Quite a few articles and blog posts have been written in the last few days in response to this piece in the Wall Street Journal outlining the investment record of John Maynard Keynes. The comments section of that article is full of people who are in disbelief at the idea that Keynes was a good money manager, and accused him of trading on inside information, using his standing in the economic world to influence policy to suit his positions, so on and so forth. I think those accusations are frivolous. I think a more valid critique can be found in the standard refutation of Keynes as a great investor, in that he was bailed out by his rich father when his bets went wrong. Even this isn’t such a terrible thing in my view, but the irony isn’t lost here given that those who invoke Keynes when determining policy call on governments and central banks to act as his father did to effectively bail out corporations and individuals who have erred by preventing the price level from falling in times of distress. I think the largest mistake made by the commenters on Keynes’ investment record is the one made by Matt O’Brien at The Atlantic. In this blog post, he makes an attempt to validate the economic policy of the man by citing how he did so well as an investor.
Right from the beginning, the main point of the article is declared:
But more importantly, understanding how Keynes outperformed the markets so much explains why he mistrusted markets so much.
Keynes made his money following a value investing strategy after eschewing the more speculative strategy that got him into trouble earlier in his career. Pioneered by Ben Graham and popularized by Warren Buffett, it entails buying a company that is undervalued and holding it until it is fairly valued. How one determines fair values such that undervalued stocks and companies are visible is beyond the scope of this post, but the point O’Brien seem to be hinting at is the fact that companies can trade in the market at prices that are detached from their true value is reason enough to abandon the market as a price discovery mechanism altogether. I’ll expand on why this is a poor interpretation in a moment. Furthering that point, O’Brien writes:
Keynes famously took a dim view of how well unregulated markets allocate capital. “When the capital development of a country becomes a by-product of a casino, the job is likely to be ill-done,” declared Keynes in The General Theory of Employment, Interest, and Money. The problem is that the mania of the markets often drives prices away from their fundamental values.
This is largely correct, particularly the reference to a casino. Casinos aren’t very good at allocating capital properly, and manias lead to problems when they end. What is ignored here is why the casino-like environment appears and where the manias come from. They are not a natural consequence of a market based economy. They are almost exclusively caused by rapid and continued increases of the money supply and credit. From the Dutch Tulip mania, to the housing bubble of the 21st century, a common feature of them all has been a prior increase in money supply and credit. This provides the impetus with which asset prices can be bid up and pushed higher, beyond their fundamental values. More often than not, the ultimate source of the increase in money supply and cheap credit has been central banks or government policy. It is far from a natural consequence of market behavior as is implied here.
If prices really can get so unmoored from fundamentals, investors are left with two basic strategies. They can ride the bubble. Or they can bet against overvalued stocks. A naive observer — i.e., an über free-market economist — might think that investors will choose the latter path. But, as usual, there’s a Keynes quote for that — this time, that “markets can remain irrational longer than you can remain solvent.” And that’s why investors don’t always short bubblicious stocks.
It is true that once in entrenched in bubble territory, the investor is presented with a rather poor set of options. Riding what is clearly a bubble is a dangerous endeavor as you are taking ‘a position that risks insolvency,’ to borrow the words of John Hussman. Selling short is equally as troublesome, given the fact that once you are already in the realm of the absurd, more absurdity is the order of the day. O’Brien then decides to take an absurd jab at free market economists by asserting that their (implied) faith in rational actors would lead them to think everyone would load up on short positions.
For a start, he is confusing economist and investor. The Keynes quote he then references is an oft repeated quote amongst investment professionals when explaining the seeming failures of capital markets to go where they should according to pure fundamental analysis. This has absolutely nothing to do with whether or not they subscribe to the views of Keynes the Economist. Quite frankly, there are many who would vehemently disagree with Keynes the Economist on most topics, while agreeing with the Keynes the Investor on a few topics. I am one of those people, and there are many others, including Jim Rogers, Marc Faber, John Hussman and so on.
Furthermore, it’s telling that the Keynes quote is so oft repeated over the years. This is because we have been in a perpetual state of oscillation between bubbles and crashes, fueled by governments and central banks using Keynes the Economist as a base to ultimately distort economies, and then prevent the inevitable corrections from completing when they do occur, further distorting economies in the process. In other words, the advice of Keynes the Investor is valuable in navigating a marketplace distorted by polices championed by Keynes the Economist. Once one understands that, statements such as the following are better understood:
It’s only a hop, skip, and a jump from thinking markets are prone to bubbly behavior to supporting a greater government role in stabilizing the economy. If investment fluctuates so wildly — and it does — then so too will jobs. The government can step into the breach and keep investment steady. But this mixed capitalism is no less capitalism. Just ask Keynes, who was no slouch as a capitalist himself.
Once markets have been distorted by cheap money emanating from central banks and/or government policy, they are prone to bubbly behavior. It then follows that when the investment decisions driven by the bubbly behavior collapse, only governments can step in to prevent, or mitigate the collapse. This is incorrectly characterized as ‘stabilizing’ by O’Brien. What is actually being stabilized is the distorted economy, full of capital misallocations and unprofitable projects. Job losses resulting from the unwinding of these projects are a positive step for the economy as a whole, given that the jobs themselves were unproductive in the first place. To the extent that governments intervene is the extent that governments prevent a proper allocation of capital, and thus a proper recovery. This is not capitalism; the socializing of losses has no place in capitalism.