Presentation Speech by Professor Ragnar Bentzel of the Royal Academy of Sciences
Translation from the Swedish text
Your Majesties, Your Royal Highnesses, Ladies and Gentlemen,
This year’s prize in Economic Sciences has been awarded to Professor Franco Modigliani for his construction and development of the theory of household saving known as the life-cycle hypothesis and for his contributions to the formulation of the Modigliani-Miller theorems regarding capital costs and the determination of corporations’ market values. These two contributions are closely inter-related. Both entail the management of household wealth and can be seen as parts of Modigliani’s extensive research into the functioning of financial markets.
According to the theory presented in 1936 by the great British economist John Maynard Keynes, it is a ‘psychological law’ that when their incomes increase, people increase their saving to such an extent that the saved share of their incomes increases. This putative law was rooted in empirical observations of saving in various income groups, and Keynes concluded that, in a period of economic growth, the share of national income that constitutes aggregate saving steadily rises.
Keynes’ theory of saving was generally accepted by his contemporaries. But, in 1942, the American economist Simon Kuznets showed that Keynes’ theory was contradicted by statistical data: in the United States saving’s share of national income had not undergone a long-term increase – despite an enormous increase in personal incomes. This contradiction was seen as a paradox, and it soon became the object of a number of studies. One of those studies resulted in a work, published in 1954, in which Franco Modigliani and his assistant, Richard Brumberg, presented an entirely new theory of household saving: the life-cycle hypothesis.
The life-cycle hypothesis derives from the simple idea that people save for their own retirement and that they therefore accumulate savings during their active years in order to be able to consume those savings during their retirement.
A stringent, mathematical formulation of this hypothesis led to a number of conclusions that could not be drawn from earlier theories, for example, that a person’s saving is not determined only by his income, but also by his wealth, his expected future income, and his age. The hypothesis also made possible a rational explanation of the Keynes-Kuznets paradox. As Modigliani and Brumberg showed, in the life-cycle model there is no unique correspondence between the cross-section and the time-series saving-income relationships.
In its original formulation, the life-cycle hypothesis was a theory of saving behavior on the part of the individual. But Modigliani has expanded the perspective of the hypothesis and in a number of writings dealt with the issue that is far more interesting from an economic-political standpoint: the conclusions the theory provides regarding aggregate household saving. Here, he has shown that the theory implies, among other things, (1) that saving is not determined, as earlier theories have suggested, by households’ income level, but rather by the rate of increase in that income level, (2) that saving is affected by population growth as well as by population age structure, (3) that saving is affected by households’ aggregate wealth and hence also by the interest rate in its capacity of capitalization factor, and finally (4) that the multiplier effect of an autonomous expenditure increase approaches the inverted value of the marginal tax rate.
With the life-cycle hypothesis, Modigliani has created a wholly new theory of household saving – a theory that has proved to be of major significance to research into consumption and saving. It has constituted the basis of theoretical and empirical analyses of many different types of problems – chiefly those involving the effects of economic-political measures. Among other things, it has been used for analyses of the effects of various social-insurance systems and the consequences of budget deficits on the economic situations of various generations.
I would like to turn now to the other contribution for which Professor Modigliani has been awarded this prize: the formulation of the Modigliani-Miller theorems.
The theorems derive from an article written by Modigliani and his colleague Merton Miller in 1958. The central theorem states that a corporation’s market value – defined as the sum of the market values of its equity stock and its debts – is independent of the size and structure of those debts, on condition that the financial markets are functioning perfectly and are in a state of equilibrium. In such instances, the average cost of capital is also independent of the debts. In a later work, the two authors showed that – with a given investment policy – a corporation’s worth is independent of its dividend policy. These theorems are intended to provide norms for comparison, and they thus presume the absence of taxes and bankruptcy costs. The authors, however, provide a thorough discussion of the effects of taxes on the validity of the theorems.
At first glance, these theorems can seem rather odd. Aren’t there always people who attach particular significance to the degree of a corporation’s indebtedness – either in perceiving a large burden of debt as a risk factor or, on the contrary, viewing a high degree of debt as something favorable? After all, it is a common view, for example, that a house is worth more if it is heavily mortgaged. Yes, such evaluations are made, of course. But they lack influence in the perfect markets posited by Modigliani and Miller. Because, in such markets, stockholders can compose their investment portfolios at no cost entirely at their own discretion. And therefore, their evaluations of risk, debt burden, and so forth will be reflected in their choice of portfolios. This does not, however, invalidate the Modigliani-Miller theorems. Were these not fulfilled, it would always be possible to conduct profitable stock transactions by selling overvalued stocks and buying undervalued ones and, possibly, by borrowing. As a result, the stock prices would change, and the values of the corporations involved would tend to approach the state of equilibrium stipulated in the theorems.
Until the latter part of the 1950s, no viable theory of corporate financing of investment, debt, taxes, and so forth had been developed. It was not till Modigliani and Miller presented their theorems that more stringent theorizing began to appear in this field. By treating financing decisions within the framework of a theory of financial-marketplace equilibrium, Modigliani and Miller provided the general guidelines for continued research in this area.
The scientific value of their contributions is therefore not limited to their formulation of the theorems themselves, but also derives to perhaps a like degree from their introduction of a new analytical method in the corporate finance discipline.