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Keynes's Way to Wealth
Timeless Investment Lessons from the Great Economist
By John F. Wasik McGraw-Hill Education
Copyright © 2014 John F. Wasik
All rights reserved.
ISBN: 978-0-07-181547-5
CHAPTER 1
Birth of a Speculator
Keynes knew how to play the market better than almost anyone else living or dead. He stayed in bed each morning until lunchtime and made not one but two vast fortunes by directing his brokers on exactly what to buy and sell.
—NICHOLAS WAPSHOTT
Before he embarked upon the life of an academic who would later counsel world leaders, the world's most influential economist began a career as a civil servant. Having scored second in a civil service exam in 1906 (he was enraged at his second-place finish) he accepted a post as a junior clerk in the government's India Office in London, where his role was humdrum. Although he didn't have much interest in India, which the British Raj ruled completely at the time, the position gave him key insights into how money worked in society and its importance to the functioning of civilization. It was hardly a glamorous job, though: Keynes's first task in the office was to ship 10 Aylshire bulls to Bombay.
Being in the heart of London gave Keynes access to his Bloomsbury friends, their engaging parties, and trips to the continent, including Spain and the French Pyrenees. As he excelled in divining the vagaries of the British-dominated Indian economy, which later led to a book, his expertise won him important supporters in government. He eventually joined the Royal Commission on Indian Currency and Finance.
Had Keynes remained an obscure government employee, he would probably have been forgotten. But he was bored and began working on a book on probability. He also wanted to return to Cambridge, where he could stimulate his intellect by being a scholar and lecturer. By mid-1908, he was back at King's College. The following year, he started lecturing on money, credit, prices, and the stock market (in 1910).
It's at the end of the twentieth century's first decade that we see Keynes's growing interest in markets, investing, and speculation. In his lecture notes, we see a curious mind that has, up until that point, not been directly engaged in investing, but had a yearning to explore. His lecture on the stock market in the Lenten term of 1910 calls it "essentially a practical subject, which cannot properly be taught by book or lecture." This may have been the point when Keynes briefly left the world of theory and book learning and prepared to engage in a subject that stirred his inner trader. Keynes invited his students into his rooms at King's College, his lanky body relaxed in a commodious armchair. Embracing the tradition of dons meeting with students in an intimate setting, he listened intently as his students presented papers in his Political Economy Club. Ever the Bloomsbury free spirit, he adorned his walls with seminude paintings by his lover Duncan Grant. Not only could students address serious economic issues, but they could gaze upon grape pickers and dancers. It's hard to tell their reactions to the brilliant but aspiring bohemian don, but many of the students later became his friends and collaborators. Keynes was incredibly loyal to them.
Although Keynes bluntly told his students, "I have myself no practical knowledge [crossed out] experience of the questions involved," he started his course by encouraging his pupils to read the Economist and other financial weeklies. How did Keynes get the investing bug? Perhaps it happened in 1905, when he was studying directly with his mentor, Alfred Marshall, the leading light of late-Victorian economics. When he returned to Cambridge in 1908, he became assistant bursar, which involved handling financial accounts and investments. When I asked Robert Skidelsky, the author of the most comprehensive biography of Keynes, when he first saw evidence of Keynes's serious interest in investing, he surmised that it was before 1910, when "like [George] Soros, I think he used the financial markets to test his theory of probability."
More Than a Hunch
To Keynes, investing must have presented some compelling intellectual challenges. What was the probability of a security going up or down? What were the factors involved? How did price movements obey the laws of averages and chance? What was one to do in the face of uncertainty, when events didn't follow the predictable rules of statistics? Since he was schooled as a mathematician and had produced a work on probability during his early teaching career (A Treatise on Probability, which was eventually published in 1921), like any inquiring investor, he wanted to know the odds involved in investing. While the Treatise is perhaps Keynes's least accessible work, it asks the age-old question of what can be quantified without subjective bias. Is there an objective method by which we can predict which stocks will soar, for example? How can we separate sentiment from reality using objective science? This was not specifically articulated in the Treatise, but it was probably entering his mind around that time:
The judgments of probability, upon which we depend for almost all our beliefs in matters of experience, undoubtedly depend upon a strong psychological propensity in us to consider objects in a particular light. But this is no ground for supposing that they are nothing more than "lively imaginations."
In this section of the Treatise, we see Keynes giving us a glimpse of the "animal spirits" that emerge from his great work, The General Theory of Employment, Interest and Money.
To understand Keynes's later ideas on market economics, you have to view his intellectual dilemma through the lens of probability. Unlike many economists of his time, he was willing to embrace "radical uncertainty," or the daunting reality that economic science was very bad at predicting the future. Markets aren't rational. They follow their own course based on behavior, not always on the ideal world of "normal" distributions.
As John Kay noted in the Financial Times, "for Keynes, probability was about believability (italics mine), not frequency. He denied that our thinking could be described by a probability distribution over all future events, a statistical distribution that could be teased out by shrewd questioning—or discovered by presenting a menu of trading opportunities."
In other words, Keynes saw that statistics could describe the present and the past, but wouldn't necessarily predict the future. In keeping with what Mark Twain said, that there are "lies, damned lies, and statistics," Keynes didn't see an economic world that could be depicted accurately by numbers alone. Past was not prologue. There was also subjective reality, the little gremlin in our heads that could find a pattern in any set of numbers that would fit a pet theory. Yet how can we separate our feelings from the rigorous rules of monetary theory, supply and demand, and other strictures of classical economics? How is behavior involved? To answer that question, Keynes had to explore the nature of the behavior beast, which became a fascinating part of his 1910 lectures.
The Beast of Speculation: Lectures Before World War I
Before World War I, Keynes's activities in the stock market were limited. Since he didn't have inherited wealth (and lecturing at Cambridge didn't pay that much at the time), he was dependent upon allowances (roughly $160 each) from his father and his mentor, Alfred Marshall, and upon tutoring fees. Although he managed to accumulate money received on birthdays and from academic prizes in a "special fund" started in 1905, he didn't really start investing in earnest until 1914, according to the editor of his papers, Donald Moggridge. Prior to that point, he'd only dabbled in a handful of stocks.
"By 1911, he was not only buying additional shares, but also making switches and helping manage certain family trust funds," Moggridge discovered.
Keynes managed to build his knowledge through experience, book learning, and teaching. Even at Eton, it was clear to his teachers and fellow students that he was an extraordinarily quick study. Though he was probably teased for his intellect and his features (his nickname was "Snout"), he was able to master complex concepts with ease. This built his confidence and allowed him to venture into areas in which he had no formal training. It also helped that he was great at math.
One of his passions became investing, although none of his academic training prepared him for this activity. At the time, there were no such things as money management programs or Chartered Financial Analysts. And if anyone was managing institutional money, the technique was pretty straightforward: you bought and held bonds. So when Keynes discovered the world of the stock, commodity, and currency markets—probably through his association with stockbroker Oswald Falk—it must have been exhilarating. Here was a venue for his Promethean analytical skills, aided and abetted by his love of gambling. Being a confident young man, he must also have had the sense that he could calculate some pretty good bets, considering that his main academic interest at the time was probability. Although it's not known which attitudes he conveyed to his students in his lectures and Economic Club meetings, it's clear that he was developing a fervent passion for investing before the Great War.
In a proper English mien, though, Keynes wanted to impress upon his students that there were important differences between investing (pretty much buy and hold), speculation, and gambling. In his 1910 lectures, he made those distinctions fairly clear. Here are his definitions:
* Speculation. "The essential characteristic of speculation ... is superior knowledge. We do not mean by this the investment's actual future yield ... we mean the expected probability of the yield. The probability depends upon the degree of knowledge in a sense, therefore it's subjective. If we regard speculation as a reasoned effort to gauge the future from present known data, it may be said to form the reins of all intelligent investing."
* Gambling. Keynes draws the line by noting that gambling isn't based on specific knowledge or reasoning, yet he voices "considerable sympathy for the bookmaker. ... They work as hard for their money as human beings can do, and their earnestness is remarkable. Thoughtful men of few words, they are as grave as judges, as reflective as metaphysicians and as pious as bishops; whatever their faults may be, they cannot be accused of frivolity or not working for their money."
* Evils of speculation. While Keynes doesn't initially make a moral judgment on speculation, he notes the harm it could cause "through the manipulation of the market through dishonest means." He's referring to seemingly ill-gotten gains by buying, selling, or shorting securities without regard to other market players or the fundamentals behind a security's pricing.
* Methods of speculation. In speaking of dealing in "promises" to buy or sell a stock, bond, or commodity, Keynes is referring to futures and options when he states, "A man who sells a promise is a bear and one who buys a promise is a bull. In the case of stocks and shares, not promises, but actual delivery is required." (More on this in the next chapter.)
Within five years of giving these lectures, Keynes was practicing (and often ignoring) what he was preaching. On the eve of the war, there was a tremendous speculative boom, so Keynes began to apply his insights to buying and selling currencies.
As his popularity with students grew, Keynes took a greater role in the governance of King's College. He was appointed to the Estates Committee in 1911 and started to understand how the college managed its money and property. Keynes quickly challenged the fact that King's kept large cash balances; he wanted to see the money put to work. Gradually winning over his colleagues, he eventually revolutionized the management of the institution's money—and that of institutions across the world.
At the time, he was also at work writing Indian Currency and Finance, which was finished in 1913 and led to his appointment to a government commission.
The years before the war afforded Keynes a new bevy of luxuries while his social life at Cambridge and Bloomsbury went into high gear. He took several vacations, visiting Greece, Sicily, Italy, and France. He played golf, gambled at Monte Carlo, and collected books and art. As his income grew, so did his propensity to indulge in the life of a bon vivant. While suffragists were chaining themselves to railings, Keynes also dabbled in liberal politics (the Labour Party was just being formed), and he edited the Economic Journal. He moved between the sophisticated worlds of the Fabian socialists (George Bernard Shaw was their literary lion) and the bohemian Bloomsbury set, which included Virginia and Leonard Woolf, Lytton Strachey, and Vanessa Bell. Whatever Bloomsbury was, it certainly wasn't the status quo. If it had flourished during the 1960s, it would have been hippie-like in its abandonment of conventional mores. Gay love was virtually on a par with heterosexual love. All Victorian notions of behavior, worldview, and culture were being thrown out the window. Keynes was one of the leaders of this revolution, which nearly crashed and burned with the onset of World War I.
The Great War: Trashing the Treaty
Keynes gained an exemption from being sent to the killing fields of France because of a Treasury appointment, which was made in 1915. Whitehall demanded dedicated men with expertise in money, currencies, and finance to handle payments for materiel. Keynes was a natural candidate to help manage Britain's finances; he had gotten his feet wet in the India Office, and his writing had elevated his profile within the government. What Britain needed was to keep the money flowing and to aid her allies. Russia and France transferred gold to the Bank of England. Once the Dardanelles was opened, Russia would boost her wheat exports. Britain loaned money to France.
Shortly after his appointment, Keynes suffered an appendicitis attack, underwent an appendectomy, then contracted pneumonia. In fact, he suffered from various ailments throughout his life, and he was constantly working, even on vacations. When the war ended, he was assigned to advise the Treasury on the Versailles Treaty, but he vehemently disagreed with the reparations that were being extracted from Germany. Based on his knowledge of exports, currency, and industrial production, he believed that Germany would be economically crushed by what France, Britain, and the United States were demanding, so he left his post and began writing a book that would change the way civilizations behave after a war. Its influence is still being felt today.
Economic Consequences: Rebel with a Cause
Keynes's insight into the potential destructiveness of the Versailles Treaty was not shared by those who were drafting the treaty. When he published The Economic Consequences of the Peace in 1919, it was soundly attacked by the British establishment. After all, wasn't it the role of a victor to demand humiliating payments from the loser? Couldn't you economically avenge the cost of millions of lives lost? Keynes thought this was a horrible concept that would destroy what was left of the once-robust German economy. In the book, Keynes not only savages the victors, but lays out a rational case for how channeling excessive payments from a devastated German people would not work. Germany could not possibly export enough goods to pay the reparations, Keynes calculated. In the final analysis, it would be a "lose-lose" situation for all parties involved and certainly would not cement the peace. The leaders of the time were infuriated with Keynes, who had broken one of the ironclad rules of being an elite British civil servant: not telling tales out of school. Although Keynes had flexible personal views on morality, it was clear that Economic Consequences was a masterwork of economic ethics. Why make a country shoulder the price of something monumental if it will never be able to pay you?
Robert Skidelsky saw Economic Consequences as a turning point in the evolution of Keynes's intellect. The economist had bolted headlong into the world of diplomacy, history, and moral reasoning. The "war to end all wars" would be nothing of the sort.
He had spoken like an angel with the knowledge of an expert. This mastery of science and words was to be the basis of all of his achievement. But there was something else. Keynes not only asserted his claim to attention but the claim of economic science to shape the future. The princes of the old world had left a dreadful mess; it was the task of the scientists to clean it up. This was a message with a powerful appeal to a rising generation.
While mentors like Moore and Marshall were revered in their own little worlds, Keynes now vaulted onto the world stage. His book became a bestseller on both sides of the Atlantic, and he morphed into a superstar in a world that had ravaged and disintegrated dynasties from Moscow to Vienna. The old world had come apart as Keynes was coming together. Not only did he dismantle the treaty in Economic Consequences, but he laid out a future economic scenario for Germany if it was imposed: "the menace of inflationism." As history tells us, inflation was the financial calamity that led to the fall of the Weimar Republic and the rise of Hitler.
Despite all of his warnings and economic figures showing the ultimate impact of the treaty, Keynes closes the book—and the era—with a prosaic aside that underscores his growing manifesto for compassionate capitalism:
In this autumn of 1919, in which I write, we are at the dead season of our fortunes. The reaction from the exertions, the fears and the sufferings of the past five years is at its height.... Our power of feeling or caring beyond the immediate questions of our own material being is temporarily eclipsed. The greatest ... events beyond our own direct experience and the most dreadful anticipations cannot move us.
(Continues...)
Excerpted from Keynes's Way to Wealth by John F. Wasik. Copyright © 2014 John F. Wasik. Excerpted by permission of McGraw-Hill Education.
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