The Nobel Prizes in science always produce interesting stories. Take the medicine/physiology award announced last week, which recognized the science that led to the Covid-19 vaccine. Vaccines are nothing new, but they used to take years to develop, always from killed or weakened viruses: smallpox, measles, yellow fever, polio.
In the early Nineties, molecular biologist Katalin Karikó became interested in possibilities of harnessing messenger RNA to the task. Gregory Zuckerman, of The Wall Street Journal, put the news last week this way on social media:
Kati Kariko was shunned for her work. Her bosses demoted her. She and Drew Weissman spent years failing to make headway. Finally, they figured out how to inject a molecule into the body for a vaccine w/out setting off the body’s defenses. Today: a Nobel.
Zuckerman is author of A Shot to Save the World: The Inside Story of the Life-or-Death Race for a COVID-19 Vaccine (Portfolio, 2021). Thanks to him, perhaps, Glamour already has published an entertaining photo essay on the Hungarian laureate. Zuckerman brilliantly depicts the complicated application of the inventions. The Nobel Prize isolates and explains the key discoveries themselves.
The stories behind prizes in the economic sciences take longer to surface and unpack. The 2023 Nobel Memorial Prize, to be announced tomorrow, likely will require time to be widely understood. Already, though, a look back at last year’s prize finds a similar story, one of peripheral interest in a subject followed by sudden emergency relevance, the backstory not nearly so happy in its case. An O. Henry ending looms somewhere in the future.
The 2022 Prize in Economic Sciences, split equally among Ben Bernanke, of the Brookings Institution; Douglas Diamond, of the University of Chicago; and Philip Dybvig, of Washington University, recognized their “research on banks and financial crises.” Specifically cited were two papers, published independently in 1983, that introduced banks to the corpus of up-to-date economic theory. In some quarters, the news was underwhelming, since neither paper seemed to shed much light on what happened in 2008.
Tucked away in the article on the award’s scientific background, however, was an interesting angle: the new work had all but eclipsed a famous earlier finding, that had been cited for its “practical applications” in one earlier Nobel Memorial Prize and had been the centerpiece of another.
In 1958, Franco Modigliani and Merton Miller, both then of Carnegie Mellon University, had shown that, under certain assumptions, the value of a firm is independent of its ratio of debt to equity. One of those assumptions was that the banking industry, which had existed for centuries, didn’t enter into the question. “The Cost of Capital. Corporate Finance and the Theory of Investment,” in the American Economic Review, argued that dividends and corporate leverage were much less important in the end than profitability. The ratio of debt to equity didn’t matter. This was the Modigliani-Miller Theorem.
To understand what happened next, it helps to go back to the beginning, which in this case was World War II. An especially good, if somewhat technical account can be found in An Engine, not a Camera: How Financial Models Shape Markets (MIT, 2006), by Donald MacKenzie, a professor of sociology at the University of Edinburgh. It unfolds against the background of the changes that accelerated dramatically after printers shipped 887 copies of Paul Samuelson’s Foundations of Economic Analysis, before melting down the book’s expensively prepared mathematical plates to cope with post-war shortages of lead.
That was enough. In university economics, Samuelson’s prize-winning thesis climaxed a swift transformation from a literary endeavor to one expressed mainly in mathematics and models, part of a complicated set of developments conveyed to the public as a “Keynesian Revolution.”
In 1947, William Mellon, founder of Gulf Oil Co, gave Carnegie Institute in Pittsburgh $6 million to establish a Graduate School of Industrial Administration (GSIA) in what today is Carnegie Mellon University. The gift was intended to transform business education from its traditional case-based educational methods to a economics-based curriculum, much as science has transformed medicine and engineering training a decade or two earlier. Founding dean Lee Bach hired, among others, Herbert Simon, Merton Miller, and Franco Modigliani
Modigliani, a wartime refugee from Italy, and Miller, Boston-born and Johns Hopkins-trained, were theorists. They had adjoining offices and liked to argue. As they discussed the prevailing literature of corporate finance, heavily influenced by the Depression’s Glass-Steagall Act, which had separated corporate finance from commercial banking, they concluded the institutional framework was missing the point. Economic reasoning showed the essential irrelevance of the distinction between issuers of equity and debt.
Organizational theorist Simon was the dominating intellectual force of GSIA; something was wrong with an argument that assumed perfect competition, he argued, but he couldn’t come up with a persuasive behavioral alternative. Indeed, so persistent was Simon’s criticism that it provoked his colleague John Muth to come up with what he called “rational expectations:” the modeling proposition that ordinary people routinely make decisions based on all available information, including the best current economic theory. Put off, Simon went on to invent the economics of artificial intelligence.
The Modigliani-Miller Theorem had emerged: “MM: You have only to mention these two letters to finance people and they know what you mean,” wrote historian Peter Bernstein, in Capital Ideas: The Improbable Origins of Modern Wall Street (Princeton, 1992). “The leverage proposition,” Wall Street called it, meant that managers – and would-be managers – could borrow as much as investors were willing to lend. Ideas about risk were adjusted. Practitioners began to “perform” the theory; that is, put it to work.
The turbulent Eighties were so long ago that EP gets tired just thinking about them. The leveraged buy-out boom began in 1982, when former Treasury Secretary William Simon led a group of investors that acquired Gibson Greetings, a greeting card company, for $80 million. Barely a year later, Gibson shares netted $290 billion in a public offering; Simon’s share was said to be $66 million. His group was said to have risked no more than just $1 million of their own money to begin the proceedings.
Young, aggressive, and often unfriendly investors began borrowing large sums of money by issuing high-yield (“junk”) bonds underwritten by Drexel Burnham Lambert, a mid-level investment bank. Such corporate raiders, as they were soon dubbed, included Carl Icahn, Victor Posner, Nelson Peltz, Robert Bass, T. Boone Pickens, Harold Clark Simmons, Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg, and Asher Edelman. They would purchase controlling positions of well-established manufacturing firms, radically change the conservative financial practices with which they were managed, and reap fortunes – often leaving ruined businesses in their wake. The boom ended after March 1990, when Drexel filed for bankruptcy, and Michael Milken, its high-yield chief, went to prison. All this according to Wikipedia.
Modigliani was recognized by the Royal Swedish Academy of Sciences in 1985, Miller shared his Nobel prize with two others in 1990. In his lecture, Modigliani steered clear of the leverage theorem to discuss his life cycle theory of saving. In his address, Miller attacked his critics and blamed the friction of tax laws, in particular, the interest deduction, for “the supposed financial excesses of the 1980s.” Simon himself won the prize in 1978, for his investigations of “the decision-making process within economic organizations.”
So much for the back-story. Diamond and Dybvig’s 1983 model persuaded a new generation of scholars to become interested in the economics of banks and their role in financial crises, which by the early Eighties were regularly occurring around the world. Bernanke’s paper stimulated interest in the other direction, in the past, and the factors that turned what otherwise might have been a familiar recession into the Great Depression.
What’s the relationship of the Diamond-Dybig model to Modigliani-Miller? M-M still stands in finance textbooks; D-D didn’t disprove it, and the role of leverage in corporate finance is today much more thoroughly understood. The University of Chicago hired Diamon to work on the money and banking problem that Modigliani and Miller had set aside. Today Diamond is the Merton Miller Professor of Finance at the university’s graduate school of business.
And the O. Henry ending of the story? For that we must wait a good while longer.