If You’re So Smart: John Maynard Keynes And Currency Speculation In The Interwar Years
London School of Economics & Political Science (LSE)
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University of Cambridge – Judge Business School, Department of Finance & Accounting
December 1, 2015
Forthcoming, Journal of Economic History
This paper explores the risks and returns to currency speculation during the 1920s and 1930s. We study the performance of two well-known technical trading strategies (carry and momentum) and compare them with that of a fundamentals-based trader: John Maynard Keynes. Technical strategies were highly profitable during the 1920s and even outperformed Keynes. In the 1930s however, both technical strategies and Keynes performed relatively poorly. Whilst our results reveal the existence of profitable opportunities for currency traders in the interwar years, they suggest that such profits were necessary compensation for enduring the substantial risks which all strategies entailed.
If You’re So Smart: John Maynard Keynes And Currency Speculation In The Interwar Years – Introduction
The interwar period was the most turbulent in the history of currency markets. The floating exchange rate era of the 1920s was marked by unprecedented foreign exchange volatility and the large European currency depreciations, whilst the 1930s are remembered for the successive waves of speculative attacks, which eventually brought down the gold standard system (Eichengreen 1992a). The interwar years also witnessed a major transformation in the practice of foreign exchange trading with the spread of dealings by telegraphic transfer and of forward contracts and a large-scale spot and forward exchange market emerged for the first time in London. Anecdotal evidence from contemporaries suggests that currency trading became a substantial activity starting in the 1920s, as speculators sought to exploit the new profit opportunities associated with floating exchange rates (Einzig 1937). Economists have long debated whether foreign exchange speculation was a stabilizing or destabilizing force for exchange rates in the 1920s and 1930s (Nurkse 1944; Friedman, 1953).1 However, whilst the literature on the causes and consequences of interwar currency instability is prolific, little is known about the risks, returns and nature of speculating in currencies during the dawn of the modern foreign exchange market.
This paper provides a study of actual currency speculation during the 1920s and 1930s. Currency investing is often considered a zero sum activity in that one foreign exchange speculator’s gain is always another’s loss. Standard finance theory also holds that any profits from currency trading arise from pure chance. Whilst currency speculation consists in betting on the future evolution of exchange rates, according to the risk-neutral efficient market hypothesis, no investor should be able to out-forecast the market on a consistent basis and the expected return from speculating in currencies should therefore be zero.2 Yet, the high volume of speculative activity on foreign exchange markets both in the interwar years and today is difficult to reconcile with the view that currency trading yields no returns at all.
There are two kinds of currency speculators: discretionary, fundamentals-based traders who rely on their own analysis of macroeconomic variables to predict future exchange rate movements; and technical traders who seek to identify market anomalies and exploit them by following mechanical trading rules. In the latter case, the recent literature has identified a few persistent anomalies in foreign exchange markets over the last thirty years and has shown that several naïve trading rules generate substantial returns (Lustig and Verdelhan 2007; Brunnermeier et al. 2009; Burnside et al. 2010 and 2011; Berge et al. 2011; Jordà and Taylor 2011 and 2012; Lustig et al. 2011, Menkhoff et al. 2012a and 2012b).
Empirical evidence on the returns to currency speculation is however wholly based on data for the post-Bretton Woods period. In this paper, we provide evidence on currency speculation in this earlier and volatile period: the 1920s and 1930s. Using a newly collected dataset of monthly spot and forward bid and ask quotations for all major currencies of the interwar period, we first report evidence on technical-based currency trading. We document the profitability of two naïve trading rules, well-known to both interwar and modern speculators alike. One is the carry trade, which consists in betting on high-interest rate currencies and against low-interest rate currencies. The other is momentum – a strategy even simpler to implement than the carry trade – which consists in betting on currencies that have recently appreciated and against currencies having depreciated.
Second, we provide empirical evidence on fundamentals-based currency trading in the 1920s and 1930s relying on a unique and previously unexploited source: the trading record of the most prominent foreign exchange speculator of the time: John Maynard Keynes. Keynes’ contributions to exchange rate theory and his writings on exchange rate policy are well known to economists and economic historians. He was the first economist to publish an explicit formulation of the covered interest parity condition (CIP) and among the first to present empirical evidence on the purchasing power parity theory (PPP). He also expressed his pessimism regarding the adverse impact of the allied war reparations on the prospects for the continental European economies and currencies (Keynes 1919), and famously criticized the British decision to return to the gold standard at pre-war parity in April 1925 (Keynes 1925). It is known that Keynes speculated in currencies (Moggridge 1983 and 1992; Skidelsky 1992). However, the nature and extent of his currency trading activity has not previously been analyzed. Between August 1919 and May 1927, and again between October 1932 and August 1939, Keynes made full use of the newly-emerged forward market to pursue a discretionary (as opposed to technical) approach to currency speculation comprising a sophisticated analysis of macroeconomic fundamentals. Although anecdotes about his speculative activities abound in the historical literature, this paper is the first to analyze Keynes’ trading record in detail and in its entirety. Drawing upon archival research and compiling a comprehensive dataset of Keynes’ trades, we describe his strategy, the risks he took and his performance.
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