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MINSKY’S TWO-PRICE THEORY OF INVESTMENT: UNCERTAINTY, FINANCIAL STRUCTURE, AND ARBITRAGE BETWEEN NEW AND EXISTING CAPITAL ASSETS
Eric Tymoigne, Lewis & Clark College Minsky’s Summer School, Summer 2010
Question 1
Whatisinvestment?Investment=addi0ontothequan0tyofphysical/capitalassets
Kt=Kt‐1+OIt
K:stockofexis0ngcapitalassets(oldcapitalassets)
OI:investmentgoodoutput(newcapitalasset)(tosimplifylet’sassumethatallinvestmentisnetinvestment)
Question 2
Whatdeterminesthelevelofinvestment?i.e.Whenentrepreneurswanttoincreasetheirproduc0oncapaci0es,howdotheychoosebetweenbuyingnewcapitalassets(investment)oroldcapitalassets(mergers,acquisi0ons)?
Minsky’sanswer:itdependsontherela0onshipbetweenthedemandpriceandthesupplypriceofcapitalassets
Thedemandpriceofcapitalassets(PId)isthepricethatentrepreneursarewillingtopayforacquiring(oldornew)capitalassets.
Thesupplypriceofcapitalassets(PIs)isthereplacementcostofnewcapitalassets.
Thesetwopricesaredeterminedverydifferently.
Question 3
Whatdeterminestherela0onshipbetweenthedemandpriceofcapitalassetsandthesupplypriceofcapitalassets?
Minsky’sanswer:itdependson:
‐ Stateofexpecta0onsofborrowersandlenders
‐ Stateofexpecta0onoffinancial‐marketpar0cipants
‐ Viewsaboutnormal/acceptable/properfundingstructures
‐ Costofproduc0onofinvestmentgoodsandmark‐upovercost.
Keynes
“If Qr is the prospec0ve yield from an asset at 0me r, and dr is the present value of £1deferredryearsatthecurrentrateofinterest,SQrdr,isthedemandpriceoftheinvestment;andinvestmentwillbecarriedtothepointwhereSQrdrbecomesequaltothesupplypriceof the investmentasdefinedabove. If, on theotherhand, SQrdr, falls shortof the supplyprice,therewillbenocurrentinvestmentintheassetinques0on”(chapter11)
“Thedailyrevalua0onsoftheStockExchange,thoughtheyareprimarilymadetofacilitatetransfersofoldinvestmentsbetweenoneindividualandanother,inevitablyexertadecisiveinfluence on the rate of current investment. For there is no sense in building up a newenterpriseatacostgreaterthanthatatwhichasimilarexis0ngenterprisecanbepurchased;whilst there is an inducement to spend on a newprojectwhatmay seeman extravagantsum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certainclasses of investment are governed by the average expecta0on of thosewho deal on theStockExchangeasrevealedinthepriceofshares,ratherthanbythegenuineexpecta0onsoftheprofessionalentrepreneur.”(chapter12)
“Nowthoseassetsofwhich thenormal supply‐price is less than thedemand‐pricewillbenewlyproduced”(Chapter17)
Keynes
“Twotypesofriskaffectthevolumeofinvestmentwhichhavenotcommonlybeendis0nguished,butwhichitisimportanttodis0nguish.Thefirstistheentrepreneur’sorborrower’sriskandarisesoutofdoubtsinhisownmindastotheprobabilityofhisactuallyearningtheprospec0veyieldforwhichhehopes.Ifamanisventuringhisownmoney,thisistheonlyriskwhichisrelevant.Butwhereasystemofborrowingandlendingexists,bywhichImeanthegran0ngofloanswithamarginofrealorpersonalsecurity,asecondtypeofriskisrelevantwhichwemaycallthelender’srisk.”(Chapter11)
Minsky
Let’scombineKeynesandFisherbyincludingtheroleof: Thepriceofoldcapital(PK)asindirectlyvaluedbyfinancialmarkets,
mergersandacquisi0ons
Thepriceatwhichinvestmentgoodsaresold(PI)
Thelender’srisk:viewsaboutpoten0aldefault
Theborrower’s/entrepreneur’srisk:viewsaboutpoten0alfailureofaproject
Overindetedness:Theroleofexternalfunding(amountofleverage)andtheviewsregardingproperfundingstructureofinvestment(acceptableamountofleverage).
Thestateofexpecta0onaboutprospec0veyieldandinternalfunds(E(Πif))
Tobin’s q
q=PK/PIIfPK/PI>1then∆K=OId>0(investmentoccurs)
IfPK/PI<1then∆K=0(Redistribu0onofcapitalthroughmergers/acquisi0ons)
PK
PI
OIOId
Tobin’s q
PKandPIcomefromtwodifferentsetofpricesandbehaveverydifferently Firstset:asset/stockprices,i.e.pricesofexis0ngfinancial(PF)andcapitalassets(PK).Theyareinfluencedby: Expecta0onoffutureprofits
Liquiditypreference
Amountofliquidassetsrela0vetoilliquidassets
Secondset:output/flowprices,i.e.pricesofnewlyproducedcommodi0es,investmentgoods(PI)andconsump0ongoods(PC).
PI=(1+markup)xunitcost
Tobin’s q
Asinvestmentgoesup: PKgoesdownbecauseofmarketsatura0on(expectedmonetaryprofits
godown)
PIgoesupbecauseofpressuresonunitcostasmoreinvestmentoccurs.
WhenPK=PI,entrepreneursareindifferentbetweenbuyingneworoldcapitalassets;therefore,wegetthelevelofinvesmentoutputdemanded(OId)andthenominallevelofinvestment(PIOId)
Minsky’s Criticism
Tobin’sexplana0ondoesnotgofarenoughbecauseitmissestheroleof uncertainty
thefundingstructureofinvestment(i.e.thepropor0onofexternalfundsusestobuyinvestmentgoods)
Expected Funding Structure: Internal Funding TheamountofexpectedinternalfundsE(Πif)determinesthe
dollaramountexpectedtobeavailabletobuyinvestmentgoods:
PIE(OIif)‐E(Πif)=0
Rearrangingwegettheexpectedamountofinvestmentoutputthatwillbeinternallyfunded:
E(OIif)=E(Πif)/PI
Expected Funding Structure: Internal Funding
E(OIif1)
E(Πif1)
PK
PI
OI
PK
PIE(Πif2)
E(OIif2)
E(Πif2)>E(Πif1)
IfOId≤E(OIif)itisnotexpectedthatexternalfundingwillbeneeded.
Expected Funding Structure: External Funding IfOId>E(OIif)itisexpectedthatexternalfunds(i.e.
borrowing)willbenecessarytobuyinvestmentgoods.
Inthiscase,thereareaddi0onalelementsthataffectthelevelofinvestment. Thereplacementcostofnewcapitalassetsincludesthediscounted
valueofdebtservicepayments.
PIs=PI+unitcostofexternalfunds
Uncertainty and acceptable funding structure Expectedfundingstructureiscomparedtowhatissupposed
tobea“normal”/“acceptable”fundingstructure.Thishasastronginfluenceon: Thelender’srisk:asinvestmentincreasesexpectedexternalfunding
growsrela0vetothenormsobankersbecomemoreworriedaboutcreditrisk.Asaconsequencethemonetaryand non‐monetary costofexternalfundsgoesup(higherinterestrates,lowermaturity,morestringentcovenants)=>PIsgoesup
Uncertainty and acceptable funding structure
Theborrower’srisk:asinvestmentgoesupandborrowinggrows,entrepreneursbecomemoreworriedaboutpoten0aldefault.Theborrower’sriskreinforcestheentrepreneur’srisk.Thelaierreflectsthedoubtthatformsinthemindofentrepreneursabouttheviabilityofinvestmentasthelaiergoesup.Entrepreneur’sriskmaygrowbeforeexternalfundingisneeded.=>entrepreneurstakethepriceofoldcapitalassetsasapointofreferenceanddiscountittodeterminethepricetheyarewillingtopayforaddi0onalinvestmentgoods
Asinvestmentgoesup,PIdgoesdownbecauseofthediscountsinducedbytheentrepreneur’sriskandborrower’srisk.
Effect of higher optimism or financial innovation
PK
PI
OIE(OIif) OId
E(Πif)
PId
PKPIs
PI
Higher optimism raises the state of expectations => PK goes up, borrower’s risk goes down (PId flatter), lender’s risk goes down (PIs flatter)
Expected internal funding
Expected external funding
PIOId–(E(Πif)+E(∆LI))=0
PId
Expected and Actual Funding Structure
PIOId–Πif=0
ΠifActual internal funding
PK
PI
OIE(OIif) OId
E(Πif)
PKPIs
PI
Implications
Theavailabilityofagreateramountofinternalfundscomparedtowhatwasexpectedbooststhestateofexpecta0onsofborrowers,lendersandfinancial‐marketpar0cipants,whichfurtherpromotesinvestment.
Atthesame0memoremacroeconomicinvestmentleadstomoremacroeconomicinternalfundsgiveneverythingelse(Kaleckiequa0onofmacroeconomicmonetaryprofit):Π=PIOI+DEF.Asaconsequence,someentrepreneursearnmoreinternalfundsthanexpected.
Investmentisahighlyerra0cmacroeconomicvariable
Theanalysiscanbeexpendedtootherdecisionsthaninvestment:consump0on,financialplacement.