Wednesday, November 19, 2008

Stocks, Flows, and the Funding of New Projects

The post is to clarify some confusion among blog readers. I wrote in the New York Times:

Although banks perform an essential economic function - bringing together investors and savers - they are not the only institutions that can do this. Pension funds, university endowments, and venture capitalists and corporations all bring money to new investment projects without any essential role played by banks. The average corporation receives about a quarter of its investment funds from the profits it has after paying dividends - and could obtain even more by cutting its dividend, if necessary.

Note that the funds referenced here are flows, and are distinct from the value of institutions that own them. A business needs cash flow -- from its own operations or some other institution -- to pay for investment. The value of the institution is only on paper. For example, a startup company could have tremendous value but no cash flow (or negative cash flow) from its operations and therefore needs outside funds to invest. Conversely, many corporations, pension funds, endowments etc., today have suffered losses in value but nonetheless have significant cash inflows from their investments and operations. Those adverse changes in no way refute or de-emphasize my point. Indeed, Luke Threinen and I predicted both reduced values and increased investment funding. Its poor cash flows that will get my attention.

The importance of flows is why I keep an eye on aggregate capital income in the economy -- the marginal product of capital -- and not the aggregate capitalization of the stock market or some other valuation measure. Aggregate capital income was low during the years prior to the 1930s bank panics; so far those flows are fine today.

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