Financial markets look at data on aggregate investment for clues about underlying profitability. At the same time, firms' investment depends on expected equity prices. This generates a two-way feedback between financial market prices and investment. In this paper, the authors study the positive and normative implications of this interaction during episodes of intense technical change, when information about new investment opportunities is highly dispersed. Because high aggregate investment is good news for profitability, asset prices increase with aggregate investment. Because firms' incentives to invest in turn increase with asset prices, an endogenous complementarity emerges in investment decisions—a complementarity that is due purely to information reasons. The authors show that this complementarity dampens the impact of fundamentals (shifts in underlying profitability) and amplifies the impact of noise (correlated errors in individual assessments of profitability). They next show that these effects are symptoms of inefficiency: equilibrium investment reacts too little to fundamentals and too much to noise. Finally, they discuss policies that improve efficiency without requiring any information advantage on the government's side.
Policy Discussion Paper, No. PDP 2007-4, October 2007
Wall Street and Silicon Valley: A Delicate Interaction