On Keynesian Beauty Contests

The price of wheat, like all commodities, is determined by supply and demand. Yet we see the seemingly unexpected in markets: the consumption of wheat is constant throughout the year, as humans never cease to eat. But supply is far from constant, as wheat is only harvested in August and September (at least before modernity).

Based on this, we would expect wheat prices to be low during the harvest season, and significantly higher during the off season. With constant demand, supply exclusively determines the price. Obviously, this is not what we see. Bread prices aren’t seasonal; monthly prices don’t regularly deviate from the annual average price. In other words, prices are never lowest during the harvest season. This pattern goes all the way back to medieval Britain.

Europe historical wheat prices

The reason for this is simple: individuals would store grain during the harvest season for sale in the growing season, evening out the supply to give wheat a constant price. Indeed, the data shows even pricing seven hundred years ago, a testament to free markets.

These storers of grains were among the first speculators. By purchasing grain from farmers during the harvest season, when prices were low, they could profit by selling it during the growing season, when prices were high. This process eliminates the seasonal impact on prices.

By profiting from the resale of wheat, speculators served the greater good in two ways. First, and most importantly, they ensured that wheat would be available to all who wanted it, regardless of time of year. Second, they helped ensure a constant price, which reflects the true value of wheat throughout the year. Speculators today continue to serve these two roles for the public.

Despite their contributions, speculators are often attacked for their seemingly unproductive, or even counterproductive, trades. Modern economists are no exception to these attacks. John Maynard Keynes offered such an attack in The General Theory of Employment, Interest and Money. Keynes argued that investors no longer determine which stocks are of the best value — rather, they seek to purchase stocks for the short-term, in an attempt to outsmart other investors.

He puts this forward in chapter 12, “The State of Long-Term Expectation,” of The General Theory:

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 judgment, 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.

According to him, many traders no longer determine which capital goods are the best investments on merit. Instead, speculators ignore the investment on merit, instead to trade on the anticipated psychology of the market. Keynes argues this speculation is harmful to markets. I disagree.

Trading Away Emotion

Keynes is the champion of human emotion in financial markets. He, along with behavioral economists, believe that markets are more subject to whim than reason. They explain the cyclical boom and bust cycle wholly in this manner. It’s Wall Street’s overzealous investments that lead markets to implode, just as it’s the bankers’ fear of lending that causes a slow economic recovery. Only with rational government intervention can we escape these whimsical marketeers in power, Keynesians argue.

Few think that markets are better when ripe with emotion. One investor’s happiness level shouldn’t dictate the price of AAPL stock any more than iPhone sales do. This would imply the price isn’t accurate, going contrary to the financial market’s goal of appraising complex goods.

But yet Keynes criticizes the only individual to rationalize the stock market: the psychological speculator. Just as a wheat speculator who knows about the harvest season can trade away monthly price fluctuations, a psychological speculator who knows about other investors’ emotions can trade away irrationality in financial markets.

It is logically contradictory to claim both that, first, speculators cause market fluctuations that don’t track real value and, second, speculators trade to anticipate market psychology.

The psychological speculator removes emotion from markets, the complete opposite of what Keynes alleges. If making markets entirely rational is the goal Keynes seeks, he is wrong in criticizing the speculator, who is the only actor actively pursuing such a goal.

Finding a Balance

Keynes is right to separate investors into two groups: speculators and the “enterprise”:

[I will] 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 …

He is also right to identify a balance between the two. With too many speculators, not enough attention is paid to the real yield of capital goods; with too few, perhaps the market is too emotional (although, based on his writings, I imagine he’d prefer a world without speculators). His failure to find the right balance, however, points to a fundamental misunderstanding of the economy as the ultimate weighing mechanism.

Keynes offers a balance of “predominance,” one which flips between favoring the speculators and enterprise:

… It is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase…

The market only turns too emotional when the speculators outnumber the enterprise:

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.

I would hope Keynes at least has the foresight to recognize that traders vote not in numbers but in capital. One speculator’s trade of $1 billion is worth equal to one hundred $10 million trades on behalf of the enterprise. Keynes acts as though financial markets are a democracy by the people, when instead they’re a democracy by the wallet.

Regardless, Keynes neglects to mention that financial markets have their own regulator on the balance between speculators and enterprise. The answer is obvious when pondering this question: how many people total should trade markets, when adding speculators and enterprise together?

We have no central planner dictating some 100,000 individuals to trade markets for a living; each of them chose to do so by free will. Instead, individuals should continue becoming traders so long as profits are to be made; once profits cease to be made by new traders, there are enough working the markets. This is the weighing mechanism of the market determining the optimal number of traders on the Wall Street floor.

Equally, this weighing mechanism works to balance speculators and enterprise. So long as there are profits to be made in predicting the yield of capital investment, we need more enterprise investors. And as long as there are profits to be made predicting market psychology, we need more speculators.

Accordingly, if there are too many speculators, their trades will cease to be profitable. We know traders are greedy — this only works to strengthen the market response. Their unlimited greed will push them away from speculation, hopefully into something more profitable and, thus, more productive.

In a democracy, one might wish that the opposing party comprise fewer than 50% of the voting population, so as to always maintain power. Comparing the financial market to a democracy only leads to false conclusions: the speculators aren’t the opposing party, and a “predominance” isn’t the end of the world.

Keynes adds another reason for a lack of sufficient enterprise traders:

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.

If speculative trading was so readily profitable, why don’t we see vast swaths of workers ditching their shovels for the trading desk? Why must Keynesian stimulus spending be undertaken if I can so readily employ myself predicting market psychology? With the knowledge of current market conditions, this claim is easily refuted. There are thousands of investors who exclusively trade long-term, Warren Buffett being the most famous. There’s little to support his argument.

Stock, Wheat & Other Capital

It’s important to note that the trading of all capital is similarly beneficial to society. One might argue that speculators trading wheat is more productive than one trading corporate stock or bonds. This argument requires a distinction between two types of capital, consumption goods and productive goods. The argument implies that the price of one is more important than the price of the other; one would have to argue that constant wheat prices are far more important than accurate stock prices.

This is where the argument touches upon ideas of socialism and central planning, ideas which leave little to be desired on behalf of its proponent.

Wheat prices being constant only means that wheat prices are accurate. The value and overall supply and demand are predictable, and thus, the price should be constant. If the price were constantly changing, we would say the price inaccurately reflects the true value of the commodity. Equally, if a commodity’s value inherently changed regularly, we would say a constant price inaccurately reflects its true changing value.

Thus, to argue that accurately pricing consumption goods is more important than accurately pricing productive goods is to forget where the consumption goods come from in the first place. Wheat is only cheap because the means of production that created it were efficient; wasteful factories and corporations only create expensive goods. The only way to quantify efficiency across the market is with accurate pricing. This is precisely how most socialist endeavours in practice end up failing to do the most basic job of feeding the population. Without accurately pricing the means of production (productive goods), there is no way to determine which methods of farming wheat are the most productive, or whether there are enough individuals employed in the agricultural field of work.

Inexpensive consumption goods require accurately priced productive goods. To argue only consumption goods deserve the attention of speculators ignores the realities of the market economy and the extensive pricing mechanism which coordinates all actors within it.

Speculation of the nth Degree

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.

Keynes may be right in believing there are speculators who try to anticipate the experts, who in turn anticipate the experts, on and on to some arbitrary nth degree. Instead, he is wrong in arguing that, as the degree n increases, the speculators become less and less useful to the public good.

In showing his fault, we must first determine the difference between first degree speculation and second degree speculation. The first might be the original wheat speculators, who purchase wheat at the harvest annually for resale throughout the year.

The second degree speculator knows the first wishes to purchase wheat annually during the harvest season. However the second knows cyclical wet and dry periods, a few years long, influence wheat yields, making it cheaper during wet periods and more expensive during dry periods. This speculator can purchase more wheat during wet periods for resale during dry periods, only to sell it back to the first speculator, who then sells it to the end consumer.

In this example, each speculator removes a factor from wheat price. The final consumer need not know whether it’s currently wet or dry, or whether it’s currently the harvest or growing season, to purchase wheat at its cheapest price. In the second degree, two factors are removed, and this would continue on to some arbitrary nth degree. As more speculators trade wheat, its price becomes more accurate, and therefore more constant.

There is no difference between a speculator who sells directly to the consumer and a speculator who sells to another speculator. The market sees no difference between one who consumes wheat to eat and one who does it for resale. Neither is inherently more productive to society; their productivity is delineated only by the profits turned by their trades. The speculator who makes the largest profit gives the greatest public good; one with a small profit, a small public good; the speculator who loses money does the public a disservice. Fortunately, speculators quickly run out of money when their trades are unprofitable.

Daily Market Fluctuations

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.

Keynes is wrong when claiming day-to-day fluctuations in markets are “ephemeral” or “non-significant.” For a stock price change to be “ephemeral,” it must occur without a corresponding change in the investment’s value. Otherwise, the price is merely updating to the new true value, a rational market response.

For Keynes to be correct, investments must rarely change value or at least do so slowly. He’s right in that, empirically, we see the opposite in markets; stock and bond prices change regularly and quickly, rarely going minutes between price updates.

However, traders know the true value of an investment changes readily, as many factors are at play. The world economy is so interconnected that every event often cascades in effect, influencing the value of other investments greatly. This ranges from changing interest rates, earnings reports, political news like adding tariffs on imports, announcements from competitors, lawsuits, journalists exposing fraud, changing market conditions, and even the weather.

By no means is this list comprehensive. Instead, it refutes the idea that investment evaluations are simple. They include a number of contributing factors, each of which changes daily. If the weather changes daily, then so must stock prices: weather events readily impact tourism, which then impact each of the services that tourism effects. To naively assume investments do not naturally fluctuate in value is to ignore all of the factors which go into them.

It is said, for example, that the shares of American companies which manufacture ice tend to sell at a higher price in summer when their profits are seasonally high than in winter when no one wants ice. The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.

His citation of anecdotal evidence here is more ridiculous than anything. If seasonal fluctuations like this were common knowledge — or just one speculator knew — they would immediately cease to exist, as they would be traded away. Just as wheat’s seasonal fluctuations immediately ceased once speculators began to purchase high and sell low, ice manufacturers and railway companies would see stable evaluations despite increased investor interest. It is the speculators here that disprove his claims. Without speculators, such seasonal fluctuations would be bound to exist. However, there exists little evidence that seasonal fluctuations continue to exist today, or even did exist a century ago. If they did exist, speculators would trade on them immediately, long before an academic like Keynes would ever hear about such an opportunity.

Markets Are Rational

Keynes’ allegations that markets are ripe with emotional influence are additionally unfounded by empirical evidence in modern markets. One of the most significant contributions to economics in the past century was the work done on the so-called “efficient markets hypothesis”, which alleges that the price of stocks consistently reflects their true value, or at least all information publicly available about its true value. Empirical evidence shows the returns on actively managed investment funds are normally distributed, implying routinely beating the market is rare if not impossible. One conclusion made from the EMH is that emotion plays no noticeable role whatsoever in pricing capital in financial markets.

Additionally, the simplistic predictions Keynes offers to model the mind of a speculator have also been empirically disproven. The “random walk hypothesis” argues that markets are completely unpredictable in their movements, and instead have more in common with completely random price action than human emotional behavior a speculator could predict.

Taxing the Speculators

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… 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.

Of course, another tax is the perfect solution. Thankfully he says “might prove” to lesson the fact that he’s clearly thought little about the effects of such a tax, as it would have no positive effect.

Even if speculation was harmful — the opposite of which has already been shown — this tax does nothing to distinguish between speculation and enterprise. This means each are equally discouraged, and instead, only the most profitable of trades may continue. We have no idea whether “enterprise” trades or speculative trades are more profitable; that depends more on the specific trade than the reason of the trade. This tax would only hurt the market, as opposed to preserve it, and would only make prices less accurate by discouraging traders from entering financial markets in the first place.

But Keynes’ great solutions don’t end at taxation. Unfortunately for those among us who desire liberty, he advocates for central economic planning of a mass scale:

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 organising 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 [monetary policy].

Keynes’s proposal here would mean a vast change in the government’s role in society and cannot stand unrefuted. Perhaps, by breaking down his proposal into easier to understand language, it will be clear how harmful this proposal would actually be.

First, he advocates for a financial market where government traders exclusively price the means of production. This is what “… calculat[ing] the marginal efficiency of capital-goods on long views and on the basis of the general social advantage” means. Accordingly, there would be little incentive for accurate prices: the profits made on behalf of their trades would go to the state (if they went to the traders, it’d be merely state-approved self-employment). Additionally, the government would be the sole determiner of the “general social advantage.” I suppose only companies that the state deems “advantageous” would be priced in such a market. Private individuals wouldn’t pick and choose which companies are best suited for their goals; the state is far better at that then you could ever aspire to be, apparently.

He then suggests the state should pick and choose between possible investments on behalf of its citizens. This is what taking “greater responsibility for directly organising investment” means, and goes contrary to the entire idea of the economic weighing mechanism we established earlier. Indeed, to Keynes it would be only just if the government dictated which restaurants and toy stores were created, or which cars were created by which workers in which cities. The ability to choose between careers would disappear, as the only way to ensure an investment is realized is with the guarantee of labor. Control over the means of production is all that communism seeks, but yet Keynes suggests it right here.

Of course, his solution is for a problem that doesn’t exist. The fluctuations in the prices for capital goods reflect true value, not the whimsical emotions of a Wall Street trader. It’s only with his fundamental misunderstanding of the role of a speculator that he could offer such an absurd state-sponsored solution. Keynes would never relinquish state control over a system he deems problematic. Freedom, after all, is a luxury few socialists can afford.