God is a Capitalist

Sunday, August 18, 2013

Is the stock market a casino?

The media often portrays the stock market as a casino. That attitude first gained academic cover with J. M. Keynes. Ludwig Lachmann wrote, “Thus, seeing the importance of expectations in asset markets, and disliking the implications of what he saw, he launched his famous diatribe on the Stock Exchange as a ‘casino.’”[1] Here are excerpts from Lachmann’s defense of the stock market against Keynes’ assault:
“Furthermore, in his Chapter 12 on ‘The State of Long-Term Expectation,’ the famous diatribe against the Stock Exchange, it becomes painfully evident that Keynes failed to grasp the nature of the problem posed by the existence of inconsistent expectations. Instead of studying the process by which men in a market exchange knowledge with each other and thus gradually reduce the degree of inconsistency by their actions, he roundly condemned the most sensitive institution for the exchange of knowledge the market economy has ever produced! [2]

“The Stock Exchange is a market in ‘continuous futures’. It has therefore always been regarded by economists as the central market of the economic system and a most valuable economic barometer, a market, that is, which in its relative valuation of the various yield streams reflects, in a suitably  objectified’ form, the articulate expectations of all those who wish to express them. All this may sound rather platitudinous and might hardly be worth mentioning were it not for the fact that it differs from the Keynesian theory of the Stock Exchange which is now so much en vogue.

“In order to defend our own view it is therefore necessary to enter upon a critical discussion of the Keynesian view of the economic function of the Stock Exchange. This view is summed up in the famous sentence, ‘When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.’ How did Keynes arrive at this conclusion?[3]

“Far more important is Keynes’ attitude to the fundamental question: Is the Stock Exchange a suitable instrument for bringing long-term expectations into consistency; is it capable of giving rise to a, socially ‘objectified’, market opinion to guide investment decisions? Here Keynes’ answer is a clear and unqualified ‘No’. ‘For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.’ This is ‘an inevitable result of an investment market organized along the lines described. For 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.’[4]
“It is readily seen that the defect criticized by Keynes is not a defect of investment markets as such, but a defect of investment markets without a provision for forward trading. Where forward trading exists, a person holding the views described could express his short-term view by selling the investment at any price above 20 for three months ahead, while expressing his long-term view by buying it, say, 18 months forward at a price below 30. If everybody did it arbitrage would do the rest by bringing the forward prices for various future dates into line with each other. Price expectations involve intertemporal price relations, and intertemporal price relations cannot be made explicit, hence cannot be adequately expressed, without an intertemporal market. All we can conclude from Keynes’ argument is not that the Stock Exchange cannot make yield expectations consistent, but that without forward trading it cannot do so.”

“But this is not all. Keynes not merely failed to realize the real nature of the specific problem he was facing, viz. intertemporal price inconsistency expressing itself in divergent expectations. He was probably unaware of the importance, perhaps even of the existence, of the class of problems of which this is one: problems of the transmission of knowledge. There is very little evidence that he grasped the economic function of the market as an institution through which people exchange knowledge with each other. The Keynesian world is a world in which there are two distinct classes of actors: the skilled investor, ‘who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame’; and, on the other hand, the ignorant ‘game-player’. It does not seem to have occurred to Keynes that either of these two may learn from the other, and that, in particular, company directors and even the managers of investment trusts may be the wiser for learning from the market what it thinks about their actions. In this Keynesian world the managers and directors already know all about the future and have little to gain from devoting their attention to the misera plebs of the market. In fact, Keynes strongly feels that they should not! This pseudo-Platonic view of the world of high finance forms, we feel, an essential part of what Schumpeter called the ‘Keynesian vision’. This view ignores progress through exchange of knowledge because the ones know already all there is to be known whilst the others never learn anything. The view stands in clear and irreconcilable contrast to the view of the role of knowledge in society we have consistently endeavoured to set forth in this book. The reader will not be surprised to learn that our conclusions on the subject of the Stock Exchange are equally irreconcilable with those of Keynes.
“We hold that the Stock Exchange by facilitating the exchange of knowledge tends to make the expectations of large numbers of people consistent with each other, at least more consistent than they would have been otherwise; and that through the continual revaluation of yield streams it promotes consistent capital change and therefore economic progress. This, of course, is not to say that the Stock Exchange makes inconsistent capital change impossible: merely, that company directors who ignore the signals of the market do so at their peril, and that in the long run a market economy substitutes entrepreneurs who can read the signs of the times for those who cannot.”[5]

[1]  Ludwig M. Lachmann, Capital, Expectations, and the Market Process, Kansas City: Sheed Andrews and McMeel, 1977, 161.
[2] Capital, Expectations, 142.
[3] Ludwig M. Lachmann, Capital and Its Structure, Kansas City: Sheed Andrews and McMeel, 1978, 68-69 quoting J. M. Keynes, General Theory of Employment, p. 159.
[4] Capital and Its Structure, 69-70 quoting J. M. Keynes: General Theory of Employment, p. 155.
[5] Capital and Its Structure, 70-71, quoting Keynes, General Theory of Employment, 156.

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