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Keynes and the efficient market hypothesis

Jamal Munshi, Sonoma State Univesity, 1992
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In chapters 12 and 13 of THE GENERAL THEORY OF EMPLOYMENT, INTEREST, AND MONEY, Keynes lays out his theory of the determinants of returns from holding assets (stock) and those of holding debt (bonds) and vents his disgust for speculatitive trading in financial assets.

Capital Asset Valuation

To a rational investor, asset valuation should be based only on the present value of the best projections of the future cash flows that the investor believes will be generated by the asset (adjusted for risk). As such, capital investment is a long term decision based on long term projections and goals.

However, by allowing the stock market to value the stock of the firm, this ideal goes wrong, says Keynes, since the "ignorant masses" buy stock only for short term capital gains rather than long term income. Keynes eschews "playing the market" which he likens to a "feeding frenzy". He despises our "animal instincts" to gamble. He feels that investors are simply trying to out-guess and out-wit each other rather than attempting to project and compute the cold mathematics of future cash flows and associated risks.

He claims that the valuation of capital assets thus established is "absurd" since it has become a forum for speculation rather than one of enterprise. He admits, however, that the liquidity and the outlet for our animal instincts provided by the market is necessary for capital formation.

Speculation is evil according to Keynes. He says that specualation causes undue and irrational fluctuations in the bond market that do not reflect real changes in economic variables. The stock market syndrome thus also affects the debt market which is turned into a casino-like venue for speculators instead of being the rational arena'of the economic man who through his liquidity preference, propensity to consume, and propensity to save, would make all his equations come out right. Mankind apparently is too stupid to follow his prescribed behavior.

Although our view of capital markets has changed since 1935, Keynes was, of course, a giant in his time and his wisdom still influences economic and financial thought. However, it helps to understand that his work was largely part of the overall response of economists to the 1929 crash and the ensuing depression. It must have seemed at the time that the system of free enterprise that we inherited from the Dutch and the British Dissenters and their Industrial Revolution may not be viable; that capitalism had failed; just as today (1995) it seems that communism has failed. And it was Keynes' work more than any other ideology that delivered us from at least the psychological depression of the times. In the midst of all the wringing of hands and grashing of teeth, he rose up and said that capitalism had NOT failed and prescribed a cure for the depression. It was a very uplifting piece of work.

Although Keynes' discussion of market mechanism was not necessary to his general theory he felt compelled to write about it anyway because no economic work of his time was deemed complete without an 'explanation' for the crash. The legacy of the crash was to make the market into the whipping boy. And Keynes' strong language in this regard can be forgiven on this score. We believe today that the market is, on the aggregate, rational and at least weak form efficient. We do not question market valuation and investor behavior. We only seek to understand them.