Monday, June 25, 2012

The Story of Q

More posts on Greece, coming right up. But first I want to revisit the relationship between finance and nonfinancial business in the US.

Most readers of this blog are probably familiar with Tobin's q. The idea is that if investment decisions are being made to maximize the wealth of shareholders, as theory and, sometimes, the law say they should be, then there should be a relationship between the value of financial claims on the firm and the value of its assets. Specifically, the former should be at least as great as the latter, since if investing another dollar in the firm does not increase its value to shareholders by at least a dollar, then that money would better have been returned to them instead.

As usual with anything interesting in macroeconomics, the idea goes back to Keynes, specifically Chapter 12 of the General Theory:
the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur.
It was this kind of reasoning that led Hyman Minsky to describe Keynes as having "an investment theory of the business cycle, and a financial theory of investment." Axel Leijonhufvud, on the other hand, would warn us against taking the dramatis personae of this story too literally; the important point, he would argue, is the way in which investment responds to the shifts in the expected return on fixed investment versus the long-term interest rate. For better or worse, postwar Keynesians including the eponymous Tobin followed Keynes here in thinking of one group of decisionmakers whose expectations are embodied in share prices and another group setting investment within the firm. If shareholders are optimistic about the prospects for a business, or for business in general, the value of shares relative to the cost of capital goods will rise, a signal for firms to invest more; if they are pessimistic, share prices will fall relative to the cost of capital goods, a signal that further investment would be, from the point of view of shareholders, value-subtracting, and the cash should be disgorged instead.

There are various specifications of this relationship; for aggregate data, the usual one is the ratio of the value corporate equity to corporate net worth, that is, to total assets minus total liabilities. In any case, q fails rather miserably, both in the aggregate and the firm level, in its original purpose, predicting investment decisions. Here is q for nonfinancial corporations in the US over the past 60 years, along with corporate investment.

The orange line is the standard specification of q; the dotted line is equity over fixed assets, which behaves almost identically. The black line shows nonfinancial corporations' nonresidential fixed investment as a share of GDP. As you can see, apart from the late 90s tech boom, there's no sign that high q is associated with high investment, or low q with low investment. In fact, the biggest investment boom in postwar history, in the late 1970s, comes when q was at its low point. [*]

The obvious way of looking at this is that, contra Tobin and (at least some readings of) Keynes, stock prices don't seem to have much to do with fixed investment. Which is not so strange, when you think about it -- it's never been clear why managers and entrepreneurs should substitute the stock market's beliefs about the profitability of some new investment for their own, presumably better-informed, one. Just as well, given the unanchored gyrations of the stock market.

This is true as far as it goes, but there's another way of looking at it. Because, q isn't just uncorrelated with investment; for most of the period, at least until the 1990s, it's almost always well below 1. This is even more surprising when you consider that a well-run firm with an established market ought to have a q above one, since it will presumably have intangible assets -- corporate culture, loyal customers and so on -- that don't show up on the balance sheet. In other words, measured assets should seem to be "too low". But in fact, they're almost always too high. For most of the postwar period, it seems that corporations were systematically investing too much, at least from the point of view maximizing shareholder value.

I was talking with Suresh the other day about labor, and about the way labor organizing can be seen as a kind of assertion of a property right. Whether shareholders are "the" residual claimants of a firm's earnings is ultimately a political question, and in times and places where labor is strong, they are not. Same with tenant organizing -- you could see it as an assertion that long-time tenants have a property right in their homes, which I think fits most people's moral intuitions.

Seen from this angle, the fact that businesses were investing "too much" during much of the postwar decades no longer is a sign they were being irrational or made a mistake; it just suggests that they were considering the returns to claimants other than shareholders. Though one wouldn't what to read too much into it, it's interesting in this light that for the past dozen years aggregate q has been sitting at one, exactly where loyal agents for shareholders would try to keep it. In liberal circles, the relatively low business investment of the past decade is often considered a sign of something seriously wrong with the economy. But maybe it's just a sign that corporations have learned to obey their masters.

EDIT: In retrospect, the idea of labor as residual claimant does not really belong in this argument, it just confuses things. I am not suggesting that labor was ever able to compel capitalist firms to invest more than they wanted, but rather that "capitalists" were more divided sociologically before the shareholder revolution and that mangers of firms chose a higher level of investment than was optimal from the point of view of owners of financial assets. Another, maybe more straightforward way of looking at this is that q is higher -- financial claims on a firm are more valuable relative to the cost of its assets -- because it really is better to own financial claims on a productive enterprise today than in the pr-1980 period. You can reliably expect to receive a greater share of its surplus now than you could then.

[*] One of these days I really want to write something abut the investment boom of the 1970s. Nobody seems to realize that the highest levels of business investment in modern US history came in 1978-1981, supposedly the last terrible days of stagflation. Given the general consensus that fixed capital formation is at the heart of economic growth, why don't people ask what was going right then?

Part of it, presumably, must have been the kind of sociological factors pointed to here -- this was just before the Revolt of the Rentiers got going, when businesses could still pursue growth, market share and innovation for their own sakes, without worrying much about what shareholders thought. Part must have been that the US was still able to successfully export in a range of industries that would become uncompetitive when the dollar appreciated in the 1980s. But I suspect the biggest factor may have been inflation. We always talk about investment being encouraged by stuff that makes it more profitable for capitalists to hold their wealth in the form of capital goods. But logically it should be just as effective to reduce the returns and/or safety of financial assets. Since neither nominal interest rates nor stock prices tracked inflation in the 1970s, wealthholders had no choice but to accept holding a greater part of their wealth in the form of productive business assets. The distributional case for tolerating inflation is a bit less off-limits in polite conversation than it was a few years ago, but the taboo on discussing its macroeconomic benefits is still strong. Would be nice to try violating that.


  1. This really is weird, I cant't believe that up to the 70's unions etc. were so strong that they could force businesses to invest against their own profitability.

    Maybe there is some not obvious reason (say, obsoloescence of fixed capital) that keeps the "normal" value of Q below 1, and higher values are just a result of financial exuberance?

    On the wikipedia page about "Tobin q" (that I checked because I didn't know about Tobin q before I read this post) there is a graph about the historycal values of Q. The only period where Q >1 was around 1930, whith a blip before 1970 that also appears in your graph.

    1. "This really is weird, I cant't believe that up to the 70's unions etc. were so strong that they could force businesses to invest against their own profitability." -- If you want a modern version of this, just look at public sector unions. Here in the UK, to Greece to most anywhere you look, the public sector is forcing its employer to act against its own interests in giving public employees ludicrous benefits.

    2. Whatever your opinion about “ludicrous wages“, thar I don't share, unions can never force private owners to invest at loss, since the owner has always the choice to not invest his money. On the opposite, the period of q<1 was a period of high material investment, as said in the post.

    3. This is not the first comment here from "farmland investments." The name and the link are obvious spam but the comments themselves seem like real attempts to contribute to the discussion. (Not one that I agree with in this case, but that's beside the point.) Has Randall Munroe's dream come true?

      On the substance, of course RL is right. But it could still be true -- I think it was true -- that in the presence of a strong labor claim on output, a workable compromise is easier to reach when investment and growth are higher than shareholders would otherwise prefer.

  2. Sorry, in retrospect bringing in the labor as residual claimant thing is a distraction here, it doesn't really belong with this argument.

    The suggestion I'm making is *not* that unions compelled capitalists to invest against their own interest, but that the "capitalist" function was more divided between owners of financial assets and mangers of firms, and that the latter preferred a higher level of investment (out of a desire for growth, market share, survival, prestige, etc.) than would have been optimal for the former.

    1. And the short run movements in q are driven by fluctuations in stock prices rather than the capital stock, so the peaks in q basically correspond to stock market booms.

  3. The absolute value of q is more indicative of accounting practice than actual valuation.

    In manufacturing, asset book value can be quite a bit lower than actual asset market value. An asset value assessment at time of corporate sale or refinancing would be more accurate than book, but these are infrequent and almost always private.

    1. Fair point with respect to levels but I still would argue that the upward trend reflects a change in the position of shareholders vis-a-vis other claimants on corporate cashflow.

    2. KH,

      The Flow of Funds measure used by JW is supposedly based on replacement cost, as required by Tobin's Q. The Flow of Funds also has a separate memo item with assets at historical cost. And the Q based on that is different, as you would expect. Nonetheless, I question the Fed's ability to even reasonably estimate the replacement cost value of capital. So, your critique probably still stands.


      Two points. If you break up the history into three periods, 1950-1970, 1970-1990 and 1990-2010, then the correlation between the Q and the investment/GDP is quite high in the first and third periods and Q appears to lead investment. The correlation is negative in the 1970-1990 period. Clearly something was very different during this period, especially from 1975-1990. Several hypothesis come to mind: (1) oil shock necessitated investment in fuel-saving technology (2) the boom in oil exploration itself (at its peak in 1981, investment in mining structures accounted for a whopping 1.8% of GDP!), (3) inflation-hedging, but capital goods prices actually lagged general prices--so not as strong an argument.

      At any rate, I sympathetic about your broader point about shift in corporate priorities in the 1980s--although I am not sure that this particular example makes the case.


  4. Srini,

    Fair points. You are certainly right about the role of oil, although manufacturing investment was also quite high. (In fact oil/gas/mining has been a larger share of business investment in the past five years than it was in the early 80s oil boom.) On inflation-hedging, I'm not convinced that's the right comparison -- consumer goods have prohibitively high carrying costs, so the relevant question is how the return on capital goods -- including both the income they generate and any price appreciation -- compares with the yield on financial assets. Given negative real interest rates for a number of years in that period and mostly strong final demand, it's hard to see how you would not get an investment boom.

  5. I may be out of my water entirely, but in the pre 70s era through whatever mechanism the wage share of corporate earnings was roughly equal to the profit share. Since the wage share was taking half the returns it seems logical from a management perspective to juice the investments to try and grow the total: bigger growth still leads to bigger income even if its split 50/50. After NAIRU robbed wages of their share of income the added dollar of investment only had one place to return.

  6. How's this for a basic explanation of the historical q-gap. For a number of fairly obvious reasons, industrial oligopolies invest in maintaining extra fixed capital production capacity, such that the more they produce, the lower their average unit output costs. The upshot is that that can always lower prices by producing more and thus deter competitors, thus stably dividing up market share between oligopolies and preserving higher mark-ups through oligopoly market share. Thus the higher investment rate than the knife-edge that financial market types might think optimal accounts for lagging q. However, there has been extensive de-industrialization and dis-investment in the U.S. economy during the last 30 years, as corps. pursued strategies of international platforming of industrial supply chains and arbitraging FX rates and market access, thus fundamentally altering rent-seeking strategies from investment in improved production to boosting financial returns. The lower level of industrial investment and the boost in financialized rents would account for the recent return to q, (which according to your chart began around 1991, with the upward deviation due to the stock market bubble).

    But then since q is dependent on stack market prices, who knows what really "determines" them?

    1. since q is dependent on stack market prices, who knows what really "determines" them?

      The assumption behind all this is that equity prices do capture the (not necessarily correct) expectations of shareholders about future payment flows from corporations.

      I don't think that's an unreasonable assumption as far as longer term movements in stock prices go, but I agree that it would be foolish to read much into movements over shorter periods.

    2. Well, yes, that's the sort of equilibrium optimizing assumption that's made by economists, the discounted PV of future expected cash flows, etc. But stock markets have historically gone through "bull" and "bear" phases, without any close correlation with underlying economic performance AFAIK. Besides which other factors can determine equity prices, such as the amount of leveraged credit that enters into stock market prices, through PE LBOs, stock buy-backs, hedge fund schemes, etc. And it all depends on what the "longer term" of stock price movements "is". (Your chart actually only shows q being approached at the end of the 1960's after a long industrial boom and bull market, then falling back, not to be approached again until around 1991. So the simplest conclusion is that q is not a very good explanatory account of either "real" investment or stock market prices).

      But then again I'm a bit surprised at this post, since earlier you we claiming that stock markets don't actually have a function in real investment motives, but were merely a means for capitalists to cash-out on their investments. And you're missing or not responding to my main point on how "real" investment strategies and financial market "expectations" don't endemically correlate, since, as you point out, there is an informational gap, and since short-run expectations of a knife-edge efficiency optimum contradict long-run rent-seeking real investment strategies and thus financial market "expectations" are likely to lag actual immanent results.

    3. As usual, John, you make me feel mainstream. :-)

      I think it's important to distinguish two sets of claims. First, that share prices reflect the "true" present value of future payments to shareholders, taking into account all available formation, etc.; or else that stock prices reflect some kind of average expectation of shareholders of future payments, based on current conditions. And second, that q guides business investment; or else that q reflects the relationship between the current capital stock and what would be optimal for shareholders, whether or not managers actually make investment decisions on that basis. In both cases I reject the first (stronger) claim, but think the second one probably holds roughy, over long periods. (In this I'm just following Doug Henwood.)

      I would also note that the position I've taken is that the stock market doesn't *finance* investment, which is different from saying it doesn't guide it, or at least influence it. If finance didn't affect the behavior of actors in the real economy at all, there'd be no reason to spend so much time talking about it.

      I do take your point that even longer-term trends in the stock market might conceivably just be speculative noise, in which case all that q would be telling us is that there were bull markets in the 60s and 90s, and a bear market in the 70s, which we already knew. But I can't quite accept that -- I think there is some additional information here.

  7. After some thinking:
    Q is calculated after subtracting.liabilities from the denominator. If firms today are more leveraged than they were 30 uears ago Q goes necessariously up. This makes the fact that usually Q<1 even weirder. Since equities are usually seen as riskier than loans low Q might just reflect risk aversion.

    1. RL-

      The interesting thing is that if you simply measure Q as the ratio of equity to tangible assets (the light orange line in the graph), the story is almost exactly the same. Firms are borrowing more, but they have simultaneously increased "lending" (i.e. acquisition of financial assets) by about as much, so it's a wash.

  8. Thanks for the link to Leijonhufvud's book!