Franco Modigliani: 1918-2003, in memoriam.
Franco Modigliani is most known for the Keynesian Liquidity Preference (LP) theory. In fact, he started and ended his career with this now well-known concept. He wrote his dissertation on the LP at the New School in 1944, and his last published article on the subject of Keynes appeared in The American Economist (2003). His earlier presentation of LP was axiomatic in nature; the assumptions being that LP is a sufficient condition to explain unemployment equilibrium, i.e., without the assumption of rigid wages, when the demand for money is infinitely elastic relative to a positive level of interest rates (Modigliani 1944, 74). He held that the dependence of the rate of interest (R) on money (M) is explained by rigid wages (W), where LP is not a sufficient or a necessary condition to explain underemployment equilibrium (Ibid., 76). Thus, he concluded that if wages are flexible, then interest rates, savings, and investment propensities will determine prices (Ibid., 76). Usually, the dominant theme of Modigliani's LP research program has been built around the special cases of wage rigidity and interest inelasticity. Tobin (1987, 25) noted that Modigliani should also have mentioned the interest inelasticity of investment demand as "... another and very important exception to the wage rigidity explanation of unemployment." But, as we can see from Modigliani's last paper (2003), he concludes, in accordance with Keynes (1979, 3) that "... the postulates of the classical theory are applicable to a special case only and not the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium."
As Modigliani stated, "... the present version differs from my previous papers, published throughout my career, starting from my first on 'Liquidity Preference'. The difference springs in part from the fact that the new presentation is meant to be understandable by a non-technical audience but in part it reflects my recent realization, that it is possible to use a model different from the prevailing one, which stresses the communality between Keynes and the classical theory. In fact, I will argue that the classical model is but a special case of Keynes's General Theory. It applies only to an economy in which wages (and prices) are highly flexible downward in response to 'excess supply', and financial markets are unimportant. It should be obvious that this special case is of very little relevance to the present-day developed economies, and so are the analytical and policy conclusions that follow from it" (Modigliani 2003, 3).
Later in life, Modigliani (1988) also had an opportunity to revisit what he elaborated on in the famous Modigliani and Miller (MM) hypothesis. The first value-invariance proposition (Proposition I) states that the "... market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate [[rho].sub.k] appropriate to its class" (Modigliani 1980, 10). Meanwhile, the original proof is based on the arbitrage: "... an investor can buy and sell stocks and bonds in such a way as to exchange one income stream for another ... the value of the overpriced shares will fall and that of the under priced shares will rise, thereby tending to eliminate the discrepancy between the market value of the firm" (Ibid., 11). This proposition stood on the back of Proposition II, "... concerning the rate of return on common stock in companies whose capital structure includes some debt" (Ibid., 13), and Proposition III, which "... tells us only that the type of instrument used to finance an investment is irrelevant to the question of whether or not the investment is worth while" (Ibid., 34). According to Miller's (2002, 421-422) assessment 30 years later, Proposition I, with its arbitrage proof, is well accepted in the economics world of today, but less so in corporate finance.
The adoption of the MM hypothesis has been overwhelming. Modigliani (1988, 150) himself discovered that young cab drivers in the Washington, D.C. area were well informed of the MM hypothesis. However, it is also important to mention that most cab drivers in that area at the time (with a foreign accent) were MBA students. In MBA textbooks, and in the programs, students are taught how to calculate the discounted value of a unit of debt to the present time, add that to the value of equity in the marginal unit of capital, which is a residual equal to the marginal unit of capital less the amount paid to the bond holders, and consider the value of many financial assets besides debt and equity, and test the value-invariance principle with and without taxes on profits, and tax deductions on debt interest (Romer 1996, 387). It is interesting to note that the robustness of the MM hypothesis stood up to the popular put-call parity analysis, or the Black-Scholes capital structure model: "The familiar Put-Call Parity Theorem ... is really nothing more than the MM Proposition I in only a mildly concealing disguise!" (Miller 2002, 434). However, the MM model had to confront a series of empirical distortions, which, according to Tobin (1985, 241), "... includes corporate income taxation, which is not neutral as between debt interest and dividends; the implications of leverage for probability of bankruptcy and loss of control; and economies of scale in borrowing which enable stockholders to borrow more cheaply through the corporation than individually." While looking at some regression results for 1960-1974, Tobin (1985, 257) found a negative sigma coefficient, a dislike for dividend protection, and indifference or a rejection of fixed debt service obligations, implying overall that "... the stock market likes leverage, and prefers payout rather than retained earnings." Another study, by Stiglitz, (1979, 784) examined more general conditions under which the MM hypothesis may hold, including Arrow-Debreu general equilibrium conditions, where securities are held based on varying states of the economy. Stiglitz found "... in the context of a general equilibrium state preference model that the M-M theorem holds under much more general conditions than those assumed in their original study. Except that they must agree that there is zero probability of bankruptcy."
In his response to the critics, Miller (2002, 425) pointed out that they were considering a general equilibrium approach from its inception, having drafted up an appendix to the original paper, but that the approach later took the form of three separate papers. An additional criticism was addressed to various parameter assumptions of the model. For instance, varying dividend policies were accommodated either by a random error term that bridges the theoretical model to reality, or by a firm's "pay-out policies" that would tend to attract a certain "... 'clientele' consisting of those preferring its particular payout ratio" (Modigliani 1980, 60). Another adjustment was made to the "method of taxing corporations on the valuation of firms," which was based on whether a firm should seek to maximize debt financing in their capital structure because of the tax advantage. In the philosophical sense of the argument, the authors did not find debt and equity financing to be "either/or" propositions, for they asserted that retained earnings can be a cheaper alternative (Ibid., 72). While Miller (2002, 444) described the Tax Reform Act of 1986 as rare "supershocks" whose validation of a theory is yet to be seen, Modigliani (1998, 154) thought it did point to a validation of the original position on taxes.
Another area of Modigliani's fundamental contribution to economics is his life-cycle hypothesis of the consumption function. First, it was Keynes who initially proposed the absolute income hypothesis, implied in his psychological law of savings, where later some anomalies were found between long-run and short-run (cross-section) behavior of the consumption function. Briefly, the long-run marginal propensity to consume (mpc) was converging to one, and the cross-section consumption function, say for socially diversified groups, had a smaller mpc and was drifting upward over time. Second, James Duesenberry's relative income hypothesis was in the mode of reconciling such observations, where personal consumption was based on the individual's relative position in the income distribution. Generally, during a downswing, households tend to dissave to keep up their consumption levels, thereby setting consumption on current income relative to previous peak period incomes. As recovery replaces lost income, consumption eventually manifests a "ratchet-effect," explaining the upward drift over time.
Modigliani had the first formulation of the life-cycle hypothesis in his 1954 article. While he recognized Friedman's permanent income hypothesis under the umbrella of "important further developments" (Modigliani 2002, 15), he makes the significant distinction that "Friedman assumes an infinite time horizon for consumption and saving decisions whereas my hypothesis depends on life being finite and differentiated--dependency, maturity, and retirement" (Breit and Spencer 1995, 151).
In fact, it is possible to find important similarities between the two contributors. Income now has two components, transitory and permanent, where transitory income is current income less permanent income. It is a known fact that consumers usually react slowly to transitory income changes because of habits and customs (Modigliani 1949). Later, when Modigliani solidified his thinking on this matter with his life-cycle hypothesis (Ando and Modigliani 1963), he reached the final stage of the model's development, where a person's consumption is a function of his/her age group, resources, and returns on capital. At the student stage, for instance, the consumer is short of income and would borrow, or spend future income to consume at his current life-cycle spending level. In the meantime, a middle-aged person with a higher participation rate and peak life-time earnings, is more likely to save and build up asset holdings. A retiree would tend to live by drawing down savings, returns from assets, other incomes such as SS, SSI, 401K, or even from the contributions of children. Overall, it is evident that somehow consumers redistribute lifetime resources over their life cycle to maximize lifetime consumption. A marginal increase in (transitory) income affects consumption only if it increases a lifetime average income. As the mpc increases, it has a significant implication for a lower propensity to save, which is: 1--mpc (Modigliani 2003, 15).
Modigliani's and Friedman's contributions to the consumption function continue as a live research program in current literature. A 2003 Nobel Laureate in economics had this to say on the recent testing of the theory of consumption in terms of the life cycle and permanent income hypothesis as elaborated by Robert Hall: "The theory was like manna from heaven to macro-econometricians. It was easily stated and understood, and appears to be easy to test" (Granger 1999, 42-43). Central to this model is the fact that consumption follows a random walk model where the next expected consumption period should be equal to current consumption. In practical parlance, consumers will tend to adjust their individual consumption so that it will not differ from an expected level. This fact reinforces the underlying principle that consumers tend to smooth out spending over time, and that this practice relates to some uncertainty about income. If consumers have a quadratic utility function, then they will want to consume at the level where their future income will equal its mean value (Romer 1996, 318). The life-cycle model has also promoted research in terms of the type of instruments families use to finance retirement. This research has made it evident that most assets are in the "locked-up" form, such as retirement programs, mortgages, life-insurance, and social security. "... (A)s long as families can make full use of locked-up accounts, their actual behavior will be almost the same as predicted by the life-cycle model" (Hall and Taylor 1997, 284).
Modigliani was also involved in making fundamental contributions to post-Keynesian economics. He co-authored two articles with Samuelson that generated much research in the area of long-term rates of return (Samuelson and Modigliani 1966a, 1966b). They have jointly contributed to the "anti-Pasinetti" theorem in the literature. Basically, the Pasinetti (1976, 276) theorem states that: "The equilibrium rate of profit is determined by the natural rate of growth divided by the capitalists' propensity to save." He derived it from the differential equation: d/dt(P/Y) = f(I/Y-S/Y). The theorem, therefore, remains an analysis of the stability of a Keynesian model of income distribution. However, Samuelson and Modigliani's dual theorem makes output per capita a function of saving of workers and brings the workers' savings rate back into the picture, whereas Pasinetti's theorem made profit a function of only producers' savings. Samuelson (1991, 182), literally re-wrote The New Palgrave dictionary's view of the dual theorem thus: "The only balanced-growth equilibrium that could then possibly be obtained would be the anti-Pasinetti equilibrium with (Y/K)** = n/[s.sub.w]" where Y is full employment income, K is capital, n is the economy's growth rate, ** is the long-run equilibrium level, and [s.sub.w] is workers propensity to save. In order to separate Modigliani's unique concerns on the "anti-Pasinetti" theorem, Kaldor (1966, 316), whose argument is based on Keynesian theory of the distribution of income, noted that "'capitalists' also spend some part of their capital gains ... and, as Professor Modigliani has reminded us, the limited length of human life must add to such temptations." Pasinetti (1936, 306), too, picked up on a concluding point in the original Samuelson-Modigliani article relating to permanent income influence on the long-run rate of return. It seems to us that what relates the argument to the life-cycle hypothesis refers uniquely to Modigliani's work, and this has not received significant attention in the literature.
Also, Modigliani was the originator of a new way of viewing macroeconomics from the labor market point of view. The NIRU that is built into the Keynesian disequilibrium model is a well known concept in modern literature, where it is defined as follows: "... there exists some critical rate of unemployment such that, as long as unemployment does not fall below it, inflation can be expected to decline--at least as long as there is some non-negligible inflation to begin with. We label this critical level the Non-Inflationary Rate of Unemployment, or NIRU for short" (Modigliani and Papademos 1976, 4). The founders proceed to explain the NIRU concept from two points of views the vertical and the downward sloping Phillips curves. This model has been used extensively to illustrate long and short run states of the economy. We should therefore differentiate between Friedman's Natural Rate Hypothesis (NRH) and the NIRU hypothesis, showing that the inflation rate is zero in the vertical case, and that the ... NAIRU can, therefore, be determined by defining a "negligible" rate of inflation. Further, Friedman's NRH hypothesis is grounded in equilibrium analysis, such as the Walrasian and Marshallian dynamics, while Modigliani's view falls within the Keynesian system, which is in the domain of disequilibrium. Friedman makes the assertion that the natural rate of unemployment "... is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets" (Friedman 1969, 8).
Moreover, although there are several factors that can prevent attainment of employment, such as "... market imperfections," (ibid) stochastic variability in demand and supply, the cost of gathering information about job vacancies and labor availability, the cost of mobility, and so on, these issues are overcome in the long run when the Phillips curve becomes vertical and is adjusted for differences between desired and actual expectation. In contrast, Modigliani and Papademos (1976) see a role for both market forces and cooperation of government, workers, and businesses to restore the previous level of unemployment after an initial displacement from equilibrium. The modern literature has not changed much from the state of Modigliani's and Papademos's NIRU concept. First, we may note a dubious change in the acronym itself from NIRU to NAIRU, where the additional "A" stands for the adjective "accelerating." Second, we note that the arguments for both NRH and NIRU represent a "slow to change" pace of the level of unemployment, which follows the mechanism that an increase in demand will reduce unemployment and accelerate inflation. Third, the arguments for NRH and NIRU are captured by two different equation systems. One equation captures price changes; the other, wage changes. Implicitly, [DELTA][p.sub.t] = f([DELTA][w.sub.t]), and [DELTA][w.sub.t] = f([DELTA][w.sub.T-1], [u.sub.t]), where w is wage, p is price, and u is unemployment. A reduced form, therefore, would be [DELTA][p.sub.t] = f ([DELTA][w.sub.t-1], [u.sub.t]). The Modigliani and Papademos fit include productivity and labor cost variables as well (Ibid., 9), and as we can see, despite the similarities in empirical approach, they permit both a classical or monetarists as well as a Keynesian view. The reason for this is that while the classical view states that market forces take control, and the Keynesian view maintains that "wage setters set wage," and "price setters set prices," we obtain, in both instances, demand and supply curves for the labor market positing the relationship between real wage rate and employment, as opposed to just money wage rate and employment.
Modigliani will be remembered as a great inspiration to economists working on the scientific methods to validate, explain, or predict economic phenomena. He was an exceptional economist who always considered both economic theory and the real empirical world. He was also one of only a few remaining Keynesians, which makes his loss even more costly to the field. We are grateful for the research he initiated in the many branches of economics, and we regret that we will not be able to see the articles he promised us on savings in China, a revisit to the MM hypothesis, and reflections on economics.
Paul A. Samuelson had this to say about his colleague, collaborator, and tennis partner: "He was a great teacher, intense and colorful. MIT was lucky to have him for forty years; he was a jewel in our crown, active to the end."
A vignette about the interaction between the editor of this journal and Modigliani in the final year of his life is illustrative of his intensity, vibrancy, and great enthusiasm. When he submitted his paper "The Keynesian Gospel According to Modigliani" to us for publication, he called five times leaving messages within the span of less than an hour. Then, at later stages of production, his drive for perfection in correcting and revising the galleys and details of the graphs was truly remarkable. Not only was he an intensely accomplished scientist as another vignette illustrates, but he knew how to maintain the balance between scholarship and family. In one of the instances with which we are familiar, he put aside, under a deadline, his unfinished work to celebrate and rejoice with his family at his great grandchild's birthday. His mentoring of, and ultimately influence on, new elite generations of economists was so successful that at one point his proteges held top positions in ten of the major European central banks. He will be remembered as a man of extraordinary genius.
Ando, A., and Franco Modigliani, "The 'Life Cycle' Hypothesis of Saving: Aggregate Implications and Tests," American Economic Review, Vol. 53, No. 1, (March, 1963), 55-84.
Breit, W., and R.W. Spencer, eds., Lives of the Laureates, (Cambridge, MA: MIT Press, 1995).
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Hall, Robert E., and John B. Taylor. Macro Economics, (New York, NY: W. W. Norton & Company, 1997 Fifth Edition).
Kaldor, Nicholas. "Marginal Productivity and the Macro-Economic Theories of Distribution: Comment on Samuelson and Modigliani," The Review of Economic Studies, Vol. 33., No. 4, (October 1966), 309-319.
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Samuelson, Paul A., and Franco Modigliani, "The Pasinetti Paradox in Neoclassical and More General Models," The Review of Economic Studies, Vol. 33, No. 4, (October, 1966a), 269-301.
Samuelson, Paul A., and Franco Modigliani, "Marginal Productivity and the Macro-Economic Theories of Distribution: Reply to Pasinetti and Robinson," The Review of Economic Studies, Vol. 33, No. 4, (October, 1966b), 321-330.
Stiglitz, Joseph E. "A Re-Examination of the Modigliani-Miller Theorem," The American Economic Review, Vol., 59, No. 5, (December, 1969), 784-793.
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|Date:||Mar 22, 2004|
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