Kaldor’s Theory of Speculation: An Overview

Fixing the Economists Article of the Week

by Philip Pilkington

I’ve been reading up a lot on economic theories of speculation as this is precisely what my dissertation is on and so far as I can tell the only real attempt to deal with speculative dynamics from a properly macroeconomic point-of-view is Nicholas Kaldor’s 1939 paper Speculation and Economic Stability. Sure, people will point to Minsky’s theories but they do not really contain a theory of speculation. The closest is really Keynes’ own A Treatise on Money but the discussion there is rather primitive. In what follows I will lay out a critical overview of Kaldor’s paper.

Kaldor sees the functioning of markets for financial assets and other things that resemble financial assets (such as commodities) as Keynes does in the General Theory; that is, he sees them as being subject to the famous ‘beauty contest‘ dynamic. This means that for Kaldor, as for Keynes, financial asset markets are based mainly on expectations and to some degree these expectations are not dependent on fundamentals and are instead subject to self-reinforcing dynamics of their own.

I totally agree with this view and for those who don’t I would suggest reading some of the latest literature being read by financial market participants which clearly states that the best way to profit is to follow (and thus help generate) trends. For example, in Kirkpatrick and Dahlquist’s Technical Analysis: The Complete Resource for Financial Market Technicians they write:

Technical analysis is based on one major assumption — trend. Markets trend. Traders and investors hope to buy a security at the beginning of an uptrend at a low price, ride the trend, and sell the security when the trend ends at a high price. (Pp9)

If that doesn’t sound like a recipe for speculation, I don’t know what does. And this view will be confirmed by speaking with market participants or watching their television programs. These people simply do not care about fundamentals in the manner which would lead them to make so-called ‘rational’ decisions in the market. (It seems to me that any trader with a Porsche and a mansion who follows trends is not engaged in any ‘irrational’ activity at all; indeed, if their goal is to be rich and their means of successfully achieving that the following of market trends then to call them ‘irrational’ is simply a perversion of the English language).

But back to Kaldor. There are many points that I agree with Kaldor on. He measures the degree to which speculation may affect a market in two ways. First of all, there is what he calls the ‘elasticity of speculative stocks’; that is, the amount of potential purchasing power there is to absorb an asset. Secondly there is the ‘elasticity of expectations’; that is, the amount to which prices will change purely in response to expectations. (He borrows this concept from John Hicks and as we shall see in a moment, this is very important). As the elasticity of speculative stocks reaches infinity the amount to which the price will rely on expectations becomes absolute, while as it reaches 0 the amount to which the prices will rely on expectations becomes nil. This is simply because the amount of speculative stocks in existence will determine the ability of speculators to speculate. Once we have a given amount for the elasticity of speculative stocks we then just have to turn to the elasticity of expectations to understand how speculation will affect the price. Again, a higher degree of elasticity of expectations will mean that excited speculators will move their money into the market in great degrees — expanding and contracting the speculative stocks — while a lower degree of elasticity of expectations will mean that timid speculators will be less inclined to move their money into the market.

In my dissertation I will be approaching the problem using a similar framework. However, I disagree with Kaldor on distinguishing between so-called fundamentals and speculation in these markets. If we are talking purely about price formation I do not think that we need to distinguish between the two sources of demand. It seems to me to just lead to messiness and confusion in what follows. The question of fundamentals only really comes in when we are concerned what might happen when speculation leaves a market — i.e. when a bubble bursts. Also the question of fundamentals is largely meaningless in actual asset markets like the stock market. It seems to me, in contrast to what Kaldor thought at the time (which we shall discuss momentarily), that “fundamentals” in markets like the stock market are entirely open to interpretation and rely heavily on investor expectations. To believe otherwise is to believe some sort of watered down version of the EMH, such as that expounded by Fischer Black in his awful paper Noise.

This is, in my estimation, a central problem of Kaldor’s paper: it’s a bit of a mess. In the later sections of the paper Kaldor tries to tie speculation into the fluctuation in output and employment. He essentially tries to rewrite Keynes’ theory of the liquidity trap. I will come back to this in a moment but first just let me point out something that I think important. Kaldor had the opportunity to overturn the neoclassical theory of price in this paper. And he could well have succeeded. But instead the paper was ignored and I think this was because it was not laying emphasis on what Kaldor’s theories meant for the neoclassical theory of price formation. Instead Kaldor focused on the annoying and banal liquidity trap argument that makes up a paragraph or two in the General Theory.

This brings us back to Hicks. In the paper, Hicks’ shadow looms large. He is referenced numerous times and it is well-known that he and Kaldor were good friends at the time. After the paper was published Hicks sent Kaldor a letter telling him that his paper had “completed the Keynesian revolution”. Actually what Kaldor was really doing was attempting to complete the Hicksian revolution. Because it was Hicks’ ISLM model that relied so heavily on the liquidity trap argument, not Keynes’ General Theory.

The liquidity trap argument in the General Theory was a simple curiosity for Keynes thrown out as a sort of supplement to the actual critique of neoclassical theory that he was putting forward. But, as is well-known, Hicks picked up on it and since then it is argued in textbooks that depressions that require fiscal policy only occur when the central bank can no longer reduce interest rates. Because Kaldor’s focus was essentially Hicksian I believe this accounts for why Keynes, after he read Kaldor’s paper, basically shrugged his shoulders and said that Kaldor might be correct that it was the speculative impulse that was behind any tendency toward a liquidity trap. Kaldor’s paper was not particularly interesting from a true Keynesian perspective, as from this perspective interest rates have uncertain effects on the level of economic activity at all times.

In joining forces with Hicks Kaldor lost a golden opportunity: namely, to shift his focus onto what his theory meant for financial asset pricing and pricing more generally. It is this matter that I hope to tackle in my dissertation.

One or two more points before I end this overview. On page 3 Kaldor seems to eliminate certain markets from being subject to speculative dynamics. In particular he takes aim at markets for goods that are bulky and thus have high carrying costs. Kaldor is just flat wrong here. With the development of contracts that can be used to speculate on these goods before they are even produced — that is, futures contracts — anything can be subject to speculation. Anything. Just look at oil which should have massive carrying costs. I’ve come to think that the only reason we cannot speculate on the price of, for example, refrigerators using a futures market is simply because no one has bothered trying. This is actually a rather profound, not to mention disturbing, thought if understood correctly and lucidly.

On page 16 Kaldor also makes the assertion that Price-Earnings ratios in stock markets are relatively stable. This is a bizarre statement with no basis in fact and seems to hint that stock markets are not subject to speculative excesses. Writing ten years after the Great Crash of 1929 one wonders what on earth Kaldor was talking about.

Finally, some claim that this paper contains the germ of what would become Kaldor’s theory of endogenous money. This is just flat wrong. The relevant graph is on page 14 of the paper and it clearly has an upward-sloping supply curve for money. It is not very steep, indicating that Kaldor was not in any way a ‘verticalist’, but it is unquestionably upward-sloping.

We can also take a biographical lesson from all this about Kaldor himself. Namely that at this stage of his life — for he was still young, had grown up under the wing of Hayek and was at this time heavily influenced by Hicks — Kaldor was only beginning to become a Keynesian. There is no question in my mind that he was not there yet. Had he followed this trajectory he would have ended up a Neo-Keynesian in the style of Hicks. But, as we all know, he did not follow this trajectory. And the world of economics is a better place for it.