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September 23, 2008

A Keynesian Lesson for Confidence

Ray Horton
Frank R. Lautenberg Professor of Ethics and Corporate Governance; Director, Social Enterprise Program
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By happenstance I’m lecturing on John Maynard Keynes in my Modern Political Economy course today. I don’t ask my students to read the whole of The General Theory of Employment, Interest and Money, which would indeed be cruel and unusual punishment, but I do require them to read chapters 10, 12 and 24. Those, to me at least, are most essential to understanding the General Theory. Chapter 12 certainly makes the carnage on Wall Street a bit easier to understand; it also is a reminder that recovery isn’t going to be easy. Quoting Keynes:

A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.

So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition. (emphasis added)

These days, Keynes is not very popular in some circles; in truth, he is a bit hard on the neo-classicists in chapter two. But behavioral economics, which is now mounting a serious attack on the neo-classicists (at Columbia Business School as well as in the discipline), owes a lot to Keynes, as the above quote makes clear. As he wrote more than seven decades ago, strengthening credit is a necessary but not sufficient condition for recovery. We need to restore some confidence too, which is probably where political leadership comes in.


by David Lane (Class of 05) - | September 24, 2008 at 1:14 AM

Ray - It seems to me that the lack of credible leadership in the whitehouse has forced Paulson and Bernake to provide both the solution to credit issues as well as the public face of leadership. I wonder if it is possible for them to do both the aggressive financial wrangling as well as confidence building.... To the contrary, by acting to shore up credit and liquidity through $700B, cutting short-selling, bailing-out companies and acting aggressively, they have effectively fed the crisis of confidence by putting a huge public face on the extent of the problem. Certainly the appearance of Paulson's conflict of interest with Goldman is undermining his credibility. Even if it is not true or at all related, this "crisis" is reminiscent of the pre-Iraq “crisis” which I admittedly I bought hook-line-and sinker (note: I voted for Bush twice - with regrets). It seems that credible leadership matters after all... who knew? If Keynes is right, this election can be well timed to inject non-affiliated leadership into this mess. Thanks for publishing your thoughts. David Lane I was in your MPE class in 2005 and we met again last year while you were visiting Seoul.

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