Keynes and Bernanke on Bubbles and Manias: Blame the Free Market

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In 1936, John Maynard Keynes’ book appeared: The General Theory of Employment, Interest, and Money. It changed the world. It justified in the name of economic theory what governments had been doing since 1932: running deficits and creating fiat money. Keynes’ ideas took over. Today, they are dominant. The 30-year break, 1978—2008 — Chicago School, rational expectations, efficient market theory — is over. Academic economists, like Dorothy in Kansas, ran for the Keynesian storm cellar. Unlike Dorothy, they made it. No trip to Oz for them!

In chapter 12, he contrasts enterprise with speculation. This is conceptually incorrect. Both rely on accurate forecasting. Both rely on transferring assets to a specific market position. He made speculators sound like gamblers. They aren’t. The emotions may be the same, but the economics are different.

A speculator operates in an uncertain market that reflects life’s uncertainties. A gambler bets on the outcome of a game — a game that is rigged for the house. The game follows the law of averages. Markets have no comparably reliable laws.

Speculators provide insight into how assets should be priced to maximize profit. This information is vital to enterprisers.

Keynes understood none of this.

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.


Keynes’ distinction between speculation and enterprise is conceptually flawed. Both the speculator and the enterpriser seek to predict asset prices in the future. The speculator must take into consideration supply and demand for capital. The enterpriser must consider prices set by futures markets. Each needs the other’s specialization.

As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase.

He offers no reason to believe this. If it is true, it has to do with specialization of production and reduced cost of entry. But speculation is inescapable in enterprise and capital markets. Men seek to forecast future prices, because profit and loss are calculated in prices.

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.

In any market, forecasters must pay attention to what other forecasters think and do. This includes assessing psychology. The goal is to buy low and sell high. What others think about the future is a major factor in predicting future prices.

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.

How does a wise investor assess the appropriate price to pay for an expected stream of income? Does he look at the interest rate? Yes; this discounts the value of that expected stream. How about the likelihood of the stream’s drying up? Of course. This is another uncertainty to consider. What about the purchasing power of the currency? Yes, indeed. Should he assume that none of this will change after he buys? Of course not. Then should he consider “a favourable change in the conventional basis of valuation.” That is what the market pays investors to do accurately. Keynes dismissed this as mere speculation. But forecasting unexpected changes that affect future prices is the heart of investing. Speculation is central to investing.

What will be the bottom line, to use the language of accounting, as every speculator should? Will the sales price be higher than the purchase price in purchasing power? A capital market operates in terms of prices. This is why economic calculation is possible. Without economic calculation in a money economy, modern society would collapse. The division of labor would contract. Most of us would starve. Keynes berated speculation. We should praise it.

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 capital development of a country is nothing like a casino, except insofar as people want to buy low and sell high. Capital has to do with the real world with all its uncertainties. A casino has to do with risk: statistically calculable returns on investment over many bets and many years. Speculation is not a game played for itself. Gambling is.

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.

On the contrary, a developed market that raises trillions of dollars in capital, providing second-by-second assessments of investors’ best guesses, is an enormous achievement. It ranks among the most important achievements in man’s history. Without capital, we would starve.


Keynes was a successful speculator. He made a fortune for himself and his university, Cambridge. This began as early as 1905. But he made his money in Britain’s stock market. That was a market for gentlemen. The upstarts across the Atlantic were not gentlemen.

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January 7, 2010

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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