Archive for November 3rd, 2009

Comparing US economy with Japan is not really right

November 3, 2009

Simon Johnson in his latest testimony to Joint Economic Committee hearing comapres US-now to Japan-1990s and says the comparisons need to be reviewed. What led Japan to keep slipping into crisis was the reluctance of Japanese to stop giving stilmulus to top notch people.

Japan did not want to force its corporate sector to adjust (i.e., in the sense of going bankrupt and renegotiate its debts), so it offered repeated stimulus. As a result, it has become stuck with a “permanent” fiscal deficit program which is now threatening their survival as a global economic power, and will – regardless of the exact outcome – burden future generations for decades.

He says US policyamkers are overdoing things by comparing all things to Japan and pressing on the policies. The main issue is to reform the fianncial system and stop giving bailouts without any reforms.

Excellent stuff.  Need to rethink about comparison with Japan and US.

Time to review Modigliani-Miller theorems?

November 3, 2009

Anil Kashyap of Chicago Univ has an interesting take on the revered Modigliani-Miller theorems.

One of the peculiarities of this crisis is that the path by which we arrived at it. The crisis came after roughly 25 years of relative macroeconomic stability. The bulk of research within central banks had shifted to studying inflation determination. The workhorse models used by central bankers mostly ignored the financial system – this is especially ironic in the U.S. since the chairman of the Board of Governors was among the most prominent advocates of paying more attention to the role of financial factors in monetary transmission.

But Chairman Bernanke held a minority view and most macro models reflected the view that the Modigliani-Miller view of capital structure was approximately correct. By that I mean that the liability side of a firm’s balance sheet was irrelevant. There was no need to figure out financing unimportant. More precisely, the structure of liabilities would not change anything about the cash flows generated by an enterprise or its value. I think the crisis has taught us that this approximation is woefully inadequate.

In deciding what we missed it is helpful to recall the three assumptions that must be marinated for the Modigliani-Miller (MM) Capital Structure Irrelevance Proposition to prevail. Berk and DeMarzo (2007) describe them as

1. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows;
2. There are no taxes, transactions costs, or issuance costs associated with security trading;
3. A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

I maintain that many of the unexpected and confusing aspects of the crisis came from underestimating the transactions costs associated with the bankruptcy, and from not appreciating how financing decisions do change cash flows.

Because of the short time I will focus on leverage and the role it played in the crisis. I make this choice because I believe the failure to understand the forces that contributed to a buildup of leverage in the financial system and costs of unwinding the leverage was probably the biggest mistake we (academics, policymakers, practitioners and the media) made.

The role of leverage is very important. I had wrote about whether Merton Miller will review his 1990 Nobel Prize speech here and importance of leverage cycle here.

How many things are changing in this crisis. I hope our B-schools are waking up to all this and changing their syllabi. You keep reading corporate governance, ethics etc are making their mark in B-schools. It will be important to see these changes as well.


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