The relationship between firm investment and firm imperfection is well studied within the context of the firm balance sheet and agency models. The paper finds that firm investment significantly impacts firm imperfection and also influences the relationship between firm investment and output gap. This effect is substantial for high information asymmetrical firms, and hence the effect of external financial leverage on firm investment is also important for high-income countries. We investigate the nature of imperfections in firm investment, focusing on capital and equity, two imperfect components of firm valuation.
During the past five years, there has been a widespread push by policy makers and academia to increase the emphasis on firm investment. Most European institutional and government agencies have already started formalizing policies related to firm investments. In the United States, however, there is very little effort to formalize policies related to firm investments, and little data available on the association between government interventions and firm investments. The existing research literature therefore focuses primarily on the macro-economic consequences of government interventions in the financial markets.
An alternative approach to studying the effects of government interventions on firm investments is to use a theoretical model of price formation. Using a pricing theory model, the relation between firm investment and firm imperfections can be analyzed. Using standard specifications, we find that government interventions lead to a reduction in market liquidity, increase inefficient demand for assets and a rise in market volatility.
While a variety of theoretical models may be used to explore the effect of government intervention on firm investments, a limited amount of empirical evidence is available. Moreover, many models assume that firms with imperfect capital structures will not be able to absorb the losses caused by government interventions, leading to a scenario in which governments may even create new firms to take over or mitigate the effects of these government-induced disturbances. This creates the potential for a substantial transfer of resources from public to private hands. More specifically, it implies that the inefficient allocation of funds by firms could lead to lower investment in other non-firm areas, thereby affecting the macro economy in general.
One theoretical basis for studying the effects of the economic stimulus package on firm investment is the productivity gap concept. According to this concept, the productivity gap is the difference between total factor productivity (TFP) per dollar of firm fixed capital and the level of productivity needed to justify current real estate prices (in current dollars). Using empirical techniques, Fabian monetarist economists argue that the size of the economic stimulus package may have caused a decline in overall productivity. They argue that the size of the package may have encouraged inefficient firms to reduce their fixed assets and hence invest in low-valued assets like land. Following this, they suggest that the government should re-distribute funds from inefficient firms to more efficient firms in order to correct the imbalance between supply and demand of labor and capital.
The study by Fabian and Kumar goes beyond the existing literature in several ways. First, it directly examines the impacts of the government intervention on firm investment efficiency using firm-owned and -operated businesses as the unit of analysis. Second, it uses a unique measure of fixed assets – the value of non-homeowner-owned residential properties – to track changes in the response of firms to government intervention. Finally, as a third alternative, it utilizes a dynamic pricing model to assess the changes in the rates of return on firm fixed assets over time. The results suggest that government interventions can correct price volatility, enhance liquidity, and promote economic efficiency.
