The relevance of Modigliani

Okonomos

His 'life cycle' theory and other works were ignored in India

Franco Modigliani, who died on September 25, was an Italian Jew who was forced to leave his country of birth in August 1939, just a few days before the Second World War broke out.

Like so many others, he went to America, where he eventually became one of the world's foremost economists who won the "Nobel" in 1985.

Recently, he took strong exception to a couple of remarks that Silvio Berlusconi made about Italian judges being "mad" and about how Mussolini's dictatorship was "benign".

He even managed to persuade Paul Samuelson, who does not normally sign such letters, to write a strong joint letter along with Robert Solow, to the New York Times.

One consequence was that Henry Kissinger decided not to go to the dinner "" but that is another story. That is how influential he was in the US.

But he was not very well known in India. Those who taught and studied economics from the 1960s till the mid-1980s knew something about his work but their successors are mostly in the dark. The reason is a rather interesting one.

Modigliani was known for two major contributions to economics, one in macroeconomics and the other in microeconomics.

Indians have always been obsessed by macroeconomics and it was therefore his analysis of the behavior of household savings that seemed more important to university syllabus setters.

This analysis was predicated on the fact that people don't want their consumption levels to fluctuate wildly from year to year.

So in order to ensure a smoothening of consumption, they save in the high-income years and spend from the savings in the low-income years.

Modigliani, who was trying to refine the Keynesian idea of a "consumption function", applied this to the lifetime savings behaviour of individuals and came up with what has come to be known as the "life cycle" theory of savings and consumption.

This depends on the observed fact that incomes tend to start low, increase, and then decrease after retirement. So young people borrow to spend more than their income, middle-aged people save a lot, and old people run down their savings.

In retrospect, this was about as useless an insight as Keynes original "consumption function" had been. But because of the Indian preoccupation with macroeconomics it was this that was emphasised in the classrooms.

A far more important paper that he wrote along with Merton Miller, albeit several years later, was largely ignored in Indian syllabi. This paper was about the valuation of a firm and it is known as the Modigliani-Miller Theorem.

Modigliani and Miller asked whether the manner in which a firm financed its activities (that is, through debt or equity or the proportion in which the two were combined) had any effect on how it was valued or how what it cost it to raise capital.

And they concluded that provided certain conditions were met, such as say zero taxes and perfectly functioning capital markets, it didn't.

What mattered crucially was the level of expected profits and risk. Given the preoccupations of the time, this was a fundamental insight because it had a huge influence on the way students were taught corporate finance.

What's more, as we have seen in India as well, it is exactly right. For instance, no one cares how, say, Reliance Industries raises its capital. All they are interested in as the record of the company in generating profits and in managing risk.

Indeed, such firms meet the key assumption of the theorem as well: their tax liabilities are as close to zero as to not matter.

What's more, exactly as the theorem predicted, their cost of capital is very low because the method by which they raise it doesn't matter to those who lend them money either as debt or as equity.

In India, of course, until the 1990s made MBAs respectable and profitable, corporate finance was a dirty word in university economics departments.

Had Modigliani been Indian and taught at the Delhi School of Economics, he may well have been consigned to the outer darkness of the commerce department. Of course, the relatively useless life cycle theory may still have saved him.

Much would have depended on when he applied for a post.