MacKenzie D. An engine, not a camera.. How financial ... - TiERA

Transforming Finance 43simplified and therefore unrealistic ‘models’ and problems” (Stigler 1988,p. 75).Having shown the irrelevance of capital structure and of dividend policy intheir simple assumed world, Modigliani and Miller then investigated the consequencesof allowing some more realism (especially in regard to taxes) backin. Just how far to go in adjusting their model to “reality” and the exact consequencesof doing so became matters of dispute between Modigliani andMiller. Attuned, as Keynes had been, to the imperfections of markets,Modigliani was the more cautious. Indeed, when first describing the irrelevanceof capital structure to a class at Carnegie Tech, he distanced himself: “Iannounced the theorem and said ‘I don’t believe it.’” (Modigliani interview)Miller, in contrast, was prepared more radically to set aside the question ofthe validity of assumptions, in the manner advocated by Friedman (Millerinterview). Modigliani and Miller’s published joint work trod a middle path—they explored the consequences of the simple assumptions of a “perfectmarket,” but also attended carefully to the effects of relaxing those assumptions—butprivate disagreement between them emerged over the range of conditionsunder which their propositions would hold, in particular in respect tothe tricky question of the effects of corporate and personal taxes (Miller interview;Modigliani interview).Despite these incipient disagreements, Modigliani and Miller found themselveson the same side with respect to traditional finance scholarship, just asthey had with respect to Herbert Simon’s critique of orthodox economic reasoning.Their sharpest dispute was with David Durand, a prominent financescholar of a more traditional, institutional bent who held a professorship ofindustrial management at MIT. Durand had himself examined what was ineffect Modigliani and Miller’s proposition about the irrelevance of capitalstructure, and had at least hinted that arbitrage might in principle enforce it.Ultimately, however, he had rejected the proposition.Institutional restrictions had seemed to Durand to be sufficiently strong tomake capital structure relevant, in particular to favor bonds over stocks:Since many investors in the modern world are seriously circumscribed in their actions,there is an opportunity to increase the total investment value of an enterprise by effectivebond financing. Economic theorists are fond of saying that in a perfectly fluid worldone function of the market is to equalize risks on all investments. If the yield differentialbetween two securities should be greater than the apparent risk differential, arbitragerswould rush into the breach and promptly restore the yield differential to itsproper value. But in our world, arbitragers may have insufficient funds to do their jobbecause so many investors are deterred from buying stocks or low-grade bonds, eitherby law, by personal circumstance, by income taxes, or even by pure prejudice. Theserestricted investors, including all banks and insurance companies, have to bid for