III. IMPLICATIONS OF THESE CHANGES FOR MONET ARY POLICY
3. THE PRICING OF THE CAPITAL STOCK
The lefthand portion of Figure 1, Figure 1a, asserts that for a given capital stock, the price per unit of capital is a func tion of the money supply. This asser tion rests upon an argu ment about how assets are valued in the face of uncer tainty and in the light of the exist ence of complex finan cial struc tures.
Underlying Figure 1a is the view that all assets—real and finan cial—are equi val ent in that they are expec ted to gener ate cash flows. These cash flows fall into two classes. The first class of cash flows result as assets do their thing—are used in produc tion processes if they are real assets or as contract condi tions are satis fied for finan cial assets. This first class will be called cash flows from oper a tions for real assets and cash flow from contract fulfill ment for finan cial assets. The second class of cash flows result as assets are sold or pledged.
The nonKeynesian theory of asset valu ation concen trates only on the first class of cash flows. In this view the cash flows that a set of real assets collec ted in a firm will gener ate are the future cash flow from oper a tions as given by total revenue minus out of pocket costs (the out of pocket costs are the vari
able costs of “cost curves analysis” with Keynesian user costs excluded from the vari able costs). Obviously for a firm these cash flows from oper a tions will be condi tional upon the state of the economy, the product and factor markets, and the manage ment of the firm.
The current fashion is to argue that assets with differ ent prob ab il ity distri
bu tions should be valued not in terms of their expec ted values but in terms of their expec ted util it ies—where the trans form a tion between income and utility reflects the units atti tude toward risk (Arrow).
Even though Keynes was skep tical of the valid ity of the Benthamite calcu lus when applied to incomes, the expec ted utility hypo thesis is a useful expos
it ory device for Keynesian ideas if it is accep ted that (1) the prob ab il it ies set on various altern at ives are subject ive and thus subject to sharp changes if appro pri ate trig ger ing events take place, and (2) the curvature of the trans
form a tions between income or cash flows and utility—the aver sion or attrac tion to risk of the various actors—is itself an endo gen ously determ ined
rela tion and will undergo both slow and sharp changes depend ing upon what happens.
The expec ted utility hypo thesis yields for each distri bu tion of expec ted incomes an expec ted utility. There also exists an income with certainty that will yield utility equal to the expec ted utility. We can call this income the certainty equi val ent income. The conclu sion on asset price form a tion has been that assets will exchange at the same ratio as their certainty equi val ent incomes. Given that a dollar yields a utility with certainty, this certainty equi val ent approach to asset valu ation yields the abso lute price of various assets.
Note that this argu ment holds for both real and finan cial assets. For debts the cash flows are given by the face of the contract and the prob ab il ity judg
ments have to be made with respect to the like li hood that the contract will not be fulfilled and the cash flow that will take place in this event.
The above valu ation theory has to be modi fied by taking into account the second way in which an asset can gener ate cash—by being sold or hypo
thec ated. Assets differ greatly in the ease with which they can be marketed or pledged. In conven tional money market analysis the market ab il ity of an asset is some times treated by allud ing to the breadth, depth, and resi li ence of its market. The same factors apply to real assets—except that the weight normally attained to the circum stances under which they will have to be sold or pledged is slight and typic ally the sales market is expec ted to be narrow, shallow, and nonresilient.
The like li hood that cash will have to be raised by selling or pledging assets depends upon the cash posi tion and the cash payment commit ments of a unit. These cash payment commit ments are embod ied in the liab il ity struc ture of firms. At any date the liab il ity struc ture of a firm is determ ined by market condi tions which ruled when the firm financed asset acquis i tions and refin anced its posi tions in assets.
Cash payment commit ments include both the repay ment of prin cipal as well as the payment of interest.4 If control over assets is financed by liab il
it ies which are of shorter life than the asset, then the cash required by the liab il ity contract over its life may well exceed the cash the assets will gener ate over these periods. In such circum stances the cash needs due to the liab il ity will have to be met by the issu ance of a new liab il ity. Such refin an cing of posi tions by sale of liab il it ies is a char ac ter istic banker’s beha vior: commer
cial banks, bill dealers, and finance compan ies normally engage in such refin an cing. At the time of its failure, the PennCentral railway had short
term liab il it ies outstand ing which had to be “turned over” for the railway to remain “liquid.” When this became impossible, the railway went bank rupt.
In Figure 2 the short run cost condi tions of a firm are sketched. The given plant defines the marginal and average vari able cost (net of Keynesian user costs) for given wage rates. The other average cost curves reflect the payment commit ments as embod ied in liab il it ies; the curves for three altern at ive balance sheets are sketched. Given an expec ted price P, the differ ences P – ACL1 and P – ACL2 indic ate the fall in output price that would lead to the cash flow from oper a tions falling short of the cash needs as given by the liab il ity struc ture.
The third average cost curve ACL3 reflects a situ ation in which the cash flow from oper a tions is insuf fi cient to meet the cash needs of the liab il it ies.
Often, but not always, this situ ation arises when the prin cipal amount of some liab il it ies falls due. If the expec ted cash flows from oper a tions Q(P – AVC) are large enough and if finan cial market condi tions are orderly a rolling over of liab il it ies will usually be feas ible. If expec ted cash flows are
“too small” relat ive to payment commit ments or if market condi tions are disorderly, such refin an cing might be expens ive if not impossible.
If the payment commit ments are large relat ive to the cash flow from oper a tions, the altern at ive to refin an cing is the sale—or the mort ga ging—
Figure 2
Accepting Accepting
Accepting Accepting Kind
Kind Kind Kind
Kind Kind Kind
Kind Kind
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of assets. The various real and finan cial assets are sale able to the extent that they can be trans ferred cheaply to easily located buyers and that they are expec ted to gener ate desired cash flows for these buyers. If an asset is a special purpose asset embed ded in a produc tion process then it has only a limited ability to gener ate cash by sale.
Thus the valu ation of assets in a capit al ist economy can be struc tured as a two stage process. One stage estim ates the value of the cash the asset can gener ate as the owning unit oper ates it in the current and expec ted economy;
the second stage estim ates the value of the cash it can gener ate by “sale,”
under pres sure, at any date. The market value is some weighted average of these two values.
If assets are equi val ent with respect to the cash flows they are expec ted to gener ate from use or contract, then assets with a poor second ary market will sell at a discount relat ive to assets with a good second ary market.
The weight attached to the like li hood that assets will have to be sold to raise cash can change rapidly and thus affect the relat ive prices of real capital assets with restric ted second ary markets to that of readily market able finan
cial assets. For real and finan cial assets there fore the market price reflects both productiv ity and contract concepts as embed ded in the expec ted cash flow from oper a tions and contract fulfill ment, and spec u lat ive aspects which reflect views as to the like li hood of circum stances arising in which a forced sale of such assets is neces sary.