Reading the interesting argument between readers commenting on Paul Murphy’s strong backing for speculators in Saturday’s FT prompted me to re-read chapter 12 of Keynes’ General Theory, and his prose is every bit as good as last time I read it, almost 20 years ago.
Keynes is quite convincing of the awfulness of speculation (although he doesn’t mention his own efforts in the currency markets). He’s right, but the current attack on speculators being led by the French and Greeks suggests a shift further away from markets towards the state would be an improvement. It wouldn’t.
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.
Today, the third-degree trading is done by computers, with quants anticipating the average expectations. But the credit default swap traders are a perfect example of Keynes’ point: they trade CDSs, betting on the performance of a bond, itself priced by the average expectation of what average opinion will be. Only a bank acting, in effect, as a CDS market-maker comes one degree further removed from the “socially useful” trading beloved of regulators.
Keynes’ arguments, as so often, resonate perfectly today, and indeed are behind most of the attacks on the markets:
A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield… In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual… the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.
The professional investor and speculator… are, in fact, largely concerned, not with making superior long-term forecasts of the probably 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.
Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity… It forgets that there is no such thing as liquidity of investment for the community as a whole… The actual, private object of the most skilled investment today 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.
To sum up, short-term speculation makes everyone short-termist, and focused only on what everyone thinks, not what anything is truly worth, since what everyone thinks is what drives the market.
He is, mostly, right. Market fundamentalists are wrong, as has been proven many times. But that does not mean there is a better system. Keynes concludes his chapter suggesting that 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” will play a greater role.
Taken to an extreme, that would be a disaster, as we saw in Soviet Russia. Central planning does not work. I’m not suggesting Keynes believed in such an extreme, of course, but China, which is currently so admired for its mixture of state planning and capitalism, shows the dangers of a heavy state hand in the allocation of capital.
The LA Times reports one example of over-investment, a $57m airport with 50 employees, through which 151 people flew last year (yes, about one Boeing 737-worth). Similar examples abound, most famously, Ordos, “China’s empty city” – you can see it on YouTube.
My point is a simple one: governments do not have any better ability to value long-term investments than the market, and are at least as likely to be seduced into wasteful mis-allocation of capital. The markets may not be great, but most of the time they are the best we have. When, occasionally, they fail spectacularly, governments need to intervene – but remember, these failures on the way up, as well as the way down. No finance ministers were complaining five years ago that speculators were wrongly allowing such a risky country to borrow at almost the same rate as Germany.
Our best hope is to muddle through: pay heed to the speculators’ warnings of errors by the “animal spirits” of the markets, and (re)design our systems, particularly our banking systems, so the system-wide costs of the inevitable capital allocation failures are minimised.