John Maynard Keynes and His Work in the Insurance Market

CONFERIR E, CASO NECESSÁRIO, AJUSTAR LOMBADA

ISBN 978-85-7052-544-4

9 788570 525444 JOHN MAYNARD KEYNES AND HIS WORK IN THE INSURANCE MARKET

 PEDRO CARVALHO DE MELLO at Columbia University and the University of Richmond, and visiting PEDRO CARVALHO DE MELLO scholar at Tsukuba University (Japan). Associate Professor (retired) of the Esalq/USP. He was Director (two terms of three years each) of CVM (Securities and Exchange Commission of Brazil), Director of BM&F (Brazilian Securities, Commodities and Futures Exchange), and Vice-President of PNC International Bank. Author of several books and articles in the areas of economics, finance, insurance and economic history. 1st edition in Portuguese: November 2012 Fundação Escola Nacional de Seguros – Funenseg Rua Senador Dantas, 74 – Térreo, 2º, 3º, 4º e 14º andares Rio de Janeiro – RJ – Brazil – CEP 20031-205 Phone: (21) 3380-1000 Fax: (21) 3380-1546 Internet: www.funenseg.org.br E-mail: [email protected]

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Reviewer Monica Teixeira Dantas Savini John Maynard Keynes AND HIS WORK IN THE INSURANCE MARKET

PEDRO CARVALHO DE MELLO English edition: February 2016 Fundação Escola Nacional de Seguros – Funenseg Rua Senador Dantas, 74 – 3rd Floor Rio de Janeiro – RJ – Brazil – CEP 20031-205 Phone: (21) 3380-1000 Fax: (21) 3380-1546 Internet: www.funenseg.org.br E-mail: [email protected]

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No part of this book may be reproduced or transmitted in any form or any manner: electronic, mechanical, photographic, recorded, or by any other means without permission in writing from the Fundação Escola Nacional de Seguros – Funenseg.

Editorial Coordination Center for Research on Insurance Economics

Editing Claudio Contador

Graphic production Hercules Rabello

Front Cover/Layout Grifo Design

Reviewer Amadeu Pumar

Virginia Thomé – CRB-7/3242 Librarian responsible for preparation of the catalogue card

M78J Mello, Pedro Carvalho de John Maynard Keynes : and his work in the insurance market / Pedro Carvalho de Mello. -- Rio de Janeiro : Funenseg, 2012. 168 p. ; 22,5 cm

ISBN nº 978-85-7052-544-4.

1. Economics and Insurance. 2. Keynesian Economics. 3. John Maynard Keynes, 1883-1946 – Life and work. 4. John Maynard Keynes – Historical economy. I. Title.

0012-1139 CDU 330:368 Table of contents

Preface ...... 7

Presentation ...... 9

Introduction ...... 11

Part I – Life and career of Keynes ...... 17 1. Main events in the life of Keynes ...... 19

Part II – Personal finance and financial management ...... 35 2. Keynes’s personal finance ...... 37 3. Keynes’s performance as fund manager of Cambridge University ...... 47 4. Keynes as investor and the lessons learned ...... 51

Part III – Keynes’s theory and works ...... 57 5. An overview of Keynes’s works ...... 59 6. Keynes and the precursors of the Modern Theory of Finance: Knight, Hicks, Fisher and Hayek ...... 67 7. Risk and uncertainty ...... 75 8. Speculation and investment ...... 85 Part IV – British economy between the wars and the financial crisis of 1929 ...... 89 9. Context of the economic history of Britain ...... 91 10. Keynes and the financial crisis of 1929 ...... 97 11. Finance, investment and risk in the british market ...... 103 12. Insurance in Britain at the time of Keynes ...... 107

Part V – Keynes as chairman and director of insurance companies ...... 115 13. Investment and risk philosophies applied to asset management of insurance companies ...... 117 14. Keynes performance in investment management of insurers ...... 127 15. Annual reports written for insurers ...... 133

Part VI – Final remarks ...... 157 16. Conclusions ...... 159

Bibliographic references ...... 163 Preface

ASSUREDLY, HISTORY, UNDERSTOOD AS THE REPORTING AND INTERPRETATION OF PAST EVENTS, PIQUES THE INTEREST OF RE- SEARCHERS AND SCHOLARS IN BRAZIL. THE WORK OF HISTORI- ANS CURRENTLY HAS THE SUPPORT OF RECOVERED STATISTICS, EASY ACCESS OVER THE INTERNET TO BROWSE LIBRARIES IN THE MOST DISTANT COUNTRIES, AND NEW TECHNIQUES OF QUANTI- TATIVE DATA PROCESSING. READING IS NO LONGER DULL, MERE DESCRIPTION OF DATES AND NAMES, AND TRANSFORMS INTO DISCOVERIES AND FASCINATING TEXTS. DESPITE THESE TECHNOL- OGY PILLARS, THE FIGURE OF THE RESEARCHER REMAINS UNIQUE.

Prof. Pedro Carvalho de Mello reflects well this new type of researcher. With solid background in Economics, M.A. and Ph.D. from the Univer- sity of Chicago, several articles published in Brazil and abroad and some books, Pedro has been dedicated to the study of history since the 1970s, when he wrote at the University of Chicago, USA, his doctoral thesis “The Economics of Labor and Slavery in Brazilian Coffee Plantations, 1850-1888”. And he always does it in a surprising way. As an executive, he worked in private institutions such as IBMEC, BM&F, PNC Bank (Pittsburgh), and public institutions, such as the CVM, and also has in his record a successful career as a professor at the University of São Paulo,

Preface 7 FGV/Ohio University College of Business and ESAGS. Combining his interest in risk and insurance market, Pedro gifts us two instigating books. In the first – John Maynard Keynes and his Work in the Insurance Market – he reveals to us that Keynes, certainly the most vibrant economist and of greatest impact in the twentieth century, was president of the National Mutual Life Assurance Society. And as such was an innovator in risk understanding and management. In the second book he updates the Portuguese version (From Keynes to the Current Economic Crisis of 2012), originally from 2012, to 2016 (new title is From Keynes to the Current Financial Crisis). In fact, Pedro discusses the international financial crisis unfolding since 2007 and seems to be endless, when every following day has new problems linked to earlier ones. In this second book, the author returns to one of his favorite themes – the financial crises – on which he has already written a book which became a classic. There is already a wide literature on the current crisis, but the understanding of its effects in the insurance market is still incomplete. Pedro covers this gap and provides a detailed description of the events of 2007-09 with an interpretation of their impacts on the insurance market. Both books have the certain destination of becoming classic readings and consultation sources for researchers. The academy and the institutions of the Brazilian insurance market have a debt of gratitude to Professor Pedro.

Prof. Claudio R. Contador, Ph.D. Center for Research on Insurance Economics

8 John Maynard Keynes and his work in the insurance market Presentation

THIS BOOK IS THE RESULT OF THE RESEARCH PROJECT FROM FUNDAÇÃO ESCOLA NACIONAL DE SEGUROS – FUNENSEG EN- TITLED “INSURANCE AND FINANCIAL CRISIS: IMPACT ON THE INSURANCE INDUSTRY. FROM KEYNES TO THE CURRENT CRISIS OF 2012”. THE RESULTS OF THIS RESEARCH PROJECT WERE PRE- SENTED IN REPORTS REFERRING TO THE TWO STAGES IN WHICH IT WAS ORGANIZED. THE REPORT OF STAGE 01 HAD THE GOAL OF STUDYING THE ECONOMIC THINKING OF JOHN MAYNARD KEYNES AND HIS WORK IN THE INSURANCE MARKET.

The choice of examining Keynes was based on three main aspects. First, Keynes was undeniably one of the greatest economists of all ages in which the work of professionals in this area are followed. Second, he was the most influential economist in world economic policy of the twentieth century, and his thought is still very present, as can be seen in the discussion of the present financial crisis 2007-2016. Third, he was an out- standing and dedicated insurance manager, who innovated in the financial sector, and conducted brilliantly his financial work in the turbulent years between the two world wars.

To write this book, I would like to thank Funenseg, for their support, and all at the Publications team, coordinated by Vera de Souza, the Universities of

Presentation 9 California, Irvine, for the support of their library, and ESAGS, a new school of administration and economy, where I currently teach after my retirement at ESALQ/USP. I dedicate this book to my friends Zélia, Franco, Lili, André, Carlo, Giacomina, Mario, Sonia, Renato, Monica, Chloé and Chafic, for the good times we spent together and that contributed so much to my willing- ness to research and write.

10 John Maynard Keynes and his work in the insurance market Introduction

MY INTEREST IN THE INSURANCE AREA APPEARED LATER IN MY LIFE, AND AM VERY GRATEFUL TO MY FRIEND CLAUDIO CONTA- DOR FOR OPENING THE DOORS TO THIS IMPORTANT SECTOR OF THE ECONOMY AND FINANCE.

My professional life, and part of my academic life, has always been closely linked to the capital market, to banks and derivatives markets. I also found out that the insurance industry can be a fascinating field of study and professional work. As a matter of fact, strategists are already forecasting that the insurance field should outweigh in importance the banking field during the twenty-first century. The entrepreneurship theme has always interested me as well. I consider the activities of business management and human resource management and administration as the “fourth” factor of production, along with capital, labor and natural resources. That is why I was charmed by the fact that Keynes, the greatest economist of the twentieth century, had a career as a professional and entrepreneur in the insurance industry. This book intends to explore these aspects, and examine the relations between the life, career, and his performance as an investor and speculator, director of the Bank of England and great statesman, and his role as Chairman of the Board of an insurance company, and director of other insurance companies.

Introduction 11 I would like to begin the book by saying that Keynes was an acting Chair- man of the Board (COB) of a life insurance company, and an executive director of another, that he devoted a great dose of economic creativity to lead the economic destinies of the insurer which he managed, National Mutual Life Assurance Society. Many may think that he might had been a “figurehead” or an “door opener” due to his growing prestige in the financial and economic world, but that was not what actually occurred. He was an active participant in the decision-making process, and an expert of all the ins and outs of a company operating in the insurance industry. We will show in this book this life as “insurer”, one of many “lives” of Keynes. The central focus of this book is that Keynes, in seeking a profitable and differentiated performance for the company he managed, adopted a bold and innovative position of financial management. He had deep knowledge of the elements of risk and the actuarial methodologies for the management of the liabilities of the insurer, and realized that his path would be very limited, if he was to works toward a differentiated performance, aiming to improve a better management of the liabilities. The actuarial improvements could have been copied by other insurance companies, as it would be common knowledge on the insurance industry. Thus, Keynes turned to an innovative management on the side of the insurer’s assets. In general, insurers invested much of their technical reserves in government securities, and, in addition to being limited to earning low interest rates from government securities, became too similar in terms of return on assets. Then the brilliance of Keynes arises: daring in asset management, investing in shares, forward market and international finances. Those were investments that led him to a world where risk mathematics did not apply: the realm of uncertainty. Keynes fought much to assert his point of view in the Board of the insurer, and investment performance was closely followed (watched, rather) by other directors. It thus becomes clear why, in macroeconomics books written by Keynes, the themes of uncertainty, liquidity trap (low interest rates), investment vol- atility, expectations psychology and the distinction between the real side (companies’ stocks, characterized by uncertainty) and the monetary side (government bonds’ interests, characterized by risk) appear so vigorously. Since my time of economics school at the Federal University of Rio de Janei- ro (UFRJ) I was influenced by the thoughts and theories of Keynes. I confess I did not understand the scope of his ideas, especially the fact – as I was to discover later – that two characteristics of his were essential for his work.

12 John Maynard Keynes and his work in the insurance market First, Keynes was a practical person, and turned to theory mainly as a means to achieve the purpose his was seeking. His goal was to develop persuasive arguments for economic policy which he recommended, which often es- caped the contemporaneous conventional thinking. Second, the Keynes’s “head” was that of a financial markets trader, in a style similar, bearing in mind the appropriate scale, with George Soros and War- ren Buffet. The key to better understand the economic thinking of Keynes, in my opinion, is to keep up with his activities in the financial market and the financial administration of the insurers and other investment channels. A few years later, I was tricked by fate. I was approved for doctorate in economics at the University of Chicago, and I ended up studying and finishing my Ph.D. at the “anti-Keynesianism temple.” I learned to criticize and to doubt Keynes with my professor Milton Friedman and his colleagues and in a way watched the triumph of monetarism as a set of macroeconomic ideas to formulate economic policies. Over the years, as I combined professional and academic experience, the pendulum went back to a more balanced state. I realized that most of the more recent work on the evolution of economic thought points out that John Maynard Keynes (06/05/1883 – 04/20/1946) and Milton Friedman (07/31/1912 – 11/16/2006) were the greatest economists of the twentieth century. Recently, reading the D.E.Moggridge book about the life of economist Harry Johnson1, my beloved teacher in two subjects in the Department of Economics of Chicago, I’ve read the following comments that he wrote in 1949:

“I might describe myself as a third-generation Keynesian – Keynesian, in that I am convinced, as many economists are not, of the usefulness of the approach originated by Lord Keynes, and the importance of the problems with which his analysis deals; third-generation, in both the time at which I came to the study of the theory and my attitude towards it.

1 Harry Johnson joined, in 1959, the University of Chicago. According to Van Overtveldt, he was seen as a “Keynesian” in Chicago, and as a “Monetarist” in other universities. Johan Van Overtveldt, “The Chicago School”, p. 135. Also according to Van Overtveldt, Lloyd Metzler was the disciple of Keynes in the Department of Economics of the University of Chicago (p.8). Harvard-educated, he was hired due to the withdrawal of Paul Samuelson for this post. Metzler arrived in 1947, but unfortunately had a brain tumor, operated in 1952, that left him incapacitated. In 1969, when I began my studies in Chicago, I attended Metzler classes. The comment from students was that, even having lost part of his brain in the operation, Metzler continued a brilliant economist.

Introduction 13 I have neither the passionate conviction of revealed truth of the first generation, with its tendency towards bibliolatry, hero-worship, and intolerance towards critical points of view; nor the pioneering en- thusiasm of the second generation, acknowledging the limitations of Keynes’ book but not of his analysis, and assuming that the “General Theory” is the starting point of economic wisdom. I regard Keynes’ “General Theory” as an extension rather than a replacement of previously existing knowledge, a book which omits not only some of the answers but also some of the questions; and I believe that further progress requires a synthesis of the Keynesian analysis with the general corpus of economic theory.’’2

Unfortunately, Harry Johnson died relatively early, and could not complete the synthesis he intended to do, and that would probably give him the Nobel Prize in Economics. While Friedman was basically an academic economist during his whole long life, Keynes, on the other hand, was a very active person in the intellectual, artistic, political and business life in England during the first half of the twentieth century. Friedman and Keynes exercised great political and ideological influence at a global level, but Keynes, unlike Friedman, was an important executive and financier. This latter aspect, little explored in economics books, served as the motivation for this book. Personally, my professional life is closely linked to banks, capital markets and international finance. I confess that I began to understand Keynes only after understanding the intricacies of financial economics. This leads me to believe that Keynes, modernly, would be an economist able to navigate easily between economic schools and business schools. Today, I achieved more balanced stage, admiring both Friedman’s work as well as Keynes’s. I consider Keynes as a more complete economist, in my personal view of the qualities that this professional should have. I am of the opinion that an economist should possess the qualities of Keynes, in the moral, ethical, historical, philosophical, sociological and cultural sense, complemented by knowledge of prices, amounts and currency. Unfortunately, in recent years, Brazilian economics taught in schools has

2 Moggridge, “Harry Johnson”, p. 126.

14 John Maynard Keynes and his work in the insurance market become more elegant, theoretical and formal, but less and less relevant to the rest of society.3 With the financial crisis of 2008, the “post-Keynesians” assumed a more important role, and, as said by Robert Skidelsky, a famous biographer of Keynes, the “master has returned.” For the purpose of our book, master Keynes has returned as well. He returned because I realized that Keynes has ever relied much in intuition, and has always been concerned more with the phenomenon of uncertainty than with risk. He returned also because, in the words of his wife Lydia Lopokova, “Maynard was more than an economist.” According to Skidelsky, in the book Keynes, the Return of the Master, “he can be seen as the most brilliant non-economist who devoted himself to the study of economics” (p.55). Keynes was actually more than an academic economist. He was the chief representative of the British Treasury at the Peace Conference in Paris, Deputy Governor for the Chancellor of the Exchequer, editor for the most importantly publication on Economy at the time, Director of the Bank of England, Trustee of the National Gallery, Chairman of the Council for the Encouragement of Music and the Arts, Bursar of King’s College (Cambridge University) and Chairman of the New Statesman and Nation journals. He was also one of the founders of the IMF and the World Bank. These Keynes activities are well known. Little known or highlighted is that Keynes was an active participant in the Insurance industry in England. He was, for many years, Chairman of the Board of an insurance company, National Mutual Life Assurance Society, and Director of another insurer. The National Mutual, founded in 1823, is still active to this day in England, with assets of £ 45 billion. It is intended in this book to restore this role of Keynes, and show how his work as manager at insurers were strongly influenced, but at the same time contributed to the development of his ideas and writings on economy. The objective is, in particular, to highlight the aspects of investment, risk and finance contained in his academic and professional work.

3 For Keynes, “(The master-economist) must be mathematician, historian, statesman, philosopher – in some degree. He must understand symbols and speak in words.” Quoted by Clarke, Keynes, p.25.

Introduction 15 It is ironic that someone so connected to the study of the effects of uncertainty was managing a company dedicated to risk management. The surprise in this regard is unfounded, however, as an insurance company is dedicated to managing both assets and liabilities. On the liabilities side is where one is faced with risk management linked to the insurance policies the company sells. On the asset side, one has to manage the investments of his technical portfolio, and facing the constraint that the investment activity is permeated by uncertainty. As we will see in this book, Keynes’s investor and speculator skills were extremely useful to administrate the assets of the company he ran as managing director in the turbulent period of the 20s and 30s both in England and the world economy. We will comment also how this knowledge was used by Keynes to develop some of his best-known macroeconomic theories. By presenting these little-known aspects of the Keynes work as an insurance professional, the objective is to inspire and motivate the Brazilian insurance industry to reflect on the ideas of risk, finance and macroeconomics, used very successfully by this brilliant economist in the management of the insurers he presided over. The book is organized into five parts. In the first part, we present his life and career, with a focus on his investor and speculator work, showing how this contributed to his economic thinking. In the second part we will speak of his work, with a focus on thoughts about risk, uncertainty and money. In the third part, we will comment on the historical context of economics, finance and insurance in Britain in the period between the wars, highlight- ing the crisis of 1929 and the Economic Recession. In the fourth part of the book, we will examine the work of Keynes as Chairman of the Board of an insurance company and, through his writings, the kind of economic advice and financial strategy that he recommended to the National Mutual Life Assurance Society and the other insurance sector company in which he was a director. Finally, in the fifth part of the book, we will present the conclusions and final considerations.

16 John Maynard Keynes and his work in the insurance market PART I Life and career of Keynes

ur goal in this first part of the book is to highlight O aspects of Keynes’s life more related to the conduct of his investment and speculation work, and to discuss his career as executive of insurance companies, focusing in his various activities as academic, insurance professional, investor and speculator. We intend to show that the multifaceted life of Keynes was the biggest ingredient behind the writing of his works.

In order to appreciate Keynes’s contribution to economic thought, it is important to examine the larger context of his life. Thus, Chapter 1 provides a brief summary of his biography. It is followed in Part II by three chapters on the various activities of Keynes in the financial world, and, in Chapter 5, in Part III, we will complement Chap- ter 1 by making a general summary of his most important economic works.

CHAPTER 1 Main events in the life of Keynes

AS COMMENTED IN THE INTRODUCTION, THERE IS A CONSEN- SUS THAT JOHN MAYNARD KEYNES WAS, IF NOT THE MOST, AT LEAST ONE OF THE TWO MOST IMPORTANT ECONOMISTS OF THE TWENTIETH CENTURY, AND ONE OF THE THREE GREATEST ECONOMISTS IN HISTORY. THERE ARE SEVERAL BIOGRAPHIES OF KEYNES. ALONG WITH ADAM SMITH, HE WAS THE ECONOMIST WHOSE LIFE AND WORK WERE MOST ANALYZED.

The most complete biographies of Keynes are Roy L. Harrod, “The Life of John Maynard Keynes”, written in 1951; D. E. Moggridge, “The Life of John Maynard Keynes: an economist’s Biography”, written in 1992; and Robert Skidelsky, “John Maynard Keynes, 3 vols”, written in 1983, 1992, 2001. The magnum opus about Keynes was the result of the dedicated efforts of many academics who for two decades organized the written work, correspondence, reports and other papers from Keynes. Under the auspices of the Royal Economic Society, it was edited by Donald Moggridge, with the title of “The Collected Writings of John Maynard Keynes”.4

4 In the general introduction to the 28 volumes of this collection, the Royal Economic Society stated that it was editing the work to be a memorial in honor of Keynes. Keynes had devoted a significant part of his life to the Royal Economic Society, mainly working as the “The Economic Journal” editor.

1. Main events in the life of Keynes 19 John Maynard Keynes was born in Cambridge, on 5 June 1883, in an upper middle class family.5 Aside from his mother, who called him John, all his friends and acquaintances called him Maynard. His father, John Neville Keynes, was an economist and professor at the University of Cambridge. His most important work was “The Scope and Method of Political Economy” (1891). In 1894 Neville was invited – but refused – to be a professor of economics at the newly founded University of Chicago. The history of economic thought would have been different if the Keynes’s father had accepted the invitation and brought his young son to live in Hyde Park... Keynes’s father’s career, over time, became more administrative than academic. His mother, Florence Ada Brown, was active in the arts and in politics, and very dedicated to social causes, having been a mayor of the city. Both studied in Cambridge and lived many years together having survived even the death of Maynard. Keynes’s childhood was peaceful, as the eldest of three brothers. In his early school years he attended schools in the city of Cambridge. The year 1897 marks an important date for Keynes – his entry into Eton.6 He had been preparing diligently to be approved in the disputed entrance exams. Eton was an aristocratic school, the most famous of the country, who trained the English elite for the top positions in the Empire. The students lived in a boarding school regime, and the school only accepted boys. Keynes was 14 when he entered the school, and stayed there for five years, until 1902. He developed oratory skills, and his own political ideas. He practiced sports, particularly rowing, despite his poor health.7 The school emphasized, by their customs and traditions, the formation of small “networks” of students. At Eton, students were exposed to a high dose of classical studies. Keynes was fond of mathematics, and sought to enroll in extra courses of this matter, instead of other courses, such as poetry and literature. At 19, near grad- uation, Keynes decided he would not try to enroll at Oxford under any circumstances, but at one of the colleges of Cambridge University.

5 It is speculated that there is a distant kinship link between Keynes, whose name originates in Normandy, and François Quesnay. Quesnay (1694-1774) was the greatest exponent of the Physiocratic School, and a precursor of macroeconomics. Of Normandic family, the inference is that the name “Keynes” is a corruption of “Quesnay”. If this is true, it’s another one of the ironies of history. 6 Keynes received a scholarship to Eton. 7 All members of the Keynes family – parents and siblings – were long-lived. Keynes, however, had a problem of bacteria in the heart (myocarditis), at a time when there was no treatment for this disease. This shortened his life.

20 John Maynard Keynes and his work in the insurance market This university was very strict as follower of the Anglican religion, but outside religion disciplines, it also possessed mathematics disciplines. In the late nineteenth century, the university decided to diversify and expand its academic scope, and set up other areas of education. New fields of studies Emerged on Classics, Moral Sciences and the Natural Sciences, which expanded the list of choices for their students. It was then expanded to other areas, including Law, History, Theology and Languages. At the turn of the twentieth century, the areas of Economics and Anthropology were added. The university was modernizing, reducing its religious character, and offering greater opportunities for teachers8. Financial problems, however, were pressing, and Keynes would later help in asset management, as Bursar of King’s College. A family discussion between Maynard and their parents arose over which of the three major Colleges at the University of Cambridge – King’s, Trinity or Saint John – should he try to be admitted, and in parallel to apply for a scholarship. In the end, Keynes chose King’s College, passed the exams and was awarded a generous scholarship. In October 1902, Keynes initiates his studies at Cambridge. King’s College was a small school with about 150 students. Although Keynes had been directed to mathematics, and was expected of him to follow a career in this field, his interests were proved wide and varied: sports, swimming, literary discussions, political themes, philosophical debates etc. England, at the turn of the century, was starting to question the long “Victorian Age”, very loaded into moral and conservatism, and the “Edwardian Era” had begun. The world was living the “Belle Époque”, and its repercussions were soon to arrive in Cambridge. In economic terms, it had been a period of great transformation. The rural and commercial England had become, in not many decades, an industrial and urban society, and became a major world power. Keynes was not a dedicated and focused student at school, but on the other hand loved the free and intense life he led at the university. Keynes, as a student, did not stand out in an exceptional way. On the other hand, he could greatly expand his intellectual horizons, and develop various sports and artistic activities.

8 According to Clarke, “the administrative structure of the modern university was slowly emerging from its monastic shell”. Clarke, Keynes, p. 22.

1. Main events in the life of Keynes 21 Two Cambridge economics professors influenced Keynes a good deal: Henry Sidgwick and Alfred Marshall. Sidgwick was a Utilitarian and interested in issues of ethics and morality, which greatly influenced Keynes. Marshall was interested in making economics a science, and to enable economics as a proper field of knowledge at the University of Cambridge. Henry Sidgwick was a member of the Cambridge Conversazione Society, known as “Apostles”, a strictly closed society among its members. It was founded in 1820 by 12 students, hence the name of the Apostles. Bertrand Russell and Ludwig Wittgenstein were members of the “Apostles”, which kept the air of a secret society. Keynes would participate in it in the future. This membership was very important and would end up marking his life. Indeed, Keynes was elected in 1903 to the Society, and stayed a member until his death. There was intense activity, with several meetings in which mandatory presence was demanded, and discussions that were formatted according to strict rituals and rules. The “Apostles” had a tendency to reject the outside world, and as main objective sought to discover the “truth”. At the time of Keynes, the following characters, among others, attend this society: E.M.Forster (writer), Lytton Strachey (historian), Leonard Wolff (writer) and GE Moore (moral philosopher). The latter would have great influence on the thought of Keynes, as we shall see. In personal terms, Lytton Strachey was the most influential. It should be noted that there was, as a backdrop, a vigorous desire by some intellectuals – including Keynes – to shock the Victorian morals of the time. At this point Keynes’s life, there are many controversies about his sexual life and that of his friends and his circle of influence. There was a humor saying circulating among the “Apostles”, that sexual relations were homo- sexual (the common case), and that heterosexual relationships would be a special case. It is ironic to realize the roots in this on the thought of Keynes when he wrote in 1936 the “General Theory of Interest, Employment and Money”, mapping differences in special cases (full employment) and the most general cases (including unemployment). After the third year at the University, Keynes had to decide on the specializa- tion – economics or public service – he would choose for the fourth and final year. At this point in his life, the figure of the great economist Alfred Marshall takes shape. He was the “economist’s economist”, a dedicated intellectual, social reformer and theorist who wanted to explain in a practical way the com- plications of the economy to the “businessmen” and for “ordinary people”.

22 John Maynard Keynes and his work in the insurance market Marshall was a friend of Keynes’s father, and tried to attract the young Keynes into the orbit of the economy. At the University of Cambridge, Marshall was the undisputed leader of a movement to make the economy study more scientific, with empirical tools for the analysis of economic facts. Marshall became a major opponent of Sidgwick, challenging the importance that the latter gave to the moral and historical aspects. Keynes was a student of the economics course taught by Marshall, and virtually this was his only formal training in economics. Keynes considered the understanding of ethics and morals a subject of great importance. G.E.Moore, professor of philosophy at the University of Cambridge, exerted great influence on Keynes. Moore (1873-1958) was professor of philosophy at Cambridge from 1925 to 1939. His most famous book was “Principia Ethica” (1903). The “Principia Ethica” book was published when Keynes was in his second year at Cambridge. Keynes and most “Apostles” enjoyed much of the book. The book Keynes affected in several ways. This book put emphasis on truth, love and beauty, and good “states of mind” that these attributes produced. Keynes was greatly influenced, for the rest of his life, by the thought of Moore. This philosopher connected happiness to kindness. This vision by Moore deeply influenced Keynes, with regards to the importance he attached to the friendship and the love of art. This can be seen through the records, writings and memories of Keynes.9 For Keynes, it would have been easier for people to be good if they had a minimum level of material comfort in their lives. For him, economic and politic actions to improve the material conditions of the population could be accommodated in the doctrinal framework established by Moore. It must be emphasized that Keynes, and the group of intellectuals around him, were staunch opponents of Jeremiah Bentham’s ideas (very influential in England), which reduced human behavior as utility search. Bentham saw poetry, literature and music as useless, in that they would be emotionally forced manifestations. Keynes’s group believed that life could not be reduced to calculations of pleasure and pain, that there existed much broader humanistic values, and that the production and accumulation of wealth were not the most important values of human existence.

9 Moggridge, Maynard Keynes, p. 114.

1. Main events in the life of Keynes 23 Moore also made a distinction between ethics and morality. For Moore, the morality was subject to ethics. According to Skidelsky, the ethics question posed by Moore was “what is good?”, or “what is bad?”, or even, “what kind of things should exist in their own right?”.10 As to the moral, the questions were: “What should I do?”, or “how should I behave?”.11 For Moore, the second type of question could only be answered with reference to the first type of question, and should also take into account the probable consequences of the action. Moore, along with Bertrand Russell and others, was strongly opposed to the philosophical concept known as “idealism”, which advocated that our knowledge of material objects such as tables and chairs, was a product of our own ideas, rather than a physical existence independent of these objects.12 Another subject in which Moore deeply influenced Keynes was Proba- bility Theory, as we shall see in Chapter 4. Keynes published “A Treatise on Probability” in 1921, but he had begun to write about it – as theme of dissertation – in 1907. According to Skidelsky, Moore believed that people should behave in order to bring the greatest possible amount of “goodness” to the universe. In Moore’s words,

“However, our knowledge of the effects of our actions is limited to be, at best, probabilistic. Since it is impossible to know the likely effects of actions that extend to the remote future, the best that can be done in most cases... is to follow moral rules that are generally useful and generally practiced”.13

Keynes was not convinced of this argument in particular, because he thought that ignorance was not a barrier to individual judgment, but a way to neutralize the unknown. In contrast, he appreciated Moore’s view of the uncertainty. This moral view of Moore, and his discovery of the limited role of probability (and risk) and the important role of uncertainty will mark his later writings and his career.

10 Skidelsky, Keynes, The Return of the Master, p. 134. 11 Ibid, p. 134. 12 Robert Cord, “Keynes”, p. 13. 13 Skidelsky, Keynes, p. 36.

24 John Maynard Keynes and his work in the insurance market In 1905, Keynes put aside mathematics and began his formal studies of economy. He began his reading with Marshall’s book, “Principles of Eco- nomics”. He enrolled in the course and went on to attend classes of the famous master, and had as tutor another famous economist, Arthur Pigou (1877-1959). Marshall was impressed with the talent of Keynes and tried to influence him to become an economics academic. Keynes, however, had other plans.14 Many friends had moved to London, and he decided to try the public service. Keynes’s father was in favor of a career in public service for his son, while Marshall was trying to persuade him to become an academic economist. Keynes decided, in the end, to abandon the academia and apply, in 1906, for entry tests for the public service. It was a competition (“Civil Service Examination”) hotly contested, with 104 candidates signed up. Keynes was placed second. In first place was Otto Niemeyer, who in the future would be the Controller of the British Treasury and Director of the Bank of England. We will find Otto Niemeyer in the 30s in Brazil, writing (for the Rothschild Bank) the first macroeconomic diagnosis of our country. Otto Niemeyer, having been placed first, had the option to apply for the only job to work at the Treasury (which was what everyone wanted). Keynes, ranked second, had to settle for the Indian Office (the consolation prize). It is known by reading Keynes correspondence that he was very upset for not having going to the Treasury, and criticized the judging panel of the competition. In 1906, at age 23, he began working in the Indian Office. It was not a rough regime of work and responsibilities were not very large. Keynes, in the two years he worked at this job, did not get to travel to India. His task was to manage the affairs in London related to the British Empire in India. In actuality, it was a complete government, but in miniature: functions related to the Treasury, Board of Trade, Civil Office, Foreign Affairs and Ministry of Defense. Managing an empire tens of thousands of kilometers away from London meant processing a large number of documents – about 150,000 – a year. It was a dull and unattractive bureaucracy, and Keynes took refuge in his studies of probability.

14 A constant in the life of Keynes was obtaining high income to maintain a lifestyle in which he lived well, traveled and bought art objects. That would not be the case by exclusively working as a teacher.

1. Main events in the life of Keynes 25 After a few months (a little less than two years), Keynes, to his satisfaction, was transferred to a department that took care of statistics and fiscal accounts. Keynes, despite his new functions, was still weary and increasingly unhappy every day with his job and his routine in the Indian Office. Keynes was thinking about resigning his job and began plotting alternative plans. His preference would be to return to Cambridge as a professor in economics. Before that, however, he would have to complete his dissertation on Probability Theory. In December 1907, Keynes submitted his dissertation, confident that everything would go well and he would win a scholarship to Cambridge. The four examiners were impressed with the work. One of them found that Keynes was even developing a “general theory” of logic, in which the deductive logic would be a special case.15 Despite the success of the presentation, two examiners found that the work did not deserve the scholarship, at least for that year. So the disappointed Keynes had to wait another year to restate his case. In the meantime, he continued to work at the Indian Office. At that time, Keynes begins to devote more time to the theater and the arts. He joins the Royal Economic Society, and begins to participate regularly in meetings of the Economic Club at University College. That same year (1908) in May, Alfred Marshall wrote to Keynes, offering a post of temporary economics professor (teaching Currency, Credit and Rates).16 Keynes accepted, and renounces his job at the Indian Office. In the following months, he got to complete his dissertation, and submit it to the judging panel. In 1909, with the dissertation approved, and with a good performance as a teacher, Keynes was elected a fellow of King’s College of Cambridge Univer- sity, a position that he would retain until the end of his life. In the same year, Keynes’s career as an economist effectively starts in a strict- er sense. Before that, Keynes had written and published several works, but related to logic, ethics, mathematics and statistics. Since then, he prioritized

15 According to Cord, the dichotomy between “specific” and “general” was a recurring theme in the work of Keynes. He would even call his masterpiece “The General Theory of Employment, Interest and Money”. Cord believes that Keynes tried to emulate Einstein, who published the “general theory of relativity.” Cord, Keynes, p. 20 and 21. 16 According to Clarke, Marshall paid Keynes with his own resources. Clarke, Keynes, p. 27

26 John Maynard Keynes and his work in the insurance market economic issues. In October of that year, Keynes inaugurated the “Political Economy Club” to discuss current problems of the British economy and world.17 This Club, over time, has become one of the important institutions of economic life in Cambridge. His academic activities were much more directed at applied research and publication than to teaching. Although he was interested in several areas of the economy, the monetary issue attracted him most. In addition to writing books and articles on economics, Keynes served as Bursar of King’s College, being responsible for the financial management of the University. During the years from 1910 to 1913, his career begins to be established. In Cambridge, Keynes was free to teach elsewhere, and he did so to increase his income. In 1911, he participated in several conferences at the London School of Economics about the finances of India.18 In this series of lectures, Keynes analyzed the monetary system of that British colony. The accumulated knowledge about India served to substantiate his book published in 1913, “Indian Currency and Finance”. That same year, Keynes becomes part of the Editorial Board of the Economic Journal. Marshall defended the name of Keynes to be the editor-in-chief, and he received this position at 28 years of age. Keynes worked in this most famous journal of the time, from 1912 to 1945. The Economic Journal was the most important publishing vehicle of economics articles for decades, until about the 70s. Keynes, in the period 1909 to 1914, would form a select circle of friends and would share with his friends an intense intellectual life. This group was very closed, known as the Bloomsbury Group. Bloomsbury was a district of London.19 This group was created by Vanessa Bell (sister of Virginia Wolff) in 1904. Vanessa Bell throughout her life remained one of the great friends of Keynes. They formed a closed circle, “dictating manners, fashions and fads”, and they used to ridicule nonmembers. They thought of themselves as more in- telligent and superior to others. It was a rebel group in relation to the social

17 According to Clarke, Keynes was elected president of the University Liberal Club and the Cambridge Union Society, the most important centers of student debates of Cambridge. Clarke, Keynes, p. 35. 18 It is interesting to note that at that time – and this would worsen in the 30s – there was a great rivalry between Cambridge University and the London School of Economics. 19 According to Clarke, “at the time, a district of London which was not yet fashionable, south of Euston Station with its town houses around elegant squares, but decadent and dilapidated”. Clarke, Keynes, p. 31.

1. Main events in the life of Keynes 27 customs of the time, rejecting conventions and leading a rather free life. They were artists, writers, intellectuals, painters, philosophers, economists etc. Some of the male members were also “Apostles”. Although there is much controversy over the Bloomsbury Group, the time has come to show that they have had great impact on the artistic, literary, economic and social life of England. Loosely speaking, they were similar to what the “Week of 1922” represented to the modernization of Brazil. An important aspect of this group was the important role given to psychology. Indeed, the concept of “uncertainty” is at the heart of the “General Theory” and the concept of uncertainty owes much to the so-called “Bloomsbury Method”, which was based on psychology as an explanation tool. Virginia Woolf and Lytton Strachey, respectively, stood out for their originality and the psychological construction of characters (V. Woolf) or biographies (Strachey). Keynes, in the “General Theory” will urge economists to abandon their somewhat geometric and mechanistic methods of thought, and to turn to psychological modes of thought. From that arose concepts such as “propensity to consume”, “expectations”, “animal spirits” etc. In 1913, Keynes had signed a contract with Cambridge University Press to publish his “Treatise On Probability” (which would take eight years to conclude), and published his book on India, mentioned above (“Indian Currency and Finance”). The Great War – as was known then what is called the First World War – broke out in 1914. The Great War deeply disturbed the humanist con- victions of Keynes, and also altered significantly the organization of his social life. In Cambridge, the University was emptied of students, and many friends of Keynes enlisted.20 In a more general level, it caused a great disappointment to the dreams of an increasingly civilized life. On a personal level, it made Keynes to change his professional plans. He wanted to go back to the government, as a way of solidarity to the war effort. When making a retrospective analysis, the First World War was really sense- less. It could have been avoided. There were economic and political tensions between European countries, but not to the point of being able to

20 The Great War (1914-1918) was the first war in history to involve a full military mobilization on a global scale. One factor that contributed greatly was the development in transport and communications in Europe in previous decades.

28 John Maynard Keynes and his work in the insurance market predict that this would lead to a long and costly war.21 As for the Second World War it is different – it was a predictable outcome (including by Keynes) – because of the way of how war reparations and compensation from the defeated countries were settled. With the outbreak of war, financial markets around the world entered in crisis, and many other countries stock exchanges suspended trading of stocks and bonds. The public income bond market was paralyzed, creating serious liquidity problems across countries. There was fear of default, and in some cases the default really came. Keynes, during these early months of the war, wrote several articles about money and the gold standard. In January 1915, Keynes is invited to work in the British Treasury. The following month, he was offered a position in Paris, in the First “Inter-Ally Financial Conference”. In the future, Keynes would make other trips around Europe and the United States to deal with matters related to war finance. Keynes had become the greatest responsible for external finance, monitoring loans and managing the complexities of cash flows to allies. On the way back to London, he received his new post: work in the Cabinet Committee on Food Prices. One of Keynes’s tasks was to follow the food price system to coordinate purchases and avoid undue price increase. In the future, this knowledge about the formation of prices of agricultural products would give him technical knowledge to be able to speculate in agricultural commodity markets. Keynes’s personal routines changed a lot in this period, because several friends of the Bloomsbury Group moved to the country side. Keynes began to form in London, in parallel, a wider circle of relationships, including government officials. His social headquarters was at 46 Gordon Square, the historic monument of the Bloomsbury Group. Keynes rented this house, formerly of Vanessa Bell ownership, to continue the group’s tradition. Several friends of Keynes began to speak out against the war, refusing to serve, claiming moral objections. Keynes, even though a Treasury official and responsible for financing the war, eventually came to oppose it, though not conspicuously.

21 The Unification of Germany, in 1871, altered the balance of power in Europe. Instead of several small and fragmented governments in Central Europe, the new Germany had become powerful. The country begins to show its power by means of militarism and an expansionist foreign policy. The Boer War, in South Africa, exacerbated tensions between Britain and Germany. Events in the multi-ethnic and the late Austro-Hungarian Empire were the final trigger.

1. Main events in the life of Keynes 29 According to Skidelsky, in late 1917,

“Keynes was convinced, as he told his mother, that the continuation of the war would mean the disappearance of the social order as we know it now...“ “...what scares me is the possibility of a general impoverishment. In a few years we will not fulfill the promise we made to a New World and in exchange this country will be mortgaged to America”.22

England early in the war had many features in Treasury. However, the weight of funding the allies and of organizing the economic war effort fell on London. By assuming increasingly important positions in the Treasury, Keynes was of great help in the war effort, by managing the accounts of the Government with regard to the financing of war activities. In the process, Keynes became – in favor of the government – a speculator in exchange rates, currencies, commodities and works of art. Near the end of the war, he persuaded the British government to buy works of art in France, going over and acquiring more than 20 paintings and sculptures. It was a great acquisition, which can be partly seen today in the National Gallery in London. For himself he acquired four paintings (Cézanne, Ingres and two Delacroix). Keynes’s participation as responsible for the finances was considered brilliant, but at the end of the war he frontally disagreed with the course followed by the victorious countries (mainly France and England). Germany surrendered militarily on 11 November 1918. The Austro-Hun- garian Empire was divided in several countries. Although there had not been a permanent military occupation by the Allied forces, in practice these two countries were treated as defeated in war.23 The total losses of the Great War, for the allies of England, were estimated at £ 4 billion.24 This total did not include the volume of the reparations. The big question would be how in this total Germany’s share of responsibility was. Keynes suggested that there was a general pardon by both sides (winners and losers). In this scheme, the United States would forgive the debts taken over by the British. The Americans refused the suggestion of Keynes.

22 Skidelsky, Keynes, p.20. 23 “Oxford Dictionary of Contemporary World History”, p. 735-737. 8.5 million people died in this war. 24 According to the Oxford Dictionary, the British Empire suffered 30% of the total costs of the war (Germany 20%, France 15%, and the United States 14%), p. 737.

30 John Maynard Keynes and his work in the insurance market The idea therefore was not accepted and the victorious countries imposed severe conditions for the defeated German government. Note that Germa- ny and its allies were not defeated in the sense of having their production capacity destroyed. The end of World War I was signed by an Armistice. In World War II there was, in this sense, a defeat. These conditions are in reference to the compensation for damages suffered by the allies and – new concept adopted for the first time – reparation based on opportunity cost (what France and other allies had to stop producing while having to use labor and other resources in the war). The allies – mainly France – confiscated the gold stock (the money supply), transferred German factories to France and demanded an income stream incompatible with Germany’s income production assets. They also dismembered important producing regions of Germany, for the sake of neighboring countries (particularly Poland, and, to a lesser extent, France, with the incorporation of Alsace and Lorraine). Keynes predicted (correctly) that the conditions laid down would be impossible to be met and would generate major disruptions to the global economy, with inflation and economic collapse of the defeated countries. The book in which he analyzed and predicted problems, published in 1920, entitled “The Economic Consequences of the Peace”, has become a classic. It costs the Keynes’s job, who resigned his position at Treasury. With the loss of employment, Keynes had to think about his future. He returned to Cambridge in 1919, but his responsibilities had been quite dimin- ished. He was used to a level of well-off income, and feared again to be sole- ly a professor, due to its lower wages. He begins to make adjustments to earn a living and have a minimum level of income adequate to the living standard he ambitioned.25 He starts a career of investor and speculator. These facets of Keynes as an investor will be described in Chapters 2, 3 and 4. In 1919, he was assigned as a member of the Board of Directors of the National Mutual Life Assurance Society, and two years later, in 1921, he became the Chairman of the Board of that company, and held that position until 1938.26 He followed a regular weekly work routine, consulting the offices every Wednesday, and also started to participate in the management of other insurance companies.

25 According to Clarke, Keynes had in 1920 an annual income of £ 5,000. About 20% was coming from his wages as a professor and the rest coming from copyrights. It would be equivalent to an annual income, in 2009, of US$ 250,000. Clarke, Keynes, p. 45. 26 He moved away from his position for health reasons.

1. Main events in the life of Keynes 31 Still in 1921, Keynes started another supplementary career, as press and radio journalist, which he maintained until the mid-1930s. He wrote articles and features for several media outlets, commenting, in particular, the development of negative economic events in the immediate post-war period of the countries that had to pay reparations and indemnities. In this activity, he begins to spread his economic ideas and realizes the power of persuasion. In the period from 1923 to 1931, he was the principal owner and CEO of a weekly newspaper devoted to economy, called “Nation and Athenaeum”, where he worked in close proximity with the editor, Hubert Henderson.27 At that time, he meets a woman who will forever change his life and habits: Russian ballerina Lydia Lopokova (1892-1981). Lydia was prima ballerina of the Sergei Diaghilev Ballet. Keynes and Lydia begin to see each other regularly and begin an affair that becomes the object of comments and rejection initially at the Bloomsbury Group. Keynes was 43 years old. In August 1925, they married and, to the surprise of many, had a fulfilling and happy marriage that lasted until the death of Keynes, at 63 years old.28 In the same year of their marriage, Keynes acquired an estate known as Tilton, near Charleston. He loved this house in the country, where he went often. Later, he was awarded, in 1942, by King George VI, with the title Lord Keynes of Tilton. In the area of economic studies, the concerns of Keynes turned to monetary problems. Keynes published in 1923 the book “A Tract on Monetary Reform”. In that book, Keynes supports the quantity theory of money. This work contains the famous passage, often quoted, about how the long term is misleading to the issues that happen in the present. Keynes says:

“In the long run we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.”29

In the mid-20s, Keynes is involved in another controversy, in addition to war reparations to the Allies, linked to the attempt by the British government to

27 Skidelsky, Keynes, p.22. 28 Keynes wanted to have children, but Lydia had miscarriage problems. So it is absurd that some authors insinuate that Keynes criticized views of adjustment in the long run due to not having children. The implication is that as he had no descendants, he did not have to worry about the future. It is utterly false. He published an article in 1930, soon after losing the child, entitled “Economic Possibilities for our Grandchildren”. 29 J.M.Keynes, A Tract on Monetary Reform, p. 65.

32 John Maynard Keynes and his work in the insurance market return to the gold standard. In 1925, to promote his contrary view, he wrote the book “The Economic Consequences of Mr. Churchill”. In that book, Keynes expressed his views against Britain returning to the gold standard.30 The book is organized into three broad issues: (i) the consequences of the return to the gold standard; (ii) the reasons for the decision of returning; and (iii) possible remedies. To Milton Friedman, it was in the area of monetary theory and policies that Keynes stood out. Friedman even considers the book “A Tract on Mone- tary Reform”, published in 1923, not the “The General Theory of Employ- ment, Interest and Money” as the most important work of this economist. Friedman also praised the two volumes of the book “Treatise on Money”, published in 1930.31 The crisis of 1929, and its economic and social consequences, will make Keynes turn increasingly to macroeconomic problems. The knowledge of the surge and permanence of unemployment in Britain – it reached 20% of the workforce – led Keynes to reflect that his earlier works were incomplete or wrong on some issues. This concern led him to undertake a great intellectual effort to build the theoretical foundations he thought appropriate to base the design of more effective economic policies. This effort culminated in 1936 with the publication of his masterpiece, the “The General Theory of Employment, Interest and Money”. A small, dedicated number of Cambridge economists gave support to consolidate the ideas of Keynes and review the progress of the book: Richard Kahn, Joan Robinson, Piero Sraffa and James Meade. The book was a huge success, and was quickly published on both sides of the North Atlantic. From 1936, the prestige of Keynes intensifies, becoming global.

30 The gold standard is a financial system tied to the price of gold, in such a way as setting each currency having its unitary value always buying the same quantity of gold. Since the amount of gold supplied and demanded was relatively constant in practice, the values of currencies and exchange rates were fixed. It was a very convenient system for countries whose banks were international creditors, as was the English case. 31 Keynes visited the University of Chicago in 1931, to attend the “Harris Foundation Lectures”. In this lecture, he debated with Jacob Viner, who was a great critic of his work. According to Van Overtveldt, Viner saw in Keynes “a heroic figure” whose personality and intellectual stature he admired greatly, and saw him as a “prophet and politician” (p. 86). In 1940, Viner organized an attempt to bestow an honorary degree in economics from the University of Chicago to Keynes, but the attempt, according to Van Overtveldt was “torpedoed” by Frank Knight (p. 86).

1. Main events in the life of Keynes 33 His physical health becomes fragile, but his intellectual capacity remains strong. In 1937, he suffers a heart attack, which will force him to decrease the hectic pace of his activities and to resign in the following year as Chair- man of the Board of the insurance company.32 With the start of World War II, Keynes will again – this time as a Counselor – provide help in the financial war effort. He writes, in 1940, a new book, “How to Pay for the War”. Keynes was always very interested in arts. One of his grandest projects was to build and operate a theater for performing arts in Cambridge. Keynes was able to raise the funds for building – largely on his own donation – and on February 3, 1936 the Arts Theatre came into operation. Keynes participated in all construction details. In 1938, Keynes donated the theater to the city of Cambridge.33 This theater works to date. In the early years, to boost box office revenues, Keynes innovated, beginning to sell food and drink in the theater itself. It was not uncommon to see Keynes himself preparing and selling sandwiches, to turn feasible the operation of the theater. With the outbreak of the Second World War, Keynes becomes a key person in the English effort of the war funding. He did not perform the more executive functions, due to the fragility of his health state, acting more in the manner of a senior statesman. In his final years, Keynes actively participates in the global economic reconstruction, as a key figure in the creation of the World Bank (Interna- tional Bank for Reconstruction and Development) and the IMF (Interna- tional Monetary Fund). After this participation, Keynes decides to return to Cambridge University but passed away on April 20, 1946, at 63 years old.

32 From this date, Keynes is semi-disabled. 33 Cord, Keynes, p. 85.

34 John Maynard Keynes and his work in the insurance market PART II Personal finance and financial management

e will examine in this part Keynes’s experience and W work as an investor and speculator. Our interest, in the first place, is to evaluate how he operated in the market to manage his own wealth. Then we will see how behaved managing third party funds. Chapter 3 will examine his management of the Chest Fund at King’s College of Cam- bridge University. Finally, Chapter 4 will address the lessons learned and the investment philosophy that Keynes developed, which in our view has served not only to administer insurance companies like to give theoretical support for many important themes of his works macroeconomic.

CHAPTER 2 Keynes’s personal finance

KEYNES HAD AN INTENSE AND MULTIFACETED LIFE. HE WORKED AS AN INVESTOR AND SPECULATOR, HE WORKED AS A FREELANCE JOURNALIST FOR SEVERAL NEWSPAPERS, JOURNALS AND RADIO, WAS MEMBER OF BOARDS OF DIRECTORS AND EXECUTIVE DIREC- TOR OF INSURANCE COMPANIES, AND FINALLY DEDICATED PART- TIME TO ACADEMIC ACTIVITIES.

Since his youth, as we saw in the previous chapter, Keynes was noted for the boldness of his personal and professional positions. Throughout his life, Keynes acted this way, combining a financial professional career with academic activities, and arranging time to develop his friendships and artistic interests. Hence some authors, such as Skidelsky, refer to the “many worlds of Keynes”. The most striking fact of Keynes’s life as an investor and speculator was the effort he put into this activity. Keynes sought to obtain income in several ways, but believed that to get rich he would have to speculate in the financial market. For those who got to know Keynes for his macroeconomic writing, such as was my experience as an economist and I believe the majority of my colleagues, it is surprising to note (through his correspondence, writings, reports and other personal documents) how his practical and theoretical knowledge as investor influenced his macroeconomic thinking.

2. Keynes’s personal finance 37 In this way, we examine in this chapter his personal experience in finance, the strategy he adopted as portfolio manager and his performance as an investor. When we add the results of this chapter with the following two chapters, we will have the background to analyze his work and his role as insurance company director. The main source of existing information lies in correspondence and personal documents of Keynes, and reports and economic writings in newspapers and journals. This material was collected, classified and analyzed in 12 volumes of the collection of the Royal Economic Society, “The Collected Writings of John Maynard Keynes.” This volume, entitled “Economic Articles and Correspondence, Investment and Editorial” was edited by Donald Moggridge.34 According to Moggridge, Keynes’s life as investor can be separated into two phases: The first from 1905 to 1919, and the second phase from 1919 to 1945.35 In the first phase, we observe Keynes operating in the financial market on a small scale by managing his savings, and giving investment advice to some friends. At this stage, his income depended more on his academic activities than on his work as an investor. In the second phase, after his departure in 1919 from the Treasury, we see a bolder Keynes, more aggressive as a personal and third party funds investor, a more leveraged speculator, and more interested in financial investment theories. We also see in this phase Keynes as Bursar of King’s College (Cambridge University), as the Chairman of the “National Mutual Life Assurance Society (1921-1938), as Director of the Provincial Insur- ance Company, as Director of several “Investment Trusts” – the Indepen- dent Investment Company (1923-46), AD Investment Trust (1921-7) and PR Finance Company (1924-36, CEO from 1932-6) – and as the instigator of the Union of 1920. Finally, one should mention that is also at this stage that Keynes established himself as the famous macroeconomist. We will be based on the above sources to characterize, in each of the two phases, the strategy he adopted as portfolio manager, and his performance as an investor.

34 Royal Economic Society, “The Collected Writings of John Maynard Keynes”. Volume 12, “Economic Articles and Correspondence, Investment and Editorial”. Edited by Donald Moggridge. 35 Moggridge, Collected Writings volume 12, p.1.

38 John Maynard Keynes and his work in the insurance market Table 1, based on Moggridge, shows the overall picture of the performance of Keynes, in his personal finances and Chest Fund management at the Uni- versity of Cambridge, and also shows the general financial indicators that serve as a comparison reference. It is shown in this table that Keynes was successful in both activities. His personal investments and the management of the Chest Fund of Cam- bridge University were calculated as index numbers, and compared with the respective index numbers of the British economy (the “Final Expendi- ture” index would be a proxy for the national income, the national accounts would only be established in 1946) of the London Stock Exchange and the New York Stock Exchange.

TABLE 1. KEYNES INVESTMENT ACTIVITIES

KEYNES KING’S PRICES

1920 100 - 100 100 100 100 100 21 96 - 106 n.a. 85 70 86 22 106 100 120 n.a. 72 80 105 23 112 159 126 n.a. 68 95 108 24 152 296 117 n.a. 67 105 113 25 140 202 114 n.a. 67 110 140 26 169 189 120 n.a. 66 115 158 27 141 204 121 234 64 135 192 28 96 61 127 226 64 130 250 29 65 36 128 228 63 105 326 1930 114 58 131 154 61 85 264 31 163 70 120 116 58 80 172 32 138 101 137 168 57 95 87 33 197 256 164 227 55 120 113

2. Keynes’s personal finance 39 KEYNES KING’S PRICES

Net “Net London New York Income Chest “Final YEARS Assets Securities” Industrial Common (1920 (1920 Expenditure” (1922 (1920 Shares Stocks = 100) = 100) (1920 = 100) = 100) = 100) (1920 = 100) (1920 = 100) 34 165 677 185 302 55 130 124 35 166 1,023 197 436 56 150 133 36 386 2,350 229 680 57 140 195 37 478 998 230 738 60 115 193 38 157 842 208 442 60 110 145 39 274 925 200 499 62 90 151 1940 299 794 183 421 70 95 138 41 364 952 222 562 78 105 124 42 322 1.178 235 557 83 125 109 43 338 1.454 273 857 88 140 145 44 366 1.648 293 981 93 145 157 45 300 1.908 346 1.124 95 160 190

Source: Moggridge, Ronald (editor). The Collected Writings of John Maynard Keynes (30 volumes). Cambridge: MacMillan Cambridge University Press, 1971. Volume XII, p. 113.

In his personal investments, Keynes was a small-scale investor, but he began to grow through investments from his friends, which he also managed. He did his financial trading with London’s Buckmaster & Moore brokers in col- laboration with Oswald T. Falk. Falk was Keynes’s schoolmate, and began his career working as actuary at National Mutual Life Assurance Society, where he would later work as director. Until 1932, when he fell out with his partners, Falk continued as member of the Buckmaster and Moore. After that date, Falk created his own firm, O. T. Falk and Partners. According to Moggridge, Falk had a strong and crude personality, being subject to outbursts of anger, and he was very firm in defense of his beliefs and opinions.36 He was an aggressive investor, who did not accept interference

36 Moggridge, Maynard Keynes, p. 348.

40 John Maynard Keynes and his work in the insurance market from clients in his investment strategies. Also according Moggridge, his relation with Keynes, in the decades they worked together, was stormy, but the two remained friends for life.37 The major differences between the two arose after 1929. As they had different styles of trading and investing, and their economic views began to di- verge, the professional relationship became very difficult, almost impossible. In 1938, Keynes had already broken all his business connections with Falk, except that they would remain members of the Board of a company, while effective control was in the hands of third parties. Keynes, in 1919, had some speculative investments (leveraged operations) in stocks, but the strong point of his activities happened in the foreign exchange market. His first major speculative operation was in foreign currencies. At that time, the old exchange rate regime of fixed exchange rates had practically disappeared, and the major currencies began to follow a regime of free float. The strategy of Keynes, according Moggridge, was simple: he sold, in the forward market currency from France, Holland, Italy, and, after March 1920, Germany. Conversely, he bought US dollars and currencies from Norway, Denmark and India in the forward market. These were leveraged operations at both ends, buying and selling. At that time, margin requirements were 10%, so you could leverage operations up to ten times capital. His speculative strategy worked well at first, and on January 2, 1920, he had profited £ 6.154.38 This initial success encouraged him to embark on a more ambitious scheme. Along with Falk, they created a Syndicate. In this Syndicate, the two planned to combine their capital and their friends’ to speculate (leveraged) in the foreign exchange market. The starting capital of the Syndicate was £ 30,000, of which, half belonged to Keynes and his friends. The Syndicate’s operations began on January 21, 1920. The market was low in liquidity, creating problems to transfer large sums of money on a few transactions. This made Falk withdraw in late March his half of the capital of the Syndicate. In the beginning, the Syndicate had great success. Profits in late April were £ 9,000 in realized gains and £ 8,000 in book (accounting) profits.

37 Moggridge, ibid, p. 348. 38 Moggridge, Maynard Keynes, p. 349.

2. Keynes’s personal finance 41 Then, the problems appeared. Currency “sold” rose in value against the Pound and the currencies “bought” (such as the Indian Rupee) had fallen in price. On May 14, the profits realized were £ 10.408, but the book (accounting) losses amounted to £ 3.146. On May 19, Falk warned Keynes that the accounting losses had exceeded the profits made, and the available coverage represented less than 10% of liabilities. The Syndicate would then have to increase its coverage or terminate some positions. The separate position of Keynes investment was a complete disaster. He lost everything. Aided by Buckmaster and Moore, who accepted an interpretation more “flexible” in the volume of pounds required to cover positions, Keynes moved quickly to put affairs in order. He closed positions, sold shares of their own portfolio, combined with the publisher MacMillan an advance for the book publishing rights “Economic Consequences” and took a loan of £ 5000 of Sir Ernest Cassel (economist and financier). When Keynes finally terminated all the positions of the Syndicate, he found that the total losses of the Syndicate reached £ 22.573. The Syndicate lost money in all currencies in which it speculated, but the biggest losses were in marks, lire and francs. In retrospect, it is clear that Keynes was right about the long-term behavior of these currency trends but he was wrong in the short-term behavior. In the final balance, Keynes was responsible not only for his losses of £ 20.837 (his father presented him with £ 2000) with the Syndicate, but also with his friends’ losses (moral debt) of £ 6.750. Keynes was not discouraged, and fought to recover losses through speculation in commodities and currencies. In late 1920, he managed to repay the loans from Cassel (£ 5,000) and the Bank (£ 4.618). During 1922, Keynes paid back the investments from his friends, paid off all their debts, and ended with assets of £ 21,000. Keynes’s losses recovery was made through speculation profits (70%) and income from journalism and copyright books (30%). From 1923 until the World War II, Keynes diversified his asset management activities. Over time, he began taking a taste for equity investment, rather than speculation in currencies and commodities. In the 1920s, Keynes believed he could use his knowledge of the deter- minants of the credit cycle (“trade cycles”), obtained his their academic

42 John Maynard Keynes and his work in the insurance market studies, to operate in the financial market. He even thought of creating a company with the name “Credit Cycle Investment Company”, but eventually decided using the name “Independent”. “The Independent Investment Company” was established in 1924 with a capital of £ 350,000. Keynes left the company, which exists to this day, in 1940. Moggridge reproduces the company’s prospectus launch:39

“It is now known that fluctuations in the values of securities with fixed interest, of short-term and long-term, and fixed interest securities in general, and also of ordinary shares, are all affected by the credit cycle. Short-term interest rate variations affect the value of long-term securities, having a greater impact than would be strictly the case, with the result that one can achieve considerable profits, only moving from one class to another at an appropriate stage of the credit cycle. Similar periodic variations also occur with the relative values of the currency, on the one hand, and the real values of goods and properties, on the other, which are reflected in the relative values of debentures and shares, since these represent liabilities in cash and property, so the same principles of variation apply from one class to another at the appropriate time. The result of the accumulated experience in these matters makes it clear that the course of events is sufficiently regular for those whom are constantly in contact with the financial situation to, in certain circumstances, antici- pate the imminent changes in the credit cycle.”

In this kind of strategy, in assuming as correct the underlying theory of the credit cycle, the “time” factor is critical. Hitting the “timing” was the secret of the business, but as Keynes learned in practice (losing money), you cannot predict it. The uncertainty was the dominant factor. Keynes joined three enterprises in the finance sector, in partnership with Oswald T. Falk, organizing the following investment companies: The AD Investment Trust (in July 1921), with a capital of £ 150,000; The PR Finance Company (in January 1923), with a capital of £ 115,000 and The Indepen- dent Investment Company (in January 1924), with a capital of £ 350,000. In these companies, Keynes worked as a strategist at asset management, while Falk served as co-director responsible for day to day operations of the companies, including short-term investments and day-trade.

39 Moggridge, ibid, p. 409.

2. Keynes’s personal finance 43 At the “Independent”, the biggest loss suffered was due to the price behavior of rubber. Keynes was a buyer (went “long”) in his contracts, but in 1928 there was a change of legislation, and spot prices plummeted. There were significant losses, and Keynes needed loans. In addition, since he bought derivative contracts “on the margin” (with credit), brokers forced him to restore funds, and he had to sell his shares. The other companies that Keynes created were not successful, and the “AD” closed its doors in 1928 (Keynes had left a year before) and the “Indepen- dent” was sold to third parties in 1931. The PR was liquidated in 1935 and reorganized. In the balance of his experience as an investor, Keynes did not have much success in the 20s. As an individual investor, Keynes achieved poor results in five out of the seven years when investing in stocks in the period 1923-29. In total, he lost £ 14.800. According to Moggridge, if he had mirrored the average yield of the market, would have had a profit of £ 10.80040. By contrast, he won £ 10,000 in total foreign exchange trade and £ 17,000 commodities trade in 1927. The remaining years of this decade were disastrous for Keynes. He lost a lot of money in speculation on commodities, and his net worth fell from £ 44,000 in late 1927 to £ 7.815 in the end of 1929.41 When the Crisis of 1929 arrived, Keynes was already financially exhausted, with little money to invest in stocks (and possibly lose everything with the crash of the New York Stock Exchange). Over time, in the 30s, Keynes continued to invest even more in the stock market. He used loans to invest (about 50% of his total capital), along with his own resources. His strategy was to diversify little, concentrating investments in a small number of stocks. This increased the risks and brought problems on occasion. Keynes was an audacious speculator. One of his episodes became famous. Keynes had a tendency of betting high, when he had funds, in the speculative side of the commodities market. In 1936, Keynes acquired (as in bought future contracts) the equivalent to one month’s of the total wheat consumption in England. It was not really an attempt to corner the market, but it was a highly significant buying position.

40 Moggridge, Maynard Keynes, p. 408. 41 Moggridge, Maynard Keynes, p. 408.

44 John Maynard Keynes and his work in the insurance market His strategy was to gain if prices would rise during the period between when he purchased it and the expiration date of the contract. The situation did not develop the way Keynes expected, and the sellers decided to deliver the wheat sold in physical quantities. It was a complicated operation, with wheat being sold in Argentina intermediated by the Chicago Board of Trade. Several wheat loaded ships entered the Thames River to deliver the wheat to Keynes. He, undeterred, figured a practical way of storage: using the chapel of King’s College.42 Keynes spent hours calculating the cubic footage of the imposing King’s College Chapel, and concluded that it could only afford to store half of the load. Keynes then acted as the most astute trader. He discovered an obscure clause, according to which the wheat that came from Argentina would have to undergo cleaning before being used to make flour. Keynes researched (and no doubt “persuaded”) the flour mills, and noticed that they did not have machines available for immediate use, and that the cleaning would take more than a month. Given the “circumstances”, Keynes was able to convince the sellers fail to make physical delivery, and to accept a more convenient financial settlement for their own interests.43 On a balance of his life as an investor and speculator in the financial market, it should be noted that although he went through bad situations at certain times, having won and lost three fortunes, Keynes had never become poor, and could end his lives with a reasonable financial net worth, equivalent to 26 million pounds today.

42 According to Clark, the church, erected perpendicular to the River Cam, was founded by King Henry VI, and is “one of the architectural wonders of Britain, its aesthetic appeal complemented by a spectacular engineering structure of great height ceilings”. Clarke, Keynes, p. 24. 43 Moggridge, “Collected Writings”, p. 10 and 11.

2. Keynes’s personal finance 45

CHAPTER 3 Keynes’s performance as fund manager of Cambridge University

IN ADDITION TO MANAGING HIS PERSONAL INVESTMENTS (AND OF HIS FRIENDS), KEYNES ALSO BECAME THE FUND MANAGER OF KING’S COLLEGE, AT THE UNIVERSITY OF CAMBRIDGE. AS BURSAR, HE RECEIVED THE SYMBOLIC VALUE OF £ 100 PER YEAR, AND RE- TAINED THAT POSITION UNTIL THE DATE OF HIS DEATH. IN THE MANAGEMENT OF THESE FUNDS, HOWEVER, KEYNES HAD TO BE VERY CONSERVATIVE, MAKING INVESTMENTS PRIMARILY IN GOV- ERNMENT BONDS. THAT’S BECAUSE THERE WERE LEGAL AND REG- ULATORY RESTRICTIONS IMPOSED BY THE CAMBRIDGE UNIVERSITY CONTROLLING THE TYPE OF INVESTMENT ALLOWED. KEYNES TRIED, FROM TIME TO TIME, TO RELAX THESE RULES, TOWARDS GREATER EMPHASIS ON STOCKS (WHICH HE CALLED “VALUE INVESTMENT”).

Keynes’s career as a financier showed ups and downs, as is common in the path of investors and speculators. His role as King’s College portfolio manager was narrated by Harrod (1951). Harrod comments that Keynes spent about half an hour or more a day researching the stock market, in his bed, early as soon as waking. Throughout the morning, he read the main financial newspapers, studied the reports of the companies, and used the phone to send purchase or sell orders to his brokers, usually in the stock, commodities and foreign exchange markets.

3. Keynes’s performance as fund manager of Cambridge University 47 Harrison (2002) describes in more detail this action of Keynes. Keynes became First Bursar of King’s College in 1924. He decided to concentrate all the resources of the School in an investment fund named Chest, in which he had total freedom of management. Since his policy was to sell the real estate of the College, and use the proceeds to speculate in the stock market, Keynes came up against strong opposition from Fellows (Advisors) of the School. In Keynes’ view, it was preferable to be a “speculator” in an asset that had a daily quotation of price and liquidity, than being an “investor” in an asset whose price was largely unknown presenting low liquidity. Keynes’s investment philosophy was changing over the years. At first, he gave much emphasis to business cycles and cyclical macroeconomic forces. Over time, he began to devote himself to the study of financial statements and company reports, turning into a “fundamentalist” analyst. This change can be seen in his writings, 1936, as explained below. Table 2, based on Moggridge, shows the performance of King’s College funds administered by Keynes. It was certainly good management, as can be seen by comparing his results with broader indicators of investment. In terms of its performance, the initial capital of the Chest was about 30,000 pounds. When Keynes died in 1946, the capital had already increased to 380,000 pounds, an average annual net growth of 12%. Note that in this period there was the Crisis of 1929 and its negative consequences in the following years. The London Stock Exchange had a decline of 15% in this period. The growth in net worth of the Chest was due primarily to capital appreciation. All dividends received, instead of being reinvested, were used to cover King’s College spending. At that point, Keynes criticized the portfolio managers of other Schools of Cambridge University, referring to them as Savings Banks. The performance of the fund managed by Keynes from 1927 to 1946 shows a growth, as measured by a geometric rate of, 9.1% per year, while the overall market of Britain’s shares fell to a geometric annual rate of slightly less than 1%.

48 John Maynard Keynes and his work in the insurance market TABLE 2. INVESTMENT INDICES “CHEST FUND” OF KING’S COLLEGE AND SECURITIES, 1920-45

YEARS Income as Total CHEST CHEST (ending in Percentage of Investments (1920=100) (1933=100) 31 August) Total Investment 1920 100 100 – 2.6% 1921 106 n.a. – 4.5 1922 120 n.a. – 5.0 1923 126 n.a. – 5.4 1924 117 n.a. – 5.9 1925 114 n.a. – 6.9 1926 120 n.a. – 6.2 1927 121 234 – 5.8 1928 127 226 – 5.5 1929 128 228 – 5.2 1930 131 154 – 5.9 1931 120 116 – 6.2 1932 137 168 – 5.2 1933 164 227 100 4.2 1934 185 302 133 4.1 1935 197 436 192 4.3 1936 229 680 300 4.5 1937 230 738 325 4.9 1938 208 442 198 5.3 1939 200 499 220 5.0 1940 183 421 186 6.5 1941 222 562 248 5.5 1942 235 557 246 5.2 1943 273 857 378 4.7 1944 293 981 433 4.3 1945 346 1.124 496 4.5

Source: Moggridge, Ronald (editor). The Collected Writings of John Maynard Keynes (30 volumes). Cambridge: MacMillan Cambridge University Press, 1971. Volume XII, p.91.

3. Keynes’s performance as fund manager of Cambridge University 49 Although Keynes acted in the Fund in less leveraged manner from how he operated with his own resources, it was still an aggressive management. According to Harrison,

“...while managing the Chest Fund, Keynes was gradually favoring long- term investments in companies whose balance sheets impressed him, and whose prospects for business growth were shown as favorable. He believed that a careful analysis of a company was more valuable than insider information. On this matter, Keynes said that ‘Wall Street dealers could make big money if they did not have insider information’...”. (p.2)

Also according to Harrison, the investment strategy followed by Keynes was, in many respects, very similar to the strategy that Warren Buffet [the third richest man in the world, and the Berkshire Hathaway Fund manager] adopted44. J. H. Chua and R. S. Woodward examined Keynes’s performance as Chest Fund manager.45 According to the authors, based on modern performance evaluation techniques, the empirical evidence indicates that Keynes was an exceptional “portfolio manager” and exceeded with much clearance the market performance in the period from 1927 to 1945.

TABLE 3. KEYNES’S PERFORMANCE AT CHEST FUND, 1927-1945

Annual return rate General index Performance Interest rate of investments of stocks traded Indicator in the of “Treasury at King’s College at London Period 1927-1945 Bank Rate” Chest Fund Stock Exchange

Arithmetic Mean 13.06% - 0.11% 1.56%

Geometric Mean 9.12% - 0.89% –

Standard Deviation 29.28% 12.55% –

Source: Chua and Woodward, p. 234.

44 Buffet himself, a legend among financiers, recognizes the influence he received from Keynes. For Buffet, Keynes was a man “whose brilliance as an investor practitioner was equal to his brilliance as a thinker”. 45 J. H. Chua and R. S. Woodward, “J. M. Keynes Investment Performance: A Note”, Journal of Finance, XXXVIII (1), March, part of the articles published in the Blaug collection. Marc Blaug, editor, “John Maynard Keynes (1883-1946)”, volumes I and II, in vol.I, p. 232-235.

50 John Maynard Keynes and his work in the insurance market CHAPTER 4 Keynes as an investor and the lessons learned

DURING THE YEARS WHEN HE ACTED AS AN INVESTOR AND SPEC- ULATOR, KEYNES ACCUMULATED GREAT EXPERIENCE ON MARKET RISKS AND UNCERTAINTIES. THIS KNOWLEDGE OF THE FINANCIAL MARKET, IN CONJUNCTION WITH PERSONAL CHARACTERISTICS OF INTUITION USE AND COURAGE AS A TRADER, SHAPED, IN A HIGH- ER DOSE THAN RECEIVED BY MOST ECONOMISTS, THE DEVELOP- MENT OF HIS IDEAS ON EMPLOYMENT, INTEREST AND CURRENCY.

According to N. Davenport, referring to Keynes, “...speculation improved his understanding of the economy, and his understanding of the economy has improved his speculation...” (quoted in Skidelsky, 1992). Speculation, in English, does not have the strong negative connotation of the word in Portuguese. Speculator is a person who takes risks based on their future vision of economic behavior. The manipulator is a different character; since he acts criminally, generally making profits based on inside information, or by creating fictitious transactions that damage the market. This side of Keynes is little explored in the economic literature. The great discussion is about his economic writings. In our opinion, however, Keynes “investor side” is a key part of the set of experiences and beliefs that shaped his macroeconomic works production.

4. Keynes as investor and the lessons learned 51 Indeed, this can be seen in his magna opus. Keynes had a singular career as an investor and speculator, which turned out to influence his main work, “The General Theory of Employment, Interest and Money” (1936). The General Theory has 24 chapters, organized into five books. Book IV brings together chapters 11-18, and is titled The Inducement to Invest. The titles of the respective chapters show the emphasis that Keynes puts on the factors influencing the investment process: (i) The Marginal Efficiency of Capital; (ii) The State of Long-term Expectation; (iii) The General Theory of Rate of Interest; (iv) The Classical Theory of Rate of Interest; (v) The Psycho- logical and Business Incentives to Liquidity; (vi) Sundry Observations on the Nature of Capital; (vii) The Essential Properties of Interest and Money; and (viii) The General Theory of Employment Re-stated. To understand the concerns of Keynes as an investor, we can characterize, schematically, two types of financial investments. The two types of investments involve buying things that do not yet exist. The first type of investment is in government bonds. In this case, although the payment is to be made at a later date, it already has its determined and certain value. There is a risk of it being more or less profitable than other forms of financial investment. The investment risk can be calculated, and lends itself to conservative strategies. The second type of investment is in shares of companies traded at stock exchanges. In this case, the value is neither determined nor certain. It will depend on the company’s performance and profitability. Since there is an environment of uncertainty, there are of course opportunities for speculation. A great leitmotiv of the work of Keynes, that pervades his books, is the role that he places on uncertainty. It is at the forefront of his macroeconomic view, particularly in the relationship between uncertainty, investment decision, the multiplier effect of investment and the determination of the GDP. We have already commented earlier that Keynes, in much of his professional life, worked in the insurance industry. We also said that Keynes exercised several activities simultaneously. This does not mean that his presidency of the insurance company (and the other directorship in an insurance company) would be a “ghost job” or that it did not require his presence. On the contrary, his biographers point out that Keynes devoted one full day a week (usually on Wednesdays) to be appear in person in the “National Mutual Life Assurance Society”. It may cause some surprise the professional choice of Keynes, to work in insurance companies. After all, these companies make the risk management of events subject to the probability distribution. Keynes, however, thought

52 John Maynard Keynes and his work in the insurance market that uncertainty, where one cannot establish probability distributions, was the dominant factor in the economy. How to resolve this paradox between the Keynesian worldview and his career choice? Insurance companies deal with risks that are inherent and not escapable of certain situations for people or businesses. The objective of the insurance business is to transfer and reduce these risks. In exchange for the premium paid by the policyholder, the insurance company bears the risk to compen- sate for losses caused by fires, car accidents, thefts and other misfortunes that may occur to families or companies. In addition to transferring, insurers contribute to reducing risks. Keynes was active in the life insurance branch. Life insurance is different as it compensates for a misfortune that cannot be avoided – our own death. If we all had a determined age to die – for example, 85 years – there would be no sense in life insurance because there would be no risk. We could, in advance, organize our financial condition and activities. In the case of life insurance, neither the insurance company, nor the individual insurance policy holder, knows the date of his death. The financial risk of his death, which will befall on third parties, is transferred, via the payment of the premium, to the insurance company. The insurer accepts the risk, because it performs actuarial studies with life tables, to find out the probability distributions of age of death. The essence of risk is being able to rely on probability distributions. For the buyer of the policy, it is worth more than the costs incurred by the insurer, since the risk of the seller is less than the risk that the buyer would have if he had not bought the insurance policy. As we shall see in Part V of the book, Keynes’s role in the insurance industry was on the side of asset management of insurance companies. Indeed, an insurer assumes liabilities – the risks of various natures that it insures – in exchange for receiving payment of premiums. The accumulated premiums are used to pay the insurance due and to accumulate technical reserves. These technical reserves need to be managed in a long-term strategy, but must also be used in critical situations, where the total payments of insurance increase much higher than expected. Thus, one of the critical areas of insurers is the financial administration of technical reserves and financial assets in general. Although there are regulatory restrictions by the government and limitations imposed by conservative internal policies of insurance companies, there are still many alternatives for administrators to perform their resource management skills. That was

4. Keynes as investor and the lessons learned 53 the main role of Keynes in the insurance company he presided over – to establish and monitor the investment policy of the National Mutual – and another insurer where he was a director. Keynes, as we shall see in Chapter 12, also worked on the liabilities side, advising companies in certain areas of insurance risks. Following up the work and professional experience of Keynes, as well as his investor and manager of financial assets activities, we can dare to say in this book that Keynes was a forerunner of the modern “asset management”. Indeed, this observation is obvious to those familiar with the modern world of finance. Like George Soros, Keynes was a sophisticated manager, having as highlight an “animal spirit of finance” intuition in combination with a brilliant perception of future economic scenarios. In my opinion, the great differentiation factor of Keynes was his intuition. Where this intuition comes from? Some authors attribute to Keynes a “female vision” that would base this sharper intuition. In terms of prehis- tory, according to this line of reasoning, men were hunters, focused on hunting to feed their group. They used primitive weapons, spent hours locating prey and could not miss the mark. They had to assess the risks involved. The women had to be defensive against external threats of various kinds. They had to be alert, watching thousands of signals. It was the world of uncertainty and intuition. I tend to agree with the view that Keynes had a very strong intuition, revealed in his works and economic essays. Perhaps the explanation is that seen above, but on the other hand, one needs to take into account Keynes’s contact with writers, poets, painters, ballet dancers, musicians and people linked to art, where the “emotional side” is much stronger than the “rational side”. According to Lawlor (2006, p. 105/106), Keynes, while establishing his theoretical framework for monetary analysis, was based on two sources of beliefs: (i) asset markets are balanced in a way so that the market negotiations moved prices to positions characterized by equalization on the margin of the expected rates of return between assets, given the views of the market; and (ii) the market psychology used and the way that traders behave in the context of uncertainty are relevant to characterize the significance, role, mo- dus operandi and effects of speculation in the asset market.

54 John Maynard Keynes and his work in the insurance market For Keynes, the essential characteristic of speculation would be the superior knowledge of possession. At the beginning of 1930, a more mature Keynes listed the three principles which a successful investment would depend on: • careful selection focused on a few investments (or few types of investments), taking into account them being inexpensive relative to their market value. To conclude whether or not they were underappreciat- ed, Keynes would take into account their potential value – measured by the present value of future net cash flows – comparing them with existing alternative investments; • firm holding of these investments in large volumes for several years, until they have fulfilled their promise, or getting rid of them, should it becomes clear there was a mistake in their acquisition; and • a balanced position of investments, i.e., a variety of risks, and opposing risks if possible, even with very large individual investments; (Lawlor, p. 149).

According to Keynes, investing would be the activity of predicting asset returns over their useful economic life, while speculating would be the activity of predicting market psychology (Harrison, p.3). In The General Theory (1936), Keynes warned the following:

“...it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, uncon- ventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes, 1936, p.115, Brazilian version).

This, undoubtedly, can be interpreted as an “outburst” of Keynes about the kind of difficulty that he was constantly facing, in the Board of the insurance company, to impose his less conventional investment management point of view.

4. Keynes as investor and the lessons learned 55

PART III Keynes’s theory and works

n the third part we will comment the works of Keynes, with I a focus on his thoughts about risk, uncertainty and money.

CHAPTER 5 An overview of Keynes’s works

KEYNES’S IDEAS WERE REMARKABLE TO SET THE DIRECTION OF ECONOMIC POLICIES FOLLOWED UNTIL THE 1960S. SEVERAL SCHOOLS OF ECONOMIC THOUGHT HAVE BEEN INSPIRED OR DERIVED FROM KEYNES. MARC LAVOIE, IN THE BOOK “INTRO- DUCTION TO POST-KEYNESIAN ECONOMICS” PRESENTS IN THE FIRST CHAPTER OF HIS BOOK THE DIFFERENT LINES OF ECO- NOMIC THOUGHT AND THEIR RELATIONSHIP TO KEYNES.46

Lavoie argued that the “Post-Keynesian School”, of which he was a participant, was just one of the many heterodox schools of economic thought. According to him, under this label of heterodoxy, where almost all were opposed to neoclassical economics, we find Marxists, Sraffians (also known as New-Ricardian), neostructuralists (focusing towards economic development themes), Institutionalists, Humanists and Social economists (“behaviourists”), Schumpeterians (also known as Evolutionary), and others.47 Post-Keynesians are not the only economist followers of Keynesian thought. There are other schools of economic thought that trace their

46 Lavoie, “Post-Keynesian Economics”. p. 1 to 33. 47 Lavoie, ibid, p.1.

5. An overview of Keynes’s works 59 greatest intellectual debt to Keynesian thought. Lavoie presents an outline of the schools and their relationships with each other.48 According to Lavoie, we observe that, starting in Keynes, the following schools or lines of thought, and its leading economists, flourished: • Keynes and Cambridge: the greatest influence came from Alfred Marshall. Leading exponents, besides Keynes, were Harrod, Kaldor, Robinson and Weintraub; • Keynesian Synthesizers: received influence of Marshall and Walras, and spread the Keynesian thought by the way of simpler models. Lead- ing exponents were Hicks, Samuelson, Modigliani, Tobin and Solow; • Post-Keynesians: received influence of the classical economists, Marx, Kalecki, Sraffa and united the theoretical ideas of those economists to the Keynesian thought; • New Keynesians: continued fairly faithful to the original Keynesian thought, although they receive influences of Keynesian Synthesizers; • Weak New Keynesian: are seen as influenced (for the New Keynesians, overly influenced) by neoclassical economists; • New Keynesians of the Third Group: new generation of “New Keynesians”; and • Keynesian Liberals: closer to a Keynes synthesis with neoclassical economists.

It is not intended to discussing the work of Keynes in this book, but, after the summary of his overall work, showing his ideas about investment, risk, speculation and finance, it is vital to understanding his role as an insurer manager. When analyzing the work of Keynes, it is observed that he changed his opinion many times. Keynes saw this as a sign of a mind open to incorpo- rate ideas that would improve his thinking. Many analysts, however, were critical of this. Clarke produces a quote about technicians of the English Treasury, which said: “When five economists gather, there will be six conflicting opinions, and two of them shall be delivered by Keynes”.49

48 Lavoie, ibid, p.3. Lavoie presents a somewhat confused figure to show the schools and their interrelationships. 49 Clarke, Keynes, p. 5.

60 John Maynard Keynes and his work in the insurance market The first of Keynes’s work was done in the field of probability. His ideas on this subject will be discussed in more detail in the next chapter. We want to highlight here the chronology of the development of his work. In 1907, Keynes presented his dissertation in Cambridge, to a judging panel of four teachers. His dissertation was a major contribution, and it was very original. According to Cord, it was the first serious attempt to develop a new theory of probability since the work of John Venn, “The Logic of Chance”, written in 1866.50 The main argument of Keynes was that, when examining the relationship between knowledge and probability, the subjective element had been overly emphasized to the detriment of the objective element. According to Cord, for Keynes that happens because knowledge is not a property of an individual but has a separate existence.51 Keynes decides to write a book on the subject of probability, based on the dissertation. Because the War of 1914, his book, “A Treatise on Probability”, was published only in 1921. Keynes’s attack on subjectivism did not remain unanswered. The brilliant young philosopher and Cambridge mathematician Frank Ramsey (1903-1930 – died very young in a car accident), offered a counter that the odds were in fact determined by the knowledge possessed by an individual.52 In this debate, Ramsey emerged victorious, and his ideas have served to support studies on the exercise of choice under uncertainty. In 1913, Keynes published the book “Indian Currency and Finance”. The purpose of the book was to provide a general framework, analyzed from a critical standpoint, of operation of the gold standard in India. It is noted that during most of the nineteenth century India was governed by the “silver standard”. In 1898, it abandoned the “silver standard” and adopted the “gold standard”. India did so because much of its trade was with Britain, which was based on the “gold standard”. The problem of the gold standard was that it limited the amount of currency that could be issued, backed in this commodity. In the practice of the “gold standard”, the coins are effectively made this metal, but paper notes were offered in notes that could be redeemed by a predetermined amount of gold.

50 Cord, Keynes, p. 19. 51 Cord, ibid, p. 19. 52 Cord, ibid, p. 20.

5. An overview of Keynes’s works 61 In many countries, the “gold standard” was a way of imposing monetary discipline and creating austere economic policies in the country that adopted the regime. To Keynes, this was not the case in India. The country managed well its monetary system, despite being a country with great poverty. Thus, Keynes supported India’s decision to adopt the gold standard, and suggested the creation of a central bank in that country.53 The book did not become a “best seller”, but helped increase the reputation of Keynes as an economist. In June 1919, after resigning from his post in the United Kingdom delega- tion that took care of the post-war agreements, Keynes began to write the book “The Economic Consequences of the Peace”. In a few months, he completed the book. The book was a huge success, and within months was translated into 11 languages.54 According to Cord, the book became famous for two basic reasons: (i) first, for its critics on the chapter of reparations, based on technical reasons; and (ii) for its vivid characterizations of the leading politicians responsible for the negotiations – Clemenceau, Lloyd George and Wilson.55 Keynes, in this book, calculated that Germany would be able to pay no more than £ 2 billion in reparations. The Allies, however, were asking for £ 24 billion. Keynes believed that there should be made an effort to integrate Russia and seek an increase in political, economic and social stability of Central Europe. Regarding the irreverence with which the three politicians were portrayed, one can note the influence of the libertarian spirit of the Bloomsbury Group. In 1925, Keynes published a book (pamphlet) called “The Economic Con- sequences of Mr. Churchill.” The world, in the previous three years, had witnessed a whole period of hyperinflation in Germany, Hungary and elsewhere. The monetary issue was in evidence. In Britain, however, the concern was with deflation. Many voters were demonstrating in favor of the return of the gold standard. The gold standard, introduced in the UK in 1821, was seen as a “British institution”. It had been suspended in the Great War. The Chancellor of the Exchequer was Winston Churchill. Churchill and Keynes were friends, at least before the publication of the book. They ex- changed many ideas on economic issues, and Keynes ended up acting as an informal adviser to Churchill.

53 The Reserve Bank of India was only created in 1935. 54 Cord, Keynes, p. 44. 55 Cord, ibid, p. 44. Keynes, it is evaluated today, was excessively harsh in his criticism of Woodrow Wilson.

62 John Maynard Keynes and his work in the insurance market On the issue of the return to the gold standard, Keynes failed to persuade Churchill. Keynes preferred that it was made a more active management of the pound, but could not enforce his desire. In April 1925, the Great Britain returned to the gold standard. It was a big failure. Years later, Churchill himself admitted it was one of his biggest mistakes. The biggest problem was the value fixed: the pound was fixed in the pre- war value of US $ 4.86 representing an overvaluation of almost 10%. The results were disastrous, because they hindered exports plenty. Coal min- ers began a general strike in 1926, reacting to attempts to cut their salaries to reduce costs. For six years the economy had suffered, so that in September 1931 the Great Britain abandoned the gold standard. Keynes was right. Despite his marriage in 1925, and in parallel of his greatest enrichment, Keynes continued to work swiftly. His ambition, in the academia, was to publish a book with great impact. This book would only be ready in Octo- ber 1930, entitled “A Treatise on Money.” He worked several years on this project, from 1925 to 1928, as a development of ideas that he had shown in the book “The Tract on Monetary Reform”. The goal of Keynes with this book was to find out the dynamic laws governing the passage of the monetary system from an equilibrium position to another. Some ideas in this book, such as the liquidity preference, would be detailed more in the General Theory. Another item contained in the book would be business cycles being governed by the volume of investments and these, in turn, dependent on the state of business confidence. There was born the idea of “animal spirits”, that is, the courage of entrepreneurs to invest based on a future scenario of uncertainty. According to Skidelsky,

“the Treatise on Money, published in 1930, is an excellent example of Keynes’s passion of generalization. In essence, Keynes built an overly complicated intellectual apparatus to show how an economy on the gold standard could, under some circumstances, fall into a trap of low employment. In the case of the monetary authority being prevented from reducing the long-term interest rates to a level consistent with investor expectations, and if domestic production costs prevented an export surplus equal to what people wanted to lend abroad, the result would be the creation of a savings surplus over investment, a sluggish level of prices and a locked economy”.56

56 Skidelsky, Keynes, p. 27.

5. An overview of Keynes’s works 63 This thought was developed and put in a broader context in the Keynes’s magna opus, “The General Theory of Employment, Interest, and Money,” published in February 1936. Between 1931 and 1935, Keynes worked hard to write this book, for which he had the support of Kahn, Robinson, Harrod and Meade quartet. As usual, he accumulated several other activities in parallel. According to Skidelsky,

“[the book] The General Theory transformed the way most economists understood the functioning of the economy. In this sense it was explicitly, and successfully, revolutionary. It also had a revolutionary effect on politics. Not immediately, but after the Second World War, the Western governments, openly or implicitly pledged to maintain a high level of employment. The General Theory is a deep exploration of the logic of economic behavior under uncertainty, combined with a short- term model for determining income, which emphasizes adjustments of quantity, not of price”.57

Also according to Skidelsky, this marked from then on disputes over the meaning of this Keynesian book, between “fundamentalist Keynesians” and “hydraulic Keynesians”.58 To him, it was the model of income determination based on the multiplier, together with the development of national accounts, what made his theory acceptable for economic policy makers. Thus, they could follow a reliable method to predict and control the movement of real variables such as investment, consumption and employment59. In the 1940s, Keynes is already a great statesman. With the War ending, he is seen as the undisputed leader of economic reforms. Ideas abound for Keynes, though his fragile state of health hindered his performance. He tries to reform the international monetary system with a “national” currency based on gold (in French, Banc d’or) and in a basket of currencies. The “Bancor”, however, was rejected by the US, and the dollar was imposed as the base currency of the Bretton Woods Agreements.60 Modern macroeconomics, based on national accounts modeled according to Keynes, emerges as an important discipline in the field of economics.

57 Skidelsky, ibid, p. 30. 58 Skidelsky, ibid, p. 30. The author is mocking economists using models, diagrams and mathematical formulas. 59 Skidelsky, ibid, p. 30. 60 The theme of Bancor reemerged in new discussions, due to the 2011 dollar crisis.

64 John Maynard Keynes and his work in the insurance market In 1964, it is published in Portuguese language the book by Dudley Dil- lard, written in 1947, with the title “The Economic Theory of John Maynard Keynes”.61 It was a book widely adopted in the Brazilian economics courses in the 1960s. The last chapter of the book examines the evolution of the Keynesian thought. Two observations by Dillard are pertinent in this context. First, to Dillard the greatness of Keynes’s work lies in its impact on economic policy.62 Second, he highlights the fact that “Keynes was not the cabinet theorist, as were many, if not most of his fellow economists”.63 Another issue that Dillard emphasizes is that “Keynes was the champion of industrial capital and opponent of financial capital, when these two interests collide”.64 Dillard concludes that:

“The essence of his liberalism is a critique of financial capitalism, combined with a strong desire to establish an environment in which to run industrial capitalism, the private enterprise system.”65

61 Dudley Dillard, The Economics of John Maynard Keynes: The Theory of Monetary Economy, 1964. 62 Dillard, p. 170. 63 Dillard, p. 271. 64 Dillard, p. 279. 65 Dillard, p. 296.

5. An overview of Keynes’s works 65

CHAPTER 6 Keynes and the precursors of the Modern Theory of Finance: Knight, Hicks, Fisher and Hayek

WE AIMED, IN THIS CHAPTER, TO HIGHLIGHT THE IMPORTANCE OF KEYNES AS ONE OF THE MOST IMPORTANT FOUNDERS OF MODERN FINANCE THEORY. THE NAME OF KEYNES IS GENERALLY ASSOCIATED WITH MACROECONOMICS, WHERE HE IS SEEN, RIGHTLY, AS ONE OF THE MOST IMPORTANT ECONOMISTS OF THE HISTORY OF ECO- NOMIC THOUGHT. IN THIS CHAPTER, WE SHOW THE THOUGHT OF THE FINANCE THEORIST (AND PRACTITIONER) KEYNES IN A COUN- TERPOINT WITH FOUR OTHER IMPORTANT NAMES IN THIS FIELD, WHICH WITH HIM LIVED THEIR THEORIES. WE WANT TO HIGH- LIGHT, IN PARTICULAR, THE ISSUES OF RISK AND UNCERTAINTY, OF INTEREST RATE AND INVESTMENT, AND OF SAVINGS.

Let’s start with Frank Knight and John Hicks, discussing risk and uncertainty.66 Frank Knight was quite instrumental for the study of earnings and motives of capitalists, and aspects of risk and uncertainty associated with entrepreneurship. On the other hand, Hicks was one of the great exponents of the theory of value and capital, and has authored several important

66 The section on Hicks is based on the article by this author, entitled “Earnings, Uncertainty, Insurance and Hedge: Hicks’s Vision”.

6. Keynes and the precursors of the Modern Theory of Finance: Knight, Hicks, Fisher and Hayek 67 works in economics.67 Hicks received the Nobel Prize in Economics in 1972. Both Knight and Hicks ideas are still very rich and inspiring. The book by Frank H. Knight, “Risk, Uncertainty and Profit” (1921), is actually constituted by two books. The “first book” (Part II of his book) is a revaluation of theory of value, demonstrating the theory of choice and exchanges; joint production and capitalization; changes and progress in the absence of uncertainties; and the prerequisites for perfect competition. The “second book” (Part III of his book) is an analysis of the effects of uncertainty on the structure and functioning of an economy of companies. It is in this part that Knight examines the topics of the meaning of risk and uncertainty; the structures and methods to deal with uncertainty; companies and earnings; the professional manager and profits; uncertainty and social progress; and the social aspects of uncertainty and profits. Let us summarize briefly Knight’s main ideas about risk, uncertainty and profit. It should be noted that the author begins by making a distinction between risk and uncertainty. This distinction is based on the idea that risk is a type of uncertainty that can be measured and quantified, while uncertainty, in its pure state, would not permit such measurement. In the course of his argument, Knight refers insistently to psychological and extra-economic factors, which caused a reaction by Hicks, as commented below. It is also to be noted in Knight’s a concern and support for the concept of a priori probability, in what would be later be known as Bayesian statistics, and that was favored by Keynes, but not by Hicks. Profits (above normal) would result from entrepreneurs facing situations of uncertainty, in a context that their returns were not fixed, but rather residual. That is, after all agents involved in the production process, under fixed income contracts, had received their income (wages, interest, rents), what may had left would be the remuneration of the entrepreneur. This above normal profit would be a compensation for facing uncertainty, such as a risk premium. Hicks’s involvement with risk theory was due to Lionel Robbins. To understand this issue, it is important to view the academic world in England in the late 1920s. Robbins was nominated to head the London School of Economics in 1929.

67 Among which stand out Value and Capital (1938), Capital and Growth (1965) and The Theory of Economic History (1969).

68 John Maynard Keynes and his work in the insurance market A little before that, Hicks had met with Robbins in Oxford to discuss his progress in economics. He showed Robbins that he was ahead of Walras and Pareto in his research. This captivated Robbins, who was also more familiar with and connected to the Chicago economists, Frank Knight and Jacob Viner, and to the Austrian school, than the English economists from Oxford or Cambridge. Robbins encouraged him to research new authors, dropping Cassel, Walras and Pareto, and going to Edgeworth, and Taussig, Wicksell and Austrians. He invited Hicks to teach General Equilibrium and encouraged the young teachers of the Department to give seminars and courses in which they could simultaneously work on research papers. Hicks began preparing a course in Risk Theory. Around this time, the LSE began to hire teachers and invite speakers with a strong continental European tradition, such as Von Mises, Schumpeter, Haberler, Ohlin and Lindhal. In the summer of 1930, Hicks gave his first course on Risk. These classes were summarized and synthesized in an article.68 A curious fact about the publication of this article. The most prestigious journal of economics at the time was the Economic Journal, the “apple of the eye” of John Maynard Keynes, who was its editor for more than 33 years, from 1911 to 1944. Hicks submitted the article to this publication, but was rejected by Keynes, who commented that it was “still raw”. To understand Keynes’s reaction, it must be taken into account, as will be shown in the next chapter, that the topic of probability was very dear to Keynes. Keynes thought that probability theory, as practiced at the time, was extremely mathematical, with little relation to the real world of economics. Keynes thought that the prediction of human behavior and events could not be done successfully only with the use of the principles of probability. Interestingly, Frank Knight also shared the reserves with which Keynes saw the relevance of mathematical probability to analyze economic phenomena. Given this already matured positioning of Keynes, the same was not impressed favorably with Hicks’s ideas, in which he saw a lack of depth on the subject that somehow reflected the still inadequate discussion level of probability theory. According to Hicks, Knight’s work laid the foundation on which any future theory of profits should be based on – the dependence of the uncertainty

68 “The Theory of Uncertainty and Profit”, in Economica: A Journal of Social Sciences, n.32, May 1931.

6. Keynes and the precursors of the Modern Theory of Finance: Knight, Hicks, Fisher and Hayek 69 profits. For Hicks, however, this was not enough. It was necessary to know not only in which economic phenomena an explanation for profit would be supported, but also to know exactly what is profit, and what are the causes that determine its magnitude. It was these last two parts that Hicks considered unsatisfactory in Knight’s work. Hicks was convinced that the economic theory of profits should be based on the methods of economic analysis, not in metaphysics or psychology. According to him, Knight put an exaggerated weight to “unmeasurable risks” or the “true uncertainties”, but that was misplaced. Moreover, the Hicks’s idea was to limit the risks, not eliminate them, as Knight wanted. Irving Fisher was the most important American economist in the first three decades of the last century. His intellectual life crossed with that of Keynes, but they had very little personal contact. In the first three decades of the twentieth century, the United States took the lead in the global economy, becoming the global symbol of economic success. According to Nasar,

“Irving Fisher, the youngest member of the Economic Department at Yale University, was by no means mediocre or inconspicuous. His eyes were bright with intelligence, his handshake was firm, he had the body and the posture of an athlete, and his face was youthful and handsome. At thirty years old, he was the only American economic theorist highly respected by Cambridge and the rest of England and the European continent. Alfred Marshall and Leon Walras, the French mathematician economist, considered him a genius”.69

In 1907, Fisher published his first work about interest rate, with the title “The Rate of Interest”, and in 1930 he published his masterpiece, “The Theory of Interest”. His theoretical treatment of the interest rate – nominal and real – and of savings formation remains very current in the modern world of finance. Fisher became, at the time of the 1920s, millionaire and famous. He was the inventor of an information cataloging system, which later became the Remington Rand company. He also became an aggressive speculator in the stock market, in he which traded leveraged, making use of loans (known as “margin account”).

69 Nasar, “Grand Pursuit”, p. 145.

70 John Maynard Keynes and his work in the insurance market The decade of 1930s marks Fisher’s downfall. His prestige and influence collapse due to failure of his analyzes – widely disseminated in newspapers and radio – overly optimistic, and his forecasts – never achieved – of an imminent return of prosperity for the US economy. According to Nasar,

“Irving Fisher was the first to realize how powerfully currency affects the real economy, and to make the case that the government could increase economic stability through better monetary management. By pointing to a single common cause for the apparently opposite diseases of deflation and inflation, he identified a potential tool – the control of money supply – which the government could use to moderate or even avoid inflationary outbreaks or deflationary depressions”.70

Irving Fisher made a pioneering contribution to the study of the formation of savings, and the role of interest rates in this process of “life cycle”. According to Colin Read, although the word “finance” may have various meanings,

“personal finance created a decision science about how we save and borrow money and how we accumulate it for the future in the sequence of coming years. In doing so, it describes the trade-off between how we consume and save in the present, in order to consume more in the future”.71

Irving Fisher had tuberculosis when he was thirty, and had to be treated in Colorado for almost three years. This was decisive in his dedication to good health, being interested in the need for funds to finance life length consumption. In this context of theoretical interest, and based on his strong mathematical instruments, Fisher developed his theory of capital accumulation, with an important role for financial mathematics calculations (discount rate, present value, compound interest, time preference, consumption im- patience, nominal and real rates, risk and uncertainty, etc.). We can draw a parallel between Fisher and Keynes. The first was an investor in the stock market, and gained a lot of money (and later lost everything) in the Roaring 20s. For him, optimism was associated with high stock prices and higher capital gains.

70 Nasar, ibid, p.170. 71 Colin Read, “The Life Cyclists”, p.3.

6. Keynes and the precursors of the Modern Theory of Finance: Knight, Hicks, Fisher and Hayek 71 Keynes, especially in the early years when he worked as financial assets manager, was an investor in bonds and fixed income. He depended on the relative profitability of securities, the behavior of inflation, and the relative risk linked to the term of the investment. Keynes knew there would be, at any time, gains and losses with no clear overall trend. Colin Read comments that:

“Both Irving Fisher and John Maynard Keynes were able to discard the instruments of their predecessors and the reigning conventional wisdom. However, the active mind of these two scholars contributed for them to “reinvent the wheel”, often with spectacular results thanks to their insights. Both reached the pinnacle of their professions and transcended the narrow world of academia to become famous names. (…) it was Keynes, however, who allowed us to understand why additional savings may not find their way to the investment market. In doing so, he helped us understand why not always savings turn into investment, increasing Fisher’s contribution on how the interest rate motivates savings and how inflation erodes the interest rate.”72

Nicholas Wapshott published in 2011 a very interesting book, which chronicles the theoretical debates between Friedrich Hayek and Keynes73. The main work of Hayek was “The Road to Serfdom,” published in 1944,74 of more ideological and macroeconomic nature. Hayek also wrote papers on the formation of savings and interest rates, and these are the subjects that we will comment, in the context of comparison with the ideas of Keynes. Wapshott comments that Keynes was an idol for Hayek in the period 1917- 1929. The first meeting was in 1928, and from there on they became friends, although opponents in the field of economic ideas. Hayek was a leading member of the “Second Austrian School” and therefore heir to the ideas of economic cycle and fluctuations, from Karl Menger, and the Theory of Capital, from Eugen Böhm von Bawerk. It would be natural for him to participate in the debate – which Keynes was one of the most active – on the role of savings in the economy. In the Depression,

72 Read, p. 60. 73 Nicholas Wapshott, “Keynes Hayek The Clash that Defined Modern Economics” (2011). 74 Hayek spent three years writing the work (1941-43) and the war hindered the publication by the University of Chicago Press in 1944. The book became a huge popular success.

72 John Maynard Keynes and his work in the insurance market Keynes’s concern was to increase the aggregate consumption and savings acted as “leakage” of the income flow. Hayek published in 1931 an essay titled “The Paradox of Saving”. In this essay, Hayek develops the argument that the production is not a single process with a single product and a certain price. There are economies of scale and complex chain of processes in production stages. The idea that the excess savings – invested in low yield assets – could reduce demand would not be correct, to Hayek. This view led him to challenge the Keynesian ideas of boost demand through investment. On the issue of interest rates, Hayek analyzed that it was an integral part of the lengthening or shortening of chained production process. Thus, the attempt to lower the interest rate to address the chronic deficiency of demand – Keynes’s position – would be innocuous, contributing only to lengthen the time of the production process. For Hayek, government intervention in the sense of reducing interest rate would interfere in the relationship between savings and investment. To conclude this chapter, we can say that these four authors, along with Keynes, were undoubtedly stimulated by the controversies of the time, and attracted by the major macroeconomic issues. They end up, however, developing microeconomic approaches to analyze the themes of savings, interest rate, risk and uncertainty. They left as legacy a major contribution to the modern theory of finance.

6. Keynes and the precursors of the Modern Theory of Finance: Knight, Hicks, Fisher and Hayek 73

CHAPTER 7 Risk and uncertainty

FOR MANY YEARS, THE BOOK “A TREATISE ON PROBABILITY,” PUBLISHED IN 1921, WAS CONSIDERED A WORK OF TECHNICAL PHILOSOPHY, WHICH DIFFERED QUITE WIDELY FROM OTHER WORKS OF KEYNES. IT WAS NOT SEEN AS PART OF KEYNES’S ECO- NOMIC WORK. IN RECENT YEARS, HOWEVER, THIS PERCEPTION HAS CHANGED A LOT. CURRENTLY, IT IS CONSIDERED THAT THE BOOK IS AN INTEGRAL PART OF THE KEYNES THOUGHT, PARTIC- ULARLY TO UNDERSTAND THE ROLE OF RISK AND UNCERTAINTY IN THE INVESTMENT PROCESS.

Keynes’s book was the first systematic study on the logical foundations of probability. There had been others in the past, which already pointed to two important developments: (i) a repudiation of a deterministic view of events, to one based on events odds; and (ii) a progress in the creation of statistical methods, especially in the social sciences. For Keynes, the probability – that is at the root of risk calculation – is not a simple statistical measure of the relative frequency of events. It also depends on expectations about future events.

7. Risk and uncertainty 75 Clarke, commenting on Keynes’s work on probability, says:

“after all, in real life, in which we live facing forward, necessarily igno- rant of the future, the consequences that seem likely to us in advance – what we reasonably expect that might occur – are all we need for decision-making.”75

According to Moggridge, for Keynes “the probability was connected to mental and cognitive processes involved in the formulation of probabilistic judgments in a broader sense, with arguments and reasoning processes”.76 There would be thus, and a priori, an objective assessment of probabilities. An important passage from the Keynes’s book is regarding knowledge. The classical theorists thought that the “perfect knowledge” based on truth would be the only valid knowledge for science, and eschewed probability to minor matters. Keynes disagrees with this view. His focus on the subject,

“although centrally concerned with knowledge instead of ignorance, he was centered on the concept of limited knowledge. From the beginning, he abandoned the view that science was based only on true knowledge. Instead, true knowledge was the upper limit of imperfect knowledge”.77

We saw in Chapter 1 the relationship between Moore’s moral thought and the interest of Keynes on probability. For Keynes, the field of probability covered that part of knowledge obtained by arguing, but it was not subjective. It was logical. The proposals could be probable, or improba- ble, with varying degrees depending on the existing knowledge volume. Moore stated that “good” could not be defined, and Keynes would state that “probability” could not be defined. In both cases, there are intuitive judgments, beyond the reach of proof. The intuitions were objective. Keynes analyzed the role of induction and introduced the concept of “a priori probability”. The last seven chapters of the book (the book has about 500 pages in total) focused on the topics of statistical inference.

75 Clarke, Keynes, p.34. 76 Moggridge, Maynard Keynes, p. 144. 77 Ibid, p. 145.

76 John Maynard Keynes and his work in the insurance market According to Skidelsky, “Keynes probability theory is both optimistic about the power of human reason and pessimistic as to reason’s ability to pene- trate the secrets of the universe”.78 Mark Blaug’s book, “John Maynard Keynes (1883-1946),” is a collection of articles by several authors on different economic themes developed by Keynes in his career and published works. We will now comment on the articles that discuss the themes of probability, risk, uncertainty and investment in the work of Keynes. Bradley W. Bateman comments on the concept of probability developed by Keynes.79 This author argues that Keynes’s thought on the probability changed twice, and explains what were these changes and the reasons for it. According to Bateman, there are in the work of Keynes two issues that cause much controversy: the distinction between risk and uncertainty, and the role placed by him on uncertainty as influencing investment and income.80 Keynes’s concern, indeed, was with the theory of probability. There are two views on it. The first is that the probability of an event is its occurrence frequency in the long term. Since the concept of probability is based on the proportion (percentage) that an event occurs in repeated attempts, it is called a random probability. The second focuses on the uncertainty of the final outcome implicit in the idea of probability. According to this second idea, the probability depends on two things: the degree of belief that one has on a hypotheses, given some evidence81 and the person’s knowledge about the chance of occurrence of an event (its relative frequency). This is called epistemic probability.82 By the time Keynes wrote his book, there already had been advances in mathematical theory allowing for a more logical formalization of probability theory. For Keynes, probability did not consist in a simple measurement of the relative frequency of events, as viewed by statisticians. In his idea, the probability also depended on expectations. This was not, however,

78 Skidelsky, Keynes, p. 38. 79 Bradley W. Bateman, “Keynes’s Changing Conception of Probability”, (Blaug, Vol. II, p. 97-119). 80 Bateman, ibid, p. 97. 81 Bateman, ibid, p. 235. 82 Bateman, ibid, p. 235.

7. Risk and uncertainty 77 a purely subjective view, because, a priori, there should be an objective assessment of probabilities.83 Keynes, in his book “A Treatise on Probability,” argues for an objective epistemic theory84, according to Bateman.85 This author points out that the Keynes’s first change was to accept a subjective epistemic theory rather than an objective epistemic theory.86 The second change was due to the early work on the use of multiple regressions for empirical studies of economy. Keynes believed that there were methodological flaws, because he was of the opinion that one should – before using the regression technique – test whether the economic variables could be characterized by a frequency distribution. Bateman cites correspondence between Keynes and Harrod, in which he says that economics is a moral science, dealing with insight and values. In this correspondence, Keynes says it also handles motives, expectations, and psychological uncertainties.87 In the second revision, Keynes comes to accept a subjective epistemic probability theory.88 Bateman’s conclusions are that: (i) Keynes did not believe in the existence of long term stable distributions of economic variables. According to Keynes, these variables were subject to fluctuations, and it was important to study them and measure them; and (ii) to him, the lack of stable distributions in the long run of economic variables meant that the probabilities employed by economic agents would not be random, but rather epistemic.89 The other author who will comment on is Brazilian, and contributed an article to Blaug’s book.90 Fernando Cardim addresses themes of probability, uncertainty and decision-making in Keynes. We will comment on the part of his article that deals with the use that Keynes made of the notions of probability and uncertainty in his works in the 30s, particularly in the “General Theory”.

83 Bateman, ibid, p. 236. 84 Epistemology is a theory of science, knowledge and methodology. According to the Novo Dicionário Aurélio, “it is the critical study of the principles, assumptions and results of the sciences already constituted, and which aims to determine the rationale, value and objective scope of them”. 85 Bateman, ibid, p. 236. 86 Bateman, ibid, p. 244. 87 Bateman, ibid, p. 248. 88 Bateman, ibid, p. 249. 89 Bateman, ibid, p. 254. 90 Fernando J. Cardim de Carvalho, “Keynes on probability, uncertainty, and decision making”. In Blaug, Volume II, p. 438 to 453.

78 John Maynard Keynes and his work in the insurance market According to Cardim, for his model of effective demand, Keynes considered essential to distinguish between short-term expectations (those governing routine decisions) and long-term expectations (in which crucial decisions were based on).91 For Cardim, investment decisions are crucial and non-repetitive, and their consequences are too complex to be understood and anticipated. Past experience in the case of investments does not give us security to indicate future direction. In contrast to investment decisions, for Cardim, the overall production decisions are not crucial. They do not implicate in irreversible commitment of resources, and may be revised in short time intervals.92 Formal logic applies to production decisions, but for investment decisions, human logic dominates formal logic and induction is impossible.93 Cardim concludes his article with the following comment:

“Keynes’s economics recognizes that long-term expectations are, then, exogenous because they cannot be definitively linked to any current variable of the economy. This does not deny continuities or the possibility of theory, but explicitly takes into account the difficulty of theoretical treatment of long-term expectations, where human logic prevails over the formal logic of probability.”94

Estrin and Holmes try to clarify the complex relationship between economic uncertainty, individual expectations and the role of government in the economy.95 In this attempt, they discuss the theme of uncertainty in the work of Keynes. According to the authors, the issue of “partial ignorance” is key to understanding the role of uncertainty in Keynes. In a famous passage from the article “The general theory of employment”,96 Keynes comments that “there is no scientific basis to be able to form any kind of probability”.97

91 Cardim, “Keynes on Probability”, p.439. 92 Cardim, ibid, p.450. 93 Cardim, ibid, p.451. 94 Cardim, ibid, p.451. 95 Saul Estrin and Peter Holmes, “Uncertainty, efficiency, and economic planning in Keynesian Economics” (vol. I, p.416-426). 96 Keynes, “The General Theory of Employment”, in Quarterly Journal of Economics, 1937, 51, 209-223. 97 Keynes, ibid, p.214.

7. Risk and uncertainty 79 This passage is very criticized by several authors, who consider it too radical. Estrin and Holmes disagree. According to the authors, Keynes did not mean that investment decisions would be largely arbitrary.98 For them, Keynes did not mean that individuals fail to act in ways consistent with economic rationality, but that even if the decision makers use the information they have in the best possible manner, even so the system may generate an undesirable, erratic or unpredictable outcome.99 Estrin and Holmes commented that, for Keynes, people make decisions as best as they can, given their intuition, instead of using guesswork or acting randomly.100 Also according to them, Keynes fully recognizes that some things are more predictable than others. They even cite a passage from the General Theory where Keynes argues that “we should not conclude from this that everything depends on waves of irrational psychology”101. The authors even go a step further to justify government action. According to them,

“uncertainty is seen as a key source of economic problems in the works of Keynes. However, since people do not necessarily have all the information that is potentially possible to have, then there is a possibility of improvement through state intervention to stimulate the information flow”.102

C. Alan Garner also comments the role of uncertainty in the “General Theory” of Keynes.103 According to him, Keynes recognized that the design of long- term expectations is fundamentally psychological.104 Gardner describes the three techniques that, according to him, Keynes identified in decision making in a world of imperfect information: (i) people assume that this is a better guide to the future than the past experiences had shown; (ii) they assume that the current opinion correctly anticipates the future prospects; and (iii) they conform with the majority of behavior.105

98 Estrin and Holmes, Uncertainty, p. 417. 99 Estrin and Holmes, ibid, p. 417. 100 Estrin and Holmes, ibid, p. 418. 101 John Maynard Keynes, “The General Theory of Employment, Interest and Money”, 1936, p. 163. 102 Estrin and Holmes, and, p.420. 103 C. Alan Garner, “Uncertainty in Keynes’ General Theory: a comment”, Vol. I, p.438-441. 104 Garner, and, p. 440. 105 Garner, ibid, p. 440.

80 John Maynard Keynes and his work in the insurance market Garner concludes his article stating that, for Keynes, expectations are not created in the first moment of probability distributions; instead, they would be produced by the human mind, under conditions of imperfect information.106 Finally, the last article we comment is focused on the theme of uncertainty.107 According to Stohs, economics often adopts the full knowledge of the case, including knowledge about the future, of an economic situation. The author argues that:

“if economic theory is to have as much credibility as the reliability of our knowledge of the future, then it is apparent that economic theory cannot be very reliable. Lack of knowledge about the future is the basis of the uncertainty that investors face when making investment decisions.”108

For Stohs, the concept of uncertainty that has gained prominence in the “General Theory” of Keynes is expressed in terms of the psychological propensities employed in his theory, and, as we saw earlier, is not con- ceptualized in the theory of probability. In investment activity, uncertainty consisted in low confidence that investors showed in their calculations on expected returns. This low confidence resulted from a lack of knowledge about the future, and this lack corresponded to the low weight of the calculation on expected returns.109 Keynes was the first economist to place the theme of uncertainty as one of the pillars of his theory. This importance given the uncertainty factor has the parallel effect of creating distrust about the weight of rationality in economics. Indeed, if the world is uncertain, how to be rational in these circumstances? In case it exists, to what degree? How it is specified? An economist, who remained forgotten many years and, one can say, os- tracized, gained international fame (after his death) with the financial crisis of 2008. His name is Hyman P. Minsky. He devoted much effort in his academic life to studying the issue of uncertainty, and was an admirer of the intellectual work of Keynes.

106 Garner, ibid, p. 441. 107 Mark Stohs, “Uncertainty in Keynes’s General theory: a rejoinder”, in Blaug, Volume I, p. 442-446. 108 Stohs, Uncertainty in Keynes, p. 442. 109 Stohs, Uncertainty in Keynes, p. 445.

7. Risk and uncertainty 81 In his book, “John Maynard Keynes”, published in 1975, Minsky stated that Keynes revolutionized economic thought. Keynes’s work incorpo- rates a number of advances and radical changes in economic thinking. Unfortunately, according to Minsky, in the process of reaching the standard version of the thought of Keynes, this revolution was aborted. Minsky’s effort was to try to recover the revolutionary core of Keynes embedded in his economic ideas.110 The main work of Minsky was in the area of financial instability. Given his interests in the subject, he was attracted by the thought of Keynes. In particular, the uncertainty theme. According to Minsky, “a description of uncertainty and decision-making under conditions of uncertainty had been, for many years, intellectual interests of Keynes... decision-making under uncertainty, which Keynes had examined in his “A Treatise on Probability” is the central theme of “The General Theory”.111 Minsky quotes a discussion between Keynes and Jacob Viner (University of Chicago), where Keynes says:

“it was assumed in the past that facts and expectations could be dealt with in a defined and calculated manner; and risks, which, it was admitted, were not given much importance, were assumed that they could be measured by an exact actuarial computation. It was assumed that the calculation of probability, although it should be mentioned that did not receive a lot of highlight, would be able to reduce uncertainty and place it in the same calculable level of certainty itself.”112

Minsky then explains what Keynes considered as “uncertainty”, and how the concept differed from “probability”. In the words of Keynes:

“by “uncertain” knowledge (...) I do not wish to make a mere distinction between what is known as right from what is only probable. The game of roulette is not subject, in this sense, to uncertainty (...) in the same way, life expectancy is only slightly uncertain. Even the weather is

110 Minsky, John Maynard Keynes, preface. 111 Minsky, John Maynard Keynes, p.64 and 66. 112 Minsky, ibid, p.66.

82 John Maynard Keynes and his work in the insurance market only moderately uncertain. I use the term in the sense of stating that a war in Europe is uncertain, or the price of copper and the interest rate in twenty years, or the obsolescence of a new invention, or the ranking of private wealth holders in the social system in 1970. With respect to these matters, there is no scientific basis on which to form any calculable probability.”113

For Minsky, uncertainty plays a very strong role in determining the behavior of: (i) portfolio investment decisions by households, companies and financial institutions; and (ii) in the assessments of companies, owners of capital assets and banks, granting loans to companies on future returns of capital assets.114

113 Minsky, ibid, p. 66. 114 Minsky, ibid, p. 67.

7. Risk and uncertainty 83

CHAPTER 8 Speculation and investment

KEYNES, LIKE DAVID RICARDO, WAS ALSO A SPECULATOR AND, A RARE FACT AMONG ECONOMISTS WHO HAVE TRIED, OBTAINED GREAT SUCCESS IN THIS ACTIVITY. KEYNES WAS PERHAPS THE MOST IMPORTANT FOLLOWER OF IRVING FISHER, A LEADING AMERICAN ECONOMIST, BY POINTING OUT PSYCHOLOGICAL REASONS FOR INVESTMENT AND SPECULATION.

Gilson Schwartz, in his book “The Capital in Play: Philosophical Founda- tions of Financial Speculation,” produces an examination and a very original assessment of John Maynard Keynes’s contribution to economic thought. There is currently a consensus that Keynes was the main responsible for changing the conception that economists had over the capitalist system. Schwartz studies the philosophical foundations of Keynesian thinking, and relates them with logic issues and probability theory, to then discuss the proposals of economic policy of the famous English economist. On a more general level, macroeconomic, Schwartz notes that the economic process is seen as a game whose end is unexpected, but imminent and abrupt. According to Schwartz,

“the capitalist economy is to Keynes primarily an organizational dynamic that unfolds in the contradictions between financial uncertainty and monetary conventions, i.e., the successes and blunders between

8. Speculation and investment 85 temporality and the institutions that manage the conventional time. There is a confrontation between the individual decision and the attempt to build organizational and behavior models subject to logics of essence or to moral and cultural standards. In Keynes, instead of the spatial figure of the market, which constrains orthodox marginalist views, there is in the foreground the “time”, the problematic future of a system whose rules can suddenly lose their meaning, which is nothing more than the speculative concern by excellence of capitalist investors (p. 16).”

It is worth reproducing the following observations made by Backhouse in his book “The Ordinary Business of Life”, while analyzing the issue of speculation in Keynes’s vision. For Keynes, facing existing uncertainty, the investment would not depend on a rational calculation of future returns, but of the state of confidence. In practice, expectations are governed by conventions, in particular the expectation that “the existing state of affairs will continue indefinitely, unless there are specific reasons to expect a change”. The implication of this, that expectations are based on conventions, is that they are prone to drastic changes in response to seemingly small changes in the news. The situation is worse in the financial world, as noted by Keynes, because investment policy is dominated by professional speculators. Thus, people do not try to make the best long-term decisions, but are concerned with how the prices of stocks traded in the market will behave, which means that they always try to imagine how other people will react to the news. The result is a great instability. As analyzed by Ingrid Rima in his book Development of Economic Analysis, due to the work and the importance of Keynes, a branch of economics called Keynesianism appeared. This branch of the economics was very important during the 1950s and 1960s, lost importance with the advent of Monetarism and the ideas of Mil- ton Friedman in the 1970s and 1980s, but still maintained a prominent role. There emerged, beginning in the 1970s, controversies about Keynesian economics. A line of thinking, known as New Keynesian, sought to make reconciliation between Keynes, monetarists and neoclassicals. However, another line of thinking, which will be the subject of our analysis, consider that the dominant economic theory in our days is incompatible with Keynes own analysis. This line of thinking, known as Post-Keynesian, much associated with Cambridge University, from England, places great emphasis on institutional forces.

86 John Maynard Keynes and his work in the insurance market Regarding the crisis, the Post-Keynesians break with the New Keynesians, who consider that in the absence of external shocks, the economy tends to move towards equilibrium. For Post-Keynesians, however, instability is endogenous to the system. This instability, in this line of thinking, reflects the uncertainty that charac- terizes the real world. Although most economists – and econometricians, no doubt – emphasize the possibility of transforming uncertainty into certainty (but with existing risk) by calculating the probabilities, the Post-Keynesians reject this hypothesis. Companies and investors are faced with the need to make decisions about investments and financial assets, but the decision rules, based on probabilities, are irrelevant in a world of uncertainty. The effect of uncertainty, which interferes in the decision-making of companies, becomes broader in a modern economy, of sophisticated use of capital, due to the existence of multiple capital assets and financial instruments. The current practice is to finance long-term capital assets through speculative finance, i.e., by issuing new debt. Since the future is unknown, such financing occurs between environments of alternating waves of euphoria or despair. There is a creation, therefore, of a fundamentally unstable environment, characteristic of modern capitalist economies. A great merit of Keynes was to emphasize the issue of intuition and psychology in macroeconomic analysis. His analysis of the role of investment in determining the level of income in the economy, and the role of investor entrepreneurs to decide these investments based on their “animal spirits”, was very fertile for subsequent ideas of modern macroeconomics. In particular, it is worth reviewing a chapter in the Keynes’s book “The General Theory of Employment, Interest and Money”, in commenting on the state of long-term expectations: a. Keynes in this chapter analyzes the factors that determine the expected return of an asset; b. Investments in capital depend on psychological expectations covering the long-term; c. This expectation will depend not only on profitability estimates, as well as the confidence with which the estimates are made; d. The state of confidence is the inverse of the level of uncertainty, and should be taken into account that, when forming the expectation of

8. Speculation and investment 87 profitability, it is assumed that this initial profitability will continue indefinitely; although practical considerations show that not be true; e. Experts and investment professionals, because of their higher qualifica- tions compared to ordinary investors, could improve the confidence of long-term forecasts; f. According to Keynes, however, these professionals are concerned “not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence” (p. 99); g. The investment markets are organized placing priority on ‘liquidity’; h. According to Keynes, “Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. (...) The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future.” (p. 99); i. According to Keynes, “there is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable.” (p. 100); j. Keynes draws a difference between speculation, which is the activity of predicting market psychology, and entrepreneurship, which is the activity of predicting the expected rates of return for the lifetime of the project; k. Keynes considered very serious the situation in which the company becomes a bubble in the speculation carousel. According to him, “when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” (p. 101). Stock exchanges if organized as investment markets aimed “liquidity” will become like casinos; and l. Keynes was a speculator in commodity markets, and made a fortune with his activities. His conclusion was that markets were fundamentally inefficient. According to him, “we devote our intelligences to anticipating what average opinion expects the average opinion to be” (p. 100).

88 John Maynard Keynes and his work in the insurance market PART IV British economy between the wars and the financial crisis of 1929

n the fourth part, we will comment on the historical I context of economics, finance and insurance in Britain in the period between the wars. We’ll see how this experience and performance of Keynes shaped his thinking on investment strategies.

CHAPTER 9 Context of the economic history of Britain

KEYNES LIVED IN AN AGE OF EXTREMES. AT THE BEGINNING AND END OF HIS LIFE, HIS WORLD WAS HOPE, PROGRESS AND TRAN- QUILITY. FOR MUCH OF HIS ADULT LIFE, HOWEVER, HE LIVED IN A WORLD OF HATRED, CHAOS, CRISIS AND WARS.

Keynes worked in insurance companies in the interwar period. The economic history of that time presented as main characteristic a low economic growth in Britain, Western Europe and the rest of the world. There was the Crisis of 1929, the unemployment of large masses of the population of developed countries, hyperinflation in Germany and other central European countries, the seizure of power by fascist regimes, the Nazis and Commu- nists, and the Civil War in Spain. Let’s start this chapter with a longer-term vision, embracing the world economy as a whole, from the point of view of the forces of economic growth. In the rest of the chapter, we will carry out an analysis of the main economic and financial events of the period. This long-term vision is based on the work of Feinstein, Temin and Toniolo.115 If we turn to the past of the rich countries today, we find that in the first half of the nineteenth century the average standard of living of its population was too low. As noted by Feinstein, Temin and Toniolo:

115 C. H. Feinstein, P. Temin and G. Toniolo, “The World Economy between the World Wars” (2008).

9. Context of the economic history of Britain 91 “during the early part of the nineteenth century, and in some regions for longer than that, the standard of living – food, clothing, housing, life expectancy and literacy – of the representative peasant family of the most advanced areas of Western Europe and North America had far more in common with the standard of living of their medieval ancestors serving in the lands of lords, than with their great-grandchildren living in the post-World War II. Most industrial workers did not live much better, since they were huddled in dirty cities and endured since their childhoods long weekly working hours in unhealthy conditions.”116

In the following 100 years, a major transformation of the economic and social conditions of the richest countries of Western Europe and North America would be observed. Modern economic growth was underway. This phenomenon is characterized by large structural changes, growth of per capita income, significant increase in consumption and savings, and increased in the relative share of industry, trade, transportation and modern services in the GDP. Another feature of this process is the growing international movement of goods, services and capital. In this sense, Britain was leading the first wave of “globalization”, which happened in the world between 1860 and 1913.117 Below is a table comparing the economic growth of Western Europe with the world at large.

TABLE 4. AVERAGE ANNUAL RATES OF GDP GROWTH, 1870-1998, WORLD AND WESTERN EUROPE

Years Western Europe World economy

1870-1998 1.74 1.48

1870-1913 1.32 1.30

1913-1950 0.76 0.91

1950-1973 4.08 2.93

1973-1998 1.78 1.33

Source: C. H. Feinstein, P. Temin and G. Toniolo, “The World Economy between the World Wars” (2008), p. 8.

116 Feinstein, Temin and Toniolo, ibid, p. 6. 117 Feinstein, Temin and Toniolo, ibid, p. 7.

92 John Maynard Keynes and his work in the insurance market It is observed in the Table that in the period between the wars – approxi- mately the years 1913-1950 here – Western Europe had its worst growth phase. Not only it was lower than in other phases of the 1870-1998 periods, but even their growth rate of GDP in the period between the wars lower than the world at large. According to Feinstein, Temin and Toniolo, the GDP of Western Europe went through major changes in the years between the wars (1919-1939). It grew in almost all years of the 20s (3.5% per year between 1920 and 1929), and had a poor performance in the 30s (0.7% per year between 1929 and 1939).118 Great Britain’s GDP had a bit better behavior than the rest of Western Europe’s, growing 1.3% annually between 1913-1950. The major economic and social problem of the 30s was the high level of unemployment. As we mentioned earlier, it was not without reason the commitment of Keynes to combat unemployment. Business history, including financial history, suffered a major discontinuity in 1914. Going back to the nineteenth century, there was a long period of almost 100 years, in which financial and insurance activity was developed, both in terms of products and markets, and in terms of institutions. Among the advances observed, we can list the adoption of the gold standard by many countries (facilitating the flow of capital between them), setting up banks under the form of corporations, monetary management, international loans on a large scale, and the increase of the importance of stock exchanges. The Great War caused a huge monetary and financial disorder. Soon after its outbreak in 1914, there was a financial crisis. In previous months, the presage of war had caused great unrest markets. In early July, the Bank of England raised the discount rate from 3% to 4% and then to 9% with the declaration of war on July 31, and the following day to 10%. Financial panic spread in the markets, stock markets suspended their business, and there was a liquidity crisis among banks. In the US, the dollar depreciated against the pound sterling. In Germany, there were bank runs and stock prices plummeted. In the main belligerent countries, the question of how to finance the war effort came to the fore. The three classical solutions would be issuing debt, printing money or raising taxes. England chose to sell assets abroad and taking on debt.

118 Feinstein, Temin and Toniolo, ibid ps.9 and 10.

9. Context of the economic history of Britain 93 With the signing of the armistice by Germany at Versailles, and the end of the war, the allies – mainly instigated by France – demanded reparations and indemnities. We have commented in another chapter their negative consequences for the international economy. German hyperinflation was quite violent, breaking down the country with repercussions on the financial markets of other countries. There are two explanations for what happened. The first explanation points to exchange rate issues and Balance of Pay- ments in Germany. Due to the excessive burden of war reparations, deficits soared, and the exchange rate ended up much depreciated. As a result, import goods prices raised too. The rise in prices spread, and the monetary authorities, fearing unemployment, increased the money supply, triggering inflation and escalating to hyperinflation. The second explanation is monetary. The Reichsbank would have “over- played their hand” by excessively expanding money supply, which served to repay government loans to cover fiscal deficits. The higher domestic prices lead to imbalance in the Balance of Payments, in this monetarist view. The pinnacle of German hyperinflation was between December 1922 and June 1923. To illustrate, the exchange rate Deutsch mark / US dollar rose from 16.51 marks in June 1921 to 43.72 in December of that year then to 1,807.8 in December 1922 and 26,202.0 in June 1923.119 The hyperinflation ended with the loss of credibility of the currency (replaced by the dollar, gold, etc.), and a very high social cost to Germany. Examining the situation in Germany, the opinion of Keynes, expressed in the book “Tract on Monetary Reform” (1924), was that inflation was a fight between the active elements and community workers and the rentiers, those who held debt securities in their investment portfolios. The workers resisted giving too much income to the rentiers, provoking distributional tensions that caused the expansion of currency and rising inflation.120 To Kindleberger, Keynes’s vision was a precursor of the social theory of inflation, which is also known as structural. When two sectors fought to increase their share of income, often times the government, rather than mediate the conflict, or decide who would lose (to Keynes, it should be the rentiers), it would prefer an escape way by printing currency and letting inflation increase.

119 Kindleberger, A Financial History of Western Europe, p. 303. 120 Keynes, Tract on Monetary Reform, p. 72.

94 John Maynard Keynes and his work in the insurance market Kindleberger concludes that:

“the German hyperinflation of 1921-23 was much more than a financial phenomenon and had deep roots in the socio-political condition of the German people, who were not willing to pay the burden of war, reparations and support their compatriots in the Ruhr by explicating the decisions of partition, but on the other hand opted to print money and let a chaotic inflation tax decide the outcome.”121

A dramatic episode for Britain was the policy of restoring the pound to the gold standard. With the end of war in 1918, Great Britain, as well as the France and Germany’s economies, was flooded with liquidity. Almost half the costs of the war were paid for with fiscal deficits, and these were largely financed by monetary expansion. Another part was funded by the issuance of debt securities. In Great Britain, months after the end of the war, business began to grow, taking advantage of the void left by Germany in the production of several industrial sectors such as coal, steel, textiles, navigation, ship building, etc. The “boom” pressured prices of raw materials and semi-finished products, and ended up stimulating the capital asset market. There was the belief, widely held in financial and political circles, that it was necessary to return to the gold standard that existed before the Great War. It was thought that with this measure Great Britain would regain its previous economic growth and prosperity. This return to the gold standard should be made in expense of any sacrifices that were needed to force down wages and prices, so that the currency values could be restored. The attempt to reach this gold standard reconstruction lasted some years in Britain, and caused much controversy. The British government, already in 1918, began preparations for restoring the pound sterling for the convertibility into gold, fixing the old pairing, before the war, valuing £ 3 17s 10 1/2 d per ounce of gold, 0.917 “fine”. At the time, alternatives were not discussed, such as free-floating exchange or conversion at a price different from that prevailing before the war. Great Britain tried to persuade other European countries to adopt the gold standard, and to promote greater cooperation between the central banks of these countries. After years of discussion, finally in 1925 there was a

121 Kindleberger, Financial History, p. 314.

9. Context of the economic history of Britain 95 return to the gold standard. The cost of this policy was too big, and failed to maintaining parity. In the mid-20s, Keynes engages in controversy, by expressing his opinions against the attempt by the British government to return to the gold standard. His opinions are published in 1925 in the book “The Econom- ic Consequences of Mr. Churchill”. Keynes discusses and questions the reasons for the decision of the return to the gold standard, analyzes the consequences of return, and very typical of his penchant for economic policy, points out some possible remedies to mitigate the potential negative consequences.

96 John Maynard Keynes and his work in the insurance market CHAPTER 10 Keynes and the financial crisis of 1929

AT THE END OF THE DECADE, THE EVENT TAKES PLACE THAT WOULD MARK THE FOLLOWING YEARS, VIRTUALLY UNTIL THE SECOND WORLD WAR (1939-1945): THE CRISIS OF 1929.

The country that suffered the greatest impact from the Crisis of 1929 was the United States. The crisis there was very severe, but recovery still came in the 30s (although there was a relapse of the crisis in 1937). According to McElvaine, talking about the United States,

“from the top of the prosperity in 1929 to the bottom of the depression in 1933, GDP fell a total of 29%, consumer spending fell 18%, construction 78% and investments an incredible 98%. Unemployment rose from 3.2 to 24.9%. By any standard that you use, the United States was in its worst crisis since the Civil War”.122

In England, the crisis was less severe, though more lasting. In fact, while in the 20s the United States was living in great exuberance, England was still skidding, covering their losses in physical and human capital caused by World War I, and the subsequent loss of business dynamism thereof.

122 McElvaine, “The Great Depression”, p. 75.

10. Keynes and the financial crisis of 1929 97 In fact, after World War I, Britain was permanently left behind from its position – in the nineteenth century – of leader of the world economy.123 To better characterize the context of the 1929 crisis, we will report to another book of my own, “Financial Crisis”, which describes and analyzes the financial episode.124 According to Mello and Spolador, there is a large literature on the “Great Crash”. After all, this was the most traumatic episode, until then, in the financial history of the world. There is already some consensus on how the events were set off and the sequence in which they occurred. What is more discussed is which the causes of the events were, and there are several interpretations, from which we selected a few, as explained below. Let’s start with the sequence of events. In the American economic literature, usually the “Crash” in the stock market is discussed in conjunction with the Great Depression. According to Walton and Rockoff,125 the Great Depression was the most important economic event of the twentieth century. Between 1929 and 1933, the American economy collapsed. In the real side of the US economy, the introduction of new production technologies, such as assembly lines for automobiles and other industrial activities, and the receipt of payments in the form of loans in the Great War, contributed to the economic boom. However, due to the existing pattern of income distribution, consumption failed to keep up production. The price of shares, in a growing spiral of incline, suffered large declines in 1929, reflecting deeper problems of the economy. The crisis spreads to the rest of the world. According to the authors, it is almost impossible to describe vividly the great terror and misery produced by the great depression. The numbers, however, give some idea: unemployment rose from 3.2% of the workforce in 1929 to 24.9% in 1933. The Gross National Product declined 46% in this period. According to them, hunger and fear paralyzed the country.

123 To the “despair” of Keynes, who never got over the fact this was England’s destination. 124 Pedro Carvalho de Mello and Humberto Spolador, “Crises Financeiras”, 3ed. 2010. 125 Gary Walton and Hugh Rockoff, “History of the American Economy”

98 John Maynard Keynes and his work in the insurance market The picture in the rest of the world was no less terrifying. As reported by Rondo Cameron,126 the Great Depression hit very severely Europe and Latin America, via capital flows and the international commodity trade. In 1931, Keynes wrote an article analyzing the financial crisis.127 On July 13, 1931, the pound sterling was under a lot of pressure in foreign exchanges, due to the financial crisis in Austria, Germany and Central Europe. The Bank of England was trying to defend the gold standard. The Prime Minister, Ramsey MacDonald, wrote to Keynes on August 2, 1931, asking for advice. Keynes replied on August 5, criticizing the British government’s policy, which, according to him:

“made effective the existing deflation, by forcing a reduction in income to the price level. They (here referring to the recommendations of the MacMillan Committee on Finance and Industry) are part and parcel of the policy of seeking equilibrium through general reductions in wages and salaries, and these recommendations would be, if seen isolated, a huge perversion of social justice... my advice is that we should not try to make the deflation effective, because, apart from the issue of it being inherently undesirable, I am convinced that this attempt would be futile and a disaster.”128

The most complete analysis of this crisis, in terms of its international reach, is presented by Kindleberger.129 Analyzing the initial steps of recovery, Kin- dleberger points out that Brazil, having begun its import substitution process in World War I, advanced significantly to become independent of foreign markets, and ended up in a strong position to continue this process during World War II. It is important, while describing the Great Depression, to make a distinction between the forces that caused the initial decline in economic activity, and those who turned a recession into a depression and a major economic disaster. According to Cameron, the “Great Crash” of the stock market was not the cause of the depression – it had already begun in the United States as in

126 Rondo Cameron, “A Concise Economic History of the World”. 127 Keynes, “The 1931 Financial Crisis”, in Moggridge, ed., The Collected Writings, Vol. XX, “Activities 1929-1931. Rethinking Employment and Unemployment Policies”, p. 589. 128 Keynes, “The 1931 Financial Crisis”, p. 590. 129 Charles Kindleberger, “The World in Depression, 1929-1939”.

10. Keynes and the financial crisis of 1929 99 Europe – but it was a clear sign that depression was on the way. In the “New York Times Index” of the top 25 industrial stocks, which in early 1924 reached 110, had already risen to 338 in January 1929, and soared further to 452 in September of that year. It was almost impossible to buy a stock without its price going up shortly thereafter, and investors amassed great fortunes. Many concluded that the permanent prosperity had arrived. Some, however, began to feel uneasy. President Hoover, along with some directors of the Federal Reserve, was worried about excessive speculation and the danger of a crash. In August, the Federal Reserve raised the discount rate (the rate at which it lent to system member banks) to 6%, as an attempt to control the credit flow to the stock market. Similar initiatives were being taken by the Bank of England and other European countries. No use: stock prices continued to rise. On September 5, Roger Babson, a respected analyst and columnist of the financial press warned that a crash was coming. The market felt, prices began to decline during the month of September, though very little, and no sign of panic. A major break occurred in late October. On 23 and 24 October (“Black Thurs- day”), there was a trading volume of 13 million shares, downward, when the normal daily volume was 3 million. Banks and investment houses went buying, but they could not alter the downward trend. There was something strong in the air, however. As Galbraith noted130, already on the 24th investors crowds screamed in Wall Street gates, and the police had to be called. On October 28 (“Black Monday”) and October 29th (“Black Tuesday”), panic seized the market. According to Galbraith, “Black Tuesday” was the most devastating day in the history of the NYSE as it combined the worst elements of the previous days: volume greater than “Black Thursday”; prices falling almost equal to the “Black Monday”. On “Black Tuesday” 16.4 million shares were sold, a sales frenzy caused by panic. On Black Monday and Tuesday, the average value of shares fell by about 25%. Stock prices continued to decline until mid-November. By then, stock prices were half of what they were worth in August. Much of the panic selling resulted in brokers selling stocks bought on margin accounts. The margin accounts were credits given to brokers to allow customers to purchase shares without having all the resources. In this system, the shares were deposited as collateral.

130 Kenneth Galbraith, “The Great Crash-1929”.

100 John Maynard Keynes and his work in the insurance market It is interesting to note that, despite the collapse, in 1930 stock prices were still above the levels reached in 1926. If all that had happened was the loss of the extraordinary capital gains achieved in the years 1927 and 1928 it would be rash to attribute the fall of 1929 as the cause of depression – after all, easy comes, goes easy. According to Walton and Rockoff, the huge psychological trauma caused by the crash was far more significant than the loss of experienced wealth. Many Americans believed that economy had entered a “New Age” of continuous and rapid progress, which would lead them to ever higher living standards. The rise in stock prices was seen as proof of that. The stock market crash represented a collapse of optimism, which affected consumer confidence and started the decline in economic activity. The crisis spread, occurring after a spectacular banking crisis. What were the causes of depression? We find, in the existing literature on the subject, two basic interpretations, a monetarist and a Keynesian. For monetarists, in particular Milton Friedman and Anna Schwartz, the main cause was a decline in the monetary stock. The decline was produced by the withdrawal of money from the banking system by the decision of the banks to increase their voluntary reserves. To increase their reserves, they had to cut their lending, producing enhanced effects of contraction and worsening the liquidity crisis in the economy. This made consumers reduce their consumption, causing a drop in the GNP (Gross National Product). According to the monetarists, the velocity of circulation of money also fell. The banking crisis would have been aggravated by monetary policy mistakes, which caused the contraction in liquidity in the economy. Although the importance of the monetary factor is not put into question, other economists, of more Keynesian inspiration, question the weight that it should be given to this question. Peter Temin fits in this group.131 The author presents an integrated view of depression, covering the experience of Britain, France, Germany and the United States. He describes the causes of depression, because it was so dispersed and so prolonged, and what caused its eventual recovery. According to Temin, the GDP fell due to lower consumer spending and a collapse in investor spending. Because of this fall of GDP, profits were reduced, workers lost their jobs, and firms and people went bankrupt. That is what caused the monetary contraction and the banking crisis.

131 Peter Temin, “Lessons from the Great Depression”.

10. Keynes and the financial crisis of 1929 101 As evidence, he points out that the interest rate was falling, which would be incompatible with a considerable decrease in money supply.

Monetarists contend that the interest rate is the price of money, not credit. Credit declined due to the fall of GDP, caused in turn by monetary contraction. Some authors recently presented the argument that there had been “asymmetric information”, causing a credit crunch crisis, which in turn sparked the other crises.

A different view of the two previous interpretations is made by Paul Bairoch.132 He questions the view that trade protectionism was what caused the crash of 1929 and the depression that followed. According to him there are three myths behind this hypothesis, which he shows to be wrong, namely: the first was thinking that there was a growing protectionism in trade policies adopted in the 1920s, which is not true. The second is related to the magnitude of the depression, which was much less severe and less general than it is imagined. The third, and final myth, concerns the performance of the Nazi-fascist economies during the depression, which was not as exceptional as is propagated. The global recovery was slow after 1933. It was also very uneven, in a world still quite unintegrated. With the Crisis of 1929, stock and commodities prices fell much, making recovery difficult, even after the resumption of liquidity in the markets. There were several banking crises, and the political world was in open boiling, with the right and left extremism polemicizing world politics. For Kindleberger,

“the 1930s are a dismal chapter in the monetary history of Europe. The World Economic Conference in June and July 1933 was a failure. Ger- many turned against the opening, and opted for authority and control of foreign exchange, Great Britain from gold standard and world trade moved to sterling area and preference for the Empire”.133

By the end of the decade, the economic scenario was very timid. The Second World War will reverse this situation and put the United States as uncontested political and economic leader. Great Britain was victorious in the war, but its glory days will stay behind.

132 Paul Bairoch, “Economics and World History – Myths and Paradoxes”. 133 Kindleberger, Financial History, p. 282.

102 John Maynard Keynes and his work in the insurance market CHAPTER 11 Finance, investment and risk in the british market

WITH REGARDS TO FINANCE AND INVESTMENT, THE INTERWAR PERIOD IN BRITAIN WAS MARKED BY VARIATIONS, DUE TO THE TURBULENT YEARS LIVED. IN CONCEPTUAL TERMS, PRIVATE IN- VESTMENT (AND PUBLIC INVESTMENT, IF DONE ACCORDING TO RATIONAL ECONOMIC CONSIDERATIONS) IS DETERMINED BY THE EQUILIBRIUM OF TWO MAJOR FORCES: THE DEMAND AND SUPPLY.

Demand for investments depends on the marginal efficiency of capital, i.e., of the ordering of capital remuneration to be invested according to the declining rates of return [DITR]. The offer of investment is based on the financial cost of the supply of resources, measured by the interest rate (expressed by the curve that describes the price of offer of investment resources [SPOF] by volume of capital offered). The intersection of the two curves, demand and supply, determines both the market interest rate and the total volume of investments. Behind the demand and supply curves there are several factors that displace those curves, such as earnings expectations, risk factors and other economic forces. According to Matthews, Feinstein and Odling-Smee, there was a favorable shift of SPOF in two periods: the years before the 1914 war, and the years after the end of World War II. In both periods, there was a combination of higher capital accumulation rates and lower profitability rate.

11. Finance, investment and risk in the British market 103 The forces contributing to this favorable shift were (e) the reduction of capital market imperfections; (ii) a decline in the export of capital; and (iii) an increase in public sector savings.134 According to the authors, the reduction of the imperfections in the capital markets and the decline in the export of capital were continuous, also including the period between the wars. However, the declines took different shapes at different stages of the first half of the twentieth century. With respect to market imperfections, the authors argue that the benefits of companies transitioning to become corporations occurred primarily before World War I, particularly for manufacturers. The increase in the size of the companies was also continuous, contributing to a broadening of the capital market. The decline in exports of capital in the interwar period resulted mainly from the lack of opportunities, but its decline during World War II resulted from controls. The government savings growth occurred after the war, beginning in 1945.135 During the period immediately after World War II there was a relaxation of government controls affecting capital investment and bank loans, a decrease in taxation of companies, and an increase in personal savings. According to the authors mentioned, these three developments led to an increase in investment until the mid-1960s, but with different intensities at different stages of the period. The price of capital, according to them, would have declined for almost the entire first half of the twentieth century. Finally, the changes in money supply conditions and monetary policies affected the SPOF at several stages, though without producing any clear trend in the long run.136 As noted above, the demand for investments depends on the marginal efficiency of capital. According to Matthews, Feinstein and Odling-Smee, differences in domestic capital accumulation occurred between periods of peace before the Second World War were much lower in aggregate than in individual sectors.137

134 Matthews, Feinstein and Odling-Smee, “British Economic Growth, p. 372. 135 Matthews, Feinstein and Odling-Smee, ibid p. 372. 136 Matthews, Feinstein and Odling-Smee, ibid p. 373. 137 Matthews, Feinstein and Odling-Smee, ibid p. 377.

104 John Maynard Keynes and his work in the insurance market In business terms, the authors present the following comments: • Manufacturing: a higher level of investment than what effectively occurred in the years between wars would have brought good returns, at least in the long run. In the period before 1914 and the period after the Second World War it is difficult to discern a shortage of funding for investments and a substantially higher level of investment would likely bring diminishing returns unless there was a concurrent an increase in the quality of these investments;138 • Trade: the temporal behavior of investment in trade was different from manufacturing. Capital accumulation was low before 1914 and high in the interwar years. The accumulation increased in the period after World War II, more than in manufacturing;139 • Infrastructure: major general influences that affected investment in public utilities, transport and communication were the same that affected investment in manufacturing and trade. These influences were the pace of economic growth, the supply of financing, and so on. The level of investment was higher in the period after World War II than in the interwar. Its impact, however, was more complicated due to (i) changes in technology; (ii) changes in demand structure; (iii) the scope for increasing the degree of capital utilization; (iv) the dominant role of government; and (v) high capital intensity140; e • Real Estate: according to the mentioned authors, the investment in real estate is governed by economic considerations. Thus, one has to take into account that the demand for occupation of real estate presents elas- ticity greater than one with the total consumer spending. At the same time, it is sensitive to relative costs. The only period when property prices fell was between 1913 and 1937.141

138 Matthews, Feinstein and Odling-Smee, ibid p. 375. 139 Matthews, Feinstein and Odling-Smee, ibid p. 375. 140 Matthews, Feinstein and Odling-Smee, ibid p. 375. 141 Matthews, Feinstein and Odling-Smee, ibid, p. 375.

11. Finance, investment and risk in the British market 105 The authors conclude that:

“There is some evidence that during periods when industrial investment was low, the cost of finance was mitigated for investment in real estate and in some types of infrastructure. It can also be argued that the sharp drop in investment in manufacturing, caused by international competition, facilitated investment in real estate and infrastructure, and this explains why Britain had a better stock of real estate compared with other countries. It is much more doubtful to assert whether investment in manufacturing would have been significantly higher if the investments in infrastructure and real estate had been lower.”142

142 Matthews, Feinstein and Odling-Smee, “British Economic Growth”, p. 377.

106 John Maynard Keynes and his work in the insurance market CHAPTER 12 Insurance in Britain at the time of Keynes

FINANCIAL DECISIONS REVOLVE AROUND TWO FACTORS: RISK AND RETURN. ONE WAY TO REDUCE THE RISK IS VIA INSURANCE. ACCORDING TO KINDLEBERGER, THE SAME PURPOSE COULD REASONABLY BE ACHIEVED WITHOUT THE INTERFERENCE OF A FINANCIAL INSTITUTION.143

He comments that in Venice, in the thirteenth century, trade ships were built to be very small, to pulverize the risks of sinking, piracy or seizure by other powers. Only later insurance companies were created and ships increased in size.144 In the Baltic region, where the Hanseatic League operated, the three major sea freight companies located in Reval, around 1949, had to spread their cargo loads between nine, eight and seven ships respectively to get insurance against risk.145 Kindleberger presents other examples caused by lack of specialized institutions in insurance, and comments that the reaction of commerce was entering into several alliances – which also changed frequently – for acquiring ships and freight. According to him, this was the normal way of

143 Kindleberger, Financial History, p. 178. 144 Kindleberger, ibid, p. 179. 145 Kindleberger, ibid, p. 179.

12. Insurance in Britain at the time of Keynes 107 trading company. In this way, they could increase the mass of capital and reduce risk.146 Over time, the practice of raising capital by selling quotas (the embryo of shares) was spreading.147 The process of granting insurance that way was unproductive. This created incentives for institutional innovation, which ended up materializing with the creation of specialized companies, insurance companies. This development occurred by spurts of progress at certain times, in parallel with the development of other banking and financial institutions. Thus, great produc- tivity gains in transport and trade activities were achieved. According to Kindleberger, the origins of insurance from a financial point of view – including primitive forms of reinsurance – began in Italy in the fifteenth century.148 The merchants of the Hanseatic League did not progress much in this field, but the British and Dutch began to get into this activity in the seventeenth century. In France, fire and life insurances were rooted on a continuing basis only after the Napoleonic wars. Marine insurance, in turn, began early in the eighteenth century, however confined to shipping ports.149 The first insurance company in Britain – The Sun Assurance Company – was started in 1680 after the great fire in London in 1666. A major expansion occurred in 1720, at the time of the famous episode of speculation (which ended in a financial crisis) known as “South Sea Bubble”.150 One of Bubble characteristics was the creation of public companies, with pulverized shares in the public. In this process of company creation, two insurance companies appeared, the Royal Assurance and London Assur- ance. The “coffee houses” in London began to gather people dealing with marine insurance as early as the seventeenth century, and in 1680 the “Lloyd’s Coffee House” was the leader.151 Frederick Martin wrote, in 1876, a book about the history of Lloyd’s. The book is focused on the analysis of marine insurance, but in this book he describes the beginnings of the insurance market in England. It presents

146 Kindleberger, ibid, p. 179. 147 Kindleberger, ibid, p. 179. 148 Kindleberger, ibid, p. 180. 149 Kindleberger, ibid, p. 116. 150 Pedro C. de Mello and Humberto Spolador, “Crises Financeiras, 3rd ed. 151 Kindleberger, Financial History, p. 180.

108 John Maynard Keynes and his work in the insurance market the story of German merchants of the Hanseatic League in London (the merchants of the Steelyard) and Italian merchants fleeing wars and settling down in London as “users” (Lombard Street). Martin describes the role of coffee houses as meeting points for people interested in maritime insurance risk, and how German traders, Lombards and English, gathered at the coffee house, created the Lloyd’s.152 The evolution of companies specializing in life insurance came next, after those of marine and fire insurance. Life insurance, at first, was done to ensure personal loans if the borrower were to die. That is, its purpose was to protect the capital used in the operation of the loan, and not to secure a peculium for the bereaved. In the eighteenth century in England, life insurance begins being offered to public persons, as a guarantee of adverse events, but this was considered illegal by the courts. However, the industry continued to try to be established, and by mid-century the first actuarial tables (“life tables”) were built. On this basis, it was possible to calculate life insurance premiums for policies. From there, the risk covering idea based on probabilities begins to be adopted for marine and fire. Kindleberger says that despite the technical progress, 50 years after the creation of the first two companies, there were only three insurance companies in England.153 Finally, it was possible to find legal ways to start stock companies, taking advantage of loopholes in the legislation (enacted after the financial crisis of “Bubble South Sea”) that restrained the creation of this type of company. The Phoenix Company and Equitable Assurance were formed in 1782, the British Fire Office in 1799, the Globe, The Rock, The London Fire and Atlas between 1803 and 1808. Between 1815 and 1830, over 29 companies were successfully founded, with highlights for the Alliance Insurance Company (founded in 1823). The idea and the practice of offering several classes of insurance is consolidated in England, and a powerful security industry arises.154

152 Martin, “History of Lloyd’s”, p. 52 to 65. 153 Kindleberger, ibid, p. 180. 154 Kindleberger, ibid, p. 180.

12. Insurance in Britain at the time of Keynes 109 According to Kindleberger,

“the insurance habit spreads widely in business, in British families and individuals of all income classes, which, above certain minimum income levels, sought to protect their current assets and, in the case of individuals, protect their families after their death.”155

The company “National Mutual Life Assurance Society”, which Keynes would become Chairman of the Board of starting on 1921, was founded in 1829. Shepard B. Clough, in his book “A Century of American Life Insurance,” states that insurers focused on life insurance are one of the most important social and financial institutions of modern times.156 According to Clough, the reason for life insurance, as well as other forms of insurance, lies in the very nature of the capitalist economy.157 In the past, according to him, society was organized in an essentially agricultural base, with families living in small areas and being largely self-sufficient.158 The exchange of products was done by barter. In the case of the death of the head of household, the children inherited. In return, they took care of parents in old age. In this type of society, there was no need for insurance. With the development of the capitalist system, this picture changed. As the capitalist system was asserting itself in society, the demand for life insurance was growing in parallel.159 According Clough, life insurers were not limited to their primary function of distributing the risk of death. For him, insurance is a form of savings. In- surance companies are very important to accumulate savings.160 To manage savings, institutional investment arises. It is in this context that the role of Keynes as administrator of insurance companies is to be understood. In a simplified view, insurance is a scheme to share the risks that are common to a large number of people, and involving losses that cannot be supported by only one individual. To make this scheme to work successfully, it

155 Kindleberger, ibid, p. 181. 156 Shepard B. Clough, “A Century of American Life Insurance”, p. 3. 157 Clough, ibid, p. 4. 158 Clough, ibid, p. 4. 159 Clough, ibid, p. 5. 160 Clough, ibid, p. 9.

110 John Maynard Keynes and his work in the insurance market is necessary to have: (i) a defined notion of which losses can be expected to occur in a number of equal risks; (ii) a number of people large enough wishing to divide this risk so as to create an average of expected losses; and (iii) that there are contributions of some sort from those who are willing to share risks, so that those who might suffer losses may receive a payment.161 What was the scene of the insurance industry in the years between the two world wars? What kind of social, political and economic conditions Keynes had to face to administer the National Mutual? Barry Supple, author of the book “The Royal Exchange Assurance. A His- tory of British Insurance, 1720-1970”, provides an overview of the British insurance industry in the 20s and 30s.162 According to Supple,

“between 1918 and 1939 the evolution of the British insurance was conditioned, as it had been in the previous two centuries, by economic change and social trends. However – as was illustrated by other aspects of British history in this period – these changes and trends not always went in the same direction. Although the economic crisis and political instability may have caused adverse effects for some types of insurances, in contrast to structural change, the long-term growth and new social habits rather expanded the market for other types. The net result was a continued expansion – but an expansion in which different types of insurances grew at different rates, thus changing (and in some respects radically changing) the basic standards of the British insurance”.163

Supple has a table, reproduced and adapted in our study, as in Table 5, on insurance premiums in the different modalities in Britain in the years 1916-1940. Fire insurance remained as the most conventional instrument. Its expansion would take place in overseas markets. The years between the wars, however, were not very conducing to services exports. It is observed that the premiums received in the fire insurance business rose from £ 32 million to £ 51 million. The fastest growing insurance in this period was due to changes in social habits and consumption standards. There was a notable expansion of automobile insurance.

161 Clough, ibid, p. 18. 162 B. Supple, “The Royal Exchange Assurance”, cap. 19. 163 Supple, ibid, p. 426.

12. Insurance in Britain at the time of Keynes 111 953 920 903 870 832 751 716 693 n.a. n.a. n.a. n.a. n.a. n.a. n.a. Sum 1.216 1.255 1.294 1.313 1.176 1.123 1.089 1.051 1.035 1.006 – Insurance Life Industrial Life Life 58.0 59.8 62.2 55.8 53.6 51.5 50.1 47.7 46.4 45.4 43.8 42.0 40.9 19.6 38.8 21.0 36.8 22.4 36.6 25.3 29.3 34.1 31.1 31.6 33.2 Industrial – Premium n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Sum 2.139 2.061 1.936 1.809 1.759 1.706 1.668 1.591 1.492 1.439 1.398 1.353 1.291 1.209 1.144 1.182 –Insurance Life Ordinary 7.6 5.7 4.3 7.9 7.7 7.3 6.7 6.0 5.5 5.7 6.0 5.8 2.1 5.8 2.8 5.5 4.1 4.9 6.1 6.6 4.9 4.6 4.9 4.5 4.5 Life – New Ordinary Life 83.9 84.1 82.8 80.5 77.3 74.3 71.5 71.4 67.9 65.3 66.8 69.8 30.2 68.2 30.5 63.9 33.8 58.5 37.8 41.9 57.9 44.1 51.5 45.6 46.8 – Total Ordinary – – – – – – – – – – – – – – n.a. n.a. n.a. 27.1 25.3 24.2 23.7 21.9 21.6 22.7 Accidents – Miscellaneous – – – – – – – – – – 55.8 56.3 13.1 54.3 15.8 51.7 19.2 48.7 23.7 33.5 44.5 36.4 40.8 34.0 37.5 Accidents: + Vehicles Miscellaneous – – – – – – – – – – – – – – – 37.9 36.6 31.9 37.4 35.3 33.3 31.9 31.3 31.8 32.5 Vehicle Vehicle Accidents 9.8 9.1 8.5 8.7 9.1 9.8 9.8 5.9 9.7 6.5 9.4 7.4 9.1 8.9 9.0 8.8 8.8 8.2 11.7 11.4 11.4 11.1 10.3 10.4 Work Work 11..6 Accidents 49.5 49.6 51.0 49.8 48.9 48.8 48.8 48.4 50.8 51.9 55.1 58.4 31.9 59.0 36.0 59.1 41.7 60.9 49.5 58.5 60.6 54.2 58.3 55.0 57.7 Fire (Net Fire Premiums) TABLE 5. INSURANCE PREMIUMS (IN MILLIONS OF £) OF FIRE, ACCIDENT E LIFE, GREAT-BRITAIN, 1916-1940 5. INSURANCE PREMIUMS (IN MILLIONS OF £) FIRE, ACCIDENT E LIFE, GREAT-BRITAIN, TABLE Year 1938 1939 1940 1937 1936 1935 1934 1933 1932 1931 1930 1929 1916 1928 1917 1927 1918 1926 1919 1920 1925 1921 1924 1922 1923 Source: Barry Supple, “The Royal Exchange Assurance. A History of British Insurance, 1720-1970”, p. 427.

112 John Maynard Keynes and his work in the insurance market The most important insurance branch, and with strongest growth, was life insurance. However, it was not very profitable. In Britain there was, at the time, the culture of “prudent businessman”.164 The premiums for ordinary life insurance increased from £ 30 million to £ 84 million. The business of life insurance even grew more between the wars than what it had grown in the period before 1914. It follows, therefore, that Keynes was, respectively, Chairman of the Board and director of insurance companies operating in branches where business was growing significantly.

164 Supple, The Royal Exchange Assurance, p. 433.

12. Insurance in Britain at the time of Keynes 113

PART V Keynes as chairman and director of insurance companies

inally, in the fourth part of the book, we will examine F the work of Keynes as chairman of an insurance company, and a director of another insurer. Through his writings, we study the kind of economic advice and financial strategy that he recommended to the National Mutual Life Assur- ance Society, where he was the Chairman of the Board, and to the Provincial Insurance Company, where he was director and gave professional advice.

115

CHAPTER 13 Investment and risk philosophies applied to asset management of insurance companies

IN THE BEGINNING OF THE 20S, KEYNES WAS VERY IMPRESSED WITH THE EDGAR LAWRENCE SMITH’S BOOK, “COMMON STOCKS AND BUSINESS CYCLES”, WRITTEN IN 1924. THE AUTHOR WAS A MEMBER OF THE ROYAL ECONOMIC SOCIETY.

In 1959 the book was published with the author’s own observations. He said that in the 20s to invest in common shares as part of an investment strategy was seen as heresy. Still very young he published the book, and was reviewed by Keynes.165 In the review of Smith’s book, Keynes defends the investment in company shares instead of fixed-income securities. He defends the idea of setting up “a well-chosen and well-diversified portfolio of common shares”.166 On April 14, 1923, Keynes responded to criticism about his views expressed in the 1922 and 1923 Reports, of the Insurer “National Mutu- al Life Assurance Society”. An article published in “The Daily Telegraph” criticized his investment policy, and Keynes wrote a letter to the Editor, defending his positions.167

165 Keynes, Review of “Common Stocks”, The Nation and Athenaeum, 1924. 166 Smith, p. 20. 167 Moggridge, “Collected Writings, Volume 12”, p. 128 and 129.

13. Investment and risk philosophies applied to asset management of insurance companies 117 Keynes looks to, in his response, clarify what he seeks with an “active investment policy.” In the aforementioned newspaper article, the critic said that there is a principle according to which an “active investment policy” is not preferable to an “inactive investment policy”, unless that the former can achieve, in the long run, a higher income than the latter. Keynes responds first with irony, saying what is preferred is a higher profit, not a higher income. But, according to him, since a higher profit leads to a higher income, the newspaper’s criteria can be accepted. Then, Keynes argues that when the average interest rate of the economy is falling, investments can appreciate without any increase in income. For him, however, the appreciation that indiscriminately applies to everyone is precisely the kind of appreciation that is not peculiar to an “active investment policy”. An “active investment policy” does not succeed, unless, over a period of years, it achieves more appreciation (or avoids more depreciation) that the average return of first class stocks, and that, consequently, leads to an increased income.168 Still in this response, Keynes protests against the idea that a differentiated investment performance should not pursued, vis-à-vis competitors. According to him, that is a fallacy. For him, the insurance company with the best performance in its investment policy will be better than the competing companies.169 On May 17, 1924, Keynes wrote an article that was published in the Nation and Athenaeum, with the title “Investment Policy for Insurance Compa- nies”. This article represents the thinking of Keynes on the subject, and is emblematic of his position as investment advisor to insurers. It will become clear, during the reading of the text, the extent of his economic, financial and political wisdom, as well as the sophistication of his investment analysis, disguised by easy and communicative language with which Keynes was addressing the public insurer. More than eighty years of its publication, the article is still very current, and can be incorporated into the strategic planning of Brazilian insurers. It is presented in the following translation (made by the author) of Keynes’s text, shown in its entirety:

168 Moggridge, ibid, p. 128. 169 Moggridge, ibid, p. 129.

118 John Maynard Keynes and his work in the insurance market “The issue of investment policy for life insurance companies has been much discussed in the last two years. The issues raised result not so much of new ideas, as new facts. The problem of a conscientious investment, as presented since the war [World War I], is clearly a new problem, and the world of life insurance is looking for their way to adapt new principles for the new conditions.

What was the investment field before the war? Leaving aside real property issues and reversals, advances in policy, and other issues, the main categories were: • Mortgages; • Limited selection of trustee securities, among which the consols were the main British title; • Shares denominated in US dollars; and

• The best classes of debentures of certain government and railroad bonds.

If the companies were to keep their average interest returns at a satisfactory level, consistent with not investing excessive capital outside of the first two categories mentioned above, there would not be a broad readiness to vary the proportions invested in different categories; and within each category there would not be much scope to gain advantage by moving from one bond to another.

Some insurance companies, however, were struggling to maintain a satisfactory level of interest return, which in some cases induced them to apply a portion of their resources in second class debentures of varied types – investments that on average did not bring good results.

During the War, there was, naturally, a large movement, both in the private and in the public sphere, in the direction of several new types of British Government Securities that were being issued. Many insurance companies got rid of almost their entirety of securities in dollars. Thus, with end of the war, several companies had a large portion of British Government Securi- ties, much higher than they had dreamed of possessing in the past.

Relative to previous years, there was not only a wider range of types of securities issued in the British Securities Trustee field, but also the compet- itive advantage of these pre-war investment categories was quite changed.

The return spread between First Class Mortgages and British Government Securities narrowed. The return on American Bonds no longer retains its former superiority relation with the return of Sterling Securities, in

13. Investment and risk philosophies applied to asset management of insurance companies 119 addition, doubts about the future course of the exchange rate introduces a new and harder factor.

All our old ideas about the safety of Foreign Government Bonds have been completely deteriorated, and the element of political risk must now receive a much greater weight than before.

Even some British Trustee Stocks need to be observed, and there is already reasonable doubt felt, that before the war would be unnecessary. Few investors, for instance, care to maintain a high position of India Stocks, and, as has been seen lately, circumstances may arise in which even the Colonial Stocks do not appear to be perfectly safe.

Thus, the issue of selection of titles cannot be resolved by the old Practi- cal Rules that were considered sufficient before. The wise investor must now doubt everything, and constantly revise his ideas, according to the changing events in the political world.

But not only new risks require a closer look. The frame of choice within a securities class creates new opportunities to obtain advantages, through judicious transfers that occur from time to time in relative prices.

Above all, the choice between short and long-term British Securities creates a problem with an aspect that varies constantly. I suppose that in the old days the choice between Mortgages and Consols had to be based on the same principles of choice of today between short and long-term bonds.

Essentially, this is an eternal problem. But the spectrum of choice effectively available for investment in securities, varying the term from the shortest to the longest, including those of any intermediate term (where available in large quantities), makes it feasible to act promptly on the basis of any based opinion that can be issued.

Most of the insurers, in some way, reach a consensus, but never support unanimously a single strategy, no matter how plausible and well-founded. Nevertheless, it is highly unlikely that the same proportional share of assets between short and long-term bonds is always correct. The same may change according to fluctuations in the business world.

Insurance companies have a special opportunity to take advantage of these fluctuations because it rarely happens that they face the need to reduce their aggregate assets. An industrial firm that maintains a portion of its net assets in Gilt-Edged Securities, to enable financing their businesses in particularly troubled times, inevitably becomes a seller from time to time.

120 John Maynard Keynes and his work in the insurance market Similarly, banks are likely to vary the volume of their investments in Gilt- Edged Securities to counterbalance the corresponding variations, in the opposite direction, of the amount of their Advances to customers.

When insurance companies sell, it is always to buy something else in its place, which puts insurers in an extremely strong position to benefit from demand fluctuations in the rest of the market.

Thus, it follows that the management of an insurance company is almost entirely directed, liking it or not, in what has been called these days as an active investment policy. Which, after all, is merely another name for being alert to the fact that circumstances change. Unfortunately, it is not possible to make someone permanently secured by any inaction policy, whatever it may be. The idea of some people that an active policy involves taking higher risks than an inactive investment policy is the exact opposite of the truth.

The inactive investor who adopts a stubborn attitude about his assets, and refuses to change his opinion merely because the facts and circumstances have changed, is the one who will suffer great losses in the long run. Par- ticularly these days, no one is so wise as to predict the very distant future. Those who stubbornly adopt the position that in the next twenty years the interest rate will fall, or will rise, is going beyond the evidence. If they want to wisely conduct their management, they need to adopt a short-term view, and be constantly prepared to change at the flavor of the changes of events.

It is equally false to believe that a form of investment involves adopting a vision, while other form does not. Each investment requires a position for a particular side of the market. The long-term securities holder is open for losses, which may even be very high, due to the depreciation of his capital. Similarly, a short-term securities holder is also open to a lower rate of return than one who planned their investments.

No one can have at the same time security of capital and income security; however, it is a great mistake to think that an insurance company, which depends on both, can neglect any of them.

It was the abandonment of these principles during the period that occurred between the “Era of cheap money” (1896/1897) and the beginning of the Great War (1914), which led to serious loss of capital for insurance companies, losses that can be seen in the financial statements and assets appreciation results. Depreciation of capital is the biggest en- emy of life insurance, and an active investment policy aims to both prevent loss of capital as much as obtaining capital gains.

13. Investment and risk philosophies applied to asset management of insurance companies 121 The ideal policy for an insurance company is to position itself, as much as possible, in a situation where it can achieve a respectable rate of return for its funds, while at the same time that ensures that the risk of really serious capital depreciation is minimal. This, naturally, is obvious. But, equally obvious, it is that there is no “golden rule” for this, no invariable method. And that, in itself, is the reason for constant vigilance, the constant review of preconceived ideas, the constant reaction to changes in the external situation; in other words, an active investment policy.

This seems to be an essential condition, but at the same time the most difficult and important task, to achieve a sound management of large Insurance Societies and Insurance Corporations, which currently administer such a considerable portion of national savings.” (article reproduced in Moggridge, 1971, Volume 12, p. 240-244.)

Smith’s book describes how he tries to prove, by way of a practical investiga- tion, the theory that common shares would be a good investment alternative. By common sense, debentures are often a better way of investment than common shares during periods when commodity prices are falling. Indeed, with commodities prices falling, it should be expected to industry profits to diminish, and as a result the dividends would be lower and the prices of common shares would fall. Meanwhile, still by common sense, the price of the debentures would naturally rise. Indeed, the interest rate of the debentures was fixed, but the interest rate of the economy tends to decline pari passu with the decline in commodity prices. Smith, however, disagrees with that common sense. Through empirical studies, he shows that even in a situation of commodities price fall, it is still worthwhile to invest in common shares. In the book, Smith simulates twelve different situations, with lists of randomly chosen common shares, in a 20-year period, and tests which would be the rate of return (dividends plus capital gains) on each investment alternative. Smith shows that, in all the cases mentioned, common shares had behaved better than bonds in terms of investment profitability. Smith’s studies were made with shares traded in the United States. Smith also argues that, in favorable phases of the cycle, companies retain profits, reinvesting them in the production process, and increasing the company’s future profitability and, consequently, of the investment in the common stock of that company.

122 John Maynard Keynes and his work in the insurance market Smith comments that the long-term trends of the common share price must be analyzed together with the short-term cyclical variations around this long-term trend. Smith, in his book, describes the main functions of investment management as:170 1. Establishing a consistent investment plan to meet the investor’s goals; 2. Determining what proportion of the fund under its management should be in stocks and what proportion should be in bonds, given the current industry and economic conditions; 3. Positioning itself in a position as to observe the changes in these conditions, and be prepared to modify these proportions in harmony with such changing conditions; 4. Studying the current conditions in several industries and industry groups, and select a diversification in those which, in a reliable database, may be assessed as being more promising; 5. Examining then the management and the financial structure of the leading companies in these industries; 6. Observing changes in the conditions of industries and, individually, corporations, and being prepared to change the investments in agreement with a solid analysis of the latest available information; and 7. Holding diversification as its fundamental principle, but establishing reasonable limitations for that diversification, in order to prevent dilution of the investment management quality.

Smith’s book contains several statistical analyzes of price series, and can be considered as one of the first books of technical analysis or ‘chartist’ analysis of stock investment. The performance of his technique was very poor in the 1929 crisis, and in the 1959 review of his book he tries to justify it. Keynes himself, at first enthusiastic about Smith’s technique, will abandon the strategy suggested in preceding years of the Crisis of 1929. The investment philosophy of Keynes kept changing over the years. In the beginning, he gave much emphasis to business cycles and conjectural macroeconomic forces. Over time, he began to devote himself more to the study of financial statements and company reports, turning to a “fundamentalist” analyst. This change can be seen in his 1936 writings, as explained below.

170 Smith, p. 41 and 42.

13. Investment and risk philosophies applied to asset management of insurance companies 123 Keynes’s view of speculation was also changing as he was gaining experience with the subject. According to Lawlor (p. 130), Keynes, in his notes for classes, in the 1910 period, related the following topics while examine the nature of speculation: • where the risks are incalculable, for example, political insurances made by Lloyds; • where the risks are more or less calculable, in two major groups: (i) the risks are not measured as averages, such as the Monte Carlo Roulette; (ii) the risks are calculated by average, and their coverage can receive premiums, such as life insurance and fire insurance; and • where the knowledge or judgment of the speculator is higher than the market. In this case, Keynes made the following subdivisions: → gambling; → insurance; and → speculation – not identical to the risk.171

As we mentioned in the previous chapter, the investment philosophy that Keynes intended to adopt in National Mutual suffered resistance from other members of the Board of Directors. On March 18, 1938, Keynes wrote a letter in response to criticism of F. M. Curzon, Board member of the National Mutual.172 At that time, there was an economic recession, and the insurance company suffered losses of £ 641,000. F. M. Curzon, the Acting Chairman (temporarily replacing Keynes, who had suffered a heart attack) started a discussion about the investment policy and demanded a settlement of the stock positions. It was the last year of Keynes as president of the insurer, and even temporarily removed, he tried to influence the Council by letter.173 In that response letter, Keynes explains his investment philosophy. The main points of the letter were:174

171 Keynes’s draft notes. 172 Moggridge, Collected Writings, Volume XII, p. 37 to 40. 173 Moggridge, ibid, p. 37. 174 My translation (and selection of excerpts) aimed to be true to the spirit of the letter, but it is not literal.

124 John Maynard Keynes and his work in the insurance market “My attitude is governed by the following general considerations... 1. I do not believe that selling at very low prices is a remedy for failing to sell when prices were very high... it would have necessitated an abnormal forecasting to notice the right time to sell; 2. I do not feel that one should criticize not selling at a better time... when, however, the price falls below a reasonable estimate of intrinsic value and long-term probabilities, nothing should be done... the right is to leave the paper quiet; 3. I do not feel ashamed of holding a stock when it reaches the bottom of the market... I do not think it is the business, let alone the duty, of an institutional investor or even a serious investor to be constantly considering whether to sell or to get out of a falling market, or feel open to criticism if the stocks depreciated it in their hands. Any other policy is antisocial, destructive to confidence and incompatible with the functioning of an economic system; 4. an investor should aim, or should be primarily aimed at the long-term results, and should only be judged for it. The fact of holding a portfolio with shares whose prices fell in a general market decline does not prove anything, and should not be the object of criticism; 5. it should certainly not be a good argument for disposing of the shares at the time that the market is least prepared for such; 6. the idea that we should sell to others and that we should all be left with nothing, except the money from the sale is not just merely fan- tastic, but destructive of the entire system; 7. the results should be examined over a longer period... if we deal with shares, it is inevitable that there are large price fluctuations; 8. If we do not make investments in shares, we must be content earning a lower rate of return, or should we be tempted to risks that are less apparent and take longer to mature, but in fact are much more serious than those associated with stocks.”

As head of a life insurance company, the theme of demographic and economic welfare, in a long-term perspective, was part of his concerns. In 1930, Keynes published an essay with the title “Economic Possibilities for our Grand- children”.175 As we mentioned earlier, the essay had been written before, when Lydia was pregnant with a child of Keynes, who ended up losing.

175 This essay became a chapter of the book “Essays on Persuasion”, p. 321-334.

13. Investment and risk philosophies applied to asset management of insurance companies 125 In this essay, Keynes tries to envision a scenario far away in time, saying:

“What can we reasonably expect about which will be the level of our economic life in a hundred years? What are the economic possibilities for our grandchildren?”176

Keynes, in the essay, estimated that the British, on average, in 2030 will be eight times better in the economic sense than in 1930.177 Keynes concludes the essay, saying that:

“I hope, therefore, that in days not too remote, that the biggest change ever seen to this day occurs, in the material environment of the life of human beings, in aggregated terms. But, naturally, it will happen gradually, not as a sudden change.

It even has already begun. The course of events will show that, simply, there will be larger classes and groups of people for whom the issues relating to economic necessity will have disappeared.”178

176 Ibid, p. 326. 177 Keynes, “Economic Possibilities”, p. 326. Keynes, apparently, will be correct in his projection. 178 Ibid, p. 331. Daring, but wise, the forecast made at the height of the Crisis of 1929.

126 John Maynard Keynes and his work in the insurance market CHAPTER 14 Keynes performance in investment management of insurers

THE MAIN TALENT OF KEYNES WAS INVESTMENT MANAGEMENT. KEYNES WAS VERY ACTIVE, IN THE CAPACITY OF INSURANCE COMPANIES’ MANAGER, TO DIRECT THE FINANCIAL MANAGEMENT OF THE SAME.

Much of Keynes’s professional life was associated with his role in the financial management of insurers he presided over. His role was not to participate in the day-to-day management, but to attend once a week, with a key activity of charting the strategic direction and investment policy. Keynes joined the Board of Directors of the National Mutual Life Assur- ance Society in September 1919 and became the Chairman of the Board of Directors in May 1921. He remained in that position for nearly twenty years, leaving the company in October 1938. He withdrew from the insurer due to illness and also to be able to devote himself to the British government in its war effort, but he continued to hold until the end of his life an informal and friendly relationship with the management staff. As we commented earlier, during the almost twenty years that he worked in the insurer, Keynes worked there a whole day once a week (usually on Wednesdays), and was responsible for writing the Annual Report.179

179 In Chapter 15 of this book we will examine each of these reports.

14. Keynes performance in investment management of insurers 127 These reports were anxiously expected by the financial community, given the academic respect and reputation of Keynes as an investment analyst. His opinion, on occasion, had the strength to influence the market price of shares.180 According to Moggridge, the Board of National Mutual had members with strong personality, and it was not unusual that there were disputes between members. A constant focus of the discussion was the investment strategy recommended by Keynes. The main points that caused controversy were: 1. for Keynes and Falk (Board member), the National Mutual should be more innovative and adventurous than its competitors, seeking to invest more in companies shares; and 2. the two proposed that evaluations to be annual instead of being made every five years, as was the custom in the insurance industry in England at the time.

Keynes also joined the Board of Directors of Provincial Insurance Company in December 1923, through Oswald Falk. In general, the theme of investment strategies occupied a large portion in the reports. In this discussion, Keynes sought to persuade the directors and shareholders of the advantages of a management based on a portfolio con- taining a diversification of shares. The usual behavior in the insurance industry, at the time, was to invest in fixed income securities. Keynes called this strategy “inactive policy”. Keynes saw this conflict between “interest rate” and “stock return” as more than a simple profitability of investment alternatives. That would be the “investor Keynes.” The “economist Keynes”, however, brought a moral stance to these discussions. For him, the “stock return” was more connected to the real side of the economy, the vigor of companies and job creation. This last point is the one that, in the background, concen- trated the actions of the “statesman Keynes”. Still on the theme of interest rates, Keynes is consistent in defending a low interest rate policy (but not too low), due to the impact in increasing investment and job creation. In the “General Theory”, Keynes develops a demand model for investments in companies’ capital, where the lower the interest rate, the greater the

180 Moggridge, Collected Writings, Volume 12, p.36

128 John Maynard Keynes and his work in the insurance market demand for investment. Since the investments had, in his conception, a multiplier effect on income, and the growth of this, in turn, was positively associated to employment, the corollary was that the lower the interest rate the more jobs would be created. During the years of economic studies, and in my subsequent academic life, an economic subject that intrigued me was the “liquidity trap”. A finance calculation and financial mathematics was built into the argument, which always seemed a step down from the “high macroeconomics” of other economists. Reading the reports finally solved my “puzzle”. The “General Theory” was written by a market player, with rare skills to be able to move from the world of microfinance to the insurance, to macro finance, to international finance, to corporate governance and to the great questions of theory and economic policies. A rare combination of talents, in a person with a privi- leged intelligence. I could attest, and agree, with the words of his wife Lydia Lopokova: “Maynard was more than an economist.” In all reports, Keynes emphasizes the importance of the stock market, and the link between companies and the real side of economy. The emphasis he puts in what is modernly called “corporate governance” is very important. Always the practical man, Keynes even suggested that insurance companies – major institutional investors in the stock market – joined forces to promote corporate governance. Thus, Keynes believes that there would be a double bonus: more stock investors, and better managed companies. An aspect that emerges from reading the reports written by Keynes is the high quality of economic and financial analysis. It is also clear the familiarity with which Keynes analyzes market deals. He does it in a way that seems to be written by a trader, someone who works every day in the financial market to make money (even if losing sometimes). Another notable aspect is the ease with which Keynes, from one paragraph to another, transitions between topics of the world economy and macroeconomics, to microeconomics and microfinance themes. In several reports, Keynes suggests new products for the insurance industry, based on his monitoring of long-term trends of Great Britain’s economy. It is also observed, in these proposals, the moral concerns that permeate his more works of academic nature. The ideas that Keynes presents, to suggest new products, generally in the segment of life insurance, make an interesting connection between consumption microeconomics and macroeconomics savings and demography.

14. Keynes performance in investment management of insurers 129 Even in the most intricate aspects of the insurance economy, Keynes shows great knowledge. He goes deep in his assessment of the actuarial techniques and methodologies for risk assessment and value of assets and liabilities, and manages to make a unique analysis of how the actuarial practice may materially distort corporate governance, lead to overly conservative investment practices and hurt the profitability of the company. Keynes expressed strong opinions, avoiding the “it depends” or “on one hand”, “on the other hand” and other ways that our profession uses to manifest. Keynes was assertive. The Insurer Reports were eagerly expected by the financial community in London. Keynes, the journalist, was more present than the academic economist Keynes. He deeply studied the management of the insurance liabilities. In his view, the actuarial techniques were well developed, and risk assessment – the basis for premium collection – quite adequate. Thus, the only avenue open to insurers would be to improve the management of assets, seeking to increase their profitability. Keynes called this strategy of “active policy”. For Keynes, the diversification of investments, and a larger investment in capital markets, would be the way to increase the profitability of the insurer he presided over. In modern market language: there is a very tight lower limit (downside) to the possibilities of reducing costs on the liability side, while on the asset side the upper limit (upside) is very wide. In this sense, the greater possibility of profit generation would be on the side of investment management. And, in this investment management, investing in government securities would impose a ceiling (cap), while in equities and derivatives there would be more possibility (and uncertainties). It is noted, in the reports, that Keynes sought to analyze economic trends affecting the profitability of insurance (especially life insurance) in general, but at the same time, trying to identify what initiatives the insurer he presided should follow to obtain a differentiated result. Keynes was a very aggressive Chairman in seeking profits for his company, mainly through an active management of investments. In the reports written by Keynes, the title and the subject of sections changed every year depending on the economic situation and the evolution of the insurance business. In each of these sections, Keynes wrote one, two or more paragraphs, depending on what he considered to be important in that year. Keynes analyzed the corporate governance of the insurer, the main aspects of risk and its measurement, the growth of liabilities and financial issues.

130 John Maynard Keynes and his work in the insurance market As a final comment, almost all readers of Keynes, especially those of the “General Theory”, emphasize the difficulty of understanding the style of writing Keynes. Well, this also is noted in the reports. Often, the sentences are very long, with several truncated ideas, and with the use of elaborate style figures. We try to do our best in the translation into Portuguese, but we believe that the “degree of betrayal” in this case can in some cases compromise the desired “level of translation.” As in all cases of translation, the ideal is to go back to the original source.181

181 Many of the translation excerpts were in free association, placing, thus, the ideas of Keynes in market terminology as we know it today. Another reason to going back to the original sources.

14. Keynes performance in investment management of insurers 131

CHAPTER 15 Annual reports written for insurers

MOGGRIDGE (1971), EDITOR OF THE COMPLETE WORKS OF KEYNES, PRESENTS, IN VOLUME XII, ALL THE ANNUAL REPORTS OF THE INSURANCE COMPANY UNDER HIS COMMAND (P. 114-254). WRITTEN BY KEYNES, THEY ADDRESS SEVERAL AREAS OF INTEREST OF THE INSURANCE COMPANY AND THE INSURANCE INDUSTRY, ESPECIALLY LIFE INSURANCE. THE ANNUAL REPORTS COVER THE PERIOD FROM 1922 TO 1938. IN 1938, AFTER A HEART ATTACK, KEYNES WITHDREW FROM THESE ACTIVE FUNCTIONS.

Below, we present a summary of the annual reports of the “National Mutual,” listing the presentation sessions organized by Keynes. We will then examine each of the annual reports, selecting from among the items covered, those who called our attention to examine the economic and financial ideas of Keynes and his philosophy of action. Thus, for some of these items, in each year, we have chosen to translate the issues that exemplify the aspects highlighted in the previous chapter on the work of Keynes, with a greater emphasis on aspects more related to finances:

15. Annual reports written for insurers 133 1. Report of 1922: Speech to the Annual Meeting of the National Mutual (02/18/1922)

• Income from insurance premiums • Operational expenses • Paid Insurance • Interest rate • Shares traded on exchanges • Comparison of values • Balance appreciation and realized profits: “the test of the success of an active investment policy lies in its ability to avoid losses when the stock value drops. Anyone can earn profits [in fixed income]... In the last two years our company has shown a balance of appreciation and realized profit of 6% above the total average of the stock exchanges. I do not believe any other company [insurer] can show an equally good result, and I’m sure it could not be obtained by an inactive policy, however good and careful that its investments had been selected.”182 • Insurers corporations and investment policy: “I dare to say that, at the present time, the corporations of life insurance will grow or stagnate, depending on the success or failure of their investment policies. The works of the great actuaries of the nineteenth century raised the actuarial science to levels that I believe cannot be enhanced by large improvements or significant innovations. Virtually all quality insurers follow today, those same actuarial rules. They operate with mortality tables based on past experience. For reasons of improvements in medical science and public sanitation, this creates room for some profit because the awards were calculated based on data that improved later. The increase in interest rates, even when including depreciation in the income tax, produces an automatic profit with respect to the rate assumed in the evaluation. These factors act on behalf of all insurance companies, and tend to put them in a stronger position, unless these advantages are discarded due to a faulty investment policy. But the investment, in contrast, offers both greater opportunities and greater risks compared to

182 Moggridge, “Collected Writings, Volume 12”, p. 117.

134 John Maynard Keynes and his work in the insurance market the past. The wide fluctuations that have occurred in recent years, even in shares of the upper classes of companies, should continue in the near future; while the breadth and choice of investments available now offer opportunities for an active policy that did not previously exist.”183 • New problems • Funds and evaluations • The increase in net income • Production and consumption • Growing popularity of Endowment Assurances • Middle-class investment: “we shall... enhance the facilities to make available to the insured the funds in cases of necessity, in anticipation to the maturity of policies. With that and other improvements, I cannot see why companies such as ours cannot become the main channel for investment of middle class savings... A Mutual Society well managed, where all profits belong to policyholders, is certainly the ideal institution for the investment of small annual savings. If the Mutual Societies (insurers) in this country are to improve their investment principles with the same success that they perfected the actuarial science, their social utility will be even greater in the future.”184

2. Report of 1923: Speech to the Annual Meeting of the National Mutual (02/29/1923)

• Growing trends in trade: “the great appreciation (of assets) provided material gains that strengthened our position. The Board’s investment policy allowed a combination of tactics so that, in the past three years, we could avoid losses when the market falls, but gaining full advantage when the market rises.”185 • Critical situation of the Ruhr • Evaluation and analysis of profit

183 Moggridge, “Collected Writings, Volume XII”, p. 118. 184 Moggridge, ibid, p. 121. 185 Moggridge, ibid, p. 122.

15. Annual reports written for insurers 135 • Popularity of the Endowment Assurance • Surrender value of policies • Line of development for the future: “excluding the colonial offices, there are now 15 Mutual Societies in the United Kingdom. Of these, 10 had total funds under £ 8,000,000.00, each, on the date of their most recent published report. This strikes me as a healthy scenario of business. I am sure that the correct line of future development is in the direction of friendship and cooperation in several issues of common interest between existing companies, rather than a future aggrandize- ment of a few at the expense of others. I think that there should be an ideal size for a life insurance company, a point where its expenses, income, staff, funds and its governing body are having a harmonious relationship with each other, and are able to reach their highest economic efficiency... I’m assuming that the company’s investment policy is active, in the sense that I used those words in the last [report]. If in our portfolio we had a very high weight of a share or class of shares, market limitations could compromise our plans...”186. • Investment principles: “there is another factor – the Board – in which the compression and concentration can bring advantage. Everyone, undoubtedly, noticed the marked tendency, in recent years, particularly in financial and investment companies, but also in industrial and commercial companies, in the direction of Boards with fewer Directors, many of whom are experts in the business in which their companies have specialized. The Directors of Life Insurers are not, in general, experts in the actuarial or medical side of this business, and, with regards to the acquisition and selection of new business, their utility should be limited. However, it is on the side of investments, where it lies, as I said last year, the bulk of the duties of the Directors. There is room for the application of the principles which, in other types of businesses, are in the hands of those responsible for its control.”187 • Business forecasts

186 Moggridge, ibid, p. 126. 187 Moggridge, ibid, p. 126.

136 John Maynard Keynes and his work in the insurance market 3. Report of 1924: Speech to the Annual Meeting of the National Mutual (01/30/1924)

• Investment policy • Review of articles of the Insurer • Five years profits • Special provisions • Class A policies • Reversionary Bonds rate • Annual distribution of profits: “the existence of extraordinarily high profit, as we have at this time, is able to create many questions about the distribution policy: (i) how to evaluate the just demands of current policyholders regarding the interests of the [National Mutual] Society as a permanent institution, older than the existing members, but still with great life expectancy; and (ii) how to best to combine the advantage of continuity and regularity with the rapid fluctuations of the modern world. Such considerations, among others, weighed heavily for us to reach a decision, which you probably will agree, that, in the future, the profit distribution should be made to policyholders annually, instead of being made at intervals of five years, as in the past. Not only this ar- rangement allows members the satisfaction of receiving a definite bonus every year, but it will also give the opportunity for a higher frequency of purchase of shares, and a closer examination of all the conditions to be considered in determining the profit distribution problem.”188 • Unexampled Strengths position: “anyway, carrying into the future a non-distributed profit of around 15% of our liabilities, we are in a very strong position to face the ups and downs of the coming years. These numbers let me emphasize again the opportunities that our institution offers for the managing of the savings of its members, and to urge each of you to increase their participation in a very safe property, by subscribing to our policies to the full capacity of their income.”189

188 Moggridge, ibid, p. 135. 189 Moggridge, ibid, p. 135.

15. Annual reports written for insurers 137 4. Report of 1925: Speech to the Annual Meeting of the National Mutual (02/28/1925) • Reserves Position • Revisionary Bonds • Bonuses future: “since we are bound of having lows as well as highs in the future, it is advisable to point out that the maintenance of the current rate of “bonus” is in no way dependent on the recurrence of the good fortune with our investments, as we had lately. It should be noted that, last year, it was not necessary to use any part of our capital appreciation for the bonus payment... Therefore, apart from any future income, excluding capital gains, and apart from the guarantee that the carrying for the future gives us against capital depreciation in the years ahead, we are in a remarkably strong position with respect to our ability to earn bonus.”190 • Interests and appreciation • Minimum of 500 pounds for the new policies • Variation proposal of risks: “with respect to the upper limit of the risks we accept, we propose to apply to the Court to vary the memorandum of association planned for our Act of Parliament. We aim to obtain au- thorization to manage on our own risk a sum of money that makes the total amount “at risk” of a life policy not to exceed £ 20,000 at any time. We have been adversely affected already for some time by the fact that the Memorandum, in strict accordance with what we have to work, states that no sum greater than £ 10,000.00, exclusive of bonus additions, is allowed to be the total risk for the compensation of life insurance. The limit of £ 10,000.00 was set in 1895, when our total funds reached only 60% of the current amount. Moreover, we are examining ways and means to reduce commission costs, and cut other business sources, which, although expensive, have proved unproductive. Finally, as an additional precaution, if the total of new businesses in a given year should reach a value that the Board considers to be the maximum in the interests of the Society, we should reserve the option of imposing a limit on the total number of lucrative businesses to be approved in that year.”191 • General prospects

190 Moggridge, ibid, p. 138. 191 Moggridge, ibid, p. 140.

138 John Maynard Keynes and his work in the insurance market 5. Report of 1926: Speech to the Annual Meeting of the National Mutual (02/27/1926)

• Appreciation of capital investments • Rising interest rates • London money market: “the success of the investment made with the Insurance Company funds depends, mainly, of anticipating the trajectory of interest rates, as far as possible. A factor that could hinder a lot the calculations are the unforeseen fluctuations in this rate. If we knew for sure what would be the trajectory of interest rates, whether rising or declining, we could act without hesitation. But, given the prevailing uncertainty, it is particularly difficult to adopt a confident attitude. On the one hand, there is a widely accepted view – even though I’m not sure I even agree with it – that the long-term trend of the interest rate will be declining. This is a function of the purchase on the account of “sinking funds” and the incessant flow of new savings. In contrast, the London market at present is out of balance with the rest of the world, and the events that shall contribute to a gradual restoration of balance are much more important now than any considerations that relate to the long-term trend. This country has not yet reached financial equilibrium, and this is the central business fact of the moment that would be wrong to ignore. The terms on which London is ready to borrow abroad are so attractive to borrowers that the investment outflow exceeds the surplus that our exports are able to produce... at least while the production costs in gold – resulting from the restoration of the exchange rate to pre-war parity – remain in their relatively high level. Unless the United States comes to offer more attractive terms for borrowers than us, or unless the production costs the measured in gold abroad, particularly in Europe, grow in significant terms, it is clear that sooner or later we will be forced to increase our loan conditions or to force a reduction of our production costs, or both. Now it is hard to see how any of these results can be achieved except through “expensive money”, which, however, will bring other undesirable consequences. A period when interest rates are rising and profits falling hits the owner of funds previously invested in two ways, as the prices of both bonds and stocks will be on a downward trend. The mere possibility of development along these lines needs, naturally, to inspire a

15. Annual reports written for insurers 139 great deal of caution to anyone who is responsible for the management of large investment funds.”192 • Influence of increasing rate of bank interest: “this does not end our bewilderment. If we knew when the adjustments required to restore the equilibrium would come, we could have traced our plans in a coordinated manner. However, last year’s experience has shown that the final adjustments could be postponed for some time yet. Last year, an improvement was achieved with respect to the adjustment of the interest rate, and almost nothing was done to adjust the production costs measured in gold. These adjustments can be postponed because of the attraction of the good results of international banks in London, partly due to the gold standard restoration and partly due to the maintenance of “more expensive” money here than in New York. The increase in the bank rate was almost totally unable to stop foreign investment and lowering production costs, but it was very effective to attract speculative money. However, obviously, it is not possible to continue indefinitely controlling national income this way.”193

6. Report of 1927: Speech to the Annual Meeting of the National Mutual (01/26/1927)

• Gross profits • Value of invested funds • Investment problems: “I called attention last year to the extraordinary high proportion of our assets that were invested in British Government Se- curities, and added that it was not the Board’s policy to retain such a large proportion as a general rule... the Board is working in a slow and gradual way in the task of finding a way to invest the funds of the “National Mutual” in securities that yield on average a higher rate of return... the Board will not forget that the depreciation of investments [due to falling interest rates of British Government Securities] was the plague on the finances of insurers in previous years, and its main concern must be to avoid such losses.”194 • Future interest rate: “in my opinion, wanting to guess what will be the future interest rate is one of the most complicated problems of the world.

192 Moggridge, ibid, p. 145. 193 Moggridge, ibid, p.146. 194 Moggridge, ibid, p. 148 and 149.

140 John Maynard Keynes and his work in the insurance market I am unable to form a reliable view on this. Before the war [World War I], Great Britain, France and Germany determined the pace of the international loan market. Is the United States the country – as we used to be – that will have savings surpluses for their own needs? Is it also going to have the confidence, given the prevailing conditions in the world today, to be prepared to be a great subscriber to each year of international first class titles paying less than 5% per year? The answer to this question will determine, due to indirect reactions, the equilibrium price of the British Government Long-Dated Securities in a more effective way than the British Treasury can create by ingenious methods for funding or to obtain resources for “sinking funds”. However, for the first time in more than three years, I am inclined to agree with the prevailing opinion that, with regards to the near future, the signs seem to be pointing in favor of a lower interest rate.”195 • Bonus statement • Incentives for Whole-Life business: “...the proportion of “whole-life” business made by leading life insurers dropped sharply since the war [World War I], and the special bonus can do something to restore in our favour the “whole-life” policy... the tendency of presidents of life insurers to lament in their annual reports the fall of “whole-life” business is not consistent, because actuarial science is able to show that they are offering these policies in relatively unfavorable terms.”196

7. Report of 1928: Speech to the Annual Meeting of the National Mutual (01/25/1928)

• Bonus fees and costs • Success of the investment policy • Market capitalization of common shares • Value of the railways stocks: “the center of gravity of business, so therefore of investment, is not the same. A “conservative” investment policy is able, in practice, to support the companies already in the market for over 50 years, instead of supporting new businesses that gather today the best brains in the business. The second reason to invest in common shares is

195 Moggridge, ibid, p. 150. 196 Moggridge, ibid, p.152.

15. Annual reports written for insurers 141 the fact that they are, undoubtedly, undervalued relative to bonds, after being made all the provisions to take into account the risk and other considerations. The fact that most well-managed and progressive companies distribute profits in much smaller volume that they generate, introduces a cumulative and compound interest that is often not noticed.”197 • Arguments against investments in common shares: “What are the arguments the other side? For surely there are important objections. Judg- ing by our experience, they are basically two. The first objection is that knowledge, attention and care must be much greater for investments in common shares. Therein results a heavier workload and responsibility put on the Board and to the executives. It means that the Directors have serious doubts in order to act, and in those cases where they for many years have not taken serious responsibilities and are aged between 70 and 90 years, there will always be doubt if it is wise to place new responsibilities on their shoulders. Moreover, for more care and attention that is given, it is extraordinarily difficult to acquire enough information to justify a substantial investment. The next major step forward in the evolution of joint stock companies with a pulverized ownership of shares shall arise, I believe, on a review of corporate law that will insist on a much greater transparency of financial demonstrations and will strengthen the work of the auditors. The second objection lies, despite a great capitalization of these companies, in the relative narrowing of the market, save some exceptions.”198 • National finances: “there are important ways in the context of public policies that can lead institutions such as insurance companies and investment trusts, which are now responsible for managing an increasing proportion of that portion of national savings that goes into the stock market, to be motivated to develop their policies, their organization and their experiences according to these lines [of public policy]. First, it is extraordinarily important that we, as a nation, do not become, over the future years, a rentier nation that depends on the interest of debt securities, and apart from living companies today, where constructive things are being done and where wealth is being generated... Secondly, the insurance companies, if in their entirety have large blocks of common shares, they can do much to remedy one of the great difficulties and ills of the present stage of evolution of public companies with shares traded on stock exchanges. Indeed, there is a complete im-

197 Moggridge, ibid, p.158. 198 Moggridge, ibid, p.160 and 161.

142 John Maynard Keynes and his work in the insurance market potence, when things are going wrong, so that shareholders – separated from each other, each with a small interest in the company –be able to jointly act against a group of directors (which may, as shareholders, have only a small interest in the company).”199

8. Report of 1929: Speech to the Annual Meeting of the National Mutual (01/30/1929)

• Comparison with the previous five-year periods • The centenary of the Company • New policy proposals • Necessities of the professionals • New series of With-Profits policies • Cheaper-Life insurance: “the public opinion shows signs of restlessness regarding the reluctance of life insurance companies to modify the terms of their contracts in concert with the conditions that are changing. With these new policies the National Mutual should be doing something to satisfy the popular demand for “cheaper life insurance.” But one should not assume that we do not continue at the same time, adhering to the views previously expressed regarding the large and growing role that life insurance should have as a means of savings for investment, as well as a mechanism for protection against the risk. The point is that different holders of insurance policy assign different degrees of importance to the investment element and the protective element, in combination with the different circumstances and requirements, with the result that a single type of policy, even when differentiated into “whole life” and “endowment assurance”, cannot equip each person with what he really needs. The trend in recent years is to offer more investment opportunities than protection. With the new series of “enhanced” or “married man” policies, offered concurrently with the policies of the first type, we are able to offer both types of facilities.”200 • General economic conditions

199 Moggridge, ibid, p.160. 200 Moggridge, ibid, p.166.

15. Annual reports written for insurers 143 9. Report of 1930: Speech to the Annual Meeting of the National Mutual (01/29/1930) • Higher interest rate obtained • Fall in value of investments: “the most important event of the year on the side of the investments was, of course, the sharp fall in the overall level of investment values – the most important movement – which takes place since 1921 [later it would become known as the Great Crash, or Crisis of 1929]”201. • Every reason to moderate satisfaction • Investments in common shares: “we have, as you know, a well-known policy of investing in common shares. It is even higher than most other insurance companies. In a year in which the common shares suffered an exceptional depreciation, we were able to manage this situation with a small percentage of losses. These losses were not only lower than the fall of the common stock market as a whole, but were also much smaller than the amount of depreciation of securities “non-gilt-edged fixed-interest securities” (private fixed-income securities). These losses were only slightly higher than those suffered by “long-dated British Gov- ernment securities” (government fixed- income securities)... the moral is that no agent which is responsible for the investment of large sums of money can expect to be immune from large market movements as a whole, be them upwards, or downwards. We will be very glad if in the long run we can obtain a greater appreciation than the average of the highs and lose less than the average of lows during the market fall.”202 • Profit sharing schemes • Centenary Bonds • Benefits for older members • History of the 100 years • Tribute to the founders of the Insurance Company • The future • Consequence fall in wholesale prices

201 Moggridge, ibid, p.172. 202 Moggridge, ibid, p. 172.

144 John Maynard Keynes and his work in the insurance market 10 Report of 1931: Speech to the Annual Meeting of the National Mutual (01/28/1931)

• Businesses of the year • Gross interest rate • Stock portfolio • Development of new businesses: “with respect to our new businesses, I believe that it will be interesting for you to know that a substantial part of them is derived from ideas of the holders of our policies, and I take this opportunity to thank them for practical interest they show for the welfare of our Society.”203 • Finance and International Trade: “I am very sorry that my pessimistic predictions about world business, made last year, were more than con- firmed. I predicted then that the centers of the storm would be found, not in the United States or in Britain, but in the major foreign produc- ers of raw materials, and we would have to look anxiously to Australia, South America, Asia and Central Europe. I added that the fall in wholesale prices had already reached the dimensions of a first-class disaster, and that, in any way, it was certain that an additional movement in the same direction would be able to be avoided. These warnings, which were much commented at the time, proved to be even overly modest. I do not see much reason to be pleased with the immediate future. In particular, I would like to emphasize that the mere relapse of a few months will not bring, by itself, a lasting recovery. Based on our experience with past disturbances, we see that only a relatively short time have passed. But, apart from that, the recovery will only come, in my opinion, after the emergence of a new and definite factor.”204 • Credit to debtor countries • The necessity for a joint action

203 Moggridge, ibid, p. 182. 204 Moggridge, ibid, p. 183.

15. Annual reports written for insurers 145 11. Report of 1932: Speech to the Annual Meeting of the National Mutual (03/02/1932)

• Investment: growing use of government bonds. “Last year was marked by an extraordinary anxiety of all those who were concerned with the safe investment in large funds. It is unprecedented the degree of depreciation suffered by each class of securities and values. Moreover, our difficulties were considerably increased by the “evilness” of the markets, in the sense that has often been proven to be impractical to achieve the desired changes of investment, whether by purchase or sale, at the ostensible market price or even at a reasonable price. It has been, in particular, a testing time for a Society [National Mutual] like ours, which is the pioneer of investment methods that are closer to investment portfolios in shares, of which is the case of most other companies. We invested an enormous portion of our resources in market stocks subject to fluctuations in their values, when compared, for example, to mortgages, where the carrying value does not change, regardless of market conditions. We were always proud to disclose the market value of our investments. We, also, never hid an investment reserve that could enable the Board to protect itself in tough times.”205 • Investments and market values • Interesting comparison of stock values • Postponing the actuarial valuation • Actuarial methods: “the bases of the actuarial valuation, over time, have remained largely conventional. An actuary does not base their expectations using the mortality rate that he and his colleagues experience in fact. Its provision for expenditure does not reflect the rate that actually happens. Above all – and of particular relevance to my present argument – they assume an interest rate that is not only different from the rates that the company effectively experience, but, as it never suffers variation, not only differs from the facts but are also not closely related with them.

205 Moggridge, ibid, p.186.

146 John Maynard Keynes and his work in the insurance market In addition to the adjustments discussed above, each actuary, individually, can introduce several measures about “minor excess supply” in their calculations. Assuming that the errors are all on the right side, i.e., on the side of exaggerating the liabilities in relation to assets – as, naturally, they always are – the evaluations become a sort of untruth competition. The biggest winners are those who base their assumptions on the farthest way of the facts, and which are the strictest in keeping them whatever the changes to facts may be. On top of all that, the rates of “bonus” also show a tendency (which, however, is weakening) of becoming stereotyped and to respond more reluctantly to the ups and downs of changing circumstances. It is evident that for institutions whose contracts extend for as long as a human life, some of the practices and customs described above have great virtue. In effect, in those cases, absolute security is not only a matter of pride, but also a necessity so they can perform the functions for which they exist (although I think not all do). They can, thus, promote caution and underestimation of favorable results, when these results have not yet passed the test of time. But in practice they do not achieve these goals in a firm and regular manner, if they are combined with a totally different method of valuation on the asset side of financial statements. A conventional assessment of liabilities, on the one hand, and an evaluation of assets “to market”, on the other, can lead to very misleading results. I am not sure that a perception of this does not lead to, sometimes, actuaries in having a bias in favor of assets that are prone to a conventional valuation, since, as there is no market price published for such assets, they do not feel an obligation to change its book value to “every wind of change that blows on the stock exchange”. Mortgages, naturally, present a good example of this type of investment, but we can also include most other investments, other than those of stock exchanges. However, looking it up with an eye without bias, it shall not be assigned an extraordinary merit to an investment that does not display a market value. The illogical consequences of the methods commonly used are illustrated in a better way when one looks at what happens when you change the interest rate, assuming that capital changes are shown in the income account. A decrease in the rate of interest, effectively received, narrows margin between the effective rate and the rate conventionally assumed, that is, weakens the basis of evaluation. But once, under normal conditions,

15. Annual reports written for insurers 147 this is accompanied by an appreciation in fixed income securities to market value, it increases the “carry-forward” and thereby increases the “ostensible strength”. In contrast, a high interest rate produces an opposite effect. It strengthens the evaluation, but decreases the ostensible force by decreasing the “carry-forward.” I have no solution to offer this dilemma, but I recommend that it continues receiving attention by the insurance world.”206 • The most prosperous country in the world • The financial crisis: “it is considered, nowadays, that it is essential to find a solution to the financial crisis. Unless the desperate situation of Central Europe complicates even more, it is legitimate to expect that the first steps in this direction are already being taken. But for me it is unthinkable that we may walk directly from the mitigation of the financial crisis to the mitigation of the industrial crisis without an intervening phase of “cheap money.”207

12. Report of 1933: Speech to the Annual Meeting of the National Mutual (03/01/1933)

• Improvement of position • Interest rate obtained • Substantial mortality profits • Evaluation of bonus reserves: “Our actuarial team shows an anxious preoccupation with the question of whether the time has not yet come to change the old and now somewhat misleading methods of evaluation. We have traditionally used them for many years in the past. We need to switch to using the most scientific methods, already adopted by one or two companies, known as “reserve valuation”... the technical details of the new method have already been explained by the actuary in his “valuation report”, which you have already received.”208

206 Moggridge, ibid, p. 190 and 191. 207 Moggridge, ibid, p. 192. 208 Moggridge, ibid, p. 197.

148 John Maynard Keynes and his work in the insurance market • Summary of changes: “as further explanation of the “bonus reserve valuation”, the estimated liability of a life insurance policy consists of the excess of the present value of the sum assured along with bonuses already declared, in relation to the present value of future payable premiums. The essence of the change is as follows: the “present value” is calculated based on certain assumptions that may or may not happen. There should undoubtedly be a substantial margin above the estimated sum as to take caution for contingencies that may affect the expectations with which the estimates were based. When a life insurer evaluates its liabilities in order to know what surplus is properly available for distribution of profits, it should not take credit for that margin, because if the bonuses were to be declared correspondingly, the margin would be used and the provision would disappear. Actuaries have to find some method to distinguish between such margin not subject to distribution and the surplus above it, which is appropriately available for immediate distribution. The method most commonly adopted in the past ensures that the margin required to meet future contingencies is to retain funds for immediate distribution, through the adoption of arbitrary assumptions about interest rates, mortality, etc., so less favorable than those that actually exist, that they have little relation to them. The result is in making it difficult, even for an expert, to evaluate what the real meaning of the net provision was obtained using the method.”209 • More adaptable method • Mr. Marks Retirement

13. Report of 1934: Speech to the Annual Meeting of the National Mutual (02/21/1934)

• Claims and expenses • Evaluation of investments • Returns obtained from investments

209 Moggridge, ibid, p. 198.

15. Annual reports written for insurers 149 • Two views: “there are two views on the economic discussion of how to invest in stocks rather than fixed income securities. According to the first view, those who are afraid to invest in long-term securities point truthfully that the increase in their prices is due largely to the purchase by banks; and they argue, again in truth, the evidence of past experience with the effect that, when economic activity recovers, banks often sell their investments in order to ensure the means to give loans to industries. They argue, therefore, believing that this history will repeat itself, that the long-term government bonds will fall in price as soon as there is a material improvement in demand for loans. I would be bold to say that the course of events will be different this time. But I would like to present some grounds that justify this conclusion, before going on to explain the reasons which seem to me to be the most critical for expecting a further decline in interest rates. This is the second view on the subject. In the years before the war, the resources of the banking system were in a more or less rigid way connected to the gold reserves of the Bank of England. Open market operations were not important and, generally speaking, the assets of the clearing banks rose or fell according to the variations of how gold entered or left the Bank of England.”210 • Resources of banks: still as a continuation to the previous discussion, Keynes presents an alternative vision, because, he said, “there is no need today that the events follow this course. The resources of banks depend both on changes in the volume of securities purchased by the Bank of England as the changes in the gold stock of the Bank. Thus, the management technique currently followed by the Bank enabled it to adjust the resources of the clearing banks for the needs of economic activity and employment.”211 • Return of Gilt-Edged stocks • Reduction of the investment field • Decreasing trend in interest rates • Conservative Policy of the Board

210 Moggridge, ibid, p. 204. 211 Moggridge, ibid, p. 205.

150 John Maynard Keynes and his work in the insurance market 14. Report of 1935: Speech to the Annual Meeting of the National Mutual (02/20/1935)

• Appreciation of invested funds • Results of evaluation • Effects of decreasing interest rates: “a life insurer gains from a fall in interest rates by the appreciation of its existing reserves, but it loses, if, as in the case of most life insurers, its aggregate reserves are growing steadily, by reason of a lower accumulation rate of future premiums with respect to existing obligations.”212 • Conflicting forces • Difficult task: “the task of maintaining a sufficiently low interest rate to be compatible with national prosperity and the “good job”, will likely present increasing difficulties. Furthermore, there may even be some doubt whether it is possible to achieve a solution through “normal” ways and with the use of traditional methods of advanced industrial community, which it is not, for various reasons, in a position to invest large sums abroad and in which, moreover, does not present high growth rate of its population.”213 • Suggestion to the Treasury: it is perceived, due to the reporting date and what we know about the development of his “General Theory” book, that Keynes was already developing some thoughts on economic policy, as seen in this section. According to him, “there is, I suggest, an important contribution to a measure that is within the Treasury’s responsibilities to adopt – that they should show confidence in the expectation in a declining interest rate in the future. It is often said that, in present lines, there is a golden opportunity to create traps against the investor, causing him to lend funds to the Treasury for an indefinite period, lamenting in the future. This advice seems to be based, as most advices, on the extremely unlikely event that the future will repeat the past. But, anyway, it is a bad advice, because the ultimate goal of the Treasury should be the es- tablishment of stable conditions that enable a gradual drop in interest

212 Moggridge, ibid, p. 211. 213 Moggridge, ibid, p. 213.

15. Annual reports written for insurers 151 rates over a long period of years ahead, and a necessary condition for that is to create a reasonable expectation that this is indeed the likely course of events.”214 • Essential factor for the interest rate • Mr. Burchell and Mr. Marks Retirement

15 Report of 1936: Speech to the Annual Meeting of the National Mutual (02/19/1936)

• Mortality experience • Investments evaluation • Interim Bonuses • Long-term interest rate: “when talking about future prospects [on the behavior of interest rates], it is generally difficult to make a clear distinction between what is considered the most desirable from the point of view of the public interest, and what is estimated to be the most likely in current circumstances. This is because, unfortunately, the course of events that is most desirable is not always the most likely! Let me explain that, on this occasion, I am particularly interested in the question of which policy is the most advisable. If the current relatively satisfactory position (although not in absolute terms) should be protected from a subsequent reaction, I am sure that it is urgently needed the further reduction in long-term interest rates – which, it must be remembered, will not produce its full effect for a considerable time. But it is natural to wonder in what manner it this outcome can be achieved [Keynes then weaves a number of specific considerations].”215 • Treasury and short-term rates • Offer of bank money • Initiatives from Treasury and the Bank of England • Prices of industrial stocks

214 Moggridge, ibid, p. 214. 215 Moggridge, ibid, p. 219.

152 John Maynard Keynes and his work in the insurance market 16 Report of 1937: Speech to the Annual Meeting of the National Mutual (02/24/1937)

• Substantial appreciation of the shares traded on the Stock Exchanges • Strengthening of reserves • Record in bonus distribution • Re-Armament and the Gilt-Edged Market • Treasury’s necessity for a coordinated policy • Possibility of avoiding inflation: Keynes, in the previous section of the report, suggested that Treasury should follow a coordinated policy to borrow resources. In this section he shows another type of concern, linked to the raising of funds by the Treasury. According to Keynes, “it is then in the hands of the Chancellor the power to obtain money without producing inflation conditions. But another question follows: how much should we pay for it? If the Chancellor, brought down by a sense of guilt, feels that for the sin of borrowing money he needs to do penance (and us too) taking up “expensive” money, the markets will respond accordingly. But he will realize that this will not facilitate his loans. On the contrary, it is much easier to borrow in a high market than a low market.”216 • The current interest rates are not exceptionally low • The new building of the Society

17 Report of 1938: Speech to the Annual Meeting of the National Mutual (02/20/1938)

• Decrease of Expense Ratio • Interest earnings • Investments evaluation • Financing of gold fields

216 Moggridge, ibid, p. 228.

15. Annual reports written for insurers 153 • Payment method • Net Hot Money • Undesirable gold • Events since September • Speculative market: “the speculative markets are quite interrelated and cannot escape the American and European influences. Moreover, they are governed by doubt rather than conviction, by fear more than the forecast, and more for the memories last longer than the prospec- tive knowledge of the future time. The price level of the stock market does not show what investors know, they show what they do not know. Having to face the perplexities and uncertainties of the modern world, the market values will fluctuate much more than it seem reasonable in light of later events; and one would expect that in such circumstances the insurance companies would show exemplary firmness. The notion of all of us selling to each other in good times is not, naturally, a practical policy for the community as a whole. However, the attempt to do so can significantly bring down prices from a reasonable level of the estimate of their intrinsic value, and become a serious impediment to constructive investment. • Those of us who helped popularize the talk about the “business cycle” (“trade cycle”) have part of the blame. I sympathize with the authorities in their appeal for the business community to not become unduly aware of recessions (“slump-conscious”). What we need is that the roles are reversed, and they become more aware of recessions. We could sleep more peaceful in our beds if we felt that they, in their respective beds, sleep less tranquil.”217 • Government appeal: “the difficulty of avoiding a disastrous depression in the modern world can be overstated. It will be necessary all our knowledge, all our preparation, all our precaution, all our skill, all our technical preparation and all our wealth of public spirit. I appeal to the Government with fervor in the heart not to lose the opportunity to add to our knowledge of essential facts and data, for only they can make intelligible the operation of the economic system and distinguish the true theories from the false with test results.

217 Moggridge, ibid, p. 238.

154 John Maynard Keynes and his work in the insurance market There is a lot at stake. We are engaged in defending freedom of economic life in circumstances that are far from favorable. We can show that a free system can work. Favoring what is called planning and management does not mean an escape from the moral principles of freedom that could have been previously incorporated into a simpler system. On the contrary, we have learned that freedom of economic life is more framed than we previously knew with the deepest freedoms – freedom of people, thought, and faith.”218

Those were the last lines of the last report written by Keynes to the insurer. They were the beautiful words of a true master, as he was called by Skidelsky. Keynes resigned from the Presidency of the National Mutual Life Assurance Society in late 1938 in order to engage in the English war effort and due to the fragility of his health, but continued until his last years quite connected to the life insurer. It must be honor to the insurance industry to have had Keynes as a devoted President of one of his companies.

218 Moggridge, ibid, p. 239.

15. Annual reports written for insurers 155

PART VI Final remarks

157

CHAPTER 16 Conclusions

THE CURRENT ECONOMIC THOUGHT BELIEVES THAT THE PRACTICAL AND INTELLECTUAL CONTRIBUTION OF KEYNES WAS ESSENTIAL TO CHANGE THE PERSPECTIVE WITH WHICH ONE EXAMINES AND INTERVENES IN ECONOMIC CYCLES. UNTIL THE ARRIVAL OF KEYNES AS AN ACTIVE ECONOMIST IN THE INTERNATIONAL ARENA, LITTLE WAS DONE IN TERMS OF A SYSTEMATIC STUDY OF BUSINESS CYCLES, AND MUCH LESS WITH RESPECT TO THE PROPOSITION OF ACTIVE STABILIZATION POLICIES.

During the nineteenth century, it was of course observed the occurrence of commercial crises, but there was not a theoretical concern in trying to understand the causes of the phenomenon, much less in trying to act upon its greater scourge: unemployment. Monetary economics, in turn, had already developed the quantitative theory of money and had already worked on the concepts of “real impacts” and “nominal impacts” to distinguish the sectors affected by changes in the money supply. However, there was very little contact between the accumu- lating knowledge in monetary theory, and the more practical side of how to properly substantiate, or even use, monetary policy. In fact, the monetary policy issues, from the nineteenth century until the mid-1930s, revolved around discussions on the interest rate of the banks

16. Conclusions 159 that were part of the role of a modern central bank, or discussions on the gold standard, silver standard, bimetallic standard, and other quarrels about the best type of currency. In the second decade, and particularly in the third decade of the twentieth century, when Keynes comes into play, progress in the theoretical study of business cycles were already being perceived, statistical centers to collect and organize economic information in a systematic way were beginning to operate. In this context, the theoretical discussions about the scope of stabilization policies were raised, while combined with an ideological debate over government involvement in the economy. On one side, the proponents of the “let for the long term” for the self-regulatory mechanisms of the market to correct the problems and, on the other side, the proponents of “acting in the short run” via a more active role of the government in correcting un- wanted business cycle trends. The Great Depression of 1929-1933 provoked, among other cataclysms, a very large challenge to existing theories, because they led to inaction of corrective economic policies. It was the classic case of a paradigm shift, in which the conventional framework of explanations no longer served to in- terpret reality. It appears then a new framework for explanations, replacing the inoperative antiques. It was called the “Keynesian Revolution”. Keynes will turn attention on the dynamics of recurrent business cycles, re- directing it to the immediate problems of consumption fall and rising unemployment. He put on the agenda the role of short-term economic policies, created a plausible theoretical framework to justify these policies, and used the rhetoric and persuasion instruments to give credibility to proposals. Keynes will advocate, for the circumstances of the time, public spending policies to stimulate demand, even if they were to create budget deficits. He will also advocate that the important thing is the short term, and one could not wait too long to allow market forces to put in place spontaneous corrective mechanisms. The great merit of Keynes was to turn to economic policy measures, but wearing them with an original theoretical apparatus, ready for empirical studies. In this task, as we have emphasized throughout the book, the “economist Keynes” was quite helped by “financier Keynes” and the “Insurer CEO Keynes”.

160 John Maynard Keynes and his work in the insurance market It is sought in this book to show a little – known facet of Keynes – his role as investment portfolio manager and insurance companies’ administrator. His professional role in insurance was more connected to the life insurance branch, and Keynes was also concerned with long term demographics. Keynes even wrote an article with the title “Economic Possibilities for Our Grandchildren”, which outlined future scenarios that are proving realistic. (Mello, 2007) It was on the investments activity which he excelled, and in this book we show some of his philosophy and economic foundation to outline investment strategies. In particular, his recommendations to adopting an active investment policy are of great relevance to the present day. In presenting these little-known and undisclosed aspects of Keynes acting as a professional insurer, the objective is to inspire and motivate the Brazilian insurance industry to reflect on the ideas of risk, finance and macroeconomics, used very successfully by this brilliant economist in the management of insurers he presided over.

16. Conclusions 161

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164 John Maynard Keynes and his work in the insurance market KEYNES, John Maynard. A Treatise on Probability. (original published in 1921). Cambridge: The Royal Economic Society, MacMillan, 1973. KEYNES, John Maynard. Essays in Persuasion. (original published in 1931). London: The Royal Economic Society, The MacMillan Press Ltd, 1972. KEYNES, John Maynard. The Collected Writings of John Maynard Keynes. Volume XII. Economic Articles and Correspondence. Investment and Ed- itorial. Edited by Donald Moggridge. Cambridge: MacMillan /Cambridge University Press for the Royal Economic Society, 1983. KEYNES, John Maynard. The General Theory of Employment, Interest and Money. (original published in 1936). London: The Royal Economic Society, The MacMillan Press Ltd, 1973. [published in Portuguese with the title A Teoria Geral do Emprego, do Juro e da Moeda. São Paulo: Editora Abril, 1983. The technical revision was made by Cláudio Contador]. KINDLEBERGER, Charles P. A Financial History of Western Europe. 2nd Edition. New York: Oxford University Press, 1993. KINDLEBERGER, Charles P. The World in Depression, 1919-1939. Berke- ley: University of California Press, 1986. LAVOIE, Marc. Introduction to Pot-Keynesian Economics. HoundMills, Basingstoke, Hampshire: Palgrave MacMillan, 2006. LAWLOR, Michael S. The Economics of Keynes in Historical Context: An Intellectual History of the General Theory. New York: Palgrave Mac- Millan, 2006. LEIJONHUFVUD, Axel. On Keynesian Economics and the Economics of Keynes. New York: Oxford University Press, 1968. MARTIN, Frederick. The History of Lloyd’s and of Marine Insurance in Great Britain. New York: Burt Franklin, 1876 (reprinted in 1971). MATTHEWS, R.C.O.; FEINSTEIN, C.H.; e ODLING-SMEE, J.C.O. British Economic Growth, 1856-1973. Oxford: Clarendon Press, 1982. MCELVAINE, Robert S. The Great Depression. America, 1929-1941. 2nd ed. New York: Three Rivers Press, 2009. MELLO, Pedro Carvalho de, SPOLADOR, Humberto. Crises Financeiras. Quebras, medos e especulações do mercado. 3. ed. São Paulo: Saint Paul Institute of Finance, 2010.

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166 John Maynard Keynes and his work in the insurance market SKIDELSKY, Robert J.A. Keynes. The Return of the Master. New York: Public Affairs Books, 2009/2010. SMITH, Edgar Lawrence. Common Stocks and the Business Cycle. A Prac- tical Analysis of the Basic Causes and Patterns of Cyclical Behavior in Economic Series. New York: The William-Frederick Press, 1959. STOHS, Mark. Uncertainty in Keynes’s General theory: a rejoinder. Blaug, Vol. I, p.442-446. SUPPLE, Barry. The Royal Exchange Assurance. A History of British In- surance, 1720-1970. Cambridge: Cambridge at the University Press, 1970. TEMIN, Peter. Lessons from the Great Depression. Cambridge, Ma.: The MIT Press, 1999. TOYE, John. Keynes on Population. Oxford: Oxford University Press, 2000. VAN OVERTVELDT, Johan. The Chicago School. How the University of Chicago Assembled the Thinkers who Revolutionized Economics and Business”. Chicago: Agate B2 Books, 2007. WALTON, Gary M. and Rockoff, Hugh. History of the American Economy. Fort Worth: The Dryden Press, 8th. Ed., 1998. WAPSHOTT, Nicholas. Keynes – Hayek. The Clash that Defined Modern Economics. New York: W. W. Norton & Company, 2011.

Bibliographic references 167

Pedro Carvalho de Mello, Master and PhD. on Economics from the University of Chicago, he is a Professor at ESAGS, Adjunct Professor at Ohio University College of Business; International Coordinator at FGV - Getúlio Vargas Foundation; member of LASFRC (Latin America Shadow Financial Committee) and member of the Fiscal Council of B2W. He was Visiting Professor at Columbia University and the University of Richmond, and visiting scholar at Tsukuba University (Japan). Associate Professor (retired) of the Esalq/USP. He was Director (two terms of three years each) of CVM (Securities and Exchange Commission of Brazil), Director of BM&F (Brazilian Securities, Commodities and Futures Exchange), and Vice-President of PNC International Bank. Author of several books and articles in the areas of economics, finance, insurance and economic history. CONFERIR E, CASO NECESSÁRIO, AJUSTAR LOMBADA

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