The General Theory and the Current Crisis: A Primer on Keynes’ Economics

Intro | Pt. I | Pt. II | Pt. III | Pt. IV

Part IV: Bubble, Bubble, Toil, and Trouble: Keynes and Financial Instability

By Alejandro Reuss

This article is from Dollars & Sense: Real World Economics, available at

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Keynes in 1918

In recent years, the United States has experienced major “bubbles”—increases in asset prices fueled by nothing more than the expectation that in the future others will be willing to pay even more—in the stock market and in real-estate markets. The S&P Composite Index, a broad index of stock prices, stood at less than 850 in early 2003, after the “” crash. By 2007, it had ballooned to over 1500. The real-estate bubble saw the Case-Shiller 20-City Housing Price Index, the main index of U.S. housing prices, more than double from 100 at the beginning of 2000 to over 206 in the middle of 2006. Both have crashed since then. The Case-Shiller Index fell to less than 150 by January 2008. The S&P lost about half its value, down to a little more than 750, between its 2007 peak and March 2009.

Sources of Market Volatility

In the words of former Federal Reserve chair Alan Greenspan, a wave of “irrational exuberance” fueled the stock market boom. It is easy to believe that daredevil risk-taking, an unreasoning faith that prices will keep rising and rising, and possibly testosterone intoxication, are responsible for asset “bubbles.” That may not be entirely false, but we chalk up bubbles exclusively to irrational behavior at the peril of ignoring the element of individual rationality in joining into a bubble and fueling its growth. In The General Theory, Keynes argued that financial-market instability, in particular, was due not merely to some “wrong-headed propensity” on the part of the individuals involved, but to the organization of financial markets themselves.

Conventional economic theory of asset markets is dominated by the “efficient markets hypothesis.” Proponents of this view argue that the price of a financial asset at any given moment reflects all the available information about its true value (e.g., stock prices at any given moment reflect all the available information about the value of a company, or real-estate prices about the value of those properties). When new information becomes available, either about a particular asset or about the national or world economy, this causes market participants to revalue the asset, and the price goes up or down accordingly. If it were possible to know now that a stock’s price would, say, go up to a specific level the next day, people would buy it now in anticipation the rise, bidding up the price today. We would not have to wait until tomorrow to get to the new, higher price. In this view, stock prices reflect the real values of the assets being traded, so far as the available information allows, and price fluctuations on the stock market and other asset markets originate from outside the markets themselves.

Critics of the efficient markets hypothesis have argued that it underestimates the instability generated within asset markets. Price fluctuations are caused not only by newly available information, but by market participants’ reactions to previous price fluctuations and prediction of how other participants will react to those fluctuations. Market participants are concerned, in Keynes’ view, not with correctly ascertaining the long-term value of an asset, but primarily with guessing what others will be willing to pay for it in the short-run. They buy and sell, Keynes argued, not on the basis of “what an investment is really worth to [someone] who buys it ‘for keeps’,” but on the basis of “what the market will value it at ... three months or a year hence.”

Keynes’ Beauty Contest

Keynes famously compared financial markets to a strange sort of beauty pageant run by London newspapers in his time. The papers published an array of photos, and readers could enter a contest in which the winner was the reader who guessed which faces would be chosen by the most other participants. As Keynes pointed out, it would not do to simply choose the photo that one found most attractive, for one’s own tastes might not match those of other entrants. Neither, however, should one choose the photo that one thought other entrants would find most attractive (for they would not themselves be choosing the one they found most attractive). Each entrant would, rather, be trying to guess what other entrants would guess about which photos most other entrants would choose.

In the same way, participants in the stock market, Keynes argued, did not generally attempt to estimate the likely returns from a company’s investments (often referred to these days as its “fundamentals”), but to “guess better than the crowd how the crowd will behave.” If other market participants are, for whatever reason, buying a particular kind of asset and driving up its price, rational participants would decide to buy as well (to benefit from the short-run increase in prices) as long as they expected that the price would continue to rise.

This makes sense, from the standpoint of an individual buyer, even if the buyer, in some sense, knows better— that is, believes that the company in question has bad long-term prospects, that “the market” has overpriced the stock, that other buyers are acting unwisely, and so on. For example, I may not think that Springfield Nuclear Power is a very well-run company, but as long as I think other people are (unwisely) going to buy its stock, pushing up the stock price, it makes sense for me to buy the stock and profit from these future price increases. As more people buy in to take advantage of a crowd-induced rise in prices, of course, they further fuel the growth of the bubble. These price increases, in turn, may induce still others to buy the stock in anticipation of further increases, and so on.

This process can dramatically unhitch the price of an asset from its “fundamentals,” at least for a time. To show that the price of a stock, of houses, or of some other asset has grown out of all due proportion, however, we must have some basis for estimating the “correct” value. For stocks, one comparison is the “price-earnings (P/E) ratio” (the ratio of the stock price to the corporation’s profits, on which stocks ultimately are a claim). For housing, one can use a ratio between housing prices and “owner’s equivalent rent” (how much it would cost to rent a similar house), or the “price-rent ratio.” By these measures, U.S. stocks and housing have been grossly overvalued during the bubbles of recent years. Economist Robert Shiller, a leading authority on asset bubbles, notes that price-earnings ratios in the mid 20s are above historical norms. In 2007, the P/E ratio peaked over 27. (It had peaked at over 44 in late 1999, during the bubble.) The price-rent ratio, likewise, went way above historical norms in 2007. The national average for the 15 preceding years was less than 17. In mid 2007, it was nearly 23.

Bubbles and the Real Economy

Some people will profit in any bubble. But bubbles do not go on forever. Some end with a fizzle (prices stop rising, and inflation gradually erodes the value of the asset); others, with a dramatic crash, as in the U.S. stock market and housing markets did in 2008. As a bubble bursts, however, the price may not simply return to the “right” level. Instead, market participants may believe that price declines now mean that prices are likely to continue to fall in the future (in effect, this is a bubble in reverse, known as a “panic selloff”). As the price of an asset declines, more and more people sell to avoid getting stuck with it, fueling a further decline, and so on. Falling asset prices may, in short, overshoot the mark in the other direction.

Keynes was concerned that the “daily revaluations of the Stock Exchange ... inevitably exert a decisive influence of the rate of current investment,” that fluctuations in stock prices affect real economic activity. Rising stock prices, which make it possible for a company to raise capital cheaply by issuing new shares, have the same effects as falling interest rates. Some investment projects, which would be unprofitable if the cost of capital were greater, will be undertaken. Plummeting stock prices, on the other hand, are like increasing interest rates. They make it more expensive for companies to raise capital, and may therefore result in decreased real investment.

The collapse of the stock and housing bubbles reverberated on real economic activity in at least two more ways.

First, people’s consumption spending is affected not only by their current income, but also their wealth (the value of the assets they own, minus their debts, at any given time). As people’s wealth increases, they spend more freely; if their wealth decreases, they curtail their spending. This is known as the “wealth effect.” Keynes described this phenomenon in The General Theory, writing that the “consumption of the wealth-owning class may be extremely susceptible to unforeseen changes in the money-value of its wealth.” The stock-market and real-estate bubbles certainly fueled increased consumption. Many people simply spent more freely because they felt financially secure. Some borrowed against the rising values of their homes, often for consumption spending. As the values of these assets have plummeted, people have cut back dramatically on consumption.

Second, the collapse of the housing market detonated a major financial crisis. Banks had bet heavily on the continued rise in real-estate prices. They extended mortgage loans indiscriminately. They bought enormous amounts of mortgage-backed securities (which pay returns to their owners based on payments made on an underlying set of mortgages). When real-estate prices plummeted and mortgage defaults skyrocketed, banks were left holding assets that were plummeting in value and were basically unsellable. Many curtailed their lending dramatically, trying to build their cash reserves as a guard against bankruptcy. The resulting tightening of credit made it difficult for consumers and firms to borrow, further dragging down spending and contributing to the deepening recession.

Is Regulation the Answer?

In the parts of The General Theory focused on financial instability, Keynes argued that the speculative short-term speculative buying and selling of securities disconnected financial markets from any real evaluation of the long-term prospects of different investments. While this was, in Keynes’ view, harmless enough if the speculation existed on the surface on a “steady stream of enterprise,” it could be very harmful if enterprise became the surface on top of a “whirlpool of speculation.”

It’s easy to see the relevance of this analysis to the current economic crisis. From the 1940s to the 1970s, banks, insurance companies, and other financial institutions were highly regulated, and financial crises were relatively rare. Since the deregulation of finance, in the 1980s, the nonregulation of ever-more-exotic financial securities, and the creation of a vast world of “shadow banking,” they have become much more frequent. Enterprise (that is, the real economy) seems to have been dragged down, as Keynes foresaw, into the whirlpool.

The chain-reaction of excessive financial risk-taking, the eruption of the financial crisis, and the deepest recession since the 1930s has resulted in calls for renewed financial regulation. As of yet, only partial and inadequate measures have been adopted, and the largest banks are flying higher than ever. Even if there were robust new financial regulation, however, that would not solve the problems that cause the Great Recession in the first place—since these problems went way beyond just excessive financial speculation or risk-taking.

Economic growth in capitalist economies depends on growing demand for goods and services to match the growing productive capacity of an economy. From the late 1940s to the early 1970s, growth in productivity was matched by growth in real wages. Ordinary workers, then, created the demand for the goods that they were producing in ever-greater abundance. Since then, however, real wage growth has stagnated, while productivity and total output have kept right on rising. The demand for these goods and services had to come from somewhere. In part, it came from the wealthy who, enjoying a growing share of the total income, spent more. In part, it came from working families that made up for stagnant wages with more hours of paid work (especially by women) and more and more debt. In large measure, though, it also came from bubbles! Remember, growing asset prices encourage people to spend more. Unsustainable asset bubbles are not just a way that the U.S. economy has failed over the last few decades—they are a way that it has worked.

This way of structuring a capitalist economy, however, is prone to periodic crises that inflict an enormous human toll. Creating an economy that does not depend on the next bubble, however, requires much more than just an overlay of financial regulation.

is co-editor of Dollars & Sense.

Sources: S&P/Case-Shiller Home Price Indices; Stock Market Winners Get Big Payoff—In Testosterone, Scientific American; Robert Shiller, Online Data; Robert Shiller, Irrational Exuberance, 2nd ed.; Where Housing is Heading, Fortune.

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