This paper is based on a long-term research program with Rachel Kranton on the implications of identity

32

See Abel (1979), Summers (1981), and Hayashi (1982). 

22

new unit of capital is the valuation of such a unit of capital in the stock market.  That valuation is

the market value of the firms’ shares divided by its capital stock, called the q-ratio.   If markets

are efficient, q is also the expected discounted value of current and expected future profits per

unit of capital.

32

Similar to the way in which permanent-income consumption contradicted a special role

for current income in the determination of current consumption, q-theory then contradicts both

the special role of current cash flow and liquid asset holdings in the determination of investment.

Since q-theory says that firms should invest in capital up to the point where the cost of an extra

unit of capital stock is equal to the present discounted value of the stream of earnings from a unit

of capital, again, as in Modigliani-Miller, investment is independent of the firm’s finance

decision.  This should not be a surprise, because the assumptions of this version of q-theory are

in accord with Modigliani-Miller: competitive financial markets and investment that maximizes

shareholder value.  Thus the firm’s current financial position should play no role in investment. 

In q-theory current profits are just one component of the stream of current and future profits that

determine the value of q.  In this sense they play no special role in the determination of

investment.  This de-emphasis of current cash flow (and thus current profits) in investment is

analogous to the denial of any special role of current income in the permanent income

hypothesis.

The discussion of the empirical validity of q-theory then also follows in striking parallel

to the empirical discussion of the consumption function.  Just as Campbell and Mankiw showed

that there was excess sensitivity to current income in the consumption function, Fazzari,

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33

See for example Fazzari, Hubbard and Petersen (1988).  Myers and Majluf (1984) also argued that cash

flow would affect investment when managers had information not available to investors.

23

Hubbard and Petersen (1988) have shown that investment depends not just upon q, but also upon

the current cash flows that the early Keynesians had emphasized. 

Economists have taken two different approaches to explain such excess sensitivity.  In

one approach, managers maximize stockholder value.  But the difference in information between

the managers and those who supply the financing of those projects results in a wedge between

the cost of internal and external financing.  This is clearest for firms that are credit-constrained. 

It is natural that the investment of credit-constrained firms will be especially sensitive to

available liquidity.

33

  This explanation is not without its critics.  Kaplan and Zingales (1997)

have found that credit constraint is fairly rare; they also find that the investment of those firms

with the least credit constraint are especially sensitive to cash flows.  Supporting this finding, it

appears that firms with cash windfalls tend to invest in projects that would have otherwise not

been pursued, as shown by a study of the capital spending of eleven firms that had won or settled

corporate law suits (Blanchard, Lopez-de-Silanes (1992)).  In a similar finding, in 1986, when

the price of oil declined dramatically, non-oil subsidiaries of oil companies cut their investment

relative to the median in their industry (Lamont (1997)).  

Agency models offer a second type of explanation for excess sensitivity.  This line of

reasoning is also perfectly consistent with sensitivity of investment to cash flow, even in the

absence of liquidity constraints.  This view explains the excess sensitivity as due to self-

interested decisions by managers.  There are many different types of such behavior, including

direct empire building, laziness and shirking, following the business strategies of others

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34

An excellent survey is given by Stein (2003). Jensen and Meckling (1976) pioneered the agency critique

of Modigliani-Miller.    

35

See for example Einrib (1975).

24

(herding), and aiming at short term gains at the expense of long-term earnings.

34

  Such agency

reasons for excess sensitivity of investment relative to the Modigliani-Miller theorem are exactly

in line with the general view in this lecture.  The five neutralities of macroeconomics fail to

describe reality, not just because of market frictions, but also because they are based on too

narrow a characterization of decision-makers’ objective functions. 

But considerations of self-interest are only one type of motivation that can explain

investment sensitivity to firms’ finances.  While agency theory views managers as concerned

about their own interests, the sociological approach to decision-making emphasizes the role of

norms.  According to this view employees—including managers—have a concept of their duties

in their respective jobs.  As mentioned earlier, work ethnographies indicate that most workers

have a concept of the duties of their jobs, and they are frustrated when unable to accomplish

them.  The sociological approach to corporate planning then emphasizes that managers’ various

conceptions of what they should do in those jobs will affect decisions.  There is even a body of

law, on the role of fiduciaries, which says that this is how managers and other employees are

legally obligated to behave.

35

  

Different managerial conceptions of ideal behavior will then affect corporate decisions.

Fligstein (1990) has illustrated the evolution of management conceptions of duty in the US with

the history of mergers in the 20

th

 Century.  Following Fligstein, their conceptions have gone

through three stages: In the beginning of the century, when corporate heads mainly had a

production orientation, the purpose of mergers was primarily to augment productive capacity; in

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