Antonio Fazio: Franco Modigliani
Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the Accademia Nazionale dei Lincei
International Conference, Rome, 18 February 2005.
* * *
1. Some personal recollections
Franco Modigliani occupies a central role in 20th century economic analysis. For his work on the
theories of saving and finance he was awarded the Nobel Prize. He made considerable contributions
on innumerable topics, as is borne out by the five volumes of his
Collected Papers.
His participation in the debate on Italian economic policy answered to the profound need of the man
and the economist, who, after analyzing problems, threw into the search for solutions the whole weight
of his civic passion, his commitment to the welfare of the community, of those he regarded as his
fellow citizens. Discussions, whether with economic policymakers or with young people eager to learn
from him, were always lively and directed to conclusions that were analytically well-founded and
socially fair.
I first met Franco Modigliani in 1957. During a trip to Italy, the first since the end of the war, he gave a
lesson in Piazza Borghese to Professor Travaglini's political economy students.
We had studied Bresciani Turroni, including his attempts to make an empirical analysis of the demand
for Egyptian cotton, and were tackling I was struck by Franco's description of the
Value and Capital.
way the consumption function was estimated, in the United States, of course. Political economy did
not end with sophisticated analyses of isoquants, the income effect and the substitution effect: it was a
practical science.
After graduating and spending some time in the Bank of Italy's Economic Research Department on a
scholarship, I was encouraged by Professor Cutilli to write to a number of American universities in
order to specialize in monetary theory and econometrics. In the end I chose Northwestern, because
Professor Modigliani taught there, and it was partly thanks to him that I was admitted.
At the beginning of 1962 Franco announced to me that he was moving to the Massachusetts Institute
of Technology and suggested I should follow him. I did, without hesitating. Under Paul Samuelson's
influence, MIT was already at the forefront of the academic world, for the originality of its research, the
quality of its teaching staff, and the constant wrestling with practical problems; among the latter, I have
pleasure in recalling Kennedy's new economic policy, which was under discussion in the States at the
time.
Franco advised me to take Samuelson's course in which was also taught
Advanced Monetary Theory,
by Albert Ando. These were the years of fierce debate between Keynesians and monetarists regarding
the role of monetary policy in economic growth and in controlling inflation. Let me recount an
anecdote. One day, someone came into the lecture hall with a large pile of Xerox copies, which he
placed on the table: it was the typescript of Friedman and Schwartz's Professor
Monetary History.
Samuelson remarked, 'Milton, Milton! We set up the Fed to adjust the quantity of money to the needs
of the economy'. In its simplicity this comment touched on one of the main points of the debate on the
importance of the quantity of money. I also attended - how could I fail to - Solow's lectures on
economic growth, based on I had confirmation of
Denison's Sources of Economic Growth in the U.S.;
their topical relevance when discussing total factor productivity in the United States and Europe with
colleagues from the Federal Reserve.
Professor Modigliani offered me the opportunity to attend a course in monetary theory ad personam. It
consisted in a sort of two-man seminar, in which he assigned me reading to complete, which we would
then analyze together. Inter alia, I was given the instruction that "...although I do not agree with a word
of Milton Friedman's conclusions regarding monetary policy, he is an author you must study, starting
with his reformulation of the quantity theory of money". Our discussions could last hours; if it was late
in the afternoon, Professor Modigliani would sometimes take me to his home in Belmont to continue
thrashing out various points over dinner; we would talk on into the evening, until Serena remonstrated
and told him to drive his student home.
Modigliani was working on a new version of his 1944 essay "Liquidity Preference" to correct a mistake
he thought he had made in that article by expressing income and wage variables in nominal instead of
real terms. I had also studied Patinkin in depth, and Modigliani explained an aspect that I had not
understood: the application of Walras' Law to macroeconomics. He "skewered" me again on this point
some years later with a criticism of the early version of the model of the monetary sector of the Italian
economy: I had included one market too many, a redundant one. After some sharp but unfailingly
gallant exchanges he acknowledged, however, that I was right about the importance of the concept of
monetary base, as distinct from money, as a central bank tool for controlling credit.
Another field of research in which Franco sought to involve me concerned the relationship between
demographic structure and formation of savings; we pursued a line of thought initiated by Giorgio
Mortara, an author I had also studied for my thesis.
I never had any doubt, thanks also to Guido Carli's encouragement, that I wanted to work for Italy's
central bank. In recalling Franco Modigliani, I shall concentrate on some aspects of his thinking that
have a major bearing on economic policy. His many important contributions to theory have already
been discussed by the other economists of note taking part in this conference.
2. The role of money and the econometric model
The complexity of macroeconomic theory, and of monetary theory in particular, is attested to by the
heated controversies that have marked it in the course of time. I have recalled the monetarists and the
Keynesians; much earlier there had been the protracted dispute between the Currency School and the
Banking School, more recently the debate on the new classical macroeconomics.
The contraposition between distinct strands of thought derives not only from alternative visions of the
working of the economy but also from a different emphasis, as a result of a different assessment of
their empirical importance, on certain aspects of the phenomena investigated. Antithetical economic
policy ideas and suggestions may then emerge. In academic debate the different approaches proceed
in parallel; often, the prevalence of one over another is connected with the occurrence of shocks
strong enough to cause a change of paradigm.
The Great Depression created a break in the secular progress of economic analysis.
The classical model, dominant until then, proved inadequate in the face of a crisis of catastrophic
dimensions. In a speech broadcast by radio on 21 November 1934 with the eloquent title "Poverty in
Plenty: Is the Economic System Self-Adjusting?", Keynes took up the question of the economic
system's intrinsic stability and answered it in the negative. While recognizing the validity of much of
classical economics, Keynes called himself a "heretic" and proposed an alternative model. He
identified an error in the prevailing theory: "There is, I am convinced, a fatal flaw in that part of the
orthodox reasoning which deals with the theory of what determines the level of effective demand and
the volume of aggregate employment; the flaw being largely due to the failure of the classical doctrine
to develop a satisfactory theory of the rate of interest."
In the Keynesian tradition, the problem of the instability of capitalist systems, especially those in which
financial intermediation is highly developed, was the subject of a penetrating essay by our friend
Fausto Vicarelli, who died so prematurely. How many episodes of instability we have seen in the last
ten or fifteen years, characterized by a rapid expansion of global finance. Episodes of instability that
caused severe hardship and social malaise in the countries affected by the crises; efforts by all the
components of society were necessary to overcome them.
Starting out from and his rereading of Hicks, Modigliani, in his article of 1944 and
The General Theory
in his subsequent paper, "The Monetary Mechanism", published in 1963, analyzed the implications for
employment of the downward rigidity of wages. With the money supply constant in nominal terms, a
diminution of aggregate demand entails a movement away from the full-employment equilibrium and
hence the necessity for an activist monetary policy.
Different aspects of the monetary and economic policy transmission mechanism, which Modigliani
analyzed and which he discussed in our Economic Research Department with reference to Italian
economic reality, are incorporated in the structure of the Bank's econometric model. Modigliani let us
have the benefit of his advice regularly during the 1960s and on numerous occasions in the following
decades. We discussed the problems of growth, of employment and of investment, in general and in
the Italian economy. The specification and estimation of the individual equations of the econometric
model were also carefully considered.
In this setting the lines of a wage policy that was later applied with good results took form with Ezio
Tarantelli through studies of the labour market.
The hallmark of the Bank's econometric model was that it combined an extensive part referring to the
real economy -employment, wages, investment, prices, effective demand -with a detailed analysis of
financial flows. This second part stemmed from the theoretical contributions of Gurley and Shaw, from
Tobin's Manuscript and from Copeland's studies on the flow of funds, a subject empirically developed
for the Italian economy by Ercolani and Cotula.
Modigliani was greatly interested in this structure of the model and threw himself into the discussions
on the Italian financial system, which also engendered ideas for improving the structure of the
markets.
The Bank of Italy has constantly used the econometric model since then as a logical frame of
reference and a tool for knowing some fundamental parameters of the Italian economy.
We used the model in intense discussions with the International Monetary Fund in order to design and
define the parameters of the policy to stabilize the Italian economy in 1974 in the wake of the first oil
crisis. This had caused an enormous imbalance in the external accounts and a surge in inflation,
which was followed by a wage explosion due in part to the indexation of wages to prices.
The success of the policy of credit restriction was immediate, thanks also to the resoluteness with
which Governor Guido Carli implemented it.
Inappropriate budget policies created new imbalances in the following years. We used the model and
its parameters again to define, under Governor Paolo Baffi, the stabilization policy of 1977-78 carried
out by the government led by Giulio Andreotti. The budget correction amounted to 5 per cent of GDP.
The positive effects on the external accounts came through within a year.
Over a span of thirty years Franco Modigliani's analyses, his diagnosis of the ills of our economy and
the suggested cures, encompassed manifold subjects, from the labour market to the problems of
retirement provision. He was motivated by the desire to penetrate the reality of the Italian economy in
order to correct its malfunctions, increase efficiency and expand employment. His interventions, above
partisan interests, were always highly appreciated by Governors Carli, Baffi and Ciampi.
3. Modigliani and economic policy
In the 1960s, the dominance of Keynesian economics was uncontested. Milton Friedman proposed an
alternative line of thought, but his ideas were not considered, save to dismiss them out of hand. But
not by Franco Modigliani.
In the 1970s the collapse of the Bretton Woods monetary order created the conditions for a worldwide
inflationary drift. As a result of restrictive monetary policies, there was also a generalized slowdown in
economic activity. Inflation refocused attention on Friedman's ideas. In the United States the Federal
Reserve had long restricted its monetary action to stabilizing interest rates - the policy of William
McChesney Martin. In this way the rise in costs and prices was financed almost automatically. With
the policy shift instituted by Paul Volcker in 1979, the Fed focused on controlling the quantity of
money. For a short time administrative ceilings were also imposed on lending by Federal Reserve
System member banks. Market interest rates soared. Inflation was curbed.
The so-called monetarist counter-revolution, which blamed activist economic policy for destabilizing
effects, sought to confine policymakers' actions within the bounds of a set of "simple rules". In reality,
this prescription reflected the basic postulate of the economy's automatic return to equilibrium, which,
as Keynes had underscored, was the keystone of classical economic theory.
In his presidential address to the American Economic Association in September 1976, Modigliani
intervened in the debate between Keynesians and monetarists, with acute arguments defending the
need for both fiscal and monetary countercyclical measures.
Modigliani was sceptical about the hypothesis of rational expectations underpinning the alleged
ineffectiveness of stabilization policies, because of the conflict with the empirical evidence. Deviations
of unemployment from its natural rate were neither transient, nor small. The factors preventing the
economy from returning to an equilibrium position within a relatively short time are incomplete
information and institutional rigidities. The hypothesis of rational expectations may apply in the long
run. Exogenous shocks necessitate stabilization measures. The postwar experience, he said, offered
confirmation of this view, but overemphasis on fine-tuning was a mistake.
Modigliani recoiled from partisan thinking and pinpointed the weaknesses of all the different models,
including the Keynesian, which he criticized for failing to consider long-term effects. He once confided
to me, "For decades we have focused exclusively on flows; in our analysis we need to go back to
considering the role of stocks."
The ratio of wealth to disposable income in Italy today is about 8 to 1, the highest among the G-7
countries.
The conclusion that stabilization policies are effective anticipated by a quartercentury the thesis
sustained by Robert Lucas in his presidential address in January 2003. Lucas offered a positive
judgment on the economic policies of the postwar period based on advances in macroeconomic
theory, both Keynesian and monetarist. Countercyclical policies did stabilize the economy and prevent
another large-scale depression, but more intensive recourse to these measures would not produce
additional welfare gains; such gains can be attained by supply-side policies.
In the classical tradition, Lucas stresses incomplete markets and the existence of rigidities and
frictions that impede adjustment.
On these points and on the compatibility of a theory of money and prices with an essentially
Keynesian model, Patinkin's analyses in "Price Flexibility and Full Employment" first and then his
tie in with specific passages in the last part of the and
Money, Interest, and Prices General Theory
provide a synthesis that, to my mind, is still valid today.
This was a lesson that served me in the mid-1990s, when I had to impose a highly restrictive monetary
policy in Italy to support the exchange rate of the lira and curb inflation. In doing so, I had in mind an
idea of the working of the economy in which the level of activity is determined essentially by effective
demand.
Perhaps, if monetarists today cannot but call themselves Keynesians, I should be tempted to assert
that - as far as stocks and sound analysis are concerned - Keynesians must similarly own to being
monetarists.
Economic theory is a great help to central bankers. In practical action, however, we must not forget
that the complexity of theory is such that it is not always possible to reach unequivocal conclusions or,
as a consequence, unquestionably correct and effective policy prescriptions. One may be confronted
with hypotheses that suggest completely different economic policy measures. It is important for
policymakers to bear in mind the multiple facets of each problem, so as to choose the model that has
the greatest explanatory power. History provides numerous examples of policy errors that were the
consequence of an inadequate theoretical apparatus. It is sufficient to recall the monetary policies of
the early 1930s and the dysfunctions of the gold exchange standard, which helped to spread the Great
Depression, with dire consequences for the world economy.
In the second place, it is necessary to have empirical knowledge of the phenomena to be acted on.
We are regularly faced with discussions of topical problems based on abstract models unrelated to the
real world. The search for solutions must begin from concrete situations. As Pareto suggested in his
Manual, to approach the optimum one must also take account of non-economic factors and
constraints. Insufficient understanding of the complex workings of a market economy affects our ability
to operate and can produce erroneous solutions.
Expectations play a decisive role in determining economic performance and the transmission of
economic policy impulses.
The lesson to be learned from Modigliani in this respect is important: he sought to grasp the essentials
of the problems, independently of preconceived notions. Together with Emile Grunberg, he made a
major contribution to our understanding of the role of expectations as early as 1954; this issue
recurred frequently in his thinking.
Governing an economy - through fiscal policy, monetary policy and structural reforms - is a
complicated task. Today, more completely than in the past, we read the various signals coming from
the economy, but even so their informational content is incomplete, not sufficient to plot a secure
course. Our knowledge, at micro and macro level, of the behavioural functions of economic agents has
improved. Yet like all the applied disciplines, economic policy remains an art.
4. Conclusions
The international economy and national economies are dominated today by the phenomenon of
globalization.
It is the sign of the times.
Globalization not only transforms economies and finance but it also impinges on social and cultural
models; it raises the urgent question, especially at international level, of the institutions required to
govern the phenomenon. To cope with the changes and anticipate the future, an approach is needed
in which ever greater specialization is combined with elements of humanistic culture. In this context
institutions such as this glorious Academy have a task to perform in the higher reaches of knowledge.
The financial system has gained a sort of primacy and autonomy at global level. Within it are
determined the levels and structure of interest rates, exchange rates, the cost of capital -here too
Modigliani docet -on the equity markets. The global financial system receives impulses from the
performance of the major economies and from central banks; by its nature it is always exposed to the
risk of instability; its raison d'être lies in bringing together the capacity for saving of some sectors with
the investment expenditure of others.
In closed systems, the major actors were firms, households and the state; in the global system the
imbalances between states and monetary areas come into play.
The international financial system is also tending to adapt the characteristics and scope of its
operations to the need to transfer resources from countries and economic areas with current account
surpluses to those with deficits. Capital flows to where productivity and, hence, profits and returns are
highest and security greatest. Basically, for closed systems -and the world is a closed system - this
has already been theorized in the Turnpike Theorem.
But the global system is a sort of free banking regime with no anchor.
The central bank governors are striving to define rules for intermediaries in order to increase stability.
Notwithstanding failures along the way, we appear able to succeed in this intent. The Basel rules,
continual consultations and banking supervision in the individual countries make a fundamental
contribution to stability. Derivatives, this new invention of finance, provide the lubricant; they reduce
and redistribute the risks. Sometimes they are transformed into fuel, pushing the system beyond the
limits of prudence.
National economies are linked with the global system through trade, but today, much more than in the
past, through finance as well. The efficiency and stability of national financial systems and their
coordination with the global market are necessary for the vitality and proper working of an economy;
they are not sufficient to ensure growth and prosperity.
Policies must in the first place correct macroeconomic imbalances and hence promote the full
utilization of productive factors; in open systems, they must foster competitiveness. From a broad
perspective, competitiveness is simply the ability of an economy to supply, through its working, an
adequate and growing flow of value added. Accordingly, it appears to me that in open systems
competitiveness comes to coincide with potential growth.
In Europe, and especially in Italy, the potential growth of GDP has diminished in recent years. The
introduction of the euro has not been accompanied by reforms capable of accelerating growth.
Monetary stability and low interest rates have brought benefits, but growth still has not ensued.
The Lisbon Agenda, valid in its general formulation, must be applied with the support of the Union and
the Member States in the individual economies by identifying the instruments for its implementation.
To judge by its public statements, the European Commission is working on these issues.
Demographic ageing -to whose implications for government budgets and macroeconomic equilibria,
related in turn to those of individuals, Modigliani devoted so much attention -is looming over Europe,
Italy and other advanced economies.
The public pension and health systems, conquests of great social value of the past century, must
continue to provide their benefits to future generations. A wisely regulated immigration policy can be a
resource, as the experience of the most advanced economy demonstrates.
It is a policy that has substantial effects on the social, institutional and legal plane; following thorough
analysis based on solid principles, the problems must be addressed in ways that avoid extreme
solutions. Our interests must be borne in mind, but also the expectations of those who leave their own
country in search of dignified living conditions, the aspiration and right of every human person.
It has been affirmed by a high authority that every person, upon coming into the world, becomes a
citizen of the world community, with the right to partake of the goods that the system can offer.
The economy is one aspect of a vaster civil society. Welfare, including economic wellbeing, is attained
through analysis, determination, cooperation and enterprise that glimpses new horizons and works
and struggles to reach them. Increased employment, the spread of work, is the goal that negates the
idea of economics as the "dismal science". It is crucial today in Italy to activate all the necessary
means to reverse the trends, to catch the updraft of the recovery, to increase the propensity to invest,
to trigger an expansionary drive.
The solutions and the proposals must come, albeit in the necessary dialectical process, from the
convergence of all the parties, institutional, economic and social.
The prospects of an economy can be seen in the willingness of firms to venture and invest. The
formation of capital, essential to raise potential growth, is tending to be dematerialized, to take on the
form of knowledge, organization and the ability and quality of men of Smithian memory. We must
recover the commitment to growth of every component of society and confidence in the future.
Practice must be founded on good theory. Economists offer recommendations for which they are
competent. Action and synthesis, in the concrete context of civil life, are up to politics.
I think these reflections would not have displeased Franco Modigliani. He would certainly have offered
criticisms and observations, suggested additions and changes. Fundamentally, however, it is his moral
strength, his passion for the good of his fellow citizens, which he passed on to us with his teachings,
that have inspired these reflections.