Economist John Maynard Keynes described the action of rational agents in a market using an analogy based on a fictional newspaper contest, in which entrants are asked to choose from a set of six photographs of women that are the “most beautiful.” Those who picked the most popular face are then eligible for a prize.
A naive strategy would be to choose the face that, in the opinion of the entrant, is the most beautiful. A more sophisticated contest entrant, wishing to maximize the chances of winning a prize, would think about what the majority perception of beauty is, and then make a selection based on some inference from his knowledge of public perceptions. This can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus the strategy can be extended to the next order and the next and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other rational agents.
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that 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 practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).
•Players choose a number from 0 to 100 (all numbers allowed, including decimals). •Teacher collects all of the chosen numbers.
•Teacher averages the numbers. Call the average X.
•Teacher calculates 2/3 of X. Let Y = (2/3)X.
•Player whose number is closest to Y wins a prize.
•If there is a tie, tied players split the prize.
Although screened by the BBC in 2012 this 3 part series is very useful for A2 students looking at macro objectives and policies. Keynes has never been more applicable or contentious than the present day.
In Masters of Money, produced in partnership with the Open University, BBC economics editor Stephanie Flanders examines how three extraordinary thinkers, Keynes, Hayek and Marx, helped shape the 20th century and continue to exert a huge influence on our world today.
Stephanie begins by looking at John Maynard Keynes. Many argue only Winston Churchill had a greater impact on British life than Keynes over the last century. Even today his ideas remain crucial to one of the most important debates of our time: how can we escape from the economic crisis? Should governments borrow and spend their way out of trouble or slash spending and reduce the national debt?
You will no doubt have seen the Keynes v Hayek Rap which was produced by econ stories. Now the debate turns to the Chinese economy – which of these economist’s policies is more prevalent? The Economist Free exchange column addressed this issue recently.
In order to maintain the level of economic activity in an economy Keynes believed in investment spending to maintain aggregate demand and employment. However, Hayek believed that investment spending might be directed in the wrong areas and would leave the economy poorly coordinated and workers stranded in the wrong jobs. Economist Andrew Batson has argued that Hayek seems to be gaining the upper hand in the battle of ideas as China is now keen to avoid the Hayek malinvestment even if there is less aggregate demand and growth which Keynes favoured. As mentioned in previous posts there has been huge investment in China in areas that normally stimulate growth in downturns – eg. creation of new cities or infrastructure projects.
There are others that say the Chinese economy has areas of its infrastructure that need to be developed. Cities like Beijing and Shenzen are congested and need investment spending on them. Although Hayek believed that malinvestment would result in a worse downturn what is different in China is that their high investment is backed by even higher savings. This means that investment projects don’t need to generate high returns in order pay back external creditors. According to The Economist the real cost of malinvestment is with the empty shopping malls, vacant apartments etc when there are poor medical facilities and overcrowding in housing. Might a more market approach be a better driver of the economy rather than that of central planning?
John Authers of the FT wrote an interesting piece on John Maynard Keynes the investor. An era of non-Keynesian policy has culminated in a classic liquidity trap in which lower interest rates to stuimulate growth in the economy has little or no effect. Nowadays Keynes is back in fashion but how did Keynes the investor perform? In his early years he was a familiar figure in the City of London, where he made a fortune in the stock market, lost it all, and made it back again. Recently an academic publication analysed Keynes’ record an an investor and from 1924 to 1946 he managed the endowment fund of King’s College, Cambridge. The chart shows that any 100 that Keynes invested at the outset would have been worth 1,675 by his death in 1946. But what is significant about his performance as an investor was that the economic environment at this time included the Crash of 1929, the Depression and World War II. As John Authers alludes to, it is difficult to compare Keynes with investors today but if you take long-term illiquid investments like forestry, real estate, private equity and hedge funds you can get a more valid comparison. The table below shows that the return on investment by Keynes was higher than that of the market under similar conditions i.e. equity growth.
How did he do it? Was it Animal Spirits?
* he invested in equities – no one wanted to invest in this area therefore inefficiencies were prevalent and profits could be made
* he steered clear of diversification
* put fairly large sums of money into enterprises that he knew something about
Keynes could see when he made a mistake, deal with it, and modify his behaviour.
Below is a chart which looks at the dangers of over optimism in markets – Keynes referred to this as ‘Animal Spirits’. Nobel economist Daniel Kahneman describes overconfidence as the engine of capitalism but there are concerns whether the success of entrepreneurs in markets is due to their skill or the fact that a lot of luck is involved. One thing is for sure – when they are successful they tend to become overconfident about their ability to survive a crisis. This in turn inflates asset prices which makes asset buyers more optimistic about borrowing more money and banks more confident of repayment. However, as we have seen it all comes to a head and the bubble bursts.
A recent article in the New Zealand Herald, by Susan Guthrie and Gareth Morgan, attacks the lack of comprehension of why we tax and why we distribute the proceeds via state transfer payments. During the industrial revolution the disparities of wealth amongst the population led economist philosophers of the “enlightenment period’ to conclude the purpose of taxation was to “favour the diffusion rather than the concentration of wealth” – John Stuart Mill. The founder of capitalist system, Adam Smith, was critical of teh inequality it brought to society and acknowldeged that tax progressivity was desirable.
Ever since moral philosophy and economics parted ways and mathematical advances reduced the subject of economics to answering “what if” questions, we’ve suffered from a vacuum of understanding of why we tax and why we distribute the proceeds via state transfer payments.
Indeed we are so preoccupied with determining how big a budget deficit or size of government we can get away with, how we can cut the cost of welfare, how next year’s outlook compares with last year’s, that the rationale for why we redistribute has, to all intents and purposes, been forgotten.
In 1948 the United Nations supported the morals of the classical economists – Adam Smith, John Stuart Mill, Thomas Malthus etc. Its Declaration of Humand Rights stated: “Everyone has the right to a standard of living adequate for the health and wellbeing of himself and his family including food, clothing, housing and medical care and necessary social services, and the right to security in the event of unemployment, sickness, disability, widowhood, old age or other lack of livelihood in circumstances beyond his control.”
Gutherie and Morgan argued that modern economics is still too focused on GDP and it doesn’t recognise the contribution of people in society that perform unpaid work or voluntary work for their communities. However once you start to exclude people from the capitalist system they become polarised and public disorder breaks out. For so long UK policies have been devoid of moral or ethical justification and this has acted as a catalyst to the riots in London and other centres.
Our tax and welfare policy is in urgent need of reconstruction so it ensures equal opportunity for all to participate and fully realise their potential in society in its widest sense – whether it be the paid or the unpaid workforce.
The chauvinism in policies that disparage unpaid work – whether it be care of the elderly, juveniles or of the community – has run way too far and will alienate more and more.