For John Maynard Keynes, Economic Theory Was a Sideline

Even as global financial turmoil induces some to advocate for freer markets, the heavier hand of Keynesian macroeconomic policy is also experiencing a resurgence.

Yet John Maynard Keynes was far more than the Ivory Tower academic economist we think we know. He was, above all, a practitioner and student of high finance. Investment and finance were his vocation, and political economics was his avocation.

Keynes came from a line of academics. His father was a renowned philosopher and senior administrator at Cambridge University. Keynes was academically precocious. As an undergraduate, he was captivated by mathematical theory, and especially probability theory.

After graduation, he served two years as a lowly clerk to the Crown, stationed in India. This otherwise unfulfilling experience gave Keynes the time to contemplate both the meaning of probability and the waning political and economic influence of Great Britain. He began to write articles on international economics that demonstrated his clear thinking. He also caught the eye of the U.K. Treasury, and soon rose to the highest echelon of international finance.


Keynes eventually realized that his worldview was incompatible with political pragmatism, and he forged an alternative career. He had frequented the highest levels of Britain’s government, arts and society. He also had been dabbling in finance as an extension of his experiences at the Treasury and as a way to invest some of his own savings and borrowings.

Keynes began to advise an exclusive clientele, and became known for the quality of his investment advice. He quickly became the financial adviser to a veritable who’s who of Britain’s intelligentsia.

Keynes first flourished by investing in bonds and foreign exchange. His interest was sparked when he amassed a small fortune for the Treasury during World War I. In his responsibility for securing foreign exchange to purchase war supplies, Keynes accumulated, and then rapidly sold, Spanish pesetas that resulted in a large drop in the sterling/peseta exchange rate and a large profit for the Treasury.

He held a dim view of the stock market, which he likened to casino gambling or a beauty contest. Keynes argued that investors don’t trade on an asset’s fundamental value, but rather in anticipation of the strategies of other investors. In turn, investors watch their colleagues, also with little regard for the fundamental underlying value of the security. Asset valuation is obscured as traders strategize over their assessments based more on animal spirits than on reason.

Instead, Keynes devoted his investment energies to bond markets -- where traders sought competitive and regular fixed-income flows -- to the construction of hedges to reduce risk, and to the foreign-exchange markets where relative economic progress and terms of trade between nations dictate equilibrium. He believed that the more rational and seasoned investors operated in these markets.

When Cambridge University needed a trust manager, it called on Keynes. Over two decades of management of the university’s Chest Fund, he garnered a spectacular 400 percent return, even though the stock market was little changed in that period. Keynes succeeded because of his long-held interest in market psychology, which dated to his 1921 book, “A Treatise on Probability.”

Valuation Theory

He observed that probability assessments by humans differ from the calculable risks in nature and science. He believed our personal probabilities are what we think they are, not those predetermined by unseen natural forces. Similarly, to Keynes, and to proponents of personal probabilities, the value of a stock is what a group of sometimes irrational speculators is willing to pay for it. Kenneth Arrow went on to enshrine this valuation theory in his revolutionary model of security prices.

A contemporary of Keynes, the investor Bernard Baruch, is reputed to have quipped that “if economists are so smart, why aren’t they rich?” When Keynes died, his net worth, mostly from his investments, was about $30 million in today’s dollars.

Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc., modeled his “value investing” after Keynes’s investment strategy, and once said the economist’s “brilliance as a practicing investor matched his brilliance in thought.” When Keynes died, the Financial Times reported: “Some surprise has been expressed about the large fortune left by Lord Keynes, yet he was one of the few economists with the practical ability to make money.”

Keynes remains an enigma. Viewed as a theorist, and one who made a career challenging conventional theory, he earned a living on London’s equivalent of Wall Street while he eschewed the emerging academic concepts of the efficient-market hypothesis and the market-disciplining effect of arbitrage.

He observed, “Markets can remain irrational far longer than you or I can remain solvent.” He viewed markets as often irrational, especially during financial crises. While politicians debate the appropriateness of Keynesian macroeconomic policy, we may learn more from his insights on the animal spirits that sometimes rule markets, especially in times such as ours.

(Colin Read is chairman of the finance department at the State University of New York, Plattsburgh. He is the author of the “Great Minds in Finance” series and other finance titles published by Palgrave Macmillan. The opinions expressed are his own.)

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