What influences our likelihood to save?

Franco Modigliani argued that the amount an individual spends remains fairly stable over their lifetime, while savings fluctuate depending on their life stage. For example, you are likely to save the most when your earnings peak, to fund your retirement. At the time, Modigliani’s Life-Cycle Hypothesis challenged the Keynesian idea that the level of savings fluctuated with income. Modigliani’s pioneering work with Merton H. Miller tackled the issue of corporate finance. Together, they reached the surprising conclusion that, in the absence of corporate taxes, the way a company is financed doesn’t affect its market value, despite whether it raises money using equity or debt. Today, the Modigliani-Miller model is still the starting point for management team decisions.

Franco Modigliani

The Sveriges Riksbank Prize in Economic Sciences, 1985

At a glance

Born: 1918, Rome, Italy

Died: 2003, Cambridge, Massachusetts, USA

Field: Macroeconomics

Prize-winning work: Pioneering analyses of household savings and functioning of financial markets

Forecasting skills: Predicted the stock market crash of 1987, three months before Black Monday

Is the budget deficit’s improvement an illusion?

Being acknowledged as one of greatest minds of the 20th century didn’t stop Franco Modigliani from challenging his friends and visitors in a sporting fashion - every encounter started with a friendly tennis game. A nice opening to far more complex matters because, with Modigliani, things never stayed on the peripheries. "I am interested in all current situations and the problems that are coming out of it. I have had a long interest in the foreign trade deficit and in the European performance," recalled Modigliani. Contrasting with the standard view that a deficit in the economy will lead to an increase in later taxes, Modigliani’s argument rather stated that the deficit causes displacement of capital, a clear illustration of his own eccentric style in the field of economics.

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Modigliani explained the "new phenomenon" – that an open economy running a trade deficit could preserve its investments, due to the fact that the scarcity of capital would drive up interest rates and attract capital from abroad. So, national investment would partly be financed by foreign savings. Using this example, Modigliani pointed towards some alarming aftereffects, saying that, "there’s an enormous shift of resources away from export and import competing goods and into other sectors. This, accompanied by an appreciation of the dollar, has led to a sharp decrease in exports and a strong increase in our imports." But, to Modigliani, this reality gave only one side of the doomed trade-deficit coin because there would also be a clamor for protectionism. "People don’t understand this enormous deficit," he said. "They think it’s due to Japan or Germany, that they are taking advantages of the United States and that this is something unfair. They don’t understand that this is due to US policy."

The solution? Not without Germany!

Part of the solution, as Modigliani explained, sounded simple: "change the deficit". But at the same time, he stated Europeans would continue to have the wrong perception that eliminating the foreign deficit is sufficient. "We are dealing with a massive deficit of a continuing type," Modigliani said.

We have reached the point where the United States has moved from the world’s greatest creditor to become the world’s greatest debtor.

But what does this deficit reflect? Modigliani partly blamed Europe’s modest growth and pointed in particular towards Germany and its high unemployment. "Germany’s expansion has been much too slow and not sufficient to absorb employment," Modigliani stated. Historically, as Europe was growing faster than the United States, the exchange of the trade zones would have been balanced.

Exactly 30 years after meeting Modigliani in 1987 at his house in Belmont, recent trends in Europe demonstrate a much slower growth and enormous levels of unemployment, with Greece topping the list with 22.5 percent unemployment, followed by Spain at 17.8 percent. At present, there’s nothing on the horizon that looks like it will help bring these numbers down.

"Germany is the key to the whole story," Modigliani explained, "because none of the remaining countries in Europe can expand alone, due to the fact that if they tried, they would run immediately into a balance of payment problems." Only strict coordination would give successful conditions for the simultaneous expansion of Europe. The only problem according to Modigliani: The Germans are afraid of expansion. "What I think they ought to understand is that however big the risk of expansion may be, the risk of not expanding is far greater."

If the world’s a chess game, what’s your first move?

Even with philosophical questions, such as the first move on a chess board, Modigliani pointed back to the necessity of leading Europe into expansion. He still might today. Europe is seriously falling behind in the world economy. The united trade zone still plays a key figure, and Modigliani’s ideas could provide useful guidelines. Back in 1987, he already knew that Europe needed investment. "It especially needs to stimulate the economy in a form that encourages the creation of more labor places," he said.

An Italian by birth, Modigliani was very concerned about the future role of Europe in the world economy and consistently suggested "linked models" to improve international relations. If foreign trade picked up - for example in Germany - then the demand for US goods would increase, and the central bank, as well as the government, would feel pressure because they need more resources to feed the export industry. And the only way they could do it is by increasing taxes and by increasing expenditure. According to Modigliani, this in return would decrease the trade deficit.

What determines the extent of our savings?

Due to his excellent (if somewhat unorthodox) theoretical and empirical approaches, Modigliani was often compared to the great physician Enrico Fermi, who was known for his rare talent to master multiple disciplines in the natural sciences. The legacy Modigliani left is vast, but two of his fields of work are of particular note.

Modigliani’s Saving Function, with which he rigorously changed the paradigm of the field, overthrew the widely held belief that consumption depends on current income. The Life-Cycle Hypothesis instead provided a novel view for the causes of saving by putting forward the idea that people tend to choose a level of consumption they can maintain over the course of their lifetimes. Modigliani’s research had great implications for policy measures. "Bequest-saving will respond to taxation," he explained. "Whereas lifecycle-saving will respond to things like social security."

The other fundamental implication of a lifecycle model reflects the behavior of countries and their saving patterns. "A country’s saving depends primarily on the rate of growth of the economy," Modigliani pointed out. "If the economy has no growth, no matter how rich it is, it will not save. Reversely, if the economy grows, no matter how poor the country is, it will save." He mentioned China as an example because it had grown faster than any other country and had increased its savings substantially.

Why are taxes are a big surprise?

It used to be thought that there were great advantages in financing firms with debt rather than with equity, as interest rates were typically lower than the cost of equity. So, Modigliani’s work, namely the famous Modigliani-Miller Theorem, produced a considerable surprise when it showed that the tax component discredited previous theories. "If there are no taxes, then it should not make any difference how a firm is financed," Modigliani told us. His findings gave a new movement to the global financial economy by proving that there existed an arbitrage mechanism that would keep a firm's level of risk and value, no matter how it was financed.

The Modigliani-Miller-Theorem set in motion a new impetus which led to an explosion of work in the field of financial economics, with works contributing to the calculation and evaluation of risk and the valuation of firms. "Our theory had a large impact," Modigliani reflected. The purpose of decision-making in management was no longer aimed at maximizing profits, but shifted towards maximizing the market value of the firm. "This turned out to be a very big advancement because profits are an undefined concept when you are dealing with uncertainty, but the market value of a company is solid."

Modigliani enjoyed his education and upbringing in sunny southern Europe. However, in the 1930s, Mussolini’s ties with Hitler’s regime intensified, and the dangers of fascism and Nazism transformed Modigliani’s life. He fled to France in 1938 and then took a trip to the United States, where he settled down and never left.

The world facing serious problems

Advancing our understanding is what moves the human race forward. Great minds like Modigliani’s have contributed to the welfare of people all over the world but, as he said in the summer of 1987: "Perhaps now, more than ever, we do face some serious problems. Some are economic, some are environmental problems, and some are problems of peace and war." Modigliani defined conflicts that remain after his death. It’s, therefore, less a surprise that with his rational expectation theory, he countered the perception that we’re less able to forecast what will happen in the future. "There are expectations to the future such that if you hold them and act accordingly, that will make the future be what you expect, make it consistent."

Why do countries have to find better ways to grow?

Hear Michael Spence's view on how countries can grow sustainably while having a long-lasting positive impact.

What does Modigliani’s work mean for us?

"Modigliani’s work has much to tell us about how consumption and savings are likely to react. This is of considerable importance to investors in the wake of a global crisis caused by dis-saving or credit."

Paul Donovan
Global Chief Economist
UBS Wealth Management

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