Chapter 10 Section 3 The "Achilles Heel" of Investment Economics

In Greek mythology, Achilles was a hero born to the sea goddess Thetis.When he was young, his mother held his heels upside down to soak in the magical water of the Styx, so he was invulnerable all over.However, his heel was the Achilles' heel because it was not soaked in the water of the River Styx.In a battle, the enemy knew this secret, and aimed at his heel with one arrow, and Achilles died tragically. The "Achilles' heel" was later hailed as saying that no matter how powerful something is, there will always be an Achilles' heel. In the entire building of neoclassical economics, a perfect theoretical system with consistent internal logic has been constructed.However, does neoclassical economics have an "Achilles heel"?If so, where is it?The "Achilles heel" of economics has long been a well-kept secret.Neoclassical economics has a deep understanding of consumption and trade, such as the "random walk" model found in consumption behavior, but it is basically in its infancy when it comes to investment, which is the weakest link. Existing economic models are unable to explain investment behavior.

Tobin's Q theory is by far the best investment model.Tobin's Q ratio is the ratio of a company's market value to its asset value, reflecting the ratio of two different value estimates for a business.The value on the numerator is the capital market value of the company, including the market value of the company's stock and the market value of the bond market capital, and the denominator is the book asset value of the enterprise.Replacement cost is how much it would cost to create the company if you were to start over from scratch.When Tobin's Q is greater than 1, it means that the capital market value of the enterprise is higher than the replacement cost of the enterprise, the stock value is overvalued, arbitrage space is formed, funds will flow from the capital market to the industry, and investment will increase.When Q is equal to 1, the arbitrage space in the capital market and industry disappears, capital will be in a state of dynamic balance, and investment will be zero.When Q is less than 1, it means that the replacement cost of the enterprise is higher than the capital value of the enterprise, the value of the enterprise is underestimated, capital will be more willing to invest in securities, and investment will decrease.However, the capital market value is determined by the capital market, and Tobin's Q theory does not further describe the formation process of the capital market value.

The stock market value of companies often has a tendency to bubble. Once the stock price rises, this rise will have a self-reinforcing effect and has little to do with investment behavior.Since the British Industrial Revolution in 1820, stock market bubbles have erupted frequently, such as the British "South Sea" bubble in 1717, the US stock market bubble in 1929 and the Japanese stock market bubble in 1990.The most recent one was the Internet bubble in the US stock market from 1995 to 2001.Robert Shiller, a professor of finance at Yale University in the United States, is keenly aware that bubbles are a typical economic phenomenon. In his book "Irrational Exuberance", he vividly compares the mass psychology that spawns bubbles to a "Ponzi scheme" , which is commonly known in China as the "rat society".The recent $50 billion financial scandal on Wall Street in the United States is a typical "Ponzi scheme." The key mechanism of the "Ponzi scheme" is that the continuous investment of the subsequent investors will bring benefits to the previous investors, so all the expectations of the previous investors before the collapse have been confirmed, indicating that human beings inevitably have a desire to maintain stable expectations. The psychological tendency, that is, to believe that the world develops in a linear manner, once the final expectation is not verified, the bubble bursts.

Investing is the "Achilles heel" of neoclassical economics.I found an interesting phenomenon. British economists are more frank than American economists about investment being the "Achilles heel" of economics. Perhaps it is because neoclassical economics was developed in the United States. Keynes believed that the level of production and employment is determined by the level of aggregate demand.Aggregate demand is the total amount of demand for goods and services throughout the economic system.Keynes believed that the lack of effective demand was due to the effects of three basic psychological factors: "consumption propensity", "anticipation of future returns on capital" and "flexible preference" for money.He pointed out that aggregate demand is the sum of consumption demand and investment demand, and aggregate demand is either insufficient in consumption demand or insufficient in investment demand.Keynes believed that the psychological expectation of the future income of capital, that is, the role of the marginal efficiency of capital, is particularly important among the three basic psychological factors.Therefore, Keynes' insufficient effective demand actually refers to insufficient effective investment.

In his "General Theory", Keynes took into account the impact of psychological factors, including irrational psychology, on long-term expectations, resulting in contradictory statements.On the one hand, he found that the "law of marginal efficiency of capital" was very unstable.Keynes wrote: The characteristic of a prosperous period is that most people have optimistic expectations about the future income of capital. Therefore, even if capital goods gradually increase, their production costs gradually increase, or interest rates rise, neither is enough to hinder the increase in investment.But in the organized investment market, most buyers are at a loss as to what they are buying, and what speculators pay attention to is not to make reasonable estimates of the future returns of capital assets, but to speculate on what the market sentiment will be in the near future. Therefore, in a market with excessive optimism and excessive purchases, when disappointment comes, it will come suddenly and violently.Not only that, when the marginal efficiency of capital collapses, people's views on the future will also be bleak and uneasy, so the liquidity preference will increase greatly, and the interest rate will still rise. This can make the investment volume drop very severely.But the center of gravity of the situation still collapses before the marginal efficiency of capital—especially capital goods, which were highly valued before.As for the preference for liquidity, unless it arises from an increase in business or speculation, it does not increase until the marginal efficiency of capital has collapsed.

On the other hand, he has no way to find the systematic reason for the instability of "the law of marginal efficiency of capital", so he has to assume that the long-term expectation is stable.He wrote: "We cannot conclude that everything depends on irrational psychology. Long-term expectations are often stable, and even if they are not, there are other factors that make them so." Keynes then defined the marginal efficiency of capital in this way : "What I mean by the marginal efficiency of capital is equal to a discount rate, using this discount rate to discount the future income of the capital asset into the present value, then the present value is exactly equal to the supply price of the capital asset."

Neoclassical economics ignores Keynes's unstable observation on the "law of marginal efficiency of capital", directly assumes a stable "law of marginal efficiency of capital", and regards it as a dogma.In Solow's neoclassical economic growth model, factors such as physical capital growth and technological progress are the main forces driving economic growth.Capital has the characteristic of diminishing marginal returns, that is, if other conditions remain unchanged, if you continue to add capital, the return of each additional unit of capital will decrease, and the last added unit of capital will have the lowest return, and the last added unit of capital will have the lowest return. It is called marginal capital, and the product quantity produced by marginal capital is the marginal income of capital, and the real interest rate is determined by the marginal income of capital.Finally, real interest rates should trend toward zero.As a result, investment opportunities disappear, capital accumulation per capita stops, and economic growth disappears.If there is to be economic growth, neoclassical growth theory must assume an exogenous variable of technological growth rate.Once there is technological progress, the marginal income of capital will never drop to zero. There will always be enthusiasm for investment, and investment opportunities will always exist, and it is assumed that long-term expectations are stable.But this is fundamentally flawed.

In my opinion, the main flaw of the Keynesian investment model and neoclassical investment theory is that the assumption of the expected gradual decline in the rate of profit is fundamentally incorrect.Keynes believed that the factor of rising interest rates "would sometimes exacerbate matters and occasionally cause panics", but he thought that was not typical and did not take into account the possibility of a technological revolution. After all, Keynes lived in the period of the Industrial Revolution , did not experience the huge impact of the information revolution.His conclusion that "long-term expectations are often stable" is only applicable to the stage of conventional technological innovation. At this stage, the uncertainty of the expected return on investment is low, so investors or companies have a stable attitude towards investment and investment opportunities." Visible and tangible", investment behavior continues to take place steadily.Neoclassical growth theory cannot explain investment behavior, so it has to assume exogenous technological progress, leaving a big unknown.

Figure 1-11 clearly shows that in the 137 years from 1871 to 2009 in the United States, long-term monthly interest rates showed a long-term trend of rising and falling.Although during the period from 1979 to 1981, Paul Volcker, the chairman of the Federal Reserve at the time, raised short-term interest rates substantially in order to control high inflation, which had an impact on long-term interest rates, but it was unlikely to play a leading role.In other words, long-term interest rates are generally less sensitive to short-term interest rates.Therefore, even when inflation is taken into account, there is an obvious trend that the medium- and long-term real interest rates in the United States rise first and then fall.

Therefore, there is no strictly monotonous relationship between the interest rate and changes in capital, and the marginal productivity theory of interest is incorrect.Long-term expectations are unstable, and there is no long-term decline in interest rates, but the possibility and reality of a substantial rise.The interest rate theory of neoclassical economics is seriously flawed.Schumpeter, a representative of contemporary economics, pointed out this profoundly in "The Theory of Economic Development": "There is an old view that interest rates must show a downward trend in the long run; this view has a profound impact on classical economics. It has become almost dogmatic to many since, and there is nothing in our theory to support it. In fact, this strong impression is mainly due to the risk factor that accounts for the figures of interest rates in the Middle Ages; clear long-term trend, the history of interest confirms rather than disproves our explanation."

Arthur Lewis, a leader and pioneer in the study of economic problems in developing countries, recognized the volatility of investment in The Theory of Economic Growth, stating, "This is not to say that there will be no volatility if the economy is not growing, but in Feeling in the dark (which is the way of growth) makes investing less sure and more likely to make mistakes. This is why many economists believe that volatility is the price of economic growth, that there is no prosperity without recession, and that if Without prosperity, capital formation would generally not be as rapid as it is now."Both the Keynesian investment model and the neoclassical investment theory assume the existence of investment opportunities. In fact, investment opportunities will eventually disappear within the scope of a productive force.In The Theory of Economic Growth, Arthur Lewis worries about high savings rates, "in theory, increased saving may depress investment, but increased saving may also promote investment. Those capitals are already so abundant that investment incentives are weak countries must take into account the possibility of excessive savings levels, or run the risk of chronic lack of investment opportunities".

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