Kaldor’s Theory of Speculation: An Overview
July 20, 2013 by pilkingtonphil
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.