Thorstein Veblen’s 1904 contributions to q and insider/outsider analysis

Abstarct

The early 20th century saw the first steps in a tradition of leading economists explaining the link between corporate finance, investment and capital valuation. The writings of Keynes, and Tobin deal with the development of an investment theory based on the financial structure. However there is no mention Veblen, whereas he made an early American analysis of corporate governance structure. Our work is based on a critical review of the literature, which is guilty of omissions, lack of accuracy and errors of formalization. So that, we focus on the reasons why Veblen’s corporate financial analysis should not be forgotten.

Keywords:

• capital valuation
• corporate governance
• financial structure
• goodwill
• Q-investment theory
• Veblen

Codes JEL::

• B15
• D24
• D46
• D72
• E22
• G32
• G34

Acknowledgements

I would like to thank Jérôme de Boyer des Roches for his valuable discussion, Thierry Granger for his interesting comments at the doctoral seminar in Dauphine in April, 2015 and Maria-Luisa Ratto and Richard Arena for their valuable proofreading.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1 Capital, Book III, ed. 1894

2 Veblen has the reputation of being a difficult writer to read. See Dieudonné (2014) for more details on the trial-and-error nature of his thinking about capitalization of assets.

3 Modern principles of the role of the structure in terms of financial value were developed in 1958 by Modigliani-Miller.

4 “I = (P’*C) is the value (as distinguished from I’, the cost of production) of the increment of new investment goods” (Keynes 1930 [1965], I, 137). With P’ = “the price level of new investment-goods” (p.137) and C = “the net increment of investment” (p.135).

5 “Let E be the total money-income or Earnings of the community in a unit of time, and I′ the part of it which has been earned by the production of investment-goods, so that I′ measures the cost of production of new investment.” (Keynes 1930 [1965], I, 135)

6 “E−I′ [is] the cost of production of the current output of consumption-goods.” (Keynes 1930, 1965, I, 135) and E−I′ = C′

7 The fundamental equations of the Treatise on Money describe a two-sector production model where the excess demand for consumption goods does not result in an excess supply of investments goods. See J. de Boyer (1982).

8 Including a risk premium. Actually, the money rate can be found in the newspaper, as the market price, while the natural rate is hidden and deduced from exogenous variables.

9 By hypothesis, Q₁=0, i.e., i.e. I′ = S. Therefore I = I′ means I = S.

10 In his preface to Wicksell’s Interest and Prices, Bertil Ohlin writes: “this natural rate is roughly the same thing as the real interest of actual business” (B. Ohlin 1898 [1936], xxv).

11 In 1936 ([1973], 140–1) Keynes referred at length to Irving Fisher (Theory of Interest, 1930; Booms and Depressions, some first principles, 1932 and The debt-deflation theory of great depression, 1933), to explain that they shared the same understanding in Fisher’s rate of return over cost and Keynes’s marginal efficiency of capital. (See, Kregel 1988, 64–65; de Boyer, 1988, 70 and M. Boianovsky 2013, 212, 215, 217).

12 However, although in Wicksell there is only one natural rate of interest, in Keynes (1936) there are many. “In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest—namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell's ‘natural rate of interest', which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level. I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the ‘natural' rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.” (1936 [1973], 242–243)

13 In a footnote, Tobin and Golub (1998) specify that: “Gunnar Myrdal (1931, 1933) long ago anticipated q, even called it Q! However, his Q was not a ratio but the absolute difference between market value and replacement cost. His articles were in Swedish and German - translate in English in 1939 by Robert Bryce, former Keynes’s student- not known to the authors of q until Klaus Schmidt, a graduate student at Johann Wolfgang Goethe University in Frankfurt called them to the author’s attention in 1994. See Schmidt (1995).” (Tobin and Golub, 1998, 150). The article in question by Klaus Schmidt published in 1995 is entitled “Tobin’s q ? Myrdal’s Q! ein Fallbeispiel für den Wert von Fremdsprachenkeantaussen”. Schmidt proposes to link the Tobinian analysis of investment with the financial structure of the company with the one of Myrdal. Actually, Schmidt was a student of Myrdal and he tries to make him recognized as one of the pioneers of what we called the Q-theory. Schmidt aims to give rise to the construction of a theory of investment choices through a new interpretation of Myrdal of Wicksellian system. In fact, Robert Dimand in 2014, in his book about “James Tobin” examines the question: “What are the historical roots of Tobin’s q?” (2014, 74). In fact, according to Dimand, even if there is indeed a Q in Myrdal’s writings (1931, 231–233; 1933, 431–4), Schmidt outclasses Myrdal (1931, 1933) because Schmidt is not aware of the Keynesian Q of 1930. Myrdal was not the first to speak of Q and to be inspired by Wicksell. Schmidt does not see that Myrdal quotes Keynes’s 1930. According to Dimand, Keynes’s Treatise on Money (1930) was “carefully studied by Myrdal” (Dimand 2014, 75) and, according to Myrdal, this treatise “is completely permeated by Wicksell’s influence” (Myrdal 1939 [1965], 8–9). However Myrdal stresses that in the Treatise “the entrepreneur’s activity commences immediately a difference in the interest rates appears; however small it may be” (Myrdal 1939 [1965], I 76). Schmidt is also unaware of the difficulty of translation when Myrdal’s “Om penningteoretisk jëmvikt: en studie over den “normal räntan” i Wicksells penninglära” (1933), was translated into german (1933) and then English by R.B. Bryce and N. Stolper in an extended version as early as 1939 (Monetary Equilibrium). Dimand (2014) mentions this on Schmidt and he draws a critical: “Indeed the real message is that investment is related to discrepancies between the marginal efficiency and the interest rate. This is in the tradition of Wicksell and of Keyne’s earlier work (1930).” (Dimand 2014, 74–75). But the filiation of Tobin with these authors is not recognized in the 1990s as the publication of Schmidt’s article gives the illusion. “Schmidt (1995), and following him Tobin and Golub (1998), did not notice that Myrdal (1931, 1933, 1939) chose the symbol Q with the expectation that his readers would be familiar with the Q of Keynes’s Treatise, and hence could not notice that Keynes (1930) in turn had selected the symbol Q for an intended audience that would think of Marshall’s quasi-rents.” (2014, 76)

14 As we seem to forget that before Tobin, Dale Jorgenson had also popularized the theory of investment. (James R. Crotty 1990, 8)

15 Without forgetting T. Greene (1897), W.Z. Ripley (1905), W.H. Lyon (1912), A.B. Norris (1913), and A.S. Dewing (1919) et al.

16 Dimand (2004) emphasizes “that this [between Veblen’s 1904 and Fisher’s] affinity also exists between Veblen (1904) and the analyses of Minsky (1975, 1985, 1986) and Tobin (1975, 1980) that draw upon Fisher (1932, 1933).” (2004, 462). A paragraph p.465 is concerned with q-Tobin without however citing his work of 1969.

17 We strongly believe, like Wesley Pech and Marcelo Milan (“Behavioral economics and the economics of Keynes”, 2009), that Keynes knew the writings of Veblen.

18 Moreover, Mitchell (1936) seeks to give prosperity to the writings of Veblen which he considers as a great economist. He vows respect and admiration, and this is visible both by his dithyrambic comments and presentations of the work of Veblen, but also through his correspondence as soon as he evokes Veblen. For example, in a letter that Mitchell addressed to Veblen himself on March 2, 1929 (WCMP, Box 11), shortly before his death, he informed him (on the occasion of the desire to publish a work rendering him a fair theoretical and academic place) : “If I don’t make a fascinating book of selections the fault will be mine“. Moreover, Veblen had a real posterity thanks to What Veblen taught (1936) as Tipton R. Snavely, among others, emphasized “Professor Mitchell has rendered a highly valuable service to economists and students of social questions by bringing together in one volume the more significant ideas of Thorstein Veblen. In addition, he has contributed a charming introduction which is quite as revealing as anything that has been written about Veblen’s own writings and “preconceptions”.” (1936, 216). It is obviously not the only one, we can also cite among the most important Joseph Dorfman (1934) or Max Lerner (1948). Following this publication, various eloquent publications showed the importance of rereading Veblen, “The artist in economics “according to Eli Ginzberg (1934), or “Gateway to Veblen’s world” according to Max Lerner (1934).Some disciples with a keen interest thus allowed the posterity of Veblen: “A quarter of a century ago Dr Wesley C. Mitchell of Columbia University remarked that in approximately ten or fifteen years he hoped that “AO” [Absentee Ownership] would be as simple for the average student to read as “the TBE” [The Theory of Business Enterprise]” (Mitchell lecture notes on history of economic thought 1934-5) (R.Schulman 1962, 319).

19 And with the knowledge of this value it is possible to manipulate the market in order to extract “secret profits for insiders” (W.Z. Ripley, 1905 [1916], xxii).

20 Because for J.M. Keynes (1936) “each capital and financial asset yields an income stream,” according to Minsky (1993, Comment on Ben Bernanke, ‘Credit in the Macro-economy’) and income streams are uncertain because they depend on subjective expectations.

21 As in J.M. Keynes: “gradual increase in the proportion of […] equity […] which is owned by persons who do not manage and have no special knowledge of the circumstances, either actual or prospective, of the business in question.” (1936, 138)

22 Myrdal was one of the first economists to include expectations theoretically in his economic calculations (André Marchal 1950). Following the Wicksellian tradition, Veblen evokes a hope of surplus profit. Wicksell just presents an analysis of the price of property defined by the rate of return, which does not involve the capitalized value.

23 Note that Dimand said with irony about the level of Veblen’s level of mathematical analysis: “The elaborate mathematical formulae in the footnotes of The Theory of Business Enterprise (Veblen 1904 [1996], 95–96n, 110n, 150n, 153n, 160n, 169–70n, 203–204n, 223n, 230n, 233n, 244n) appear to me to be a straight-faced parody of mathematical economists such as Fisher, comparable to Alan Sokal’s Social Text parody of the postmodernist side of the science wars.” (Dimand 2004, 469). The interpretation of the most relevant ideas and their selection in his various writings is a difficult task because of the repetition of ideas (Sweezy 1957) but also because of his sometimes confused way of formalizing them (Ayres 1963). Let us also note that his nephew, Oswald Veblen was a great mathematician.

24 In addition, an extensive literature exists on Tobin’s q (see footnote 87, but also Hayashi (1982), Baxter and Crucini (1993)), which appears as an important gauge to measure business behavior and as a way of modeling that emerged in the 1970s. This is a basic model which summarizes the useful information and puts profitability and investment into perspective, hence the popularity of this ratio. The better understanding of company behavior is the result of modeling efforts over the long term, by several theorists, to obtain the necessary estimation methodology.

25 “The question of fair prices and reasonable profits has some reference to current rates of interest. […] New investments are made on the basis of current rates of interest and with a view to securing the differential gain promised by the excess of prospective profits over interest rates.” “The question of the turnover becomes, under the circumstances of the modern corporation finance, in great part a question of the interval between the purchase and sale of the capital engaged in industry on the one hand, and of the magnitude of the discrepancy between actual and putative earning − capacity on the other hand, rather than a question of the period of the industrial process and the magnitude of the output and its price.” (Veblen 1904 [1996], 218 and footnote 102)

26 We use here Crotty's (1990) article but note that Brainard and Tobin publish a response the same year “On Crotty's critique of q-theory” in which they ask “why Crotty has created a fictional Tobin who thinks otherwise.” (1990, 548) and reject Crotty's interpretation of Tobin. Yet Crotty's article has been quoted many times in the literature and it is not because they refuted Crotty's ideas that it legitimizes Crotty's totally misreading. There may therefore be errors of interpretation in Tobin's interpretation of the maximization ratio, but we share Crotty's analysis that Tobin has very little interest in the management issue. Indeed, Tobin opts for a “capital account approach” (1969, 17) and speaks of “investors” (Brainard and Tobin 1977, 142) but it is in fact an analysis in terms of “properties” that absolutely does not highlight the principal-agent problem. He does not consider the figure of the manager as particularly important, to treat differently. In any case, this is not what emerges from his writings. Brainard and Tobin denounce “Crotty cites it as a failure of q-theory and an example of managerial independence” (1990, 546) but Tobin does not emphasize the imbalance of power, he is not interested despite the conclusion: “we [Brainard and Tobin] are so far from being thorough-going neoclassicals that we are quite comfortable in believing that corporate managers and other economic agents respond to market noise and are in any case sluggish in responding to the arbitrage opportunities of large deviations of “q” from par” (Brainard and Tobin 1977, 548). They point out that q-theory is a hypothesis and that “Yes? Q-theory works best if managers act in the interests of the stockholders.” (1977, 543), “the surely are divergences of interest between managers and owners” (1990, 544) even if finally not so far from “The neoclassical theory of corporate investment is based on the assumption that the management seeks to maximize the present net worth of the company, the market value of the outstanding common shares.” (1977, 527–8). Certainly in 1977 they underline the intellectual motivations of the elaboration of the Q-theory but not once is question of the managers.

27 However, even the comprehensive article of Hannah (2007) “The ‘divorce’ of ownership from control from 1900 onwards: re-calibrating imagined global trends” does not cite Veblen for these changes in the operation of the company’s management.

28 Keynes, in 1936, also made the company a central institution of the economy, in the passage about casino capitalism in Chapter 12.

29 Although there are Bolbol and Lovewell (2001) and Stravelakis (2013) “Hilferding over Marx: a political economy viewpoint of struggles in the left 1900–1933 and the modern revival.” See also Jérome de Boyer “Marx and Hilferding on profit of enterprise and promoter’s profit” (2015).

30 See Sophie Boutillier, 2010, “L’entrepreneur artisan. Entreprendre et dynamique du capitalisme essai d’analyse d’Adam Smith à David Audretsch” for an interesting summary.

31 “Ce ne sont pas les capitalistes industriels, mais les managers qui sont l’âme de notre ‘système industriel’” (1968, 1147 Le Capital, Livre III, Cinquième section, Chap. 15)

32 “Here Marx succinctly formulates a thesis that was proposed sixty years later by A.A. Berle and G.C. Means in The Modern Corporation and Private Property, 1932. It can be used as an epigraph to any sociological analysis of managerial functions in large capitalist firms and companies possessing the rights of private property […]” .

33 He also derived the notion of captains of industry: “Industriekapitäne” (Capital, 1872 [1903], volume 1, 457).

34 “C’est maintenant les capitalistes industriels et commerciaux qui dictent les conditions au capitaliste financier” (Marx, 1894 [1959], 156)

35 In addition, Hilferding drew on Marx to develop his analysis of leverage that allows him to propose a promoter’s profit: “neither a swindle, nor some kind of indemnity or wage. It is an economic category sui generis” (Hilferding, 1910, 112), but both Veblen and Hilferding make the same mistake in using a capitalization rate whose risk premium does not vary with the indebtedness (De Boyer, 2003).

36 Marx speaks of “a whole system of swindling and cheating” (1864–1875 [1909] Capital, Vol III, chapter 27), what is call “tripotages de crédit” in the French version (1894 [1968], 1786).

37 See P.H O’Hara “Veblen’s critique of Marx’s philosophical preconceptions of political economy” (2006) and A.H Mouhammed “A Critique of A Marxist Critique of Thorstein Veblen” (2008).

38 “But this centralization, which only redistributes the social capital already to hand, and melts a number of old capitals into one, works in its turn as a powerful agent in the metamorphosis of old capital’s most powerful levers of centralization – competition and credit.” (Annotations to Karl Marx’s Capital by Hans Ehrbar (2005). Available at http://marx.economics.utah.edu/das-kapital/akmc/cic25.htm).

39 We find the same idea in Tobin and Golub: “if new debt or equity securities are issued to raise the cash, the successful prospectus leads to an increase of share prices.” (1998, 149)

40 Under certain assumptions: identical taxation on all modes of financing, completeness and absence of imperfection on the financial markets. See Cobbaut, Théorie Finanicère, Economica, 1987 or Stiglitz (1969). The American Economic Review, 59(5), 784–793. It should be noted that Modigliani and Miller subsequently integrated into their theorem such elements as corporate taxation and agency problems, responding to the questioning of their hypothesis of market perfection, which they release.