Finance theory and the Fed

Eugene Fama says,

Actually, the central banks don’t do anything real. They are issuing one form of debt to buy another form of debt. If you are an old Modigliani–Miller person the way I am, you think that’s a neutral activity: You’re issuing short-term debt to buy long-term debt or vice-versa. That’s not something that should have any real effects.

Pointer from Alex Tabarrok.

Two papers that influenced my view of banking in general and central banking in particular were Bank Funds Management in an Efficient Market, by Fischer Black, and Banking in the Theory of Finance, by Fama. Both take seriously the modern theory of financial markets that begins with Modigliani-Miller. One could see smoke coming out of Scott Sumner’s ears even before he responded.*

In a Modigliani-Miller world, the financial structure of one firm does not matter. Investors use the financial markets to adjust their portfolios to undo the effects of one firm’s changes to its financial structure. The public ultimately holds what it wants to hold. If it doesn’t like the mix of securities that one firm creates (by substituting bonds for equity, for example), it has ways of dealing with that. The metaphor that I would propose is that a single firm’s changes to its financial structure is like me sticking my hand in the ocean, scooping up water, and throwing it in the air: I don’t make a hole in the ocean.

Modigliani-Miller is not strictly true. But it is the best first approximation to use in looking at financial markets. That is, you should start with Modigliani-Miller and think carefully about what might cause deviations from it, rather than casually theorize under the implicit assumption that it has no validity whatsoever.

Taking this approach, I view the Fed as just another bank. Its portfolio decisions do not make a hole in the ocean. That heretical view is the basis for the analysis of inflation in my book Specialization and Trade.

*Sumner’s response is actually beside the point, in my view. The Modigliani-Miller theorem does not in any way rely on different asset classes being close substitutes. It relies on financial markets offering opportunities for people to align their portfolios to meet their needs in response to a corporate restructuring.