Friday, October 17, 2008

Modigliani-Miller, RIP

Even a casual observer knows that the current financial crisis was partially caused by high leverage ratios. But did you know that a Nobel Prize in Economics [sic] was awarded for a theorem that "proved" that leverage ratios don't matter? Yes, it is called the Modigliani-Miller theorem:

Leverage doesn't matter!

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same.

See if you can spot the completely unrealistic efficient market "no-arbitrage" assumption used to prove the theorem:

Proposition: VU = VL, where VU is the value of an unlevered firm = price of buying a firm composed only of equity, and VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity.

To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. [Ha ha ha ha!] Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

If U and L are banks investing in risky mortgage assets, which do you think is going to collapse due to a run when those assets are marked down? (See here for more problems.)

Believe it or not, Nobelist Myron Scholes invokes Modigliani-Miller in this debate over stronger financial regulation at the Economist web site. ***

Here is what I wrote in a post back in March 2008 (Privatizing gains, socializing losses).

I'd like to hear a believer in efficient markets try to tell the story of Bear Stearns' demise. One week it was OK for them to be levered 30 to 1, the next week it wasn't? When the stock was at 65 people were comfortable with their exposure to mortgages, but then suddenly they weren't? Come on.

My corollary to the Modigliani-Miller theorem: A Nobel in Economics ain't no Nobel in Physics. (Sorry, Krugman.)

*** Footnote: I do agree with Scholes' point that any argument for regulation needs to take into account the benefits from innovation that we might be giving up.


Anonymous said...

Because physics is easier? Also, Joe the plumber really doesn't care for physics.....

Anonymous said...

Also see Satyajit Das's The Rise and Fall of Finance (on his blog).

Carson C. Chow said...

Actually, the Economics Nobel ain't no Nobel. It's the Bank of Sweden Award in Honor of Nobel.

STS said...

Economics Nobel is to Physics Nobel roughly as "stylized fact" is to fact.

Anonymous said...

When you could win either medal - economics or physics - then you can talk.

But you, sir, are no Krugman. Not even close. But you can dream.

Ever noticed that the most insecure people - the ones who are often just outside the very top of the profession, the jealous ones who want to be the star so bad they can taste it - are the ones who try to elevate themselves by tearing down others? It's kind of sad to see someone who wants to prove their own worth so much that they have to criticize others. And it's worse when the person doing the criticizing only thinks they get economics (uhm, econ isn't finance - do you know the difference? It could be considered a small subfield, but to suggest it defines economics is ignorant. And that's just for openers, I've read your superficial uderstanding of economic issues...actually, make that finance issues, I haven't seen much econ here.)

Why is it so important to you to "prove" to yourself that physics is better than economics, ever ask yourself that? (And by what norm is it better? Oh, the one you choose, I see.)

Is it like gay marriage ruining good marriages somehow - when econ gets a medal it somehow dilutes the "real" one? That's just funny. Econ is so powerful they're undermining physics!!! Must . . . destroy . . . now . . .

So what have you done as creative, and novel as Krugman? He explained 50% of trade flows that nobody had even noticed for 150 years - it's Adam Sith, David Ricardo, and Paul Krugman. Then, to top it off, he created two brand new fields that are very noteworthy ont their own.
When you are mentioned with people of that status, then get an attitude.

People are more interested in economics than physics, that must really get your goat. Nobody gives a damn what Steve Hsu discovered, and it probably doesn't much matter in the grand scheme of things (could even be wrong - you all are quite arrogant, but that doesn't mean it won't all come crashing down some day, especially string theory - Steve Hsu could be wasting his life on nonsense, he doesn't really know). Krugman's work has made a real difference in millions of people's lives. His work matters to people, it has made their lives better in a real, tangible sense. Can you say that about your work? When you can, then you wil have earned the right to diss Krugman. But as it stands, his achievements dwarf yours.

Steve Hsu said...

Hey anonymous tough guy, perhaps you'd like to defend Modigliani-Miller rather than go off on an ad hominem tangent? I don't have an opinion on Krugman's work, although I do generally agree with his op-eds.

If you don't like my opinions, don't read the blog. I call things like I see them, and if I find something intellectually vacuous (like your comment) I say so. You can read what I said about this year's physics Nobel further down the page. And by the way, I *have* heard from physics Nobelists many times that they don't respect the economics prize. I heard it again just last summer. But I find it odd that you think only they are entitled to an opinion.

It doesn't bother me at all that people are more interested in economics than physics. I'm obviously quite interested in economics myself. Very few people can understand or have an informed opinion about fundamental physics.

And, finally, I don't work on string theory. If you paid attention you would know that from any number of posts / comments I have made. I conclude that you either aren't very smart or don't really read the blog.

Anonymous said...

One more note.

A big part of the financial crisis came from physicists behind the scenes in hedge funds and elsewhere not understanding the force of the Lucas critique. They totally blew it - just as Lucas predicted would happen if people adopted such strategies. Kind of funny. Here we have a Nobel prize winner in economics predicting how oh so smart physicists would fail. And he hit the nail on the head - it's just what happened (that was a very small part of what Lucas got his Nobel for).

If you don't understand the Lucas critique and how it relates to the crisis, you have no business commenting on any of this. If you do understand it, and it seems easy but it's very subtle, then it's hard to see how you could possibly carry the attitude you have.

We'd all be better off right now if physicists had stayed away from finance, or at least if they had learned some economic theory so they would actually know how to use the tools they have. Unfortunately, they didn't think they needed the theory, or that it had anything to teach them, and we have a mess to clean up because of it. [Unlike Krugman, who has helped so many people, they did real damage, and we're all paying for it now.]

STS said...

It's an interesting empirical question just raised: were economists as a group any wiser to the crazy risks in our financial system than the ex-physicists? Unfortunately it would be difficult to measure. Lots of people are now retrospectively 'wise'.

I think the risks were taken for very elementary reasons to do with incentives. The models were almost incidental to the usual confidence game of getting people to let you manage their money for a fee. Whatever the modelers did or did not believe about their models took a back seat to the incentives. And will continue to do so ;)


Isn't MM really just a sort of ideal gas law? Everybody knows there's more to it, but to a first approximation the details of capital structure don't play a role? It isn't that MM is worthless, just that it seems naive. It functions within a context where there are episodic Private Equity bubbles. For a while debt *doesn't* matter and then ... suddenly ... it DOES again. MM has nothing to say about that more interesting, nonlinear dynamic.

And for context, I appreciate Krugman and think he deserved his prize. Perhaps particularly because his approach is so light on the math -- he doesn't get caught up in quite the level of spurious mathematical sophistication that others do, so he's better able to identify and communicate novel insights.

Roger Bigod said...

What happened was that some economists, seething with envy of "real" sciences, got the bank to put up a prize mentioning Nobel in the title, so that they could pass it off to the ignorant as a "Nobel Prize". It's false advertising. The term "pathetic" used to be used as a term of art in the Ivy League for situations where someone tried too hard to move up in status but didn't get it right and actually looked more tawdry for the effort. Perhaps the saddest touch is that they couldn't just say "Economics" but had to tart it up with the pretentious "Economic Sciences".

Which is not to say that some economists have had more constructive effects than many accomplishments that got Nobels in the real sciences. More people have reason to be grateful to Keynes than the discoverer of the microwave background radiation. Nonetheless it is deserving of a Nobel because it told us something important about nature, and Keynes didn't.

That said, Krugman is a good guy and deserves it if anyone does.

Carson C. Chow said...

Hey Steve,

I think you've definitely made it to the big leagues to have someone this pissed off at a post!

Steve Hsu said...

Carson: Sheesh! Somehow criticizing an earlier Nobel and the standards of the prize in general is an attack on Krugman?

I've thought MM was crazy since a certain friend of ours took a course from Modigliani and explained it to me over a decade ago :-)

BTW, the regression post was something I have been meaning to write for a long time -- we had an interesting discussion about in Pasadena, if you remember.

Something I didn't mention in the post is that by looking at siblings you can break the E component into shared (e.g., family income, education level) and non-shared environmental factors (difficult things to get at like the individual child's peer group, experiences with teachers, etc.), and all the effect comes from non-shared stuff! Since social policy can only affect the shared (coarse) E variables, it is hard to see how we can improve things for large groups of people.

Carson C. Chow said...

Well as you wrote in your most recent post, intervention at the lowest levels could have a big impact. We probably should devote resources to creating support structures for children in severely distressed families. At least we could try to make sure everyone can attain their maximum. We can also try to arrange the economy in such a way as to reward a wider array of skill sets. It's not just the high IQ types that can contribute. The ability to spend 8 hours in a coal mine is certainly no mean feat.

Steve Hsu said...

Sorry to have digressed -- this discussion should go under the Turkheimer post!

Yes, I think for very disadvantaged kids it is implied by the Turkheimer research that the shared E has an effect.

When you restrict the range of E to cover middle to upper class families the IQ outcomes seem to only depend on non-shared E, so it is very idiosyncratic.

David said...

It always struck me that M-M flattened out the effect of time too much. It's a temporally local idea that is vulnerable to changes in the global environment.

Economics, in general, is chock full of implicit, naive assumptions about time [and consequently time based risk].

Roger Bigod said...

But it must be true, because it's a Theorem.

And I am Michiko, Empress of Japan.

Anonymous said...

The discussion of which prize is "better" left aside, the post shows a complete misunderstanding of the MM theorem, which unfortunately makes the post look petty and uninformed. There are a million things to criticize in the financial sector, MM is not one of them.

MM does emphatically (and indeed, explicitly) NOT say capital structure does not matter. It says that, abstracting from taxes, information asymmetry, agency costs (between mgrs and shareholders as well as between shareholders and debtholders), and a fixed investment policy, one cannot increase the value of the firm by changing the capital structure.

Their point was that ANY notion of increasing the value of the firm through leverage has to come from one of these sources - alleviating info asymmetry or agency cost or whatever.

If you can't link it to one of the 5 things, you are simply changing the size of the cake slices (debt and equity), not the size of the whole cake. It tells us WHICH imperfections of reality matter, and which don't.

Misunderstanding of MM has contributed to the crisis. But apparently if even physicists cannot understand it, what chance do we mortals have...sheesh.

I don't know where you learned this about MM, but wherever it was, I would ask for my money back.

Steve Hsu said...

As you state the result it is trivial and not worthy of any prize.

I believe it received so much attention because market fundamentalists (e.g. at Chicago) actually felt the idealized assumptions were *realistic*. I am critical of the claim that the theorem has much to do with reality. (By the way, even if I leave aside taxes, info asymmetry, agency costs, etc. the no arb assumption is still not realistic!)

If I recall there was even a famous study by Fama and French which claimed to show empirically that capital structures didn't matter in the valuation and performance of firms. So I guess in the real world there are no agency costs, limits to arbitrage or information asymmetries.

I am 100% sure that it is taught in many settings (e.g., business schools) as a realistic result (not "true only if we neglect these five or more conditions, none of which are satisfied in the real world"), to the head-scratching response of students with real business experience.

The person who first explained the "theorem" to me was taking a course from Modigliani himself at MIT, and, yes, he and his fellow students were led to believe it was true of the real world.

If the correct understanding of the result is as you state -- i.e., the leverage doesn't matter conclusion is totally unrealistic -- why does Nobelist Myron Scholes use it to argue against the need for more financial regulation (see link)? Is he not talking about the real world?

Steve Hsu said...

PS Here is a discussion by Miller: MM 30 years later.

Note the last paragraph. RIP means that recent events show conclusively that the theorem does not apply to the real world. You might claim that no one ever believed that MM applied to the real world, but from what Miller writes it is obvious that many economists did think so.

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