Gospel according to Mert (minus contraception)

Selected Works of Merton H. Miller
October 17, 2003

Merton Miller (1923-2000) was a Nobel prizewinner and a giant of economics and finance. His output may not have changed our lives and our political environment, as Milton Friedman's did, but it certainly affected the thoughts and behaviour of those of us who have been active in economics or finance over the past 45 years at least.

Anthologies, even those as elegantly produced as this, arouse suspicion. However, Bruce Grundy has the right credentials as editor, both as a former student of Miller and as an academic at Melbourne Business School, who was formerly at the Wharton School and Stanford University. He has selected 22 of Miller's 84 journal articles, six of his 133 research monographs, reviews, speeches and so on, and three chapters from his eight books. The result is a good insight into the incredibly prolific "Mert", as he was known among his close friends. It is also a tribute to Miller as a man and a thinker that so much of his work was co-authored not with slave PhD students but with his peers.

But I have mixed feelings of admiration and frustration in reading the volume on finance. Admiration for Miller's command of mathematical and statistical tools; frustration at the way economists offer answers to problems that are intellectually interesting but of no practical relevance to humble practitioners such as myself, while keeping their distance from our day-to-day problems.

For example, what use is it to know the market value of a firm when the real issue is the value of individual debt, equity and hybrid securities? Even knowing that the total market value is simply allocated among all securities does not move one an inch further in the real world.

Miller is to be greatly respected for his unstinting commitment to research. In his preface, Grundy no doubt paraphrases Miller's instincts:

"Universities [can] survive competition from specialised teaching institutions only if [they bundle] added value - ie, if the teachers [are] better quality teachers because of their costly research." But research relies on data. I have been for too long both a recipient and a provider of economic and financial data not to treat it with suspicion. Even the best filtering techniques cannot remove the combined effect of gaps, errors, good-faith approximations and so on.

In his understanding of economic issues - of how they interact and of their logical hierarchy - Miller surpasses all my expectations. With his research done and his propositions proved, he shows an almost religious attachment to them, like the Catholic church's attachment to its teachings in matters of sexuality, ignoring the fact that millions of believers use contraception.

In the same spirit, he seems to reject all that is not rational in the economist's doctrine of rationality. As he remarked in his 1976 presidential address to the American Finance Association: "Why then do economists keep trying to develop models that assume rational behaviour by firms? They are not, I insist, merely hoping to con their business-school deans into thinking they are working on problems of business management.

Rather they have found from experience... that the rational behavior models generally lead to better predictions and descriptions at the level of the industry, the market and the whole economy than any alternatives available to them. Their experience, at those levels, moreover need involve no inconsistency with the heuristic, rule-of-thumb, intuitive kinds of decision-making they actually observe in firms. It suggests rather that evolutionary mechanisms are at work to give survival value to those heuristics that are compatible with rational market equilibrium, however far from rational they may appear to be when examined up close."

He continued: "But we must be wary of the reverse influence that merely because a given heuristic persists, it must have some survival value and, hence, must have a rational 'explanation'."

And, as a philosopher and scientist, he concluded with this gem: "Neither in nature nor in the economy can the enormous variation in forms we observe be convincingly explained in simple Darwinian terms."

Though ill equipped to defend Darwin's theory, I feel strongly that economic rationality should not be placed on a pedestal. The rationality of Hobbes is not today's rationality. Rationality is time and culture-dependent in an art such as economics. For economics is not a science since its propositions cannot be falsified, even if it has appropriated a number of scientific methods of analysis.

Miller benignly dismisses behavioural finance. This is particularly evident, and in my view a shortcoming, in his Nobel prize lecture in 1990 on leverage and in his seminal work, Executive Compensation, Taxes and Incentives , co-authored with Myron Scholes. Here Miller seems to ignore the substantial change in utilisation of the assets of the company by virtue of the psychological changes in management's attitude when it is no longer appropriating a share of income but a share of the assets. This is a not-uncommon oversight since most people look at behavioural finance as a way to understand investors' preferences and prejudices rather than the change in corporate governance that managers as substantial subsidised shareholders bring about.

In the context of the leveraged buy-out boom, Miller was seemingly surprised and perhaps hurt. He states: "That Franco Modigliani and I should be credited with inventing these takeovers is doubly ironic since the central message of our Miller and Modigliani Propositions was that the value of the firm was independent of its capital structure. Subject to one important qualification... you couldn't hope to enhance shareholder value merely by leveraging up. Investors would not pay a premium for corporate leverage because they could always leverage up their own holdings by borrowing on personal account." This strikes me as endearingly naive - close to the National Rifle Association's argument that it is people who kill, not guns.

The Miller and Modigliani propositions could never be morally neutral in the way in which they removed need for self-restraint on debt. Indeed, the 1976 presidential address mentioned above, under the heading "Debt and taxes", quantifies historical and expected costs of bankruptcy proceedings and considers them inadequate to undermine "M&M". What further moral fig leaf did the LBO specialists need to go on a rampage? It is totally irrelevant that the M&M propositions did not provide a rational case for LBOs; they removed the residual fear that practitioners may have had. It is rather like the atheist who proclaims that God is dead and then wonders why the moral standards of those who agree with him may have changed.

The vast majority of what Grundy has selected has remained untouched by the passing of time and is as relevant today as when written. One exception perhaps is a paper co-authored with A. Charnes and W. W. Cooper on "Application of linear programming to financial budgeting and the costing of funds". It would be hardly worth mentioning, were it not for two telling sentences: "Here linear programming offers a way of bypassing some of the technical difficulties which have been encountered in connection with attempts to evaluate projects... on the basis of their 'rates of return'.

In addition, with a programming formulation, some of the harder parts of the task of tracing through the interactions of proposed investments with each other and with the existing facilities can be left to the mathematics."

This is reminiscent of the claims first made for computer music. The idea of using mathematical procedures as a substitute for genuine understanding sounds dated and a little bit reckless; but it was common enough in those optimistic years.

Had I not been asked to review these books, I doubt if I would have had the diligence to read them in full. But having done so, I feel better for it.

If I have done any injustice to a great economist, I know that his thousands of disciples will find it hard to forgive me. But I shall sleep easier knowing that most of them will not bother to read my critique, being too busy pushing forward the frontiers of thought opened up by Mert.

Rudi Bogni is a former investment and private banker, currently a director and trustee of several companies and foundations.

Selected Works of Merton H. Miller: A Celebration of Markets: Volume 1: Finance; Volume 2: Economics

Editor - Bruce D. Grundy
Publisher - University of Chicago Press
Pages - 417 and 392
Price - £52.50 and £45.50
ISBN - 0 226 547 6 and 548 4

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