No, I’m not actually going to go on a rant about the merits of Keynesian economic policy (although I could).   Rather, I wanted to tell you about a chapter of his 1936 book General Theory of Employment Interest and Money about the role of expectation in financial markets.  I stumbled upon this chapter, “The State of Long-Term Expectation,” doing some research for a paper keeping me in on a Saturday night, and I think it perfectly sums up the misaligned incentives created by the over-liquidity of financial markets (then and now), which have contributed heavily to the spiraling downfall of the financial sector.

So here’s his general argument.  Investment markets are, in theory, set up to direct capital to firms in an efficient, market-based manner based on the expected output that a firm can produce using this capital.  There are some reasons that this might not work out perfectly, e.g., investors don’t have enough knowledge to accurately assess a firm’s marginal productivity of capital, or they may not be able to obtain the credit they need to invest in what they think will be profitable firms.  But these problems are not unique to financial markets as separate from any other type of market.

What sets financial markets apart, rather, is that most investors 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.”  Thus investment becomes a form of psychological competition, in which the object is not to direct money to superior firms in the hopes of getting a good return, but rather to outwit other investors and make short-term gains.  These misaligned incentives directly contributed to the recent market crash, as what has amounted to a severe negative bubble has ruined children’s hope for a college education as much as it has hurt impending retirees’ 401(k)’s.  As Keynes puts it, “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.”  And it has been ill-done.

But Keynes has a unique and still-applicable solution to this problem.  In order to curb rampant speculative gamesmanship, he suggests imposing a “substantial government transfer tax” on all financial transactions.  This would reduce the liquidity of the money flowing through financial markets solely due to psychological calculation, making investment an activity in, well, actual investment.  Of course, this type of tax might not be politically viable.  But as always, Keynes’s decades-old work provides valuable insight into our current problems.