Re: Fundamentals

["John M. Legge" <jlegge@xxxxxxxxxxxxxx>]

I think that John V should at least skim D&P's book before he casts doubts
on their conclusions.

Valuation of an uncertain revenue stream is a precondition for investing in
its generation.  Marshallian orthodoxy asserts that the future is either
known or is stochastically ergodic, and so it is possible to compute a net
present value, given the current cost of funds, and justify investments
where the NPV is positive.

Keynes appears to have rejected this by his assertion of fundamental
uncertainty, leaving investment decisions to "animal spirits".

Dixit showed that one form of uncertainty, the geometric random walk, could
be analysed to produce a present value; but the effective discount rate was
far higher than the cost of funds.  An enterprise with a cost of funds of
five per cent might, RATIONALLY, refuse to invest in proposals where the
present value was not positive when discounted at fifteen per cent or
possibly much more.

Among the uncertainties facing any investment is that a decision by the CB
to raise interest rates may reduce the investment's present value; but by
not investing until the prospective returns would be positive at three times
the current CB rate the investor gains a certain degree of insulation from
such CB antics, and from other unknown and therefore uncertain shocks.  You
don't, following D&P, need animal spirits: just very attractive proposals
which in turn means high effective demand and the expectation that
government and CB policy will keep it high.

D&P's logic leads to a demonstration of liquidity preference under
uncertainty: if no available projects meet the hurdle rate (determined
empirically or by their formula: a strong point for D&P is that the computed
hurdle rates and the pragmatic ones are very close) and investor/capitalist
is better off holding cash than putting money into an inferior investment.

The logic, as formalised by D&P but practiced informally by most managers
contemplating sinking money into revenue generating investments is:

1. What is the current demand for the good or service that the proposed
investment would produce, and what profit stream would be generated by
meeting that demand?

2. How resilient is this demand to shocks, such as mad CBs, furious
competitors, changes in public taste, etc?

3. Have I/we got a reasonable chance of recovering our investment with a
positive net return before the good luck runs out?

Dixit demonstrated that these three questions can be formally resolved into
a "hurdle rate", and investments whose present value is not positive at this
hurdle rate should be rejected in favour of holding cash or short term
secure liquid investments like 90 day bills.

These arguments do not contradict Keynes or Post Keynesians; rather, having
accepted, in common with K and PK that liquidity preference is real, Dixit
goes on to demonstrate that it is a rational response to uncertainty and
makes a reasonable fist of quantifying it, at least for business investment
decisions.  (The high propensity to save among the aged could be brought
into the D&P schema by noting that, given the high probability of a
relatively near death, only investments/expenditures with a very high short
term return should be preferred to liquidity and the possibility of putting
the money concerned into a high short term return investment if one should
appear in the future.)

The geometric random walk is a reasonable model of non-ergodicity plus
inertia (Paul D's preference) or the consequences of incomputable complexity
(my, and I think JBR's, preference),

JML




> -----Original Message-----
> From: pkt-owner@xxxxxxxxxxxxxxxx [mailto:pkt-owner@xxxxxxxxxxxxxxxx]On
> Behalf Of John Vertegaal
> Sent: Saturday, 24 March 2001 8:24 AM
> To: POST KEYNESIAN THOUGHT
> Subject: Re: Fundamentals
>
>
>
>
> The lack of a rejoinder by JML has left my argument hanging
> in mid-air, so maybe it's worthwhile to substantiate it a bit
> by putting some meat on its bones.
>
> >"John M. Legge" <jlegge@xxxxxxxxxxxxxx> wrote:
>
> >>Dixit and Pindyck, in their "Investment Under Uncertainty"
> >>were able to demonstrate a method for determining the
> >>fundamental value of a revenue stream modelled as a
> >>geometric random walk.  This is nonstationary and therefore
> >>nonergodic.
>
> >IMHO, Dixit and Pindyck, and by implication JML and anyone
> >else putting their _faith_ in microeconomic determinants
> >are pushing on strings.
>
> What I mean to say is that the "fundamental value of a
> revenue stream" is not due to any particular capital in
> question, but instead to the inversion of myriad capitals
> economy-wide through the demand function at the retail level.
> And that these capitals, after having been the cause of this
> "fundamental value of a revenue stream", critically depend on
> how the first capital proceeds with this revenue for their
> own realization as (re)productive capitals.
>   Although new credit can of course accomplish that same
> function, such activity is a step above being "fundamental"
> and forces the economy into an quest for unrelenting growth;
> quite unnecessary for any but the financial sector, as simple
> depreciation allowances can account for and produce all the
> growth we need naturally.
>
> Because costs are disbursed before revenue can be realized
> and this realization is complex, [i.e. profit income depends
> on the direct spending of realized profit income, allowing
> through further direct spending a whole new group to realize
> their revenue etc., (in ever decreasing significance, but in
> an overlapping mode with later rounds)] _no_ determinate
> economic platform exists at any time from which the next step
> (up) can be taken.
>
> The argumentation of D and P is no more substantive than post
> hoc, ergo proctor hoc.
>
>
> >The interest rate, so called "determined" by the CB, may
> >very well be disequilibriating, throwing all relevant
> >determin[istic] equations out of the window.  The quest for
> >microeconomic fundamentals _is_ nonsens[ical].
>
> The only "link" between the rate(s) of interest and the
> rate(s) of profit, is that as costs they are imposed by those
> so empowered, on the economy for resolution; without the
> knowledge that the ability to resolve in the aggregate, and
> in real terms, lies singularly with the beneficiaries of rent
> and profit income.
>   As such _any_ "rates" are theoretically resolvable, putting
> the economy in an unencumbered reproductive mode; and have
> nothing to do with the rate of economic growth, regardless of
> how it's measured.  Thus it is satiation, and not unlimited
> wants and desires, that determines economic health or the
> lack of it.  Demand determines supply.
>   The baton of the "maestro" not only is a wand without
> magic, in the hand of an ignoramus it is a scimitar apt to
> inflict suffering.
>
> John V
>