Pasinetti on the Roots of the Present Financial Crisis, that Is, the Modigliani-Miller Theorem

Recently, Pasinetti (2012: 1,440) has drawn from his own framework an interesting interpretation of the financial crisis which started in 2007-2008. He states: ‘It is a crude fact that, from then [i.e. the appearance of the Modigliani-Miller theorem in 1958] onwards, the dominant theory on savings, investment and growth has sharply changed track’, given by the so-called Modigliani-Miller theorem. For Pasinetti, the Modigliani-Miller Theorem contributed ‘to generating a dramatic shift in economic, monetary and financial policies over the past few decades (ibid.)’. He continues:

One may say that the Modigliani-Miller theorem demonstrates, under certain, specific, ideal conditions...that the market value of a corporation does not depend on its financial structure: in short, it does not depend on its debts to assets ratio. The theorem has in this way led theorists (and financial operators!) to believe that increasing indebtedness has no counter-indications, without considering that an absolutely necessary assumption for reaching such a conclusion is that corporations must always remain in the same category of risk, which of course is impossible if the corporation’s indebtedness increases. In even simpler, immediate and practical words, the theorem has led to the belief that there is no difference between the two traditionally considered alternatives regarding the allocation of each single firm’s profits, i.e.: (i) that of using them internally by adding them to the existing capital stock, or (ii) that of immediately distributing the dividends to the shareholders (ibid.: 1,442; italics in original).

Pasinetti’s conclusion is straightforward. For the Classical and Post-Keynesian schools, the traditional role of the ‘capitalists’ or ‘entrepreneurs’ is to reinvest profits, not to distribute them. In the Post-Keynesian model, new investment must ensure full employment of the system, the absorption of net new labour, and the generation of ‘that process of capital accumulation that characterizes our capitalist economies’ (ibid.; italics added). That is why, for Pasinetti,

The Modigliani-Miller theorem came to introduce a sharp break with the whole Classical—and by implication Keynesian—approach. It channelled all economic arguments to a supposedly micro-economic process founded on the rational behaviour of the single economic agents, in the search of efficiency for the corporation’s investments, internal or external, in the belief that efficiency was associated, not so much with the traditional maximization of profits, since this could generate complications in regimes of uncertainties, but with the maximization of the corporations’ market value (i.e. of the value of the corporations’ shares, as evaluated on the stock exchange market). All this of course within a cultural context of supposedly perfect knowledge, perfect communication of information, and an institutional framework of perfectly automatic self regulating free markets (ibid.: 1,442—1,443; italics added).

In this way, Pasinetti’s analysis comes full circle. It started in the mid-1950s from the argument that the industrialized world was then, and still is, characterized by a highly unequal distribution of income and wealth, and fluctuating unemployment often in the presence of excessive production capacity. After nearly six decades as an economist, Pasinetti thus points out an additional failure of mainstream economics.