His investing acumen explains why Keynes was skeptical of markets and favored public spending.
How would you like to outperform the stock market by 8 percentage points a year? This isn't some Madoff-style pitch. It's what economist John Maynard Keynes did over a twenty-year period that spanned the Great Depression. As Jason Zweig of The Wall Street Journal points out, it's an investing performance that puts Keynes in very elite company over the past century -- Warren Buffett company, to be exact. But more importantly, understanding how Keynes outperformed the markets so much explains why he mistrusted markets so much.
Keynes famously took a dim view of how well unregulated markets allocate capital. "When the capital development of a country becomes a by-product of a casino, the job is likely to be ill-done," declared Keynes in The General Theory of Employment, Interest, and Money. The problem is that the mania of the markets often drives prices away from their fundamental values. Keynes compared it to a newspaper beauty contest. Imagine a competition where you're supposed to pick out the six most beautiful faces from a group of 100. But remember, this is a contest. The winner is the person who picks out the six most popular faces. It's not a question of which faces you think are the most beautiful. It's a question of which faces you think other people think are the most beautiful. Of course, being a savvy individual, you realize this -- so you pick the faces you think other people will think other people will pick. And so on, and so on. The same applies to stocks.
If prices really can get so unmoored from fundamentals, investors are left with two basic strategies. They can ride the bubble. Or they can bet against overvalued stocks. A naive observer -- i.e., an über free-market economist -- might think that investors will choose the latter path. But, as usual, there's a (possibly apocryphal)** Keynes quote for that -- this time, that "markets can remain irrational longer than you can remain solvent." And that's why investors don't always short bubblicious stocks. Not only can a stock stay overvalued longer than an investor can afford to bet against it, but doing so opens them up to potentially unlimited losses for only limited gains.* (After all, a stock can theoretically rise an infinite amount, but it can only fall a finite amount). It's much easier to buy an overpriced asset in the hope that it will keep going up and up -- before unloading it on the greater fool. That's unfortunately a fairly apt description of what the big banks belatedly did as the housing bubble collapsed.
Of course, there's a third option: buy undervalued stocks. It's not easy, but so-called value investing is how Warren Buffett managed to catapult himself up the ranks of the world's richest individuals. It's also how Keynes managed to generate such outsized returns during the turbulent period from 1924 to 1946. Which makes sense. If you think the social dynamics of markets push prices away from their fundamental values, you'd look for cases where that's happened -- and your risk of losing money is low. In other words, hold and buy stocks that the market underappreciates.
It's only a hop, skip, and a jump from thinking markets are prone to bubbly behavior to supporting a greater government role in stabilizing the economy. If investment fluctuates so wildly -- and it does -- then so too will jobs. The government can step into the breach and keep investment steady. But this mixed capitalism is no less capitalism. Just ask Keynes, who was no slouch as a capitalist himself.
* Credit default swaps change this calculus. CDS appreciate in value as the asset an investor is betting/insuring against declines in value.
** The original version of this article incorrectly identified this line as a Keynes quote, while there's some doubt whether he actually said it.
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Matthew O'Brien is a former senior associate editor at The Atlantic.