The Importance of State of confidence in Long-Term Expectation

Chapter 11 explained that the scale of investment depends on the relation between:

• the interest rate and
• the schedule of the marginal efficiency of capital corresponding to different scales of current investment

The marginal efficiency of capital depends on the relation between:

• the supply price of a capital-asset
• its prospective yield.

What are the factors which determine the prospective yield of an asset?

These may be:

historical

Examples are:

• capital-assets in general
• the strength of the existing consumers’ demand for goods which require for their efficient production a relatively larger assistance from capital

future-based

Examples are future changes in:

• the type and quantity of the stock of capital-assets
• the tastes of the consumer
• the strength of effective demand during the life of the investment
• the changes in the wage-unit in terms of money which may occur during its life

We may sum up the state of psychological expectation which covers the latter as being the state of long-term expectation; — as distinguished from the short-term expectation upon the basis of which a producer estimates what he will get for a product when it is finished if he decides to begin producing it to-day with the existing plant, which we examined in Chapter 5.

We should not put great weight on very uncertain matters.

[1] We should be guided by facts which we are confident with, even though they may be less relevant to the issue.

This is why the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations.

Our usual practice is to take the existing situation and project it into the future. We modify it only when we expect a change.

Some of our decisions are based long-term expectation.

This long-term expectation does not solely depend on the most probable forecast we can make.

It also depends on our confidence of this forecast.

If we expect large changes but are very uncertain on how these changes will take, then our confidence will be weak.

Practical men always pay the closest attention to the state of confidence.

But economists have not analysed it carefully. We merely discuss it in general terms.

The state of confidence is relevant to economic problems through its influence on the schedule of the marginal efficiency of capital.

Two integrated factors affect the rate of investment:

1. The schedule of the marginal efficiency of capital
2. The state of confidence

The state of confidence is relevant because it is one of the major factors determining the marginal efficiency of capital, which is the same thing as the investment demand-schedule.

There is, however, not much to be said about the state of confidence a priori.

Our conclusions must mainly depend upon the actual observation of markets and business psychology.

This is why the ensuing digression is on a different level of abstraction from most of this book. For convenience of exposition we shall assume in the following discussion of

My discussion on the state of confidence assumes:

• that there are no changes in the interest rate.
• changes in investments were solely due to changes in expectation of their prospective yields and not to changes in the interest rate at which these prospective yields are capitalised.

The effect of changes in the interest rate is, however, easily superimposed on the effect of changes in the state of confidence.

The Stock Market

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.

Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible.

Our basis of knowledge for estimating the yield of a railway, copper mine, textile factory, the goodwill of a patent medicine, Atlantic liner 10 years from now is really nothing.

Those who seriously attempt to make any such estimate are often in the minority. Their behaviour does not govern the market.

In the past, enterprises were mainly owned by those who undertook them or by their friends and associates.

Back then, investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life.

• They did really rely on a precise calculation of prospective profit.

The affair was partly a lottery. Its ultimate result largely depended on whether or not the abilities and character of the managers were above or below the average.

Some would fail. Some would succeed.

But even after the event, no one would know whether the average results in terms of the sums invested had exceeded, equalled or fallen short of the prevailing interest rate.

If we exclude the exploitation of natural resources and monopolies, it is probable that the actual average results of investments, even during periods of progress and prosperity, produced less than expected.

Businessmen play a mixed game of skill and chance. The average results of which to the players are not known by those who take a hand.

There might not be much investment arising from cold calculation if humans felt:

• no temptation to take a chance,
• no satisfaction in constructing a factory, railway, mine or farm without profits

Decisions to invest in the old-fashioned type of private business were, however, decisions largely irrevocable for the community as a whole and the individual.

Nowadays, there:

• is a separation between ownership and management
• are organised investment markets

A new factor of great importance has entered.

• It sometimes facilitates investment, but sometimes adds greatly to the system’s instability.

In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed.

But the Stock Exchange revalues many investments everyday.

• The revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments.

It is as though a farmer could decide to remove his capital from the farming business between 10-11AM and reconsider whether he should return to it later in the week.

But the daily revaluations of the Stock Exchange are primarily made to facilitate transfers of old investments between investors. They exert a decisive influence on the current investment rate.

This is because:

• there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased.
• there is an inducement to spend on an extravagant new project if it can be floated off on the Stock Exchange at an immediate profit.[2]

Thus, certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur.[3]

How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice?