Online Debate on the Financial Crisis at Economist.com

Proposition: "It would be a mistake to regulate the financial system heavily after the crisis"

Pro: Professor Myron Scholes, Stanford University
Con: Professor Joseph Stiglitz, Columbia University
Moderator: Henry Tricks, Finance Editor, The Economist


Comment to the Moderator on Professor Scholes' Opening Statement:

Sir,

The financial system needs to be regulated mainly because the theoretical underpinnings of modern finance are quite weak and outdated. For example, let us take the Modigliani-Miller theorem which forms the central theme of Professor Myron Scholes' Opening Statement in this debate. This theorem states that the value of a firm is independent of its debt-to-equity ratio. For its simplicity and effectiveness, this theorem is definitely a creditable achievement of modern economics. Indeed, its discoverers Professors Franco Modigliani and Merton Miller went on to win the Nobel prize in Economics (at different times), for this theorem and other achievements. When this theorem was first established more than 50 years ago, it applied very well to the industrial economy of that time.

In those days, if an entrepreneur wanted to start a business for the first time, say a small factory or a retail shop, his/her initial investment (down-payment) would have to be substantial, say 25 percent or more. A financial institution, like a community bank, would lend the rest of the money. The bank can verify that its money is being used to actually build the factory, a physical asset, and thus it has a fairly good understanding of how its money is being employed for making profits. After several years, if the business runs successfully, the entrepreneur goes back to the bank to help build a second factory. After this process happens a few times, the company has grown quite large, having established a successful business model with a well-understood revenue/profit stream. At this point, the entrepreneur realizes that to reach economy of scale, (s)he has to jack up his/her business plans by an order of magnitude, and (s)he would have to find access to much larger sources of finance. The result is that the company goes public. Note that the entrepreneur also benefits personally because his/her own investment in the company, which is now made into shareholding claims, has become more liquid. The company could issue more shares in the stock market, i.e., increase equity, or issue bonds in the credit market and/or get more loans, i.e., increase debt, to raise capital for its further business ventures.

Now, by the time the company has reached this situation, invariably, its balance sheet would have grown to include far more than just equity and debt. Due to accumulation of profits over the years, it would have reserve funds. Then again it would have to pay into its employees' pension funds. It would be helpful for the reader to keep in mind some large corporation of the 70s and 80s, like Bethlehem Steel. The company would have a large number of assets and it would indeed be a huge undertaking, far more than just the sum of its equity and debt. The Modigliani-Miller theorem says that the total value of the firm, as given on its balance sheet, would not be dependent on the ratio of its equity and its debt. Moreover, the creditors (those who have furnished the company with its debt) can also understand the business model of the company by verifying the company's assets, which are mostly tangible and real. Here I would like to point out that it is not in the creditors' interest to take over the company, because the entrepreneur-industrialist brings substantial expertise about how to pursue profit-making opportunities during the day-to-day functioning of the company. In this context, the theorem provides the (very) useful information that while analyzing the balance sheet of the company, one need not worry about the debt-equity ratio.

In contrast, there are a lot of problems when one tries to apply the Modigliani-Miller theorem to figure out whether regulation of today's finance industry should stop with 'capital requirements and pricing flexibility', as mentioned in Professor Scholes' Opening Statement. Now, a typical 'bulge-bracket' investment bank (like the top few Wall Street firms) would have about 30 to 40 billion dollars in capital (equity + accumulated profits). However the bank would have borrowed over 800 or 900 billion dollars to finance its operations (and hence the oft-quoted leverage ratio figure of 25 to 30). At this point, it might be helpful for the reader to actually see the balance sheet of a publicly traded Wall Street investment bank (it is available for free on Yahoo Finance).

Now where did the 800 to 900 billion dollars come from? They came from the pension funds and the mutual funds. Hence, there is a serious problem here. If you asked a pension fund manager in 2003 about the details of the mortgage securities, (s)he would have had no idea how the whole process works, because financial innovation was happening at a furious pace, and there was a whole alphabet soup of CDOs, CDSs, AAA MBSs being created newly every week or so. Thus, while the industrial economy of the 1950s, 60s and 70s had the entrepreneur operate at leverage ratios less than 10 and gave his/her bankers a fairly good idea about the business model, the technology and the innovation, in sharp contrast, the creditors of the contemporary finance firms have no way of knowing whether their money is being employed in the business venture in a sensible manner. And most importantly, the entrepreneur whose own stake is only 40 billion dollars controls the whole of the 900 billion dollars. Unlike the situation in the industrial economy, the long-term economic contribution of the entrepreneur is quite suspect precisely because a financial crisis could wipe out his/her business venture (40 billion) whereas the total value (900 billion) is more stable.

This is the fundamental weakness of modern finance theory. If the common (wo)man had followed the news about Wall Street since the beginning of this year, (s)he would have mostly heard about the high leverage ratios in the investment banks, about sub-prime mortgages, about the credit freeze and how it is all going to come down on Main Street as a huge financial meltdown. In talking about debt and equity, the Modigliani-Miller theorem gives the illusion that the whole of the 900 billion dollars is a part of the investment bank, when in fact, that money belongs to the pension funds. The pension funds and mutual funds carry anywhere from 20 to 50 trillion dollars of people's savings (source: Wikipedia). So, the discussion among financial experts in the media should have focused on these large accumulations of capital. This approach would have avoided fear and panic in the financial markets, but perhaps it would have also made it impossible for the Wall Street investment banks to extract more than 20 percent returns on capital year after year.

Thus, the financial system needs to be regulated until the experts of modern finance can go back to the drawing board and work out a more stable foundation. Instead of promoting financial innovation in the markets, they should conduct credible research in finance at the universities. Having said that, I have to mention that I am also quite worried that after this Presidential election in America the extreme leftists would take control of the government and the media which would lead to tax-and-spend liberalism and big government. There is a grave risk that re-regulation would quickly become excessive.

Coming back to Professor Scholes' Opening Statement, further objections to modern finance theory can be made from other perspectives. The first objection is based on the economics of asymmetric information. For an excellent overview of this perspective, please see Professor Kenneth Arrow's article 'Risky Business' in The Guardian on October 16, 2008. The second objection is more subtle. It says that economic risk cannot be quantified so easily as modern finance theory presumes. For this perspective, see Professor Edmund Phelps' article 'Our Uncertain Economy' on March 14, 2008 in The Wall Street Journal.

While the first and the second objections concern the focus of modern finance on risk management at the level of a company-firm, by far the most common criticism of finance theory is that it is ineffective in containing systemic risk. This perspective has been given much needed theoretical heft and some respect by Professor Gary Becker's article 'We're Not Headed for a Depression' on October 7, 2008 in The Wall Street Journal. Particularly striking is his statement, "The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system". Lastly, please check out my blog-post where further clarifications about the current financial crisis are given: http://selvasblog.blogspot.com/2008/10/faq-on-current-financial-crisis-q1.html


Further critiques of the Modigliani-Miller theorem from more advanced perspectives

1) Professor George Akerlof has proposed a new formulation of maco-economics which takes the Modigliani-Miller theorem as one of the given conditions of the economy (he calls these conditions neutralities). Then he attempts to derive these conditions in a rigorous way by extending on the traditional micro-economic assumptions that a firm would aim for profit-maximization and a consumer would aim for utility maximization. The extensions he assumes are basically norms on the behavior of the consumer, which he calls 'realistic norms'. Please see his Presidential address to the American Economic Association in January 2007, 'The Missing Motivation in Macroeconomics'. However, one should note that the Modigliani-Miller theorem is far from the last word even in the industrial economy of the second half of the 20th century. One should recall how many large corporations, e.g., Bethlehem Steel, had underfunded their pension plans for prolonged periods of time. In the case of the steel-making corporations, when it was finally discovered that their balance sheets had simply been out-of-touch with reality for the better part of two decades, they went into bankruptcy courts. The pension plans and health benefits of their employees had to be foregone, and they were sold for fire-sale prices to become what is now Arcelor-Mittal steel company.

2) Demographically, the aging of the baby boomers has meant that the typical American investor is aging (as measured by average age or median age). Hence portfolio management advisors would invariably be advising their clients that they need to reduce risky investments as they approach retirement. In the aggregate, this means that as a nation, the United States, and similarly, other advanced industrial countries, would prefer progressively more cautious investments in the next two decades or so. However, in saying that it does not matter whether a firm prefers debt or equity to finance itself, the Modigliani-Miller theorem does not address this demographic reality well. In fact, with the entrepreneurial culture in a capitalist society, the equity-holders take full control of the firm, even though their own stake is as much as 30 times less than the debt-holders. In modern times, there is also the conflict of interest between share-holders and management. These developments are at odds with the demographic realities of today. Thus a different theory of finance that takes into account (i) the changing risk tolerance of the population, and (ii) the relative stakes of the management, creditors and shareholders could definitely be more suited for the future.