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Title: The Futility of Reform of Financial Markets: Notes on Keynes’ Chapter 12
Date: 07-Oct-2009
Category: Opinion Essays
Source/Author: Stephen B. Young, Global Executive Director, Caux Round Table
Description: John Maynard Keynes: Speculative Conventions and Reform of Financial Markets As we reflect on last year's meltdown of financial markets one year on, reforming such markets seems to finally be on the rise in political agendas. In reading John Maynard Keynes's complex treatise on employment, interest and money, we were compellingly fascinated by his Chapter 12 on the dysfunctional role of speculative conventions and financial markets in setting the prices of long-term assets. It seems to us that no reform of financial markets can be considered sufficient until a remedy is found for the flaws in market pricing pointed out by Keynes in this chapter. The Caux Round Table has drafted a short essay on the lessons we've learned from reading that chapter of Keynes' General Theory.

In a month or so, the United States Congress will begin consideration of legislation to reform American financial markets, taking into account lessons learned from the meltdown of 2008, which has been given the name of the “Great Panic” or the “Great Crunch” to distinguish it from the “Great Depression” of the 1930’s. Framing the issues for the Congress are several proposals of the Obama Administration. And they are limited in scope.

In keeping with traditional responses to market failures, these proposed reforms first look to non-market decision-makers to countermand the preferences of market makers that would seem to introduce excessive risk to the public good. Thus it is proposed that the Federal Reserve System would become a “super regulator” of systemic risk in financial markets.

The concept behind the proposed reforms is to monitor and contain “systemic risks” to the financial system. The goal is not to prevent future asset bubbles and resulting collapses in asset prices, but to isolate such market volatility from public bailouts.

Second, the Obama Administration has proposed that financial products sold to consumers be vetted and approved by a public agency just as pricing and capital investment decisions of public utilities have long been vetoed or ratified by public utility commissions.

Third, it has been proposed that more information about derivatives be made public when they are bought and sold.

But the central thrust of the Obama Administration reform proposals seems to be enhancing the power of the Federal Reserve System to forestall the accumulation of systemic risks which might lead to another sudden collapse of confidence in financial markets.

The goal behind such supervision seems to be separation of private risk from public remediation. The cost of private risk should be born only by private risk takers. If private investors seek higher returns by running higher risks, then they should absorb the losses associated with such risks as well. Whenever there is market failure, private investors should take all the losses. There should be no public bailouts and rescues of for-profit financial firms. The losses will hit only the pockets of those who signed up to shoulder the risks thereof.

A just ethical comment on last fall’s massive deployment of public funds and credit to offset the deflationary effects of the Great Panic was that in the run up to and the bursting of the asset bubble in securitized consumer debt and home mortagages, CDOs and CDSs, the “gains were privatized and the losses were socialized.” Many who took profits out of the system in return for providing faulty financial intermediation were able to keep their gains while the Federal Reserve System and the US Federal Government had to pay for many of the losses they had caused with their imprudent business strategies.

This “socialization of the losses” is not the entire story. Many – owners of Bear Stearns, Lehman Brothers, and other failed firms, for example – lost the value of their ownership interests. But the reality of recession caused by the asset bubble was such that governments had to spend funds to clean up a mess made by private financial markets in order to protect standards of living for ordinary citizens and asset prices in general.

The common weal of the global economy was put at hazard by certain leaders in financial markets. Governments had an obligation to contain that hazard as best they could. Now they want to prevent a recurrence of such expenditures on their parts and such dangerous and thoughtless behaviors on the part of private markets.

The proposition that we can isolate private financial markets and let them alone to do whatever they please because government can prevent the accumulation of systemic risks in the future rests on a premise about the nature of private markets. That premise is known as the “efficient market thesis”.

Believers in efficient markets hold that all the information needed to make sound pricing decisions is available to market participants and they buy and sell back and forth until prices of goods and services reach contingent equilibria between the opposing forces of supply and demand. Under conditions of efficiency, no one can be wiser than a market for very long. Its prices are assumed to be the most correct possible under the circumstances. The efficient markets thesis is a version of the “wisdom of crowds” convention.

Systemic risk, it is argued, undermines the desired conditions of efficiency in markets. A few players have such market power that their decisions overwhelm a market’s capacity for self correction. They can impose their biases on prices. Their risks, then, become socialized to affect the outcomes experienced by others who had no intention to participate in such risky undertakings. This seems to have been the case, for example, with AIG, which had sold so many guarantees of the borrowings of others (CDSs) that its bankruptcy would crash collateral values and balance sheet viability for thousands of other companies and transactions. AIG posed a risk to the system. It was too big. It created an inefficient market by accumulating excessive risk for itself and so, for others as well.

So, it would seem probable then that prevention of systemic risk accumulation would allow us to leave markets to themselves to buy and sell as they see fit. This would be the logic for adoption of the core Obama Administration reforms.

But there is a flaw in the efficient market hypothesis, one exposed by John Maynard Keynes in Chapter 12 of his famous General Theory of Employment Interest and Money. In this Chapter 12, Keynes explained how markets for financial instruments function. He wrote about stock markets and any other market for financial contract rights where traders buy and sell contracts for future shares of income and capital appreciation, in the form of debt, equity, warrants, options, futures, derivatives, etc.

Keynes asserted that in any such market something he called the “state of confidence” directed its energies in the setting of prices. The “state of confidence” in any financial market was that socialized state of belief about what prices should be that had a disproportionate effect on reaching outcomes in efficient markets. The “state of confidence” was more powerful in the aggregate, according to Keynes, than the independent decisions of particular buyers and sellers.

No financial market, argued Keynes, could escape the directing influence of the “state of confidence.”

Now, the “state of confidence of any financial market was the sum of two subordinate conditions. One was “a speculative convention” peculiar to that market and the second was the “state of credit”.

The “speculative convention” is the variance from a mean of various ideas and conjectures about the future in the minds of buyers and sellers. A wide variance from a mean point of view, or a broad consensus, produces a stable speculative convention. On the other hand, a narrow variance with resulting lack of consensus indicates unsettled intentions among buyers and sellers and so more volatile pricing movements.

Now, much buying in financial markets is done with credit, or leverage. For example, at its fall, Lehman Brothers had leveraged its capital 44 times in order to buy financial products. Without access to credit, most market makers fail. Thus, the “state of credit” is vital to the activity level of financial markets. The “state of credit” according to Keynes is “the confidence of lending institutions towards those who seek to borrow from them”. The 2008 meltdown in Wall Street occurred due to a sudden collapse in the confidence level of lenders. There was a “flight to quality” as those with cash refused to lend it for any purchase except for purchase of the most secure and highly valued assets, such as US Treasuries.

Thus the pricing outcomes of any efficient financial market will reflect the equilibrium “state of confidence” in that market, which in turn will reflect the nature of any “speculative conventions” and the intensity, positive or negative, of the “state of credit”.

Dysfunctions such as asset bubbles in financial markets occur due to shifts in “speculative conventions” and the “state of credit”. Firmly held “speculative conventions” and intensely positive “states of credit” will produce a “state of confidence” leading to asset bubbles. Changes in “speculative conventions” and collapses in positive “states of credit” will end asset bubbles and trigger rapid declines in asset prices, leading to financial crises.

“Speculative conventions” are co-determinative of the “state of credit”. As long as a “speculative convention” holds the imagination of buyers and sellers, the prices determined by than convention will have the respect of lenders into those financial markets. But when the terms of a convention lose their persuasive appeal, lenders choke, worry suddenly about risk and seek more security for or higher returns on money lent. When faith in a convention collapses completely, lenders pull out from credit markets and the “state of credit” turns abusively negative.

This is another way of saying that financial markets don’t always get asset prices right. They price assets according to “speculative conventions” only. If the conventions become excessively irrational, then, as night follows the day, prices will be excessively irrational as well.

As Keynes noted, there is no necessary conformity of “speculative conventions” to fundamental economic realities. Such conventions are first, only conventions; they are not an external objective truth but only the mental inventions of buyers and sellers. Second, they are speculative in two senses: they are merely guesses – theoretical speculations - as to what will happen and they incorporate taking a chance on the future.

There is a necessary disconnect between speculative conventions and future reality just as there is a necessary disconnect between illusion and truth. Speculative conventions can be no more than approximations of the future; they can never be guarantees of what will be. Conventions are subjective, formed as much by emotions and prejudice as by common sense, and may or may not fully align with objective reality.

This fact applies with particular force to valuations. The holy grail of any financial investment, its summum bonum, the sanctum sanctorum of a financial contract, is its value. The perceived value of the instrument relative to its market price drives its market. A perfect market would always price an instrument - a share of General Motors, a CDO, etc. – at its “true’ value. And, its
”true”value would reflect justly and fairly the money returns in capital and income that its owner will receive.

Asset bubbles, for example, occur when prices wildly exceed realistic values; and panics occur when prices wildly underestimate longer term values.

And when faith in a convention so collapses, even equity investors are hard to come by, even though asset prices are dropping and long-term bargains become more and more available.

The presence of speculative conventions inside efficient markets holds those markets in permanent slavery to occasional outbursts of “irrational exuberance”.

Financial markets have a casino-like aspect as they are driven by traders who think only for the moment. As Keynes said: “When the capital development of a country becomes a by-product of the activities of a casino, then the job is likely to be ill-done.”

If financial markets were only casinos isolated from society like the casinos in Macao or on remote Native American reservations in Minnesota and Wisconsin and off-limits to all but gamblers who like to lose their money on a regular basis, then we could ignore them and their capacity to take our money. Keynes even noted in his chapter 12 that “it is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges.”

Thus the Obama Administration’s reforms seek to isolate irrationally exuberant market outbursts from drawing on the public fisc when irrational exuberance collapses into irrational panic.

This is a notable goal but a minimal one. Why can’t modern capitalism so balance markets that speculative conventions themselves are brought within the bounds of rationality? In other words, why can’t we have financial markets that actually get prices right with minimal destabilizing volatility?

The need to get such prices right is important. Correctly pricing assets is necessary for sound economic growth and the provision of finance for business enterprise. Whether we like it or not, however, financial markets are necessary for capitalism. Funds are needed to run real economies and liquid markets perform the wonderful function of collecting funds from some to pay over on condition to others who will put them to work in creating real economic wealth.

No modern economy can afford to over isolate its financial markets and confine them only to gamblers who love to bet on future prices of assets. Where one gambler wins, another loses and cash changes hands. But an economy needs access to the cash to invest in production and doesn’t want to be at risk of paying too much for assets, or not having access to cash when the gamblers panic and asset prices collapse.

Thus the proposed Obama Administration reforms do not go far enough. They leave our capitalism too exposed to “immoral” greed and irrational pricing.

To save ourselves from harm, we must confront Grendel’s mother in her watery den, not just kill her bloodthirsty son; we must take on the operations of “speculative conventions”.

The problem posed by “speculative conventions” is that they can’t be regulated, or dictated for markets. They arise in freedom and have complete intellectual randomness. No one can force a convention on either a buyer or seller. Their own individual thinking, ambitions, emotions, insights, fears, calculations, knowledge guides their acceptance or rejection of conventional wisdom. Their personal self-interest and self-regard drives their behaviors.

Now, here Keynes had a brilliant insight into investors which is the heart of his Chapter 12. He noted that experience and common sense has taught most investors in financial markets that they are best rewarded in the short-term not by making superior long-term forecasts of the probable yield of an investment over its whole life. No, as traders in financial markets, they are more likely to profit if they can foresee “changes in the conventional basis of valuation a short time ahead of the general public.” Keynes adds: “They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.”

The battle of wits among buyers and sellers, therefore, is to “anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years.” For, as Keynes said, “it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.”

In a most famous paragraph, Keynes described as would a social-science researcher the workings of financial pricing: “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 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 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.”

The prudently risk-averse investor, therefore, just as much as the overconfident, greedy investor, seeks to know not where the market should be but where, in the minds of other investors, it most likely will be.

To make financial markets for capital more moral and less dysfunctional to the harm of the common weal, we need to influence this process of formation of speculative conventions. We need to better tie the process to long-term valuations that reflect the dynamics of the real economy more than to the speculations that run rampant in the traders’ casinos. In short, we need speculative conventions that are less volatile and better align with fundamentals of wealth creation.

Keynes made a distinction which should inform our thinking today and our reform efforts between the activity of forecasting the psychology of the market, which he called “speculation” and the activity of forecasting the prospective yield of assets over their entire life, which he called “enterprise”. He worried that in very liquid investment markets, there was a tendency for speculation to predominate over enterprise.

It is enterprise, we must never forget, that drives the wheels of wealth creation and so ameliorates conditions of social injustice. Speculation just moves cash from one gambler to another.

Keynes noted that: “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. … The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism, which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.”

And, if we can constructively reform the process of making and unmaking speculative conventions in financial markets, we will reap the additional benefit of moving the “state of credit” to a higher and more sustainable level of confidence.

Thus, we can influence the over-all “state of confidence” in financial markets to keep them running smoothly consistent and profitable for all.

More challenging dynamics than containing systemic risks still await thoughtful reform efforts.

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