Keynes, The General Theory: Chapter 12

John Maynard Keynes,The General Theory (BN Publishing, 2008), pp. 147–164.

The state of long-term expectations

I.

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.”

II.

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.

III.

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.)

IV.

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.

V.

What are some of the factors which affect the “contemporary problem of securing sufficient investment” (p. 153)?

  1. 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;
  2. 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;
  3. The mass of “ignorant” (p. 154) investors will be subject to waves of optimism, or alternatively pessimism;
  4. “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 [1]),

  1. The “state of credit” (p. 158): the confidence banks have in borrowers.

VI.

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.

VII.

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.

VIII.

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.

6 thoughts on “Keynes, The General Theory: Chapter 12

  1. Blue Aurora

    Excellent, Jonathan. I’m glad to see that you’ve paid attention to the footnote reference made by John Maynard Keynes on Page 148 in Chapter 12 of The General Theory to A Treatise on Probability. The second reference to this footnote is found on Page 240 in Chapter 17 of the book. Keynes’s concept of the weight of the evidence is tied to his approach to uncertainty, and one letter in the CWJMK (I believe in Volume XXVIIII) indicates this. Dr. Michael Emmett Brady would approve of your notes on this Chapter, I believe.

    Speaking of the connection between A Treatise on Probability and The General Theory, have you read Dr. Michael Emmett Brady’s paper with Rogerio Arthmar on the connection between George Boole and John Maynard Keynes? It’s going to be published as “Boole, Keynes, and the Interval Approach to Probability” in Italy’s History of Economic Ideas.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1546726

    If you would like a less technical paper to help you understand The General Theory, I recommend Dr. Michael Emmett Brady’s 2009 article in the International Journal of Applied Economics and Econometrics, co-authored with Carmine Gorga: “Integrating the Formal, Technical, Mathematical Foundations of Keynes’s D-Z Model of the Theory of Effective Demand Into Keynes’s Decision Theory: Toward a New (and Final?) Interpretation of the General Theory”. It notes that Keynes came to the same conclusion with past figures in the history of economic thought on speculation and investment: namely, Thomas Aquinas and Adam Smith.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1406842

    Reply
  2. Blue Aurora

    Excellent, Jonathan. I’m glad to see that you’ve paid attention to the footnote reference made by John Maynard Keynes on Page 148 in Chapter 12 of The General Theory to A Treatise on Probability. Keynes’s concept of the weight of the evidence is tied to his approach to uncertainty, and one letter in the CWJMK (I believe in Volume XXVIIII) indicates this. Dr. Michael Emmett Brady would approve of your notes on this Chapter, I believe.

    Speaking of the connection between A Treatise on Probability and The General Theory, have you read Dr. Michael Emmett Brady’s paper with Rogerio Arthmar on the connection between George Boole and John Maynard Keynes? It’s going to be published as “Boole, Keynes, and the Interval Approach to Probability” in Italy’s History of Economic Ideas.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1546726

    If you would like a less technical paper to help you understand The General Theory, I recommend Dr. Michael Emmett Brady’s 2009 article in the International Journal of Applied Economics and Econometrics, co-authored with Carmine Gorga: “Integrating the Formal, Technical, Mathematical Foundations of Keynes’s D-Z Model of the Theory of Effective Demand Into Keynes’s Decision Theory: Toward a New (and Final?) Interpretation of the General Theory”. It notes that Keynes came to the same conclusion with past figures in the history of economic thought on speculation and investment: namely, Thomas Aquinas and Adam Smith.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1406842

    Reply
  3. JCatalan

    The last paper might be interesting, but I wouldn’t be able to get to it anytime soon. Maybe after I finish The General Theory, depending on other reading priorities. I don’t necessarily agree with Keynes’ assumptions in this chapter, even I accept the broad notions of expectations and uncertainty.

    Reply
    1. Blue Aurora

      I see. Do you think the paper on George Boole and John Maynard Keynes would bore you to death?

      Also, just for the record, Dr. Michael Emmett Brady is fond of using these mathematical concepts: LUB and GLB (Least Upper Bound and Greatest Lower Bound respectively). Complete uncertainty or ignorance, according to Dr. Michael Emmett Brady, has a weight of evidence equating to zero. Likewise, complete certainty, has a weight of evidence equating to one. But uncertainty is in general, in the face of partial knowledge, and is best modelled like this:

      0 ≤ w ≤ 1

      Reply
      1. JCatalan

        I’ll have to read more on Brady’s views on uncertainty, especially his criticism of the post Keynesian interpretation, but from what you write here I don’t think I agree with him. There is a lot of information that has a “weight of evidence” of zero, and I think much of the future fits this category. Certainly, Keynes seems to agree with me, which is why he argues that most investors put most weight on the present and project it into the future.

        Reply
        1. Blue Aurora

          While I can’t speak for Dr. Michael Emmett Brady, I think that he say that there are a lot of cases where the weight of evidence would approach zero, but it isn’t quite zero.

          The weight of evidence would be more like this:

          0 ≤ w

          As in to say, less than or equal to zero. According to Dr. Michael Emmett Brady, Keynes would say that our knowledge is slight or flimsy, but he would not say that we know nothing.

          P.S. When are you going to correspond with Dr. Michael Emmett Brady? He is willing to correspond with other people via e-mail, and he supplies his e-mail address on his SSRN account.

          Reply

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