Saturday, January 16, 2010


A Glib Interview With Eugene Fama

Oh man, I think we need to come up with our version of Cass Sunstein and pay Eugene Fama to stop defending the free market. He warmed up by the second half, but I think Fama started off this interview horribly. (HT2CP) I've seen progressive bloggers laughing themselves silly over it, and I don't blame them.

I am going to do a Mises Daily on this, after I calm down and regain perspective. But in the meantime, do any Free Advice readers know enough about the Modigliani-Miller theorem to evaluate this portion of the interview?
[Cassidy:] So what is the solution that problem [of moral hazard from government bailouts]?

[Fama:] The simple solution is to make sure these firms have a lot more equity capital—not a little more, but a lot more, so they are not playing with other people’s money. There are other people here who think that leverage is an important part of they system. I am not sure I agree with them. You talk to Doug Diamond or Raghu Rajan, and they have theories for why leverage in financial institutions has real uses. I just don’t think that those effects are as important as they think they are.

[Cassidy:] Let’s say the government did what you recommend, and forced banks to hold a lot more equity capital. Would it then also have to restructure the industry, say splitting up the big banks, as some other experts have recommended?

[Fama:] No. If you think about it...I’m a student of Merton Miller, after all. In the Modigliani-Miller view of the world, it’s only the assets that count. The way you finance them doesn’t matter. If you decide that this type of activity should be financed more with equity than debt, that doesn’t particularly have adverse effects on the level of activity in that sector. It is just splitting the risk differently.

[Cassidy:] Some people might say one of the big lessons of the crisis is that the Modigliani-Miller theory doesn’t hold. In this case, the way that things were financed did matter. People and firms had too much debt.

[Fama:] Well, in the Modigliani-Miller world there are zero transaction costs. But big bankruptcies have big transaction costs, whereas if you’ve got a less levered capital structure you don’t go into bankruptcy. Leverage is a problem...
OK so help me out here. Isn't the whole point of the MM theory that a firm's leverage is irrelevant? So on the one hand, it seems Fama is contradicting himself--saying "yes let's limit leverage because I believe in a theory that says leverage is irrelevant to finance."

On the other hand, maybe Fama is saying, "Since leverage doesn't gain a firm anything, in the presence of implicit government bailouts, let's limit it."

Someone who knows MM please help me out. Fama said so many other absurd things that I don't want to unfairly pick on him for this one, if it's fine.

"Krugman wants to be the czar of the world. There are no economists that he likes. (Laughs)"

From my lecturer in Finance and Accounting

The assumptions on MM are:
- no arbitrage
- interest for credit and deposit are equal
- no credit limit
- not tax and transaction cost
- investments can be divided infinitly
- market value of liabilities corresponds to the market value of financial liabilities
- interest on borrowed capital corresponds to interest rate of the market
-companys dont go bankcrupt

MM is so sterile to the real world, so Fama is contradicting himself in saying "leverage matters".
Hey Bob, for your article, are you going to again claim that bubbles contradict EMH, and ignore any posters who point out your error?

Just curious.
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Fama and Cassidy are both wrong or confused. Leverage does matter in banking due to the implicit/explicit subsidy of deposit insurance and the TBTF doctrine. But this is entirely consistent with Modigliani Miller.

To quote from my post here : "Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value."
"In a simple Modigliani-Miller world, the optimal leverage for a bank is therefore infinite. Even without invoking Modigliani-Miller, the argument for this is intuitive. If each incremental unit of debt issued is issued at less than its true economic cost, it adds to firm value."

For a good explanation of the MM hypothesis, try this document by Mark Rubinstein . Creditor guarantees via TBTF or deposit insurance violate assumption 2 on page 5 i.e. the pie is no longer fixed if each incremental unit of debt is issued at less than economic cost.
I thought it was a great interview, but I agree the opening was rather rough.
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