The global financial crisis has been blamed on everybody from bankers to rating agencies to politicians. Federal Reserve Chairman Ben Bernanke on Wednesday cited the baleful influence of two people whose names rarely come up in the blame game: Nobel Prize-winning economists Franco Modigliani and Merton Miller.
In a speech in Boston marking the Fed’s centennial, Bernanke said central bankers didn’t pay enough attention to the workings of the financial system in the years leading up to the crisis in 2008, partly because they were under the influence of a theorem developed by Modigliani (who died in 2003) and Miller (who died in 2000). The Modigliani-Miller theorem, which is taught in business schools and economics PhD programs, says that under certain narrow conditions, it doesn’t matter how much debt a company takes on: what investors care about is the value of the company’s underlying assets, not how they’re financed. The company’s value is unaffected by the ratio of debt to stock that it issues.
The Modigliani-Miller theorem doesn’t apply in the real world, where heavily indebted companies that go bankrupt cause huge collateral damage. But the elegant theory helped convince some macroeconomists that they could focus on the big picture of economic growth while leaving the particulars of finance to the specialists. At least that appears to be Bernanke’s takeaway.
“In retrospect,” he said, according to his prepared remarks, “it is clear that macroeconomists—both inside and outside central banks—relied too heavily during that period on variants of the so-called Modigliani-Miller theorem, an implication of which is that the details of the structure of the financial system can be ignored when analyzing the behavior of the broader economy.”
Bernanke didn’t blame Modigliani and Miller personally, only other economists’ interpretation of their work. In any case, he said, the lesson has been learned.
“The financial crisis and the ensuing Great Recession reminded us of a lesson that we learned both in the 19th century and during the Depression but had forgotten to some extent, which is that severe financial instability can do grave damage to the broader economy,” Bernanke said at a conference organized by the National Bureau of Economic Research. He said, “In a sense, we have come full circle, back to the original goal of the Federal Reserve of preventing financial panics.”