The possible discrepancy between the market valuation of firms and the replacement costs of the underlying assets has long been noted by economists, going back at least as far as Knut Wicksell (1) and Thorstein Veblen. For the modern period, this discrepancy has been the foundation of an investment theory now termed Q theory. Following John Maynard Keynes, James Tobin and William Brainard have argued that stock market booms encourage new investment (Brainard and Tobin 1977, 235-262). During a stock market boom, production of new capital equipment could, in the words of Keynes, "be floated off on the Stock Exchange at an immediate profit" (1936, 153). "It is common sense," said Tobin, "that the incentive to make new capital investments is high when the securities giving title to their future earnings can be sold for more than the investments cost" ( 1996, 14). This ratio of the market valuation of firms to their "replacement costs" has been dubbed Q and has been utilized extensively since the late 1950s to model new investment expenditures. (2) It has also been used to explain "takeover mania" by "egregious undervaluations" relative to "the fundamental value of the underlying assets" (Tobin 1984, 6-7).
Modern Q theory derives from Keynes' remarks in the General Theory and is innocent of any knowledge of its antecedents. In fact, however, Veblen's early formulation of capital theory captured a ratio that was virtually identical to Q. Veblen put the discrepancies of capital valuations at the very heart of a historiography of "capital"--a historiography that understood "capital" as acquiring different meanings in accordance with time period and the alteration in industrial structures. But far from understanding discrepancies in capital valuations as strategic for growth (as modern Q theory emphasizes), Veblen put these discrepancies at the very heart of his theory of evolutionary finance and crises. Veblen held that the discrepancy between the "normal rate of profit" and actually realized profit in nineteenth century competitive capitalism devalued capital and undercut businessmen's resolve in pursuing growth. In the transition into the modern period of oligopolies and monopolies, the rise of intangible "goodwill" allowed an expanded capitalization--what today would be called a rise in Q. For Veblen, such an increase in market valuation did not portend investment growth (as Q theory would have it) but a slow-down in production and new investment. Veblen also maintained that such an increase in Q allowed an expansion of leverage that constantly threatened inflation and possible financial meltdown.
In this essay, I claim that modern Q theory could benefit from Veblen's insights into monopoly power. Today, the disconnect of modern Q theory from its origins in Veblen's theory of capital is total. At base, this disconnect reflects modern capital theory's total abandonment of any historical inquiry into changes in the industrial structure and how these changes have affected capital spending, lf Q theory were efficacious in predicting new investment and mergers, this neglect might not be justified but at least it might be explainable on the basis of efficaciousness. But Q theory has not proved its worth. Models relating Q theory to new investment expenditures generally do not predict well (Chirinko 1993, 1875-911). It may be that this inability to forecast relates to "problems constructing empirical counterparts to the unobserved theoretical q variable" (McCarthy 2001). But it may also be due to a neglect to study the industrial structure in terms of how modern oligopolies actually respond to boom and bust conditions. lf Q theory fails to correctly predict the levels of new investment in booms, at least the increase in new investment experienced in booms corresponds to what Q theory would (qualitatively) and tautologically (3) predict. Not so with mergers and acquisitions. As I will show below, mergers and acquisitions actually expand relative to new investment during stock market booms--that is, during the time when mergers and acquisitions become expensive. On this point, modern Q theory is simply wrong on the facts. As I will show below, such anomalous behavior can best be understood by monopoly power--the very power that Veblen discussed in reference to high security prices. I will also explain why monopoly power might undercut the ability of existing Q models to correctly predict new investment.
An examination of Veblen's Q theory not only provides insights into how progress might be made in positive economics but also highlights Veblen's normative framework. In the hands of Veblen, Q theory illuminated the inadequacies of the business system itself. By putting emphasis on the monopoly power underlying "intangible" assets, Veblen's Q theory unearthed the privation, insecurity, and inequitable distribution of wealth and income that the modern business system generates. In a final section, I sketch out how recent events testify to Veblen's enduring legacy.
Veblen's Historiography of "Capital"
A historiography of Veblen's Q follows a historiography of Veblen's famous distinction between industry and business. From his earliest economic writings in the QJE (1892) to his Theory of Business Enterprise (1904) to his critique of Irving Fisher's theory of capital (1908) to his writings in the Dial (1918-1919) to his Absentee Ownership (1923), Veblen held that "capital" was an evolving concept identified "substantially, [as] a habit of thought of the men engaged in business, more or less closely defined in practice by the consensus of usage in the business community" ( 1998, 150). In the bulk of these writings, Veblen constantly demarcated the business-industry distinction as evolving from an original unity of the two under the "old order" of artisan craftsmen and natural rights. In this older order--identified with the writings of Adam Smith--the artisan involved himself not so much in business but "livelihood," caught as he was in the personal identity of himself and his craft. Income was received in accordance with work and skills, and the work was materially visible in tangible items. "Capital," if it could be called that, consisted of the workshop and tools, which, themselves, were part of the owner's livelihood. Returns to capital could not be distinguished from the proceeds of livelihood. Technological advance was so slow that capital items might depreciate through wear but not through obsolescence. Any notion that capital items could acquire different "valuations" in accordance with market valuations or replacement was simply not possible as the returns from capital could not readily be distinguished from the returns to its owner.
Veblen's distinction between business and industry thus could only truly begin with the advent of the machine age, in which the scale of industry was sufficiently large that the business function severed the businessman from personal identification with work (industry) and where technological advance undercut the valuations of older vintages of capital. For Veblen, it was this separation of business from industry and a concomitant shifting of valuations of capital that lay at the basis of nineteenth century crises. As early as 1892, he could write that "industrial depression means, mainly a readjustment of values" ( 1998, 112). By this "readjustment" he meant that new technological advances made obsolete existing capital installations so that "the nominal accepted valuation of the capital, on which its returns are computed, exceeds its actual value as indicated by its present earning capacity (112). Veblen was groping toward a full-blown theory of capital as "putative" earning capacity that anticipates a modern theory of share price and contrasts this valuation with actual expenditures on plant and equipment. In other words, Veblen anticipated a modern theory of Q.
Unlike modern Q theory that maintains that capital valuation discrepancies generate growth, Veblen's theory suggests that these discrepancies form the basis for crises. Earlier expectations of high "putative" earnings on earlier investments are dashed in the course of technological advance and affect current investment:
The trouble lies not primarily with the rate of profit on new investments as indicated by the rate of interest on money seeking investment, but with the rate of profit on property already invested and capitalized in the past.... There may be much that is unsatisfactory with respect to the making of new investments; but that class of difficulties is evidently an effect, never a cause, of the trouble that exists with respect to the earning capacity of capital already invested in the past. (Veblen  1998, 110; italics added) Notice how Veblen anticipated modern Q theory in understanding how changing valuations of existing capital stocks influence new investment flows. But unlike modern Q theory where the business community assesses the relative valuation of older capital and rationally calculates the most profitable course of action, Veblen puts the translation factor in the subjective outlook of the investing groups--a factor somewhat akin to Keynes' "animal spirits." According to Veblen, industrial depression "is, primarily, to a very great extent, a psychological fact" (italics added). The readjustment of values involves a "lesion of the feelings of the property owner" (Veblen  1998, 112-113). Later, in his Theory of Business Enterprise, Veblen conceived of economic depression as "a malady of affections" induced by a "discrepancy between that nominal capitalization which they [businessmen] have set their hearts upon through habituation in the immediate past and that actual capitalizable value of their property which its current earning-capacity will warrant" (Veblen  1978, 237). Veblen, of course, was pushing his point that industry waits on business and were it...