John Maynard Keynes introduced the concept in his book, The General Theory of Employment, Interest and Money, in 1936. It goes something like this. The stock market behaves like a beauty contest in which people are asked to select the six faces they like most from a selection of around 100. Those picking the most popular face are entered into a prize draw to win a fantastic prize. How do you go about maximising your chances of being in the prize draw. According to Keynes, you don't choose what to you is the prettiest face:"It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there aresome, I believe, who practisethefourth, fifth and higher degrees."
And so it is with the stock market. Or housing markets. Investors would be prepared to pay more for something that it is worth if they believe that others will pay even more for it in the future. And so you get bubbles in these markets which grow and grow, even if the fundamentals don't justify the high prices being paid. But bubbles burst and when they do, the rational thing to do is to keep selling whilst you believe that everyone else believes that prices will continue to fall. In short, what we have experienced over the last month or so is a classic failure of markets to value assets at their correct value.
Inevitably at this time, there is a more traditional beauty contest playing itself out. The contestants are flaunting their ideas for how best to rescue the economy from the downturn which we now know officially is under way. Alistair Darling thinks the solution, in part, is to bring forward public expenditure plans. A group of 16 economists writing in yesterday's Sunday Telegraph think not - best to rely on interest rate cuts, they say.
So, my question is 'who wins the economists' beauty contest (who is right) and why'? Usual rewards on offer ...
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