Outline Keynes’s analysis of the stock market as set out in chapter 12 of The general theory of Employment, Interest and Money showing how he reaches the policy proposal that investment market should be made less liquid. Consider whether for Keynes the stock market can be viewed as an efficient institution. A. In his book “The General theory of Employment, Interest and Money” John M. Keynes revolutionised macroeconomic thinking by breaking away from the orthodox ‘classical’ supply side theories and introducing an innovatory concept of aggregate demand.
Paul Samuelson in his 45-degree line diagram and John Hick’s through his IS/LM framework have tried to interpret Keynes’ message in the general theory by discussing equilibrium in the goods and the money markets. However, authors like John Robinson and Richard Haan, (who worked closely with Keynes when he was developing the general theory) stressed on the inadequacy of these frameworks, and emphasised on the importance of Chapter 12 of the General Theory where Keynes discusses the investment market as an important determinant of aggregate demand, which in turn, determines output and employment in the economy.
In Chapter 12 of the general theory Keynes debates about the behaviour of people on the stock market rather than entrepreneurs, and creates an important link between physical investment and varying stock prices. His argument is that stock prices have a direct relationship with physical investment, where when stock prices are deflated entrepreneurs wont bother to invest, as they can take control of a company at a cheaper value, (by buying shares) without having to go through the arduousness of setting up a new business.
Similarly, when stock prices are inflated physical investment will go up, as it is more feasible to set up a new business, together with the possibility of selling it on the stock market for an immediate profit. So, effectively, Keynes implies that the volatility of the stock market is a direct threat to physical investment and through aggregate demand; output and employment. In his analysis of the stock market Keynes attributes this volatility in stock prices to the actual features of the stock market, which can be described as:
Institutional Structure: Keynes argues that fluctuations in stock prices are mainly because of the structure of the stock market; that long-term investors do not dominate the stock market, instead it is dominated by short-term speculators seeking to buy and sell investment/shares for immediate profits. He compares the existing stock market with the past when investors were bound to any investment they made, and focuses on the fact that now it is easier to get rid of investment simply by selling shares in the open market.
This creates a destabilising factor in the economy with physical investment varying with stock prices, and thus, (through aggregate demand) output and employment. Keynes rejected an earlier explanation that agents try to calculate the fundamental value of companies and estimates of future trajectories. According to Keynes fundamental uncertainty prevails in the stock market. Fundamental uncertainty is defined by the absence of probabilistic circumstances, i. e.
that investors have no idea of what is going to happen in the next twenty or thirty years, which companies will do well or what sort of market conditions will prevail. The probability of something happening is so uncertain that investors can’t base their decisions on it. This, directly leads to the question that how do investors make their decisions? How do they decide what shares to buy and what to sell? Here, Keynes says that agents fall back on conventions.
The Role of Conventions: Conventions are pieces of information that people already posses. This information does not necessarily have to be related to their future predictions, but it has to be reliable. An important idea here is that agents assume that the present conditions will prevail in the future and play the dominant role in the companies’ future performances. This means that with stable information and a continual of present conditions there should be stability in the market.
Keynes also argues against this, saying that these conventions will collapse as new information comes on to the market. This new information can be in the form of rumours, articles from journalists, company announcements etc, and will serve to change the present views and predictions of the agents operating on the stock market, and thus create fluctuations in stock prices. The re-establishment of Conventions: Now, this leads on to the idea that conventions have to be re-established if people are to make predictions.
Keynes rejected the idea that conventions are re-established by professional investors who engage in calculating the true value of companies’ assets, and stressed that basically; everyone on the market is trying to outguess each other. Everyone is trying to predict which company will do well based on personal opinions. Consensus in these predictions or average opinion leads to conventions being re-established to aid investment decisions. Clearly, investment in stock (and thus, stock prices) based on fundamental uncertainty and market conventions will vary a lot and equally have a fluctuating effect on physical investment.
This physical investment is an important part of aggregate demand in the Keynesian system of macroeconomics and equally determines output and employment. With such frequent and massive variations in output and employment the overall economy suffers a great deal of instability. Keynes points out to the importance having a stable and consistent level of aggregate demand (output and employment) saying, that it is imperative to make the stock market less liquid to achieve consistent levels of output and employment