John Maynard Keynes,The General Theory (BN Publishing, 2008), pp. 147–164.
The state of long-term expectations
We now know that the rate of investment depends on the relationship between the rate of interest (which will be covered in the next chapter) and the marginal efficiency of capital. The latter, in turn, is a relationship between supply price (minimum income necessary to justify investment) and prospective yield. This chapter will focus on what influences the prospective yield.
This latter concept is dictated by two categories: what we know and what we don’t know (future oriented uncertainty). The first is made up of things like the stock of capital goods and the state of existing consumer demand. The second is composed of factors like the future stock of capital goods, future preferences and consumer demand, and future wages. In other words, future uncertain factors which will influence the profitability of the investment. This Keynes refers to as the “state of long-term expectations.”
Keynes argues that it would be “foolish” to form expectations on the basis of the very uncertain (different from the very improbable; ftn. #1, p. 148); what we are most (or somewhat) confident about is likely to be more important. This causes a further degree of asymmetry (Keynes uses the word disproportionate), and therefore the entrepreneur is simply likely to project the present state of affairs into the future. The state of long-term expectations depends not only on the forecast made, but on the confidence placed on the prediction.
This brings us to the idea of the “state of confidence.” This is a major factor in determining the marginal efficiency of capital, or the investment demand schedule. However, the “state of confidence” is an empirical variable, in that “not much can be said about [it]… a priori” (p. 149). For the rest of the chapter, to simplify discussion, we will assume that the rate of interest is fixed and that all impact on the marginal efficiency of capital is wrought by changes in confidence.
The knowledge available to accurately plan investments is scarce; this uncertainty, or radical ignorance of the future, shrouds production. Entrepreneurs who try to predict the future state of affairs in five or ten years are “in the minority and their behavior does not govern the market” (p. 150).
There was a time when entrepreneurs embarked upon investment only as a way of life, where long-term yields were largely unknown and even once investments were completed few knew whether the yield was below, on par with, or above the prevailing rate of interest. Entrepreneurship is partly skill and partly chance; Keynes suggests that if human nature had no inclination towards risk-taking, there might not even be much long-term investment.
Something which distinguishes old investments from modern investments is that the latter were mostly irrevocable. However, given modern stock markets and other forms of information transmission, investments can be revised even on a daily basis. This adds to the complexity, though. The stock exchange gives an opportunity to purchase existing investments, or start a new one and then sell it at an “intermediate profit” on the stock market. Also, equity prices are not just influenced by “professional” entrepreneurs, but by all market agents who partake in it.
(Ftn. 1, p. 151 might interest some. In Treatise on Money, Keynes suggested that a rise (fall) in the price of equities is analogous to a fall (rise) in the rate of interest. He revises this here, arguing that instead a rise (fall) in the price of equities is analogous to a rise (fall) in the marginal efficiency of capital. The implications are the same, however.)
In practice, entrepreneurs rely on a convention: that present conditions will continue, unless we have reason to expect change. This doesn’t mean that they actually think there will be no change, rather it is an assumption that that present valuations are correct. As long as this convention remains intact, we can expect stability. Therefore, short-term investments run lesser risk: they are “liquid” for the entrepreneur and “fixed” for the community. That is, they don’t run the risk of being inadequate five or ten years down the road.
What are some of the factors which affect the “contemporary problem of securing sufficient investment” (p. 153)?
- Since the stock market allows non-managers and non-owners to purchase equity, or part of the investment, the knowledge surrounding that particular investment falls in quality;
- Day-to-day fluctuations in the equity prices tend to excessively influence the market — in other words, stock market prices represent an inherent instability in modern investment markets;
- The mass of “ignorant” (p. 154) investors will be subject to waves of optimism, or alternatively pessimism;
- “Expert” investors, rather than forecasting the state of future yields, instead aim at predicting future valuation of equity prices in accordance with how the “ignorant” masses will value them.
We see, then, the “anti-social” (p. 155) character of equity markets, where speculators follow the ignorant masses in valuing investments. Keynes argues that there is a paradox between the object of liquidity for the individual and the illiquidity of investment for the community (this is also where Keynes mentions “time and ignorance” [p. 155]). Modern equity markets undermine the necessity for long-term, stable investment. Investors don’t choose the best investment, but what they think others will recognize as the best investment.
Why are long-term investors no longer prevalent in markets? These run a higher risk than short-term prediction, and require much more work; intelligent investing, therefore, tends to concentrate in the short-term. Investors are also running against their biological clock, making short-term profits more lucrative than long-term profits of equal value. Finally, successful long-term investors have no advantage in public relations, meaning that in bad times they will be treated equally as poorly as other, more rash investors.
The fifth and final factor discussed (although, here it’s labeled ),
- The “state of credit” (p. 158): the confidence banks have in borrowers.
Two definitions (p. 158),
(i) “Speculation:” “…forecasting the psychology of the market.”
(ii) “Enterprise:” “…the activity of forecasting the prospective yield of assets over their whole life.”
While speculation need not necessarily be predominate over enterprise, as investment markets organize and evolve speculation gradually becomes a more important activity. Fore the reasons established above, Keynes sees the growth of financial markets in this way as a negative outgrowth of the capitalist system. For this reason, he proposes means — such as higher taxes on gains — to make equity markets more expensive to access. However, the problem is that there is also advantage that the expected liquidity of equity makes investors more willing to take risks, which is fundamental. No less, where money can be hoarded, these kinds of assets are attractive alternatives.
Keynes proposes directing more spending towards consumption, since if there is a pessimists’ mood then the individual might rather choose to neither invest nor consume.
Apart from speculation, there is also the problem of “spontaneous optimism.” This is the famed “animal spirits” — the sudden urge to do something positive; to choose action over inaction. But, these are not mathematical calculations; i.e. it would be analogous to claiming the driving force being emotional and psychological impulse rather than instrumental rationality. As such, a loss in this optimism may cause damage in that it will reverse the trend of investment. It exaggerates both booms and busts; it therefore behooves society to create an environment that promotes and stimulates good feelings and optimism (p. 162: Keynes on regime uncertainty). Keynes’ basic point is that the instrumental rationality of an omniscient rational being is not something proper to assume.
What factors mitigate radical ignorance?
In many investments, due to both compound interest and capital obsolescence, short-term investing may actually be preferable to its long-term ilk. Some long-term investments (e.g. housing and apartments) can enjoy the safety of long-term contracts, which spread the risk between investor and client. Otherwise, other long-term investments — such as utilities — may enjoy “natural monopoly” privileges, giving some sense of security in prospective yields. Also, there is public investment, in areas which are seen to be socially desirable. With the state of long-term expectations properly considered, we must turn to the rate of interest which also plays a heavy role in deciding the rate of investment.