[great Minds In Finance] Colin Read (auth.) - The Life Cyclists_ Fisher, Keynes, Modigliani And Friedman (2011, Palgrave Macmillan Uk).pdf

The Life Cyclists Fisher, Keynes, Modigliani, and Friedman

Colin Read

The Life Cyclists

Great Minds in Finance Series editor: Professor Colin Read Titles include: The Life Cyclists The Portfolio Theorists The Pricing Analysts The Efficiency Hypothesists

Great Minds in Finance Series Standing Order ISBN: 978–0–230–27408–2 (outside North America only) You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above. Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England

The Life Cyclists Fisher, Keynes, Modigliani, and Friedman Colin Read

© Colin Read 2011 Softcover reprint of the hardcover 1st edition 2011 978-0-230-27413-6 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2011 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-32429-3 ISBN 978-0-230-34944-5 (eBook) DOI 10.1057/9780230349445

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Read, Colin, 1959– The life cyclists : Fisher, Keynes, Modigliani, and Friedman / Colin Read. p. cm. Includes index. 1. Finance—History. 2. Economics—History. 3. Economists—History. 4. Life cycles—Economic aspects—History. I. Title. HG171.R337 2011 330.15092'2—dc23 2011029575 10 9 8 7 6 5 4 3 2 1 20 19 18 17 16 15 14 13 12 11

Contents List of Figures and Tables

vii

Preface to the Great Minds in Finance series

viii

1 Introduction

1

2 A World Before Fisher

5

Section 1: Irving Fisher

10

3 The Early Years

11

4 The Times

20

5 The Theory

25

6 Applications

41

7 Life and Legacy

52

Section 2: John Maynard Keynes

59

8 The Early Years

61

9 The Times

71

10 The Theory

89

11 Applications

107

12 Life and Legacy

121

Section 3: Franco Modigliani

128

13 The Early Years

129

14 The Times

135

15 The Theory

141

16 Applications

154

17 The Nobel Prize, Life, and Legacy

161

Section 4: Milton Friedman

166

18 The Early Years

168

19 The Times

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Contents

20 The Theory

179

21 Applications

186

22 The Nobel Prize, Life, and Legacy

190

Section 5: What We Have Learned

196

23 Combined Contributions

197

24 Conclusions

202

Glossary

205

Notes

209

Index

215

List of Figures and Tables Figures 5.1

The utility curve

27

5.2 The trade-off of two goods at one point

28

5.3 A trade-off of one good for another

29

5.4 An indifference curve and various points

30

5.5

31

The wealth line

5.6 The wealth line and various indifference curves

32

5.7 Intertemporal consumption and the discount rate

35

9.1 The Standard and Poor’s stock market index 1920–1932

78

10.1 A narrow distribution of output around full employment

101

10.2 A wide distribution of output around full employment

102

10.3 Graph of investment and the interest rate

103

10.4 Pessimistic investment and the interest rate

103

10.5

105

Keynes’ liquidity preference

11.1 US Federal Reserve discount rate 1913–2010

108

11.2 US Federal Reserve discount rate 1960–2010

109

11.3 US Treasury six-month bond interest rate 1960–2010

110

15.1 Lifetime consumption and asset accumulation

145

Tables 15.1 A simple life cycle example with overlapping generations

146

15.2

A simple overlapping generations model with rising income

147

15.3

An overlapping generations model with constant income

148

15.4 An overlapping generations model with rising income 15.5

An overlapping generations model with more modest growth

149 150

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Preface to the Great Minds in Finance series This series covers the gamut of the study of finance – from the significance of financial decisions over time and through the cycle of one’s life to the ways in which investors balance reward and risk; from how the price of a security is determined to whether these prices properly reflect all available information – examining the fundamental questions and answers in finance. We will delve into theories that govern personal decision-making, those that dictate the decisions of corporations and other similar entities, and the public finance of government. This will be done by looking at the lives and contributions of the key players upon whose shoulders the discipline rests. By focusing on the great minds in finance, we draw together the concepts that have stood the test of time and have proven themselves to reveal something about the way humans make financial decisions. These principles, which have flowed from individuals, many of whom have been awarded the Nobel Memorial Prize in Economics for their insights (or perhaps shall be awarded some day), allow us to see the financial forest for the trees. The insights of these contributors to finance arose because these great minds were uniquely able to glimpse a familiar problem through a wider lens. From the greater insights provided by a more expansive view, they were able to focus upon details that have eluded previous scholars. Their unique perspectives provided new insights that are the measure of their genius. The giants who have produced the theories and concepts that drive financial fundamentals share one important characteristic: they have developed insights that explain how markets can be used or tailored to create a more efficient economy. The approach taken is one taught in our finance programs and practiced by fundamentals analysts. We present theories to enrich and motivate our financial understanding. This approach is in contrast to the tools of technicians formulated solely on capitalizing on market inefficiencies without delving too deeply into the very meaning of efficiency in the first place. From a strictly aesthetic perspective, one cannot entirely condemn the tug-of-war of profits sought by the technicians, viii

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Preface to the Great Minds in Finance series ix

even if they do little to enhance – and may even detract from – efficiency. The mathematics and physics of price movements and the sophistication of computer algorithms is fascinating in its own right. Indeed, my appreciation for technical analysis came from my university studies toward a Bachelor of Science degree in physics, followed immediately by a PhD in economics. However, as I began to teach economics and finance, I realized that the analytic tools of physics that so pervaded modern economics have strayed too far from explaining this important dimension of human financial decision-making. To better understand the interplay between the scientific method, economics, human behavior, and public policy, I continued with my studies toward a Master of Accountancy in taxation, an MBA, and a Juris Doctor of Law. As I taught the economics of intertemporal choice, the role of money and financial instruments, and the structure of the banking and financial intermediaries, I recognized that my students had become increasingly fascinated with investment banking and Wall Street. Meanwhile, the developed world experienced the most significant breakdown of financial markets in almost eight decades. I realized that this once-in-a-lifetime global financial meltdown arose because we had moved from an economy that produced things to one in which, by 2006, generated a third of all profits in financial markets, with little to show but pieces of paper representing wealth that had value only if some stood ready to purchase them. I decided to shift my research from academic research in esoteric fields of economics and finance and toward the contribution to a better understanding of markets by the educated public. I began to write a regular business column and a book that documented the unraveling of the Great Recession. The book, entitled Global Financial Meltdown: How We Can Avoid the Next Economic Crisis, described the events that gave rise to the most significant economic crisis in our lifetime. I followed that book with The Fear Factor, which explained the important role of fear as a sometimes constructive and at other times destructive influence in our financial decision-making. I then wrote a book on why many economies at first thrive and then struggle to survive in The Rise and Fall of an Economic Empire. Throughout, I try to impart to you, the educated reader, the intuition and the understanding that would, at least, help you to make informed decisions in increasingly volatile global economies and financial markets.

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Preface to the Great Minds in Finance series

As I do so, I describe how individuals born without great fanfare can come to be regarded as geniuses within their own lifetime. The lives of each of the individuals examined in this series became extraordinary, not because they made an unfathomable leap in our understanding, but rather because they looked at something in a different way and caused us all thereafter to look at the problem in this new way. That is the test of genius.

1 Introduction

This first book in the Great Minds in Finance series begins by establishing a framework upon which all the subsequent discussions rest. We describe how individuals make financial decisions over time and why these decisions change as we age and our circumstances change. The early financial theorists, including Irving Fisher, Frank Ramsey, John Maynard Keynes, Franco Modigliani, Milton Friedman, and others, recognized that the static time-independent models of classical economics were ill-equipped to describe how households balance the present and the future. It is this expansion of traditional economic models to such intertemporal decision-making that defined the development of personal finance. Intertemporal choice is often labeled the Life Cycle Model by macroeconomists and by finance theorists. To you and me, it explains why we expect to earn interest on our investments even if we take little risk. It also predicts how one may conclude that the prevailing interest rate in financial markets presents a good opportunity to save. Meanwhile, others regard the same interest rate as a good opportunity to borrow, depending on their various individual characteristics. The first financial theorists created a new discipline of personal finance by first posing and then answering the following six questions. Why do people save? How does inflation affect savings? Why do additional savings not always translate into new investment? How does a household’s savings pattern change over its lifetime? Why is the national savings rate quite volatile over the business cycle? Likewise, why are individual savings also volatile? We look at the resolution of these questions not in isolation but within the context of the void in financial understanding that these great minds successfully filled. In doing so, finance theory was forced to both discard and augment the prevailing theories of classical economics to that day. 1

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We will begin with the early life and times of these great minds because it is apparent that their life experiences informed their great insights. We then describe their significant theory and insights into financial decisions, followed by the various ways their insights were applied by others. Each section concludes with the recognitions earned by each of these contributors that would place them in the annals of financial history. We examine four great minds that contributed the most to our understanding of how individuals and organizations order and optimize financial decisions. The discussion begins with the contributions of Irving Fisher, an iconoclast theorist and practitioner who laid the groundwork for the financial modeling of intertemporal choice. This is followed the description of his theories with those of his contemporary, and sometime nemesis, John Maynard Keynes. While Keynes is most identified with his theory of the macroeconomics of depressions, he also had a significant number of insights on the role of money and interest rates in financial markets. Indeed, in his time, he was perhaps the leading social commentator on finance and on the various motivations of consumers in their financial and investment decisions. While Keynes’ model was profound in its originality and insight, and its simplicity and intuition made it most amenable to every introductory class in macroeconomics, it was incomplete in its motivation of how individuals make different financial decisions over a lifetime. By treating households as monolithic and alike, Keynes failed to offer the sufficient richness that modern and complex financial markets demanded. Two academicians, each with one foot in public policy and another in ideology, rectified these shortcomings and, in turn, created the industry of personal financial management. Franco Modigliani and Milton Friedman were no less colorful in their lives and they lived in equally dynamic times. But while Modigliani’s humble roots and creative insights were best suited to the ivory towers of academia, Milton Friedman became an icon who would rival Ayn Rand as the champion of unfettered markets. There is one factor that two of these great minds shared: Modigliani and Friedman each won the Nobel Memorial Prize in Economics.1 Irving Fisher and John Maynard Keynes would also have likely earned a Nobel Memorial Prize had they written and lived at a time when the prizes were in existence. This collection of prize-winning economists established the foundations for the study of finance. However, their backstories are fascinating. Each of these great minds also dabbled in the markets themselves. One of them, Irving Fisher, amassed great wealth but also suffered great

Introduction

3

misfortune. Two of these great minds advocated the now controversial practice of eugenics. One of the great minds had to flee Europe and was the victim of anti-Semitism in his adopted nation. Each of these individuals was most vocal and public with their views on markets. And each lived and viewed the Great Crash and the Great Depression from different perspectives and ages, drawing distinct conclusions from their unique experiences. We cannot properly understand their theoretical conclusions without an exploration of the unique and challenging times that shaped each of these great minds. As the life and times, contributions, and applications of these great minds in finance are discussed, the reader is asked to ponder how their contributions have been incorporated into his or her own financial decision-making. These innovators of personal finance have created a broad-based understanding of financial markets that has benefited us all and will do so for all who follow us.

The meaning of finance While the word “finance” has many meanings, we delve here into an area of finance employed by us all, whether we know it or not. Personal finance creates a decision science around how we save and lend money and how we accumulate for the future over time. In doing so, it describes the trade-off between how we consume today and how we save today to consume more tomorrow. Personal financial decisions have become exceedingly complex as individuals have access to diverse and increasingly sophisticated financial instruments that could not have been contemplated just a few decades ago. While the workings of these more sophisticated tools will be the subject of later books in this series, the foundation of financial management rests on the premise that an interest rate is related to the rate of return of an asset and our collective market valuation of rates of return at different periods of time. This basic interplay between rates of return, our discounting of the future, and the market determination of the interest rate is augmented by measures of risk and uncertainty. Likewise, this interplay between risk and return will be covered in the next book in the series. However, we begin by telling the story of how economists and financial theorists began to recognize how interest rates are determined and how social and economic variables combine to affect interest rates. As we model the role of the interest rate, we will also describe how our individual regard for interest rates changes through our lives. We will

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see how we respond by making different financial decisions throughout our lives even if the prevailing interest rate does not change. As we describe these responses, we will also learn how and why each of us must create an evolving financial plan that adapts to our evolving circumstances over our life cycle. This interplay between our individual socioeconomic characteristics, such as age, income, life expectancy, family size, income sources, expectations, and other factors, will explain how, why, and when we make our critical financial decisions, along with how our collective decisions in turn define markets and may cause them to evolve. We will even be able to see how our socioeconomic realities and our markets have come to influence markets and economies elsewhere, and how their markets have come to affect us most profoundly. As we proceed, we describe our individual financial life cycles as we enrich and inform the economic models that are so critical in predicting our financial future and driving our national economic policies. We begin with the first insights from more than a century ago that permitted the Life Cyclists to redefine what we understand about investment and how personal investment portfolios are constructed over our life personal investment portfolios.

2 A World Before Fisher

Milton Friedman, the icon of laissez-faire economics, called Irving Fisher “the greatest economist the United States has ever produced.”2 To place his contributions in context, let us first outline the level of sophistication before Fisher’s insights at the cusp of the twentieth century. As we do so, we will see that a novel insight into a familiar problem is the hallmark of a great mind. We also see that great minds often take innovative concepts much further than could be contemplated by others at the time. Once we understand their enlightenment, their innovations seem obvious. We will see that personal financial decisions have been with us since time immemorial. However, the discipline of personal finance has only developed relatively recently. Its viability as an essential discipline required a few precursors. First, surpluses had to exist. Before agriculture and the specialization of our labor, we lived a nomadic lifestyle that could not suffer surpluses. We produced only what we could carry and we lived off the land and animals only to the degree that they satisfied our daily needs. Humankind would not accumulate surpluses until it could enjoy earth’s bounties while also living at one place. To take advantage of the seasonal fruits of the land, humankind had to build permanent structures durable enough to last for years, preserve food surpluses that would span the seasons, and create more than one would need in one season to allow consumption in another. As humans learned the value of creating more than they could instantly consume, they were at once recognizing the advantages of specialization and the intricacies of asset accumulation. From then on, their specialization, sacrifices, overproduction, and saving one day would be balanced with consumption needs and the vagaries of 5

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production in another. A new understanding of markets, and savings and investment, became necessary, as would new financial institutions. To see this, consider the choices each of us must make with regard to the trade-offs between the present and the future. Our career choices create a range of options we can use to optimize the accumulation of surpluses today. Our consumption choices today affect our saving for consumption tomorrow and our rate of capital formation. Our investment decisions, in turn, affect our rate of capital accumulation, and our retirement decisions determine how our capital will decline over time. We take this grand balancing act as given in our personal finances because we are well-accustomed to markets and accumulation. However, the financial principles we have so wonderfully mastered have not been long understood. After the agricultural revolution tens of thousands of years ago and after the Industrial Revolution that allowed families in the developed world to accumulate assets, humans were forced to better understand some rudimentary finance theory. We begin with the profound effect the Industrial Revolution had on the financial markets we take for granted today.

A dynamic economy and static economics Up to the second half of the nineteenth century, economists were unable to explicitly model how our economic decisions evolved over time and through our mortal life. The world of production and consumption was decidedly static. Value was directly measured by the cost of producing goods, with little acknowledgement of the intrinsic value humans placed on the goods produced and consumed. Instead, much of the discussion and the debate was over who should garner the surpluses and incomes arising from new production in the Industrial Revolution. For instance, Karl Marx (1818–1883) had advocated that labor should earn the profits accruing to production, while the in-vogue theory of capitalism commended the profits to the owners of the technologies that had made labor so much more productive. There were commentators who advocated for each of these two very different theories. However, these theories, though dramatically different in their implications on the ownership of wealth, nonetheless failed to resolve dilemmas that are still argued today. The then-standard theories that focused on the cost of production as a measure of value failed to explain why water has a low price, and presumably is of low value, even though it is essential for life itself. Meanwhile, diamonds command a high price and yet they are of little immediate utility.

A World Before Fisher 7

This seemingly nonsensical observation would be squarely addressed by the “marginalists.” Writing in German around a school of thought espoused by the Austrian School founder Carl Menger (1840–1921), these economic philosophers pointed out that value is jointly determined by the interplay between the production costs of a good and the increments to our valuation of the consumption it can create. Menger noted: There is no necessary and direct connection between the value of a good and whether, or in what quantities, labor and other goods of higher order were applied to its production ... Whether a diamond was found accidentally or was obtained from a diamond pit with the employment of a thousand days of labor is completely irrelevant for its value.3 In another instance, Menger’s contemporary Eugen von Böhm-Bawerk (1851–1914) used a simple analogy that better described how humans make decisions. If a farmer has available to him five bushels of grain, he may choose to save one bushel for seed, use two bushels to make flour and consume, use yet another bushel to make whiskey, and use the final bushel to feed the parrots that would entertain him. However, were he to lose one of the bushels, he would not simply use four-fifths of the amount for each application; rather, he would likely sacrifice feeding the parrots. In other words, humans consume goods in such a way that they first consume those they value most, followed by activities or consumption that provide them with lesser improvements to utility. Consequently, if supply increases, the value they place on the last amount consumed actually decreases. Using this analogy based on the marginal theory of consumption and production, goods with a high cost attached to the last amount produced will be consumed at a level that offers a commensurately high value for the last bit consumed. The demand for a good represents our incremental valuation of more consumption, and the supply for a good reveals the incremental cost of producing more. When demand and supply are in balance, the last bit of the good demanded and supplied is equated at one common price. These realizations also occurred to English-writing economists later in the nineteenth century. However, the great works and insights of the Austrian School would not be translated into English until the midtwentieth century.

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The insight of marginalism was that the value of the goods we consume is based on the subjective values we place upon them, rather than on the cost of producing them. Our valuation of the collection of goods we produce and consume is not entirely reflected in the prices we pay and hence the incomes we generate for others. Indeed, we wrest with the same paradox today. Accountants can tell us that the value of our national income is equal to the sum of goods and services we produce. However, such an approach underestimates the value we place on consumption in total and neglects those things we enjoy but for which there is no price. The simplest approach of earlier economists also neglected the value of production and consumption at different points in time. The resources used to produce a good in one year do not differ from the resources needed to produce the same good in another year. Consequently, the value of production, and hence consumption, should remain static over time. If so, it is not clear how one would sacrifice consumption in one period to secure greater consumption in a later period. In other words, there was no good model that could describe the incentive to save.

The prevailing interest rate The prevailing and inadequate “productivity theory of interest” had, before the innovations of the Austrian School, argued that the interest rate merely measured the productivity of an investment in capital. The interest earned effortlessly by the employment of a piece of physical capital was merely the measure of the profits flowing to it over time. Yet why would the owner of this physical capital receive such a profit, or “surplus,” if he committed no effort to production, in contrast to the toil of workers that divine value from their employment of the machine? Instead, Böhm-Bawerk offered the profound insight that would successfully explain interest rates by making a simple observation. The interest rate was not defined by the valuation of a physical piece of capital over time, through the flow of profits it could create; rather, it was the undervaluation of physical and financial capital from the onset that created an upfront price that was lower than its flow of future profits. The discount rate was viewed as the term that sufficiently reduced the amount that would be paid for a capital good to yield an expected flow of profits in the future. For instance, a machine that can yield $1,000 of profits for each of the next ten years but yields no profits or scrap value thereafter is not worth the entire $10,000 to one today. Instead, its value

A World Before Fisher 9

today is discounted below the sum of future profits in the future. This discount rate arose because no investor would be willing to purchase a flow of future income in return for an equivalent value today. Specifically, let the flow of future earnings of $1,000 per year for ten years be valued at $8,000. We can then calculate the effective rate “d” that discounts these future returns so that they are valued at $8,000 today: $8, 000  

$1, 000 $1, 000 $1, 000  … 1 d (1  d)2 (1  d)10 10

$1, 000

 (1  d)t

t 1

The rate at which one discounts the present value of such a future flow is then compared to the interest rate. If the prevailing market interest rate is lower than the discount rate, one would find it profitable to borrow money to purchase the investment right to the flow of future income. These investment decisions align the discounted future flows of income and consumption to the interest rate as the measure for the cost of capital. The Austrian School instead devoted its efforts to a better understanding of why humans would discount the value of future profits. It is this discount rate that gives rise to the interest premium. This fresh way of looking at a familiar problem is a hallmark of all great minds.

Section 1: Irving Fisher

We begin with the first theorist who was able to translate the insights of the Austrian School that came before him with the mathematical rigor that would allow us to convert rhetoric and logic to science and mathematics. This pioneer, Irving Fisher, is considered by some to be the most brilliant economic theorist ever. Certainly, if eclecticism and intellectual diversity is a measure, he may well be the most fascinating. In this first section, we will discuss why people save and how inflation affects our incentive to save. Fisher answered these questions in a most elegant way.

3 The Early Years

It is not unusual for important events in one’s youth to influence significant decisions in adulthood. At times, these same events can influence an entire career. Yet it is rare when such events influence and perhaps create an entire discipline of study. In this respect, Irving Fisher’s early life takes on greater meaning. Irving Fisher never completed an autobiography. Much of what we know of Fisher’s life comes from a biography by his son, Irving Norton Fisher.4 However, Irving Norton Fisher did not document the profoundly significant tie between his father’s life experience and economic theory, even though he does allude to some significant points of his father’s character brought about by early life events. Irving Fisher’s life was influenced by many before him. He could trace his family back to a Fisher line that first migrated from Germany to Ireland in the sixteenth century and then from Ireland to the new US colonies in the eighteenth century. In pre-revolutionary America, Irving’s early American predecessor, William Fisher, together with his 14-year-old wife, made their way by covered wagon to a log cabin in Troy, New York, just 40 miles from where Irving would be born a century and a year later to William Fisher’s great-grandson, George Whitefield Fisher. George would father Irving after he too settled in this region of central New York State. Irving Fisher’s father was not born wealthy, even if he was provided with a good education and an innate intelligence. His family’s financial condition prevented him from attending Yale University until he reached the age of 22 in 1856. George graduated from Yale in 1859 and would establish a Yale tradition in the Fisher family that his third child, Irving, would continue for the rest of his life. Formal university study was much less specialized in the nineteenth century. In fact, the study of economics, and especially finance, did not 11

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exist. Indeed, while the founder of modern economics, Adam Smith (1723–1790), published “An Inquiry into the Nature and Causes of the Wealth of Nations” just 80 years before George began his studies at Yale, Smith did so not as a professor of economics, or of mathematics, but as a professor of religion and moral philosophy. Adam Smith had studied economics from a humanistic perspective. A product of a Calvinist era and the Industrial Revolution, he acknowledged that economics was an essential component of the study of human toil, opportunity, and happiness. Indeed, the first two books in his fivevolume set that constituted The Wealth of Nations would be classified today as philosophical, sociological, and anthropological. Before the emergence of the modern and highly specialized university, the humanities of religion and philosophy were interwoven in formal study. It was not unusual in those times for one to study religion as a basis for a liberal arts education. Irving Fisher’s father George sought his divinity degree as he simultaneously mastered languages. As part of his program in pursuit of his religion studies, George was required to move from seminary to seminary in the adjoining states of New York, New Jersey, and Connecticut. It was at one of these pursuits, in Charlotteville, New York, that he met his future wife, the teenage Ella Wescott, a pupil who was more than a dozen years younger than he was. Ella Wescott had an American family tree with even deeper roots than the Fisher line. Her family could trace itself back to 1636 Puritan New England. Like George’s predecessors in the Fisher family, Ella’s ancestors also fought in the War of Independence that created the United States of America. Ella was brought up within a strict Victorian tradition and was well prepared to accept the role of the wife of a travelling minister who moved from one parsonage to another. When her husband was ill, the young Ella mustered the composure necessary to preach in his stead. She was strong in character, and this character would be tested in her later life. Ella had four children with her husband George. Cora was born before her father graduated from Yale Divinity School. The second child, who lived barely a month, was named Lincoln, following the inspirational emancipation of the slaves by President Abraham Lincoln in 1862. By the year of Lincoln Fisher’s birth, the family was living in Saugerties, a bucolic rural town on the Hudson River, about 40 miles south of Albany, the capital of New York State, just as the American Civil War was drawing to its end. On February 27, 1867 Irving Fisher was born in Saugerties. He would assume the responsibility of the elder male and would not have a

The Early Years 13

brother for seven more years. By then, the family had moved again, first to New Haven, Connecticut, and then to Peace Dale, Rhode Island, where they would remain for 12 years. A year before the birth of a last sibling, Irving’s brother Herbert, the family confronted mortality once again with the loss of Irving’s sister Cora to typhoid fever when Irving was just six years old. The family eventually returned to New Haven, Connecticut. By then barely a teenager, Irving could not have known that he would spend much of the rest of his life in New Haven. He began high school there in preparation for entry to Yale, but would move briefly with his family to St Louis, Missouri, to complete his preparatory school studies for university, as his family moved without him to another parish in Cameron, Missouri, almost 300 miles away. Irving had matured from an inquisitive and adventurous boy to one who was studious and most interested in mathematics and literature. He thrived in his pre-college studies in St Louis where he lived with his aunt and her family. While there, he wrote in a letter to his parents that he contemplated delaying his attendance to Yale for a year so that he could better enjoy the great books and literature that would round off his education. In stating his case, he noted that Americans too often follow the premise in life to “Hurry, Haste is speed.”5 Already, he was growing conscious of investment in the present and the pace of time in one’s future. The Smith Academy of St Louis allowed Irving to hone his academic skills and philosophical bent. In June 1884 he delivered a commencement speech to his preparatory school classmates in which he contrasted two political-economic philosophies. More than 100 years before its dissolution and the rise of Soviet-style communism, he expressed the terror and uncertainty that might occur as Czarist Russia was thrust into free market principles. He read: Men cannot enjoy the benefits of civilized liberty without restrictions. Law and Order must prevail, else confusion takes their place, and, with the coming of Confusion, Freedom vanishes. So, if the radical Nihilists should realize their designs to the fullest extent, there is reason to believe that Russia like France, would merely exchange a reign of Tyranny for a reign of Terror.6 Young Irving’s political-economic bent would eventually transcend to a much more free-market ideology in his later life. Following graduation and the successful completion of his entrance examinations to Yale, Irving’s contemplation of delayed entry to college

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would be fulfilled, but for unexpected, tragic, and profound reasons. He had joined his father, mother, and brother, who by then had moved to Berlin, New Jersey, from the family’s parish in Cameron, Missouri. His father had become progressively more ill and the family had relocated so that he could fall under the care of his wife’s brother, Dr William Wescott. George Irving suffered from what was then called consumption but which is now known as tuberculosis. A few days after joining his family as his father’s condition worsened, Irving discovered that he had been admitted to Yale to begin in the fall of 1884. Barely a week after that, his father died. Irving felt the pressure to grow up more quickly than he perhaps would have liked. He remembered some of his father’s last words – a lament that George had wished he was in a better position to provide for young Irving’s future financial needs. The suddenly smaller family returned to New Haven to continue with Irving’s education in the fall of 1884, but without the father and breadwinner. Irving, his mother, and his brother were all forced to work industriously to support the family and Irving’s education.

A harsh financial reality Irving believed one of the best opportunities to earn money for his family and his education would be from competitive academic awards and prizes. He was highly motivated to garner more than his fair share of these awards and showed a determination based on a real need not shared by most of his classmates. He put great pressure on himself to excel, for financial reasons, even as he became increasingly preoccupied with avoiding the fate that befell his father, his sister, and even a brother he had never known. Health and finances became a driving theme that not only affected his determination but determined his life work in ways he could not have known. Another theme that would also follow Irving for the rest of his life was his belief that his peculiar combination of intellect and industriousness could produce better inventions. He was constantly designing such inventions and seeking new patents at a rate that one would associate more with Thomas Alva Edison than the economist Irving Fisher. Many of his inventions did not pass muster with the US Patent Office, often to his chagrin and contempt. Young Irving believed from an early age that he had unique and profound insights, and was frustrated when others either did not see his vision or did not agree with his estimation of the quality or uniqueness of his ideas. However, the

The Early Years 15

terse dismissal by the US Patent Office of his best ideas would not deter him, as his later life proved. Given his inherent resilience, confidence, and entrepreneurial bent, Fisher’s die was cast, perhaps more so than for most individuals of his age. These various factors would influence his life’s work and would be formative in the creation of the first theory of economic decisions over the different periods of an individual’s life. We now call this approach the Life Cycle Theory, even though Fisher would not have known it as such. Intertwined in this theory is the need to invest in one’s future while young, the recognition of the fragility and mortality of life, the role of saving in one period to permit consumption in another, and the need to care for one’s health at all times. Fisher would devote his efforts to each of these dimensions at one time or another and would produce the first theoretical foundation for the interweaving of these dimensions into a cohesive whole. While he strove to create for himself and his family the life trajectory he so desired, he would also on occasion inexplicably jeopardize all he worked for, but always with the best of intentions, self-confidence, and optimism.

College at Yale Upon entry to Yale in the fall of 1884, shortly after the death of his father, Irving felt young no more. He had become preoccupied with finances, with his health and vigor, and with the need to succeed and to secure academic financial awards. These preoccupations would remain with him for the rest of his life. All the while, he corresponded with a friend, Will Eliot, with whom he would remain close in thought and expression, even if they lived on opposite sides of the North American continent. Irving had met Will while at the Smith Academy in St Louis. His letters to Will would document the thoughts throughout his life, and would offer consistent glimpses of his emerging intellect. For instance, in one letter to Will, while visiting his birthplace, Saugerties, for the summer, Irving wrote about his first formal explorations in what would be his major theoretical contribution. He pondered the dismal nature of a “short limited life” and noted the dual role of duty and pleasure as a motivation for life.7 He also challenged Will’s faith. Irving preferred to rely on reason over religion, which was obviously a leap from his faith as the son of a man of God. He also boasted to Will of his expertise in mathematics. He called himself the “undisputed monarch of the college in mathematics” and

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The Life Cyclists

asked for Will’s indulgence if he sounded a bit egotistical, even if such a conclusion was simply an “honest judgment” of himself, just as he would judge another.8 A year later, in a letter written in the summer of 1886, two years into his studies, he documented with Will another brush with mortality in the passing of his college roommate Graham from pneumonia. He went on to add that he had decided his life’s work would be in mathematics and in better understanding the principles that govern the conduct of one’s life.9 Irving Fisher was not yet cognizant of the emerging study of economics. From the Greek words “oikos” and “nomics,” or the laws that govern our surroundings, economics is a discipline that tries to define the laws or principles that govern the choices we make in life. Yale did not have such a field of study. Despite this, Fisher seemed destined to soon find economics, even as economics had long since found him. While at college, Fisher felt a great competition with one other student in his class, Henry Lewis Stimson (1867–1950). Born into a wellto-do New York family and having been given every opportunity in life, Stimson seemed to consistently snatch the top prize from Irving’s grasp at every turn. Fisher once explained his seemingly perennial role as second best in his mind as a product of Stimson’s superior station in life, even if he thought the faculty would agree that Irving’s ideas and thoughts were superior to those of his overachieving competitor. Henry Stimson would go on to serve as the US Secretary of the Army in both world wars and as the US Secretary of State under Herbert Hoover from 1929 to 1933. This competition, at least in Irving’s mind, lasted longer than the college years, as Fisher subsequently worked to also attain the ear of President Hoover at the onset of the Great Depression, and then that of his rival and successor, Franklin Delano Roosevelt (1882–1945).10

Graduate school In his graduation year, Fisher felt he had realized his destiny. This time around, he took pride in earning a $200 prize for a mathematical solution competition and another $500 per year prize that would fund his postgraduate studies at Yale. His scholarship toward a PhD would last three years, thus making this award worth $39,600 in value today and well above the $100 cost of tuition per year at Yale at that time.11 He went on to confide to a friend that, as he read his commencement speech, entitled “Conservatism as Presented by the Comparative Study of Man,”

The Early Years 17

he glanced at his fellow students and reported that they were moved to tears. In what was becoming characteristic braggadocio, he went on to report that a number of students claimed the valedictory speech was “the best they had ever heard.”12 Like everything else Fisher valued, he threw himself into his postgraduate studies in 1888. In a letter to the father of his former (and by then deceased) roommate, in which he also asked whether the father could lend him money to underwrite his education, he noted that his interest and study in mathematics was not a viable career choice. Instead, he confided his interest in the study of political economy, even though he recognized that study, too, was one only for those who were independently wealthy. Despite his preoccupation with money and his emerging high regard for moneyed people and the creation of new wealth, Fisher’s economic reasoning continued to develop in parallel to his mathematical skills. He was most impressed by a mentor at Yale, Professor Josiah Willard Gibbs (1839–1903), a physical chemist. In 1863, Gibbs earned the first Yale PhD in engineering. He was also honored as the first person to apply the second law of thermodynamics to geological processes and was credited with developing the technique of vector analysis. Fisher, as a protégé of Gibbs, seized upon Gibbs’ geometric approach to his research proofs. Fisher also noted the tremendous economy of Gibbs’ work, in which he extracted “the maximum of results from the minimum of hypotheses.”13 He was most honored that Gibbs would show such an interest in his own PhD thesis in economics, entitled “Mathematical Investigations in the Theory of Value and Prices,” especially in his use of vector analysis and geometric methods in economic proofs. As the recipient of Yale’s first PhD in economics, Fisher perhaps even identified with Gibbs who had received Yale’s first PhD in engineering. Fisher’s other influence in the late 1880s as he studied for his PhD was William Graham Sumner (1840–1910). Sumner, like Gibbs and Fisher, had earned a Yale PhD and had stayed in New Haven. At the time, Sumner was one of the country’s most respected political economists. A very popular teacher at Yale, he rallied against imperialism and advocated for the gold standard and for laissez-faire free markets. His approach as a liberal political economist from a sociological perspective likely appealed to Fisher’s humanistic ambitions for the new field of economics. Sumner was also influential in establishing the new study of sociology and taught the first sociology class in the English language.14

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It was Sumner who encouraged Fisher to produce a thesis in the thenunconventional field of mathematical economics. When Fisher asked Sumner why he would recommend an approach so foreign to his own, Sumner responded that his lack of use of mathematical techniques in his own work professed to his ignorance of a useful technique rather than as a condemnation of an unnecessary technique. He directed Fisher to the work of Europeans like Augustin Cournot (1801–1877), Leon Walras (1834–1910), and Francis Ysidro Edgeworth (1845–1926). In 1891, three years after beginning his postgraduate studies, Fisher defended his thesis. A year later, his thesis had been published and was subsequently translated into a number of languages.15 The year 1891 was not memorable solely for the completion of a thesis that would garner significant regard. That fall, he also met in New Haven a Miss Margaret Hazard of Peace Dale, Rhode Island. Fisher had come to idealize and romanticize those aspects in life he felt were consistent with his world view and self-image. He equally romanticized his recollections of Margaret Hazard as well. While they were familiar with each other from his childhood residency in Peace Dale, when he again met Margaret in 1891, he confided that she was the perfect girl he had defined in his mind seven years before.16 Two years later, on June 24, 1893, they were married in Peace Dale. At the time, the Narragansett Times reported in words that Fisher could not have better produced himself: The village of Peace Dale was in gala dress, for it was the wedding day of Miss Margaret Hazard and Professor Irving Fisher of Yale, whose brilliant career at Yale, as prizeman, valedictorian, instructor and now professor of mathematics has been eagerly watched with a feeling of pride, that Peace Dale shares in his successes.17

Fisher’s apex in academia Fisher had clearly hit his personal and professional stride. By 1895, at the young age of 28, he was asked to head the Department of Political Economy at Yale. While he soon found himself embroiled in petty university politics over his move from the mathematics to the economics department, the promise of a lifelong job, and at a $1,000 raise in salary, equivalent to a raise of $26,400 today,18 appealed to his nascent concerns about status, financial security, and lifelong income. By 1898, he and his wife had produced two daughters, he was earning international acclaim for his academic work, and he had enjoyed five

The Early Years 19

happy years of marriage. That fall, he suffered from a persistent fever that was eventually diagnosed as tuberculosis, the ailment that had killed his father. The leading sanatorium in the region of that time was found in the cool Adirondack Mountains at Saranac Lake, near Plattsburgh, New York. Between treatment at the famed Trudeau Institute, which is still in operation today as a research facility in infectious diseases, and the clean air of Colorado Springs, Fisher would be kept from New Haven and his colleagues for three years. He did not return to his work at New Haven until 1901, physically cured of tuberculosis but afflicted with a lifelong exaggerated concern regarding his health and mortality. This new personality quirk would have a profound effect on his work, his insights into mortality, and in the way he would devote his energies.

4 The Times

Irving Fisher was a pioneer in economics. While mathematics is now a requisite skill in any advanced study of finance or economics, the use of mathematics in economics was still unusual in the late 1800s. Obviously, without mathematical techniques, now called the quantitative school, there could be no finance theory. The qualitative and descriptive approach to social sciences that prevailed at the time could not possibly answer the questions of when and how much, which are so important in finance theory and financial planning today. Fisher must be credited for firmly placing economics and finance on a seemingly irreversible and much more rigorous path. However, to understand the transition from qualitative economics to quantitative finance and the contribution Fisher made in spanning this gulf, we must spend some time understanding the state of thought and the limitations of theory in his time. Fisher’s PhD contribution was in the theory of supply, demand, and price determination. He acknowledged the work of his predecessors, William Stanley Jevons (1835–1882), Rudolf Auspitz (1837–1906), and Richard Lieben (1842–1912), even as he derived, through different paths and techniques, results similar to the work of Leon Walras (1834–1910) and Francis Ysidro Edgeworth (1845–1926).19 Fisher’s approach was a combination of geometry, vector analysis, and mathematical expressions. He peppered his analysis with rhetoric, not unlike the thought experiments used to motivate Einstein’s Special Theory of Relativity in 1905.

Fisher’s PhD thesis During those times there was an uneasy tension between the qualitative approach that described the utility, or benefit, that motivates human 20

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behavior, and its mathematical representation. Fisher sought definitive results, unlike the work of peers who tried to overreach themselves by creating some sort of quantitative scale that could measure psychological phenomena. We have discussed Fisher’s preference for theories of broad implication but without imposing too many demands on the underlying principles. Using a novel approach, he was able to avoid complete definitions of the various forces of pain or pleasure, pride or prudence that so influence our decisions but also defy measurement. He also avoided rigorous definitions of concepts that defy definition, but would instead seek to determine the conditions that individuals must balance in order to make their individual and collective decisions. Fisher likened our financial decisions to water finding its own level. For instance, even if an individual could not describe to another individual in any meaningful or universal way precisely how much he or she valued a given bit of consumption, he or she could note that he or she valued a bit of consumption of one good perhaps twice as much as the consumption of a bit of another good. If one’s valuation of a bit of one good versus another is expressed as a ratio equal to two, we should be able to predict that the price of the first good must be twice as high. If not, our relative internal valuation of the last bit of each good differs from the market valuation of each good. We should then consume more of the good which we value comparatively highly but which the market does not to the same degree. As we consume this good more intensively, our incremental enjoyment will diminish until balance is restored. In this sense, Fisher established in a unique way the concept of balance or equilibrium. The process by which we grope toward this equilibrium or attain homeostasis, from the Greek for “standing still,” could be applied to economic problems just as the concept of equilibrium is used to describe physical processes. Dynamics, stability, equilibrium, and adjustment processes were mathematical and physical concepts that had been drawn into economics and finance ever since. Fisher went further. His already-demonstrated penchant for devices and patents was tapped as part of his thesis. To demonstrate his concept that markets converge toward equilibrium just as water finds its own level, he produced an elaborate hydrostatic model that showed how various components change their position as the level of water is changed. Because it would be virtually impossible to calibrate such a device to represent the complexity and diversity of real-world markets, his model could not be considered as what we might today call a computational equilibrium model of the economy. However, in the era before digital computers, models using hydraulics, or voltages in circuits, were

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commonly employed to represent analogies to real phenomena. Fisher’s hydrostatic equilibrium model may have well been one of the first analog computers and the first computer of any kind devoted to modeling the market economy. Now, of course, such modeling is commonplace, but in 1891 it had not previously existed. Indeed, Francis Edgeworth commented in the prestigious Economic Journal in 1893 that: The theory of Exchange which is based upon marginal utility has received from Dr. Fisher some very happy illustrations. Observing that most economists employ largely the vocabulary of mechanics – equilibrium, stability, elasticity, level, friction, and so forth – and profoundly impressed with the analogy between mechanical and economic equilibrium, Dr. Fisher has employed the principle that water seeks its own level to illustrate some of the leading propositions of pure economics … We may at least predict to Dr. Fisher the degree of immortality which belongs to one who has deepened the foundations of pure theory of Economics.20

Brushes with mortality It was ironic that Edgeworth would use the term “immortality.” After Fisher’s bout of tuberculosis and his three years of fear, depression, exercise, and healing, he became more aware of what we would today call risk aversion. He described in a letter the definition of inward optimism “as a reaction from, or resistance to, outward misfortune. Lucky is the man who learns some of these things without having to pay so high a price for them.”21 Fisher, more than any economist at the time, had become aware of the present and the future, and the uncertainties and interest and discount rates that make one and the other equivalent. The first major treatise from Fisher would come 15 years after his recuperation from tuberculosis and his sudden confrontation with mortality and life’s uncertainties. The themes of the future and of life cycle planning would motivate his next major works, The Nature of Capital and Income and The Rate of Interest. From his challenges and explorations, he had uncovered a glaring incompleteness in our understanding of income, capital, interest, and depreciation. In doing so, he created the theoretical foundations for what could come next. The vacuum in the literature that Fisher successfully filled arose because economics had never quite come to terms with time in its economic modeling. Fisher credited for his insights a Scottish-Canadian

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economist named John Rae (1796–1872), who had published his Statement of Some New Principles on the Subject of Political Economy while working near Montreal as a lumberjack in 1834. Rae was the first to describe a “theory of capital” and, by doing so, developed what we now call intertemporal choice. Indeed, Fisher would dedicate his 1930 book The Theory of Interest to Rae and to the Austrian economist Eugen von Böhm-Bawerk. In 1834 Rae wrote: In every period of its duration, its whole capital and industry might still have been employed, though upon different objects, in the manner that was most advantageous at the time. In every period its revenue might have been the greatest which its capital could afford, and both capital and revenue might have been augmented with the greatest possible rapidity … We assent to the propositions, “the industry of the society can augment only in proportion as its capital augments, and its capital can augment only in proportion to what can be gradually saved out of its revenue,” because we see that the augmentation of industry and capital, the saving from revenue and increase of capital, are concomitants of each other; we perceive not that in the application of these propositions, the sense in which we assented to them is abandoned, and that the augmentation of the capital of the society is assumed as the cause, and the sole cause of the increase of its industry, and the saving from revenue, as the cause, and the sole cause, of the augmentation of its capital.22 While these premises may now be commonplace to even the accountant, the notion of capital as the rate of accumulation of profit over time, to be optimized at each period of time for greatest advantage at the time, is the basis of intertemporal choice and finance theory. Fisher developed this nascent theory of capital and interest still further when he summarized in The Rate of Interest that: … the rate of interest is dependent upon very unstable influences, many of which have their origin deep down in the social fabric and involve considerations not strictly economic. Any causes tending to affect intelligence, foresight, self-control, habits, the longevity of man, and family affection, will have their influence on the rate of interest … the rate of interest is not a narrow phenomenon applying to only a few business contracts, but permeates all economic relations. It is the link that binds man to the future and by which he

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makes all far-reaching decisions. It enters into the price of securities, land, and capital goods generally, as well as rents, wages, and the value of all “interactions.” It affects profoundly the distribution of wealth. In short, upon its accurate adjustment depend the equitable terms of all exchange and distribution.23 In short, the rate of interest is the foundation upon which all finance theory, and much of economics, rests.

5 The Theory

No great mind had earlier placed the rate of interest in the context presented by Irving Fisher. He had taken a notion developed in 1834 – that capital accumulation and the interest rate interact to optimize human wellbeing at each moment of time – and tied together capital and interest with the concepts of mortality, wealth, foresight, family regard, and self-control. More than two decades after the publication of The Rate of Interest in 1908, Fisher revisited and rewrote the treatise in 1930. Retitled The Theory of Interest and redefining self-control as impatience, he redrew intertemporal choice in a way that has been applied in finance ever since.

The discount rate Before Fisher, the traditional view of the interest rate focused only on investment opportunities. As discussed earlier, the discount rate was viewed as the term that sufficiently reduced the amount that would be paid for a capital good to yield an expected flow of profits in the future. For instance, a machine that can yield $1,000 of profits for each of the next ten years, but with no profits or scrap value thereafter, is not worth $10,000 to one today. Instead, its value today is discounted below the sum of future profits in the future. This discount rate arises because no investor would be willing to purchase a flow of future income in return for an equivalent value today. The rate at which we discount the present value of such a future flow is then compared to the interest rate determined in financial markets. If the prevailing market interest rate is lower than our discount rate, we would find it profitable to borrow money so that we could invest in the right to the flow of future income. In addition, those with a discount 25

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rate lower than the interest rate would be willing to offer their financial capital to investors in return for fixed periodic payments that we call interest. We will see next that we make investment decisions so that the rate we discount future flows of income, and consumption, aligns to the interest rate, or cost of capital. Fisher broadened this definition significantly and enriched our understanding of the role of savings as well. He wrote: The rates of preference among different individuals are equalized by borrowing and lending or, what amounts to the same thing, by buying and selling. An individual whose rate of preference for present enjoyment is unduly high will contrive to modify his income stream by increasing it in the present at the expense of the future. The effect will be upon society as a whole that those individuals who have an abnormally low estimate of the future and its needs will gradually part with the more durable instruments, and these will tend to gravitate into the hands of those who have the opposite trait … This progressive sifting, by which the spenders grow poorer and the savers richer, would go on even if there were no risk element. But it goes on far faster when as in actual life, there is risk. While savings unaided by luck will ultimately enrich the saver, the process is slow as compared with the rapid enrichment which comes from the good fortune of those few who assume risks and then happen to guess right.24 In one broad stroke, Fisher defined the motivations for and the effective process of personal finance theory. His brief commentary was rich indeed. To understand its implications, we will now describe the theory using methods that would have been familiar to him at that time.

The indifference curve Much of the debate around, and objection to, a more formal and mathematical approach to human decision-making centered around the measurability of human satisfaction. Early writers, most notably William Stanley Jevons, created the notion of a utility curve, which embodied the measurement of human satisfaction arising from the decisions they make and consumption they enjoy. However, this intuitively appealing but practically vexing and immeasurable approach was decidedly contemporaneous. If it were possible to measure their utility, we can presume that human satisfaction or happiness should rise if we were permitted to enjoy more

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of any valued good or service. In other words, if we could express our happiness as a mathematical function, this function should increase with consumption. We can also surmise that this utility should increase at a decreasing rate. In other words, we enjoy the first bit of any consumption, when the good remains scarce to us, but increasing consumption of the good gives us a smaller and smaller increment to our satisfaction. We may even eventually satiate on a good, meaning we have enough, and further consumption could even make us feel worse off. Such a relationship between the consumption q of a good and the satisfaction or enjoyment U(q) it creates should look roughly as follows.

Utility

q Figure 5.1

The utility curve

This characterization of utility that rises with increased consumption, but at a decreasing rate, is intuitively appealing. However, it has one fundamental problem. It seems unlikely that we could construct any meaningful measure of human happiness or satisfaction. Early economists realized that not only did a utility curve defy measurement, it could not explicitly include the deferred consumption consumers expect to enjoy in the future. Fisher recognized the fundamentally immeasurable nature of utility. The criticism was not that individuals could not know how they regard their consumption of a good or their internal valuation of a bit more consumption of one good compared to a bit more consumption of another; rather, individuals have no objective scale that would allow them to compare their own enjoyment to the enjoyment of others.

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Consequently, Fisher and others embraced an approach with a more easily justifiable framework. At the same time, Fisher was able to explicitly compare consumption not just at one period of time but over multiple periods. In doing so, he successfully tied our own natural desire to consume sooner rather than later with the interest rate that links finances from one period to another. These indifference curves are actually deceptively simple and powerful. Rather than imposing the requirement of measurability on and between individuals, we can instead ask, for any combination of goods, just how individuals would be willing to trade one good for another. For instance, if one enjoys q*A units of one good and q*B of another, regardless of cost, at what rate would one be willing to sacrifice the first good to attain one more unit of the other? If the sacrifice of a small (marginal) amount of one good for another can be done in a way that preserves overall happiness or satisfaction, the individual would be indifferent between his or her consumption before and after the trade. Graphically, if there are two goods A and B in quantities q*A and q*B and our willingness to trade one for another is considered, the trade-off might look like this at a given initial combination of A and B. qB

q*B

q*A Figure 5.2

qA

The trade-off of two goods at one point

The slope of the line between the point is the change in the quantity of B for a change in the quantity of A the individual can enjoy. A flatter line denotes one would give up a lot of good A to get a bit more of good B. On the other hand, a steep line implies good A is relatively more valuable to the individual; one would exchange a lot of good B for only a little more good A. Of course, the individual can compare the consumption of one good for the other for any combination of goods A and B. Specifically,

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consider the trade-off of one good for another along a locus of points that all give the individual the same level of satisfaction. For instance, we can look at two more points of such indifference to the combination of q*A and q*B. qB

q*B

q*A Figure 5.3

qA

A trade-off of one good for another

Each of these points denoted by the stars in Figure 5.3 yields the same level of satisfaction for the consumer. However, the point on the upper left of the graph yields the same level of satisfaction by consuming more of good B and less of good A. In other words, good B is relatively more abundant, while good A is more scarce. The line showing the rate of trade-off between two goods reflects these different relative abundances. Because good B is more abundant, the consumer will trade a fair amount of good B for a marginal increase in good A. Alternately, to the lower right, satisfaction is attained by consuming more of good A and less of good B. In this case, the line drawn through the allocation of good A and good B is flat. This flatness reflects the fact that good A is relatively abundant and hence the individual would be willing to trade more of that good for a marginal increase in the amount of good B. An individual’s willingness to trade a small (marginal) amount of good A for some of good B, while keeping the level of satisfaction constant, is called the individual’s marginal rate of substitution (MRS). This willingness to substitute good A for good B gradually changes to reflect how much of each good one has. In fact, this gradual change in how one regards good A to good B, while always maintaining the same level of satisfaction, is measured by the slope of a line that connects all the combinations of A and B that yield the same level of satisfaction or happiness.

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The Life Cyclists qB

q*B

q*A Figure 5.4

qA

An indifference curve and various points

While this approach sounds deceptively simple and avoids the necessity of asking individuals to measure their overall satisfaction in any way that is meaningful to others, it is actually an incredibly powerful approach. These indifference curves must logically obey a number of reasonable premises. First, an indifference curve must be downward sloping as a reflection of the necessity to have more of one good if one has less of another along any line of constant satisfaction or indifference. Second, these curves must flatten as we move to the right. This flattening of the curve for a greater amount of good A, or the steepening of the curve for a lesser amount of A and a greater amount of B, is a demonstration of what economists call diminishing marginal utility. In other words, a greater abundance of something implies we value a bit more (on the margin) at a decreasing rate. Abundance dilutes our valuation of a good, while scarcity heightens how much we value it. Third, there must be an indifference curve that runs through any possible combination of goods A and B. We can start at any arbitrary such point and vary the amounts of A and B, while maintaining the same level of satisfaction. Each one of these indifference curves must have the same general shape as in Figure 5.4. Finally, none of the plethora of possible indifference curves can cross another. If two indifference curves were to cross, the unique combination of the two goods at the crossing point would yield two different levels of satisfaction. Such a result would produce a logical inconsistency.

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The mapping of these various indifference curves for various combinations of goods A and B, or even our deduction that an individual’s willingness to trade one good for the other changes, would appear to be an esoteric exercise. However, this approach comes to practical life once we impose upon the graph an interpretation that is much more concrete.

The budget constraint To bring meaning to these graphs, we next look not at the wishes and desires of the consumer, but rather at the amount of resources a consumer can bring to bear to purchase goods (or services). If we remain focused just on two goods, one can presumably use a given wealth W to buy only good A or only good B. The amount of good A one can purchase with wealth W depends on its price pA, i.e., qAmax  W/pA, while the maximum quantity purchasable of good B is qBmax  W/pB. For a given wealth W and the prices of the two goods, we can trace out one’s maximal purchase of good A or good B, or any combination in between. qB max qB =W/pB

Wealth line

qAmax =W/pA qA Figure 5.5

The wealth line

Finally, we can combine on one graph the wealth line, which describes the feasible, and the indifference curves, which define the desirable, to determine what an individual consumer ought to do to stretch financial resources and yield the highest possible level of satisfaction. If indifference curves close to the origin are of low satisfaction and the higher indifference curves resulting from greater consumption yield higher

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levels of satisfaction, the consumer would choose the highest indifference curve that the wealth line can (just) support. This equilibrium point occurs where the wealth line is just tangent to an indifference curve. qB max qB =W/pB

q*B

q*A Figure 5.6

qAmax =W/pA qA

The wealth line and various indifference curves

We can immediately glean a profound conclusion from the indifference curve analysis. Notice that individuals align themselves with the greater market. To see this, recall that the slope of an indifference curve is given by our willingness to give up some of the good on the horizontal axis, or good A, to receive some of the good on the vertical axis, or good B. Let us recall that the individual’s marginal rate of substitution is the trade-off that governs the individual’s decision and only has meaning to that individual. The market, too, values one good relative to the other. If the price of good A is twice that of good B, the market has determined that good A is twice as valuable. It is not difficult to show that the wealth line has a slope equal to these relative prices pA/pB. To see this, we calculate the slope of the wealth line. This line rises from the origin to W/pB while it runs from the origin to W/pA. The slope of the wealth line is then: W/pB  p A / pB W/p A In other words, optimizing individuals choose their consumption so that their marginal rate of substitution between the two goods mirrors the relative rate of the market values of the two same goods.

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To see this, consider how you would respond if, at the margin, you internally value good A at three times the rate per unit as you do good B. If the market instead values good A at only twice the rate, and hence twice the price, you would choose to consume more of good A because your personal relative valuation is greater than the market premium. Indeed, you would continue to do so, and consequently dilute your marginal enjoyment of good A, until your internal valuation is aligned to the valuation that the market dictates to you.

A new application for an old technique One characteristic that frequently defines great minds is their ability to look at a familiar condition in an unconventional way. Fisher interpreted these indifference curves, the wealth line, and equilibrium in a new way, which shed light upon a previously murky area. In his novel and powerful interpretation of these indifference curve figures, Fisher suggested that the axes can instead represent the amount of consumption C0 today, which we call period 0, and, for illustrative purposes, consumption C1 in a year, called period 1. The previous principles apply to consumption in periods 0 and 1. Individuals would be willing to trade some consumption today if they could receive some additional consumption next year. Of course, most people would want even more consumption next year for the consumption sacrificed today. Fisher offered many reasons for this. Primarily, he noted that individuals have impatience for the future. Let us explain why. First, Fisher was highly cognizant of human frailty and mortality. The death of his brother, father, sister, and college roommate induced upon him a lifelong concern for health. Certainly, his bout of tuberculosis and long recovery from it sharpened his own sense of mortality. It was not long after he recovered that he produced his seminal work that described the nature of human impatience. Certainly, all mortals will discount the future. Even if there were no other reason to discount the future, there is always a probability of less than one that an individual will be alive to enjoy the future. Mortality creates a bias toward certain consumption today versus the probability of consumption in the future. There are other reasons to regard the future with less intensity than our regard of today. Let us presume that the contingent future will also create an opportunity to re-evaluate our decisions in the future. Again, the better understanding of our decisions today against the

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contingencies and choices we are offered in the future creates a bias for present consumption. Finally, there is always a human bias for the world we know over the world we have yet to know. Humans by nature seem to prefer enjoyment today over enjoyment deferred. Only through inducements of even greater enjoyment in the future are we typically willing to defer consumption today by saving today. Certainly, various great minds have augmented Fisher’s concept of impatience. However, Fisher’s concept of a natural preference for consumption today over consumption in the future remains an underpinning of finance theory ever since. To see the implication of the unidirectional arrow of time on our economic decisions, let us reconsider Fisher’s indifference curve analysis in a new light. Instead of comparing our consumption of one good and another at one period in time, the horizontal axis measures total consumption expenditures today, while the vertical axis represents consumption in one time period, perhaps one year, in the future. If we recast our analysis in this way, the various conclusions we made about indifference curves remain valid. For instance, if the contemporaneous consumption of one good in greater intensity results in diminishing marginal returns, so would the consumption of our combination of goods in a given period. Similarly, if we trade off consumption of one good for another at one instant, we will also trade off consumption of all goods at one instant for the totality of consumption in another instant. Of course, we must develop a common unit of measurement for the totality of consumption in one period or another. This common unit is most conveniently the amount we spend on consumption in each period. Consumption is most conveniently expressed in the currency spent in each period. Consumption C0 is then the amount of wealth or income devoted to consumption in period 0. Likewise, consumption C1 is the amount of consumption one can afford in the next period using the remaining resources in period 1 and those carried over from period 0. This approach creates particular significance for those levels of consumption that are constant from period to period. Recall the interpretation of the indifference curve as the marginal rate of substitution, or the rate we value consumption of one good relative to another. In this intertemporal interpretation, the slope of the indifference curve when C0 equals C1 is the rate at which we value consumption in period 0 to that in period 1. Because we intrinsically value present consumption over future consumption, the sacrifice of one unit of consumption today commands more than one unit of consumption in the next period.

The Theory

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The slope of the indifference curves at all points in which C0  C1 must then be steeper than 1, the even trade slope. Let us label this slope as (1  d ). We can interpret the symbol d as the differential by which we discount consumption in the next period over consumption today. C1

C0 =C1

Slope –(1+δ)

C0 =C1 Figure 5.7

C0

Intertemporal consumption and the discount rate

Consider a discount rate of d  .1 or 10 per cent. This rate implies that we favor present consumption at an additional rate of 10 per cent over consumption in the next period. This discount rate will depend on many factors, as future great minds will conclude. However, the principle is important. Implicit in our decisions of how much to consume in one period relative to another is an internal notion of our individual discount rate d . This discount rate is alternatively called the rate of time preference. Next, let us include the income we can devote to spending over both periods. Let our wealth over two periods be given by the income Y0 in period 0 plus the income Y1 from period 1. A critical assumption of many intertemporal models is that income from period 1 can be accessed in period 0 through borrowing in capital markets. In addition, let the interest rate in these capital markets for borrowing and savings be given by r. Should the individual so desire, he or she could borrow against future income. In the two-period version of this model, the equivalent present value of wealth today is then W  Y0  Y1/(1  r), where r is the interest rate. The wealth tomorrow could then potentially be W(1  r), assuming none of the wealth is used for period 0 consumption. Just as in the single-period model described earlier, we can determine how much individuals could consume in the extreme in period 0 were

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they to consume nothing in period 1. This level of consumption would be equal to W. Conversely, if they were only to consume in period 1, they would be able to consume W(1  r). As before, we can calculate the slope of the wealth line that allows us to partition consumption between the two periods. As before, notice that the wealth line has the slope equal to (1  r). To see this, note that the wealth line rises from the origin to W(1  r) while it runs from the origin to W. The slope of the wealth line is then: W (1 r ) (1 r ) W Let us assume for the moment that an individual’s discount rate d coincidentally equals the interest rate r in the capital market. If so, individuals will optimize their satisfaction by choosing consumption in periods 0 and 1, with their wealth line tangent to their intertemporal indifference curve. This optimizing point will result in equal consumption in both periods. Recall that a 45-degree line emanating from the origin of the graph will pass through points on indifference curves with a slope of (1  d). All points above that line, for which C1 is greater than C0, will have a steeper slope, while all points below the 45-degree line for which consumption in period 0 in greater than that in period 1 will have a flatter slope. We have derived the most significant result from Fisher’s analysis of intertemporal consumption. It also predicts why some people borrow and others save. Let us see what decisions would be made if the prevailing interest rate r were greater than an individual’s discount rate d. The wealth line would then be steeper than the individual’s marginal rate of intertemporal substitution line along an equal consumption-ray emanating from the origin with a slope of one, along which C0  C1. Because the wealth line is steeper than the indifference curve along this equal consumption-ray, the individual will translate this difference in slopes by reaching a higher level of utility and by consuming more in period 1 than in period 0. This observation has profound implications on saving behavior. If the individual’s income is constant from period to period, but consumption is rising, the individual must be saving in the first period to enhance consumption in the second period. We can see from Fisher’s model that when individuals discount the future less than does the market, as measured by the prevailing interest rate, consumption is less than

The Theory

37

income early on and rises over time. Alternatively, when individuals are more “impatient” or discount the future at a rate greater than the prevailing interest rate, they borrow against the future to support greater consumption in the present. Of course, for a variety of reasons that we shall encounter later, individuals differ in their regard for the future, their willingness to forego present consumption, their sense of mortality, and the number of years for which they plan. Consequently, each of these factors will also affect the optimal intertemporal trade-offs between consumption and their motivation to save. However, in one brilliant stroke, Fisher was able to wed both the capital mobilization side of the marketplace with the actions of individuals through their saving and borrowing decisions.

The Fisher equation Fisher was the first to describe how an individual’s innate preference for the present versus the future determines the path of consumption over time. Up to now, we have only examined savings and consumption decisions in real terms. The consumption C0 and C1 represents the amount of goods and services one consumes in each period. Wealth W represents the household’s real purchasing power, while the interest rate r is the additional share of consumption a household can consume in period 1 if it forgoes consumption in period 0. Ultimately, people are motivated by this ability to consume. While a nation measures itself based on how much it actually produces or on the number of people employed, wealth is ultimately important for the consumption it can generate. Humans respond to the tangible. Fisher next explicitly included inflation in his analysis, as inflation reduces the amount of tangible consumption saved wealth can support. Money and its growth, prices, and inflation complicate economic decision-making. Fisher strove to remove this complication, which can only hinder individual decision-making. If the distorting components of such nominal variables are removed, we are left with real variables that allow us to better make our economic choices. Unfortunately, some of the most significant economic variables are in nominal terms. For instance, when Fisher modeled how consumers respond to the prevailing interest rate, the return on their savings was measured by the nominal, or inflation-unadjusted, interest rate, perhaps as published by the bank. Fisher was able to incorporate into his analysis a simple and intuitive adjustment that would allow him to remove the distorting effect of inflation from published interest rates.

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Inflation is measured as the proportional increase in prices, usually over one year. It is assumed that consumers will allot their income and wealth between two periods with the expectation that their income in each period can purchase consumption as they had planned. However, if inflation sets in, the income they assigned to purchase future consumption is able to purchase less. Fisher modeled the effect of inflation on future consumption. Let the symbol p represent the rate of price increases over the year. If the consumer sets aside savings of S for the next period consumption, and if these savings earn a nominal (posted) interest rate i, then the consumer will have an amount S(1  i) available for consumption of goods that will cost (1  p) times the amount they would command in the previous period. Without such inflation, a real interest of r would permit consumption of S(1  r) in the next period. We can use this logic to deduce the relationship between nominal interest rates and real interest rates: S(1  i)/(1  p)  S(1  r) or (1  i)/(1  p)  S(1  r) Multiplying through by (1  p) gives: (1  i)  (1  r)(1  p) Further multiplying through the parentheses yields: 1i1rpr p If the inflation rate π is small, the above expression reduces to: r艐ip In other words, the real or inflation-adjusted earnings on savings are approximately equal to the nominal interest rate i less the inflation rate p. A subtlety not immediately recognized in the Fisher equation is that the Fisher approximation is just that, an approximation, not an identity, because of the very nature of the measurement of interest rates and inflation. In fact, prices can be viewed as changing in a constant manner. However, the inflation rate is calculated periodically, usually annually, as the compounded effect of the change in prices over time.

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Similarly, the nominal rate of return on savings is often calculated annually, but is sometimes compounded semi-annually or even daily. For instance, consider an interest rate of 12 per cent. If this return is calculated only once, at the end of a year, the value of $1.00 in savings would have risen to $1.12. If half the savings rate is calculated twice each year, compounding results in a return that is larger: $1.00(1  12%/2)(1  12%/2)  1.1236 A 12 per cent return, compounded twice yearly, translates into a higher return of 12.36 per cent. This is because half of the interest rate is calculated on the savings for six months, yielding $1.06, while the other half of the interest rate is calculated on the larger amount of $1.06. Similarly, if the interest rate were compounded monthly, the effective annualized return equivalent to a simple interest rate is as follows: $1.00(1  12%/12)12  $1.1268 or a yield of 12.68 per cent. If interest is earned on a continuous basis, savings grow exponentially. The correct expression for the value of $1.00 after a year is then given by: $1.00e12%  $1.1275 The continuous calculation of the return on savings results in an annual rise of 12.75 per cent. Alternatively, the effective continuous-time return consistent with a simple, annually compounded return of 12 per cent is given by: ln(1.12)  11.33% In fact, if the nominal growth variables of interest rates and prices were calculated based on continuous growth equivalents, the Fisher equation would become exact, and its intuition would be justified. To see this, let savings grow exponentially in nominal terms at a continuous rate i, but also depreciate because of the continuous increase in prices p. Then the net real growth r over any interval in time t is given by: e rt  e it ept  eitpt  e(ip)t Taking the natural log of each side and dividing by t gives: rip We see that the Fisher equation is indeed an identity, and not an approximation, if nominal variables are all calculated in continuous time.

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The Fisher equation, in its exact formulation, makes intuitive sense and was instrumental in our understanding of the effect of money and inflation on our economic decisions. Wealth is increased exponentially by the rate of interest it earns, but is eroded continuously in its purchasing power due to inflation. The nominal increase in our wealth, less the eroding effect of inflation, nets out to our real ability to consume. Our intuitive interpretation, based on a sense of continuous growth of our assets through interest and continuous depreciation through inflation, is best represented by the Fisher equation. Interestingly, Fisher did not himself comment on the unifying effect of this intuition or on an exact form of his equation. Indeed, few commentators have noticed this unifying recasting of the Fisher equation since then. Nonetheless, the Fisher equation is most often quoted as an exact relationship and without the subtlety of continuous time. The Fisher equation remains commonly used today to calculate real interest rates from the published nominal interest rates and the rate of inflation. The construction of methods to immunize the effects of inflation preoccupied Fisher and would be the catalyst in his creation of a financial fortune and the bulk of his work over his subsequent career in economics. Fisher delved into various methods to immunize financial markets from inflation. In doing so, he established the novel and special role for inflation with a legacy that lasts today. Indeed, the observation that households make consumption decisions based on the real, inflationadjusted interest rate and that inflation may not be a neutral variable was also the first crack in the classical theory.

6 Applications

In one fell swoop, Irving Fisher unified what had been two distinct areas of research. Ever since Adam Smith, there had been significant discussion on the meaning of the interest rate as a reward to capital. Eugen von Böhm-Bawerk had realized that there was a discrepancy between the amount one was willing to invest and the flow of profits in the future from that investment. For instance, a $10,000 investment that could generate annual returns of $1,000 for ten years and have no remaining residual (or scrap) value thereafter would not be considered profitable. Instead, the investor would demand either a higher annual return or would be willing to purchase the annual return for a lower discounted investment value. There is a sufficient additional annual return, or lower initial investment, that would make one willing to proceed with the investment. We often use the term “discount rate” as a synonym for the interest rate. It becomes a measure for how we discount the future to create an equivalent financial value in the present. It is a relatively simple finance exercise to calculate this implicit discount rate r. For a given present investment I0, a flow of annual returns xi for each period t from 1 to T, and a final year return and scrap value X T, the interest rate (or discount rate) is determined to balance the following equation: I0  x1/(1  r)1  x2/(1  r)2  … + xT1/(1  r)T1  XT/(1  r)T If the scrap value is zero and the return each period is constant, the expression reduces to: t T

I0 

x

∑ (1  r )t

t 1

41

9780230274136_07_cha06.indd 41

8/30/2011 3:32:17 PM

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Let 1/(1  r)  z. Then the expression can be written as: t T

I0 

∑ xzt

t 1

This expression is called a series. Let us look at the series that goes to period T. We can rewrite it as: x*(1  z  z2  ···  zT ) If we multiply the expression by (1  z), we obtain: x*(z  z2  ···  zT )(1  z)  x*(z  z2  zT )  (z2  ···  zT1)  x*z(1  zT ) Or: t T

∑ xzt

 x * z *

t 1

1  zT 1 z

Recall that z  1/(1  r). Then (1  z)  1  1/(1  r)  r/(1  r) and 1/(1  z)  (1  r)/r. We obtain: I0  x*(1  1/(1  r)T1)(1  r)/r  (x/r) * (1  1/(1  r)T ) This expression simplifies significantly as the time horizon becomes exceedingly long. As the horizon T goes to infinity, the expression 1/(1  r)T becomes zero for any positive interest rate r. The value of the investment I0 for a stream of income x beginning in period 1 and going to infinity becomes: I0  x/r For instance, if the interest rate is 10 per cent, the present value of a certain investment with a return of $1,000 per year is $10,000. Alternately, the effective yield on an annuity that costs I0 and earns x per year forever is given by: r  x/I0

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We can also derive the same results using continuous time. The value I0 of the future flow of returns x, discounted at a rate r and with a scrap value XT becomes: I0 

∫0 xert dt  XT erT T

 x(1  erT )/r  XT erT  x/r as T →  Either set of expressions allows us to interpret the significance of the interest rate. It is the value of the future flow of income, as a share of the present investment, for an infinitely lived annuity. These present value calculations also provide us with the basis for our familiar bond pricing equations that are commonly used in finance today.

The significance of the interest rate The intuition for the significance of the interest rate was not universally understood before Fisher. The present value calculation related the interest rate to the annual returns and the amount an individual would be willing to pay for an annuity or for a flow of profits from an enterprise. While an analysis of uncertainty will be postponed until the second volume in this series, the approach provides us with an equivalency between investment and expected returns. Before Fisher completed his analysis, there was no general understanding of the process by which savers would determine their savings rate. Until one could model the savings rate and balance the supply of savings at various interest rates to the investment opportunities at various interest rates, it was not possible to determine the equilibrium interest rate that balanced supply and demand. The Fisher intertemporal model allowed students of finance to better understand the motivation of savers in providing these funds to entrepreneurs for investment in profit-producing ventures. While Irving Fisher’s use of the term “impatience theory” might sound odd now, it connoted our preference for consumption today over consumption tomorrow. We have discussed a variety of reasons why humans might be impatient, such as our regard for an uncertain future, our own mortality, or our belief that we have options tomorrow to create consumption tomorrow. While we cannot directly measure an individual’s impatience, our awareness of Fisher’s two-period intertemporal consumption model nonetheless increased our awareness of some

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of the factors that affect the intertemporal consumption and savings decisions of individuals.

The price of bonds Fisher was also well aware of the complicating factor that households must use money as the vehicle to purchase consumption in one period and another. What differentiates money from consumption, though, is that money is eroded by inflation, while consumption, especially in consumer durables, can insulate the household from inflation. Consequently, the Fisher equation would allow us to factor expected inflation into our calculations of the consumption money could purchase in one period compared to another. One of Fisher’s most significant realizations was the usefulness of inflation-indexed bonds. A bond is merely a promissory note that stipulates a lender will receive a set of periodic, often annual, payments for a number of years, followed by the repayment of the face value of the bond. These periodic payments are often called coupon payments because bonds once had removable coupons printed along their rim that could be redeemed for the annual or semi-annual interest payment. If the bond price p is correct, the periodic interest payments should compensate the purchaser for their delay in income and consumption. The final payment of the face value of the bond returns the principal investment to the bond buyer. As before, the value of the bond would then be: p  C/(1  r)1  C/(1  r)2  ···  C/(1  r)T1  F/(1  r)T where p is the price of the bond, C is the annual coupon payment specified on the bond and F is the face value of the bond that will be returned to the purchaser or owner upon maturity. Such a tool would be an ideal mechanism for an entrepreneur to raise capital for a project that is expected to yield profits greater than the coupon rate for more years than the bond time horizon, and with some scrap or accumulated value (no smaller than the face value of the bond) that could be returned to the bond purchaser upon maturity. The bond issuer can try to anticipate the prevailing interest rate r and offer an appropriate coupon rate that will permit a bond with a face value of, say, $10,000 to sell for $10,000. If the coupon rate C offered is a little less than what the bond market would pay, based on the market-clearing interest rate r, the bond will be priced under its face value. On the other

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hand, if a bond offers a higher coupon payment than the prevailing interest rate r would earn for an investment of face value F, the bond will sell at a premium. In other words, previous or original bond issues will be sold or resold at a premium above their face value if the coupon payment is higher than the bond face value at the interest rate prevailing for other instruments of similar risk and maturity. Falling prevailing interest rates give rise to increasing valuation of existing bonds, while rising prevailing interest rates make existing bonds, and their predetermined coupon payments, less desirable. Consequently, the prices for such bonds fall. Fisher viewed bonds as a primary method for matching savers with entrepreneurs. They are superior to loans because they can be written with well-understood terms that can easily be digested in the marketplace. These instruments are also liquid. Because they follow well-established underwriting practices, they can be subsequently sold. Savers can then share in the returns of successful entrepreneurs, but can also retain the option to liquidate themselves from the relationship should their personal circumstances or preference for present and future consumption change. Banks can also engage in a similar exercise. However, they must match long-term borrowers with depositors who can withdraw their savings at any time. Banks manage this potential liability through the law of large numbers. If their deposit base is sufficiently broad, they can predict the value of deposits over time with some certainty. This assurance of capital allows them to match short-term deposits with long-term loans.

A profitable application of the Fisher equation There remain two issues that must be managed by the bond market. The first is the balance between risk and uncertainty, which will be covered in the next volume of this series. Bond markets can indicate risk and uncertainty to potential buyers through a system of bond ratings that is typically conducted by a handful of bond-rating agencies at the behest of bond underwriters. The second is inflation. Fisher recognized that many buyers of bonds do so because they want to ensure they have sufficient financial resources to fuel their future consumption needs. This savings for deferred consumption goal would require coupon payments over the lifetime of the bond and the face value returned upon the bond’s maturity to rise with inflation. Fisher’s intertemporal consumption model, combined with the Fisher equation, commends a bond that would allow for rising coupon

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payments and a maturity face value that kept pace with rising prices. For this reason, Fisher advocated inflation-indexed bonds. We have already seen that the way the inflation rate is published  as an annual return rather than as the product of continuous growth in prices  somewhat distorts the Fisher equation. There is however another difficulty. If the insight from the Fisher intertemporal model was to even out the flow of the utility of households over time, we recognize that the pattern of consumption will also adjust to take into account those goods that are becoming relatively more expensive and those that are becoming relatively cheaper because of inflation. For a common set of preferences for all goods, a household will substitute away those goods which have prices that rise faster than inflation and toward those goods whose prices rising more slowly than inflation. To indemnify savers from the vagaries of changing prices and instead allow them to focus solely on the optimization of intertemporal utility, an inflation index must be chosen that properly measures changing consumption patterns with changing prices. Of course, if all goods are equally available, equally demanded, and change in price at an equal rate, the use of a fixed basket of goods and commodities from which all price changes can be documented would be a simple matter. However, in an evolving economy, some goods or services that might be demanded in one era may not even exist in another. Consider, for instance, the ubiquitous nature of videocassette recorders (VCRs) just a decade ago. Now, VCRs are uncommon and will likely soon become completely obsolete. Instead, a much better, cheaper, and more efficient technology, the DVD recorder, has all but replaced VCRs. In an evolving economy, goods come and go. Any consumer bundle that is used to document the quantity and amount spent on consumption by a representative consumer in one decade may not even be feasible in another decade. If bonds are to successfully indemnify savers from changes in prices and market bundles, they must be linked to an inflation index that can successfully track shifts in consumption patterns in addition to the increase in the price of purchase for such a representative consumption bundle. Fisher actually postulated 40 criteria that should be met by an ideal inflation index.25 In doing so, he created quite an industry for himself, as we will soon describe. The essential criterion is that the ideal index and indexed bond should allow the purchaser to hedge against the uncertainty of future prices and consumption patterns. In other words, it should allow a future income that will provide a given utility for a representative household.

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Fisher saw the need for a proper index as a fundamental issue in finance theory. Indeed, he proclaimed: Perhaps the most important purpose of index numbers is to serve as a basis of loan contracts.26 Fisher saw the essence of all intertemporal financial decisions to take root in the appropriate determination of the rate of change of prices. While finance theory has well incorporated the Fisher equation in its analyses, a more sophisticated and subtle understanding of the appropriate index for the inflation rate has eluded significant discussion among financial theorists and practitioners alike. Of course, the appropriate index for inflation has been fully integrated into our public policy discussions. Public pension payments take up a large and growing share of public expenditure. For instance, the USA, which offers public pension payments that are modest in comparison to many of its European counterparts, devoted 4.8 per cent of its gross domestic product (GDP) to social security benefits in 2009. This ratio is expected to rise to about 6.1 per cent of GDP in 2035.27 Depending on the interest rate structure of government-issued bonds, this payment often represents the single biggest government expenditure in most economies. How these payments keep pace with inflation is a serious public finance issue. In addition, the indexing of these payments affects the consumption and wellbeing of a large and growing number of a nation’s citizens. Politically charged discussions around the appropriate way to measure inflation and index public pensions is an important public policy issue. There has also been a growing recognition of and appreciation for inflation-indexed bonds, especially in the wake of the global recession and inflation of the late 1970s and early 1980s, and the hyperinflations that still afflict nations on occasion. Surprisingly, though, little has been said about the appropriate method to index such bonds, even though $1.5 trillion of such bonds were included in international bond markets in 2008.28 In fact, none of the bonds, from the Treasury InflationProtected Securities (TIPS) issued by the US Treasury to the Inflation Linked Gilt (ILG) in the UK, the Real Return Bond (RRB) from the Bank of Canada, as well as others, use an inflation index that is more sophisticated than their nations’ simple consumer or retail price index.

A bond before its time In his day, Fisher was not advocating for a more holistic inclusion of inflation in the market for loanable funds because of some concern

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about equity or the burden on taxpayers; rather, he was concerned about the chilling effect of inflation on real interest rate certainty. While the nominal interest rate is well documented on every bond and in every loan agreement, savers’ abhorrence of risk may induce them to avoid long-term savings. The resulting failure of long-term debt markets can stymy long-term economic growth and instead direct the economy toward short-term decision-making. As a simple example, consider the prospects of an individual who bought a home and received a mortgage when the inflation rate was characteristically low. If debt markets are relatively myopic, the uncharacteristically low inflation rate will translate into a low interest rate. Such a new homeowner would then hope for inflation. Should such inflation occur, the prevailing interest rate will rise, but the mortgage rate locked in for a long term of typically between 15 and 30 years will not. The homeowner’s wage will typically rise with income, making the mortgage increasingly affordable. In addition, the price of the home will usually rise with inflation, further improving the loan-to-value ratio for the homeowner. While the long-term borrower has everything to gain when the inflation rate rises, the lender likewise loses. The interest the lender earns is paid in a currency that has reduced purchasing power when compared to the money lent. Of course, the reverse is true when inflation drops. Again, if interest rates are myopic, a fall in prices means the interest rate on a loan made in a period of higher prices factors into it an expectation of higher inflation. The interest payments the lender earns in a deflationary environment are at a premium. Indeed, if lenders are able to sell their financial instruments, they can typically command a premium above the face value of the instruments. They earn a premium flow of income and can translate this premium into a capital gain if they wish to sell their promissory note to another potential holder. Fisher preferred for lenders and borrowers to focus on defining their optimal pattern of consumption over time, without regard for speculation of inflation. He sought a solution to this problem through the construction of inflation-indexed bonds.

The Fisher equation revisited A second area of substantial insight and significant research potential is in the accuracy of the Fisher equation. Recall that, in its simplest and most commonly regarded form, the real rate of interest r yielded by a

Applications

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financial instrument is equal to the nominal interest rate less the rate of inflation: rip Certainly, we cannot deny the ex post accuracy of this equation. The purchasing power yielded by payments from a long-term loan contract is derived from the nominal interest payments reduced by the depreciation in money’s purchasing power. However, the interesting question in finance is whether markets are successful in pricing securities ex ante to yield the expected real interest rate after the fact. While finance practitioners would imagine that the Fisher equation is met, albeit with some noise arising from other uncertain factors, in fact the empirical evidence suggests that the relationship is not even imperfectly demonstrated. Indeed, there are a number of new finance tools that can come to bear to better measure the observed relationship between real and nominal interest rates. Should the theoretical tools prove successful in identifying yields in bond markets that are inefficient, theory tells us that this inefficiency could create significant arbitrage profits. Researchers in finance have observed that the real, or inflationadjusted, rate of return in financial markets has remained relatively consistent only if our analysis is qualified somewhat. Theory suggests that there should be some consistency in the real interest rate. Fisher’s analysis demonstrated that the supply of savings that make their way into the market for loanable funds should depend on the preferences of the population for current and future consumption. Obviously, long-term economic growth and productivity, population growth and demographics should affect an economy’s profile and preference for savings. If economic and population growth are close to a constant and steady state, we would expect real returns to remain within a limited range. Indeed, research supports this intuition to a degree. For instance, Peter Phillips demonstrated that the real interest rate moved within a relatively small range if some caveats were imposed.29 In particular, the real interest rate must remain approximately constant within a regime. However, these regimes will shift over time. For instance, at the time of writing, some of the major developed nations of the world were enduring a new regime in the form of the longest recession since the Great Depression. Such an economic calamity infused a sense of pessimism and an uncomfortability with uncertainty

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that was no less profound than the optimism for the future that prevailed in the boom and speculative bubble of the late 1990s. Some believe that the effect on the collective investor psyche from the Great Recession will be of similar spirit, if not of similar magnitude, as the financial conservatism that frustrated financial markets for decades in the aftermath of the Great Crash in 1929 and the Great Depression of the 1930s. Eventually, Fisher concluded that the dynamics which gave rise to the Great Depression created a new and unfortunate investment climate.30 He observed that easy credit in the Roaring Twenties, often collateralized by rising asset prices in a stock market bubble, created the conditions that gave rise to the Great Depression and a financial regime change.

Debt deflation Through the insights Fisher derived from his famed equation, he recognized that deflation and over-indebtedness could become even more problematic than the effects of inflation on financial markets. He came to believe that the high leverage and borrowing on margin had fueled excessive speculation and an asset bubble. He defined a series of factors that could create a dangerous bursting of the speculative bubble. The sequence would begin with margin calls as falling stock market prices erased the collateral of banks and forced borrowers to liquidate their assets. Such widespread margin call-induced stock sales created an environment for distressed selling that further reduced stock market values and established a dangerous positive feedback loop and a downward stock spiral. The result of the pulling back of credit was a contraction in the money supply just as asset prices were falling rapidly. Meanwhile, the value of companies plunged, with reduced profits brought about because of a suddenly pessimistic consumer sector. This loss of consumer confidence moved cash to the sidelines, which was increasingly hoarded by households rather than spent. The resulting shift downward of money demand, even in an environment of decreased money supply, reduced nominal interest rates. However, Fisher argued that, as a consequence of the Fisher equation, the real interest rate would actually rise because of the ensuing deflation. For once, the real interest rate would actually exceed the nominal interest rate and could even push nominal interest rates into negative territory. The financial world has recently experienced this phenomenon. The credit crisis of 2008 brought global financial markets to the brink of

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complete failure. The failure of a couple of major investment banks, combined with severe liquidity crises among a few more, created a credit crisis that could not be fully offset by aggressive money creation. As central banks purchased bonds to infuse cash into the banking and financial system and lower interest rates as a consequence, banks were left with unprecedented cash but also with low interest rates and few qualified and willing borrowers. Such major regime shifts should be expected to force financial markets to deviate from prevailing trends in the real interest rate. If Fisher’s prediction regarding the relationship between the real and nominal interest rates, through the rate of inflation, is accurate, then the pathway will remain highly dependent on the prevailing market psyche. Rather than being a statistically stationary relationship, this relationship is likely to be characterized by other market determinants that financiers find challenging, if not impossible, to quantify. Often, financial commentators are left with an appeal to the unknowable animal spirits that sometimes grip our financial markets, with little opportunity to arbitrage and profit from the regime shift until the shift has stabilized and no further arbitrage opportunities remain. The significance of this challenge is that we sometimes cannot deduce the expected nominal interest rate simply by estimating the expected inflation rate. If there are other fundamental financial forces, the economy may remain in a state of flux and the regular relationship between the real and the nominal interest rate may not be maintained until the economy re-equilibrates. While the Fisher equation may be accurate as a mathematical identity, it is not helpful in determining either the real or nominal interest rate, even if the inflation rate could be known with some certainty. Surprisingly, however, it was Fisher’s pursuit of the ideal inflation index, which would indemnify bondholders from inflation risk, that would lead to his fortune. And confidence in his own considerable brilliance would lead to his subsequent misfortune.

7 Life and Legacy

There is no doubt that Fisher clarified and elaborated upon the contribution of others in the interpretation of impatience as a motivation for present and future consumption and savings. His insights from the intertemporal theory of consumption have been invaluable, even if any precise predictions remained elusive. The overall approach to decisions over time remains today the essence of our understanding of financial markets. In addition, the implications of the Fisher equation remain one of the most frequently discussed, and perhaps misunderstood, of all financial relationships. Given his contributions to our understanding of financial decisions over a lifetime, it is indeed ironic that finances so vexed Fisher over his lifetime. Indeed, his is a rags-to-riches story, a few times over, that seems to defy all the rationality and intuition he brought to the financial world. Yet he is forever remembered as the American economist who established in the mainstream of economics and finance a quantitative and analytic approach that is the epitome of rational analysis and financial market rationality. We have seen the hardship that Fisher faced early in life, the indelible mark it made on his regard to the fragility and mortality of life, and the importance of financial security given a precarious future. The deaths of close family and friends, his long recovery from tuberculosis, and his fastidious exercise and diet regimen all stemmed from his life experiences. Meanwhile, while he was born of modest means and learned to excel to provide for his own financial security, he always remained supremely confident in his own abilities and in his capacity to provide for himself and his family. Indeed, his hubris appeared odd and misplaced, especially given his humble beginnings and his descendance 52

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from men of the cloth. If there is one way to describe Irving Fisher, it would be that he belies easy characterization. We know that Fisher was inventive. His water device, designed to illustrate the equilibrating effect of the market just as water finds its own level, was ingenious, even if it had a Rube Goldberg element. Even as a teenager, he considered himself an inventor and was quite disappointed as a young adult when officials at a piano factory did not share the enthusiasm he had for a device he felt would improve on piano design. He had a number of such brushes with the US Patent Office, encounters which typically left him angry that patent bureaucrats did not appreciate his insights sufficiently to grant him his requested patents. He had designed a portable, collapsible three-legged stool for viewing sporting events, a new projection for the map of the earth, and a device to determine whether a meal was sufficiently nutritionally balanced in its portions. He had created a number of sundials to tell time, a new type of bed rigged by ropes and pulleys, a tuberculosis tent, and an electric blanket.31 Nonetheless, all his life Fisher strove to discover the invention and secure the patent that would make him wealthy beyond dispute. We have no reason to doubt his creativity, so we should not be surprised that he did indeed strive to discover an innovation the world would demand. Eventually, he succeeded and his innovation made him incredibly wealthy. Certainly, every decade of Fisher’s life was dramatic. The loss of his father in the 1870s, his attendance at Yale under scholarship in the 1880s, his appointment to Yale and his brush with death in the 1890s, and his great theoretical insights that went to print in the 1900s, from the The Nature of Capital and Income32 in 1906 to The Rate of Interest33 in 1907, were challenges and successes that few others face in a lifetime. However, it was the 1910s, followed by the high finances of the Roaring Twenties, that made him a wealthy man and a figure known to Wall Street like no other academician up to that point, and perhaps ever since. Fisher’s great financial successes stemmed from his almost fanatical belief in his own insights and abilities, and in his equally obsessive effort to construct the various indices for inflation that he believed would revolutionize the markets for both loanable funds and global finances. This fanatical belief made him wealthy, but not in the ways one would initially imagine.

A better mousetrap Fisher’s efforts to sort and organize large amounts of data so that he might calculate his various inflation calculations for bond indexing

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induced him to develop an indexing system that would be more efficient than the card catalogue commonly employed at the time to record his data. As he sorted the price data needed to calculate his price indices, he would cut each card along the bottom and organize the cards by inserting these slits along an aluminum rail. The rail could be straight or bent into a circle. By bending the cards from a vertical position, the first line of each card could be exposed so that the reader could quickly see the heading that summarized its content. As he had done with many inventions in his past, Fisher tried to peddle his inventive insight. As was typical for him, he was incredulous at the ignorance of various office equipment companies to which he unsuccessfully pitched his new idea. In his frustration, he started his own Visible Index Company following receipt of a patent for his device in 1913. By 1919, his venture had grown to occupy a three-storey building. In those early days in the telephone industry, rows of women operated manual switchboards that connected telephone lines with wires and jacks. They needed to know which line went to which person. Fisher landed a contract with the New York Telephone Company to streamline the requisite indexing and operator functions. Soon his index system company merged with its chief competitor, the Remington Rand Company, which was subsequently merged again and renamed Sperry Rand. The mergers made him a wealthy man. His invention was the precursor to what we now know as the Rolodex card holder. This wealth also sowed the seeds of his subsequent riches-to-rags story. As his wealth grew, Fisher also became a benefactor for a group called the Life Extension Institute and organized around the premise of healthy living and the extension of human longevity. He became an advocate for the growing movement of eugenics. Advocated by the cousin of Charles Darwin (1809–1882), Francis Galton (1822–1911) took Darwin’s notion of biological survival of the fittest, applied it to humanity, and created a social movement. In the extreme, Galton viewed social welfare programs as coddling the weakest elements of society and, in turn, weakening its genetic stock. The American writer Herbert Spencer (1820–1903) also promoted the concept of Social Darwinism during America’s Gilded Age in a way that caught the attention and positive reinforcement of self-made industrialists like Andrew Carnegie and futurists like H.G. Wells. By the twentieth century, the principle of Social Darwinism was increasingly used to justify racial purity, the Nazi movement and its promotion of a superior race, and eugenics. Like so many other self-made

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people in that era, Irving Fisher subscribed to this theory of eugenics and its effort to advocate practices aimed at improving the genetic characteristics of society. He also delved into politics and the debate over the First World War, and stated: The greatest problem of all is the problem of bettering the permanent health, that is the innate vitality and sanity of the human race, the problem of eugenics. The marks of this war will be felt a thousand years hence. That is the real tragedy of the war. We are medically selecting the best young men to send them off to war. When this war broke out, having myself studied eugenics, it nearly broke my heart. I live within sound of the Winchester Arms Works, and when through the night I could hear the grinding and groaning of the machinery turning out guns, and realized what it meant for the human race, I could not sleep … It does not disturb me at all to think of the great tax it is, to think of the economic destruction, to think of cutting off so much wealth, shooting it into the air; that does not bother me. That hole will fill up in a generation. It does not worry me much to think of the destruction of human life. We all have to die sooner or later. It is not the quantity of life; it is the quality of life that disturbs me If we could only reverse it, if we could only induce our enemies to join with us in setting up on each side, not the best young men but the worst; … to get rid of all the degenerates, – I would look upon the war as the best thing that ever happened eugenically.34 Fisher’s forays into business and politics began to eclipse his Yale duties. He attempted to contribute to the war effort in other more profound and less controversial ways. During the First World War, he advocated holding down the cost of living in that inflationary circumstance by indexing wages paid to an inflation measure of his calculation. In his own corporation, he had applied the principle of indexed wages by raising wages at a rate according to his inflation calculation. Up to that point, classical economists had assumed that money and prices had no real effect on the economy. They claimed that a doubling of the money supply would double prices, including wages. However, in applying this notion of money neutrality, Fisher discovered a human problem that classicists would deem irrational. When prices fell, he attempted to lower wages but still preserve the purchasing power of his staff. In doing so, he was taken aback by the discontent he created among his employees. He received a first-hand education in the human characteristic of

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“money illusion” as his employees demonstrated a repeal of money neutrality. There seemed to be some psychological component to money, wages, and prices that Fisher and other economists of the time had not anticipated. Fisher had inadvertently discovered another crack in the classical model, one which his contemporary, John Maynard Keynes, would subsequently push wide open.

Foray into politics By the end of the war, Fisher was expressing his patriotism by assisting politicians in the position of moving the nation forward. He used his financial independence to create and support a group named the ProLeague Independents. He also took leave from Yale to travel the country in support of the Democratic Party during 1920, the year Republican Warren Harding was elected President of the United States. Fisher had backed the unsuccessful candidate, Governor James M. Cox of Ohio, and his running mate, Franklin Delano Roosevelt, in that election. Four years later, Fisher again took leave to campaign on behalf of John Davis, who ran against Calvin Coolidge for the presidency. Again, Fisher backed the unsuccessful candidate. Coolidge would go on to become the thirtieth President. Fisher used these opportunities to position himself and his ideas for the economy with those who could adopt his “pet schemes for bettering mankind.”35 He also used these forays into politics to advocate on behalf of the eugenics movement. Fisher found himself devoting most of his energy to politics, eugenics and business during the Roaring Twenties and under the laissez-faire twoterm Republican administration of President Calvin Coolidge. By then, his wealth and the shares of Kardex Rand he had given to his mother had risen in value to $660,000, equivalent to more than $8 million in 2010 values. Fisher was the equivalent of a multi-millionaire. He found himself devoting less time to his academic pursuits at Yale and more to investing his earnings. As was not unusual in those giddy times on Wall Street in New York City, he used his wealth as collateral to borrow more and invest still more, often in his own company.

A Wall Street oracle Fisher’s up to that point unwavering faith in markets and classical economics was a product of his classical training. Every rise in the market created a greater value for his portfolio, which afforded him the ability

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to buy more stock. His intrinsic optimism in the future of the US economy was a reassuring voice for a market that was becoming increasingly jittery in the latter years of the Roaring Twenties. Indeed, just days before the Great Crash on October 29, 1929, he proclaimed that “stock prices have reached what looks like a permanently high plateau.”36 Some of the jitters and gyrations in the market in the days and weeks before the Great Crash were explained away by him as the process of “shaking out of the lunatic fringe,” in a vetting process not unlike his view of eugenics and the human race. He further predicted that prices had yet to catch up with the underlying value in the market and should still go much higher. At a meeting of bankers less than a week before Black Tuesday, Fisher reaffirmed his belief that “security values in most instances were not inflated,” and in the winter after the Great Crash, he continued to proclaim that the recovery was imminent. However, Fisher himself had lost substantially from the Great Crash, and even casual observers knew it. By the time of the Crash, he was heavily invested and heavily in debt. He used his Remington Rand stock as collateral to buy more stock and to invest in many new ventures. The Crash caught him by surprise and he lost almost everything. Despite the dramatic downturn, he remained optimistic about his ability to pick winners in an economy where there would be no winners for a decade or two to come. Had he instead liquidated his stock at the peak of the boom, he would have been left debt-free and retained almost $10 million (or the equivalent of $125 million today). His belief in financial rationality and his faith in calling the market cost him dearly. It seemed that Fisher, the brilliant theorist, had anything but a Midas touch in his own political and financial affairs. By the presidential election of 1932, when the country and the world was immersed in the first global depression, he had switched parties. Rather than backing the ultimately successful Democratic candidate, Franklin Delano Roosevelt, he instead switched his allegiances and backed the incumbent Republican President Herbert Hoover, who would go on to lose the 1932 election. While the professorial oracle of Wall Street had been disgraced in the eyes of the public for his optimism over what he thought would be a short-lived adjustment in 1929 and for his very public loss of millions of dollars in the Great Crash, and notwithstanding his support for Hoover, Fisher’s willingness to abandon the classical conclusion of money neutrality in favor of an activist reflation policy in a deflationary Great Depression was taking hold. He visited with President Roosevelt

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in 1934 and took great personal satisfaction when Roosevelt adopted some of his ideas. But while the country was slowly shedding the classical policies that had prolonged the Great Depression and was beginning to show signs of modest economic renewal by 1934, Fisher’s personal good fortune continued to elude him. He had managed to hold on to some highly speculative investments that he had hoped would be his family’s financial salvation. They too failed. Meanwhile, the US government’s Internal Revenue Service had calculated that he owed back taxes of $75,000 from transactions made in 1927 and 1928.37 Fisher was financially ruined. He had to go through the humiliating exercise of donating to Yale a family estate he had been building in New Haven for more than 30 years, under the proviso that he and his family could live out his last years there. In a vote of compassion, Yale agreed. The eminent Professor Irving Fisher would not be homeless. He accepted mandatory retirement from Yale a year later, in 1935, at the age of 68. Fisher’s wife died five years later, in early 1940. He continued to write and study until the end. He advocated for a consumption tax, another idea that has also recently regained currency, as has his argument for inflation-indexed bonds. In addition, he tried to convince John Maynard Keynes to assert his influence at the 1944 Bretton Woods United Nations Monetary and Financial Conference to move from a gold standard toward a standard of money creation that prevented banks from creating money by loaning out more than they had in cash deposits. Keynes thanked Fisher for his contributions to Keynes’ thinking many years earlier and respectfully declined to advocate on behalf of Fisher’s last idea. Fisher died in 1947 at the age of 80. His death brought forward genuine notes of appreciation for his clarity of thought and exposition almost half a century earlier and for his energy in his later years toward the common good. His ideas live on today for their intuitive appeal and for the issues upon which his theories shone a bright light.

Section 2: John Maynard Keynes

There could not be two economists who differ more than Irving Fisher and John Maynard Keynes. Fisher spent a life concerned about his own mortality and betting on the next high card that would provide him with the great wealth that would eventually elude him. Keynes lived a comfortable life of privilege, but in service to the public. Fisher’s lifelong belief that he was on the verge of wealth and success was quite irrational, as any reformed bettor would have to admit. And yet he is viewed as one of the towering figures of the assumption of rationality in economics. On the other hand, Keynes cast off the assumption of the uber-rational classical economics approach in his academic studies and in his career as a financier, but emerged as the developer of the most prevalent and applied economic theory of all time. Both, too, had an ironic sense of timing. Fisher rode the wave of the Roaring Twenties and created the equivalent of over $100 million in today’s values for himself. When the stock market crashed in 1929, in a pique of wishful thinking, he argued publicly that the market would recover and all would be fine. Consequently, he lost almost all of his wealth and much of his public status. Meanwhile, Keynes established his position in our financial history precisely because he developed a superior model of financial markets and the macroeconomy in the aftermath of the Great Crash of 1929 and while a Depression-ridden economy slid further into the first global depression. He also cemented his position as the pre-eminent economist of his time with his deft statesmanship during the decade following his theoretical debut. However, regardless of their differences, these men shared one important characteristic that we see time and time again in great minds. Both Irving Fisher and John Maynard Keynes skirted the mainstream or, as

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Keynes’ contemporary, John Kenneth Galbraith, called it, the conventional wisdom: It will be convenient to have a name for the ideas which are esteemed at any time for their acceptability, and it should be a term that emphasizes this predictability. I shall refer to these ideas henceforth as the conventional wisdom.38 Both Irving Fisher and John Maynard Keynes were capable of discarding the conventional wisdom by using the tools of those who came before them. However, the active minds of both scholars often meant that they would reinvent the wheel, often with spectacular results or new insights. Both reached the pinnacle of their professions and transcended the stodgy world of academia to become household names. In addition, both were larger than life, in very different ways. It was Keynes, though, who would allow us to understand why additional savings may not find their way into the investment market. In doing so, he helped us understand why savings do not always equal investment, augmenting Fisher’s contribution regarding how the rate of interest motivates savings and how inflation erodes the rate of interest.

8 The Early Years

To understand John Maynard Keynes is to grasp the most conventional environment of which he was a product – at least the environment that bred the elite of Victorian England. While the Victorian period ended with Queen Victoria’s death in 1901, just as Keynes entered his senior year at Eton, the world’s most elite preparatory school, he was enjoying his formative years as the British Empire was reaching its apex of global reach and power. John Maynard Keynes was born in late spring, on June 5, 1883, 16 years after the birth of Irving Fisher. But while Fisher was born to a family who moved frequently on a clergyman’s salary, Keynes was solidly of the upper crust of the Victorian intellectual elite. Indeed, his parents would live out their entire adult life in his boyhood home, at the center of the Cambridge intellectual elite, and would outlive their son.39 Keynes’ father, John Neville Keynes, was one of a long line of ancestors who shared a family name that dated back, by John Maynard’s own account, to the Cahagnes of 1066.40 The name, changed to Keynes in the 1300s, was regarded as being of reasonably high repute and of high intellectual and social standing. John Maynard’s most immediate ancestors afforded his family to be firmly ensconced in Victorian comfort. His grandfather was a manufacturer and celebrated practicing horticulturalist who lived in Essex, barely 50 miles from where John Maynard’s family lived for the majority of their lives. John Neville Keynes was their only child, born in 1853, 30 years before the birth of John Maynard. John Neville Keynes almost immediately initiated the Keynes family’s destiny in higher learning and academic overachievement. He was educated in preparation for college in what was then Amersham Hall but is now known as Queen Anne’s School. This school was an elite 61

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institution that would prepare “the sons of dignified gentlemen” for college.41 John Neville Keynes remains one of its most noted alumni. Following Amersham Hall, John Neville attended University College in London and then Pembroke College, Cambridge under a scholarship in mathematics. With a precociousness that we have come to associate with great minds, he was first appointed to an academic position at Cambridge in 1875 at the age of 22. While at Cambridge, John Neville married Florence Brown, the daughter of noted minister John Brown. John Brown had studied in the USA and had received his doctorate at Yale Divinity School. Back in the UK, he was well known for his liberal conservative leadership and teachings.42 His strong reputation among theologians earned him a fellowship at Yale in 1899–1900 to deliver the prestigious Lyman Beecher Lecture Series, where he would have just missed a convalescing Irving Fisher, himself a descendant of a Yale Divinity School graduate.43 John Maynard’s mother engaged in all the activities expected of the wife of one of John Neville Keynes’ standing at the University of Cambridge. She led a number of local charitable efforts to raise the lot of the downtrodden and was instrumental in the establishment of a living facility for tuberculosis patients.44 The year after John Maynard’s birth, John Neville had published his first major book, in the subject of philosophy. The treatise, called Formal Logic, remained in print through subsequent revisions for decades.45 Consequently, John Maynard would be treated to an intellectually stimulating childhood, with a father who was a noted author, philosopher, logician, academic leader, and political economist. The family parlor room was regularly filled with other noted authors and intellectuals engaged in the deep discussion of topics important to the Cambridge community, which was then considered the center of the intellectual world. John Maynard’s birth was followed two years later by a sister, Margaret, and, two years after that, by a brother, Geoffrey. Margaret married Archibald Hill in 1913, who would win the 1922 Nobel Prize in Physiology. Geoffrey married Margaret Elizabeth Darwin, granddaughter of Charles Darwin and relative of eugenics pioneer Sir Francis Galton, and would become a noted surgeon and biographer.46 The Keynes family was a happy one at 6 Harvey Road, beset by none of the tragedies that punctuated Irving Fisher’s upbringing. John Maynard Keynes’ interest in economics came honestly. His father was a member of the founding council of the British Economic Association and would go on to sponsor the prestigious Economic

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Journal, for which John Maynard Keynes himself would act as editor for 33 years.47 A mathematics student in his graduate studies and a social scientist and economist in his professorship, John Neville Keynes had followed a track almost identical to the unusual one of Irving Fisher. Indeed, one of John Neville Keynes’ close economic colleagues and collaborators was Alfred Marshall (1842–1924), who had also motivated some of Irving Fisher’s early work. Marshall was considered to be one of the giants of formalizing the principle of marginal analysis in economic study and was also one of the great influences on Irving Fisher. Marshall would even try to induce John Neville Keynes to become the first editor of the Economic Journal, even as others tried to entice him to join the faculty at Oxford.48 Instead, John Neville remained at Cambridge, where he would publish, in 1891, The Scope and Method of Political Economy, a treatise that was considered to be an excellent survey of the state of the emerging discipline of economics.49 John Neville Keynes went on to become the principal administrator for the University of Cambridge, a position he held from 1910, and was regarded in high esteem in that position as Registrar until he retired in 1925. Just as Irving Fisher helped establish a formal degree in economics at Yale, John Neville Keynes was instrumental in the creation of the first degree program in economics at Cambridge.50 Obviously, John Maynard Keynes’ economic pedigree came quite naturally and at an early age. His distinguished biographer Roy Harrod (1900–1978) related that, upon being asked the meaning of interest when he was just four years old, he responded: “If I let you a halfpenny and you kept it for a very long time, you would have to give me back that halfpenny and another too. That’s interest.”51 John Maynard Keynes did not emerge as a particularly precocious student at first. Nevertheless, he did show an aptitude for mathematics, even if his headmaster complained that he seemed to quickly lose interest in problems.52 This characteristic, shared by many great minds, of being bored by problems that were anything less than most challenging may have explained his initially unspectacular performance in school. However, by his teenage years, Keynes began to bloom. He also grew rapidly and would soon tower over his classmates. At the same time, he began to prepare for examinations to enter Eton, the world’s most elite and exclusive school with the reputation of being the “chief nurse of England’s statesmen.”53 Having been founded by King Henry VI in 1440, Eton’s history had spanned six centuries by the time Keynes graduated. Eton was where

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the English elite went to prepare for attendance at England’s top universities. A noted Eton commentator once proclaimed: “No other school can claim to have sent forth such a cohort of distinguished figures to make their mark on the world.”54 After a three-day examination at Eton in 1897, Keynes was admitted to the preparatory school at the age of 14. He was accepted as a top student in the examination in mathematics and went on to excel at Eton in the liberal arts education the school provided. He won a number of academic prizes while at Eton, in much the same way as Irving Fisher had accomplished in his studies. However, while Fisher desperately craved the recognition and needed the financial rewards to alleviate his chronic financial preoccupations, for Keynes the awards were enjoyable but without great significance or necessity. As Keynes neared graduation in 1902, he stated his preference to attend King’s College at Cambridge, in his father’s shadow and near his family home. For a student of Keynes’ background, there would only be two choices – Cambridge and Oxford – and Oxford would be out of the question for a Cambridge man. Keynes was accepted to Cambridge on a scholarship in mathematics and the classics. While at Cambridge, Keynes studied mathematics prodigiously and worked out his nervous energy through rowing, as had Irving Fisher at Yale. However, the curriculum at Cambridge was not one that we would recognize today. Students dabbled in various subjects as they and their tutors saw fit, rather than subscribing to a strict and predefined course of study. Keynes was most impressed by the quality of minds around him, including those of his classmates and upper classmen. He thrived on the great debates outside of the classroom with individuals who were themselves destined for greatness in service to England.

A maturing scholar The greats at Cambridge also recognized Keynes. Early in his attendance at King’s College, he was asked to join a secret and highly elite group called the Cambridge Apostles or, more simply, “The Society.” Clearly, for Keynes at Cambridge, everything and anything was possible. He was immersed in an exciting intellectual climate, surrounded by the elites of academia and future elites of English public service, and at a time during which the power of Great Britain was at its peak. Within a college of students viewed as future giants, Keynes was a giant himself. He had been elected Secretary of the Union, which

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predestined him to be President of the Cambridge Union Society, the oldest student society in the world. He was also elected President of the University Liberal Club. Meanwhile, he was named as the top ranking in his studies in mathematics. By the fall of 1905, and in his final year at Cambridge, Keynes had to decide whether he would pursue the law and a potential career as a politician or some other form of public service. It may seem odd today that the best and the brightest would not strive for either academia or for the highest echelons of the private sector. However, in an era of British strength and geographical reach, the civil service was, for many of the brightest, the highest calling. Keynes made the decision to sit the exams for the civil service in early 1906. Knowing that he must excel in the civil service exams to obtain a placing that would fast-track his public service career, Keynes began to devote himself to the studies that would serve him well in the future. He became an intensely interested, if late-coming, student in economics and, given his mathematical aptitude, he found himself excelling in the newly emerging mathematical approach to economics. One of the founders of this “marginalism” approach was none other than his teacher, Alfred Marshall, a mentor who had also mentored Keynes’ father almost two decades earlier. Marshall would confide to John Neville Keynes: Your son is doing excellent work in Economics. I have told him that I should be greatly delighted if he should decide on the career of a professional economist. But of course I must not press him.55 Keynes was also exposed to the great minds of William Stanley Jevons, cited by Irving Fisher as the first mathematical economist,56 and Arthur Pigou, another pioneer of modern economics. There can be no denying that his economics education was first rate and that he was a first-rate student. However, he was not dogmatic in his devotion. He was also interested in psychology, which would emerge as an influence that would cause him to deviate from his classical economics training and its emphasis on the measurable. He was warming to economics, relating to a friend that mastery of the subject matter would be most helpful: I find Economics increasingly satisfactory, and I think I am rather good at it. I want to manage a railway or organize a Trust or at least swindle the investing public … It is so easy and fascinating to master the principles of these things.57,58

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The civil service However, Keynes’ destiny in service to his country was frustrated when he disappointed himself in his scores on the civil service exams. He had received excellent marks in English and history, but was quite a bit lower down in mathematics and economics. In a fashion similar to that of Fisher when he thought, likely quite appropriately, that he was smarter than those grading his work, Keynes remarked that “I evidently know more about Economics than my examiner.”59 Regardless, on the strength of his overall score, Keynes was permitted to enter the civil service. In the modern era of economics ever since colleges established programs in the discipline, almost every great mind in economics or theoretical finance has been firmly attached to an academic position at a major college. In a departure from this pattern, Keynes accepted a government clerical position in the civil service and was dispatched to India in 1906. He toiled away during the day as a bureaucrat in India. In the evenings, he pondered great questions in statistics and economics. During those years, he proclaimed that the most significant thing he did in his official capacity was to assist in the transportation of a pedigree bull to Bombay. After two years as a bureaucrat he resigned from his government post and returned to Cambridge to continue his academic work.60 There was no firm offer for Keynes to come to Cambridge to lecture upon his resignation from his civil service post in 1908. Instead, he returned to work as a research assistant, paid personally by his father and Alfred Pigou, the rising star of the emerging economics department at Cambridge.

Return to Cambridge Upon his repatriation to his familiar Cambridge, Keynes had to devote himself to his assigned duties by day, none of which challenged him intellectually. But by night he continued to explore probability in the hope of marrying probability and the logic of induction into a thesis on probability that could act as a dissertation to earn a fellowship and stipend at Cambridge. This serious academic work would not come to complete fruition until 1921, more than a decade later. While his body of scholarly work by 1908 was reasonably well received by his Cambridge sponsors, he was not offered the Cambridge fellowship. However, he was granted a lectureship in Money, Credit, and Prices.61

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Meanwhile, in 1909 he published his first academic paper in the Economic Journal regarding the monetary relationship between Britain and India, earned his fellowship at Cambridge, including a stipend of £120, and won the Adam Smith Prize for an essay on index numbers, the same topic that was fascinating Fisher in America. Over the next couple of years, he had managed to scrape together a living between his fellowship stipend, tutoring, research, and awards. By 1911, he was made editor of the Economic Journal, the same journal that had once asked his father to take on the role of founding editor. By 1913, he completed his first book, Indian Currency and Finance, published by Macmillan, and accepted a Royal Commission seat devoted to the study and oversight of Indian finance. His talent for writing and economic analysis soon emerged, as he was chosen to author the Commission’s report. He was beginning to be recognized for his exposition ability, his competent analytical skills, and the reasonableness and practicality of the assumptions he brought to economic problems.

The war years and Keynes as a public financier Keynes’ superlative skills of exposition and keen analytical ability soon drew the attention of David Lloyd George, Britain’s Chancellor of the Exchequer, the equivalent position to the Finance Minister or Treasury Secretary in other nations. Keynes was asked to join the Treasury in 1915 to offer independent advice to Lloyd George’s civil service officials. When, later that year, Lloyd George’s election as Prime Minister meant he was replaced as the Chancellor of the Exchequer by Reginald McKenna, Keynes was given a more formal role in analysing finance policy for the nation. Within two years, Keynes reached his pinnacle in government administration. With the end of the First World War in 1918, he was asked to analyze the ability of Germany to pay for reparations following their loss. He argued that to bleed Germany dry financially was certainly not in Germany’s best interests, but was also not in the interests of Britain or the USA. Frustrated with the direction his country’s administration was taking with regard to this important post-war part of its economic policy, he resigned from the civil service. Instead, Keynes embarked on a decade of eclecticism, both personally and professionally. He began to divert his attention to the world of business and finance. He was added to the board of directors of a life insurance company and, within two years, would become its director. He began trading on currency markets with borrowed money and even

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made some large profits briefly, which he would soon lose. However, he found his financial stride and would soon make, and keep, even greater financial profits. Keynes’ financial prowess eventually caught the attention of his alma mater. He was soon asked to run the finances of King’s College as its bursar and would also become a financial advisor to many well-heeled patrons of the arts in his neighborhood in London. In 1921, he would finally publish his Treatise on Probability.62

The brilliance of a great mind It is worth recalling that Irving Fisher faced hardship, mortality, and financial ruin for much of his life, and transformed his experiences into resilience, a fanaticism about health and longevity, and an almost pathological optimism that his misfortunes would turn to good fortune. Quite divergently, Keynes grew up with every opportunity and had an uncanny ability to be in the right place at the right time. He invariably managed to translate his charmed life into myriad opportunities and successes, almost of his choosing. However, at the same time, he was an amazingly quick studier of any new situation and was an acute observer of human nature, even if his class separated him from true hardship. Keynes especially doubted that the classical foundation of probability theory, with its emphasis on the measurable, was a realistic portrayal of the way people contemplated data to inform their financial and economic decisions. He was also skeptical of the artificial assumptions economists made as a matter of scientific necessity so that they could impose the assumption of rationality in their analyses. To the financial theorist even to this day, assumptions of convenience are often a sufficiently small price to pay for the creation of an elegant theory. However, Keynes had a sense for the details that would both complicate and enrich, rather than simplify, human decision-making. He sought detail over elegance and was unwilling to accept a beautiful explanation of an artificial problem as a matter of convenience or esotericism. Keynes demonstrated his almost uncanny understanding of the convoluted path of human decision-making, especially in financial affairs. His insights began with his study of the logic that underlies probability theory, as described in his Treatise on Probability. He realized that a discipline of probability or finance built upon the tabulation of past occurrences is intellectually precarious if probabilities and data are interpreted through the eyes of humans. If we are to use probability

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and finance to predict human decision-making, we should better understand how the data is logically interpreted and absorbed by decisionmakers. He noted: Perception of probability, weight, and risk are all highly dependent on judgement … [and] the basis of our degrees of belief is part of our human outfit.63 Keynes’ insight is a major and fundamental departure from classical probability and classical economics. We will return to his insights on subjective probability when we incorporate probability and uncertainty into the financial models of return and risk in the next volume of this series. Keynes would characterize his investment success on his belief that humans do not follow elegant models of perfect foresight, unbiased observation, and calculated decisions. Rather, humans remember the past through anecdote, measure the present based on circumstance, and view the future through a lens unavoidably distorted by the prevailing mood. In doing so, Keynes was focusing on the economy from an almost psychological perspective. Few economists had the boldness to do so ever since the mathematical approach to economics, introduced by his teachers Jevons, Marshall, and Edgeworth, came into vogue in his discipline. However, we shall see that an overly analytical and mathematical approach was ill-prepared for the emotional and global events that would soon unfold first in Britain and then the USA and beyond. Meanwhile, in the 1920s, as Keynes thrived and profited in the financial community of London, Irving Fisher was also having a streak of good luck on Wall Street. Both men were both doing so in an environment in which it seemed almost no one could lose. However, unlike the currency and insurance markets in which Keynes at first dabbled and then immersed himself, for which there are always winners and losers in every transaction, Fisher’s foray into high finance was in the market for equities. During the Roaring Twenties the stock market doubled and doubled, and doubled once more before crashing in 1929, recovering 90 per cent of its value by 1930 and crashing again for another decade and a half. Fisher, too, was trained and well versed in the school of classical economics. Indeed, he was as much a member of that school of rational decision-making and a heavy emphasis on mathematics as he was an originator of the theory of intertemporal choice that is at the core of finance theory. Fisher’s lens through which he viewed the world was

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one of the same elegant models, perfect foresight, unbiased observation, and calculated decisions that Keynes so eschewed. These two individuals would never have a great debate over their respective theoretical and speculative bents. Keynes reached the apex of his career in the carnage following the Great Crash. Fisher’s influence was derived from his optimism in the future of the US economy, despite a speculative bubble, and in his faith that, in the long run, sense and order would prevail. Fisher’s zealous faith, derived partly from the assumption of rationality that characterized the classical school and partly from hope of financial redemption, was reassuring when all thought the Roaring Twenties would transcend into the Terrific Thirties. This same blind faith appeared unrealistic, perhaps even insulting and deceitful, when so many were ruined in 1929. Meanwhile, Keynes was pointing to dangers on the horizon in the 1920s and was much more intellectually prepared for the Great Crash and the subsequent global depression. The early years of the 1930s would determine the fate of each of these great minds and of their respective legacies in the world of finance.

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Irving Fisher had provided the world with the first formal and elegant model to motivate personal finance. But while his analysis refined and expanded the state of the art of mathematical methods in finance theory until the middle of the early twentieth century, he was unable to tease from the analysis what must be left for more elaborate techniques. Even before John Maynard Keynes’ insights, the first substantial expansion on Fisher’s approach flowed from a great mind whose brilliance blazed like a shooting star.

Frank P. Ramsey and a mathematical theory of saving The first substantial expansion on Fisher’s approach occurred from a great mind whose life was all too short. Frank Plumpton Ramsey was born in 1903, just after Irving Fisher had convalesced from tuberculosis and had returned to Yale to contemplate the role of the interest rate in motivating personal savings. Ramsey had a mathematical and academic pedigree that matched the pedigree of Keynes, with a father who was a mathematician and college president. Ramsey was an eclectic youth and student by the time he enrolled to study mathematics at Trinity College, Cambridge. Like Keynes before him, he was fascinated with the classics, politics, philosophy, and especially mathematics. He would settle on the formal study of mathematics but would continue to dabble in other academic areas during his short life. By the age of 23, Ramsey had completed his dissertation in mathematics with the precociousness we have come to expect of great minds. Like Keynes, he was elected to King’s College, with Keynes’ support, 71

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and became a lecturer in mathematics. Despite his young age, he soon became Director of Studies in Mathematics at the College. At the same time, he enjoyed the company of Keynes and of Keynes’ economic contemporary, Piero Sraffa (1898–1983), with whom he enjoyed conversations on the emerging discipline of economics at that time. In four brief years, Ramsey produced a prodigious amount of significant work in philosophy and logic, mathematics, and economics. Many of his theorems and works are still considered to be significant and sophisticated today. Keynes had encouraged Ramsey to turn his prodigious talents toward some unresolved questions in economics. Keynes later claimed that Ramsey had a penchant and an interest in economics, beginning at an early age. Under Keynes’ urging, Ramsey accepted the challenge of solving three unresolved problems in economics. Each of these papers turned out to be seminal. However, in large part because of the unparalleled sophistication he brought to the problems and his analysis, his papers were not well understood or well absorbed at the time. Indeed, some of the techniques he used for his paper on economic growth would be considered to be cutting edge even today, more than 80 years later.

A seminal work on savings One of Ramsey’s most significant works, “A Mathematical Theory of Savings,” was published in Keynes’ Economic Journal in 1928.64 This paper used the sophisticated technique called the calculus of variations to determine the optimal savings rate for an economy so that it could maximize future utility. Let us recall that Irving Fisher had determined the role of savings as a way to maximize the utility derived from consumption over two periods. Fisher also alluded to a longer time horizon, but was unable to muster the mathematics necessary for what we would now call a dynamic optimization problem. Ramsey has an excellent intuitive grasp of the intertemporal problem, as could be seen by his simplifying assumptions. He adopted an infinite time horizon in his analysis of the optimal savings for a nation presumed to span multiple generations. In addition, he did not take on the issue of population growth, technological growth, or changes in preferences. While he offered a prescient tip of the hat to future Nobel Prize winner Robert Solow (1924–) for Solow’s conclusion generations later that any societal rate of time preference greater than zero is “ethically

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indefensible,”65 Ramsey also derived Fisher’s rate of time preference in a section of his paper that covered household decisions over time. Ramsey treated consumption as generating utility, and labor as generating disutility. The goal was to optimize the difference of the two, called net utility, over time by employing labor and capital in production. By treating both the consumption and production side of the market, his model would now be classified as a dynamic general equilibrium model. Within this general equilibrium framework, Ramsey derived conclusions identical to those that Fisher had derived within a more primitive model. The relative marginal utilities of consumption in different periods are dictated by the real interest rate and the rate of time preference. Ramsey also exercised his financial intuition by noting for the reader the difference in financial returns and the return to utility across different periods. He pointed out that the discounting of future utilities must be distinguished from the rate of discounting of future sums of money. In doing so, he indicated an understanding of the separation of financial decisions to amass wealth and the subsequent consumption decision to optimize utility. In his general equilibrium, continuous-time model, Ramsey affirmed the intuition and results from Fisher’s simpler model. He demonstrated that if the rate of interest is less than the rate that one discounts utility, the marginal utility will rise and consumption will fall over time. If society subscribed to this same rate of time preference, he concluded that the economy would consume its capital, equivalent to a farmer eating his seed, until consumption is inevitably forced to subsistence levels.66 Ramsey also demonstrated in his more sophisticated model that, in steady state, in which an economy’s discount rate coincides with its interest rate, the rate of interest, the discount rate, and the marginal productivity of capital all coincide. Finally, Ramsey hinted at a model for an individual’s consumption and savings over an entire life cycle. He noted that if the interest rate r exceeded the rate of time preference r: … he will save when he is young, not only to provide for loss of earning power in old age, but also because he can get more pounds to spend at a later date for those he foregoes spending now … He will for a time accumulate capital, and then spend it before he dies. Besides this man, we must suppose there to be in our community other men, exactly like him except for being born at different times.

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The total capital possessed by n men of this sort whose birthdays are spread evenly through the period of a lifetime will be n times the average capital possessed by each in the course of his life. The class of men of this sort will, therefore, possess a constant capital depending on the rate of interest, and this will be the amount of capital supplied by them at that price. (If r > r, it may be negative, as they may borrow when young and pay back when old.) We can then obtain the total supply curve of capital by adding together the supplies provided at a given price by each class of individual. If, then we neglect men’s interest in their heirs, we see that capital has a definite supply price to be equated to its demand price. This supply price depends on people’s rates of discount for utility, and it can be equated to the rate of discount of the “marginal saver” in the sense that someone whose rate of discount is equal to the rate of interest will neither save nor borrow (except to provide for old age). But the situation is different from the ordinary supply problem, in that those beyond this “margin” do not simply provide nothing, but provide a negative supply by borrowing when young against their future earnings, and so being on the average in debt.67 Ramsey, in one elegant treatise, summarized and extended Fisher’s observations on two period savings into an extended time horizon, and discussed the role of saving while young to support oneself while old. Ramsey was the bridge between Fisher a generation before and the Life Cyclists who would follow a generation later. A few years after its publication, Keynes would describe his paper as: … one of the most remarkable contributions to mathematical economics ever made, both in respect of the intrinsic importance and difficulty of its subject, the power and elegance of the technical methods employed, and the clear purity of illumination with which the writer’s mind is felt by the reader to play about its subject. The article is terribly difficult reading for an economist, but it is not difficult to appreciate how scientific and aesthetic qualities are combined in it together.68 Very soon after these brilliant and elegant insights, Ramsey suffered from jaundice, a complication of liver problems. He died on January 19, 1930 at the young age of 26. Year for year, in his brief career, he probably made a more profound impact, and was so far ahead of his time, than any economist before or since.

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Meanwhile, as the Great Depression tightened its grip, economists were forced to grapple with the most significant economic displacement in decades and the first in an era when many argued that there could be no more severe depressions. The forces that sowed the seeds of a looming economic malady had begun a decade earlier. Following the First World War, Great Britain’s finances were under pressure.

A study of contrasts – Britain and the USA in the 1920s The 1920s in Britain and the USA was a new era. It would also test the power of the Fisher model of the interest rate. The First World War, the war to end all wars, concluded in 1918, but had left the three economic superpowers of Britain, Germany, and the USA broke. A fiscal hangover was left in the wake of the euphoria and optimism following victory. In an effort to seek financial redress, Britain and the USA sought reparation from Germany that was sufficiently onerous to eventually induce Germany to fight another war a couple of decades later. Obviously, the ability of Germany to quickly pay the victors for their costs was hampered by its own post-war circumstances. If the annual reparation payments were too onerous, Germany would have little ability and little incentive to pay, and if the payments were not large enough, economic recovery in Britain and the USA would be delayed. Britain’s domestic fiscal concerns prevailed as a matter of post-war policy. However, the result was a Britain-Germany-USA recessionary triangle that would delay the post-war recovery until the decade of the 1920s was well underway. The period immediately after great wars follows a now familiar pattern. A patriotic shift toward wartime production expanded the capacity of factories and drew non-traditional workers into the labor force. When the (mostly young) men returned from the war, a highly mobilized and productive workforce and industrialized nation had to shift from wartime to civilian production. The necessary shifts in the pattern of unemployment of the labor force caused some temporary displacements that resulted in temporary and often substantial unemployment. However, the pent-up demand arising from delayed consumption during the war years often results in renewed growth once the temporary unemployment imbalances are overcome. This familiar pattern resulted in a recession after the Vietnam War, the Korean War, the Second World War, and the First World War. Britain and, to a lesser extent, the USA experienced such a recession. However,

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these recessions were typically rather brief responses to the sudden decrease in wartime production and an upward blip in unemployment. Soon, production resumed in spectacular fashion. The post-First World War era was one of optimism following the successful defense of a way of life in the USA and Britain, a period of rapid technological development that was heralded in with the Chicago World’s Fair two decades earlier, cars, trucks, aeroplanes, and a burgeoning middle class. The 1920s marked the financial and economic democratization of the Gilded Age. No longer would income accrue only to those industrialists who became impossibly rich in the late 1800s. The 1920s was the era of the Great Gatsby, rags-to-riches for the masses, and the democratization of financial markets. For the first time, a large number of households enjoyed the comfort of savings. Millions would have the luxury of meeting their daily and monthly needs with resources to spare. They began to ponder their financial futures in unprecedented ways and they responded just as other wealthy people before them had always done. They also sought opportunities for investment in the stock market. At just the right time, Fisher’s intertemporal consumption model provided the theoretical justification for a sudden penchant for saving today to enable even greater consumption tomorrow. While the Roaring Twenties began with an agricultural crisis, as costs rose but prices fell, and rural America and the English countryside remained beyond the technological and cultural revolution of fastgrowing cities, millions of others were enjoying the first middle-class Renaissance. Economists and social critics wrote about conspicuous consumption and a new leisure class as wealth and investment both grew at unprecedented rates.69 Near the end of this great boom, the then US President Calvin Coolidge declared in his December 4, 1928 State of the Union speech that: “No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time. In the domestic field there is tranquility and contentment … and the highest record of years prosperity.”70 Coolidge had presided over two presidential terms in which the rich and the middle class were getting richer. The Federal Reserve, formed in 1917 to manage the US money supply and money creation in the banking industry, recorded an index of industrial production that almost doubled from 67 in 1921 to 126 in 1929. By 1929, there were almost as many cars being produced in the USA as there would be a generation later in President Eisenhower’s optimistic post-Second

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World War era in which there was “a chicken in every pot and a car in every garage.” The 1920s was also an era of great real estate booms, indeed bubbles, in the USA, especially in the State of Florida. These real estate booms, aided by the need to put only 10 per cent down, and the stock market booms on Wall Street, were fueled by the same element – easy and cheap money. They were also fueled by the claims of crooks, like Charles Ponzi, a charlatan from Boston who tried to capitalize on the Florida real estate bubble by selling property in a town that did not actually exist.

A bubble primed to burst Speculative bubbles share one essential ingredient. We now know that such Ponzi schemes require a constant inflow of new money. The real estate booms of the early 1920s began to falter as willing buyers were soon exhausted in the late 1920s. The level of activity in the housing boom declined by almost 90 per cent in three short years.71 The end was near. Just as a hurricane gains energy from the warm waters below and then draws in more energy through its vast and growing circular rotation, a speculative bubble draws in money from new investors and spins the increase of wealth into even greater artificial wealth creation. As the market grows in perceived value and stock prices, demand increases paper wealth. This increased wealth creates a greater capacity to buy more stock by borrowing against collateralized stock. Increased wealth creates more wealth, and more wealth still, so long as investors are willing to “let it ride” and reinvest every capital gain. Consequently, over the period, the valuation of the stock market was dramatic. Between 1921 and 1929, the stock market doubled, and doubled, and nearly doubled once more. Some, most notably Milton Friedman, who is discussed later in this book, argued that the policies of the US Federal Reserve and its British counterpart, the Exchequer, exacerbated this speculative bubble and dramatically worsened its subsequent deflation. Professor Lionel Robbins (1898–1984) of the London School of Economics later testified that the Fed’s willingness to move the rate of interest it offered banks to hold cash assets from a rate of 4 per cent to 3.5 per cent encouraged banks to seek returns through more lending.72 In addition, with a bust in speculative housing, more and more money was borrowed to reinvest into the stock market.

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Figure 9.1

Oct-22

Jul-25

Apr-28

Dec-30

The Standard and Poor’s stock market index 1920–1932

Of course, there had been speculative bubbles before and, indeed, many are also fueled by high levels of borrowing. Sir Isaac Newton (1643–1727) was renowned to have lost £7,000, the equivalent of millions today, in his investment in the South Sea Company in 1720. He even proclaimed that it was easier to judge the motion of the heavenly bodies than the madness of people.73 However, past speculative bubbles were battles of wits among titans and the otherwise wealthy. The burgeoning middle class and the democratization of financial markets were new phenomena in the Roaring Twenties. Certainly, Fisher’s analysis of the interest rate and intertemporal consumption and savings was an accurate description of the steadystate trade-off between the present and the future. However, few until the 1920s had the luxury of engaging in such a trade-off. When one lives from paycheck to paycheck, intertemporal choice is an esoteric concept. We will also discover that the Fisherian view of intertemporal choice does not model some of the uncertainties that would soon confront investors in the late 1920s. Fisher’s model works well in a steady state in which much is known and understood and from which rational and careful decision-makers ponder and plot the pattern of consumption and savings that optimizes their long-term utility. It does not say anything about the hysteria of speculative bubbles, the wisdom of a relaxed Federal Reserve policy on borrowing, or even the ability to write off accumulated debt through bankruptcy. There was something missing in the Fisher model that was yet to be exposed.

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Meanwhile, Fisher was reiterating his belief that the stock market had established a new plateau in 1929, from which it would rise still further. Moreover, the common man became an investor in common stocks. By 1928, the stock market became increasingly volatile, even if it remained fantastically profitable. Clearly, investors were becoming edgy, if not manic. These gyrations up and down, but mostly up, were beginning to give many pause for thought regarding the financial soundness of the market. And such gyrations were by no means predicted by Fisher’s famous model. Before the freewheeling 1920s, the steady-state pattern of investment and market behavior was established by rather stodgy and well-heeled titans of industry that diversified their portfolios by purchasing the stock of companies run by other titans of industry. In the 1920s, however, Professor Charles Amos Dice observed that the market was blinded by a “vision for the future and boundless hope and optimism.” He remarked that these new investors were no longer drawn from those constrained by the “heavy armor of tradition … and finally joined, in despair, by many professional traders who, after much sack-cloth and ashes, had caught the vision of progress, the Coolidge market had gone forward like the phalanxes of Cyrus, parasang upon parasang, and again parasang upon parasang.”74

An unravelling In the recent global financial meltdown of 2008, there was no shortage of skeptics. Indeed, at any moment, and especially during an economic boom, there are almost always both vocal champions and skeptics. The difference between a kook and a sage, though, is whether their prophecies are fulfilled. Then, as now, we remember the prophets and forget the kooks. In the Roaring Twenties, however, there were prophets galore, perhaps because the run-up was protracted, as were the signs of imminent decline. One of the champions of the economic boom was none other than Irving Fisher. We should recall that he had become independently wealthy in the stock market run-up. So confident was he in the strength of the US economy in general and the ingenuity of his product and his company in particular that he too rolled every dollar of profit and dividend back into the purchase of even more shares. He had long since almost completely abandoned his teaching and instead had become more associated with Wall Street than the ivory tower.

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Fisher’s concept of the interest rate, his linkage between real and nominal interest rates and the rate of inflation, and his corresponding insights into the money supply and inflation had made him a media fixture. He used his notoriety to full advantage, perhaps like no economist since, with the possible exception of John Maynard Keynes, and he did so in a way that few economists have since dared to follow. He was an unabashed optimist about new market heights, a minimalist of dark clouds on the horizon, and ultimately mistaken in his predictions. These dark clouds were long in the making. By 1926, the market was showing signs of increased volatility. By 1928, the volume of shares traded was also increasing dramatically, especially on some particularly painful days of stock market decline. A record for volume was set on March 12, 1928. This record was subsequently broken a number of times that month. Trading volume was growing so large that the specialists on the floor could not keep up. It would take two hours or more after the closing bell to even figure out where particular stocks stood after all trades were in. Investors were becoming increasingly anxious and timely market information was becoming increasingly rare. Nonetheless, the market continued its upward march, and would even reach some new highs in those heady days of Fisher and President Coolidge optimism. However, 1928 was an election year, with the prevailing Republican Party expected to hold the President’s office, with Herbert Hoover replacing Calvin Coolidge. It became difficult to comprehend the contrast of true optimism from the Republican Party with the pessimism and fear-mongering from the Democrats. Of course, it is often hard to separate rhetoric from reality in any presidential election year. Certainly, there was a large amount of rhetoric aimed squarely at the market in 1928. Herbert Hoover won the presidential election in November 1928. The optimism that immediately and temporarily follows the election of most Republican presidents boosted the market to new heights once again and to new record volumes. By the end of the year, the New York Stock Exchange traded almost a billion shares, or about 60 per cent more than the previous record from the previous year. Some stocks made amazing gains. For instance, the Radio Corporation of America (RCA) went from $85 to $420, almost a 400 per cent gain.75 However, post-election euphoria quickly ended with a December letdown. The market was chasing returns on investment through quick capital gains, not dividends. Few investors seemed motivated by any concern as to whether the holding of stock in the long run would allow

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them to profit from these companies’ strong future cash flows. In other words, investment associated with the means of production was being lost in the shuffle for investment fueled by more and more buying and in the pursuit of capital gains rather than dividends. The Ponzi scheme, which originally marketed a fictional town in Florida, was being replicated in New York financial markets.

The margining of small investors Much of the problem rested with an increasing use of margins in stock purchases. Investors were purchasing Florida real estate on speculation with only a 10 per cent down payment. By doing so, banks allowed investors to buy ten times the real estate they could otherwise buy and magnified their (assumed) profits tenfold in the process. The small cut the investors would have to carve out to pay the bank for its interest was assumed to be insignificant compared with the profits to be had. Certainly, there was no expectation that a new property owner would ever enjoy the land but for the harvest of profits it would provide when subsequently sold to the next get-rich-quick investor. Investment and savings were becoming separated from consumption, unless there somehow emerged a vastly larger level of future consumption that could absorb these new investment-fueled production opportunities. However, with assumed investment returns increasing exponentially, while population and actual production were increasing only arithmetically, something would have to give. Increasingly, even small stock market “investors” were also leveraging themselves highly and, in doing so, created effective demand for many more securities than would otherwise be the case, just as hopeful real estate tycoons were quickly gobbling up improbably large tracts of land. By borrowing a large share of the cost of such stock purchases, speculators earned the right to profits on much larger blocks of securities, while paying a modest fee to the banks that provided them with the margin loans. New York banks, flush with cash from a Federal Reserve that was providing substantial cash liquidity to its member banks at favorable interest rates, were bankrolling this speculative bubble. These banks would claim that the enabling of such financial Ponzi schemes was sound. Banks had collateral for their loans in the form of stocks that seemed to rise in value on a continuous basis and could be sold at almost a moment’s notice. First, investors from all over the world came to the New York banks to borrow and to the New York investment firms to speculate. Soon, these banks were flush with the money of

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eager savers hoping to lend and secure an attractive double-digit return from speculators with an almost insatiable demand for cash to invest. By 1929, however, the market momentum was beginning to lose steam. Once all new buyers had come to market and all new money had been lent, there was nothing to continue to inflate the market. At that point, prices need not fall, but nor would they continue to rise. However, if one held a stock portfolio that had risen to astronomical values but would not rise much further, there was no longer any sense in paying double-digit margin interest rates for stagnant price growth. By 1929, it was time to sell. And sell they did. This selling highlights the danger of margin accounts in a declining market. Consider the example of the purchase of $100 of stock. An investment bank that has a 50 per cent margin requirement would allow an investor to purchase another $100 of stock using the entire block of $200 of stock as collateral. It did so because it realized its $100 loan was sufficiently secured by $200 of stock collateral except in the presumed unlikely event of a 50 per cent fall in the value of the stock. Of course, if the interest rate was only 10 per cent on the loan and the portfolio rose by 10 per cent in a year, the investor would make a gross profit of $20 and would have to turn over $10 to the investment bank as interest. However, if the investment yielded a larger return than the prevailing rate of interest, the investor could make out much better. For instance, over the period from 1921 to 1929, the average return was 40 per cent per annum. In such a case, the investor would have a gross profit of $80 and a net profit of $70 after the bank was paid its interest, or an effective 70 per cent return on the initial $100 investment. Regulations have subsequently been developed that would prevent investment banks from extending too much credit. The obvious reason is the risk that banks take and that permeates a highly leveraged market. To see this, let us assume that the interest rate was zero and the investor leverages twice on a stock originally worth $1. The original investment of $100 permits a purchase of $200, including margin. If the stock doubles in value, or increases by 200 per cent, to $600, the investor would be permitted to borrow another $300 to purchase another 100 shares. The investor now has 300 shares valued at $900, of which $400 has been borrowed. If the stock subsequently falls back to a price of $1.33, the value of the portfolio falls to $400, or the same amount owed to the bank. Even though the stock is still trading well above the initial purchase price, investors would have lost their entire investment.

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A deeper hole There were certainly many opportunities to get financially deeper and deeper into a highly leveraged portfolio. From a level of 63.90 on August 24, 1921, the Dow Jones Industrial Average peaked at 381.17 on September 3, 1929. This factor-of-six rise represented an average annual return of 22 per cent, during a period of modest inflation and with the equally modest tail wind of an annual 5 per cent rate of industrial productivity increase. The Fed had kept the party going by maintaining an average discount rate of 4.5 per cent over the decade. With the effect of leverage, investors could easily net a 40 per cent annual return, which would result in a doubling of their investment value every two years. Perhaps the best measure of the inflation of the speculative bubble was the growing price/earnings ratio over the decade. In 1921, the market expected approximately $1 of annual earnings per share for a stock valued at $6. Just before Black Tuesday on October 29, 1929, the market was trading at a multiple of 32 of earnings. This inflation of the speculative bubble was giving cause for concern. In mid-February 1929, the New York Federal Reserve Bank first floated the idea of raising the discount rate from 5 per cent to 6 per cent. However, a reluctant President Hoover and the Federal Reserve Board in Washington stalled the increase until just months before the Great Crash. Some still argue that the Fed should have begun deflating the bubble earlier. Others maintain that the Fed’s monetary tightening precipitated the calamitous stock market freefall. Throughout that summer, the Federal Reserve Board was meeting on an almost daily basis. The Fed was unusually short of statements, given its obviously heightened scrutiny. Meanwhile, with each wave of selling, more investors were caught in margin calls, precipitating subsequent selling and a statement from the Fed that it would continue to provide the liquidity that the market required. To lend credence to these calls for market calm, various pundits were paraded through the press. For instance, in June, noted financier Bernard Baruch (1870–1965) proclaimed that “the economic condition of the world seems on the verge of a great forward movement.”76 Princeton Professor Joseph Lawrence (1896–1950) stated that “the consensus of judgment of the millions whose valuations function on that admirable market, the Stock Exchange, is that stocks are not at present over-valued.”77 And, of course, Professor Irving Fisher of Yale would make his famous pronouncement that stocks appeared to have hit a permanently high plateau.

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The country was listening. Butchers and bakers, doctors and lawyers, professors and teachers had all become investors first and professionals second. Indeed, many were “earning” more income from investing than from their primary employment. As such, they hung on the optimistic words of prognosticators. Soon, though, more ominous tones were appearing in the newspapers. The week before the Great Crash, newspapers began noting that margin calls had been issued following a dramatic drop on Thursday October 24, 1929. On the following Monday, Irving Fisher labeled the fall and the calls as a natural and well-appreciated exodus of the lunatic fringe from the market. But, despite the attempts to prop up the market with organized buying and rhetoric, volume was increasing and was mostly initiated by those clamoring to sell their stock. The market went into a freefall on Black Tuesday (October 29, 1929). It began selling stock at a rate per hour that was over three times the previous record rate. Those on the trading floor and on Wall Street could manage to get out. Those more distant could not. Billions of dollars of margin calls were issued, forcing the automatic liquidation of stock. There was financial carnage as distant lenders pulled their money out, leaving the New York Fed and investment banks to try to maintain liquidity and order as best they could. Even after the Great Crash of 1929, Irving Fisher remained almost self-deceivingly optimistic. He reiterated that stocks had hit a plateau, albeit at a lower level than he had expected in his earlier pronouncement. The basis for his optimism was that the market had risen based on “sound, justified expectations of earnings” and that “for the immediate future, at least, the outlook is bright.”78 To his credit, Fisher did not merely bury his head in the economic quicksand. As the Great Depression progressed, he warned against the dangers of deflation. Rapidly falling asset prices could easily cause the value of major assets, like homes and businesses, to fall below the amount owed on them. In such conditions, asset holders retained little or no equity in their investment and hence had little allegiance to their property. At the same time, the value of debt, in dollar terms, increased as the value of the dollar declined. This dangerous mix of rising relative debt and falling allegiance to the responsibilities and care of highly leveraged assets had the potential for the almost complete destruction of credit markets. Fisher had recognized this looming problem but had been almost entirely discredited because of his zealous market advocacy during the final year of the speculative bubble. His own financial failures and the

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specter of the once-brilliant professor who was too blinded to save himself meant that his clarion calls to avert a deflation fell on deaf ears. Rather than listen to the concern of the old guard, the public was increasingly looking for a more hopeful voice. Keynes would fulfill that role.

The speculator In contrast to Fisher, Keynes was more skeptical of the impending regime shift, sensing a more fundamental problem. He contended that the classical model upon which Fisher subscribed simply could not adequately describe the nuances of transitional periods when investors were running for cover. At the same time, Keynes was developing his sense that the market is sometimes dictated by animal spirits. This collective psychological force departs from reality in a way that he regarded as distinctly American: If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology at the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organization of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market.79 Keynes was distinguishing between the traditional Fisherian role of savings and investment to provide for future consumption and the enterprise of battling of wits to usurp another’s share in a constant sum game. He would not quarrel with Fisher about the necessity and importance of retained earnings and sacrificed consumption today to create greater opportunities and more consumption tomorrow. Growth in our economy required us to invest in our productive and collective future. However, metaphors drawn from gambling aptly describe the less fortunate aspect of speculative investment. Investors talk about “backing the right horse” or of a stock “starting fast out of the gate.” By projecting

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qualities of gambling on investment, this battle of wits between investors replaced the discovery of innovation among producers as the primary determination of value. The expected discounted flow of future returns became less relevant than the ability to divine what the masses believed of a stock before they realized such value themselves. Then, as now, the successful investor was the prophet of our collective zeitgeist rather than the backer of the better mousetrap.

The schism Certainly, Irving Fisher and John Maynard Keynes had radically different upbringings, different temperaments, different degrees of optimism and realism, and very different adherences to the assumptions and prescriptions of the classical model. They shared in the degree to which they each believed the interest rate, the inflation rate, and the money supply must be factored into our financial decisions, even if their conclusions would have been different in 1929. After all, both were trained within the classical school of economic thought, the prevailing approach at the time. Moreover, both began to depart from the unfortunate tenet of the static classical school that dealt only with an equilibrium that balanced supply and demand. In periods in which demand becomes deficient, the classical model had little to offer with regard to the time it would take to re-establish balance. It seemed less well adapted to explaining this deepening economic depression. Indeed, as the Great Depression unfolded, the views of Irving Fisher became more closely aligned with those of his radical contemporary John Maynard Keynes. Fisher’s eternal optimism in his judgment of the market and the ability of reason to trump emotion made him more the product of Coolidge prosperity and positivism. He witnessed the new “Fordism,” a scientific approach to management that he expected would pay almost untold dividends. The first formalization of what we would now call supply chain management and just-in-time inventory methods convinced him that the recessionary effect of excessive inventories would be a thing of the past. In extending Say’s law that supply creates its own demand, Fisher believed that better supply, and the increased productivity of a new inventive and entrepreneurial class, of which he considered himself a member, would create even greater demand. He even saw the potential for greater economic growth arising from the prohibition of alcohol.80 Part of Fisher’s optimism was in the myopic faith that markets rise over time very much for the same reasons that some people believe

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progress marches on. This blind faith also fueled the recent credit crisis of 2008 that led major economies into the Great Recession. The belief that real estate values always rise, based on the seven-decade pattern since the Great Depression, caused excessive leveraging in housing markets. When the real estate house of cards collapsed, credit dried up worldwide, investment and consumption plunged, and the stock market crashed. We were once again reminded that the past can never be a theoretical justification for future events. Then, Fisher did not understand this dynamic. More recently, others, too, forgot that lesson. We shall next try to understand who was correct, at least in their ability to understand the peculiar circumstances of the Great Depression and its stubborn maintenance of a high level of unemployment and a low level of investment. Let us recall our previous discussion over the applications of the Fisher equation. We have discovered that the real interest rate, defined approximately by Fisher as the nominal interest rate less the inflation rate, holds relatively constant only if we narrow our scrutiny to certain periods of time. Our intuition would suggest that these periods, or financial regimes, should share a common sense of financial outlook. The shift from the Roaring Twenties to the Great Depression is likely to be one such regime shift. Our question is whether Fisher’s classical characterization of financial markets in the Roaring Twenties is at odds with that of Keynes, whether the classical characterization of interest and inflation explains better what happened in the wake of the Great Crash or whether one of the theories subsumes the other and successfully explains the events of both regimes.

A question of semantics? One might ask why it matters if one theory works well in explaining and predicting one financial regime and another theory is better suited for another regime. So long as we understand which regime we are in, we can choose the theory that works best. For instance, a theory that created order and coherence during the Roaring Twenties could well explain the speculative bubble in the 1990s. Alternatively, a theory that explained the Great Depression might be more apt in explaining the behavior of financial markets since the credit crisis and over the Great Recession. However, a unifying theory is handy and not just for esoteric reasons. Consider as an analogy Newton’s explanation of gravity and the mechanics of moving objects. The theory worked well for almost 300 years and is still used today for many analyses. Albert Einstein (1879–1955)

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subsumed into his General Theory of Relativity everything Newton could demonstrate, but within a context that was much richer and more powerful. And if a researcher wanted to explain a previously unexplained phenomenon, he or she would be wise to begin with the unifying theory as its basis. In this respect, a critical comparison of two competing models of interest rates, inflation and investment matters. If one theory can explain the other but not vice versa, we should look to the broader theory to help us create order and hone our institution for what might happen in the future. Such a unified approach also liberates us from having to discern a regime shift. The wisdom of such determinations is often only evident years after the regime shift occurs. Keynes offered us a broader unified model of financial markets.

10 The Theory

By the Great Depression, Fisher’s theory of savings and investment had prevailed for a generation. He saw savings and investments as two sides of the same equation. One represented savings and consumption deferred today to provide for more consumption tomorrow. The other was savings directed toward the creation of future capacity to produce and thus to fuel tomorrow’s consumption. Technically, inventories also represented investment. However, this balance between inventory and capacity was, in Fisher’s words, “managed by captains of industry” who understood the workings of the modern economy better than anyone who had come before them.81 Keynes argued otherwise. Trained from the classical perspective and, indeed, influenced by Fisher and his distinctly classical theory of investment, consumption, and the interest rate, Keynes also subscribed to a melding of the hard mathematics of the classical school and the emerging study of psychology in the social sciences. It was his more expansive vantage point that would allow him to integrate the incomplete personal finance of Fisher with the global financial meltdown of the Great Depression era.

A fresh new era The Roaring Twenties had created innovation not only in industry; it was an era of innovation in art, in music, and in popular culture. The invention of radio fueled a great run-up in the stock of RCA, but also created mass media and a greater sense of social movement. It became easier to connect to and identify with “the crowd.” The sheer crowd momentum drove the increase in stock value and also attracted the attention of psychologists at the time. 89

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One such psychologist was Gustave Le Bon (1841–1931). In the 1920s, there was renewed interest in his late nineteenth-century book The Crowd: A Study of the Popular Mind.82 Commentators began to recognize the power of leadership to focus on the collective will of large groups. While Adolf Hitler and Benito Mussolini may have read this as a prescription to direct the masses, others at the time began to recognize that the collective will of a bull market could lead investors into a speculative bubble. Financial commentators discovered that such a crowd mentality can be dangerous. Without any natural stabilizing forces, an optimistic crowd mentality can suddenly turn pessimistic. Indeed, Sigmund Freud (1856–1939) warned us in 1922 about the dangers of a herd mentality: It is of the very essence of panic that it bears no relation to the danger that threatens, and often breaks out on the most trivial occasions … the loss of the leader in some sense or other, the birth of misgivings about him, brings on the outbreak of panic … the mutual ties between the members of the group disappear, as a rule, at the same time as the ties with their leader.83 Keynes, too, expressed his grave concern. In The General Theory of Employment, Interest and Money, he commented: Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.84 This collective departure from rational thought, a phenomenon Keynes would be the first to label “animal spirits,” was akin to the “cosmological constant,” as Einstein would later, and regrettably, impose on his theory to preserve its utility in the wake of seemingly contrary data. It was the opening volley in the discarding of classical economics, at least in the short run. Psychologists now label such a departure from rational thinking as cognitive dissonance. This dissonance is caused by an uncomfortable

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incongruity between what an individual or group believes and new information confronting the group. Consequently, the group may accept the new information and incorporate it into a modified view or consider it to be false because it forces the group to re-evaluate a viewpoint that has been long held or successful. Examples of cognitive dissonance are quite prevalent, especially in circumstances in which the acceptance of contrary information can induce displacement, discomfort, or pain. Such cognitive dissonance seems inescapably human, sometimes with grave results. For instance, a large and sudden, perhaps even mistaken, sell order on a major financial market can create an irrational mass sell-off, as witnessed on May 6, 2010, the day of the notorious flash crash in which the market dropped by 9 per cent in just moments for no clear reason. Under such group cognitive dissonance, a collection of potential victims find their collective rejection of even the most rational new information mutually comforting. The group then tends to emphasize appealing “facts,” very much as Fisher did so publicly in the days and weeks after the Great Crash. Paraphrasing Karl Marx’s famous quote, faith in the prevailing market sentiment becomes the opiate of the masses. Keynes was certainly not the first to observe such animal spirits and cognitive dissonance in the stock market. More than 70 years earlier, William Worthington Fowler (1833–1881), in his book Ten Years on Wall Street; or, Revelations of Inside Life and Experience on ’Change, described his experience in the panic of April 1864: The feeling and condition of the stock-men, after the panic of April 18th, 1864, had subsided, can never be forgotten by the actors in those scenes. Wall Street was like a city of the dead, a kind of Pompeii or Herculaneum, when the volcanic fires were still seething, and the lava still hardly cooled, which had buried, in the course of one brief sun, the high raised hopes, the garnered fortunes, and the financial identity of thousands. Men hardly dared inquire what might be the status of their debtors, for fear they should know too clearly, the certainty and irreparableness of their own losses… But how stood the quartette after the storm? During the week preceding the panic, we were engaged in bolstering each other up, not by money, for we thought ourselves impregnable in that respect, but with arguments in favor of another rise. We knew we were wrong, but tried to convince ourselves we were right.85

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By the onset of the Great Depression and the election of Franklin Delano Roosevelt, the thirty-second President of the USA, there was no longer any collective denial over the fragility of the economy. In a wave of a new and pessimistic popularism that had swept away a decade of euphoria, Roosevelt spoke in his inaugural address on March 4, 1933: Only a foolish optimist can deny the dark realities of the moment. Yet our distress comes from no failure of substance. We are stricken by no plague of locusts. Compared with the perils which our forefathers conquered because they believed and were not afraid, we have still much to be thankful for. Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply. Primarily this is because the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men. True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish. The money changers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.86 Within this backdrop not of rational classical economics but of the animal spirit of human psychology, John Maynard Keynes offered a new interpretation of the workings of savings, investment, and the interest rate. For the first time, a model steeped in market psychology was successfully applied to financial markets.

A fresh approach What distinguished Keynes from more traditional predecessors like Irving Fisher was that he practiced a successful financial career from outside academia. He had the classical economics training that was

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standard and remains common today. However, he also worked as a financial advisor and invested sizeable portfolios on his own behalf and on the behalf of others. Today, he may well have become a successful mutual fund or hedge fund manager, and might have gone on to work on the fund of an elite college and to advise prime ministers, finance ministers, and presidents. His advice was prized because he understood the theoretical work of the ivory tower, but he also understood the realities of politics and of human decision-making. It was from this varied background and set of interests that he developed his theory of money, income and interest rates. Keynes begins with a grand statement and stinging rebuke on what he perceived as the Achilles’ heel of the classically determined interest rate: The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. For there would obviously be a natural tendency towards the optimum employment of resources in a Society which was functioning after the manner of the classical postulates. It may well be that the classical theory represents the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away.87 In the Depression era, with high and persistent unemployment and with a stock market that had lost 90 per cent of its value by 1932, Keynes was not alone in challenging the conventional wisdom of classical economists. Even Irving Fisher, one of the fathers of classical economic theory, was beginning to doubt its conclusion of money neutrality. Instead, Keynes was stating the obvious. The classical model – and its assumption that the interest rate would adjust to sufficiently motivate and equate savings and investment – fails when entrepreneurs refuse to invest in new projects and when savers mistrust the bankers that act as intermediaries in the creation of such an equilibrium. Keynes had to start from a new perspective. Keynes’ suspicion of excessive optimism and exuberance was partly due to the differing reality on his side of the Atlantic Ocean. While the US economy was booming in the Roaring Twenties, the British economy had not successfully transitioned in the aftermath of the First

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World War. Stubborn double-digit unemployment in Britain remained about twice the average found in the same decade in the USA. It was not until the onset of the Second World War, two decades after the end of the First World War, and only a couple of years after Keynes’ classical rebuke, that the British Great Depression ended, after almost an entire generation. Clearly, if the classical theory would eventually deliver the economy to full employment and hearty investment, it was in no great hurry. Keynes’ rebuke was in the making ever since his frustration with the British and American positions on German reparations following the First World War, and since the publication of his widely read The Consequences of the Peace. But while Keynes initially harboured a faith that good management could repair an underperforming economy, he increasingly began to realize that economic leaders did not have the will, understanding, or wherewithal to act as the puppeteer of the classicist’s invisible hand. Instead, by 1930, with the publication of A Treatise on Money, and by 1936, with The General Theory of Employment, Interest and Money, Keynes had concluded that major economic interventions were necessary to move the economy back to the classical equilibrium. He would begin by taking on a number of tenets of the classical model, one by one.

The neutral money axiom Keynes first took exception to a conclusion that had begun to trouble many Depression-era economists. It had been believed that the supply of money served no purpose other than to determine the price level. If the money supply is doubled, the means to purchase a fixed amount of production is doubled and the prices for all goods and services likewise would double. In other words, money is neutral. It should not affect any of the real variables in the economy, like the level of production, employment, or the real interest rate, perhaps as determined by Fisher’s model. Fisher, too, had recognized the fallacy of money and price neutrality. When prices rose, his employees gladly accepted commensurate wage increases. However, when prices fell, the same employees were loath to accept wage cutbacks. Clearly, inflation was not a neutral variable and could affect the real price, and hence the quantity demanded of labor. Likewise, Keynes argued that the size of the money supply affected the decisions of savers. Rather than merely representing a medium that permits other, more fundamental, transactions, the medium of money

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is an asset in itself. Up to that point, money was not considered an asset, but was merely a medium of exchange that permitted consumption. Instead, savings as the difference between income and consumption were plowed back into the economy as investment. Keynes’ insight was that households hold money as one part of their savings portfolio. The role of uncertainty in our investment decisions will be covered in the second volume of this series. For now, let us assume that there are only two assets in which a household can invest. One earns a real, inflation-adjusted interest rate, perhaps as measured by the Fisher equation. However, the interest-bearing savings vehicle cannot be used in itself for consumption and requires some effort to liquidate so that it can be spent. Alternatively, the asset called money, made up of the cash we hold and the deposits we have in our checking accounts, can easily be converted to spending in order to facilitate consumption. For the first time in financial theory, it was argued that money served three financial purposes. According to Keynes: it allows us to make the transactions that fuel our consumption needs; it acts as a ready precautionary resource to protect us from unforeseen expenses; and it serves as a speculative asset. Sometimes, a saver may be more comfortable holding cash than other assets. These transaction, precautionary, and speculative reasons to hold cash rather than an interest-bearing asset will depend on the opportunity cost of saving in an interest-bearing form. If one is to save in a safe interest-bearing asset, the real interest return, according to Fisher, would be approximately the nominal interest rate on the asset less the inflation rate. On the other hand, the return from holding cash is zero, less the depreciating effect of inflation. Consequently, the difference in the return from saving in interest-bearing assets compared with saving by holding cash is the nominal interest rate. The nominal interest rate balances this interest rate-sensitive demand for cash and the supply of cash as manipulated by the monetary authorities and the banks. This interest rate will then affect investment, which, in turn, will balance the savings of households, the budget surplus of the government, and the savings of foreigners in the domestic economy. In a simpler version of this relationship in which we disregard government and foreign savings, the decision of entrepreneurs to invest interacts with the decisions of households to save. However, in normal times, Keynes noted that the investment decisions of entrepreneurs and the savings decisions of households respond to the interest rate, as Fisher had

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argued, but also to the level of current employment and income in the economy. As the money supply rises, the interest rate falls, investment rises, and income also rises to support the greater need for savings. As the first theorist that developed a pathway for monetary policy effectiveness, Keynes had repealed the law of money neutrality.

The gross substitution axiom Also invoked in Keynes’ new “liquidity preference” theory of monetary effectiveness was a repeal of the classical concept of the gross substitutability of factors and goods. In the classical model, the reduction in the use of one good or service, perhaps because its price had increased, could be compensated by the increase in another similar factor or good. For instance, if there was a shortage of the physical capital used for production because it began to command a greater share of future profits, entrepreneurs would simply employ more labor. The physical capital used to produce, labeled K, includes the machinery of the factories and the technologies that at times replaced labor, labeled L, and at other times enhanced the effectiveness of labor. In the classical economics model, this relationship is simply written as: Y  f (K, L) In other words, an entrepreneur can produce output and income Y by employing either capital K, labor L, or a combination of the two. A surplus of labor, for example, would result in a lower price of labor and a shift by entrepreneurs toward greater use of labor, thereby partly ameliorating the labor surplus. Through this pathway of equilibrating prices, as Fisher had determined so physically in the hydraulic computer for his dissertation, surpluses are eradicated. In this abstract system of flexible prices and the substitution of factors and goods for each other, no factor will remain in surplus for long. And while we may consider our labor to be unique and distinct, in the abstract production function f(K,L) of the entrepreneur, labor differs little from machines. However, if there are rigidities in the amount of labor or capital employed, or the price of labor, as Fisher discovered, the entrepreneur may in fact be unable to adjust the wages of labour factor owners as freely as the classical model presumed.

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The past and present cannot predict the future Finally, Keynes had been troubled since his undergraduate days about the use of probabilities calculated today to predict events tomorrow. In his A Treatise on Probability, published in 1921 but which he began writing in his civil service appointment before the First World War in India, he drew the distinction between knowledge, rationality, and probability. He stated: There is, first of all, the distinction between that part of our belief which is rational and that part which is not. If a man believes something for a reason which is preposterous or for no reason at all, and what he believes turns out to be true for some reason not known to him, he cannot be said to believe it rationally, although he believes it and it is in fact true. On the other hand, a man may rationally believe a proposition to be probable, when it is in fact false. The distinction between rational belief and mere belief, therefore, is not the same as the distinction between true beliefs and false beliefs. The highest degree of rational belief, which is termed certain rational belief, corresponds to knowledge. We may be said to know a thing when we have a certain rational belief in it, and vice versa … it is preferable to regard knowledge as fundamental and to define rational belief by reference to it…88 In essence, Keynes believed that the mere knowledge of the predictions of the classical model does not dictate market behavior. Yet there remain arguments today that suggest otherwise. The modern rational expectations school recently resurrected the classical theory by arguing that arbitrage would move a derailed economy back on track. This argument is based on the premise that there is always a stock of smart money that is ready to enter any market to profit from any deviation from its classical prescription. As with much of the classical model, this conclusion that arbitrage will always save the day does not explicitly describe how fast this process might happen. Rather, it seems likely that arbitrageurs feel no compelling need to sweep in until just before they believe a market will turn around. According to Keynes, this could take a long time indeed. Keynes also argued that the classical equilibrium is a tautology. Knowledge of what could be does not make it so. If one relaxes the assumption that the economy will settle only at the classical, full employment equilibrium, Keynes demonstrated that the economy can

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come to rest at many combinations of income, employment, investment, savings, and interest rates.

A common misinterpretation Most modern interpreters of Keynesian theory, often called neoKeynesians, attribute rigid prices as the main reason why a market may persistently underperform at a high level of unemployment and low or negative growth. Such market frictions can occur. For instance, if an institutional artifact such as contracted or regulated minimum wages prevents a wage reduction during an economic downturn, economizing employers may be forced to lay off workers rather than reduce salaries. While such regulatory or institutional barriers may prevent or delay a groping toward equilibrium, this mechanism was not the one employed by Keynes. Rather, in his contemplation of the importance of money, Keynes made the following observation. If workers are paid in money wages rather than in a share of actual production, employers can only surmise that their production will generate sufficient demand for their product. Ultimately, the demand for an entrepreneur’s product still comes down to the decision of a consumer to consume today or to defer consumption by hoarding cash or by saving in a mode that finds its way into investment in more capital goods. Fisher’s intertemporal model of savings was certainly a subset of Keynes’ liquidity preference approach. Households will delay consumption and transactions today if the rate of return is sufficiently high to make such deferred consumption attractive. However, Keynes’ model had the additional degree of flexibility that hoarded cash need not translate into new investment and the creation of jobs, income, and demand. This additional allowance by Keynes meant that the income created through production may not result in an equivalent amount of demand through consumption and capital investment. The classical theory had missed this subtlety because it held no special role for money other than for transactions and consumption. Similarly, in the classical model, the only reason for households to save is to defer consumption today for additional and predictable consumption tomorrow. However, in the Keynesian model, households would defer spending today precisely because the future is unknowable. At the same time, Keynes provided the financial world with an explanation for why our decision to defer consumption is related to income and economic growth, and why the composition of our savings is also

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affected by income. He noted that our ability to save depends on our income. As income rises, so does our capacity to save, but there is also an increased possibility that some of our savings will not find their way into the demand for investment goods like new factories, machines, and technologies. However, as our income falls because of an economic downturn, we may decide to save more for fear of economic vulnerability and may hold more of these savings in non-productive but more liquid and certain forms such as cash, rather than investing in productive capacity that would be the economy’s salvation. The reduced consumption that can occur during an economic downturn is then exacerbated by a concomitant increase in money savings and a reduction in the amount of income made available for loans to entrepreneurs. The shortage of loanable funds could also raise the interest rate.

Animal spirits However, the economic fears of entrepreneurs can also make economic matters worse. It is here too that Keynes recognized the role of animal spirits, that part of human decision-making which depends on what we imagine the future might hold rather than on what the classical model tells us our economic future should hold. The classical model predicts future demand for the product of entrepreneurial investment to be determined in a fully employed economy. Certainly, when the economy is fully employed, such an extrapolation would make sense. However, if productive capacity can be increased sufficiently quickly, there is no need to invest in greater productive capacity until economic recovery and growth becomes more apparent. Even an entrepreneur who makes a profit during a downturn may still choose to hold these retained earnings in cash rather than reinvest the profits. Companies, too, will horde cash during a downturn so that they do not need to pay the carrying costs of investments in productive capacity that are not yet needed until they anticipate the imminent return to economic growth. In effect they, too, are motivated by some of the same factors that influence the liquidity preference of households. Keynes noted that expectations invariably affect the investment decisions of entrepreneurs as well: The considerations upon which expectations of prospective yields are based are partly existing facts which we can assume to be known more or less for certain, and partly future events which can only be

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forecasted with more or less confidence. Amongst the first may be mentioned the existing stock of various types of capital-assets and of capital-assets in general and the strength of the existing consumers’ demand for goods which require for their efficient production a relatively larger assistance from capital. Amongst the latter are future changes in the type and quantity of the stock of capital-assets and in the tastes of the consumer, the strength of effective demand from time to time during the life of the investment under consideration, and the changes in the wage-unit in terms of money which may occur during its life. We may sum up the state of psychological expectation which covers the latter as being the state of long-term expectation; – as distinguished from the short-term expectation upon the basis of which a producer estimates what he will get for a product when it is finished if he decides to begin producing it to-day with the existing plant … It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change. The state of long-term expectation, upon which our decisions are based, does not solely depend, therefore, on the most probable forecast we can make. It also depends on the confidence with which we make this forecast – on how highly we rate the likelihood of our best forecast turning out quite wrong. If we expect large changes but are very uncertain as to what precise form these changes will take, then our confidence will be weak … There is, however, not much to be said about the state of confidence a priori. Our conclusions must mainly depend upon the actual observation of markets and business psychology.89 The resulting preference for liquidity by entrepreneurs and corporations is heightened when there is a subjective belief that future cash flow may be hampered. Businesses are bound by contract to fulfill future obligations to employees and contractors. However, their future sales are less certain than their future obligations. If sales falter during a

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downturn, while obligations continue, businesses must have a greater cushion of cash to avoid bankruptcy. Faltering sales also reduces the access of businesses to inexpensive credit and creates a higher likelihood of insolvency or bankruptcy. Both of these contingencies are costly to the firm and are avoided by hoarding cash during downturns. In turn, investment suffers. This need for greater liquidity occurs even in times of high economic variability but with constant average growth. Let us assume that output in the economy is centered around full employment output YFE. If the economy has been and is expected to maintain output within a narrow range around full employment, then the probability of a temporary decrease of output to YLow is relatively small, as shown by the shaded area in the following figure. Probability

YLOW YFE

Income and GDP Y

Figure 10.1 A narrow distribution of output around full employment

On the other hand, economic output that is volatile but still centered around the classical full employment solution creates a greater risk of insolvency and mandates a greater level of liquidity. As such, businesses must hold more of their assets in cash to cover an increasing probability of financial exigency. Consumers also have a stake in the fortunes of firms. As equity owners of the shares of firms, households are “invested” in firms. This form of investment differs from the investment in capital goods, the plants and equipment that increase a firm’s productivity and future production. Rather, this investment is the vernacular definition which most households share. Much of our retirement accounts and savings are typically

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YLOW YFE

Income and GDP Y

Figure 10.2 A wide distribution of output around full employment

held in assets like corporate stocks and bonds that are more speculative than cash holdings. As the profits of firms become more volatile or turn downwards, the value of and return on these stocks and bonds likewise turn downwards. The declining value of these assets make them a less desirable and less perfect substitute for cash, and induces households to sell these assets and hold more cash. The money hoarding of firms in uncertain times also induces greater money hoarding by households. During times of full employment and classical equilibrium, the investment motive of entrepreneurs depends primarily on their ability to generate returns greater than their cost of capital. A low cost of borrowing allows many profitable new projects and investments to cover interest costs on borrowing. Alternately, as the interest rate rises, fewer projects are profitable, net of serving their debt, and investment falls. However, when market outlooks turn negative, there may be no interest rate that would make investment attractive, at least until the entrepreneur anticipates an economic turnaround. When investment is so low that it becomes decoupled from the interest rate, there is little the monetary authorities can do to stimulate the economy. Indeed, it is this decoupling that induced Keynes, the first monetarist in the discipline of economics, to steer away from monetary policy as the prescription for an ailing economy. Nonetheless, Keynes was one of the first to link the fortunes of households and investors through money and savings. We shall see later in this book that others further formalized this link. However, the classical

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Real interest rate

Level of investment Figure 10.3 Graph of investment and the interest rate

Real interest rate

Level of investment Figure 10.4 Pessimistic investment and the interest rate

model that prevailed before Keynes did not explicitly tie the fortunes of firms to those of households. Instead, suppliers and demanders made independent decisions through a decentralized marketplace. There was little discussion about their strategic interdependence and the destabilizing effect that such a feedback loop could create. The Great Depression changed our understanding of such feedback loops between firms and households.

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We have seen the example of reduced consumption and increased money hoarding by consumers that fed into reduced profits and increased demand for liquidity by firms. This increased liquidity by firms and their reduced investment at a time of excess capacity in turn makes corporate stocks and bonds a poorer substitute for more liquid and safer assets like cash. This reduced substitutability further fuels the movement of households toward money hoarding and tightens the downward economic spiral. This process can also work in reverse to inflate a speculative bubble. If entrepreneurial investment is booming, in anticipation of increasing future profitability, then this buoyancy in capital markets induces higher prices for corporate equities. In such exuberant times, equities become a more attractive substitute for hoarded cash and households will shift their preferences toward equities rather than money demand. This increased availability of capital and the enhanced opportunities in a growing market creates a positive feedback loop that results in even more productive investment, a greater capacity for future production, increased output and income, and a greater motivation for households to save in the equity market. Just as the feedback loop can bring about a recession, these speculative frenzies can create an artificial financial boom.

A Keynesian solution If Keynes argued that the linkages assumed in the classical model are broken when the economy deviates from full employment and the outlook of economic decision-makers turn negative, he did not simply offer complications with no solutions. He recognized two avenues to overcome the insufficient demand that money hoarding creates. His first remedy, now called fiscal policy, was to use government spending and tax policy to compensate for the deficient demand of consumers. This fiscal or tax policy need not fill the entire gap in income and output vis-à-vis the classical full employment equilibrium. Rather, government policies need only be large enough to compensate for reduced consumption or investment in the first round. The fiscal policy would then create new second-round demand, which would then create additional rounds, albeit of decreasing demand until equilibrium is restored. Once households and investors realize that the full employment equilibrium has been restored, they, too, can resume the spending, saving, and investment patterns predicted by the classical model. Finally, Keynes proposed a monetary policy as well. If the monetary authorities can inject sufficient cash and liquidity into the banking and

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loanable funds markets, the greater supply of money lowers the price of holding money, or the nominal interest rate. If this reduction in the interest rate can encourage entrepreneurial investment, the deficiency in demand can be remedied within the private sector. Again, once households see the economy attain the full employment classical equilibrium, aggressive monetary policy can be discontinued as households and corporations resume their demand for goods and for additional productive capacity. However, the monetary authorities can become impotent in remedying these failings in spending on consumption and investment during a downturn. First, they can undertake too little monetary expansion early on and find themselves forced to undertake too much expansion when money hoarding is in full force. If such a situation occurs, any additional liquidity provided by the monetary authority is simply absorbed in cash reserves at banks or in the checking accounts of households. Second, if households and corporations decide to hold cash on the sidelines, additional rounds of monetary loosening become futile. This phenomenon, which Keynes labeled a liquidity trap, simply lowers the prevailing interest rate to the point where it can go down little further. Keynes had demonstrated that the power of the monetary authority to affect the money supply could, in turn, interact with money demand to determine the interest rate. However, driving the interest rate too low, through excessive expansion of the money supply, ultimately reduces the incentive to invest in our own economic future.

Real interest rate

Liquidity trap

Level of investment Figure 10.5 Keynes’ liquidity preference

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Even if the monetary authority does not expand the money supply so dramatically that interest rates are driven near zero and additional cash is simply absorbed by hoarding consumers, banks, and corporations, it can lose control of monetary policy through the avenue of pessimistic entrepreneurial investment shown above. Consequently, if the monetary authority commits insufficient intervention early in a downturn, the interest rate can remain arbitrarily low but with little effect on investment in capital goods. Only with recovery, a willingness to begin to shift hoarded cash into consumption and investment spending, and the re-establishment of a healthy link between the interest rate and investment can monetary policy renew its potency.

11 Applications

In a dramatic departure, John Maynard Keynes’ approach used little mathematics, no calculus or statistics, and little of the language that had been embraced by the economics discipline by the 1930s and 1940s. Rather, Keynes used intuition to describe those phenomena that the classical model had not covered. However, Keynes would stretch this point further. He stated that he neglected the mathematical approach not as a casual or convenient measure; rather, the various market psyche phenomena he was describing defied measurement. These factors also defied the application of the tools of mathematics that so depended on measurability. By requiring measurability, economics and finance neglected an uncomfortable truth that would fundamentally change the conclusions of the mathematical models. In effect, economics and finance sacrificed a description of outof-equilibrium phenomena precisely because a relaxation of the need for measurability would move the social sciences of economics and finance toward being a social art rather than a social science. Keynes stated: Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world.90 Keynes was a heretic among those looking for mathematically elegant solutions to complex human problems. Ironically, he saw sometimes aggressive and coordinated human intervention, through government on some occasions and through the monetary authority on others, as 107

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the way to cure the failings of our economy. However, in doing so, he created an art of a discipline that was well down the path of viewing itself as a science. Until recently, the Keynesian policy prescriptions had fallen out of vogue. A global economic sense that wavered between moderated optimism and exuberance kept us well away from the cycles of money hoarding, the liquidity trap, and pessimism in the investment strategies of firms that so troubled the financial markets of the Great Depression. At the time of this writing, in early 2011, almost three years into the longest and most significant recession and stagnation since the Great Depression, there is renewed interest an understanding of the Keynesian explanation for why an economy can so stubbornly maintain an underemployment equilibrium. The great stagnation that began in 2008 pushed the economy into a region of inflation and interest rates that had never been expected to occur again and which had not been seen since the Great Depression. In an attempt to jump-start an ailing economy, the monetary authority of the USA, the Federal Reserve, had pushed the interest rate it charged to its member banks to 0.25 per cent, a level not seen in the USA since the formation of the Federal Reserve in 1914. Never before has the Federal Reserve encouraged banks to borrow from it in an effort to boost the amount of cash at banks and motivate

16 14 12

%

10 8 6 4 2 0 1910

1930

1950

1970 Year

Figure 11.1 US Federal Reserve discount rate 1913–2010

1990

2010

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banks to lend. As a result, the US and European banks became flush with cash. This dramatic increase in cash liquidity began with the credit crisis of 2008. The breakdown in the mobilization of private funds for private investment that began in 2006–2007 as a consequence of the subprime mortgage market meltdown induced central banks worldwide to supplement this breakdown in liquidity with monetary authorityinduced liquidity. Central banks also pledged to induce as much cash as possible in the balance sheets of banks by purchasing government bonds held by banks and their customers. This unprecedented effort by central banks to expand the money supply forced the effective interest rate offered to banks down to a historically low level in the range of 0.00–0.25 per cent. If we confine the scope to the last 50 years, we can compare how the federal funds rate is correlated with the US Treasury six-month note rate. The two graphs demonstrate that the federal funds interest rate available to banks to supplement their liquidity is correlated with the interest rate on short-term, six-month US Treasury bonds, which are considered to be an almost risk-free savings opportunity and a relatively close substitute for money. When returns on such investment fall below 16 14 12

%

10 8 6 4 2 0 1960

1970

1980

1990

2000

Year Figure 11.2 US Federal Reserve discount rate 1960–2010

2010

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%

10 8 6 4 2 0 1960

1970

1980

1990 Year

2000

2010

Figure 11.3 US Treasury six-month bond interest rate 1960–2010

0.5 per cent, there is little reason not to hold assets in the form of cash. There is an incredible amount of liquidity in the financial marketplace and the cost of borrowing has never been lower. Meanwhile, publicly traded corporations have almost unprecedented levels of cash but are unwilling to invest in new plants until market demand returns. For the first time since Keynes wrote his General Theory, many major economies are suffering a liquidity trap and have little effectiveness left in potential future monetary policy. In an important speech on August 27, 2010 at an annual conference in Jackson Hole, Wyoming, the Chairman of the Federal Reserve, Ben Bernanke (1953–), iterated the Fed’s monetary policy: In 2008 and 2009, the Federal Reserve, along with policymakers around the world, took extraordinary actions to arrest the financial crisis and help restore normal functioning in key financial markets, a precondition for economic stabilization. To provide further support for the economic recovery while maintaining price stability, the Fed has also taken extraordinary measures to ease monetary and financial conditions.

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Notably, since December 2008, the FOMC [the Federal Open Market Committee – see glossary] has held its target for the federal funds rate in a range of 0 to 25 basis points. Moreover, since March 2009, the Committee has consistently stated its expectation that economic conditions are likely to warrant exceptionally low policy rates for an extended period. Partially in response to FOMC communications, futures markets quotes suggest that investors are not anticipating significant policy tightening by the Federal Reserve for quite some time. Market expectations for continued accommodative policy have in turn helped reduce interest rates on a range of short- and medium-term financial instruments to quite low levels, indeed not far above the zero lower bound on nominal interest rates in many cases. The FOMC has also acted to improve market functioning and to push longer-term interest rates lower through its large-scale purchases of agency debt, agency mortgage-backed securities (MBS), and longer-term Treasury securities, of which the Federal Reserve currently holds more than $2 trillion. The channels through which the Fed’s purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well. … Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus. I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities,

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(2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists – namely, that the FOMC increase its inflation goals. A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longerterm securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC’s recent decision to stabilize the Federal Reserve’s securities holdings should promote financial conditions supportive of recovery. I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses. Bernanke went on to add: The FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile

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to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.91 Later in the fall of 2010, the Federal Reserve formally announced another round of monetary loosening of up to $600 billion. While the Fed had acknowledged in the Jackson Hole speech that there was a risk of reduced effectiveness in its monetary policy as it over-exercises that policy avenue, it was concerned about another danger – the fear of deflation. Recall Fisher’s equation which states that the real interest rate is equal to the nominal interest rate less the inflation rate. If there is deflation, a real interest rate of perhaps 2 per cent can occur if the nominal interest rate falls to 1 per cent and there is a mild deflation of only 1 per cent. However, when nominal interest rates fall to 1 per cent or less, there is little reason to save in financial instruments instead of cash. Households will hoard cash in such deflationary circumstances. However, even more problematic is the consumption decision of households that see little or no opportunity to save through financial markets and a reduced motivation to purchase consumer durables. Bernanke, like perhaps no other Federal Reserve Chairman, was a student and lifelong expert on the Great Depression, and well understood the destructive dynamics of deflation and depressions.

Blurring the line between consumption and savings Consumer durables are an alternative saving instrument when households wish to avoid traditional financial markets. A consumer durable is an item, such as an automobile or even a house, that will provide consumption services over multiple years and will also retain some asset value into the future. If there is severe inflation, it is wise to spend income quickly before the money has a chance to depreciate. However, much of what we normally purchase can spoil or can only service our consumption needs for a brief period. High inflation induces an increase in the purchase of consumer durables so that households can stretch those consumption expenditures well into the future. In other words, consumer durables act as a substitute for saving. Alternately, deflation has the reverse effect. Falling prices encourage households to delay their consumption until later. By doing so, households expect that they can purchase the same consumer durables at a lower price in the future. In other words, the realization or

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expectation of deflation reduces consumption and further depresses current economic activity. To avoid this reduction of consumption and its concomitant reduction in economic activity, households must be convinced that prices will not fall. The Federal Reserve announced in the fall of 2010 that it would inject more cash into the economy not to convince households that it could create a resurgence of borrowing and investment in new plants and equipment; rather, it was using its monetary tools to ensure that the markets were flush with so much cash and liquidity that prices could not fall. The Fed must open up the monetary spigot to ward off deflation but must, at the same time, be prepared to quickly turn off the spigot before an unacceptably high level of inflation subsequently sets in. The ability to correctly time its monetary policy so precisely is most difficult. However, failure to ward off a dangerous deflation is even more problematic, as Japan painfully discovered over a lost decade that began in the 1990s and transitioned into a lost generation by the late 2000s.

The role of banks and the interest rate While a central bank can offer banks all the liquidity they might need, it requires banks to actually create money. Short of dropping money from helicopters, central banks require the banking industry to play its part. What the central bank can do is to pad the balance sheet of banks with excess cash. Banks are required to hold cash assets equal to about 10 per cent of their liabilities to depositors. The remaining mix are slightly less liquid assets, primarily government bonds, short-term loans and mortgages, or long-term loans, their least liquid asset of all. The art of banking is in balancing these various assets to ensure that they earn the largest return from the higher interest rate assets without jeopardizing their solvency. A bank must always strive for the greatest return from the (usually) least liquid and longest term assets, but must all the while ensure that it has a sufficient amount of short-term and more liquid assets on hand to cover the needs of its depositors. Because depositors can demand their deposits at any time, a bank is in the business of anticipating withdrawal risk. It must also face the risk of prepayment of long-term assets, a risk that rises as interest rates drop. A bank must maintain a precarious balance over time by establishing the optimal mix of liabilities, its deposits, and the loans that constitute its assets. Banks allocate these assets across the spectrum of maturities and liquidity to balance risk and reward. Should a bank find itself with too

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much or too little cash, it can temporarily lend to or borrow from other banks or borrow from the monetary authority. However, the interest rate it might earn on short-term lending is relatively small and may not be sufficient to cover the interest rate it promised its depositors. Certainly, banks prefer to lend to longer term borrowers willing to pay a higher interest rate determined by their demand and by the collective supply of loanable funds from banks and near-banks. It is the decisions of many lenders, from banks and their competitors, and the needs of entrepreneurs that ultimately determine the market interest rate on personal and commercial loans and on mortgages. However, while the monetary authority can provide funds to banks to ensure that they do not fall temporarily short of cash, the willingness of borrowers and banks to borrow and lend sets the prevailing marketwide interest rate and level of investment. The monetary authority does not set these interest rates, even though it may influence them. As noted in the previous chapter, it is even possible that the monetary authority can lose almost all its influence in reducing the interest rate. Once the discount rate it offers its member banks nears zero per cent, there is little else it can do of much influence through its discount window. Even if this discount window tool is exhausted, a central bank can still engage in what are called “open market operations.” By purchasing existing government treasury securities in the secondary market, a central bank can cause its member commercial banks to be more flush with cash. Certainly, if a central bank purchases the securities directly from a bank, the bank’s balance sheet will be more cash-rich and short- to medium-term asset-poor because of the bond sales to the central bank. However, even if the central bank purchases the securities from private individuals, these individuals find themselves more cash-rich and bondpoor. Because individuals keep their cash in the bank accounts, for the most part, banks again find themselves managing more cash. Either way, banks that find themselves with more cash than is required by federal cash reserve requirement mandates will then look for avenues to invest their excess cash in ways that will earn a return that will generate revenue for them. Ideally, they would lend the money out to creditworthy entrepreneurs. However, if there is a dearth of such lending opportunities, perhaps because entrepreneurs are also cashrich and do not want to invest in new plants and equipment until the economy improves, or if entrepreneurs are so hurt by a poor economy that they are not a good credit risk, banks may have no medium- to long-term lending opportunities. Ironically, they may respond to the

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monetary authority’s open market bond purchases from banks and their customers by using the cash to repurchase bonds. The increased frequency of bond purchases that would result, of course, has the effect of increasing the demand and price of bonds or, equivalently, reducing the yield and effect interest rate on bonds a little more, until, on rare occasions, bond yields can actually turn negative, as witnessed in the aftermath of the credit crisis of 2008. To compound the irony of an ineffective monetary quantitative easing, short-to medium-term interest rates decline, which would even further pinch the ability of banks to generate revenue if they must convert these excess monies into interest-bearing assets that offer lower yields than those that were sold from under them. This frustration in the execution of a bank’s business plan that requires it to borrow money from depositors and lend it out at a higher rate to borrowers becomes problematic when interest rates become too low. The decreased bank profits also make banks more conservative in their lending practices, as their cushion from which to take some lending risk is reduced. If there is such excessive quantitative easing that interest rates are forced very low when, at the same time, there are few willing and creditworthy borrowers, additional quantitative easing may compound, rather than reduce, the economic problems.

The interest rate While economists often speak of the interest rate as a monolithic number, there are as many interest rates as there are investment vehicles. Some of these interest rates are predetermined and fixed. For instance, the rate on a mortgage or car loan may be fixed. However, even these fixed interest rate instruments are not entirely fixed. If the interest rate on similar mortgage or loan instruments falls, the borrower may choose to refinance his or her loan. This prepayment risk must then be absorbed by a bank that will be forced to exchange its expected flow of returns from the original loan with smaller returns from the refinanced loan. Of course, this prepayment risk does not occur in an environment of tightening credit and rising interest rates. However, in an environment in which interest rates drop sufficiently, banks often pay a price, even on their existing long-term investment assets. Consequently, even a fixed interest rate will not necessarily provide a fixed return. Similarly, if the interest rate offered on a long-term bond is fixed, it will not provide a fixed yield.

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To see this, let us demonstrate the way prices, the interest (or coupon) rate, and yields are related for bonds. In the next volume in this series, we shall look more closely at risk. For now, let us assume that, in exchange for the purchase price P of the bond, the bondholder has the right to obtain a risk-free coupon rate return c offered on a bond for the life T of the bond. Upon maturity, the face value F of the bond is returned to the bondholder. These securities are called bonds if they have a maturity over ten years, notes when maturity falls between one year and ten years, and bills when the maturity is 13, 26, or 52 weeks. Because coupons are redeemed every six months, the shorter duration bills do not offer a coupon payment. Instead, they typically sell at a price lower than the face value returned to the buyer upon maturity. The US Treasury-issued government securities have a face value that can range from $1,000 to $1 million. If this coupon rate c is less than the prevailing interest rate i for similar instruments, then the bond would not be attractive. Instead, savers would want to purchase the close substitute that offers the higher return. However, these bonds could be sold at a discount, either at the initial auction of the bonds or subsequently. It is not difficult to calculate the value of a risk-free security that offers a fixed return and then returns the face value upon maturity. Let us first calculate this value P that a secondary market would be willing to bid for a Treasury bill. We will then cover the slightly more complicated case of bonds and notes. The price P of the Treasury bill is simply the present value of the security that will pay a face value of F upon maturity. This maturity T is less than one year for bills, with no coupon payments c paid in the interim. The value of this security depends on the prevailing risk-free nominal interest rate i at each point in time. The formula, in continuous time, is given by: P  FeiT Because the prevailing nominal interest rate i is greater than zero, eiT is less than one, and the price P of the Treasury bill is necessarily less than the face value F. In essence, the note is sold “at a discount,” with the discount rate representing the foregone nominal interest rate i the saver could have earned otherwise.

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We can also see that the price P of a Treasury note rises in proportion to its face value F and also falls with the alternative nominal interest rate i and the time to maturity T: dP/dF  eiT  0 dP/di  T FeiT  0 dP/dT  i FeiT  0 The inverse relationship between the price of a bill on the secondary market and the prevailing interest rate is well understood. As the interest rate i rises, the prices of Treasury bills of similar risk and maturity fall. The pricing of notes and bonds is similar. For the sake of simplicity, as before, let us assume that interest rates and returns are in continuous time. Then the present value and price P of a note or bond that has T periods until maturity and offers a coupon rate c per dollar of face value is a function of the prevailing nominal interest rate i for other risk-free assets of similar maturity: P 

∫0 cFeit dt  FeiT T

We can divide both sides of the equation by the face value F to directly measure whether the price of a bond is at a discount or premium: P/F 

∫0 ceit dt  eiT T

Solving this bond pricing integral gives: P/F  (c/i )(1  eiT )  eiT Note first that the above expression simplifies if the nominal interest rate i is equal to the coupon rate c per dollar of face value: P/F  1 when c  i, or PF The price of a bond is equal to its face value if it offers a coupon return c that is equivalent to the yield offered on similar risk-free assets of the same maturity.

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Intuitively, the price of a note or bond would rise if it offered a higher coupon rate: d(P/F )/dc 

∫0 [ eit dt T

⎛1⎞  (1  eiT )]⎜ ⎟  0 ⎝i⎠

As before, we can also determine how the prevailing interest rate i for other risk-free assets of similar maturity will affect the degree to which a note or bond sells at a discount or at a premium. An application of Leibniz’s rule gives: d (P/F )/di 

∫0 tceit dt  TeiT T

The integrand is negative at all times, which allows us to conclude that the value of a bond in the secondary market is negatively related to the nominal interest rate: d (P/F )/di 

∫0 tceit dt  TeiT T

 0

As the prevailing interest rate rises, the price of existing bonds falls to ensure that they yield, through their coupon payments and their discounted or premium price, a return equivalent to financial instruments of comparable risk. We can apply Leibniz’s rule once more to determine how the price of a note or bond is affected by the time to maturity: d(P/F)/dT  ceiT  ieiT  (c  i)eiT > 0 if c > i < 0 if i > c A longer maturity makes a note or bond more valuable if its coupon rate exceeds the prevailing interest rate on risk-free assets of similar maturity and sells at a greater discount if its coupon rate is less than the comparable market interest rate i. Such risk-free assets as US government securities act as versatile vehicles that adjust in price to yield the same return that prevails in the marketplace. However, up to now, we have discussed only the interest rate, or the various interest rates as a function of the maturity of the underlying instrument, for risk-free assets only. In the next volume in this series, we will incorporate risk into the analysis. We can already see that there is no single interest rate in the Fisher or the Keynesian theory.

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Instead, there are a plethora of interest rates and effective yields for even risk-free bonds, based on their coupon rate and maturity. These various interest rates give households an opportunity to defer consumption at any point in time, with some knowledge of the amount of consumption they can purchase in another period in the future. This proposition is true if consumers accept the market’s expectation of inflation that is incorporated into the nominal interest rate, as supposed in the Fisher equation. However, we must still consider how households’ regard for whether a prevailing market interest rate creates an opportunity to save for retirement or borrow to invest in their future at different points in their life cycle.

12 Life and Legacy

John Maynard Keynes’ legacy stems primarily from his theory of optimal economic policy during recessions and stagnations. However, forgotten in the invocation of Keynesian policies to expand macroeconomic output and income, and to reduce unemployment, is that Keynes stood squarely in the middle of the debate over the meaning and significance of interest rates. Like Irving Fisher, the father of a classical interpretation of the role of the interest rate, Keynes also tied consumption, future consumption, and savings to the interest rate. In doing so, he was equally significant in our interpretation of the interest rate and its effect on consumption and savings. While Fisher is often regarded as a pioneer in the study of finance, Keynes is rarely remembered for his contribution to our understanding of interest rates and personal finance. Rather, we must remember that Keynes’ most influential treatise, The General Theory of Employment, Interest and Money, expressly described the role of, and a new interpretation for, the interest rate and devoted one of the three main sections to the interest rate and investment.

The legacy of Keynes Following the Great Crash of 1929, the classical model predicted that there should be no dramatic or cataclysmic economic change. In the week after the Crash, factories continued to churn out goods and the unemployment rate did not rise substantially. Indeed, one year later, the Dow Jones Industrial Average on the New York Stock Exchange had recovered 90 per cent of its value. However, the classical model, as espoused by Fisher, did not take account of consumer psychology. Instead, it was driven by what could be. The potential production for a well-managed economy dictated its 121

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results. In fact, if the economy does not behave as efficiently as suggested by the classical economy, this difference is sometimes called an X-inefficiency, suggesting that it arises for reasons unknown, not unlike the animal spirits identified by Keynes. One aspect of this creeping underperformance that became apparent in 1930 was a growing pessimism on the part of consumers. Obviously, part of this pessimism arose from the loss of household wealth because of the stock market crash. In other words, if households felt that their future income, or what we will soon call our permanent income, had suffered because of the Great Crash, then they would be expected to adjust their pattern of consumption downward and savings upward. If, however, there was a dearth of promising investment opportunities, savings could be kept in cash and economic output would suffer. The subsequent but brief stock market recovery in 1930, too, may have been deceptive. Less sophisticated and well-heeled investors lost heavily and may have been forced to liquidate through margin calls. Hundreds of thousands of other investors were so terrified by the Great Crash and by their losses that they would move their assets into cash, as Keynes eloquently suggested and as we, again, saw following the credit crisis of 2008. While the market temporarily recovered 90 per cent of its value, the recovery was based on the prices determined by a much smaller volume of traders. There was simply an insufficient depth and wealth in the market to support the valuation of firms following the Great Crash of 1929. In 1929 and the few years thereafter, much of the motivation behind the downward price spiral that would soon ensue was a change in consumer sentiment. Indeed, as firms were approaching the end of the Roaring Twenties, many agreed with Fisher’s optimism that predicted the economy would soon enter the “Terrific Thirties.” However, as a consequence of increasingly fearful and timid consumers in 1930, consumption and, with it, the sales of firms began to drop. This contraction meant that inventories grew, which gave the statistical impression of continued investment. Meanwhile, the cutback on new investment and the reduction of production meant that lay-offs began. At the same time, some overextended banks and investment houses failed, which made nervous households even more financially fearful. In the next few years, the downturn precipitated a cascading of bank failures. At the beginning of the Roaring Twenties, 30,000 banks were operating in the USA. Through the 1920s and the Great Depression, banks failed at a rate of 550 per year.92 These bank failures also wiped out more household savings and forced more households to withdraw their savings from the financial markets.

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Finally, it is not unusual for any economy under tremendous stress to retrench. This retrenchment was already underway with some of the economic travails and volatility of 1928. In response, the Smoot Hawley Tariff Act of 1930 was designed to sustain domestic growth by discouraging imports. However, at the same time, Europe and Britain in particular were still trying to recover from the aftermath of the First World War. The “beggar thy neighbor” discouragement of imports by the USA solicited the expected response from its trading partners. The beginnings of a trade war would not help either side of the Atlantic avert the consequences of reduced trade for both sides. Keynes, in his A Treatise on Peace, had already warned nations of the consequences of onerous economic policies designed to further one nation at the expense of another. As early as 1920, he recognized what we now call the Prisoner’s Dilemma. What might appear ideal and opportunistic for one group or individual at the expense of another would be problematic for both if the other groups or individuals adopted the same strategy. As a high-level civil servant at a critical time, Keynes well understood the necessity for win-win strategies, especially in those economically most challenging times when households and nations find a win-lose, constant sum game outlook most appealing. Keynes’ “paradox of thrift” had this very quality. While the thriftiness of consumers from 1930 onward seemed to be the only sensible strategy for households concerned about preserving wealth in uncertain times, it is this very thriftiness that brought on reduced consumption and, from that, reduced aggregate demand, employment, output and income, and brought about financial ruin. These losses further depressed stock prices, wealth and economic investment, and tightened the downward spiral even more dramatically. Consumers, in their pursuit of an individually optimal strategy, confounded the entire economy and ultimately the collective wealth and income of consumers, including themselves.

The stature of Keynes, then and now In 1936, with the publication of his General Theory, Keynes had reached the apex of his career and, it turns out, his life. He was still relatively young at 53 years old and should have been able to maintain the vigor that would allow him to “campaign” his new and controversial theory, as a world in the midst of a global depression would have listened with rapt ears. However, Keynes had suffered a bout with appendicitis in 1915. The illness had been complicated by a pulmonary embolism and would give

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him problems for much of his adult life. This lifetime of heart strain culminated in a thrombosis of his coronary artery and made him gravely ill. He had to cancel an increasingly active calendar and commit to an extended recuperation.93 At the same time, Keynes’ corporate directorship duties commanded his attention, as did the accelerating recognition that Britain must prepare for Germany’s rebuilding of its armament industry and threatening of its neighbors. While he was unable to attend to all those who desired his appearance, he continued to write. For instance, he produced a paper that was, as was typical for him, focused on the pending war preparation predicament. The paper recognized that economies, too, must invest in the future, especially as they may prepare for war or hardship. He argued that the government must play the leading role in such investment, not because it is best positioned to do so but because there are no other sectors that could do so. The private sector lacked the prescience to do so and would create gyrating commodity prices if such preparation were left to the free market. His notion of “stockpiling” was soon to be applied commonly, in Britain, the USA, and Canada, as these nations found themselves newly entangled in a war with Germany.94 Ironically, Keynes found himself returning to the same policy matters in preparation for the Second World War as he had a quarter of a century earlier with the onset of the First World War. He had argued for a transfer from consumption to savings so that resources could be diverted to the war effort.95 His recycled ideas resulted in a book entitled How to Pay for the War in 1940.96 His argument for a compulsory war savings bond has been invoked many times since, most recently in the war on terror following the attack on the World Trade Center in 2001.97 The innovation of his treatise on war finance was the extension of his Depression-era theory into wartime and the incipient shortages and inflation of commodity prices that it inevitably brings about. He had recognized that an economy accelerated beyond its natural capacity by wartime necessity may solve the problem of unemployment but would inevitably create a destabilizing inflation. By injecting himself into this discussion of compulsory savings and reduced consumption in order to cool the heels of inflationary forces and to direct resources to the war effort, Keynes was once again in intellectual demand. His emphasis on a method of expanded savings from the public, rather than from forced taxation, allowed the USA and Britain both to partially fund the war without a significant increase in the interest rate and a reduction in private investment in the productive capacity of either nation. His method of forced savings would also

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avoid the shortages and displacements that price controls and rationing cause. In fact, authorities on both sides of the Atlantic induced patriotic savings, through war bonds, price controls, and rationing, and thus adopted Keynes’ recommendations, albeit only in part. In this period, Keynes counseled prime ministers and presidents, who would meld his ideas on the economy with political reality. He continued to manage the finances of King’s College, Cambridge, joined the Bank of England as a director, and continued as a director on the board of a major insurance company, a governor at Eton, and as the editor of the prestigious Economic Journal. He also continued his devotion and major patronage in the arts in support of a lifelong interest and of his ballerina wife, Lydia Lopokova, Lady Keynes. His support of the arts had consumed a significant amount of his energy in his adult years and had also been the most significant beneficiary of his generosity. He also supported other causes. Perhaps most notorious in our present times was his interest and belief in eugenics, the practice of the genetic purification of the population, a fascination which he shared with his predecessor, Irving Fisher. By the latter half of the Second World War, Keynes had become an economic statesman. He became immersed in his last great contribution – the motivation and assembly of the United Nations Monetary and Financial Conference in 1944 and its creation of a World Bank that could facilitate finances among the developed and allied nations. Commonly called the Bretton Woods Conference, after the town of the same name in New Hampshire, the event gathered representatives from all 44 Allied nations at the Mount Washington Hotel on July 1–22, 1944. The Bretton Woods Conference culminated in an International Bank for Reconstruction and Development, the General Agreement on Tariffs and Trade (GATT), and the International Monetary Fund (IMF). It also created the system of managed exchange rates that remained in place until movement away from the gold standard and toward freely floating exchange rates were adopted in the 1970s at the behest of the then President Richard Nixon. President Franklin Delano Roosevelt opened the Conference with the following words: The economic health of every country is a proper matter of concern to all its neighbors, near and far.98 Lord Keynes was the chief British representative. The Conference remains arguably the single most significant conference of economic

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powers to date and represented the pinnacle of Keynes’ influence on the world stage. Keynes made the closing speech and the 730 delegates punctuated his exit from that global stage with the singing of “For he’s a jolly good fellow.”99 In contrast, while Irving Fisher had sought the ear of the various political leaders for a lifetime, he never attained the role of economic statesman he so furtively desired. Throughout the Great Depression and challenged by his self-determined movement from modest means to great wealth, and back to less than modest means, Fisher tried to interest leaders in his ideas of price indexing and monetary growth. Indeed, he had written to Keynes while Keynes was attending the Bretton Woods Conference in an attempt to induce Keynes to champion an approach to monetary reform he favored. Following the war, Keynes also busied himself with the negotiation of loans from the USA to promote the recovery of Britain. His diplomatic forays to Washington DC and his advocacies on behalf of an effective international monetary system were taxing and were punctuated by a series of heart attacks. He died on April 21, 1946 at the relatively young age of 62, only a few weeks after returning from America. Irving Fisher died a year later. Keynes’ wife, Lady Lydia Keynes, would not pass away for another 35 years. When contemporaries now speak of Keynes, they invariably refer to a theory of unemployment and the recommendation of government spending as a remedy. The neo-Keynesian interpretation of his theories invariably says little about his contribution to the interaction between interest rates, consumption, savings, and the role of financial markets. Rather, his theory is typically invoked to justify an injection of government spending to reverse the pernicious effect of the paradox of thrift and its concomitant reduction in consumption. Contemporaries commonly argue that Keynesian theory ought to be used to guide a temporary response to a short-term disequilibrium. Once the economy re-establishes itself at the full employment, classical equilibrium, the Keynesian prescription can be abandoned and the economy can resume its long-term solution. In other words, Keynes’ theories are relegated to the explanation of a short-term disequilibrium phenomenon. When asked about this shortterm interpretation, Keynes famously exclaimed: The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again. (Emphasis added.)100

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Many have interpreted Keynes’ pronouncements as advocacy for expedient government solutions to pressing economic problems. Actually, he was noting that his theories, especially his General Theory, should not be regarded as a temporary fix to a short-term problem. His theories demonstrated how the economy can come to rest for an extended period at an equilibrium different from the classical equilibrium, with potentially high unemployment. Instead, he was imploring commentators to recognize that a depression can be an almost permanent state unless there is a coordinated effort to overcome the psychological forces that at times bring an economy and financial markets to their knees. Keynes should be remembered as the first to detail the reasons why we consume and would thus augment Fisher’s theory of why we save. Keynes also introduced a much richer interpretation of the interest rate. The interest rate should not be viewed simply as a price that would equilibrate savings and investment. Instead, Keynes refined the meaning of investment as the creation of additional future productive capacity and noted that savings can be placed in a variety of different instruments, some of which he would consider to be true productive investment and others which would serve the savings function by responding to the needs of consumers to preserve the value of their wealth, rather than simply defer consumption, as Fisher would have maintained. Consequently, there is not simply one interest rate or one monolithic investment market. Moreover, the decisions of consumers with regard to their personal finance are much richer and much more prone to financial market failure than the classicists would admit.

Section 3: Franco Modigliani

John Maynard Keynes vastly enriched Irving Fisher’s simplistic but revolutionary classical description of savings and the interest rate. In doing so, Keynes motivated present consumption by including its dependence on current income. At the same time, he also described the other side of the same coin, household savings, as the difference between disposable income and present consumption. Most importantly, he demonstrated that savings need not equal the investment in an economy’s productive capacity. However, Keynes did not fully incorporate the important role of future income and wealth expectations in the consumption, and hence the savings, decision, even if at times he alluded to such a link. Consequently, he did not provide a blueprint for a lifelong cycle of consumption and savings. Without such an integration, our understanding of financial markets remained incomplete. We next turn to the work of Franco Modigliani, whose contributions filled this conspicuous gap. He would discover how households determine lifetime consumption and why consumption is much steadier, and savings are more volatile, than Keynes predicted. For the first time, he also understood why economic growth expands savings, both at the national and household levels.

13 The Early Years

In 1918 Irving Fisher was on his way to making his first million dollars and was contemplating the suitability of the term “utility,” coined by Professor William Stanley Jevons.101 Students of economics and finance still ponder this term today. Keynes was working on his first major and popular book, The Economic Consequences of the Peace. Fisher was 51 years old and Keynes had just turned 35. Meanwhile, in Rome, Italy, on June 18, 1918, Franco Modigliani was born. Franco Modigliani represented the third generation in the evolution of our understanding of savings and the interest rate, and the creation of the study of personal finance from its economic roots. He would also be the first person to preside over both the American Economics Association and the American Finance Association. Modigliani is certainly an esteemed name. Franco’s distant cousin, Amedeo Modigliani, a contemporary of Picasso, is often mentioned in the same breath as Van Gogh.102 Amedeo died before Franco was two years old, after a short life during which he created memorable modern-style paintings and sculptures. He passed away before an Italian of Jewish heritage would be in grave danger in Italy. It would not be long before anti-Semitism would dictate his cousin Franco’s fate. Franco’s mother, Olga Flaschel, was an activist on behalf of the poor. His father, Enrico, was a well-known pediatrician and a social activist in Rome. Together, they advocated for young unwed mothers who had unplanned pregnancies. His family life was loving, committed, and surrounded with a compassion for the less fortunate. Franco’s family had lived in Rome for centuries, likely following the expulsion of the Jews from Spain.103 His grandfather was a tradesman, as were three of his grandfather’s four children. Franco’s father Enrico was 129

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the first in the family to attend college, aided by his two older brothers because their own father had died while Enrico was still young. Enrico had an Italian zest for life, laughter, and song, a love for life that Franco would inherit. However, like his father before him, he would die quite young, before Franco would even enter college at the precociously young age of 17, just as Irving Fisher had experienced half a century before him. Franco’s mother played an important role in his upbringing. Olga was of Italian and Polish decent, with a Polish grandfather, Emilio Flaschel, from Krakow, and an Italian grandmother, Ernestina Cagli, from Florence. Olga’s father, Emilio, was an arbitrageur, dealing in pearls and coral between Poland and Italy. The Flaschels’ daughter Olga was unusual in her day. She had graduated from the University of Rome, the city where her father created a lucrative and elegant pearl and jewelry shop. Olga was fluent in French, German, Italian, and, eventually, English. She was a Renaissance woman in the heart of the Renaissance region. In addition, she instilled her spirit of volunteerism and command for languages on Franco, who would eventually learn to speak Italian, English, German, and French, and study Greek and Latin. Just as Irving Fisher had shown a great inventive and capitalist streak at an early age and John Maynard Keynes had demonstrated a knowledge of the interest rate in childhood, Franco Modigliani had an early foray into the monetary system and finance as a teenager. He spent part of one summer at a seaside resort home of his cousins. There they played to earn a currency based on caramels, gum drops, and peanuts. The commodity-based economy they created required a finance minister to monitor and manage the exchange rates between the commodities and Franco was elected to the position to prevent arbitrage between the currencies. Unfortunately, their informal little youth group caught the attention of the local fascists, who shut these budding republicans down for their subversion.104 Franco did not initially thrive in high school. He was viewed as an underachiever and had been scolded as a response to one of his essays with the comment “They that sow the wind shall reap the storm.”105 Franco earned a fresh start and a clean break when he managed to transfer to one of the best high schools in Rome, Italy’s equivalent of Eton in England. However, his stay there was briefer than most. He decided to take the graduation exams a year early, after only two years of liceo study. As was the pattern for these great minds, he was precocious; despite having previously skipped the fifth grade of grammar

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school, he managed to pass the exams with little to spare. However, his decision to begin attending college in 1935 was fateful. Had he not been able to complete college by 1939, as a Jew in Italy at the beginning of the Second World War, he would have little opportunity to complete at all. Franco enrolled to study law in 1935 at the University of Rome. At that time, the law school curriculum included economics, for which he discovered a natural affinity. His facility for German and his penchant for economics were instantly employed so that he could translate German journal articles into Italian on behalf of the Traders’ Federation, a group active in Italian politics in the run-up to the fascist era. At that time, Keynes’ thoughts on price controls were, rather ironically, all the rage in the German press. The Italian government, too, was exploring price controls as a way to cope with its war campaign in the Second Italo-Abyssinian War over the nation now called Ethiopia. There could have been no more expedient way for 17-year-old Modigliani to rise to the head of the class than through his translations. Indeed, his essay for the year’s competition on price controls won the top prize. While, like many intellectuals and college students at the time, Modigliani was anti-fascist, his prize was awarded to him in person by Benito Mussolini.106 A couple of years into college, Modigliani became reacquainted with the granddaughter of his maternal grandmother’s lifelong friend from Florence. Serena Calabi had met Franco when they were children. However, upon their reintroduction in Rome, Franco rapidly fell into a love that would last for the rest of his life. Franco and Serena soon became inseparable.

A new life However, while Franco and Serena remained together in Europe and soon married, they found themselves in exile from Rome. Serena’s father had increasingly run afoul of local authorities as fascism began to take hold. He advised his daughter and future son-in-law to flee Rome. They eventually found themselves first in Lausanne, Switzerland, and then in Paris, where Franco would complete studies toward his degree. Through his studies, he was able to qualify for his Juris Doctor degree, which he accepted during a brief trip to Rome in 1939 at the age of 21. That year, Franco and Serena were married at the Italian Consulate in Paris. From there, they made their way to the USA. On August 28, 1939, the Modiglianis arrived in New York. Four days later, the Second

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World War broke out in Europe. Modigliani’s timing could not have been better. Many of Serena’s Calibi family had come to the USA earlier. The young Modigliani couple had a community of family and of other Jewish exiles awaiting them in New York. This group supported each other, while Franco earned a modest income importing Italian books into New York, at least until Italy entered the war in 1940. He also secured a full scholarship to the New School for Social Research in New York City, where he could pursue graduate studies in economics in a most rich intellectual environment at a most turbulent time. While at the New School, Modigliani came under the tutelage of Jacob Marschak, a brilliant theorist well versed in the mathematical techniques coming into vogue in economics and who was also an economist who fled Europe ahead of Hitler. Marschak exposed Modigliani to new mathematical tools and Modigliani also immersed himself in the new theory of Keynes as America struggled to come out of the Great Depression. He was particularly influenced by the Keynesian prophecy that macroeconomic markets can remain in a persistent and troubling equilibrium almost indefinitely unless there is sufficient government intervention. He had found another lifelong love – for economics. Modigliani continued his book business and work on his thesis for the New School. He also accepted a teaching position at a women’s college within Rutgers University in New Jersey and another at Bard College at Columbia University. He would rejoin the New School in 1944, the same year in which he succeeded in publishing a version of his thesis on liquidity preference in the prestigious Econometrica journal.107 In 1947 Modigliani was invited to join Harvard by the economics faculty there. He explored the idea, but was convinced by the economics department head at Harvard that he would be better off as a big fish in a smaller pond. He attributed the encounter to anti-Semitism and an anti-European bias that was informally promulgated within higher education in the USA in the aftermath of the Second World War and the run-up to the Cold War.108 The following year, however, Modigliani was invited to the University of Chicago on a $3,000 fellowship, which was very generous at that time. There he continued his work on what would become the Life Cycle Hypothesis and also gained a professional relationship with Milton Friedman, another future Nobel Laureate; he also began to work at the nearby University of Illinois on a research project entitled “Expectations and Business Fluctuations.”109 He was at once immersed in the new and influential areas of savings and the interest rate, expectations, choice

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under uncertainty and game theory, and forecasting. He understood intuitively that this new branch of study was significant in its importance. He likely did not know that it would form the basis for the study of modern personal finance.

The Illinois years Modigliani thrived at the University of Illinois. By the age of 32, he had become a full tenured professor, something most economists did not secure until their late thirties or forties, especially at the most prestigious schools. This relationship would last for only a few years. The person who hired him and a number of other young economists had awakened and frustrated an old guard of the economics faculty that was both unproductive and resentful. Soon, Modigliani was the only young economist who remained in the economics department at Illinois. At that point, he realized he must seek a healthier environment. When he left, the local newspaper proclaimed “Modigliani Leaves With A Blast – Now There Will Be Peace in the Department of Economics: The Peace of Death.”110 Were the story covered on the sports page, it might have offered a familiar headline: “Old Guard 1, Change Agents 0.” However, the Illinois experience was formative for Modigliani. While working on a research project on expectations and business fluctuations, he began to contemplate whether expectations could create the instabilities that had beset finances and the economies of the world for the previous two decades. He had admired the work of Keynes and had been receptive to the inclusion of psychology in financial decision-making. Certainly, the eclectic approach that integrated the social sciences that was the hallmark of the New School also prepared him for a more expansive view than the deterministic classical school could provide. Throughout the “Expectations and Business Fluctuations” project, Modigliani became aware of a fundamental motivation of managers: to plan a firm’s production chain to reduce the destabilizing effects of seasonal sales fluctuations. An even production flow rate could reduce the costs of overtime and of change that would otherwise be imposed if the production process were exposed to wild fluctuations. Managers must learn to plan for a longer production cycle than the mere short run.111 Modigliani also learned to appreciate the sophistication that managers applied to forecast future supply and demand to inform their production and inventory decisions. He recognized that some aspects of our expectations are irrelevant. If a firm must plan and scale up for the peaks, those decisions became irrelevant once demand falls off

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following a seasonal peak. Modigliani was one of the first to capitalize on inventory theory as an analogy that could be extended to savings and investment decision-making. Finally, Modigliani recognized that the failure to take into account predicted cyclical variations could lead to serious forecasting problems. Many understand seasonal variations and appropriately look at same quarter, previous year numbers to better predict same quarter, current year market dynamics. However, variations may also occur monthly rather than seasonally or quarterly. In addition, there may be longer cycles involving economic growth and population dynamics that most do not consider, let alone model. He began to recognize that forecasting and the creation of rational expectations for the future was a much richer, underappreciated, and potentially fertile area of research. Such modeling has obvious applications to financial markets. From this basis, his Life Cycle Hypothesis approach to lifelong savings and the interest rate began to form in his mind.

14 The Times

John Maynard Keynes had provided those who study personal finance with a new understanding of the role of savings. His model determined that the savings rate should depend on a household’s level of income. Irving Fisher had earlier developed a model under the not unreasonable assumption of what are known technically to be homothetic indifference curves, for which the savings rate remains constant as income rises. Keynes departed from this assumption and instead offered motivation for a vast array of instruments that acted as imperfect substitutes for each other in our financial decisions. Savings were a substitute for current consumption. However, savings were not merely deferred consumption; they represented aspects that were precautionary and speculative and could be realized in many ways, some of which flow into traditional investment markets that increase future productivity, but others of which do not. Of course, Fisher initiated the discussion of consumption and savings within the first well-specified formal model. Moreover, Keynes added dramatically increased richness in the factors that affect our savings decisions and the interest rate. While Keynes’ model added theoretical richness, it had a serious shortcoming: it did not include in a household’s decisions what they expected to earn in their future. To be sure, Fisher speculated about the importance of lifetime income in his 1930 version of The Theory of Interest. However, no theorist had yet fully studied the financial decisions of individuals faced with a lifetime of planning. Likewise, no researcher had ever described the macroeconomic implications of a more complete model. The time was ripe for such an elaboration. Keynes had developed a theory of consumption and savings that was driven primarily by the level of one’s income in a given period. He had 135

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postulated the following relationship between disposable income and consumption at every point in time: C  C0  bY while savings are simply income less consumption: S  (1  b)Y  C0 The term C0 was labeled autonomous consumption and represented that necessary element of consumption to support life even if income was zero. In such a case, the household would have to borrow (dissave) to support its essential consumption. As income rose, a constant share b of their income would permit increased consumption. This share was labeled by Keynes as the marginal propensity to consume out of current income. From these expressions, it is simple to show that the average savings rate S/Y should rise with income: S C  (1  b)  0 Y Y We see that, as income rises, the savings rate continues to rise as it asymptotically approaches 1  b. However, this increasing savings rate becomes problematic. Increased savings would increasingly exhaust productive investment opportunities and would result in steadily decreasing investment reward.

A problem with savings Within Keynes’ simple model, consumption would not keep pace with increased income. These results are paradoxical because consumers must purchase the goods that a growing economy produces. In addition, the model did not sufficiently motivate the reason for additional savings. Surely, households do not save simply for its own sake. Every household recognizes that savings provide economic security for later years when income is expected to decrease or cease. Such a static model of savings seems incomplete. At the same time, the model would not provide a good fit with the long-term data. The economies of the USA and Europe had experienced

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wild gyrations in income and employment from the Roaring Twenties to the Dirty Thirties and then the Warring Forties. Each of these decades was fundamentally different from the others in terms of income, economic temperament, expectations, and employment. However, over 25 tumultuous years, the average level of consumption, as a share of income, remained relatively constant, as did savings by age as a share of expected lifetime income. Clearly, there was some stabilizing factor that tended to even out the savings decisions of households, even if these savings could find their way into a fair number of assets, depending on market conditions.

The consumer as king Prior to Keynes and Franco Modigliani, Say’s law dictated the economic day. The early nineteenth-century political economist Jean-Baptiste Say (1767–1832) had argued that the supply of goods and services created its own demand. This premise extended the microeconomic concept of equilibrium in individual markets to the macroeconomy, under the premise that a macroeconomy was simply the aggregation of a large number of microeconomic markets. If it was the supply of goods and services that created income and it was the income that allowed consumers to purchase production, then supply created demand. Consequently, in this classical paradigm, there was no need for government intervention in markets so long as producers created the goods that consumers would demand. Keynes was troubled by this simplistic classical conclusion. He recognized that demand in the aggregate was not constituted solely by the collective decisions of a monolithic consumption sector. Instead, consumers and government, the foreign trade sector, and entrepreneurs investing in new productive capacity all combined to create demand. In addition, their incomes from which to spend were not so immediately formed from the income generated by producers. In other words, the financial world recognized the importance of the decisions of consumers. Personal finance became much more important as a determinant of the success of the macroeconomy than as a consequence of it. There was also greater recognition of the differences among various classes of consumers. If the wealthiest 1 per cent of all households own 40 per cent of all wealth, changes in the spending pattern of this significant group could have a dramatic effect on the overall economy.

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Keynes, too, had reflected upon the incompleteness of his model in a way that was not unlike the observation of Fisher. In his 1936 treatise, Keynes noted that: … men are disposed, as a rule and on the average to increase their consumption as their income increases, but not by as much as their increase in income.112 Keynes imagined that it would be a relatively simple matter to determine the actual rate of savings as a function of income. However, as empirical work was time-consuming and tedious, in contrast to the compact and powerful mathematical analysis employed by theoreticians, he left it to others to fully flesh out such issues as the rate of savings and consumption, out of disposable income (after tax), from the data. Most notably, Keynes commented on the work of the RussianAmerican economist Simon Kuznets (1901–1985), who had demonstrated remarkably steady rates of savings over almost 70 years.113, 114 This stability occurred in spite of vastly different interest rates and somewhat different incomes from economic era to era. However, as Modigliani noted in his 1949 paper “Fluctuations in the Savings Income Ratio: A Problem in Economic Forecasting,” a 1945 paper by Arthur Smithies (1908–1981) had obtained better results only by allowing the savings rate to trend downwards over time.115, 116 The increased consumption rate was attributed to the increased urbanization of the population in the USA. With its associated higher rate of spending, there was a narrowing of the distribution of income and a greater availability and affordability of consumer durables that could act as both a consumption and an investment vehicle. Smithies concluded that these trends over time should make the savings rate decline. He introduced a time variable to a saving function that would otherwise remain stable to capture this trend. However, Modigliani observed that spinning this trend forward would result in predictions wildly different from what were actually observed after the Second World War. Modigliani found this trend approach unfulfilling. Instead, he seized upon the argument in a 1947 paper by Dorothy Brady (1903–1977) and Rose Friedman (1910–2009), the wife and lifelong partner of Milton Friedman.117 They observed that the savings rate, as a share of income, rises with income. These rates, though, were highly variable across various income classes. Modigliani was aware of other budget studies that demonstrated that savings seemed to be affected by income in other periods apart from

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the current period. Even Keynes had once argued that “a man’s habitual standard of life usually has first claim on his income.”118 However, Modigliani believed that future expectations of income, rather than the stickiness of habit, was a more likely explanation of variability in the savings rate. Modigliani did in fact toy with the concept of savings stickiness. For instance, in 1949 he modeled the savings and consumption rates based on the greater of current income and the peak income in years in the recent past. This ratcheting effect in consumption would result in greater variability in savings, the residual between current income and consumption that ratchets toward peak consumption over previous years. Instead, he argued: There is strong reason to suppose that as aggregate income increases, persons moving into progressively higher income brackets do not tend to acquire the saving habits characteristic of persons formerly in the income bracket; on the, contrary, they may tend to save less … A marked fall in income below an accustomed level, such as occurs during a cycle, creates strong pressure on acquired consumption habits. This pressure tends to be met by partly maintaining at the expense of saving. That is, savings tend to bear the brunt of a cyclical change in income, falling proportionately more than consumption and income as income declines. Similarly, as income moves back toward the initial level, there is pressure to restore the initial relation between income and saving. In other words, the saving-income relation tends to retrace the same cyclical path in the opposite direction, saving rising relatively faster than consumption as income increases.119 Modigliani later admitted in his autobiography that the backward-looking solution may have been a mathematically convenient way to better fit the data. However, much later he confessed that: … the solution of Kuznets’s enigma (of remarkably constant savings) was, at bottom, altogether ad hoc, lacking analytic foundation.120 Modigliani had admitted that he had been enthusiastic about his novel approach, but had also become a bit sidetracked. Perhaps he was sidetracked less than were his contemporaries. Others would propose equally intellectually unsatisfying but practically appealing explanations. For instance, in 1949 James Duesenberry

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(1918–2009) suggested a psychological dimension. However, such psychological explanations were little better than Keynes’ intuitions a decade and a half earlier. Duesenberry had suggested that consumers try to keep up with the higher consumption intensities of their peers. This concept of “keeping up with the Joneses” was reminiscent of the social commentary of Thorstein Veblen (1857–1929) in his book The Theory of the Leisure Class half a century earlier. Sociological at times and sarcastic at others, Veblen’s exposition developed the concept of conspicuous consumption, in which households’ consumption decisions mimic the decisions of those around them. This, too, would create a stickiness in consumption and a volatility in savings. Veblen’s precursor to what became known as the “relative income hypothesis” was soon replaced by an alternative and more intellectually satisfying approach based on wealth rather than income. This new approach, which Modigliani capitalized on first, grew out of a paper published by Roy Harrod (1900–1978), Keynes’ well-known biographer. In a 1948 paper, Harrod postulated that households save to provide for their retirement years, a concept Fisher had noted almost half a century earlier.121 While Harrod was a Keynes contemporary, admirer, and noted Keynes biographer, he accurately noted that Keynes’ model was static in time. While it discussed variables, primarily the interest rate, that explicitly span time periods, there was nothing in Keynes’ model that described how economies evolve and grow as time marched on. Harrod himself was interested in dynamic models. The well-known Harrod-Domar growth model, in which he determined how an economy would grow based on its savings and its productivity of capital, is but one example.122 Indeed, the entire study of finance is explicitly time-variant, as financial markets are defined precisely to evolve, to span time periods and transport wealth, income and risk from one time period to another. Harrod was perhaps the first to recognize that savings are necessarily dynamic and must be treated over time, with a recognition of the changing circumstances of households and as a measure that connects investment and hence growth, along a dynamic path of evolving equilibria. Harrod had lobbed the first volley. Modigliani was ready to serve. A more satisfying story would soon emerge.

15 The Theory

In the early post-war period, there remained little understanding of the personal financial decisions of households. Various researchers had noticed discrepancies in the data that more simplistic models from Irving Fisher and John Maynard Keynes could not explain. The data suggested that consumption remained remarkably stable over time, which implied that savings, as the difference between disposable income and consumption, would be highly volatile as income changed. Savings, too, seemed to follow a steadier path. Others, including Franco Modigliani, had offered alternative models that better fitted the data. However, these models remained intellectually unfulfilling.

Kitchen sink econometrics One problem with the approaches to measure the trend in savings over the dramatically different decades of the 1920s, 1930s and 1940s was that there were not a plethora of data years. Let us say that there were 30 data pairs of consumption and income over these 30 years. Researchers were attempting to fit savings or consumption to income over these 30 data pairs. However, the addition of every explanatory variable designed to predict the savings rate would reduce the degrees of freedom of the analysis. To better understand the concept of degrees of freedom, let us use a simple analogy. If we plot two pairs of data on a graph, we can perfectly fit the trend between the two points with a straight line. In other words, we model the dependent variable y as a function of the independent variable x, or y  f(x), as a linear function, i.e. y  mx  b, the familiar equation for a line. Two y values associated with two x values can be 141

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represented perfectly as if they follow a linear relationship between x and y. If we have three such pairs of data, we can still fit the three y values by postulating a quadratic polynomial relationship y  f(x)  ax2  bx  c. By creating a new variable x2, we can again discover a perfect fit between this quadratic equation and the data. Similarly, if we have four data pairs, we can postulate that the data is described by the cubic polynomial y  f(x)  ax3  bx2  cx  d. These three variables x3, x2, x and a constant term can perfectly fit four data points. We see that we can always improve the fit between data and our model simply by adding more cleverly chosen independent variables, in this case polynomials. Econometric modelers must be careful to introduce additional explanatory variables that further our intuition. Otherwise, a modeler can simply add more independent variables, hoping each would help improve the fit without furthering our understanding of the relationship. Modelers who add explanatory variables merely to improve their ability to fit the data are sometimes accused of throwing everything into the analysis but the kitchen sink. The fit improves, or at least becomes no worse, but our understanding becomes muddled. Given the possible interrelationships between independent variables, the modeler cannot discern which independent variables are most profoundly explaining the dependent variable. Modigliani later admitted that his early attempt to explain the relationship between income, savings, and consumption fell into the trap of variables in search of a problem rather than a problem in search of explanatory variables. He confided in his memoir that there was no strong reason for his 1949 paper to include a peak past income in addition to a household’s current income in its explanation of current savings and consumption. He confessed his addition of past peak income was ad hoc, or literally “for this” from the Latin. In other words, it was designed simply to help solve the current problem, with no generalizable power and with no intuitive appeal that would further our understanding of the way in which financial markets work. The National Bureau of Economic Research volume in which Modigliani’s 1949 peak income paper was published also featured comments by leading theorists to Modigliani’s approach. One noted researcher, Wassily Leontief, suggested that Modigliani use a five-period distributed lag of income as a way of smoothing out consumption. If the goal was to show that consumption was surprisingly stable as income or interest rates changed, then a focus on smoothed past income would have a stabilizing effect. Modigliani correctly rejected this idea for two reasons,

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one of which was the kitchen sink effect. Simply adding more income years to explain a single year of consumption would reduce the degrees of freedom of the analysis and would naturally increase the fit. Second, Modigliani was already skeptical of the behavioral explanations that must accompany a backward look at income to explain present or, indeed, future consumption and savings. As Modigliani pondered this problem, he quite literally began to recognize the need for more forward thinking. His past experiences in the analysis of corporate inventory decisions convinced him that savings for households might serve the same function as inventories for firms. They tended to smooth out the effects of an entity’s fluctuation of income.123 In his original inspiration for his admittedly unsatisfactory 1949 approach, he also noted that higher income households typically had a high savings rate. One reason for this high savings rate is that they own more assets and these assets experience capital gains that go unrealized until the wealthier and higher income households sell them. This asset value rises with savings. Similarly, the savings rate is higher in wealthier countries than in poorer countries. However, countries that anticipated higher future income would tend to consume some of this income forward by ratcheting up current consumption and reducing their savings. Modigliani also realized that households anticipating higher future income would begin to save less. Finally, he noted what other researchers had observed: rural farm families tend to save more than urban families with similar incomes. He set out to develop a theory that would explain these perplexing phenomena that could not simply be explained by looking at such data as past historic income.

A too brief collaboration with Brumberg Often, great insights occur at a moment in time. One or a few individuals look at a familiar problem in an unconventional way. Once the fresh approach is fully fleshed out, their insights from a moment of brilliance seem obvious. This is the clarity that comes from brilliance. For instance, Albert Einstein once pondered what it would look like if one turned on a flashlight while travelling very quickly. No matter what speed he was travelling, the beam of light should travel away from him as rapidly (186,262 miles per second) as we have always known. However, someone travelling away from the individual with the flashlight would also see the beam of light travelling at the speed of light. In other words, if the speed of light is always constant, from the

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perspective of any viewer, the only way that both perspectives could be possible is if time elapses differently for various viewers. Hence, a simple insight produced the theory of relativity. Physics was changed forever. Modigliani was still at the University of Illinois at the time of his insightful breakthrough with Richard Brumberg that has ever since underpinned the discipline of personal finance. In his autobiography, he related the story of his involvement with Brumberg. Mr Brumberg was a first year graduate student who quickly became a friend of the Modigliani family. Modigliani was still pondering his concerns voiced in the 1949 paper. He proposed to Brumberg that they work on the problem together. When Modigliani was asked to participate in a conference at the nearby University of Minnesota, he asked his graduate student colleague along for the 500-mile drive. Modigliani and Brumberg left the short conference with more questions than answers. They did not accept the conventional wisdom that the rich save and the poor borrow. In doing so, they revisited Fisher’s concept of savings. Household savings should allow a family to smooth out consumption over a lifetime, in much the same way as Modigliani had argued that inventories smooth out the production process. In other words, savings cannot be viewed at one period in time. It is something optimized over a lifetime, a constant dance between income that rises and falls, and consumption that should remain relatively constant, with savings acting as the bridge between the two over time. Fisher, of course, had a similar recognition almost 50 years earlier and Keynes too had some appreciation of this richer motivation for savings. However, no researcher had placed savings within a life cycle model and no one had explored the macroeconomic and financial market consequences of this recasting of savings and the interest rate. The model Modigliani and Brumberg produced while on that road trip was deceptively simple, even for the context of the period (the early 1950s) in which they were writing. The model was simple in that it assumed a zero interest rate and did not incorporate inflation. To include inflation would not add anything to the model if it was fully anticipated. Moreover, the model could easily accommodate an interest rate without changing its conclusions. On that fateful trip, Modigliani and Brumberg made the following assumptions: • An individual lives L years in adulthood. • An individual works for the first N years, at a constant income Y.

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• An individual would then retire for M  L  N years and would earn zero income. • An even level of consumption C per year would be maintained throughout the entire adult life cycle. • A(t) gives the level of accumulated assets at any given point in time. • An individual begins adult life with zero financial assets, i.e. A(0)  0. • In the simple model, the rational individual would attempt to fully exhaust assets upon death, i.e. A(L)  0. Over this period, consumption C  NY/L and savings over the working career is Y  C  (M/L)Y. Over M retirement years, the accumulated savings is depleted. A simple diagram for their problem is shown in the figure below.

Dollars

Peak assets A(t ) Y C

Savings

Dissavings

N Figure 15.1

Years L

Lifetime consumption and asset accumulation

This model is very simple and does little to defy intuition. People earn an income Y which is greater than their consumption C. This difference, called savings, is aggregated over their working career. These assets are then spent in retirement, as their income decreases to zero, to support consumption for an additional L  N years. In effect, the individual saves for retirement. Based on this very simple model, Modigliani and Brumberg teased out some significant results that are both powerful and surprising. In that first week after their fateful trip back from Minnesota, they calculated some simulations for a simple life cycle model overlapping generations.

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These simulations were painstakingly created by hand, without the advantage of computers or Excel spreadsheets. Nonetheless, despite the necessary simplicity in their simulations, they made some discoveries almost immediately. Let us create a simple chart that demonstrates what would happen if there are just five overlapping generations. Let there be a new generation every ten years. Generation one enters the workforce at year zero, generation two at year ten, and generation three at year 20. Let each generation live for 40 years (L  40), work for 30 years (N  30), and live in retirement for ten years (L  N  10). Finally, let income each decade from each working generation be $100 and spending $75. In the Keynesian model, this would represent an average and marginal propensity to consume of 0.75 or 75 per cent. It is a simple matter to aggregate the levels of income, savings, assets, consumption, and aggregate wealth in this simple example. We can also explore the steady state of this simple model. The resulting table for this simple example shows what would happen to subsequent generations with regard to consumption C, savings S, dissavings DS, net savings NS, and accumulated assets A as the income of generations of wage-earning households is summed as average income rises.

Table 15.1

A simple life cycle example with overlapping generations

First generation Second generation Third generation Fourth generation Fifth generation

Y

C

S

DS

NS

A

$100 $200 $300 $300 $300

$75 $150 $225 $300 $300

$25 $50 $75 $75 $75

$0 $0 $0 $75 $75

$25 $50 $75 $0 $0

$25 $75 $150 $150 $150

We can see that by the fourth generation, collective income peaks at $300 per decade. Even though each generation consumes only $75 per decade, by the fourth generation, made up of four living generations, three working and one retired, consume 4*$75, or $300. By then, income equals consumption, savings balance dissavings DS, accumulated assets peak at $150, and the net savings rate is constant. If we stretch this model out to another (fifth) generation, we can see that the model has established a steady state. The macroeconomic characteristics in the fifth generation are the same as those in the fourth

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generation. In this simple and highly stylized model, the consumption of one generation over its life cycle equals its income, its average assets equal $37.50, and its net savings equal $0. In this very simple example, the average net savings rate is $0 as well. Let us tweak the model with one more feature. If we impose growth of about 7 per cent per year, the rule of 72 tells us that output should double by 72/7, or approximately once every ten years. To simplify, let the first generation earn $100 in their first decade, $200 in their second decade, $400 in their third, and nothing in their fourth, or retirement, decade. Let us also assume that households are myopic, in that they cannot factor into their spending accelerated income growth in the future. While Milton Friedman subsequently addressed this myopia, in Modigliani’s model, the expected future income at the beginning of decade one would then be two decades at $100 income per decade. At the beginning of decade two, the household would expect one additional decade of work before retirement at an income that has risen to $200. At each decade, in this simple model with a zero interest rate, for the sake of simplicity, the household would divide its present and future income by its remaining decades to live to arrive at its (smoothed) level of consumption. From there, we can generate the following table.

Table 15.2

A simple overlapping generations model with rising income

First generation Income Expected future income Consumption Savings Beginning assets Ending assets

Decade 1

Decade 2

Decade 3

Decade 4

$100 $200 $75 $25 $0 $25

$200 $200 $142 $58 $25 $83

$400 $0 $229 $171 $83 $254

$0 $0 $254 –$254 $254 $0

As before, the household completely consumes its accumulated savings by the end of its last decade. We can also observe that economic growth each decade permits a growing rate of consumption every period. It is a simple matter to create an overlapping generations table for subsequent generations. Let us now explore the savings rate in steady state by adding additional overlapping generations into the mix.

148 Table 15.3

An overlapping generations model with constant income

Decade First generation income Expected future income Consumption Savings Beginning assets Ending assets Second generation income Expected future income Consumption Savings Beginning assets Ending assets Third generation income Expected future income Consumption Savings Beginning assets Ending assets Fourth generation income Expected future income Consumption Savings Beginning assets Ending assets

1

2

3

4

$100 $200 $75 $25 $0 $25

$100 $100 $75 $25 $25 $50

$100 $0 $75 $25 $50 $75

$0 $0 $75 ($75) $75 $0

$100 $200 $75 $25 $0 $25

$100 $100 $75 $25 $25 $50

$100 $0 $75 $25 $50 $75

$0 $0 $75 ($75) $75 $0

$100 $200 $75 $25 $0 $25

$100 $100 $75 $25 $25 $50

$100 $0 $75 $25 $50 $75

$0 $0 $75 ($75) $75 $0

$100 $200 $75 $25 $0 $25

$100 $100 $75 $25 $25 $50

$100 $0 $75 $25 $50 $75

$100 $200 $75 $25 $0 $25

$100 $100 $75 $25 $25 $50

Fifth generation income Expected future income Consumption Savings Beginning assets Ending assets

5

Sixth generation income Expected future income Consumption Savings Beginning assets Ending assets Totals Income Consumption Savings Savings rate

6

$100 $200 $75 $25 $0 $25 $300 $300 $0 0.0%

$300 $300 $0 0.0%

$300 $300 $0 0.0%

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In the overlapping generations version of the model, we again see that no economic growth resulted in a steady state zero savings rate. We next repeat the analysis with income doubling every decade and consumers re-evaluating their future consumption at the beginning of each decade based on their revised expectations of future income and on their better-than-expected savings. Table 15.4

An overlapping generations model with rising income

Decade First generation income Expected future income Consumption Savings Beginning assets Ending assets Second generation income Expected future income Consumption Savings Beginning assets Ending assets Third generation income Expected future income Consumption Savings Beginning assets Ending assets Fourth generation income Expected future income Consumption Savings Beginning assets Ending assets Fifth generation income Expected future income Consumption Savings Beginning assets Ending assets Sixth generation income Expected future income Consumption Savings

1

2

3

4

5

6

$100 $200 $75 $25 $0 $25

$200 $200 $142 $58 $25 $83

$400 $0 $242 $158 $83 $242

$0 $0 $242 ($242) $242 $0

$200 $400 $150 $50 $0 $50

$400 $400 $283 $117 $50 $167

$800 $0 $483 $317 $167 $483

$0 $0 $483 ($483) $483 $0

$400 $800 $300 $100 $0 $100

$800 $800 $567 $233 $100 $333

$1,600 $0 $967 $633 $333 $967

$0 $0 $967 ($967) $967 $0

$800 $1,600 $600 $200 $0 $200

$1,600 $1,600 $1,133 $467 $200 $667

$3,200 $0 $1,933 $1,267 $667 $1,933

$1,600 $3,200 $1,200 $400 $0 $400

$3,200 $3,200 $2,267 $933 $400 $1,333 $3,200 $6,400 $2,400 $800

(continued)

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Table 15.4

Continued

Decade

1

2

3

4

5

6

Beginning assets Ending assets

$0 $800

Totals Income Consumption Savings Savings rate

$2,400 $1,892 $508 21.2%

$4,800 $3,783 $1,017 21.2%

$9,600 $7,567 $2,033 21.2%

Observe that, when there is economic growth, the savings rate reaches a positive steady state rate, in this case 21.2 per cent, even as income doubles every decade. We can recalculate these figures with a more modest growth rate. For instance, when we regenerate the model with a more typical 1.9 per cent annual growth rate, which would compound to a 20 per cent economic growth rate over a decade, we obtain the following figures. Table 15.5

An overlapping generations model with more modest growth

Decade

1

2

3

4

First generation income Expected future income Consumption Savings Beginning assets Ending assets

$100 $200 $75 $25 $0 $25

$120 $120 $88 $32 $25 $57

$144 $0 $100 $44 $57 $100

$0 $0 $100 ($100) $100 $0

$120 $240 $90 $30 $0 $30

$144 $144 $106 $38 $30 $68

$173 $0 $120 $52 $68 $120

$0 $0 $120 ($120) $120 $0

$144 $288 $108 $36 $0 $36

$173 $173 $127 $46 $36 $82

$207 $0 $144 $63 $82 $144

$0 $0 $144 ($144) $144 $0

$173 $346 $130

$207 $207 $153

$249 $0 $173

Second generation income Expected future income Consumption Savings Beginning assets Ending assets Third generation income Expected future income Consumption Savings Beginning assets Ending assets Fourth generation income Expected future income Consumption

5

6

(continued)

The Theory Table 15.5

151

Continued

Decade Savings Beginning assets Ending assets

1

2

3

4 $43 $0 $43

Fifth generation income Expected future income Consumption Savings Beginning assets Ending assets

5 $55 $43 $98 $207

$75 $98 $173 $249

$415 $156 $52 $0 $52

$249 $183 $66 $52 $118 $249

Sixth generation income Expected future income Consumption Savings Beginning assets Ending assets Totals Income Consumption Savings Savings rate

6

$498 $187 $62 $0 $62 $518 $478 $41 7.9%

$622 $573 $49 7.9%

$746 $688 $59 7.9%

In this simple example, the savings rate attains a steady state value of 7.9 per cent economy-wide. The savings rate falls to that approaching what we find in developed nations once retirement savings and housing appreciation are taken into account. This very simple example immediately explained a number of characteristics that previously defied explanation. It demonstrated that zero economic growth generated zero net savings. It also showed that savings were not simply a product of per capita income; rather, savings occurred because consumption did not grow as quickly as income grew. In other words, consumers do not, or cannot, easily borrow against future growth, and hence consumption trails economic growth. Ironically, this ability to borrow against anticipated future earnings increases consumption but also decreases the availability of savings and hence the capacity to invest in future productive capacity. Modigliani and Brumberg’s Life Cycle Model also demonstrated that savings are not simply a product of the greater capacity of the wealthiest to invest their income. In this very simple model, there was no discussion of the distribution of income and no requirement to

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impose income inequalities to generate savings. Finally, it showed, in a convincing manner, that consumption could be modeled as a function of a household’s lifetime, or permanent, income rather than simply on a household’s transient current income. It was the first well-developed model that managed to address the burning questions and misunderstandings of the day within a formal framework and without resort to ad hocery. However, this simple life cycle model was only the beginning. While it certainly clarified that economic growth can generate savings, it was not a full dynamic model of either finance markets or the macroeconomy. Of course, financial theorists can see that savings would find their way into the market for investment funds that entrepreneurs could draw upon to create the capacity to grow. The high savings rate of a growing economy would combine with the demand for loanable funds to lower the interest rate, enhance investment in economic capacity, and further induce economic growth. This positive feedback loop explained the dramatic savings rate and growth rate, and the frequently low interest rates found in the world’s most dynamic economies. We will not describe the other rich results one could tease from this model with regard to the macroeconomy. The personal finance richness of this model is equally substantial. It demonstrates that savings are both a product and a creator of economic growth. These phenomena do not occur because households are backward looking, as in previous attempts to explain smoothed consumption and volatile savings. Rather, savings occur because households are not fully able to capitalize on speculative growth until it is realized. The Life Cycle Hypothesis model also does not treat uncertainty. It did not need to do so to substantiate the claims Modigliani and Brumberg sought to draw from it. Indeed, their work could also be considered as one of the first rational expectations models. From that perspective, it incorporated the Keynesian principle to better understand what motivated the household savings decision, doing so in a way that would not offend the classical school, and introduced the notion of rational expectations for the future. Despite its simplicity, the model established the framework for the study of personal finance. The simplicity of the concept and intuition and the calculus-free approach that relies instead on some basic accounting of a phenomenon to which we must all subscribe was the beauty of the Life Cycle Hypothesis model. The growing income of a younger cohort creates the wealth and output for young and the retired alike. These savings, by producing more than their consumption, allowed

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others to consume without producing. So long as there was economic growth, there could be savings and security in retirement. The ability of the Life Cycle Hypothesis to explain a number of phenomena, from the macroeconomic level of savings to our understanding of the microeconomics of personal finance, was as profound as was Keynes’ description of the role of consumption and savings in an underemployed economy. For the first time, financial researchers had the tools to explain why the overall level of growth in the economy would affect the savings rate. It also produced a rich model within which economic policy could function to produce more plausible and meaningful results. Finally, the personal finance discipline had a foundation for its understanding of the motivation of households in their saving and asset accumulation decisions.

16 Applications

While the fresh but simple approach by Franco Modigliani and Richard Brumberg produced some starkly insightful and profound new results, we can now include their insights while at the same time unifying the results of Irving Fisher and Frank Ramsey by utilizing the recent technique of optimal control theory.

A calculus approach While Modigliani and Brumberg developed their intuition through simple examples, their model is amenable to a classical calculus approach. Let a household derive utility U at each time t and sum this utility arising from consumption C over a lifetime lasting L years and from income Y over a working career of length N. The household then maximizes: L

U ∑

U (Ct )

(1  dt ) t 0

over time, subject to the constraint that the present value of all future consumption is equal to the present value of all future income: L

N

C

Y

∑ (1 t r )t ∑ (1 t r )t 0

0

where d is the familiar rate of time preference and r is the interest rate used in the same way that Fisher used these terms almost half a century earlier. 154

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Alternately, we can express the maximization problem in continuous time: max ∫ U (C(t ))edt dt L

C (t )

0

像∫ C(t )ert  ∫ Y (t )ert L

N

0

0

This generalized form can allow for a change in the income pattern Y(t) for an individual over time or for macroeconomic growth of income over time. For instance, if income grows at a constant rate g corresponding to growth of the macroeconomy, the problem becomes: max ∫ U (C(t ))edt dt L

C( t )

0

像 ∫ C(t )ert  L

0

∫0 Ye N

( g r )t

We can then use the tools of calculus to determine the path of consumption C(t) and savings: S(t)  Y(t)  C(t) over their life cycle. This dynamic optimization problem can be solved by expressing the problem as a current value Hamiltonian function. The current value Hamiltonian is: H(c(t), S(t), (t))  U(c(t))  (t)(rS(t)  y(t)) where S(t) is the level of savings at each point in time t over the planning horizon t ∈ (0, L) such that: dS(t)/dt  rS(t)  y(t)  c(t) The method of optimal control requires that the solution obey the following first order conditions: ∂H U ′( c(t )) l(t ) 0 ∂c ( t )

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∂H ∂l( t )  r l(t ) dl(t ) ∂S(t ) ∂t ∂H  rS(t ) y(t ) c(t ) dS(t )/ dt ∂l(t ) We can also assume that the system of first order conditions satisfies the constraint that savings at the initial time S(0)  0, while savings at the end of the life cycle likewise also equal zero, i.e. S(L)  0. From the first condition, we obtain: U (c(t))  (t) and U (c(t))c (t)   (t), or  (t)/(t)  c (t)U (c(t))/U (c(t)) From the second condition, we see that: ( r  d) l(t )

∂l(t ) , or ∂t

( r  d) l′(t )/ l(t )

Then: c (t)U (c(t))/U (c(t))  d - r The law of diminishing marginal utility requires that U (c(t))  0 and U (c(t))  0. Then the path of consumption c(t) is increasing over time if r  d , decreasing if r  d, and constant if the interest rate r coincides with a household’s discount rate d. As with Modigliani and Brumberg’s simpler exposition and Ramsey’s model a generation earlier, a household that has access to efficient capital markets will smooth out lifetime consumption, first by borrowing as income starts low, then by saving in the middle years, especially if income is expected to grow, and finally by living off the savings in retirement. Likewise, savings will start off negative, peak at retirement if income grows steadily and fall to zero at the expected end of the life cycle in year L. As an example, consider a very simple utility function U(c)  2c . The first order condition c (t)U (c(t))/U (c(t))  d  r then becomes: c (t)/c(t)  r  d

and

c(t)  c0 e(r–d)t

As before, if a household aligns its rate of time preference to the market rate, then the level of consumption remains constant over time.

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We can determine savings by first determining the level of lifetime income. Let income begin at y0 and rise at a rate g  0 over the working career of length N. The pattern of potential savings will then follow the following differential equation: dS(t)/dt  rS(t)  y0egt subject to the initial condition that the household has zero savings at the beginning of the life cycle. We can solve this linear differential equation as follows: S(t)  ert {兰y0e gtertdt  k)  ert {兰(y0e(gr)t)dt  k)  y0 te rt  ke rt  y0e gt/(g  r)  ke rt

rg otherwise

From the initial condition S(0)  0, we see that the constant k must equal: k0 rg y0/(g  r) otherwise Generally, when r g, savings are given by: S(t)  y0te rt  (e gt  e rt)y0/(g  r)

rg otherwise

At the end of the working years, this level of savings must be discounted back to time t  0 to give the net present value of future income: PV of future income and savings  y0N rg  (e(gr)N  1)y0/(g  r) otherwise This formula for the value of gross savings must support lifetime consumption. From this lifetime gross savings pathway, we can calculate the net savings rate after consumption. To do so, we first calculate the net present value of consumption over the entire life cycle of L years: C( L )

∫0 c0e( r d)t ert dt L

 c0 (1 edL ) / d

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This expression gives the cost of lifetime consumption, which is feasible from the lifetime savings above. Combining the two, we can calculate the level of consumption c0 at the beginning of the life cycle: c0  ((e(gr)N  1)/(1  edL))y0d/(g  r) and the path of consumption c(t) is given by: c(t)  ((e(rd)t (e(gr)N  1))/(1  edL))y0/(g  r) As before, consumption remains constant if r  d, rises if if r  d, and falls if r  d. Finally, the addition to savings can be calculated as follows: s(t)  y(t)  c(t)  y0(egt  (e(rd)t/(1  edL))(e(g  r)N  1)/(g  r)) t  N  y0(e(r  d)t /(1  edL))(e(g  r)N  1)/(g  r) tN It is possible to draw a couple of conclusions that are becoming increasingly relevant. First, notice that the path of savings s(t) increases as a household’s starting income y0 increases. It is this higher starting income, as a consequence of economic growth, from later cohorts that gives rise to a higher net savings rate economy-wide. In the case when r  d and consumption is constant, savings will also rise over the life cycle region in which income is positive and will be depleted after t  N. The analysis also demonstrates that the savings rate decreases as the number of work years increase. This is because there are more work years to provide for consumption and fewer years in retirement. Similarly, note that consumption increases as the number of work years N increase. Finally, observe that consumption decreases and the savings rate increases with an increase in longevity. Similarly, we can show that savings decrease and the pattern of consumption increases if there are other forms of retirement income from pensions or social security. Consequently, consumption would unambiguously fall and savings would rise if individuals anticipate early retirement. The combination of these effects is relevant for our current economy, which is wrestling with an inverted population pyramid as so many baby boomers enter retirement. Should a household not have access to borrowing, consumption would be constrained to the level of income until such a point as the

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earning rate of the household rises to meet a recalculated lifetime income. At that point, the length of the life cycle L would be shorter, but the analysis remains as above. Additionally, if there is any change in income or expectations, the household could recalculate its consumption path. However, the same general results are obtained. Recall that Modigliani and Brumberg also concluded that the savings rate for the overall economy is positive when there is economic growth, even if, on average, some are adding to savings and others are reducing their savings at any given time. To understand this result, consider the overlapping nature of households’ savings decisions. The savers entering the labor force in one decade will begin with a lower level of income and a lower anticipated lifetime consumption level. Both these conditions imply that they will generate lower savings throughout their planning horizon and will retire with more modest savings and consumption. However, another cohort entering the labor force a decade later will do so at a higher income trajectory if there is economic growth. Consequently, the cohort will also need to support higher lifetime average consumption and will have to save more, in absolute terms, to do so. The higher level of savings in the first decade for the second cohort, compared to the first cohort in its second decade, results in positive net savings. As we saw, these savings grow with a growing economy. Likewise, the aggregate savings rate can fall with economic contraction. Elaborations of this model could also determine the results on savings and consumption if workforce entry is delayed through education or investment in human capital. Presumably, upon workforce entry, the initial salary y0 will be higher, but so is the ability to amass savings over a shorter number of years in the workforce relative to the number of years in retirement. Both these effects will result in a higher individual savings rate, all other things being equal.

Effect of market regime changes on the life cycle The Life Cycle Model’s predictions are based on the rational expectations and planning of a household that anticipates an estimable growth of income, an expected retirement date, a known interest rate, and an expected longevity. Personal finance practitioners know well that these conditions can change dramatically over a lifetime. The interest rate can deviate from long-term averages for a decade at a time. Statutory retirement ages and social security benefits can change as well.

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Finally, human longevity is rising with increased affluence and medical technology. Consequently, while the Life Cycle Model provides many empirically testable and intuitive predictions, it must be viewed as dynamically changeable. If conditions such as income or the growth of income, the interest rate, the retirement age, or the expected lifespan change at time t, an individual household would have to recalculate the optimal level of consumption and savings with a new t  0, a new retirement horizon N  t, and a new time to the end of the life cycle L  t. Major economic events, like the huge run-up in asset values during the 1990s, the subprime mortgage-led housing bubble of the early 2000s, or the market crash in 2008, each mandate a recalculation of the Life Cycle Model. Given the difficulty of reducing consumption levels once they have been ratcheted up, the ability to save is hampered if there are reductions in expected income. Consequently, even the decision of when to retire can become a strategic one. Further complicating the ratcheting of consumption is the effect of a rapid build-up in savings through capital gains. For instance, in a stock market asset bubble or a housing bubble, households can convert to cash and consumption when returns are in excess of those originally assumed in their life cycle planning. In doing so, they can ratchet up consumption by borrowing against excess savings. The model would then suggest that, should their asset values return to normal, the increased temporary consumption would force a dramatic downward consumption readjustment as savings replenishment becomes necessary. The ability to tap into excess returns, through margin loans on financial assets or home equity loans on housing assets, can create personal finance vulnerabilities. The response of households to these vulnerabilities explains the decreased consumption rate and increased savings rate that often follow the deflation of a speculative bubble.

17 The Nobel Prize, Life, and Legacy

Each in their own way, Irving Fisher, John Maynard Keynes and then Franco Modigliani made profound contributions to the field of personal finance. Fisher described the process by which those with a high individual rate of time preference would borrow at a lower prevailing interest rate and would represent the demand for loanable funds. On the other hand, those willing to save because the interest rate offered in market equilibrium was larger than their rate of time preference provided the supply of funds to lending markets. By modeling savings as the difference between disposable (after tax) income and consumption, Keynes also offered a model for savings. However, before Modigliani’s work with Richard Brumberg and his subsequent work, there was no model that neatly tied together the path of personal finance for one household over a lifetime and for an entire nation. Partly as a consequence of some perplexing results from Simon Kuznets during the 1940s that seemed at odds with the Keynesian model, there was a rush of explanations for what we now call the Life Cycle Model of savings. Modigliani and Brumberg arrived first in the race to offer an acceptable and testable hypothesis to explain the gap in understanding. Their success and Modigliani’s subsequent life’s work eventually earned Modigliani the Nobel Prize in Economics and catapulted him to the presidency of the American Finance Association. Unfortunately, Brumberg did not have time to enjoy the accolades that the model would earn. Modigliani and Brumberg’s seminal article appeared in 1954.124 In 1952 they both departed the University of Illinois, Modigliani to the Carnegie Institute in Pittsburgh and Brumberg to Johns Hopkins University in Baltimore. They continued to collaborate for another year toward their seminal 1954 paper. By the 161

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summer of 1953 the paper was finished and Brumberg completed his PhD, later receiving a position at Cambridge. As Modigliani reports it, Brumberg had suffered from heart and circulatory problems since birth. The year after their 1954 paper, Brumberg died from what was reported as a brain tumour or a cerebral embolism.125,126 The final collaboration between Modigliani and Brumberg would not appear in writing for another 35 years. Their final work, essentially as it stood in 1954, was included in the second volume of Modigliani’s collected works published in 1979.127 Modigliani was disheartened by the loss of his colleague. While at his new academic home at Carnegie, he continued to work on the Life Cycle Hypothesis, but also began to look at issues related to the financial value of firms. Both these strands of research were ultimately related to the new approach to business cycles based on rational expectations of households and investors. By 1960 Modigliani had moved to the Massachusetts Institute of Technology, where he would remain, except for some brief visiting forays, for the remainder of his career. He continued his interest and work in personal finance, rational expectations, the business cycle, and the financial valuation of firms. He also concerned himself with some of the first large-scale models of the macroeconomy, upon which groups like the Federal Reserve would come to rely in their efforts to fine-tune the economy and model the constraints imposed when there is a large amount of public debt.

The Prize The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel is the only Nobel Prize awarded to a discipline of social sciences. Actually, when Alfred Nobel created the original prizes as a way to create social good from his invention of dynamite, there was no well-developed scientific theory of the way in which humans make personal decisions. Consequently, there was no Nobel Prize yet in those fields. Rather than being administered by the Alfred Nobel Foundation, the Nobel Memorial Prize was created by the central bank of Sweden. The first prize of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded in 1969 jointly to Ragnar Frisch (1895–1973) and Jan Tinbergen (1903–1994) “for having developed and applied dynamic models for the analysis of economic processes.”128 By 2010, 42 prizes had been awarded to 67 laureates. Modigliani won the seventeenth Nobel Prize in Economics and was its twenty-third recipient.

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Kenneth Arrow (1921–) was an American researcher who also shared with Modigliani an interest in the inventory problem in the 1950s.129 Arrow had won the fourth Nobel Prize in Economics in 1972 with John Hicks (1904–1989), 13 years before Modigliani. Modigliani’s wife Serena had learned from Arrow’s wife that, should the Nobel Committee call early one morning to inform one of winning the prize, one should immediately take a shower. Within minutes, reporters would be at the doorstep.130 Modigliani’s telephone rang early one morning in the fall of 1985. The Committee announced that the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded to Modigliani “for his pioneering analyses of saving and of financial markets.”131 The Committee remarked that Modigliani helped define the interaction between household wealth and financial markets. While his predecessor Keynes certainly placed the psychology of savings into the financial realm, Keynes was never able to resolve the theory of savings as a share of national income and the empirical data that was emerging in the 1940s. Modigliani and his graduate assistant Brumberg solved this paradox and, in doing so, created a new theory and study of household savings. The Committee also noted that this new theory of household savings was at once able to resolve the paradox between theory and the data and to resolve how policy-makers could model the effects of social insurance, pensions, and budget deficits on the level of national and personal savings. Modigliani gave a paper entitled “Life Cycle, Individual Thrift and the Wealth of Nations” as part of his Nobel Prize address.132 In that 1985 paper, he summarized the contributions and limitations of Keynes’ theory of savings and wealth, and the ways in which this seminal paper did not fit the data. This observation he graciously acknowledged was the insight of Kuznets in his 1946 paper, the unpublished work of Margaret Reid (1896–1991), and the 1947 paper by Dorothy Brady and Milton Friedman’s wife, Rose Friedman. Modigliani also paid tribute to James Duesenberry’s 1949 paper, Margaret Reid’s unpublished hypothesis of a permanent, as opposed to our more transitory current, income, and his own work in 1949 as precursors to the more complete theory. In his effort to explain why consumption does not appear to be nearly as cyclical as income and the gross domestic product, he noted the Duesenberry-Modigliani hypothesis that consumption ratchets up over time but can only slowly respond downward. He noted the intuition but also the practical limitations of this hypothesis at that time.

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In the version of the Life Cycle Model that had evolved by 1985, Modigliani was able to extend his results in a number of directions. For instance, he allowed for adjustments in the length of one’s working and retired life, an imposition of the liquidity constraint that might prevent households from borrowing from future wealth to support present consumption, and a relaxation on the requirement of rationality and personal finance self-discipline. Indeed, he offered evidence that individuals do not seem to be constrained by myopic decision-making, especially as the retirement date draws near. Finally, he also included a discussion of bequests in his Nobel lecture, a reality that perhaps became apparent given the large size of the cash prize associated with the award, especially when the award is given to a single recipient. Like Fisher 50 years earlier, Modigliani offered prescience into some of the emerging public finance issues of today. He too commented that a consumption tax is more equitable because, in effect, it taxes permanent rather than transitory income. He also expressed the concern of how deficit financing affects a household’s life cycle savings plan in unfortunate ways. As opposed to the rational expectations school of thought that has since evolved, the national debt crowds out the ability for household savings to flow into the investment that perpetuates economic growth and thus enhances national savings.

Later years Modigliani remained active following his renown for the creation of the Life Cycle Model. He designed the first extensive computational economic model that was used by the US Federal Reserve for decades. Since his modeling experience with the University of Illinois project in the 1940s, he remained an early adopter and user of computers for data analysis. With his Massachusetts Institute of Technology colleague Merton Miller, he constructed a model that demonstrated that debt or equity financing is equivalent in corporate finance. He also demonstrated that neither the debt-equity ratio of a firm nor its dividend strategy should affect corporate value under certain conditions. By contributing to our understanding of corporate finance policy through his discussion, he placed himself squarely as a founder of both personal finance and corporate finance. Modigliani also advocated for the ability of individuals to borrow from their personal tax-sheltered pension plans. Indeed, he received a patent for this financial concept, which is now commonly used for

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households to maintain their optimal savings and consumption plan across the entire life cycle. In the mid-1970s, Modigliani foresaw the dangerous combination of an external supply price shock and fully price-indexed wages. He predicted that the resulting spiralling inflation, as policy-makers and employees try to immunize themselves from an inflationary supply shock that must be integrated, could force a recession if not properly managed. He worked for years to make this economic point to his home country of Italy. Finally, the Italian population would ratify his concept as a way to recover from the stagflation of the early 1980s. However, his advocacy and that of his Massachusetts Institute of Technology colleague, Ezio Tarantelli, cost Tarantelli his life. The controversy of their proposed reforms caused Tarantelli to be murdered by Italy’s Red Brigade just a few weeks before the successful national referendum in Italy that would eliminate wage indexing in labor contracts.133 From his home in Cambridge, Massachusetts, Modigliani would remain interested in Italian political and economic affairs. He even took on Italy’s Prime Minister Berlusconi, whom Modigliani viewed as acting in unbecoming and undignified ways, and who was thus eroding the decorum of Italian politics. One of Modigliani’s proudest moments also had a finance dimension. His granddaughter Leah became an investment banker for Morgan Stanley in New York and emerged as an influential Wall Street voice. In 1997 the two Modiglianis developed the Modigliani Risk-Adjusted Performance measure, most commonly known as the M-squared measure. An extension of the Sharpe Ratio that is commonly used in the pricing of financial assets, and which will be more fully described in the third volume of this series, the M-squared measure has the advantage that it is interpreted as a percentage and, as such, can be much more easily interpreted. This measure allows financial professionals to measure risk-adjusted returns of mutual funds relative to a benchmark portfolio. Franco Modigliani died in his sleep in Cambridge, Massachusetts on September 25, 2003 at the age of 85. Just the day before, he and his wife had dined with the illustrious Harvard economist John Kenneth Galbraith and his wife.134 Modigliani had remained active at the Massachusetts Institute of Technology to the end. He had worked there for 28 years, until his retirement in 1988, but continued to teach one course per year following his retirement. He was survived by his wife of 64 years, Serena, two sons, many nieces, nephews, and grandchildren. His legacy lives on.

Section 4: Milton Friedman

The Life Cycle Hypothesis successfully explained personal savings behavior. It also explained why a growing economy created an increase in savings. Before the theoretical development of the Life Cycle Model, the explanation of savings rested primarily on an individual’s preference for present versus future consumption as compared to the market’s preference, which was incorporated into the interest rate. The Life Cycle Model also helped to resolve why consumption remains remarkably stable over time, in contradiction to the prevailing macroeconomic model developed by John Maynard Keynes in 1936. Consequently, it was immediately interjected into the macroeconomic discussion of the theory of consumption. The Keynesian macroeconomic model was used to debunk the classical approach of Keynes’ predecessors, including the colorful Irving Fisher. By injecting a discussion of savings and consumption squarely into the center of the classical/new economics debate, economists were divided into two camps – classicists and Keynesians. The Life Cycle Model actually bridged the gap between the two schools. Its main proponent, Franco Modigliani, was a Keynesian in the sense in which he believed that government fiscal and monetary policy could be used to reform or invigorate a flagging economy. Meanwhile, another life cycle theorist at the time, Milton Friedman, had developed a model that is used almost synonymously with the Life Cycle Hypothesis. Friedman was very much a classicist in that he believed individuals acted as if they were rational. By emphasizing the significance of future expectations, he helped motivate a new rational expectations school of thought. However, as we shall see, his model was, in fact, fundamentally

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different in terms of outlook and economic philosophy from the model produced by Modigliani. Friedman also went on to develop other economic theories in contrast to those of John Maynard Keynes. Indeed, these two perhaps cast a longer shadow than any other subsequent economists. Friedman also stands in starker contrast to Keynes than any economist since.

18 The Early Years

Like those founders of personal finance before him, Milton Friedman lived an interesting life punctuated by events that would form his thinking. Like Franco Modigliani, Friedman was from a Jewish heritage. However, unlike Modigliani, who had to flee to the USA to escape the oppression of fascism, Friedman was born into a family that was already firmly, if just barely, rooted on US soil. Much of what we know of Friedman’s life, as related in these pages, came from the subject himself. As a couple who viewed themselves on the cusp of history, he and his wife Rose wrote an interesting memoir entitled Two Lucky People.135 Friedman’s mother and father both came from a town that was then known as Carpatho-Ruthenia, but is now known as Berehovo. Located in western Ukraine, near the border of Hungary, it was, until the First World War, the capital of the Kingdom of Hungary’s Bereg County. Following the First World War, it became part of Czechoslovakia, then part of the Soviet Union, and, finally, part of the Ukraine. Milton’s father, Jeno Saul, was born in 1878. Jeno Saul was multilingual. His family spoke Yiddish and Hungarian. He had also learned German and would learn English when he made his way to the USA. Jeno’s mother, and Milton’s grandmother, also had a son by a different father, who was much older than Jeno. Because Jeno lived under the shadow with a much older brother Friedman, he too became associated with the Friedman name. From then on, a Friedman lineage was established for Jeno and his progeny. Milton and his siblings would be the first generation to carry that name on from their Eastern European Jewish roots. Consequently, Milton never came to know the ancestors of his original family name and could not recall his family’s Eastern European name, nor could he 168

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establish any connection to the many Friedmans who had written him from Eastern Europe asking if he could be their relation.136 At the very young age of 16, Jeno Saul emigrated to the USA in 1894 and found a home in Brooklyn, New York. His courage at that young age may have only been exceeded by the courage of Sarah Ethel Landau, his future wife, who also emigrated from the same village, CarpathoRuthenia, and would also settle in Brooklyn a year after Jeno, but at the even younger age of 14. Almost immediately, Sarah found herself working in the notorious sweatshop sewing mills in New York City at the time. Nonetheless, she related to Milton that she was grateful for the opportunity to earn a living and start a new life in a land of opportunity. She shared the same willingness to pull herself up by the bootstraps in the Horatio Algerstyle American Dream to which so many immigrants subscribed. This sense of self-reliance could not help but influence Milton’s view of the economic world. Milton believed it to be unlikely that his mother and father could ever have met in their common home town because Saul had left the town to live with his half-brother in Budapest at a young age. However, their common home town likely brought them together while they were living in Brooklyn. Jeno and Sarah were married in that first decade of a new century in one of the most economically vibrant cities of the world. Jeno made a living catching as catch can as a small trader willing to explore any entrepreneurial opportunity that might present itself. They set about creating a family and gave birth to three girls, and then Milton, between 1908 and 1912.137

Childhood Milton was born on July 31, 1912 at his home at 502 Barbey Street in Brooklyn, New York. When he was barely a year old, his family moved across the Hudson River to Rahway, New Jersey. Rahway would be Milton’s home for his most formative years. A town of less than 20,000 people at that time, it was on the main PhiladelphiaNew York rail corridor and offered good access to those commuting to New York City. His childhood home on Main Street was almost literally underneath the railroad tracks, as the Penn Central Railroad ran along an elevated trestle just feet from it. Milton’s mother and father were industrious. They ran a small sewing factory out of their home for a few years and then sold that home so that they could open a dry goods shop across the street at 104 Main

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Street. His mother ran the home business while his father commuted into the city to earn a meager living at whatever enterprise he could find. Milton recalled that his parents seemingly constantly discussed how they could manage their personal finances. Unlike the implications of the theory of Irving Fisher, who was advocating his finance model of optimal savings from New Haven, Connecticut, just 100 miles away, the Friedmans were constantly living and consuming one paycheck behind their income. They would juggle their finances by paying bills with post-dated checks and would then cover those checks with another series of post-dated checks.138 Milton remembered little of his childhood. However, one childhood scar he never forgot was when a bump in the road forced him up into the windshield of his father’s Model T Ford. His characteristic line below his right nostril was a lifelong reminder of that accident. He also remembered falling out of the Model T Ford, but, fortunately, he only received a skinned knee.139 Despite their difficult personal finance challenges, Milton’s parents shared a belief in the importance of education. Like the other precocious great minds, Milton, too, was accelerated through grade school. He had been attending Washington Public School in sixth grade, at the age of 11, when he was transferred up to the next grade and into Columbus School, still within walking distance of the family home. Young Milton apparently adopted a love for asserting facts, sometimes loudly, at an early age. He recalled that his propensity to almost shout during discussions caused him to be nicknamed “shallow,” an ironic juxtaposition with the saying “still waters run deep.” It would appear that he was not disturbed by such labels. When his class was required to each sing a few notes in preparation for an elementary school graduation ceremony and his teacher told him rather dismissively that his turn “doesn’t matter,” he shrugged it off as a perfectly legitimate statement of fact relating to his lack of musical ability. Some children would be hurt by such a remark. Criticism did not upset young Milton, though, even if it caused his future wife, Rose, to attribute his lifelong disinterest in music to that flippant comment.140 Milton’s parents instilled in him a faith in education and also a faith in their Jewish heritage. While he maintained a lifelong faith in the value of education, his religious faith zealously culminated in his Bar Mitzvah at the age of 13 and transcended into complete agnosticism almost immediately thereafter. Clearly, he was able to subscribe to one set of beliefs with almost religious fervor at one stage of his life and

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completely reject it for another view of the world shortly thereafter with equal fervor. Some would regard this sense of shifting attachments as a lack of conviction. Friedman instead characterized it as an ability to acknowledge, accept, and embrace new ideas that seem to better fit an evolving reality. Like Irving Fisher before him and Franco Modigliani later on, Milton Friedman lost his father early in his life, during his teenage years. As he prepared to enter his senior high school year, at the age of 15, his father died of angina. This condition of reduced blood flow to the heart, which causes a deterioration of the heart muscle, is typically a result of obstructions or a spasm of the coronary arteries. Milton himself was also diagnosed with angina in his adult life, which was treated successfully with heart bypass surgery. Milton went on to graduate from high school in 1928, at the height of the Roaring Twenties, near New York City, which most typified that freewheeling economic and cultural era. He did not seem to be highly influenced by that free-wheeling era and, instead, left high school with an appreciation for the classics, geometry and mathematics, debate, history and civics, and reading.

College years As Friedman contemplated college, a couple of his high school teachers, both recent Rutgers University graduates, encouraged him to attend their alma mater, barely a dozen miles away from his home. He was a child of a family that had struggled financially and was headed by a widowed mother. The fact that only Rutgers offered him a scholarship was the deciding factor in his decision to attend. Friedman also had to work to pay the other bills beyond his tuition scholarship. He was fortunate to find a clerk’s job at a local department store at a wage of little more than 30 cents an hour for a 12-hour day every Saturday. Following the Great Crash of 1929, he was even more fortunate to retain that job for the entire four years that he attended college, until his graduation in the midst of the Great Depression in 1932. Friedman proved industrious as well. While at Rutgers, he arranged to work with the secondhand book buyer and seller Barnes and Noble to buy back textbooks. Part of the agency agreement with Barnes and Noble, in addition to his 5 per cent commission, was the right for Milton to buy back books at 45 per cent of the list price. In the spirit of trading and arbitrage of which his father would be proud, he built a

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successful book-buying and trading business at each academic year end and then, having already identified those texts that would be reused in the subsequent year, sold certain select books back to students in the fall. His foray into intertemporal finance was quite innovative for an 18 year old. Interestingly, a decade later, Modigliani also earned a livelihood as a book buyer and seller while working at Rutgers University. Friedman also began a summer school program, sold fireworks, and even sold encyclopedias door-to-door up to 1932. He earned what could only be regarded by a young college student as princely sums in those lean Depression-era years. Like Irving Fisher and John Maynard Keynes, Friedman began college as a mathematics major and ended studying economics. His conversion to economics was influenced by an economics professor named Arthur F. Burns (1904–1987), a recent graduate of Columbia University, and the writings of classical economist Alfred Marshall. Burns went on to become the Chairman of the US Federal Reserve System. He was also a child of Austrian-Hungarian Jewish family from a city barely 150 miles from where Friedman’s parents were born. A professor who seemed so urbane, intellectual, and mature to Friedman, but who was actually only eight years older, Burns became a strong influence. Friedman credits him with the requisite standards of scholarship – fact checking, referencing, and an open mind – that influenced his subsequent intellectual work.141 In fact, when Burns died in 1987, Friedman wrote a memorial passage that was almost autobiographical and was a testament to self-reliance and an open society. He wrote: As one looks over Arthur’s life, one cannot but marvel at the human potential that a free society can release. A boy of ten arrived in America speaking not a word of English, the son of parents in poor economic circumstances who settled in Bayonne, New Jersey. Eleven years later, he was graduating from Columbia University as a Phi Beta Kappa and the same year earned a master’s degree. His parents were able to provide little or no financial assistance. He earned his keep by a wide variety of jobs. In addition, he received some scholarship help for tuition. … He went on to become a world-famous scholar, a professor at a leading university, the director of research of a prestigious economic research institute, president of the American Economic Association, and subsequently a major public figure – all entirely on the basis of personal qualities, not as a result of influence of any kind … What a

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testament to the benefits that a policy of free immigration has conferred on the United States.142 With the change of perhaps two or three words, this statement could have easily served as Friedman’s own eulogy. Friedman was also exposed to and influenced by another young faculty member named Homer Jones (1906–1986). Jones was required to teach insurance and statistics, courses that were both mandatory for actuarial studies, to which the mathematically interested Friedman transitioned toward before ultimately ending up as an economics major. Jones was a University of Chicago graduate and inevitably influenced the still impressionable Friedman to take his entrepreneurial savings and make his way to the University of Chicago for graduate studies in economics. The Chicago school was renowned for its emphasis on self-reliance and individual freedom even then. Professor Jones related stories about the famous economist Frank Knight (1885–1972) and his stress on the need to cultivate a free and entrepreneurial spirit. Surely, given Friedman’s already demonstrated penchant for free enterprise, the notion of an entire department that cultivated his already-established set of economic values must have seemed like a dream.

The Chicago years It is sometimes difficult to discern whether one chooses a life or whether life chooses one. In any regard, Friedman chose to study at the University of Chicago in 1932, and he and the Chicago school became intertwined. However, this time around he had two scholarship offers, only one of which was in economics. He packed his bags and drove west with two classmates. Friedman loved the intellectual life at Chicago and also met there the love of his life, Rose Director. Rose, too, was born into a Jewish family from an Eastern European town within 100 miles or so of the home town of Milton’s family, in what is now the Ukraine, in late 1910, 19 months before Milton’s birth. Her family moved very soon thereafter to the USA and settled in Portland, Oregon. Like Milton’s father, Rose’s father was first a peddler and then a merchant in Portland, and, like Milton’s parents, her family valued education. After her precocious intellect was cultivated in high school, she headed off to college, first at Reed and then to the University of Chicago, as an economics major to join her older brother Aaron, who first studied and then joined the faculty at Chicago.

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It was in a graduate level course in price theory offered by the brilliant Professor Jacob Viner (1890–1972) that Rose and Milton first met. And it would be due to the influence of Frank Knight and the Chicago school world view that their intellects would coalesce. Friedman’s initial year at Chicago was much more financially challenging than was his stay at Rutgers. He had an excellent job working in a menswear department in New Brunswick, New Jersey, was able to raise some extra money waiting tables, and had his business ventures. He tried to replicate his previous successes when he arrived in Chicago, but found it much more difficult to put himself through school in a new town in the Midwest during the depths of the Great Depression. Unable to find an academic position, he sought other opportunities. When one of his mentors, Professor Henry Schultz (1893–1938), found him an opportunity to study at Columbia on a doctoral fellowship upon completion of his master’s at Chicago in 1933, he jumped at the chance. There he was able to broaden his mathematical skills under the guidance of Harold Hotelling (1895–1973). When he returned to Chicago the next year to continue work under Professor Schultz and resume his relationship with Rose, he was already amassing an extensive economic toolbox. In the summer of 1935 and then the fall of 1937, two years that bookended Keynes’ The General Theory of Employment, Interest and Money in 1936, Friedman had travelled to Washington DC to find employment in New Deal-related economic analysis. He found himself working on projects dealing with the pressing economic issues of the time. The first was on the design of a study on consumer decisions. His insights from that project would later influence his A Theory of the Consumption Function. The second project, in the fall of 1937, allowed Friedman to work with Simon Kuznets at the National Bureau of Economic Research on Kuznets’ income studies. This work, and their joint paper entitled “Incomes from Independent Professional Practice,” contributed to his Columbia University doctoral dissertation. It was this dissertation that led him to his discovery of permanent and transitory income. The combination of Friedman’s work on the consumption function and on income was also influenced by fireside chats with two friends of Rose and Milton, Dorothy S. Brady and Margaret Reid, both of whom also produced provocative papers that would try to address Kuznets’ data on the steadiness of consumption and the sensitivity of savings over the business cycle. Indeed, Modigliani, too, cited Brady and Reid, and Milton Friedman’s wife Rose, and their interpretations of Kuznets’ observations as highly influential in his Life Cycle Hypothesis model.

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By 1945, both the Great Depression and the Second World War were over, and Rose and Milton were married. The next year, Friedman’s dissertation was accepted at Columbia University and he was invited back to Chicago to replace his esteemed and influential professor, Jacob Viner, who had left for Princeton University. Friedman remained associated with the University of Chicago for the rest of his professorial career. His stay at Chicago would be punctuated by visiting years elsewhere, including Cambridge, England, from where the Keynesian tradition still flows, and by travels as an economic advisor around the world. But while the Great Depression was well over by then, the great debate on consumption and savings was not.

19 The Times

In the midst of the Great Depression, during which Irving Fisher had been disgraced for his faith in simplistic classical remedies to an almost perpetually painful economic problem, and John Maynard Keynes was penning his The General Theory of Employment, Interest and Money in frustration with the classical model, Milton Friedman was cultivating his Chicago-influenced views and Franco Modigliani was about to enter college. There were emerging three schools of thought, which Friedman eloquently summarized years later in his memoirs, in recollection of a public debate between himself and the economist Abba Lerner of the London School of Economics: I was myself first strongly impressed with the importance of the Chicago tradition during a debate on Keynes between Abba P. Lerner and myself before a student-faculty seminar at the University of Chicago sometime in the late 1940s (or perhaps the early 1950s). Lerner and I were graduate students during the early 1930s, preKeynes’s General Theory; we have a somewhat similar Talmudic cast of mind and a similar willingness to follow our analysis to its logical conclusion. Those have led us to agree on a large number of issues – from flexible exchange rates to the volunteer army. Yet we were affected very differently by the Keynesian revolution – Lerner becoming an enthusiastic convert and one of the most effective expositors and interpreters of Keynes, I remaining largely unaffected and if anything somewhat hostile. During the course of the debate, the explanation became crystal clear. Lerner was trained at the London School of Economics, where the dominant view was that the depression was an inevitable result of the prior boom, that it was deepened by the attempts to prevent 176

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prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by “easy money” policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate weak and unsound firms. By contrast with this dismal picture, the news seeping out of Cambridge [England] about Keynes’ interpretation of the depression and of the right policy to cure it must have come like a flash of light on a dark night … It is easy to see how a young, vigorous, and generous mind would have been attracted to it… The intellectual climate at Chicago had been wholly different. My teachers regarded the depression as largely the product of misguided policy – or at least as greatly intensified by such policies. They blamed the monetary and fiscal authorities for permitting banks to fail and the quantity of deposits to decline. Far from preaching the need to let deflation and bankruptcy run their course, they issued repeated pronunciamentos calling for government action to stem the deflation – as J. Rennie Davis put it, “Frank H. Knight, Henry Simons, Jacob Viner, and their Chicago colleagues argued throughout the early 1930s for the use of large and continuous deficit budgets to combat the mass unemployment and deflation of the times.” There was nothing in these views to repel a student; or to make Keynes attractive. On the contrary, so far as policy was concerned, Keynes had nothing to offer those of us who had sat at the feet of Simons, Mints, Knight, and Viner.143 The die seemed cast in those days during the Great Depression at Chicago. Indeed, Friedman claimed that the bulk of those economists who did not subscribe to Keynes’ theories resided in Chicago. He clearly believed that the Keynesian view was inappropriate. The Great Depression was exacerbated, if not caused, by a great deflation. He was convinced, much like Fisher, that deflation was the culprit, not necessarily some sort of inherent deficiency in consumption. This world view would come into play as Friedman grappled with a theory of consumption and then developed his permanent income hypothesis, for which he would win the Nobel Prize. The split between the non-interventionist classicists, the government interventionist Keynesians, and the Chicago school has defined economics ever since. It is clear that all now believe the classical model fails to describe why an economy can remain off-kilter for dangerously

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long and painful periods. Given such a broad acceptance, the issue comes down to whether government can remedy economic malaise or whether prudent and predictable monetary policy can do so beyond the pale of self-serving political manipulation or mismanagement. It was from this sense of self-reliance and suspicion of government intervention that the economic philosophy of the Chicago school flowed. And with the waning of such Chicago stalwarts as Frank Knight and Jacob Viner, it was Milton Friedman in particular who would carry the torch. Of course, the responsibility to act as the face of a social science philosophy required complete immersion in and acceptance of its basic tenets. These tenets were not something Friedman had to learn; rather, he had lived and absorbed them and they were at his core. These tenets included a faith in the human entrepreneurial spirit and a profound skepticism in any entity that might try to bind or manipulate that spirit. This young, self-made, entrepreneurial son of Eastern European immigrants was precisely the type of individual that could carry forward the philosophy of a meritocracy built upon self-reliance and ability rather than privilege and influence. Chicago had its man.

20 The Theory

Milton Friedman’s permanent income hypothesis was controversial from the onset. It was not that the theory was an unreasonable or empirically untestable one; rather, it was the offshoot of a strand of research that Simon Kuznets and Friedman had pursued in the mid-1940s. The goal of Kuznets and Friedman was to better understand consumption. Kuznets recognized early on that the level of consumption was more stable and savings less stable than Keynes’ General Theory would suggest. The supposition was that there was some sort of smoothing variable that prevented consumption from shifting rapidly with changes in income. Some had resorted to rather unsatisfactory theories not unlike the theory of downward wage rigidity. Wage rigidity theory argued that while employees will tolerate higher wages, they will not accept reductions in wages. For instance, if a group of ten employees was asked to choose between a 10 per cent wage bill reduction through an across-theboard wage decrease of 10 per cent or through the lay-off of one worker, nine out of ten of the employees would choose the lay-off. They might argue that it would be too difficult to quickly lower consumption, given that so many elements of consumption are locked in by loan contract or custom. Similarly, it is argued that there is a ratcheting upward of consumption just as there could be for the upward march of wages. Once one commits to a higher pattern of consumption, through the purchase of larger homes, etc., it becomes difficult to scale back consumption. However, while wage ratcheting is due to the asymmetry between wage increases and lay-offs, the same argument does not extend to consumption. Instead, Kuznets and Friedman argued that an investment in one’s human capital may provide for a longer term stability in income that 179

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another individual who is poorer in human capital might not have. For instance, a doctor or a dentist may be in equal demand at certain times, as might be a bridge worker. However, the steady demand for the doctor’s or the dentist’s human capital creates for these individuals a greater “permanent” income and makes it safer for such individuals to ratchet up consumption accordingly, with little fear of forced consumption reductions later. While this thesis does not seem controversial, the authors went further in a way that prevented them from publishing their results for years. They had drawn a conclusion that doctors benefited from greater permanence in income generation than dentists because of the power of the American Medical Association to limit competition in an effort to create steady and high doctor salaries. The political controversy of this supposition in some quarters delayed the publication of their paper. Because Columbia University required publication of some form of a dissertation before it would reward a PhD, Friedman’s academic progress was also frustrated. Friedman and Kuznets summarized their concept of permanent and transitory income as follows: The dichotomy between permanent and transitory components of a man’s income ... necessarily does violence to the facts. An accurate description of the factors determining a man’s income must substitute a continuum for the dichotomy. This continuum is bounded at one extreme by “truly” permanent factors – those that affect a man’s income throughout his career – and at the other by the “truly” transitory – those that affect his income only during a single time unit, where the time period is the shortest period during which it seems desirable to measure income ... Between these extremes falls what may be called “quasi-permanent” factors, factors whose effects neither disappear at once nor last throughout a man’s career.144 Friedman believed as a matter of social science philosophy that no theory had any validity unless it could produce some empirically testable hypotheses that could substantiate the theory. The challenge for him in the ensuing years was to produce an empirical test for his theory. However, no test of permanent income could be created if data was necessarily backward-looking and Friedman’s concept of permanent income had a rational expectation of future income implication. Instead, he produced a measurable theory by developing a methodology that we now call adaptive expectations.

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Friedman began by modeling consumption Ct in a period t as the sum of a permanent and a transitory component: Ct  CtP  CTt Similarly, income has both permanent and transitory components: Yt  Y tP  YTt These transitory components of income and consumption are unanticipated, average zero over time, and are not correlated over time with each other. Consistent with Keynes’ notion of the propensity to consume, Friedman assumed that households spend a share b of their permanent income on permanent consumption: C tP  bY tP Friedman recognized that permanent income is an empirically unobservable variable. He assumed that households would adaptively determine changes to their permanent income by interpolating some share of their total income in one period and the permanent income they deduced in a previous period. This rate by which they adjust their income expectations is given by a constant l that is between zero and one: P

P YtP  Yt1  l(Yt  Yt1)

In other words, households anticipate that a share of any observed increase in income is partly permanent and partly transitory. We can rearrange this expression to determine that current permanent income is simply a weighted average of current transitory income and past permanent income: P

Y tP  lYt (1  l)Y t1 If permanent consumption is a constant share b of permanent income, then: P

C tP  Ct  C Tt b(lYt  (1  l)Y t1) or

P

Ct  b(lYt  (1  l)Yt1)  C Tt

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Of course, Y P remains unobservable for period t – 1. However, we know that: P

P

Yt 1  lYt1  (1  l)Y t2 Then: P

Ct  ( blYt  b(1  l)lYt1  b(1  l)2Y t2)  CTt Using this substitution, Friedman was able to avoid the dilemma of the determination of the permanent income in period t and t  1 by substituting in a measure of permanent income in t  2, multiplied by the factor b(1  l)2. However, because b and (1  l) are both less than one, the expression b(1  l)2 is even closer to zero. We can continue this pattern by then calculating permanent income at t  2 as a function of the known income in t  2 and permanent incomes from even more distant time periods: Ct  blYt  bl(1  l)Yt1  bl(1  l)2Yt2  ···  bl(1  l)s1Yts1  b(1  l)sYts1  CTt If this equation is taken back to s sufficiently distant time periods, the expression b(1  l)s becomes vanishingly small and the measurement P of permanent income Y ts1 in that time period becomes increasingly irrelevant and can be dropped. From this expression, we can observe that the short-run marginal propensity to consume dCt/dYt is given as lb  1, as Keynesian theory would require. We can also calculate an expression for consumption in the current period as a sum of the short-run income and the permanent consumption: Ct  blYt (1  l)Ct1  CTt (1  l)CTt1 Ct  CTt  blYt (1  l)((C)t1 CTt1) CP  blY P (1  l)CP lCP  blYP CP  bYP In other words, the long-run permanent propensity to consume is larger than the short-run marginal propensity.

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Adaptive expectations Friedman took a clever leap by deducing household expectations for future income based solely on the measurement of past data. It is this theoretical leap, labeled adaptive expectations, in which past data is used to predict the future that also helped form the basis for modern finance. In his book, Friedman went on to compare his adaptive expectations model to actual consumption, income, and savings behavior. Using his ingenious specification of the model, in which a series of consumption decisions each incorporated a measure of the individual’s permanent income, he could deduce this unobservable expectation of future income. He noted: The permanent components of income and consumption can never be observed directly for an individual consumer unit; we can only observe ex post what it spends and what it receives. We can, however, make inferences about the permanent components for groups of families from observed data if we accept certain assumptions about the relation between permanent and transitory components.145 Friedman viewed this work on income and consumption, and hence savings, as his finest achievement.146 It was a classical approach in some sense because it assumed that households behave rationally to changes in income by adjusting consumption only modestly. Households were, in essence, determining their permanent income with every consumption choice they made. Friedman did not describe to us how consumers make these consumption and savings decisions. However, he was able to glean the result of these decisions from the data. Consequently, his model was descriptive rather than prescriptive.

The test Friedman was motivated primarily to develop a theory that could be tested to determine its validity. He hypothesized that individuals consumed and saved as if they understood and accurately determined their permanent income. In finance and econometrics, a model is constructed as a way to simulate in the mathematical abstract the actions of agents, be they households, investors, or firms. This model is then tested against the data. Under Friedman’s approach to economics and finance, a successful model is one that has yet to be rejected against the data. However,

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because models are used to abstract the ways in which humans make their often intuitive decisions, they cannot ever be proven as a law of nature – unless, of course, someday we understand precisely how the human mind works and how complex markets function. It could then be argued that the accuracy of the model is in its ability to mimic and predict market movements and individual decisions. This utility is a pragmatic measure, which would have us prefer a model that predicts very well, even if it seems to make unreasonable assumptions or adopt unorthodox or nonsensical methods. Friedman was a lifelong advocate for an approach called “positive economics.” This approach, first described by John Neville Keynes (1852– 1949), John Maynard Keynes’ father, specified that analysis is strongest when it limits itself or focuses on what is, rather than what ought to be, in the opinion of the expositor. In his book The Methodology of Positive Economics, published in 1953, just a few years before his A Theory of the Consumption Function, Friedman argued that a model should be judged based on its predictability rather than on the elegance or realism of its assumptions.147 His theory of the consumption function was at once elegant and potentially practical. While he did not model how individuals determined their permanent income, his approach lent itself to empirical verification. The primary tool of econometrics, now and then, is the regression model. A regression posits that a series of independent variables, in this case past incomes plus current transitory consumption, determine a dependent variable, in this case current consumption: Ct  blYt  bl(1  l)Yt1  bl(1  l)2Yt2  ···  bl(1  l)s1Yts1  b(1  l)sYts1  CTt To perform this regression, the researcher would require consumption data for a large number of periods and income data for these periods and at least s additional periods. In this case, the regression is said to be linear because the independent variables influence the dependent variable in a linear fashion. However, in practice, the data set must contain many more consumption and present and past income combinations than s periods. A regression is stronger to the degree to which the number of dependent variable points explained exceeds the number of independent variables used to explain the data. To garner this strength, Friedman would have

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to use data that is typically generated annually, sometimes measured quarterly, and rarely tallied monthly. He would then be forced to use data that went back many years, through wartime and depression, booms and busts, and with every possible change in consumption psychology from era to era. As noted earlier, extending such analyses through major regime changes presents significant modeling challenges. His methodology also used what econometricians call a distributed lag. The coefficients of various forms of b and l must take the very particular form specified in his derivation. He also introduced additional variables that inevitably reduced the power of the regression. The econometric techniques and challenges were rather daunting for the time and the tests for the validity of his results for such distributed lag constructs were not well understood. In the empirical chapters of his seminal paper, Friedman reported some of his own results but also recast the results of other researchers within his framework. Today, the technique in which researchers aggregate the results from many other studies into their own collective study is called meta-analysis. Friedman’s meta-analysis demonstrated that the data and analyses of others were not inconsistent with his own characterization of the problem and the solution. We qualify this characterization as “not inconsistent.” This is because one cannot use empirical techniques to conclude that one model is superior to others if they all offer plausible explanations and fit the data with comparable success. In Friedman’s definition of positive economics, a model cannot be rejected, even if it can make sense of the data no better or no worse than a more intuitive approach like the Life Cycle Hypothesis produced by Modigliani. Within Friedman’s own definition of positive economics, his model was a tremendous success.

21 Applications

Milton Friedman’s results were significant, even if they differed substantially from those of Franco Modigliani. Both Modigliani and Friedman were motivated by the need to explain empirical observations in the rate of savings of households. Both correctly surmised that savings could not be determined without modeling consumption – as it is consumption, now or in the future, that Irving Fisher demonstrated to us would determine the saving decision. Modigliani broached savings directly in his Life Cycle Hypothesis. However, his approach was firmly within the scope of what could be and, from that analysis, an explanation for what is. Friedman, on the other hand, was not as formal or as explicit in what could be. Instead, he introduced the notion of a permanent income as a theoretical construct and a starting point, not unlike Modigliani’s lifetime income. Friedman felt no need to match Modigliani’s formality in modeling the future. Indeed, he argued that a permanent income was based not on an elaborate life cycle, but rather against an infinite time horizon. Friedman assumed that individuals make their own determination of the permanent income. His task was to deduce this permanent income through mathematical logic and then attempt to measure it and the consumption determined by it: The hypothesis has many empirical implications in addition to those already stated about the regression of measured consumption on measured income. For example, it can be used to decompose the dispersion of measured income, and also of measured consumption, into the parts attributable to transitory and permanent components. It implies that if consumer units are classified by their income from 186

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one year to another, the regressions of consumption on income for such groups will, under plausible conditions, be parallel and differ in height by amounts that can be specified in advance; and that the common slope will be steeper than the slope of the regression for all units combined by an amount that can be calculated from a characteristic of the income distribution for the group as a whole. It can be used to predict the correlation between the ratio of measured saving to measured income of the same units in different years. For aggregate data for a country like the United States that has been experiencing secular growth, it implies that the elasticity of consumption with respect to measured income computed from time series will be higher, the longer the period spanned by the data, and the longer the elementary time unit of observation; that it will also be higher when computed from data on aggregate consumption and income than from per capita data and when computed from data in current prices than from data in constant prices.148 Friedman recognized that his model was one resolution to the observation that consumption does not vary as much as does income, while savings vary significantly over the business cycle. He also drew the clever conclusion from his Permanent Income Hypothesis that the long-run propensity to consume was larger, as income rises over time, than the short-run propensity. However, while it had many superficial similarities to the Modigliani Life Cycle Hypothesis, it was not the same. For instance, Modigliani’s model was based on the present value of lifetime wealth potential, not just income, and each model made different predictions. While the permanent income in Friedman’s approach could be viewed as a measure of the potential permanent (infinite time horizon) income flow from lifetime income, a temporary increase in wealth would have little effect on this permanent income. On the other hand, transitory changes in income strongly affect transitory consumption in the same period. We should recall that Friedman could not directly measure permanent income. Rather, he estimated permanent income from past income plus any change in income in the current period. This last period income, with the transitory effect removed, then acts as a basis for permanent income. Meanwhile, any increase in this income from the past to the present will not be considered permanent. Hence, permanent consumption holds steady, which is not inconsistent with the data both Modigliani and Friedman observed.

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However, while Friedman could still calculate savings each period as the difference between actual income and actual consumption in each period, unlike Modigliani, he did not explicitly treat savings. Modigliani’s model also made the same observations provided by Friedman, including consumption that was based on his own sense of permanent life cycle income. He explicitly modeled savings as the difference between income and consumption, and thus concluded that savers are not necessarily the rich but rather are those that have unexpectedly high incomes over certain periods. Friedman’s motivating observation was that savings do not rise as rapidly as income in an economy. He observed that the perception of increased savings occurs because those at the top of the income distribution often benefit by increased transitory income, and hence increased savings, during a period of rising income. A general and permanent rise in income will not result in such a rise in savings because consumption will rise likewise. Friedman also noted that this same growth often saddles those on the lower end of the distribution of incomes with transitory declines in income, resulting in depleted savings. The increased transitory savings of one group in the income distribution is negated by reduced savings from another. Friedman argued that the Keynesian notion of increased savings with economic growth is unfounded. However, this result was at odds with many studies and with Modigliani’s result. Studies had shown that, as income rises, so does the ratio of household wealth to its income. This wealth arose from accumulated savings and cast into question Friedman’s belief that consumption and savings both represent a constant share of household income. Indeed, Friedman argued that households continue to save at the same rate, through their wealth-derived permanent income, even once retirement and the end of life approaches. Modigliani observed that savings follow a life cycle, while Friedman’s adaptive, infinite horizon model does not. This difference creates an important distinction. In Friedman’s Permanent Income Hypothesis model, growth creates an expectation of increased income, and hence increased consumption and decreased savings. Conversely, in Modigliani’s model, increased income arising from economic growth results in an increase in consumption needs in later years and an increase in savings now. Actually, Modigliani was quite charitable in his regard for Friedman’s approach. He noted that both models successfully debunked the old paradigm and the simplistic Keynesian prophecy that only the rich

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saved. He noted that, in either model, the ratio of savings to income would have to increase if transitory income increased. This is because an increase in transitory income variability increases the link between current and transitory income. Consequently, savings would increase. For instance, the data had long noted that farmers save more than urban workers, even given equivalent net incomes. Because, for instance, a civil service employee has a very steady income source, it is simply not as necessary to “save for a rainy day” to smooth over income fluctuations. As such, the observed increased savings rate among farmers and rural households was explained successfully in these models. Rather than attribute to farmers a high marginal propensity to save in general, it was noted that they had an average propensity to save out of their transitory income, which, for farmers, was a greater share of their income. Another observation that had interesting sociological implications was the conclusions that could be drawn from two different populations. For instance, let us compare a population A that typically is wealthier on average than a population B. Within each population would be some individuals with similar incomes. Conventional wisdom might suggest that those with a certain income in the higher average income population A would save more than someone with the same income from the lower average income population B. However, the data suggests otherwise; those with the same income in the lower average income population B save more than their counterparts in the higher average population A. To add further support for the Life Cycle Hypothesis model, by tracking the level of savings for a given household over time, we find that savings decrease as retirement draws near. This result cannot be derived from the more limited Permanent Income Hypothesis model.

Public policy ramifications Nonetheless, Friedman drew strong conclusions from his model and explored the implications on public policy. For instance, a large portion (1  ) of any tax rebate would typically be saved because the rebate would be considered transitory income. On the other hand, a permanent tax decrease would be saved at a lower rate (1  ) because it would have a stronger effect on permanent consumption. This wisdom remains at odds with the conventional wisdom that tax rebates stimulate consumption and that tax reductions stimulate savings.

22 The Nobel Prize, Life, and Legacy

Apart from his theories, Milton Friedman set the tone by which his profession would be judged. Economics branched from esoteric discussions of class and the human condition and into the realms of money, finance, savings, and high finance. Like John Maynard Keynes before him, Friedman also gave voice to an approach that no longer insisted on mathematical elegance but was instead willing to take the more pragmatic approach of results over refinement. Friedman preferred substance over style. As a first-generation American, he railed against elitism and influence, and believed all should be judged based solely on merit. In his models, too, what mattered to him was results, not elegance. Like the other great minds documented here, Friedman was skeptical of conventional wisdom. While commentators often invoke the expression in support of a traditional or commonly held belief, it describes quite the opposite. Indeed, John Kenneth Galbraith invoked the expression as a call to reject conventional thought. This unconventional approach was something upon which Friedman would agree, even if he rarely agreed with the school of thought emanating from Galbraith’s Harvard University of Cambridge, Massachusetts, the bastion of tradition within the US education system. Nor would he agree with the school of economic thought espoused in Cambridge, England, one of the two stalwarts of tradition in the UK. Friedman rebuked the emerging Keynesian orthodoxy that was prevalent following the Great Depression and into the war years. Like Franco Modigliani and others, he worked to demonstrate that the Keynesian consumption function was an oversimplification that did not fit the data. He also rejected Keynes’ policy prescription. As a young Rutgers student, he was at first impressed by Keynes’ pre-General Theory book 190

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A Treatise on Money.149 Friedman had followed up this thesis with his own description of the failure of the Federal Reserve to stem the depression. In what has become a highly regarded analysis, he argued that the Fed performed precisely the wrong policy by tightening the supply of money, and hence the liquidity of banks, in the aftermath of the Great Crash. It was his belief that the prudent policy at the time would have been to ensure sufficient monetary liquidity to allow for the forces of equilibration to return the level of unemployment to its natural rate. By the time Friedman wrote his influential A Monetary History of the United States: 1867–1960 with Anna Schwartz, his belief in the superiority of a society based on merit rather than tradition was firmly ensconced into his libertarian persona and prevailing mode of thought. He believed that the best that government could do would be to create an environment for a healthy private sector.150 While he agreed with the monetary transmission mechanism formulated by Keynes, in which the monetary authority provides the liquidity in financial markets to ensure they function efficiently, he did not agree with Keynes’ conclusion that government was in the best position to place a derailed economy back on track. Nor did he agree with the fiscal policy of government spending in lieu of sufficient consumption; rather, he argued for an autonomous central bank that maintained sufficient monetary liquidity, but no more. Friedman was intelligent, an excellent debater, and of quick mind. His predilection was to conclude that the best policy choice would always be one that relied on the merits of the private sector rather than the politically tainted machinations of the public sector. Because he had such a command of the theories of others and the economic history of the world’s largest economy, he could quickly and efficiently draw upon the facts that would support his world view. Consequently, he was a most formidable proponent of this view. This ability would lead him to the highest levels of academia, politics, and society. In addition, it would lead him to become the most recognized economist of the latter half of the twentieth century. Friedman continued to expand his influence in the 1960s and 1970s following his important works on consumption and savings, and on the money supply. While he increasingly devoted energy to the economic enlightenment of politicians and the public, he also spent more time away from the University of Chicago. He had, for years, maintained a second home in Vermont, about 25 miles north of Dartmouth College. He also found himself travelling around the world during this period

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to proffer his advice on monetary reform and the cultivation of free markets.

The Nobel Prize On the morning of Thursday, October 14, 1976, Friedman left Chicago to travel the 280 miles to campaign in Detroit, Michigan on an amendment to its state constitution. Not surprisingly the amendment would limit state government spending and was quite controversial in that traditionally working-class state. Friedman was accustomed to controversy and some argued that he relished it. However, even he thought the number of reporters amassed at his Detroit speaking engagement was unusual. As he got out of the car, reporters asked what he thought about the award. He asked them to what award they referred, to which they responded “why the Nobel, of course.” He had not yet heard of the announcement of the award. Rose and Milton Friedman were a team, without any doubt. An important and perhaps misunderstood aspect of Milton’s meritocracy principle is that he felt compelled to make others aware of his skills and accomplishments. Within the elitist system, which he preferred to disband, such personal aggrandizement would be considered unbecoming. However, a meritocracy is about open information rather than the politics of cigar-filled rooms. If Milton did not, at times, work hard to further his reputation, then who would? Rose would and did. Rose Friedman posed two questions about the timing of the Nobel Prize: first, why did people expect Milton to earn the Prize earlier and, second, why did it take so long?151 As discussed earlier, the Nobel Memorial Prize began in 1969, decades after the creation of the other Nobel Prizes. The Nobel Memorial Prize is also only given to living recipients. At its inception in 1969, there were two towering figures in economics – Paul Samuelson and Milton Friedman. Paul Samuelson went on to win the second Nobel Prize in 1970. However, it would not be for another six years that Milton Friedman would win a Nobel Prize. The Friedmans believed, and many agreed, that his life’s work had finally been honored, but that his advocacy for libertarianism and free-market economics had delayed his award.152 When the award was announced, Robert Skole, then a Swedish reporter, wrote in Nation magazine153 that: “We journalists waited two hours past the original time set for the Academy of Sciences to announce its Economics Prize … [the] Friedman announcement was delayed, and

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it was pretty obvious that some members of the Academy were arguing against him.” In addition, in the October 24, 1976 edition of the New York Times, multiple Nobel Prize-winner Linus Pauling, along with Nobel Prize winner David Baltimore, wrote: “In a deplorable exhibition of insensitivity, the Nobel Memorial Committee on economics has awarded the prize this year to Milton Friedman.”154 Meanwhile, the Wall Street Journal came to Friedman’s defense: Given any remote chance to gun down an affective spokesman for conservative economics as a secret fascist and torturer, even Nobel Laureates can, we see, succumb to an itchy trigger finger. With so powerful a compulsion at work, the myth about Mr. Friedman in no doubt in a good many minds. But anyone who takes the time to learn the facts should recognize the smear as McCarthyism of the left.155 Few would deny that Friedman was a polarizing and provocative figure. This controversy could do nothing but enhance his notoriety and public interest. The Royal Swedish Academy of Sciences awarded the 1976 Prize in Economic Sciences in memory of Alfred Nobel to Friedman for “his achievements in the fields of consumption analysis, monetary history and theory, and for his demonstration of the complexity of stabilization policy.”156 The Committee prefaced their press release for the award with the assertion that his name was primarily associated with the role of money in inflation and monetary policy. In doing so, they noted, he rebalanced the stabilization policy discussion from its previous emphasis in government fiscal policy intervention. Rather astutely, the Committee noted that Friedman was defined as a reactionary in what had become the conventional wisdom of Keynesian policy. In an almost unprecedented commentary that acknowledged his unconventionality, they noted that it was his independence and brilliance in stimulating lively scientific debate, and the influence he garnered, that was also being recognized. Beyond his contribution to scientific discussion and controversy, and his monetary theories, the Committee singled out his theory of consumption as his most significant contribution in the purely social scientific realm. It was Friedman’s consumption function theory that created a significant discussion on the role of lags in economic phenomena. Recall that the lagged structure of past incomes was used to derive permanent income and hence current consumption. He had, in his

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studies with Simon Kuznets and in his work on the theory of consumption, recognized that lags can affect such important variables as consumption and their effect on the business cycle. On that basis, he was well aware of the necessity to understand such observation lags, decision lags, and effect lags in the proper design of stabilization policy. He was also cognizant of the possibility of policy hangovers, as the effect of policies remains beyond the time necessary to remedy the economic malady. For these reasons, Friedman advocated that a stabilization policy can ultimately be destabilizing. Instead, the Committee acknowledged his advocacy of simple, steady, and transparent macroeconomic and financial rules to avoid the unintended and, to him, inevitable and unfortunate results of public economic policy. Finally, the Committee recognized Friedman’s contribution to our understanding of the role of expectations and the concomitant effect of our expectations in neutralizing economic policies or shocks and re-equilibrating our economy. To this the Committee was referring to Friedman’s most influential Presidential Address to the American Economic Association in 1968. In that speech, he argued convincingly that the often-discussed economic trade-off between inflation and unemployment was a short-term phenomenon. Once households adjust their expectations accordingly, this “Phillips Curve Tradeoff” would be replaced by economic activity that he labeled as the Natural Rate of Unemployment (NRU). This concept emerged as the basis for the new classical school of thought.

Later years Friedman’s almost unabashed advocacy made him a controversial public figure. By 1977 he had reached the age of mandatory retirement at the University of Chicago and had accepted a position as a Senior Research Fellow at the equally conservative Hoover Institution at Stanford University in California. He once again found himself in a supportive and free market-oriented environment. One of the first projects Friedman embarked on soon after his arrival in California was a ten-part television series for the US Public Broadcasting Service (PBS). These one-hour shows, entitled Free to Choose, were aired in the USA beginning in 1980, but were also broadcast in a number of other countries. These talks and town meeting-style discussions, and the subsequent best-selling book of the same name, placed Friedman firmly into the social dialog of a nation in the midst of post-Watergate

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political turmoil and on the cusp of the presidency of Ronald Reagan, whom he served as an unofficial advisor.157 In the words of Rose: As we look back at the events chronicled in this chapter, it all seems like something of a fairy tale. Who would have dreamed that after retiring from teaching, Milton would be able to preach the doctrine of human freedom to many millions of people in countries around the globe through television, millions more through our book based on the television program, and countless others through videocassettes.158 Friedman’s social and economic influence waned in the 1990s, based perhaps on the more centrist shift of US social and economic policy under President Bill Clinton and the success of the economy in promoting very strong economic growth and creating a budget surplus after decades of deficits. Milton and his wife Rose published their personal memoirs in the book Two Lucky People in 1998. Milton Friedman died on November 16, 2006. At the time of his death, the New York Times reported the loss of the spiritual heir of Adam Smith, the broadly acknowledged founder of economic science and the most eloquent describer of the theory of free-market economics. The liberal British newspaper The Guardian reported upon his death: Milton Friedman, who has died aged 94, was one of the greatest economists of all time. He may come to be included in the same category of pre-eminent figures as Adam Smith, Ricardo, Marx and John Maynard Keynes. When he began his main work, while professor at Chicago University in the 1950s and 60s, Keynesian orthodoxy dominated almost all academic macro-economics, and much of public policy in this field. By the time Friedman’s project was mostly complete, in the 1970s and 80s – with a Nobel Prize in 1976 – that orthodoxy had been shattered.159 Milton’s lifelong partner Rose died three years later, on August 18, 2009, at the age of 98 of heart failure. She was survived by a daughter, Janet, a son David, four grandchildren, and three great-grandchildren.

Section 5: What We Have Learned

This book is the first in a series of discussions about the great minds in the history and theory of finance. While the series addresses the contributions of significant individuals to our understanding of financial decisions and markets, this first title establishes a framework upon which all subsequent discussions rest. We began by describing how individuals make personal finance decisions over time and why these decisions alter as we age and our circumstances change. These analyses allowed us to better understand what we already know: humans have an intrinsic desire to sacrifice today to provide for a better tomorrow. The work of these financial theorists created the basis for what we now know as personal finance. In turn, these theorists answered for us the following six questions: why do people save? How does inflation affect savings? Why do additional savings not always translate into new investment? How does a household’s savings pattern change over its lifetime? Why is the national savings rate quite volatile over the business cycle? Likewise, why are individual savings also volatile? We have answered these questions through the context of the lives of Irving Fisher, John Maynard Keynes, Franco Modigliani, and Milton Friedman. The lives of each of the individuals covered in this volume become extraordinary not because they made an unfathomable leap in our understanding, but rather because they looked at something in a different way and caused us all to forever look at the problem in this new way. That is the test of genius. We next summarize the combination of their contributions.

23 Combined Contributions

These great minds motivated our knowledge of what we now call personal finance. As a consequence of their contributions, we now think of financial markets not only as a tool to mobilize capital for industry but also as the vehicle that evens out our consumption over our lifetime, prepares us so that we may retire in comfort from our working life, and insures us against the vagaries of the business cycle. Irving Fisher laid the first cornerstone by formalizing in a mathematical model and a graphical presentation the meaning of savings as the trade-off between present and future consumption. In a brilliant stroke, he allowed us to understand the interplay between our own internal preference for the present and the future and the market’s regard through the interest rate. Fisher’s simple model also demonstrated to us how a change in our own discount rate and the rate at which the investment market discounts the future will affect savings. His model was both elegant and seminal. It also ratcheted up the expectations of mathematical rigor that has been the hallmark of the study of personal finance ever since. Fisher then went on to act as a champion of destiny for American financial markets. His timing was perilous, as his advocacy was at its highest just as the market peaked and then plunged. While his economic analyses still taught us much, it became clear that his theories did not tell us everything. However, Fisher remained a classical economist in his faith that markets always clear and hence that savings would always match desired investment. This classical model would prove to be sorely tested in the Great Depression. It was this gap in the classical model that John Maynard Keynes filled and, in doing so, made a number of contributions to our understanding 197

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of the financial system. While he is most remembered for his Keynesian theory, his contribution to our understanding of savings and investment remains most significant today, even though his macroeconomic theory has both its supporters and detractors. Keynes pointed out that there is a dichotomy. Previous treatments of savings and investment in the classical school assumed that savings were monolithic and essentially homogeneous, and that investment was too. Investment was viewed in the classical model as the flow of funds into capital markets that were used to add to the capital stock and our ability to produce more tomorrow for some sacrifice today. Capital was considered equivalent to the seed for a farmer. However, Keynes showed us that savings may not always be directed toward productive investment. Instead, while savings may serve our need to hold assets for precautionary or speculative purposes, some of those assets can be held in cash. Indeed, our faith in the banking system and in investment markets affects our decision for the mode we choose to save. In addition, our willingness to choose investment over the money market depends on the interest rate. In essence, Keynes demonstrated that savings do not necessarily equal investment in our productive capacity. Households could choose to save in ways that produce no more in the future. These failures of the investment market created a role for public policy to cure market failure. Keynes also was skeptical of those aspects that we call investment but which do not result in increased future production. He viewed speculation as serving little productive purpose. He argued that some or, perhaps, much of the investment market more closely resembles gambling over pieces of a fixed pie rather than directing resources to expand the size of the pie. Finally, Keynes also added a psychological dimension to the study of savings. In his The General Theory of Employment, Interest and Money, Keynes hypothesized that consumption rose with income and that savings were simply the difference between income and consumption. However, since consumption does not rise as quickly as does income, savings too would rise with income. However, Keynes was unable to place his model within a dynamic framework that explicitly described changes in savings over time. Savings are by their very nature an exercise over time, so we would have to wait for more sophisticated tools to link savings to other variables, like the interest rate, in addition to the income described by Keynes. If there could be one complaint about Keynes’ novel approach and insights, it might be that they were incomplete. While their simplicity

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allowed his contemporaries to better understand an exceedingly complex convolution of factors, his assumptions and predictions relating to savings over time did not quite fit the observed data. Elaborations on his model would be necessary. Franco Modigliani and Richard Brumberg responded to the incompleteness in the Keynesian model and, in doing so, were the first to popularize the term “the Life Cycle.” Actually, a generation earlier, Frank Ramsey had described the dynamic model of household savings within the context of the present and the future and over an individual’s life and a perennial society. His results extended Fisher’s insights into a truly dynamic and intertemporal general equilibrium framework, but the sophistication of his methods were perhaps too advanced. His time had not yet come and he died just a couple of years after his most significant paper was published. While the context of savings and investment had already been established by Fisher, Keynes, and Ramsey, Modigliani carried the mantle of the Life Cycle Hypothesis after the untimely death of Brumberg, his young collaborator. Modigliani’s Nobel Prize-winning analysis demonstrated to us the financial significance of one’s career path, followed by retirement, in an elegant life cycle model. In doing so, he created a science of the study of personal finance. At the same time, he resolved some major weaknesses in Keynes’ theory of consumption and savings, and demonstrated how a growing economy would mobilize a growing saving stock that, in turn, would allow the economy to grow. There was finally a time-dynamic context for savings and the interest rate. Personal finance was born. Modigliani’s Nobel Prize was well deserved as he gave motivation to the study of personal finance. However, his model was forward-looking. While his intuition was helpful, it required us to impose on the household great insights about what the future may hold and the ability to adjust consumption at every period as a result. If people did not rationally calculate as Modigliani’s model would suggest, then, perhaps, they nonetheless behaved as if they had such rational expectations and abilities. A contemporary of Modigliani and also a winner of a Nobel Memorial Prize was the colorful and controversial Milton Friedman. He too arrived at the conclusions that individuals make their savings and consumption decisions based on some sense of the “permanent income” that will fuel their lifetime consumption path. However, he worried less about how one would arrive at a calculation of permanent or lifetime income, and instead had faith in the fact that individuals could determine their

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path of lifetime income and consumption. He set about constructing a method to reveal the level of what households surmise their permanent income to be, based on their past decisions as revealed by consumption and income data. Friedman’s approach was thus one of revealing expectations in an adaptive way. Past decisions could reveal the future. His approach and his empirical bent were very different from those of Modigliani, even if he arrived at some similar conclusions. Perhaps unsurprisingly, one conclusion Friedman was not able to draw was an effective role for public economic policy. By determining a path of consumption and savings almost as a destiny, any actions of government would be somehow undone by households. This adaptive approach, while quite a departure from the forward-looking Modigliani approach, was certainly consistent with Friedman’s world view, unblinking faith in the private sector, and skepticism of the public sector that made him such a controversial figure. Each of these contributors allows us to think of personal finance in a broader, more expansive, and more sophisticated way. However, their focus was primarily on the savings rate over a lifetime as a consequence of the return on savings. To this we must next add the risk-return tradeoff into the mix.

Implications for personal finance The work of these great minds produced for us an awareness of the life cycle of personal finance. Certainly, within that model, our preference for a healthy return and our abhorrence of risk are important. However, the simple recognition that our goal is to smooth out lifetime consumption and that we must balance our earning potential, retirement date, and length of life accordingly is the underpinning of personal finance. These researchers produced results over the first half of the twentieth century that we still grapple with today. For instance, Modigliani proposed that retirement savings could be tapped to increase consumption in an individual’s early years as a way to permit dissavings in the absence of incomplete capital markets. This principle is also commonly applied as households tap into their home equity to subsidize midlife consumption. However, as we have painfully discovered, imprudent access to lifelong savings may have disastrous consequences. When global housing markets declined in 2008–2009, many households were forced to re-evaluate their personal finances and recalculate when they might be able to retire.

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All the great minds, from Fisher to Keynes, Modigliani, and Friedman, discussed the advantages of a consumption tax to replace income tax. Such a consumption tax biases the consumption/savings trade-off by making consumption relatively more expensive. Consequently, the national savings rate is increased and individuals are able to better provide the self-sufficiency they will need for their retirement. In addition, by replacing income tax with a consumption tax, the incentive to avoid income tax by working less is reduced. Finally, it is argued that a consumption tax better tracks and taxes lifetime income and hence is superior, as a tool of tax policy, to an income tax that tracks only current income. These models were also useful in surmising the effects of governmentprovided pensions. Such pension schemes can be regarded as augmenting retirement savings by government fiat. Consequently, these forced savings shift the private savings rate down. However, if state-sponsored pension plans are not fully funded or if these balances do not reach back to fuel the needs for economic investment, macroeconomic growth may suffer. Finally, these great minds, and Fisher in particular, advocated the need to index our financial instruments so that these markets are protected against the vagaries of inflation. Treasury Inflation-Protected Securities (TIPS) provide the type of protection that Fisher recommended. Indeed, the proper measure of inflation with which to index TIPS to maintain a constant real return still remains an open and debated issue, as it did in Fisher’s time.

24 Conclusions

One cannot help but be struck with the larger-than-life personas of four very different individuals who would found and define the field of personal finance. From self-made descendants of pioneer stock to British blueblood, and a pair of brilliant theoreticians with Jewish immigrant heritage, each embraced their upbringings to enlighten their insights into the cornerstones of personal finance. Irving Fisher transcended academics to become a millionaire many times over and a Wall Street titan. Along the way, he developed an elegant model of savings and the interest rate over time that, for the first time, took account of the intertemporal nature of personal financial planning. This founder of analyses of our financial life cycle was also a health fanatic, no doubt because of brushes with death for himself and his family, and a proponent of eugenics. Like others in his day, he had great faith in the power of the social and physical scientists to re-engineer their economic and physical environments. Fisher was a man of blind faith in free markets, and his faith was ultimately his financial ruin. Before the Great Crash, he was arguably the most well-known economist of his day. Following his exuberance before the Crash and the malaise afterward, he left his Wall Street podium disgraced and crestfallen, even though he himself began to recognize the shortcomings of his own economic philosophy. Fisher’s dimmed star was replaced by someone who came from privilege, as opposed to Fisher’s humble beginnings. Fisher shared with John Maynard Keynes a mutual lifelong advocacy for the controversial social engineering then called eugenics. Indeed, shortly before his death, Keynes stated that eugenics was “the most important, significant and, in addition, genuine branch of sociology which exists.”160 However, Keynes accepted that the free market sometimes fails, a 202

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conclusion to which Fisher, his classical predecessor and peer, would not dare subscribe. Keynes was a towering man and a towering figure who defined and dominated economics for the first half of the “economics century.” He delivered a message that the public found compelling. Financial and productive markets sometimes fail, savings are sometimes put to less than productive use, and government can do something to fix an ailing economy. Consequently, Keynes became well known by a public that became desperately interested in the workings of the economy. Perhaps like no other since Adam Smith, and no other following him, Keynes contributed to the popularization of economic theories and to a better understanding of savings and investment. However, his model of savings, while intuitively attractive, was insufficiently rigorous to tease out all the necessary results. Of the four great minds, Franco Modigliani brought the greatest grace and elegance to the mix. He was eloquent and oozed panache. He was also generous with his words and for his contemporaries, developed great insight with his theories, and provided an intuitive framework for the analysis of the life cycle of personal finance decisions. His analysis furthered our intuition and his simplifying assumptions were not problematic. Finally, Milton Friedman was the most diminutive in size, but was arguably as towering in his stature as Keynes. Some of his stature was selfcultivated, but his contributions to personal and high finance, economics, and public policy are undeniable. Friedman almost single-handedly established in the public mind the notion of libertarianism. His intuition too was easy to comprehend and he had an ability to see through a problem with great insight, even if his angle was, at times, somewhat doctrinaire. Friedman also communicated best the direction in which the study of personal finance must proceed. While these four great minds each added to our understanding of the personal finance decision, our analysis remained incomplete by the middle of the twentieth century. The financial discipline had gone from static models to the dynamic context that is so essential for practitioners and theorists in the saving decisions of households. However, one ingredient remained elusive. Friedman became increasingly convinced of the need to model how uncertainty and human anticipations determine the path of a dynamic economy. Trained in the static world of classical economics, but steeped in the real world in which economies seem to retrench in the face of uncertainty, Friedman became increasingly convinced of the wide gulf between classical economic prescriptions and real-world economic tribulations. Just as in the 1920s, when his mentor, Frank Knight, first

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recognized the complexity and subtlety of uncertainty, Friedman began to recognize the profound costs uncertainty imposes on economic and financial decision-making. In a manner characteristic for Friedman, his solution was to reduce regulation, and its intendant uncertainty, bolster market mechanisms, and increase transparency. This introduction of uncertainty into the dynamics of personal finance was the next challenge for the financial literature and will be the subject of the next book in this series. However, what each mind brought to the problem was the casting away of conventional wisdom. While we hear the term “conventional wisdom” often used as an appeal for acceptance of the status quo, it actually means something entirely distinct from the broadly accepted truth. Conventional wisdom is often false; rather, it is frequently invoked as a shield against an open mind and the consideration of new information. These theorists each opened our minds and, in the process, often met with criticism because of their penchant for making theories richer and fresher, but less conventional. Albert Einstein was once purported to have said that “Great spirits have always found violent opposition from mediocrities.”161 If many entertain and try to absorb one’s new view of the world, then we have established interest. If a few also become highly critical of a new approach, we have likely established relevance. These great minds were unconventional, interesting, and relevant. They overcame the inertia of conventional wisdom by allowing us to view old problems in new light, and often to realize new problems that we did not know existed before. Their models were so eloquent and intuitive that the expert was left thinking “why did I not think of that?” or “the concept is so familiar that perhaps I did once think of that.” The intuitive appeal of these ideas is also so accessible that the layperson should be able to understand and absorb the theories of personal finance. These are the qualities of genius. The genius of Irving Fisher, John Maynard Keynes, Franco Modigliani, and Milton Friedman was not necessarily in the sophistication of their models but in the insights that we all can draw from their results. Each in their own way brought the study of personal finance out of the ivory tower and into our living rooms. Their new intuitions allowed us to make better personal financial decisions. Ultimately, because of their works, we became more financially secure or can realize more opportunities. They made tangible differences in lives, in financial markets, in societies, and in economies. And while they each received accolades and awards throughout their lives, the rewards of their work have been bestowed upon us all. Upon the foundations built by these four great minds, personal finance was born.

Glossary Asymptotic – the value that a variable converges on in the limit as time goes to infinity. Autonomous consumption – the minimum amount of necessary consumption regardless of one’s income level. Bond – a financial instrument that provides periodic (typically semi-annual) interest payments and the return of the face value upon maturity, in exchange for a fixed price. Budget constraint – the amount of income made available by a household in a given period to support consumption. Calculus of variations – a mathematical technique that can determine the optimal path of a variable, like savings or consumption, over time. Central bank – the primary monetary authority in a nation that often acts as the bank for commercial banks. In the USA, the central bank is called the Federal Reserve. Classical model – a microeconomic-based approach to economic decision-making that assumes all actors are rational and maximize their self-interest, and is driven by the principle that prices adjust quickly and freely to ensure that supply is equal to demand. Cognitive dissonance – the observation that humans may simultaneously and uncomfortably hold a common but irrational perspective. Consumption – the purchase of goods and services to satisfy a household’s wants and needs. Consumption tax – an ad valorem tax levied evenly on all goods and services. Corporate finance – the study of financial decisions made by corporations to maximize shareholder value. Correlation – the statistical relationship between two variables, typically measured by demonstrating that the movement of one variable is associated with the movement of the other. Coupon rate c – the periodic payment to the owner of a bond. Deflation – a measure of the rate by which prices fall over time. Derivative – in mathematics, the instantaneous rate of change of one variable as a function of the change of another. In finance, a financial instrument that derives its value from another underlying asset or instrument. Differential equation – an equation that specifies the relationship between the rates of change of a collection of variables. Discount rate – the rate at which humans will reduce the value of future income in the determination of its present value. This term is also used to signify the interest rate set by a nation’s central bank. Dissavings – borrowing that results when consumption exceeds income. Dynamic – the analysis of a process as it changes over time. Equilibrium – a state in which a relationship converges upon a constant balance. Face value F – the nominal value of a bond that is returned to the bondholder upon maturity. 205

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Federal Open Market Committee – the committee of the US Federal Reserve Board that determines the policy for bond purchases and sales as a method to adjust the amount of cash and liquidity in a monetary system. Federal Reserve – the central bank of the USA. Fisher equation – an equation that derives how one can calculate a real return on an asset by subtracting the inflation rate from the nominal interest rate. Full employment – the characterization of a macroeconomy when all those who wish to have a job are employed. Gross domestic product – the level of production, output, and income in a macroeconomy. Homeostasis – the property of a system to attain and maintain a stable and constant balance or relationship. Homothetic – a property of indifference curves in which the ratio of consumption between one period and another is constant as permanent income changes. Income – the flow of financial resources that are used to support consumption or are diverted toward savings. The term is also used as a measure of total earnings by all participants in a macroeconomy. Income tax – a government tax levied based on the amount of one’s income. Indifference curve – a locus of points of constant utility derived from consumption of one good or service and another, or of consumption of all goods and services in one period and another. Infinite time horizon – an economic planning horizon that has no end: for instance, an infinitely lived individual or society would make decisions with due consideration to an infinite future. Inflation – a measure of the rate by which prices rise over time. Interest rate – the rate of periodic payments, as a share of the principal amount borrowed, to compensate for the inherent preference of humans for the present over the future. Intertemporal – a reference to decisions made across time. Keynesian model – a model developed by John Maynard Keynes that demonstrates that savings may not necessarily be balanced with new investment and the gross domestic product may differ from that which would result in full employment. Life cycle – the characterization of a process from its birth to its death. Life Cycle Model – a model of household consumption behavior from the beginning of its earning capacity to the end of the household. Lifetime income – a conversion of a household’s present and future income to a net asset value today. Liquidity preference – a description of the amount of assets a household or firm would prefer to keep in highly liquid form. This amount depends, among other factors, on the interest or other earnings sacrificed if assets are kept liquid. Marginal propensity to consume – the rate of increase of consumption as a share of an increase in income. Marginal propensity to save – the rate of increase of savings as a share of an increase in income. Marginal rate of substitution – the rate at which one would willingly substitute the consumption of one good or service for a unit change in consumption of another, while maintaining the same level of overall satisfaction.

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Maturity – in reference to a bond or financial instrument, the time at which the instrument becomes due and the financial relationship ends. Mortgage-backed securities – a derivative financial instrument that derives its asset value on a collection of underlying mortgages; in other words, a financial security that is backed by a collection of financial securities. Myopia – a process of decision-making that looks at the past or the present rather than the future. Nominal interest rate – the listed interest rate on a financial instrument. Optimal control theory – an extension of the calculus of variations that is a powerful tool in the modeling of dynamic processes. Ordinary least squares – a linear regression method that determines the relationship between a dependent variable as a weighted sum of independent variables. This technique minimizes the squared difference between the dependent variable and the predicted amount from an estimate of a weighted combination of the independent variables. Before the recent advent of significant computing power, this readily calculable technique was used to estimate relationships between dependent and independent variables. Permanent income – the share of income that is considered permanent and constant in the future, as opposed to transitory income. Personal finance – the study of household and personal savings decisions as a method to enhance lifetime consumption. Rate of time preference – the rate at which an individual or a household will discount the future over the present. This rate is determined by individuals based on their inherent risk preference, their age and life expectancy, their expectations of future earnings, and the evolving time dynamics of their consumption needs. Real interest rate – the return on a financial instrument in terms of its buying power adjusted for inflation. Regression – a technique used to fit a dependent variable as a weighted sum of independent variables. Relative prices – the measurement of the price of one good, service, or instrument at one time in comparison to the price of another good, service, or instrument, or the same item at another time. Return – the expected surplus offered to entice individuals to hold a financial instrument. Risk – in finance, the degree of uncertainty associated with exchanging a known sum for a larger future but less certain sum. Savings – the difference between current income and consumption that can be set aside to support future consumption. Say’s law – a principle widely interpreted to suggest that the production of goods and services generates sufficient income to ensure the demand for the goods and services. This premise is often characterized as “supply creates its own demand.” Static – the consideration of mathematical, physical, or economic relationships that do not change over time. Transitory income – the share of income that is considered transitory and timevarying, as opposed to permanent income. Treasury Inflation-Protected Securities (TIPS) – a method, originally proposed by Irving Fisher, that provides Treasury bond holders with indemnification from inflation.

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Glossary

Uncertainty – the degree to which the value of future variables cannot be fully known today. Utility curve – an unmeasurable but philosophically helpful construct that relates an individual’s level of happiness or wellbeing to the level of consumption of a good or service. Volatility – a measure of the degree of uncertainty and unexplained movements of a variable over time. Wealth line – a locus of points that connects various levels of consumption of goods over time for a given and known level of income or wealth.

Notes 1. I say the Nobel Memorial Prize in Economics with some precision because most people now drop the term “memorial” from its name. This is because the Prize is not technically a Nobel Prize. It is awarded by a group distinct from the Nobel Committee, even if it is awarded in the same weeks and in the same location as are the prizes first contemplated by the Norwegian inventor of dynamite, Alfred Nobel. In fact, only the Nobel Peace Prize is awarded in Norway. The others are granted in Sweden, the country that was united with Norway in Nobel’s time. The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was created in 1968 on the 300th anniversary of the Sveriges Riksbank, Sweden’s central bank. That said, from hereon in, I shall refer to the award as the Nobel Prize in Economics, even if it is often a Nobel Prize in Finance. 2. Milton Friedman, Money Mischief: Episodes in Monetary History. San Diego, CA: Houghton Mifflin Harcourt, 1994, p. 37. 3. Carl Menger, Principles of Economics, trans. James Dingwall and Bert F. Hoselitz. New York University Press, 1981, p. 146. 4. Irving Norton Fisher, My Father – Irving Fisher. New York: Comet Press, 1956. 5. Ibid., p. 11. 6. Ibid., p. 13. 7. Ibid., p. 21. 8. Ibid., p. 24. 9. Ibid., p. 25. 10. http://history.state.gov/departmenthistory/people/stimson-henry-lewis, date accessed June 1, 2011. 11. http://www.measuringworth.com/uscompare/result.php?use[]=DOLLAR& year_source=1888&amount=700&year_result=2010, date accessed June 1, 2011. 12. Fisher, My Father, p. 33. 13. Ibid., p. 42 14. http://en.wikipedia.org/wiki/William_Graham_Sumner, date accessed June 1, 2011. 15. Fisher, My Father, p. 45. 16. Ibid., p. 52. 17. Ibid., p. 60. 18. http://www.measuringworth.com/uscompare/result.php?use[]=DOLLAR& year_source=1895&amount=1000&year_result=2010, date accessed June 1, 2011. 19. Fisher, My Father, pp. 45 and 46. 20. Ibid., p. 51. 21. Ibid., p. 85. 22. John Rae, “Statement of Some New Principles of the Subject of Political Economy, Exposing the Fallacies of the System of Free Trade, And of some 209

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23. 24. 25.

26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36.

37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50.

Notes other Doctrines maintained in the Wealth of Nations,” entered according to the Act of Congress in the year 1834, by Hilliard, Gray, & Co., in the Clerk’s Office of the District Court of the District of Massachusetts, http://socserv2. socsci.mcmaster.ca/~econ/ugcm/3ll3/rae/newprin.html, date accessed June 1, 2011. Fisher, My Father, pp. 131, 132. Ibid., pp. 133–4. John Geanakoplos, “The Ideal Inflation-Indexed Bond and Irving Fisher’s Impatience Theory of Interest with Overlapping Generations,” in Robert W. Dimand and John Geanakoplos (eds), Celebrating Irving Fisher – The Legacy of a Great Economist. Oxford: Blackwell Publishing, 2005. Irving Fisher, The Purchasing Power of Money. New York: Macmillan, 1911. http://www.ssa.gov/OACT/TRSUM/index.html, date accessed June 1, 2011. Barclays Capital Research A, “Global Inflation-Linked Products: A User’s Guide,” February 20, 2008. Peter C.B. Phillips, “Econometric Analysis of Fisher’s Equation,” American Journal of Economics and Sociology, 64(1) (2005), 125–68. Irving Fisher, “The Debt-Deflation Theory of Great Depressions,” Econometrica, 1(4) (October 1933), 337–57. Fisher, My Father, pp. 159–60. Irving Fisher, The Nature of Capital and Income. New York: Macmillan, 1906. Irving Fisher, The Rate of Interest: Its Nature, Determination and Relation to Economic Phenomena. New York: Macmillan, 1907. Fisher, My Father, p. 179. Ibid., p. 219. “Seriously Off Track: When Smart People Get the Future Wrong,” New York Times opinion page, December 27, 2010, http://www.nytimes.com/interactive/ 2010/12/27/opinion/2010127-predictions.html, date accessed June 1, 2011. Fisher, My Father, p. 284. John Kenneth Galbraith, The Affluent Society. New York: Houghton Mifflin, 1958, Chapter 2. Roy Harrod, The Life of John Maynard Keynes. New York: W.W. Norton and Company, 1951. Ibid., p. 5. http://en.wikipedia.org/wiki/Amersham_Hall, date accessed June 1, 2011. Samuel Macauley Jackson (ed.), The New Schaff-Herzog Encyclopedia of Religious Knowledge. New York: Funk and Wagnalls, 1905, p. 1912. http://www.library.yale.edu/div/beecher.html, date accessed June 1, 2011. Harrod, Life of John Maynard Keynes, p. 11. Ibid., p. 7. http://www.pbs.org/wnet/redgold/innovators/bio_keynes.html, date accessed June 1, 2011. Harrod, Life of John Maynard Keynes, p. 10. Ibid., p. 10. John Neville Keynes, The Scope and Method of Political Economy. London: Macmillan, 1891. http://www.newworldencyclopedia.org/entry/John_Neville_Keynes, date accessed June 1, 2011.

Notes

211

51. Harrod, Life of John Maynard Keynes, p. 8. 52. Ibid., p. 13. 53. “Eton – the establishment’s choice,” BBC News Online, London, September 2, 1998, http://news.bbc.co.uk/2/hi/uk_news/162402.stm, date accessed June 1, 2011. 54. Ralph Nevill, Floreat Etona: Anecdotes and Memories of Eton College. London: Macmillan, 1911. 55. Harrod, Life of John Maynard Keynes, p. 107. 56. Irving Fisher, Mathematical Investigations in the Theory of Value and Prices. New York: Cosimo Classics, [1892] 2007, Appendix III, “The Utility and History of Mathematical Method in Economics,” p. 109. 57. Harrod, Life of John Maynard Keynes, p. 111. 58. http://www.maynardkeynes.org/john-maynard-keynes-economist-1905-to1914.html, date accessed June 1, 2011. 59. Harrod, Life of John Maynard Keynes, p. 121. 60. Ibid., p. 122. 61. http://www.maynardkeynes.org/john-maynard-keynes-economist-1905-to1914.html, date accessed June 1, 2011. 62. John Maynard Keynes, A Treatise on Probability. London: Macmillan and Company, 1921. 63. http://www.maynardkeynes.org/john-maynard-keynes-reparations-probabilitygold.html, date accessed June 1, 2011. 64. Frank P. Ramsey, “A Mathematical Theory of Savings,” Economic Journal, 38(152) (December 1928), pp. 543–59. 65. Ibid., p. 543. 66. Ibid., p. 555. 67. Ibid., p. 558. 68. John Maynard Keynes, “Frank Plumpton Ramsey,” in John Maynard Keynes, Essays in Biography. New York: W.W. Norton, 1933. 69. Thorstein Veblen, The Theory of the Leisure Class, Introduction by John Kenneth Galbraith. Boston: Houghton Mifflin, 1973. 70. Kenneth Galbraith, The Great Crash. New York: Houghton Mifflin, 1954 (reprinted 1997), p. 1. 71. Ibid., p. 6. 72. Lionel Robbins, The Great Depression. New York: Macmillan, 1934, p. 53. 73. John Carswell, The South Sea Bubble. London: Sutton, 1993. 74. Charles Amos Dice, New Levels of the Stock Market. New York: McGraw-Hill, 1929. 75. Galbraith, The Great Crash, p. 18. 76. American Magazine, June 1929. 77. Galbraith, The Great Crash, p. 70. 78. Irving Fisher, The Stock Market Crash – and After. New York: Macmillan, 1930. 79. John Maynard Keynes, The General Theory of Employment, Interest and Money. New York: Harcourt Trade, 1964, p. 160. 80. Fisher, The Stock Market Crash, p. 176. 81. Fisher, The Nature of Capital and Income, p. 298. 82. Gustave Le Bon, The Crowd: A Study of the Popular Mind. New York: Macmillan, 1896.

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Notes

83. Paul Roazen, Freud: Political and Social Thought, 3rd edn. New Brunswick, NJ: Transaction Publishers, 1999, p. 228. 84. Keynes, The General Theory of Employment, pp. 161–2. 85. William Worthington Fowler, Inside Life in Wall Street: On How Great Fortunes are Lost and Won with Disclosures of Doings and Dealings on Change, including the Secret History of the Noted Speculations since the Crash of 1857, the Great Rises and Panics of the Age, and How They Were Produced, Including Full Descriptions of the “Black Friday” of 1869, and an Inside View of the Great Panic of 1873. Hartford, CT: Dustin, Gilman, and Company, 1873, pp. 322–3. 86. http://www.archives.gov/education/lessons/fdr-inaugural/images/address1. gif, date accessed June 1, 2011. 87. Keynes, The General Theory of Employment, Book 1, Chapter 3, section III. 88. Keynes, A Treatise on Probability, p. 10. 89. Keynes, The General Theory of Employment, Book IV, Chapter 12, sections I and II. 90. Ibid., Book VI, Chapter 24, section III. 91. http://www.federalreserve.gov/newsevents/speech/bernanke20100827a. htm, date accessed June 1, 2011. 92. John Steele Gordon, “A Short Banking History of the United States,” Wall Street Journal, October 10, 2008, http://online.wsj.com/article/ SB122360636585322023.html, date accessed June 1, 2011. 93. Harrod, Life of John Maynard Keynes, p. 479. 94. Ibid., p. 485. 95. Ibid., p. 489. 96. John Maynard Keynes, How to Pay for the War. New York; Harcourt, Brace and Co., 1940. 97. http://www.samuelbrittan.co.uk/text92_p.html, date accessed June 1, 2011. 98. http://www.worldlingo.com/ma/enwiki/en/United_Nations_Monetary_ and_Financial_Conference, date accessed June 1, 2011. 99. Harrod, Life of John Maynard Keynes, p. 584. 100. John Maynard Keynes, A Tract on Monetary Reform. London: Macmillan, 1923, Chapter 3. 101. Irving Fisher, “Is ‘Utility’ the Most Suitable Term for the Concept It is Used to Denote?” American Economic Review, 8 (1918), 335–7. 102. http://www.alumni.hbs.edu/bulletin/2000/april/profile.html, date accessed June 1, 2011. 103. Franco Modigliani, Adventures of an Economist, New York: Texere LLC, 2001. 104. Ibid., p. 6. 105. Ibid., p. 7. 106. Ibid., p. 11. 107. Franco Modigliani, “Liquidity Preference and the Theory of Interest and Money,” Econometrica, 12(1) (January 1944), 45–88. 108. Modigliani, Adventures of an Economist, p. 53. 109. http://nobelprize.org/nobel_prizes/economics/laureates/1985/modiglianiautobio.html, date accessed June 1, 2011. 110. Modigliani, Adventures of an Economist, p. 68.

Notes 111. 112. 113. 114. 115. 116.

117.

118. 119. 120. 121. 122. 123. 124.

125. 126. 127.

128.

129. 130. 131.

132. 133.

134.

213

Ibid., p. 58. Keynes, The General Theory of Employment, p. 94. Ibid., pp. 127–8. Simon Kuznets, The National Product since 1869. New York: National Bureau of Economic Research, 1946, p. 119. Arthur Smithies, “Forecasting Postwar Demand: I,” Econometrica, 13(1) (1945), 1–14. Franco Modigliani, “Fluctuations in the Savings Income Ratio: A Problem in Economic Forecasting,” National Bureau of Economic Research, 11 (1949), 370–443, at p. 373. Dorothy Brady and Rose Friedman, “Savings and the Income Distribution,” in Studies in Income and Wealth, Volume X. New York: National Bureau of Economic Research, 1947. Keynes, The General Theory of Employment, p. 88. Modigliani, “Fluctuations,” pp. 384–5. Modigliani, Adventures of an Economist, p. 53. Roy Harrod, Toward a Dynamic Economics. London: Macmillan, 1948. Roy Harrod, “An Essay in Dynamic Theory,” Economic Journal, 49 (March 1939), 14–33. Modigliani, Adventures of an Economist, p. 69. Franco Modigliani and Richard Brumberg, “Utility Analysis and the Consumption Function: An Interpretation of Cross-section Data,” in Kenneth K. Kuhihara (ed.), Post-Keynesian Economics. New Brunswick, NJ: Rutgers University Press, 1954, pp. 388–436. http://www.answers.com/topic/franco-modigliani, date accessed June 1, 2011. Modigliani, Adventures of an Economist, p. 68. Franco Modigliani and Richard Brumberg, “Utility Analysis and Consumption Functions: An Attempt at Integration,” in Andrew Abel (ed.), The Collected Papers of Franco Modigliani: Volume 2, The Life Cycle Hypothesis of Saving. Cambridge, MA: MIT Press, 1979, pp. 128–97. “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1969.” http://nobelprize.org/nobel_prizes/economics/laureates/1969/, date accessed June 1, 2011. Kenneth Arrow, T. Harris and J. Marschak, “Optimal Inventory Policy,” Econometrica, 19 (1951), 250–72. Modigliani, Adventures of an Economist, p. 110. “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1985,” http://nobelprize.org/nobel_prizes/economics/laureates/1985/, date accessed June 1, 2011. http://nobelprize.org/nobel_prizes/economics/laureates/1985/modiglianilecture.pdf, date accessed June 1, 2011. Francesco Giavazzi, “Professor Franco Modigliani: Nobel prizewinning economist and author of the ‘life-cycle theory of spending,’” The Independent, September 29, 2003, http://www.independent.co.uk/news/obituaries/professor-franco-modigliani-548827.html, date accessed June 1, 2011. Louis Uchitelle, “Franco Modigliani, Nobel-Winning Economist, Dies at 85,” New York Times, September 26, 2003, http://www.nytimes.com/2003/09/26/

214

135. 136. 137. 138. 139. 140. 141. 142. 143. 144. 145. 146. 147. 148. 149. 150. 151. 152. 153. 154. 155. 156.

157. 158. 159.

160. 161.

Notes business/franco-modigliani-nobel-winning-economist-dies-at-85.html, date accessed June 1, 2011. Milton Friedman and Rose Friedman, Two Lucky People. University of Chicago Press, 1998. Ibid., p. 19. Lanny Ebenstein, Milton Friedman. New York: Palgrave Macmillan, 2007. Friedman and Friedman, Two Lucky People, p. 21. Ibid., p. 22. Ibid., p. 23. Ibid., p. 30. Ibid., pp. 30–1. Ibid., pp. 40–1 Milton Friedman and Simon Kuznets, Income from Independent Professionals. New York: National Bureau of Economic Research, 1945, p. 352. Milton Friedman, A Theory of the Consumption Function. Princeton University Press, 1957, p. 222. The Charlie Rose Show, December 26, 2005. Milton Friedman, “The Methodology of Positive Economics,” in Milton Friedman, Essays in Positive Economics. University of Chicago Press, 1953. Friedman, A Theory of the Consumption Function, p. 224. John Maynard Keynes, A Treatise on Money. New York: Harcourt, Brace and Company, 1930. Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960. Princeton University Press, 1963. Friedman and Friedman, Two Lucky People, p. 444. Ibid., p. 445. Robert Skole, “En-Nobeling Milton Friedman,” Nation, January 22, 1977, p. 68. Editorial letter published in the New York Times, October 14, 1975. Editorial, Wall Street Journal, December 19, 1975. “The Prize in Economics 1976 – Press Release,” http://nobelprize.org/ nobel_prizes/economics/laureates/1976/press.html, date accessed June 1, 2011. Milton Friedman and Rose Friedman, Free to Choose: A Personal Statement. New York: Harcourt Brace Jovanovich, 1980. Ibid., p. 503. Charles Goodhart, “Obituary: Milton Friedman,” The Guardian, November 17, 2006, http://www.guardian.co.uk/news/2006/nov/17/guardianobituaries.politics, date accessed June 1, 2011. John Maynard Keynes, “Opening Remarks: The Galton Lecture,” Eugenics Review, 38(1) (1946), 39–40. Quote from the New York Times, March 19, 1940.

Index Arrow, Kenneth, 163 Asymptotic, 205 Auspitz, Rudolf, 20 Autonomous consumption, 205 Baruch, Bernard, 83 Bernanke, Ben, 110, 112, 113 Böhm-Bawerk, Eugen von, 7, 8, 23, 41 Bond, 45, 47, 205 Brady, Dorothy, 138, 163, 174 Brumberg, Richard, 143, 144, 145, 151, 152, 154, 156, 159, 161, 162, 163, 199 Budget constraint, 205 Burns, Arthur F., 172 Calculus of variations, 205 Central bank, 109, 205 Classical model, 205 Cognitive dissonance, 205 Consumption, 34, 147, 148, 149, 150, 151, 174, 184, 205 Consumption tax, 205 Coolidge, Calvin, 56, 76, 79, 80, 86 Corporate finance, 205 Correlation, 205 Coupon rate c, 205 Cournot, Augustin, 18 Darwin, Charles, 54, 62 Deflation, 205 Derivative, 205 Differential equation, 205 Discount rate, 205 Dissavings, 205 Duesenberry, James, 139, 140, 163 Dynamic, 205 Edgeworth, Francis Ysidro, 18, 20, 22, 69 Einstein, Albert, 20, 87, 90, 143, 204 Equilibrium, 205

Face value F, 205 Federal Open Market Committee, 111, 206 Federal Reserve, 76, 77, 78, 81, 83, 108, 110, 111, 112, 113, 114, 162, 164, 172, 191, 205, 206 Fisher equation, 37, 38, 39, 40, 44, 45, 46, 47, 48, 49, 50, 51, 52, 87, 95, 120, 206 Fisher, Irving, 1, 2, 5, 10, 11, 12, 14–23, 25–8, 33, 34, 36–41, 43–76, 78–80, 83–6, 87, 89, 91, 92–6, 98, 113, 119–22, 125–30, 135, 138, 140, 141, 144, 154, 161, 164, 166, 170, 171, 172, 176, 177, 186, 196, 197, 199, 201, 202, 203, 204, 206, 207, 211 Fowler, William Worthington, 91 Freud, Sigmund, 90 Friedman, Milton, 1, 2, 5, 77, 132, 138, 147, 163, 166–8, 170–96, 199, 200, 201, 203, 204, 211 Friedman, Rose, 1, 2, 5, 77, 132, 138, 147, 163, 166–8, 170–96, 199, 200, 201, 203, 204, 211 Frisch, Ragnar, 162 Full employment, 206 Galbraith, John Kenneth, 60, 165, 190 Galton, Francis, 54, 62 Gibbs, Josiah Willard, 17 Gross domestic product, 206 Harrod, Roy, 63, 140 Hicks, John, 163 Homeostasis, 206 Homothetic, 206 Hoover, Herbert, 16, 57, 80, 83, 194 Hotelling, Harold, 174 Income, 22, 53, 138, 147, 148, 150, 151, 187, 188, 189, 206 Income tax, 206 Indifference curve, 206 215

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Index

Infinite time horizon, 206 Inflation, 38, 47, 206 Interest rate, 206 Intertemporal, 1, 35, 206 Jevons, William Stanley, 20, 26, 65, 69, 129 Jones, Homer, 82, 121, 173 Keynes, John Maynard, 1, 2, 56, 58–71, 72, 74, 80, 85–7, 89, 90–9, 102–5, 107, 110, 121–33, 135–41, 144, 153, 161, 163, 166, 167, 172, 174, 176, 177, 179, 181, 184, 190, 191, 195, 196, 197, 198, 199, 201, 202, 203, 204, 206 Keynes, John Neville, 61, 62, 63, 184 Keynesian model, 98, 146, 161, 199, 206 Knight, Frank, 173, 174, 177, 178, 203 Kuznets, Simon, 138, 139, 161, 163, 174, 179, 180, 194 Lawrence, Joseph, 83 Le Bon, Gustave, 90 Lieben, Richard, 20 Life cycle, 206 Life Cycle Model, 1, 144, 151, 159, 160, 161, 164, 166, 206 Lifetime income, 206 Liquidity preference, 206 Marginal propensity to consume, 206 Marginal propensity to save, 206 Marginal rate of substitution, 206 Marshall, Alfred, 63, 65, 69, 172 Marx, Karl, 6, 91, 195 Maturity, 207 Modigliani, Franco, 1, 2, 128–34, 137–45, 147, 151, 152, 154, 156, 159, 161–6, 168, 171, 172, 174, 176, 185, 186, 187, 188, 190, 196, 199, 200, 201, 203, 204 Mortgage-backed securities, 207 Myopia, 207 Newton, Isaac, 78, 87, 88 Nominal interest rate, 207

Optimal control, 207 Ordinary least squares, 207 Permanent income, 207 Personal finance, 3, 137, 159, 199, 207 Pigou, Arthur Cecil, 65, 66 Ponzi, Charles, 77, 81 Rae, John, 23 Ramsey, Frank, 1, 71, 72, 73, 74, 154, 156, 199 Rate of time preference, 207 Real interest rate, 207 Regression, 207 Relative prices, 207 Return, 47, 66, 207 Risk, 85, 165, 207 Robbins, Lionel, 77 Roosevelt, Franklin Delano, 16, 56, 57, 58, 92, 125 Savings, 72, 135, 138, 141, 147, 148, 149, 150, 151, 198, 207 Say, Jean-Baptiste, 86, 137, 207 Schultz, Henry, 174 Smith, Adam, 12, 13, 15, 41, 67, 195, 203 Smithies, Arthur, 138 Solow, Robert, 72 Spencer, Herbert, 54 Sraffa, Piero, 72 Static, 207 Stimson, Henry Lewis, 16 Tinbergen, Jan, 162 Transitory income, 207 Treasury Inflation-Protected Securities (TIPS), 47, 201, 207 Uncertainty, 208 Utility curve, 208 Veblen, Thorstein, 140 Viner, Jacob, 174, 175, 177, 178 Volatility, 208 Walras, Leon, 18, 20 Wealth line, 208