Presentation Speech by Professor Assar Lindbeck of the Royal Academy of Sciences
Translation from the Swedish text
Your Majesties, Your Royal Highnesses, Ladies and Gentlemen,
One of the most common prejudices among ordinary people concerning economics is that it is mainly about money and finance. However, in the case of this year’s prize in economics, this conception is in fact not too far from the truth.
The Laureate of this year, James Tobin of Yale University, has been awarded the prize for his analysis of how changes in financial markets, i.e. the markets for money and financial assets, influence the real markets where decisions are taken about consumption, production and investment. This is an important issue because the effects on the economy of economic policy, monetary as well as fiscal policy, are to a large extent transmitted via the monetary and financial markets.
The starting point of Professor Tobin’s analysis is a mathematically formulated risk theory of the allocation by individual firms, institutions and households of their portfolios among different assets-such as cash, bank deposits, bonds, shares and physical assets of various types. This year’s prize gives him in fact a unique opportunity to practice his theories very concretely for himself!
The individual agents in Tobin’s portfolio theory are assumed to base their decisions on the yield and risk that are connected with the entire portfolio of assets and liabilities. By adding the portfolio decisions of all agents, we obtain the total demand and supply of various types of assets for society as a whole. By way of an analysis of the interaction between demand and supply, it is then possible to explain equilibrium prices and interest rates for the various assets, such as bonds and shares.
The next step in the analysis is to study how changes in various financial markets – for instance due to government budget deficits or changes in exchange rates or exchange reserves – are transmitted to decisions on consumption and investment. A particular feature of Tobin’s analysis of these so-called “transmission mechanisms” is that there is assumed to exist a very broad surface of contact between financial and real markets. The whole spectrum of claims, liabilities, market prices and interest rates on all types of assets, in principle, plays a part in the transmission of impulses from monetary and financial markets to real markets.
Of particular interest in Tobin’s analysis is the way in which changes in financial markets influence investment in buildings and equipment. Professor Tobin’s theory goes back to important contributions by economists like Knut Wicksell and John Maynard Keynes, according to whom investment decisions are determined on the basis of the relation between capital costs and expected return on real investment. One of Professor Tobin’s main contributions is to give this old theory both a more solid theoretical structure and an empirically and statistically more useful formulation than earlier.
The letter “q” has in this connection become a symbol for Tobin’s portfolio theory. If someone in the audience on a visit to Yale University would see some students running around in T-shirts with the letter small “q” on the front, you could conclude that you are looking at graduate students in economics. “q” simply expresses the ratio between the market value of a physical asset on the one hand, and the cost of producing this asset all over again, on the other. For instance, if in a certain situation the market value in the stock market of a firm is lower than the cost of reproducing the same type of physical asset of the firm, so that Tobin’s q is smaller than unity, it will be more profitable for firms to buy each other out than to invest in new buildings and equipment.
One of the economic problems of many countries today, not least for Sweden in the seventies, has been exactly that the market value of firms as recorded in the stock market, has become too small as compared to the costs of building new plants. The result has been low investment and low economic growth rate. Tobin’s analysis in fact gives a pedagogically simple and convincing picture of the important part played by the stock market as a source of information and a mechanism of allocating saving and investment in the national and international economy.
The last step in Tobin’s analysis is to explain how changes in consumption and investment influence national income and how this change in turn is divided into changes in production volume and prices. In this context Professor Tobin has discussed the consequences of stickiness of wages, and therefore also of prices, which means that a generally restrictive economy policy in the short run results in a fall in the production volume and the level of employment rather than in the rate of increase in wages and prices. As we know, this is a basic dilemma of economic policy: the disadvantages in the form of cutbacks in production and employment come first, while the benefit in the form of reduced inflation comes later.
You have laid a solid, and empirically applicable, foundation for studies of the functioning of monetary and financial markets, and you have also shown how changes in these markets influence the magnitudes of consumption, investment, production, employment and economic growth.
Your achievements are characterized by a rare combination of keen insight, analytical skill and a good common sense for practically relevant problems. Your scientific contribution is well anchored in the tradition of central economic theory, and your originality is a natural part of the continuous long-term accumulation of basic scientific knowledge in economics.
It is a great pleasure to convey to you the congratulations of the Swedish Royal Academy of Sciences, and to ask you to accept from the hands of His Majesty the King the 1981 Prize in Economic Science dedicated to the memory of Alfred Nobel.