Originally published in Flourishing March 2012.
The American economist James Tobin was born on March 5, 1918. He received the 1981 Nobel Prize “for his analysis of financial markets and their relations to expenditure decisions, employment, production, and prices.”
Tobin argued that one can’t predict the effect of monetary policy on output and unemployment simply by knowing the interest rate or the rate of growth of the money supply. Monetary policy has its effect, he claimed, by affecting capital investment, whether in plant and equipment or in consumer durables. And, although interest rates are an important factor in capital investment, they are not the only factor.
Tobin introduced the concept of “Tobin’s q” as a measure to predict whether capital investment will increase or decrease. The q is the ratio between the market value of an asset and its replacement cost. For example, if an asset’s q is less than one—that is, the asset’s value is less than its replacement cost—then new investment in similar assets is not profitable.
Tobin’s insight was also relevant to his ongoing debate with Milton Friedman (Nobel Prize 1976) and other monetarists. Tobin argued that his q, by predicting future capital investment, would be a good predictor of economic conditions.
Tobin’s portfolio-selection theory is another of his contributions. He argued that investors balance high-risk, high-return investments with safer ones so as to achieve a balance in their portfolios. Tobin’s insights helped pave the way for further work in finance theory.
James Tobin died on March 11, 2002. mh
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