From: rob@KAMAN.COM (Rob Vienneau)
Newsgroups: sci.econ
Subject: Re: Should we limit the shorts life time.
Date: 27 Jul 92 17:18:53 GMT

WARNING: LONG (122 lines)

I know nothing about short-selling. Nevertheless, I have some
observations about capitalistic financial structures from a certain
abstract theoretical viewpoint that I think is a contribution to this
debate.

John Maynard Keynes had a lot of very practical experience with the
London stock exchange, enough to make him (and some funds he managed)
a fortune. According to certain economists, some fundamental insights
of his General Theory are based on his understanding of finance. See
especially chapter 12 of _The General Theory of Employment..._. Hyman
Minsky is a modern day economist who I find particularly good about
developing these ideas.

A book I recently read argues that Keynes focused on what has been
called the distinctly human trait of "creative rationality," the
adaptation of the environment to human needs. Some argue that
Neoclassical economics, including the New Classical (Macro)Economics,
ignores this aspect of economic behavior in that these theories only
discuss the optimal response of individuals to a given environment.

In less abstract terms, financial structures have evolved to fulfill
particular needs. Some individuals want to concentrate on the
production of goods, and somehow avoid the inherent risks involved in
price movements between the time they purchase inputs (e.g. seed corn)
and the time (e.g. harvest) they sell outputs. Others desire to
speculate on just these risks. Some want to make investments that are
not liguid for the community (e.g. the construction of a new factory),
but do not want to assume this lack of liquidity.

A variety of financial instruments and markets are continuously
evolving to meet these and other needs. Although the institutions of
the "Street," NASDAQ, the "City," etc. have evolved as the result of
specific decisions by specific persons at specific times, these
individuals did not foresee the results of their individual activities
and decisions.

In particular, we have many means by now in trading in second-hand
debts, which, according to Keynes, "is the essence of money." Now many
of these debts represent financing for long term investment projects.
But those who buy and sell stocks and bonds are often more interested
in how their prices will move in the short term. They are not
interested in the actual underlying performance, but how others will
soon anticipate that performance. This is what Keynes called
"speculation." These instruments are typically traded much faster than
the projects they represent can come to fruition. Furthermore, Keynes
(following Frank Knight) made a distinction between risk (in which one
can confidently assign probabilities to outcomes) to uncertainty (in
which one cannot). Examples Keynes gave of uncertainty are the
prospects of a general European war in the next decade or the
treatment of private ownership of wealth in 30 years. Keynes argued
that economic decisions, where the participants worry about these long
term prospects ("Enterprise" was Keynes' technical term), are
inherently uncertain.

Keynes compared Speculation to a beauty contest in which the judges
are picking winners not on their opinion of which contestant is the
most beautiful, but on their opinion of who the other judges will
pick.  But the other judges are all looking at it from this same
viewpoint. Keynes stated that he believed some play this game looking
at it from the second or third order, as well.

The Fundamentalist Keynesian/Austrian economist G. L. S. Shackle
talked about inherently unstable equilibrium. The equilibrium price of
a stock or bond reflects a balance of Bearish and Bullish opinion.
The fact that different views exist about the future is vital to
Keynes' ideas, especially as developed in _The Treatise on Money_
(which I haven't read). The mere passage of time will cause some to
decide they are wrong. Opinion will change, and so will the resulting
equilibrium.  Note that this change is not the result of any change of
data outside the economic system.

Minsky talks about the tendency to build "layers of debt." Leverage is
a wonderful thing, but it can all go bad rather suddenly. If something
unforeseen happens, I may be unable to continue a stream of debt
payments that I have contracted. My debtor, in turn, may not be able
to pay his debts as well, and so on down the line. Just such events
are the sort that result in investors re-evaluating the future
prospects of various financial instruments. Suddenly, those who
thought they had plenty of ability to pay off debts when they come
due, find that their evaluation of their wealth cannot be realized in
the market. And their debts are being called. A crash results, with
consequences to people whose only participation in Wall Street is
working and buying in the U.S.A.

But the normal incentives of unregulated capital markets, according to
Minsky, are to build just such fragile financial structures. The
excesses of the 80s, the junk bonds, the S&L lootings, are not the
result of bad people taking over, but the normal functioning of
unregulated capitalism. Institutial reform is needed, but no one time
answer exists. New financial instruments and new institutions will
evolve in the future, and consequently new government policies will be
needed.

These ideas suggest why Keynes argued that prices on the stock
exchange reflect a conventional wisdom that is liable to sudden and
violent shifts of opinion. Unregulated capital markets are inherently
unstable. Given the role of finance, capitalism is inherently unstable
to a certain extent. Under a Laissez-Faire policy, booms and busts
will occur and the transition to a depression will be a crash.
Government should try to insure, through a partial "socialization of
investment," that Speculation does not predominate too much over
Enterprise, while capital markets still serve their socially useful
function. This regulation should not be concerned with individual
prices, but the rules of the game. For example, suggestions in keeping
with these ideas are a tax on stock purchases, prohibition of the
selling of certain instruments such as stock market indices, and rules
for buying on margin.

Obviously, these ideas are hard to formalize. So, despite Keynes'
great reputation, the response of the majority of the economic
profession has been to ignore them. They do not make it into the
textbooks at any level, including those expounding "Keynesian"
theories, and most students of economics and finance are completely
ignorant of them. As a consequence, those who do not let common sense
intrude into their professional knowledge end up missing a fundamental
understanding of capitalism. And so their policy advice becomes
dangerously wrong.

                                      Robert Vienneau
                                      rob@kaman.com
Newsgroups: sci.econ,talk.politics.misc,alt.politics.clinton