Veblen's Q-Tobin's Q
Medlen, Craig, Journal of Economic Issues
The possible discrepancy between the market valuation of firms and the replacement costs of the underlying assets has long been noted by economists, going back at least as far as Knut Wicksell (1) and Thorstein Veblen. For the modern period, this discrepancy has been the foundation of an investment theory now termed Q theory. Following John Maynard Keynes, James Tobin and William Brainard have argued that stock market booms encourage new investment (Brainard and Tobin 1977, 235-262). During a stock market boom, production of new capital equipment could, in the words of Keynes, "be floated off on the Stock Exchange at an immediate profit" (1936, 153). "It is common sense," said Tobin, "that the incentive to make new capital investments is high when the securities giving title to their future earnings can be sold for more than the investments cost" ( 1996, 14). This ratio of the market valuation of firms to their "replacement costs" has been dubbed Q and has been utilized extensively since the late 1950s to model new investment expenditures. (2) It has also been used to explain "takeover mania" by "egregious undervaluations" relative to "the fundamental value of the underlying assets" (Tobin 1984, 6-7).
Modern Q theory derives from Keynes' remarks in the General Theory and is innocent of any knowledge of its antecedents. In fact, however, Veblen's early formulation of capital theory captured a ratio that was virtually identical to Q. Veblen put the discrepancies of capital valuations at the very heart of a historiography of "capital"--a historiography that understood "capital" as acquiring different meanings in accordance with time period and the alteration in industrial structures. But far from understanding discrepancies in capital valuations as strategic for growth (as modern Q theory emphasizes), Veblen put these discrepancies at the very heart of his theory of evolutionary finance and crises. Veblen held that the discrepancy between the "normal rate of profit" and actually realized profit in nineteenth century competitive capitalism devalued capital and undercut businessmen's resolve in pursuing growth. In the transition into the modern period of oligopolies and monopolies, the rise of intangible "goodwill" allowed an expanded capitalization--what today would be called a rise in Q. For Veblen, such an increase in market valuation did not portend investment growth (as Q theory would have it) but a slow-down in production and new investment. Veblen also maintained that such an increase in Q allowed an expansion of leverage that constantly threatened inflation and possible financial meltdown.
In this essay, I claim that modern Q theory could benefit from Veblen's insights into monopoly power. Today, the disconnect of modern Q theory from its origins in Veblen's theory of capital is total. At base, this disconnect reflects modern capital theory's total abandonment of any historical inquiry into changes in the industrial structure and how these changes have affected capital spending, lf Q theory were efficacious in predicting new investment and mergers, this neglect might not be justified but at least it might be explainable on the basis of efficaciousness. But Q theory has not proved its worth. Models relating Q theory to new investment expenditures generally do not predict well (Chirinko 1993, 1875-911). It may be that this inability to forecast relates to "problems constructing empirical counterparts to the unobserved theoretical q variable" (McCarthy 2001). But it may also be due to a neglect to study the industrial structure in terms of how modern oligopolies actually respond to boom and bust conditions. lf Q theory fails to correctly predict the levels of new investment in booms, at least the increase in new investment experienced in booms corresponds to what Q theory would (qualitatively) and tautologically (3) predict. Not so with mergers and acquisitions. As I will show below, mergers and acquisitions actually expand relative to new investment during stock market booms--that is, during the time when mergers and acquisitions become expensive. …