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)

Fisher

(Fisher 1932, 11)

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))

Minsky’s Diagram

PK

PI

OIE(OIif) OId

E(Πif)

PId

PKPIs

PI

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

PIs

PK

PI

OIE(OIif)

E(Πif)

PK

PI

Expected Funding Structure: External Funding

Uncertainty and acceptable funding structure   Expectedfundingstructureiscomparedtowhatissupposed

tobea“normal”/“acceptable”fundingstructure.Thishasastronginfluenceon:  Thelender’srisk:asinvestmentincreasesexpectedexternalfunding

growsrela0vetothenormsobankersbecomemoreworriedaboutcreditrisk.Asaconsequencethemonetaryand non‐monetary costofexternalfundsgoesup(higherinterestrates,lowermaturity,morestringentcovenants)=>PIsgoesup

PIs PKPK

PI

OIE(OIif) OId

E(Πif)

PI

Uncertainty and acceptable funding structure

Uncertainty and acceptable funding structure

  Theborrower’srisk:asinvestmentgoesupandborrowinggrows,entrepreneursbecomemoreworriedaboutpoten0aldefault.Theborrower’sriskreinforcestheentrepreneur’srisk.Thelaierreflectsthedoubtthatformsinthemindofentrepreneursabouttheviabilityofinvestmentasthelaiergoesup.Entrepreneur’sriskmaygrowbeforeexternalfundingisneeded.=>entrepreneurstakethepriceofoldcapitalassetsasapointofreferenceanddiscountittodeterminethepricetheyarewillingtopayforaddi0onalinvestmentgoods

  Asinvestmentgoesup,PIdgoesdownbecauseofthediscountsinducedbytheentrepreneur’sriskandborrower’srisk.

PId

PK

PI

OIE(OIif) OId

E(Πif)

PKPIs

PI

Level of real and nominal investment

I = PIOId

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.