Stumbling and Mumbling

Author: chris dillow   |   Latest post: Thu, 16 Aug 2018, 01:44 PM


Facts vs hand-waving in economics

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On Twitter this morning Jason Smith asked a good question. Is this, he asked, an "anonymous blog comment from a simpleton? ... Or analysis from a prominent financial economics professor?":

A company has $100 in cash, and $100 profitable factory. It has two shares outstanding, each worth $100. The company uses the cash to buy back one share. Now it has one share outstanding, worth $100, and assets of one factory. The shareholders are no wealthier. They used to have $200 in stock. Now they have $100 in stock and $100 in cash. It's a wash.

It could be from the professor, because this is a clear statement of the famous Miller-Modigliani theorem, that a firm's value is independent of its capital structure.

Equally, though, it could be from a simpleton because we have abundant evidence from around the world that share buy-backs do in fact raise share prices (pdf). Cliff Asness has explained why:

First, repurchases might signal that management believes that shares are undervalued...Second, because interest payments are tax deductible, debt financed repurchases can be viewed as good news due to the resulting lower tax burden. Third, investors may feel as though it is better for management to return excess cash to shareholders, rather than chasing less economic "pet" projects. This kind of agency cost is often characterized as "empire building," and avoiding it has long been viewed as one of the benefits of returning cash to shareholders.

In other words, the assumptions behind the Miller-Modigliani theorem do not hold: these include no taxes, no agency problem and full information.

This is not to criticize them. I've always read their theorem (pdf) not as saying "capital structure doesn't matter", but rather: "when you see a share price change in response to a change in capital structure, it's because (at least one) explicitly-stated assumptions do not hold."

There's one of these assumptions I want to focus on. It's that shareholders know as much about the firm as management. If this were the case, buy-backs or dividend cuts would not have any signalling merit. But of course they do: we were reminded of this this morning, when Debenhams share price fell after its dividend cut (though it has since recovered*).

Now, the assumption of full information - not just in this instance but in others - is sometimes justified as a necessary simplification. For me, this won't do. Bounded knowledge is not some contingent accident we can assume away. It is the human condition**. Assuming that men are gods is no basis for analysing real human behaviour, which is what economics should be.

And this brings me to my beef with comment that Jason cites (and the many more in that vein). Economics, for me, is not about armchair theorizing. It should begin with the facts, and especially the big ones. The facts are that share buy-backs do usually matter, so thought experiments that say otherwise are wrong from the off. Similarly, the fact that wage inflation has been low for years (pdf) is much more significant than any theorizing about Phillips curves. And to take another example, the fact that most fund managers don't beat the market (pdf) in the long-run counts for vastly more than theorizing about the pros and cons of the efficient markets hypothesis. (Feel free to add other examples.)

For me, economics should above all be an empirical discipline. The extent to which it is - especially in the way undergraduates are taught - is a debate I'll leave to others.

* As of this writing.

** Hayek was explicit about this, which is a big reason why he was not a mainstream neoclassical economist.

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