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April 19, 2018



«Economics, for me, is not about armchair theorizing.»

That's a category error: you don't define "Economics", tenure committees define it, and they award tenure to people who have a long record of publishing "internally consistent" ("armchair theorizing") papers.

That's the choice of the people who fund research and tenured jobs in "Economics", and it is their right to define "Economics" that way.

As to the nearly extinct and almost forgotten study of the "political economy", as the very name says "political economy" research is "an empirical discipline" about the economy of the "polis", of a country.

But Economics has to be "internally consistent" with the "three fables" of JB Clark. If you don't like that, endow tenured positions at universities.
Ken Lay of Enron endowed 35 (thirty five) professorships of Economics (and even some of accounting...).


«Ken Lay of Enron endowed 35 (thirty five) professorships of Economics (and even some of accounting...).»

And here is a fabulous quote from the notorious B de Mandeville, "An Essay on Charity", 1732:

“A rich Miser, who is thoroughly selfish, and would receive the Interest of his Money even after his death, has nothing else to defraud his relations, and leave his Estate to some famous University: they are the best Markets to buy Immortality at with little Merit; in them Knowledge, Wit and Penetration are the Growth, I had almost said, the manufacture of the Place: There Men are profoundly skill'd in Human Nature, and know what it is their Benefactors want; and there extraordinary Bounties shall always meet with an extraordinary Recompense, and the Measure of the Gift is ever the Standard of their Praises, whether the Donor be a Physician or a Tinker, when once the living Witnesses that that might laugh at them are extinct.”
“Of all this our subtle Benefactor was not ignorant, he understood Universities, their Genius, and their Politicks, and from thence foresaw and knew that the Incense to be offer’d to him would not cease with the present or a few succeeding Generations, and that it would not only last for the trifling Space of three or four hundred Years, but that it would continue to be paid to him through all Changes and Revolutions of Government and Religion, as long as the Nation subsists, and the Island it self remains.”


To belabor the point: «the way undergraduates are taught» is pretty much irrelevant.

"Economics" is defined by what Economists (like Mankiw or Hubbard) do, so what matters is whatever gives access the the role of Economist. And that's the tenure committees of Departments of Economics and secondarily the editorial committees of "top journals".
RWER reported an inebriated confession by an Economist:

«I found myself sitting next to a very likable young middle-aged academic tenured at an elite British university, whom henceforth I will refer to as Doctor X and whose field is closely associated with this blog. ... Every year I publish papers in the top journals and they’re pure shit.” Doctor X, who by now had had a glass or two, felt bad about this, not least because “students these days are so idealistic and eager to learn; they’re really wonderful.” Furthermore Doctor X could and would like “to write serious papers but what would be the point?” ... The amount of funding Doctor X’s department receives depends not on how many papers or their quality its members publish, but instead on in which journals they are published. The journals in Doctor X’s field in which publication results in substantial funding will not publish “serious papers” but instead only “pure shit” papers, meaning ones that merely elaborate old theories that nearly everyone knows are false. Moreover, even to publish a “serious paper” in addition to the “pure shit” ones could taint the department’s reputation, resulting in a reduction of its funding. In any case, no one at a top university would read a “serious paper” because they only read “top journals.”»

Ralph Musgrave

I support the Miller-Modigliani theory. It’s a good basis for arguing that bank capital ratios should be much increased, because according to MM there is no effect on the cost of funding banks if capital ratios are increased. And the higher bank capital ratios are, the less likely the bank is to go insolvent: hey presto – fewer 2008 type bank crises.

Re Chris’s suggestion that MM is not valid because of the different tax treatment of income from capital and deposits, that is the most popular criticism of MM in my experience. The flaw in that criticism is that tax is an entirely artificial imposition which should thus be ignored for the purpose of working out real costs. If government taxed red cars more heavily than other cars, that would make red cars SEEM more expensive than other cars, but of course that “red car tax” would not mean the REAL COST of red cars was higher than other cars.


'I’ve always read their theorem .. not as saying “capital structure doesn’t matter”, but rather: “when you see a share price change in response to a change in capital structure, it’s because (at least one) explicitly-stated assumptions do not hold.”': that is also my interpretion, but apparently not that of Miller himself. In a keynote speech at a conference I heard him argue that all in all, "imperfections" such as asymmetric information hardly matter and capital structure IS basically irrelevant.


«"imperfections" such as asymmetric information hardly matter and capital structure IS basically irrelevant.»

Sure, sure, such hand-waving passes for "Economics" science, because of course the very different ways bankruptcy and voting rights are impacted by different capital structures do not matter in "Economics", and don't drive at all behaviour in the political economy.

Dissemblers. The "political economy" approach is to recognize that firms are institutions (partly in the political and sociological domain) as well as economic entities, and that therefore institutional changes matter a very great deal to economic behaviour, because the distribution of power matters, because there is more than one agent and less than an infinity of identical agents.
M Pettis in his "The Volatility Machine" is that the portfolio theory used by CFOs should be applied to national balance sheets too, because balance sheet composition actually matters a lot under stress, and matters even in normal conditions. What Modigliani-Miller say is that all the talk about portfolio theory taught in business schools is irrelevant.

I have no doubt that Modigliani-Miller is "internally consistent".


I can't see MM applies in this case. The firm's capital structure did not change following the share buy back. It started off as all-equity financed firm and it ended as an all-equity financed firm.

Luis Enrique

I'm not sure about this. Armchair theorising starts from empirical observation. Prices are observed to rise, why might that be? The armchair theory that a shareholder should be no better off if a dollar held by a firm she owns is given to her, is useful and important. Combined with the observation that buy backs do affect prices, it forces you to ask better questions about why that might be. Without that armchair theory, we'd understand less, I think.

In one of my few published papers, my coauthor introduced a lovely quote from Klee about the point of art being to make something visible. By stripping stuff away. Armchair theories can do that.


«It started off as all-equity financed firm and it ended as an all-equity financed firm.»

Ahem, no it started being financed with $100 cash and $100 equity. The cash is an asset and the shares corresponding to the equity are a liability, but that is in accounting terms, not in Economics.
The MM case is usually illustrated with debt so imagine the case where it borrows to buy back one $100 share: before assets $200 factory $200 share liabilities, after assets $200 factory, $100 debt liabilities, $100 share liabilities.
The "has cash" or "borrows cash" cases are entirely symmetrical from the point of view of Economics, a cash holding is a negative debt.

From an institutional point of view of course replacing a shareholder with a creditor makes a big difference, because the legal rights (voting, bankruptcy) of a shareholder and a creditor are very different, and depend on circumstances, so called "reality".

But then from for a political economist the first case is also different: it matter whether the firm has [#1] assets $100 factory and $100 cash and $200 share liabilities, or [#2] $100 factory and $100 share liabilities because in case [#1] the firm is far more liquid than in case [#2].

Another way to look at it is that MM boils down to two uninteresting hand-wavings:

* Under neoclassical assumptions the long term rate of profit and the risk-adjusted rate of interest are the same, that is there is no "equity premium".

* Therefore "borrowing" from shareholders or from creditors is the same, if one disregards all the institutional differences.

Most neoclassical theorems are like that: the conclusion is implicit in the assumptions.

The way to write "pure shit" papers in Economics or other disciplines is to define the result one wants to prove and then search for the assumptions that imply that result. The catchphrase is "in this model ...".


«a cash holding is a negative debt.»

In particular in "Economics" only "net" matter, so absolute levels of debt don't matter: a $100 cash holding is the same as a having both a $1 billion+$100 credit towards a penniless tramp and a $1 billion debt to the mob, it all nets out in the end. :-)



Yes, if the firm had borrowed the cash in the first place then its balance sheet would show a liability of £100 and share capital of £100 so the capital structure would consist of 50% debt and 50% equity.

But this is not the case. We are told that the firm's assets are cash = £100 and a factory = £100 and that these have been financed by shares = £200.

Assets = Liabilities + Capital. This is an immutable law

derrida derider

"I’ve always read their theorem ... not as saying “capital structure doesn’t matter”, but rather: “when you see a share price change in response to a change in capital structure, it’s because (at least one) explicitly-stated assumptions do not hold.”

The mark - indeed purpose - of a good theory is NOT necessarily that it be empirically true but that it shows the importance of its assumptions. The classic example in economics is the Coase theorem - Ronald Coase developed it NOT to assert that costlessly defined and enforceable property rights are a sufficient condition for perfect efficiency but to show the practical importance of "costlessly", a condition which never obtains.

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