The Nobel Series : Father of Portfolio Selection Theory
James Tobin showed how individual decisions determine equilibrium price and interest rate, and how fluctuations in financial markets get transmitted to real markets
The Nobel Prize in Economics in 1981 was awarded to James Tobin, who was at Yale University, USA at that time. The prize was given for his analysis of financial markets and their impact on consumption, investment, production, employment and prices. As the Nobel Prize website tells us:
James Tobin's achievements cover a broad spectrum of economic research. He has made substantial contributions in such widely differing areas as econometric methods and strictly formalized risk theory, the theory of household and firm behaviour, general macro theory and applied analysis of economic policy. His most outstanding and significant research contribution, for which he has been awarded the Nobel Memorial Prize in Economics for 1981, belongs to the theory of financial markets and their relation to consumption and investment decisions, production, employment and prices.
Tobin is best known for proposing the Portfolio Selection Theory, which basically tells us how individual economic agents decide the composition of their assets. In this article, we will cover Tobin's major works and their importance in public policy.
Main works of James Tobin
Tobin began his undergraduate studies at Harvard University in 1936 — the same year in which Keynes' General Theory was published. It was therefore natural that Tobin was influenced by Keynes' work early in his studies. After his undergraduate degree, Tobin enrolled for graduate studies and got his Masters degree in economics in 1940. In 1941, he published his first article 'A Note on the Money Wage Problem' in the Quarterly Journal of Economics, which was based on his Master's thesis. He took a break after his Master's degree and in 1941-42, he worked as an economist for the Office of Price Administration in Washington DC. Tobin was in the Naval Reserve during World War II. After the war, Tobin came back to Harvard for his PhD which he completed in 1947. In 1950, Tobin joined Yale University as a faculty in the Economics Department and stayed there till his retirement.
Tobin was Keynesian in his approach and contributed a lot to develop the microeconomic foundations of Keynesian theories. However, there were four major areas of his contribution:
Portfolio Selection Theory: As mentioned above, Tobin won the Nobel Prize for his Portfolio Selection Theory. The theory says that changes in financial markets influence the investment decisions of economic agents over various classes of assets. With Harry Markowitz, Tobin developed the foundations of modern portfolio theory. The key 'separation theorem' proved by Tobin [1958b], is that in a world with one safe asset and a large number of risky assets, portfolio choice by any risk-averse portfolio holder can be described as a choice between the safe asset and the same portfolio of risky assets.
This decision depends on the weighted risks and expected rates of return of holding these assets.
Portfolio selection constitutes the transmission mechanism through which government monetary and fiscal policy can influence macroeconomic aggregates, such as consumption, investment spending, employment, and inflation. The theory is well explained on the Nobel website and excerpts are reproduced below for an easy understanding:
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 yields and risks 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.
Baumol-Tobin Model: This is a model of demand for money. At the most basic level, it emphasizes the role of money as a medium of exchange. The model looks at the costs and benefits of holding money. The benefit is convenience and avoiding trips to the bank and the cost is the foregone interest. Hence the amount of money an individual holds is directly proportional to the fixed cost of bank trips and level of expenditure and inversely proportional to the interest rate.
Tobin's q concept: Tobin's q is the ratio of an asset's market value to its book value (or replacement cost). According to Tobin, there is a link between fluctuations in investment and fluctuations in the stock market. The market value is nothing but the value of the capital as determined in the stock market and the replacement cost is the price of that capital if it were purchased today. In financial terms, a q value greater than one indicates that the stock market values the installed capital higher than the replacement cost; a value less than one indicates the opposite. In macroeconomics, Tobin's q is therefore one of the determinants of investment spending by firms. A firm with a q greater than one would be expected to reinvest profits into capital spending, thus moving q back towards one.
Tobin's tax on foreign currency transactions: After the Bretton Woods agreement collapsed, one witnessed the development of various pegged and floating currency exchange rates around the world. Tobin proposed that a small, per-transaction tax on currency exchange transactions would discourage speculation in the form of frequent, large, short-term currency transactions. Given the size of large international financial institutions relative to the size of many developing economies, large scale speculation in the foreign exchange market has major macroeconomic consequences for smaller economies. A Tobin tax is intended to cushion the effect of such speculation for these economies.
Tobit model in econometrics: Tobin contributed to econometric modelling while outlining his Portfolio Selection Theory. The model he proposed was given the name 'Tobit Model' by Arthur Goldberger. Tobit modelling is an econometric technique to estimate the influence that a set of independent variables may have on a dependent variable whose possible values are limited, or "censored", above or below a given threshold (usually at zero).
Tobin and public policy
Tobin had a public persona in addition to his academic life. He took a break to flirt with public service when he joined as a member of President John F Kennedy's Council of Economic Advisors from January 1961 to July 1962. He was a co-author of a report on the state of the US economy along with Walter Heller, Kermit Gordon, Robert Solow and Arthur Okun. He called this "the manifesto of our [Keynesian] economics, applied to the United States and the world economic conditions of the day."
Tobin was also an advisor to 1972 presidential candidate George McGovern. Tobin believed that government regulation often causes damage. "We should be especially suspicious of interventions that seem both inefficient and inequitable," he wrote; "for example, rent controls in New York or Moscow or Mexico City, or price supports and irrigation subsidies benefiting affluent farmers, or low-interest loans to well-heeled students."
Tobin also served on the Board of Governors of the Federal Reserve and the Council of Economic Advisors.
Tobin's work has found wide applications in public policy. For example, his q concept has been used to address the problem facing various firms — that the stock market value is too small as compared to the costs of building new plants. Tobin's analysis tells us that the stock market can give us
valuable information on how savings and investment can be allocated at the national level and even at the international level (since MNCs operate across borders and are listed on multiple stock exchanges).
Tobin's work also taught us how to look at the impact of monetary policy in a novel way. His transmission mechanism from the financial sector to the real sector is an innovative way to explain how monetary policy impacts macroeconomic variables like output, employment, the balance of payments and inflation. Differing with Milton Friedman, he suggested that the demand for money responded to interest rates and that a constant growth rate for some monetary aggregate is unlikely to contribute to economic stability. Both monetary and fiscal feedback rules can, in principle, help stabilise the real economy. It may be recalled that according to Friedman, fiscal policy was ineffective in its impact on aggregate demand.
Tobin passed away on March 11, 2002, but left behind a rich legacy of work in several areas ranging from macroeconomics to econometrics. He has been rightly referred to as the greatest macroeconomist of his generation. His research in portfolio selection and asset
pricing theory (especially the Portfolio Separation Theorem), econometric methodology (especially the Tobit model) and his pioneering work using both time-series and cross-sectional data to estimate food demand functions, Tobin's q, the 'Tobin Tax', the monetary and fiscal policy effectiveness debate with Milton Friedman and others are only some of his contributions.
Views expressed are personal