One of the first financial guys I ever met told me confidently “the economy and the markets have nothing to do with one another.” Recently I was interviewing potential new writers for a financial newsletter, which I’ve been asked to help launch, and one of them (a professor of economics) told me that “the financial markets and the economy are two different beasts entirely.” Where do people get such ideas?
One place they got them is from John Maynard Keynes who saw the movements of financial markets as being like a gigantic casino, moving randomly in response to people’s animal spirits which he believed were throwbacks to our animalistic instinctual forebears. His intellectual grandson Harry Markowitz applied that basic idea with more mathematical rigor while creating Modern Portfolio Theory, which Markowitz said was different from classical economics because it ignores supply and demand; in other words, the underlying economy.
First let’s look at the master. Here’s my friend Mark Skousen in his excellent book The Making of Modern Economics on the irrationalist stream in Keynes and his compulsion to sever economics from finance:
“Keynes complained of the irrational short-term ‘animal spirits’ of speculators who dump stocks in favor of liquidity during such crises. Such ‘waves of irrational psychology’ could do much damage to long-term expectations, he said. ‘Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate resources upon the holding of liquid securities’… According to Keynes, the stock market is not simply an efficient way to raise capital and advance living standards, but can be likened to a casino or game of chance. “For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs–a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.”
Instead of placing finance on a proper foundation of economics, Keynes grounded them both in psychology; arguing that the handling of money is a kind of neurosis. According to the definitive history of Keynes’ early intellectual circle, The Cambridge Apostles:
“In the early 1930s, Keynes became increasingly disillusioned with capitalism, both morally and aesthetically. The ideas of Sigmund Freud were fashionable at that time, and Keynes adopted the Freudian thesis that money making was a neurosis, a somewhat disgusting morbidity one of the semi-criminal, semi-pathological propensities which one hands over with a shudder to specialists in mental disease.”
Following his Freudian impulses, which according to the biographies were not often suppressed, Keynes reduced thrift itself (on which all investing depends) to a sexual neurosis, calling it ‘the fetish of liquidity’.
“Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate resources upon the holding of liquid securities.”
The origin of modern portfolio theory, really of almost all modern finance, is found in Harry Markowitz’s decision to take Keynesianism to its natural conclusion. Classical economics is about production, supply and demand. Markowitz threw all of that out. From his Nobel Prize acceptance speech:
“There are three major ways in which portfolio theory differs from the theory of the firm and the theory of the consumer which I was taught. First, it is concerned with investors rather than manufacturing firms or consumers. Second, it is concerned with economic agents who act under uncertainty. Third, it is a theory which can be used to direct practice, at least by large (usually institutional) investors with sufficient computer and database resources.The fact that it deals with investors rather than producers or consumers needs no further comment.”
In plain English: MPT acolytes are not concerned with firms (in which they invest) or in the consumers (from whom the firms in which they invest receive their revenues), but only in the economic agents known as investors. But don’t worry, they’ll have computers.
But what will the computers compute? For Markowitz and for the huge intellectual superstructure which is built on his ideas, they will compute based on price movements; what we call volatility. Markowitz called it ‘variability’. Again from his Nobel Speech:
“The basic principles of portfolio theory came to me one day while I was reading John Burr Williams, The Theory of Investment Value. Williams proposed that the value of a stock should equal the present value of its future dividend stream…It seemed obviousthat investors are concerned with risk and return, and that these should be measured for the portfolio as a whole. Variance (or, equivalently, standard deviation), came to mind as a measure of risk of the portfolio... These were the basic elements of portfolio theory which appeared one day while reading Williams.”
But why is variability the true definition of risk. Markowitz didn’t get the definition from Williams, whom he had been assigned to read. In fact Markowitz claimed that the reason he came up with the idea of variance as a risk metric is because Williams had provided no risk definition of his own. This is patently false: the second half of The Theory of Investment Valueincludes penetrating chapters describing the risks which arise from socialism or from Keynesian inflation. Perhaps Markowitz never finished his reading assignment.
One wonders how the history of finance would have been different if he had read and had understood Williams’ masterful application of free-market economics to finance. But instead Markowitz chose a purely emotionally subjective foundation for financial theory. Price movements make people uncomfortable. (As someone involved with managing portfolios, I can vouch for that.) With no objective economic criteria for risk such as low growth or high inflation, MPT defaults to the subjective: investors don’t like a lot of price movement, therefore a lot of price movement equals risk.
But is all of that right? Does the world of economics and finance have order and structure and act according to principles, or is it nothing at all but bestial, twitching, random spasmodic emotion? Is the economy really severed from markets? Is the brainstem really severed from the body? Our last couple of columns show that at least as regards the relationship between markets and economic growth, there is one which can clearly be discerned if one asks the right questions.
Next week, Lord willing: the right questions…
Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a columnist for Forbes.com.