Commentary: In the news is the sale of Modigliani for $157 million, the second highest price paid at auction for a painting. But economists, when we hear the name Modigliani, don’t think of a painter of modernist nudes named Amedeo, rather of the Nobel prize winning economist named Franco.
Modigliani—the economist not the artist—was born in Italy in 1918 and was a refugee from fascist Italy, first in Paris and later in the United States. He became a naturalized U.S. citizen in 1946.
Modigliani won the Nobel prize primarily for his work on the theory of consumption, particularly his work on the Life Cycle Hypothesis of consumption. This theory starts with the assumption that people seek to consume a constant amount over their lifetimes.
But to do this, the young, who lack resources, have to borrow. The middle aged have then have to save to pay off the debt they accumulated as youths and to amass wealth for retirement. In retirement, wealth saved when middle aged is spent down. The prediction then is that consumption is greater than income when young, less than income when middle aged, and greater than income in retirement.
Not that surprising a finding, perhaps, but it is how Modigliani then applied his theory when the cleverness comes in. For example, Modigliani’s theory predicted changes in national savings rates as the baby boomers aged from youth to old age.
The theory also predicts that Social Security, which guarantees a minimum income in retirement, will reduce savings in middle age. This isn’t a big deal if Social Security is fully funded as savings by the Social Security Administration just replaces savings by middle aged households. But Social Security isn’t fully funded, so to the extent Social Security runs an actuarial deficit, national savings is reduced.
Modigliani also well known for the Modigliani-Miller Theorem, which is an important underpinning of current thinking about capital structure. M&M, as financial economist affectionately calls the theorem, argues that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, the value of the firm is unaffected by how it is financed. The level of debt to equity is irrelevant.
The idea underlying M&M is the following. Suppose two firms are otherwise identical accept that one firm is debt-leveraged and the other is not. By borrowing funds in the right proportion and using the borrowed funds to buy shares in the debt free company, the buyer can “transform” the debt free asset into a leveraged asset; therefore, the return to both the leverage and unleveraged firm should be the same.
M&M is a fundamental building block of financial theory, not because it explains how markets work but because it does not. In real life, contrary to the theorem, a corporation’s level of debt does matter, and understanding why this is so is critical for understanding how the financial system works. My dissertation from nearly 30 years ago, dealt with how asymmetric information shapes deposit contracts issued by banks to their customers.
Christopher A. Erickson, Ph.D., is a professor of economics at NMSU. He has taught money and banking for 34 years. The opinions expressed may not be shared by the regents and administration of NMSU. Chris can be reached at firstname.lastname@example.org.