cycle has persisted and

will never cease, because unfortunately for investors, Keynes was correct – we ultimately

make decisions based on instinct, not logic.

 References

Smith, A. (2002) The Wealth of Nations. Oxford, England: Bibliomania.com Ltd. [Web.]

Retrieved from the Library of Congress, https://lccn.loc.gov/2002564559.

Akerlof, G. A., & Shiller, R. J. (2009). Animal spirits. economist.com.

https://www.economist.com/media/pdf/animal-spirits-akerloff-e.pdf