Beauty contests, stock markets, and uncertainty

Posted: 4 September 2011 in Uncategorized
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Mark Tansey, “The Innocent Eye Test” (1981)

Recent volatility in U.S. stock markets has forced economists like Robert Shiller to go looking for the appropriate framework.

Not surprisingly, he finds some guidance in Keynes’s General Theory, particularly chapter 12. But all that matters for Shiller is Keynes’s so-called beauty contest example:

professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

What Shiller fails to inform his readers is that chapter 12 is about much more than picking faces in newspaper competitions. Keynes begins with the proposition that investors are subject to fundamental uncertainty (as against probabilistic risk). Therefore, they are guided not by rational calculation but by “animal spirits”:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

And, for Keynes, the combination of uncertainty and animal spirits was particularly characteristic of U.S. stock markets:

If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, “for income”; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. 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. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism — which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

While Shiller wants to play around with the beauty-contest metaphor in order to understand playing in the stock market, he doesn’t want to think about is what happens to mainstream economic theory and policy when uncertainty, animal spirits, and so on are taken seriously.

He also ignores the effects on the rest of us when bankers and investors are allowed to shift the risk from themselves to debtors and employees. In the casino of contemporary capitalism, those making the decisions take home the profits and everyone else pays the costs.

That much is quite certain.

Comments
  1. […] has prompted a rediscovery of uncertainty—not unlike during the First Great Depression when Keynes argued that investors were subject to fundamental uncertainty (as against probabilistic risk) and […]

  2. […] has prompted a rediscovery of uncertainty—not unlike during the First Great Depression when Keynes argued that investors were subject to fundamental uncertainty (as against probabilistic risk) and […]

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