Pre-funding and post-funding investments

I have no idea if this is original, but I was thinking about the Keynesian theory of investment while doing something else and it occurred to me that you can explain it in terms of pre-funding or post-funding. The Modern Monetary Theory people think this distinction, applied to banks, has really important consequences for monetary policy. Do banks look at how much money their customers have deposited and then decide how much to lend, or do they choose which loan applications to greenlight and then work out how to fund them? If it’s the first, monetary policy should be able to influence investment through the so-called credit channel. If it’s the second, not so much.

The analogous distinction for investment decisions would be whether entrepreneurs look at the supply of financing first, and then decide what to do with it, or whether they assess opportunities first and then think about how to finance them. In an accounting sense, the distinction would be whether you looked at the operating level P&L first and then the financing section or the other way around. The first option suggests a strong credit-channel relationship and monetary dominance, the second doesn’t.

Keynes certainly thought that entrepreneurial decisions were driven by whether the prospect was any good rather than by the availability of financing. To operationalise this a bit, this is to say that an investment worth taking forward should be potentially profitable enough at the operating level to work out wherever we are in the monetary policy cycle. This is, after all, why the distinction between operating and financial results even exists. As a result, if entrepreneurs actually think this way, monetary policy can choke off investment (in principle the central bank could set an interest rate of 1000% or the bank regulator could close the banks) but it can’t do much to increase it.

This has some interesting consequences for different institutional set-ups. If the great majority of capital investment comes from businesses’ retained profits, it’s effectively pre-funded. John Kenneth Galbraith thought the huge role of retained profits in investment was a major reason for the stable economy of the postwar era because investment from this source was largely internally driven and didn’t change much. What variance there is, though, might be quite interest-sensitive, and maybe this supports Galbraith’s point. If it’s mostly bank-financed, you’d expect that kind of downward-only sensitivity. If it’s equity, you’d expect pure animal spirits.

In practice, of course, nobody goes to the bank and asks for a loan to finance an enterprise of great advantage, no-one to know what it is, like the South Seas Company. That said, there is a whole class of financial institutions that are wholly pre-funded and specialise in equity investments – venture capital funds. VCs, though, don’t choose between investing in start-ups and keeping cash on deposit. Rather they choose between different prospects, and if they told their clients they had decided just to stick the money in the bank, the clients would want it back.

(Update: This isn’t actually a problem. VCs don’t invest in the economic sense, they provide financing. Start-ups pitch VCs, not vice versa.)

An underrated difference between the classical and Keynesian theories of investment is the idea of what an investment actually is. The classical version sounds basically like a deposit account or at best an index fund, the Keynesian one like a start-up.