Why Financial Structure Matters Joseph E. Stiglitz The Journal of Economic Perspectives, Vol. 2, No. 4. (Autumn, 1988), pp. 121-126.
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Journal of Economic Perspectives- Volume 2, Number 4 -Fall 1988- Pages 121 -126
Why Financial Structure Matters
Joseph E. Stiglitz
he 1958 paper by Franco Modigliani and Merton Miller has been justly hailed as a landmark in the modern theory of finance. What has not beensufficiently emphasized is the importance of the paper to the development of economic theory and practice. Indeed, it is ironic that a paper which purportedly established that one need not pay any attention to financial structure-that financial structure was irrelevant-should have focused economists' attention on finance. Merton Miller gives what must be part of the explanation in his preceding paper inthis issue: by providing conditions where financial policy was irrelevant, conditions which were close to the assumptions used by most conventional economists, the paper forced a reexamination of those standard assumptions. That reexamination is still going on. The M M results have such great intellectual power and appeal that their direct effect has sometimes been to lead economists astray. Thisresult may perhaps be seen most forcefully in the work in investment theory. In the major study done prior to MM, that of Meyer and Kuh (1959), financial variables (like profitability) were identified as having important independent effects on investment. But the paradigm that became dominant following the publication of MM, most forcefully articulated by Dale Jorgenson and his associates, arguesthat in the absence of taxation, financial structure (for instance, the magnitude of the firm's equity base) or cash flow would make no difference to the level of investment. Theory drove the econometrics: financial structure variables were excluded because "economic theoryx-that is, Modigliani and Miller-said they should be excluded. Only recently, as a developing and substantial body of economictheory says once again that such variables should be included, have econometricians included profit variables again in their specifications Joseph E . Stiglitz is Professor of Economics, Stanford University, Stanford, California.
Journal of Economic Perspectives
of the causes of investment. And lo and behold, they appear to be significant! One of the lessons to be learned here isthat economists should be careful in being overly dogmatic in the theoretical strictures we impose on our econometric models. Though it may be going too far to advocate "letting the data speak for itself" without any theoretical guidance, economists should at least be attentive to those whispers which the data occasionally emit. Again ironically, some of the most productive responses to the M M...
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