Modigliani's Masterpiece

It's commonly accepted when we're young -- and flush -- that we should save for the future and, as we grow older, draw on our savings to support ourselves. But before 1954, those assumptions were anything but a given.

It is thanks to the pioneering research of Franco Modigliani that we understand that savings isn't just a habit of the rich; that when we're young we should make savings and buying decisions with an eye on our future needs, not necessarily those of our progeny. And while it now seems commonsensical, Modigliani proposed the hypothesis that we tend to shortchange our nest eggs when money is tight.

Undercelebrated among the masses but widely read by business students the world over, the Nobel Prize-winning economist who pioneered these now-common understandings passed away at his Cambridge, Mass., home on Sept. 25 at the age of 85. But the fruits of his research live on and shape the way we save, spend, and invest our capital.

Modigliani had a 40-year career at the Massachusetts Institute of Technology, in addition to consultancy positions at the Federal Reserve System, the U.S. Department of the Treasury, the Bank of Spain, and the Bank of Italy. "He was the greatest living macroeconomist," Paul Samuelson, a fellow Nobel laureate and professor emeritus at MIT's Alfred P. Sloan School of Management, said in a statement after his colleague's death. "He revised Keynesian economics from its Model-T, Neanderthal, Great Depression-model to its modern-day form."

So what does that have to do with those of us facing skyrocketing insurance costs, an uncertain economy, kids heading to expensive colleges, and an unending and confusing array of investment choices, all of which seem to have some sort of tax consequence?

A lot, actually.

For rich and poor
Simply put, the "life-cycle theory" that earned Modigliani and one of his students, Richard Brumberg, the Nobel Prize, brought to life the old adage, "Save it when you need it least; have it when you need it most." Today, this savings hypothesis is a cornerstone of economic theory and public policy, not to mention financial education like we champion here at The Motley Fool.

Modigliani long suspected that people in nearly every social stratum save money during their early careers to provide for their needs in old age. He showed how people vary their level of savings over their lifetime, and helped explain different rates of savings in societies with older or younger populations. His theories countered what other economists asserted at the time -- that wealth accumulation was mainly a tool for the rich to pass along an inheritance to the next generation.

Modigliani showed us that savings isn't borne out of luxury, but out of necessity.

You can indirectly thank Modigliani for that pension plan that will supplement your retirement. Also thank him for those tax breaks you get as you draw down your savings during retirement. And it is because of him that your kids understand (or at least should take into consideration) that they cannot count on a windfall from your estate to make up any shortcomings in their own savings.

Others have come up with more compelling titles and commercial ways to explain this savings mindset. (Die Broke: A Radical Four-Part Financial Plan comes to mind). But the ideas are classic Modigliani.

It should be noted that his hypothesis was deemed a failure by his colleagues back in the day. For one thing, in the Keynesian (as in John Maynard Keynes) world of economics (in full swing when Modigliani was a child), personal savings was feared by economists who thought that a population that saved was dooming the economy to Depression because of underconsumption.

Seems silly now, doesn't it? But not to Modigliani, who took a lot of guff while trying to get policy makers to heed his research and put some safeguards into place.

Oh, and that Nobel prize for his life-cycle theory work? That didn't get delivered until 1985.

Adventures of an economist
It is hard to separate economic theory from economic policy. Modigliani would often caution against confusing the two. "Economists agree about economics -- and that's a science -- and they disagree about economic policy because that's a value judgment," he said. "I've had profound disagreements on policy with the famous Milton Friedman. But, on economics, we agree."

But even Modigliani had a hard time keeping theory and strategy distinct. His research set out to answer the kinds of questions that were sure to shape policy. How is it that the rich seem to stay rich, generation to generation? How much of wealth is earned and saved during the lifetime of the well-to-do, and how much of it is inherited? Does Social Security impinge on investment?

He raised the concerns that his colleagues would go on to study for years to come. In his later career, he had a louder voice on the social effects of economics by taking a stand on Social Security policy, for instance. It is Modigliani's large-scale model of the U.S. economy (built over five years) that the Federal Reserve System uses to gauge the expected effects of policy.

Corporate finance was another interest of the educator, and his thinking propelled the issue of financial markets. In 1961, with Merton Miller of the University of Chicago, he wrote the paper that first advanced what is now known as the "efficient markets" hypothesis. (Attention business students: This is the Modigliani-Miller theorem that holds that the market value of a stock depends primarily on future earnings expectations. Class dismissed.)

Even his autobiography, Adventures of an Economist, written in 2001, takes a very human and applicable approach to economics, describing its social and political impact on our everyday lives. He writes about his childhood in a fascist Rome, his flight from Nazism, and his arrival in the United States with the grace of a novelist, not a numbers cruncher.

Despite a career that gave us ideas of staggering import, Modigliani was humble about his achievements, telling a Boston Globe reporter in 1985, "All my students have outdone me in rigor, but this is perhaps not too hard."

Yet even Modigliani recognized that special marriage of talents he possessed -- the ability to understand the science of money and the larger impact our behavior has on society. "I think there are a few things in economics that I can do that the average guy cannot do, not even in his gut."

Here's to gut instincts, and the art of economics Franco Modigliani mastered.

Since Dayana Yochim didn't go to business school, as you can see in her profile, she only recently was introduced to the ideas of Modigliani.


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