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 markets should be made less liquid. Consider whether for Keynes the stock market can be viewed as an efficient institution. John Maynard Keynes has been one of the most influential economists till date.
One of his famous works, set out in Chapter 12 of The General Theory of Employment, Interest and Money, is still used in the macroeconomic context amongst modern economists where he has analysed the stock market and considered policy proposal that investment markets should be made less liquid. The question that is being asked here is what made Keynes come up with these policy proposals to make the investment markets less liquid.
In order to answer this query, I would first have to study, understand and outline the material on stock market set out in Chapter 12 by Keynes. After doing so, I will figure out the reasons why Keynes was interested in making investment markets less liquid. Lastly, I will present my opinion on Keynes view of the stock market - if he saw the stock market as an efficient institution or otherwise. Keynes Chapter 12 has been considered more adequate as compared to his previous works that was interpreted in the 45-degree line diagram and the IS/LM framework.
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Chapter 12 incorporates the role of uncertainty and the role of expectations. This role of fundamental uncertainty is considered extremely essential in the context of macro-economy, a fragile system that is subjected to continuous change. In Chapter 12, the fundamental question that Keynes asks himself is, "Why does physical investment vary so much". Keynes considered investment as the most influential component of aggregate demand, which in turn determined output and employment in the economy.
Investment had fluctuated heavily in the 1920's and 1930's which was a major concern for Keynes as these fluctuations directly affected the level of output and employment in the economy. Hence, the main aim of Chapter 12 was to explain the frequently experienced phenomena of wide fluctuations in the level of new physical investment leading to fluctuations in output as a whole. Keynes saw an analysis of the stock market as relevant to this issue because stock market prices are seen as likely to have a direct impact on the rate of current physical investment.
Keynes suggested that it is not in the hands of the entrepreneurs as to decide if they wished to invest but the level of investment rather depended on the behaviour of people in the stock market. Keynes argued that if stock prices are buoyant and robust, physical investment will tend to be high as it would be profitable for entrepreneurs to set up a new business and consequently selling it on the stock market at a high price for immediate profits.
Similarly, if stock prices are deflated and depressed, physical investment will be low as entrepreneurs would rather buy an existing business at a lower price in the stock market than building up new business. Hence, the volatility of stock markets, which is on a moment to moment basis, is considered extremely dangerous for the economy as it directly affects the rate of physical investment and hence the level of output and employment through aggregate demand creating instability in the economy.
Keynes argues that the reason for having fluctuations in the stock market is due to its institutional structure. The stock market is dominated by short-term investors who buy and sell shares on a short-term basis because the structure of stock market, a modern financial market, allows investors to sell their shares on the stock market whenever they want to. In this way, the amount of cash invested in buying shares is not 'stuck' as investors can get hold of that initially invested cash by selling it off immediately.
In the past, this had been impossible where entrepreneurs could only invest on a long-term basis in their own business. Keynes suggests that in the stock market today, the problem occurs when buying and selling of existing capital assets occurs too frequently and includes an all to frequent movement into holding money. He states that rarely are the purchases made with the intention of retaining assets over the long period. Hence, it is the feature of the stock market activity with a frequent decline in the valuation of existing stocks that leads to fluctuations in terms of new physical investment.
It is now worth knowing on what basis do entrepreneurs decide upon the shares they wish to invest in when the stock market is so volatile. It is here that the role of fundamental uncertainty and the role of conventions come into play. Fundamental uncertainty is defined by the absence of any probabilistic function and this uncertainty is very prevalent in the stock market. Investors have virtually no idea of how any company may perform in the next five or ten years. There is no scientific assumption or probability function that investors can use in working out the future yields of the company they wish to invest in.
So what then determines the actions of investors as to which shares to buy and sell. The role of conventions and its re-establishment help entrepreneurs in making this decision. Conventions refer to pieces of information about companies that investors and entrepreneurs already posses. These pieces of information can be in the form of company's past records and performance in various sectors. However, this reliable information need not necessarily be helpful in predicting future yields of the company.
All this does is that it provides the investor with a clearer picture of how the company has performed in the past and on the assumption that present conditions will prevail in the future, the investor gets the idea of how well or worse the company may continue to perform in the future. However, Keynes argues here by claiming that the assumption about present conditions prevailing in the future is imaginary and wrong. He indicates that new information in the form of government information, rumours and information by speculators keeps coming on to the market which causes the conventions to collapse.
Hence, stock prices fluctuate from their initial value which in turn causes wide fluctuations in the level of physical investment. This forces investors to therefore re-establish conventions in order to make accurate future predictions of stock prices. The distinction between enterprise and speculation is drawn out here. Enterprise is when judgement is solely based on working out the future expectations of the company based on all the reliable information available. This is usually the role of the professional investors.
On the other hand, speculation refers to investors trying to make a judgement based on what the average opinion expects the average opinion to be. In other words, they devote their intelligence in finding out the majority of the common average opinion so that they are able to make the most out of their investments. Keynes compares this notion of re-establishing conventional valuations with the "beauty contest" whereby participants are required to find out what the average opinion thinks the average opinion is going to be in recognising the prettiest face.
Re-establishing conventions in order to obtain the future yields of a company accurately is hence very difficult and sometimes just impossible. In conclusion, Keynes suggested that stock markets should be made less liquid as the fundamental uncertainty that exists in stock markets causes massive fluctuations in stock prices which in turn affects the level of physical investment directly. The end result in instability in the economy as fluctuating physical investment will cause the aggregate demand curve to shift up and down resulting in constantly changing level of output and employment.
Therefore, Keynes came up with a couple of policy proposals which were targeted to reduce liquidity in the stock market. His first suggestion was to impose a transfer tax which would force investors to pay a huge tax if they wish to sell their shares. This would obviously force the entrepreneurs to re-consider before deciding to invest in the stock market. Keynes, however, thought that this would discourage financial investment as investors will not be able to get hold of immediate cash so he came up with another proposal.
This proposal involved giving entrepreneurs no option. Entrepreneurs would either have to consume all their income or invest it. This would ensure a stable level of aggregate demand. Keynes, being a liberal thinker, felt that restricting people's choices was economically unacceptable as people should have the freedom to invest with their income. In my opinion, Keynes view of the stock market is that it is an inefficient institution to the extent whereby people spend a substantial part of their income as investment (buying shares) in order to make easy money.
This may not only be hazardous to the investor as he is taking a risk by floating his earnings but also this financial investment can create fluctuations in the level of physical investment and hence affect aggregate demand causing instability in the economy. However, it seems to me that Keynes does want the stock market to be open for investment to those entrepreneurs who have extra cash to invest, more on a long-term basis, because they always have cash other than that invested on the stock market to be invested physically in the development of new and existing business.
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