Bank advice for the forgetful

07/08/2012 § 2 Comments

Front page of the Dominion Post business section was the Reserve Bank wagging its finger at the economy. The guts of it are on the Bank’s website. The main message:

“But it is fair to note that we have suspected for a long time that New Zealand’s private and external debts were too high to be sustained,” Dr Bollard said.

Getting older is strange. I remember things, how things were — and not just from some book, but because we lived and breathed them.

Fifteen years ago, we lived and breathed two financial ideas. One was the Modigliani–Miller theorem (the other was the Black–Scholes model of asset prices). Wikipedia helpfully summarises MM:

The basic theorem states that, under a certain market price process…, the value of a firm is unaffected by how that firm is financed.

Most of the time, we just discarded the phrase between the commas, the one that says it all depends on the market being just so. Instead, we carried on as if equity and debt were basically equivalent. It didn’t matter because equity demanded a return and would seek it wherever it could, which was equivalent to paying for borrowed funds. Given the predictability of asset prices afforded by Black-Scholes, risk could be managed — it could be priced into the asset valuation which was independent of finance structure. What we believed was true for firms we then also shifted to households. It didn’t matter how you structured the financing for your household assets — debt was as good as equity.

It turned out that Minsky was right in a way that Modigliani and Miller were not. MM of course had the get-out-of-jail-free card stuck between those commas, but that didn’t matter to the firms and investors who believed the vulgar version of the theorem.

Now, Dr Bollard tells us that the debts were too high. When he says, ‘we have suspected for a long time’, it is fair to ask who this ‘we’ is. Fifteen years ago, the greybeards and the young hustlers told us something else. In those days, debt was equivalent to equity and the path to greater riches through leverage.

Now, ‘we’ think they were wrong. Then, when we accumulated the debt, we thought they were right.

If Dr Bollard wants to wag his finger at someone, he should start with the experts.


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§ 2 Responses to Bank advice for the forgetful

  • Michael Reddell says:

    I was co-author of the speech. If you read the whole speech you will find that we refers to the rbnz, including a quote from an old don brash speech on the same subject.

    • Bill says:

      The Brash speech is from 2002, long after the MM fashion had changed attitudes towards debt. Modigliani was awarded the Nobel in 1985, which helped give the idea official validity.
      Even if RBNZ was right in the 1990s (and I can’t comment on that), the finance experts still took us down this road of debt that Dr Bollard now decries.

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