The Great Depression of the 1930s was one of the most traumatic events of the 20th century. It was especially shocking given the advances in Western civilization during the 1920s. With the exception of the Austrian School, the length and severity of the Great Depression caused many economists to question classical laissez-faire and free market capitalism. According to history of economic thought scholar, Mark Skousen: “At the macroeconomic level, the threat came from radical Marxist economists. In the 1930s, Marxism was gaining popularity at universities. Paul Sweezy of Harvard taught and defended Marxism, and Sidney and Beatrice Webb returned from the Soviet Union to the London School of Economics with the belief that Stalin had launched a “new civilization of full employment and economic superiority".

More measured economists sought an alternative to wholesale socialism, nationalism, and central planning. From this school emerged John Maynard Keynes. As Skousen points out:“Keynes presented that capitalism is inherently unstable and has no natural tendency toward full employment. Yet at the same time, he rejected the need to nationalize the economy, impose wage and price controls, and interfere with the micro foundation of supply and demand. All that was needed was for the government to take control of the wayward capitalist steering wheel and get the country back on the road to prosperity. How? By deliberately running federal deficits and by spending money on public works that would expand demand and restore confidence. Once the economy got back on track and reach full employment, the government would no longer need to run deficits and the classical model would function properly….But beyond this, no obvious case is made for a system of state socialism that would embrace most of economic life.”

In 1936, Keynes published his magnum opus, The General Theory of Employment, Interest and Money. In The General Theory, Keynes challenged the neoclassical economic model that the market would naturally establish full-employment equilibrium. Keynes argued that demand, not supply, is the key variable governing the overall level of economic activity: “In a state of unemployment and unused production capacity, one can enhance employment and total income only by first increasing expenditures for either consumption or investment. Without government intervention to increase expenditure, an economy can remain trapped in a low-employment equilibrium.” Keynes thus advocates for an activist economic policy by the government to stimulate demand in times of high unemployment.

 Keynes’ General Theory is often viewed as the foundation of modern macroeconomics, but it was not until the 1950s when Paul Samuelson of the Massachusetts Institute of Technology (MIT), and later, other MIT economists began translating and refining Keynes work did Keynesian economics gain its widespread acceptance as the foundation of macroeconomic. By so doing, MIT, along with Harvard’s Alvin Hansen  and Cambridge’s J.R. Hicks, set the stage for the Keynesian Revolution and later the neo-Keynesian economic schools dominated by MIT.

Over the last 50 years, there have been 10 Nobel Laureates from, MIT: Paul Samuelson (1970), Franco Modigliani (1985), Robert Solow (1987), Paul Krugman (2008), Robert C. Merton (1997),  Peter Diamond (2010), Jean Tirole (2014), Bengt Holmstrom (2016), Abjijit Banerjee and Esther Duflo (2019), and Joshua Angrist (2021). This article examines the life and major works of its three founders: Samuelson, Modigliani, and Solow.

Paul Samuelson

Paul Samuelson was born May 15, 1915, in Gary, Indiana. His family moved to Chicago, where at age 16 he began his studies at University of Chicago, earning a B.A. degree in Economics in 1935. He completed his PhD in Economics in 1941 at Harvard University. As a graduate student at Harvard, Samuelson studied economics under Joseph Schumpeter, Wassily Leontief, Gottfried Haberler, and Alvin Hansen. At Chicago, he was schooled in monetarism and neoclassical economics, but at Harvard he was converted to Keynesianism by his mentor Alvin Hansen. After graduating, he became an assistant professor of economics at MIT when he was 25 years of age and a full professor at age 32. He spent his career at MIT, where he was instrumental in turning its department of economics into a world-renowned institution by attracting other noted economists to join the faculty, including Robert Solow, Franco Modigliani, Robert C. Merton, Joseph Stiglitz, and Paul Krugman.

Samuelson first showed his talent and passion for economics with his dissertation that was later published in 1947 as Foundations of Economic Analysis. In this work, he claimed that mathematics should be the primary exposition of economics, breaking from Alfred Marshall who believed that the study of economics required understanding math, statistics, business, history, and philosophy. Samuelson’s economic and political views were greatly influenced by the time period in which he grew up. Samuelson married a Radcliffe summa cum laude, Marion Crawford, also an economist. Together they had six children. He served as an advisor to both John F. Kennedy and Lyndon B. Johnson, advising Kennedy to cut taxes in 1964 to help stimulate economic growth through deliberate deficit financing. He also served as a consultant to the United States Treasury, the Bureau of the Budget, and the President's Council of Economic Advisers. During the 1960s, Samuelson wrote a weekly column for Newsweek magazine along with Milton Friedman.

 In 1948, Samuelson published his best-selling economics textbook: Economics: An Introductory Analysis.  Over the next half century, eighteen editions of the book were published in over forty languages, with over four million copies sold, making it the best-selling economics textbook of all time. The textbook has been praised for explaining economics through simple algebra and clear graphs. The book also delineated the principles of Keynesian economics. In the tradition of the great economic texts of Alfred Marshall and John Stuart Mill, Samuelson’s Economics has survived more than a half-century of dramatic changes in the world economy and the economics profession: peace and war, boom and bust, inflation and deflation, Republicans and Democrats, and an array of new economics theories” (Skousen, 358).

In Economics, Samuelson brought Keynesianism concepts and principles to the classroom: the multiplier, the liquidity preference function, the liquidity trap, wage rigidity, the paradox of thrift, and countercyclical fiscal policy. He is often cited for his description of the Keynes equilibrium state of unemployment using the “Keynesian cross”— an income-expenditure diagram. The diagram shows Keynes’s underemployment equilibrium where savings (S) is increasing with national income (NI), while investment (I) is fixed. The economy, in turn, is at equilibrium income level (M) where S = I, that falls short of full-employment income (F). Samuelson, in turn, explains the fixed level of investment in terms of Keynes’s liquidity trap, where interest rates (r) are so low that a change in rates will not increase capital investment or stimulate the economy. The model thus describes how a market economy can be indefinitely stuck at less than full employment.  Keynes and neo-Keynesian also argued that under such conditions, monetary policy would be ineffective tool to stimulate the economy; instead what was needed was a fiscal policy stimulant. Samuelson compares capitalism to a car: “The private economy is not unlike a machine without an effective steering wheel or governor. Compensatory fiscal policy tries to introduce such a governor or thermostatic control device” (Samuelson 1948: 412).

With the Keynesian cross, Samuelson also explains Keynes’s “paradox of thrift.” The theory proposes that during a recession, an exogenous increase in desired thrift (upward shift of SS line) results in a decrease in total savings. When the public decides to save more in an economic downturn, consumers buy less, producers lay off workers, and households end up saving less. The “paradox of thrift” was an attack on the classical orthodoxy of Adam Smith and J.B. Say.

Samuelson also believed that uninvested savings were a waste. He explains this in terms of his “hydraulic Keynesianism” diagram that shows savings leaks out of the system. He argued that technological change, population growth, and other dynamic factors keep the investment pump going. Income rises and falls with changes in investment, its equilibrium level, at any time, being realized only when intended savings at Z matched intended investment at A. The Keynesian model leads to the conclusion that consumption is more productive than saving.

In Economics, Samuelson also shows how government spending has a higher multiplier than a tax cut, since 100% of a federal program is spent, while some of the tax cut is spent and some is saved. From this, he posited the balanced budget multiplier theorem that says an equal increase (decrease) in government expenditure and taxes leads to an increase (decrease) in aggregate output by an amount equal to the government expenditure increase (decrease).

In addition to his book, Samuelson authored and co-authored over 380 papers (these are published in Samuelson's Collected Scientific Paper) in a number of economic fields: consumer theory (revealed preference), welfare economics (Lindahl–Bowen–Samuelson conditions), finance (option pricing model,  efficient-market hypothesis, turnpike theorems and Cambridge capital controversy), public finance, macroeconomics (neoclassical synthesis), and international economics (Balassa–Samuelson effect and the Stolper–Samuelson theorem). Samuelson, along with Robert Solow, also popularize the Phillips Curve, showing unemployment and inflation were inversely related. This was later criticized by Milton Friedman, Friedrich Hayek, and other economists in the 1970s when the U.S economy suffered from a combination of both unemployment and inflation—stagflation. From both his articles and texts, Samuelson argued for a progressive tax system to redistribute income, endorsed Social Security taxes, farm aid, unemployment compensation, and other welfare programs as being “built-in stabilizers” in the economy, and argued for regulated markets.

As with Keynes, not everyone accepted Samuelson’s teachings. Samuelson’s economic principles were criticized from both sides. Neoclassical economists attacked his text for its socialistic tendencies, while socialist criticized it for its capitalistic tendencies. Some identified Keynesianism and neo-Keynesianism with Fabian socialism, Marxism, and fascism. However, under Stalin's reign, Samuelson’s Economics was forbidden in soviet libraries. As one of the leading neo-Keynesian proponents, Samuelson’s solution to this cyclical nature of the economy was government intervention through fiscal policy. This contrast with the Chicago School’s monetarism doctrine that argued that fiscal policy is not as important as monetary policy in addressing business cycles.  Like Keynes, Samuelson’s defense of Keynesian fiscal policy during recessions contrasted with the views of Austrian School economists Ludwig von Mises and F.A. Hayek. Both Mises and Hayek argued that the expansionary monetary policy of the 1920s led to inflation, a bubble, and then a burst, leading to the depression. They further argued that the government should do nothing during a recession, allowing for wages and prices to fall, which would increase demand.

Paul Samuelson won the Nobel Memorial Prize in Economic Sciences in 1970. When awarding the prize, the Swedish Royal Academies stated that he "has done more than any other contemporary economist to raise the level of scientific analysis in economic theory." He passed away on December 13, 2009 at the age of 94. In announcing his passing, Greg Frost, MIT News, wrote: "In a career that spanned seven decades, he transformed his field, influenced millions of students, and turned MIT into an economic powerhouse."

Franco Modigliani

In 1962, Franco Modigliani joined Paul Samuelson on the faculty of MIT. Modigliani was born June 18, 1918, in Rome, Italy. He studied law at the Sapienza University of Rome, graduating in 1939. During his studies, he wrote several essays for the fascist magazine Lo Stato on production management of socialist economies. The same year, he and his future wife immigrated to the United States where he enrolled at the Graduate Faculty of the New School for Social Research. His PhD dissertation was an extension of John Hicks' IS–LM model. Before joining Samuelson at MIT in 1962, he taught at Carnegie Mellon and Columbia University.

In 1958, Modigliani collaborated with Merton Miller to developed what is known as the Modigliani–Miller theorems for corporate finance. Today, Modigliani and Miller theorems are featured in most managerial finance books. Their three theorems address the questions of whether the value of a firm is affected by a company’s decision to finance by equity, debt, internally through retained earnings, or externally.  Their first theorem posits that in a no tax case, changes in capital structure (choice of debt and equity financing) have no impact on the value of assets (value of debt plus the value of equity). Modigliani and Miller argued that given two identical firms except that one is financed with debt (levered firm) and the other is financed by equity (an unlevered firm), in equilibrium, the values of their assets must be equal. Modigliani and Miller argued that if they were not, then investors would be able to earn an abnormal return by forming leverage buyout companies—actions that would serve to equalized the value of levered and unlevered firm. When applied to deficit spending by the government, The Modigliani-Miller theorem implies that, for a closed economy, state borrowing is merely deferred taxation, since state spending can be financed only by money creation, taxation, or borrowing, and therefore monetary financing of state spending implies the subsequent imposition of a so-called inflation tax.

In their second theorem, Modigliani and Miller (1963) show that it is the U.S. tax code that makes capital structure decisions important. Specifically, they argue that given interest is tax deductible and dividends are not, the greater a firm’s debt-to-equity ratio, the greater proportion of its earnings flow to investors (creditors and shareholders) and the less to the government. Thus, by increasing debt, more earnings flow to investors, which increases the value of the firm—thus, it makes a difference if the firm calls its investors a creditor or a shareholder. Going from their first theorem to their second, Modigliani and Miller established that capital structure decisions are important because of the tax laws. In fact, the surge in junk bond sales in the 1980s often is explained in terms of the activities of investment bankers (e.g., Michael Milken) persuading institutional investors to hold higher yielding junk bonds instead of equity, with the higher yields made possible because of the tax laws.

In their third theorem, Modigliani and Miller posit that a firm’s decision to finance its investment internally through retained earnings (i.e., exiting shareholders financing the investment by giving up their dividends) or externally by selling new stock or borrowing is irrelevant. The irrelevance in the choice of financing is due to offsetting tradeoffs between the two types of financing.  With internal financing, shareholders give up early earnings in return for greater earnings in the future with no dilution in the value of their claims. With external financing, shareholders receive early earnings but give up part of the total amount of future earnings, allowing for dilution.  Modigliani and Miller showed that these two tradeoffs exactly offset each other; thus, there is no gain in value by financing either internally or externally.  The argument for the irrelevance of financing (sometimes referred to as dividend policy) is based on a purely financial criterion, and leads to firms basing their dividend policies on other non-financial reasons, such as tax considerations.

In 1966, William F. Sharpe developed what is now known as the Sharpe ratio. Sharpe originally called it the "reward-to-variability" ratio. Sharpe calculated each fund’s average return and standard deviation and then ranked each in terms of their average risk premium per level of risk as measure by their standard deviation. In 1997, Modigliani and his granddaughter, Leah Modigliani, developed what is now called the risk-adjusted performance (RAP) measure. Their measure was an extension of the Jensen Index or alpha. The RAP measures abnormal returns, defined as the return above or below a fund’s risk-adjusted return. For example, a fund that is highly correlated with the market (Beta of one), should earned the same return as the market.  If the market is up 10%, it should earn 10%; if the market is down 10%, it should be down 10%. If the fund has a RAP (or alpha) of 2%, then it always does 2% better than its risk-adjusted return. If the market is up 10%, its up 12%; if the market is down 10%, it is down only 8%.  Today, the RAP is am important measure of portfolio performance. Funds that consistently have positive RAPs outperform the market. In fact, a popular investment website is called “Seeking Alpha.” Modigliani along with Frank Fabozzi also authored the popular text Capital Markets: Institutions and Instruments (1996, 1998), which set the foundation for study of fixed-income analysis and part of the CFA curriculum. 

In economics, Franco Modigliani is best known for his life-cycle hypothesis, econometric model, and rational expectations. His life-cycle hypothesis (1966) is a theory based on the assumption that observed consumer behavior is the result of rational consumers maximizing utility by allocating a lifetime stream of earnings to an optimal lifetime pattern of consumption. With a constraint that their present value of consumption be equal to the present value of their expected income, consumers will maximize their utility by borrowing and lending.  

The hypothesis shows how people are more likely to save during their working years in order to have money to spend during retirement. When people are young, they acquire debt due to making big essential purchases, such as buying a car or house. They then must save money from their income in order to pay off these purchases, thus starting the saving process. After people finally pay off their debt, they continue to save part of their income, for they carry on the habit of saving they developed while they were younger. Typically, these savings are spent later in life when they stop working and retire. The life-cycle theory extended John Maynard Keynes’s consumption function, where consumption is simply a function of income, to one where consumption is a function of the present value of a person’s income stream and includes income from labor, assets, and property. Modigliani’s model suggests that a change in income that is not accompanied by a change in expected future income would cause relatively small change in consumption.  In 1967, Modigiani and Albert Ando  teamed up with economists at the Federal Reserve Board in Washington to develop an econometric model of the economy to conduct statistical impact analysis and forecasting. Their model incorporated Modigliani’s dynamic consumption functions.

Macroeconomic models today incorporate the expectations of individuals, firms, and government institutions about future economic conditions. Rational expectations theory holds that individuals use their own rationality, available information, and past experiences to influence future decisions Rational expectations theory is used in economic modeling to explain the determinants of interest rates, aggregate output, inflation, and exchange rates. The theory is generally associated with the Chicago School, where it was used by Robert Lucas Jr. in macroeconomics. However, the origin of the rational expectations hypothesis is often credited to Modigliani’s 1954 work with Emile Grunberg.

 In 1975, Modigliani developed with one of his former students, Lucas Papademos, the natural rate of employment concept, termed non-inflationary rate of unemployment (NAIRU). The rate measures the level of unemployment that can be reached before wages and inflation start to rise. If unemployment falls below the NAIRU level, then inflation will accelerate. If unemployment is at the NAIRU level, then inflation and wages are constant. 

 In October 1985, Modigliani was awarded the Nobel Prize in Economics for his pioneering analyses of saving and of financial markets. Many economists believe he should have won another Nobel Prize for his work. He died in Cambridge, Massachusetts in 2003, while still working at MIT and teaching until the last months of his life. He was 85. His close friend Paul Samuelson said of him that he “always took his work seriously, but never himself".

Robert Solow

Alongside Paul Samuelson and Franco Modigliani is Robert Solow. Solow was born on August 23, 1924, in Brooklyn, New York. He excelled academically, entering Harvard in 1940 on a scholarship at the age of 16. In 1941, Solow left the university and joined the U.S. Army. Fluent in German, he served in North Africa and Sicily, intercepting and interpreting German messages. After his discharge in 1945, he married Barbara Lewis. He returned to Harvard in 1945, where he earned his BA, MA, and PhD in economics. At Harvard, he studied under Wassily Leontief, and worked as his research assistant on the U.S.  input–output model. In 1949, Solow joined the economics department at MIT teaching  econometrics and macroeconomics. For the next 40 years, he and Paul Samuelson (his office was right next to Paul Samuelson) worked together on many theories: von Neumann growth theory (1953), theory of capital (1956), linear programming (1958) and the Phillips Curve (1960).

 Robert Solow is best known for his contribution to the modeling of economic growth. In his 1956 article, “A contribution to the theory of economic growth,” he extends the Harrod-Domar growth model, explaining how economies grow through the saving, investment, and capital formation process. In this process, aggregate output in time period 0, initial GDP-0 , gives rise to a certain level of aggregate savings, S-I, and new capital investment expenditures, I-0. The new level of investment expenditures, in turn, changes the economy’s existing capital stock, ΔK (plants, equipment, machines etc.), and the new level of capital changes the level of aggregate production. The new level of output gives rise to a new savings and investment level, I-1, which changes the capital stock and leads to a new aggregate output level, GDP-2, new investment levels and capital, and so on:

In his 1957 article, “Technical Change and the Aggregate Production Function,” Solow argued that economic growth is not solely a function of capital and labor, but the result of technological innovation. According to Haines and Sharif (2006), Solow was the first to develop a growth model with different “vintages of capital,” where technology is assumed to be constantly improving. Consequently, the products of this technology (the new capital, K), leads to a new level of vintage capital that is greater than the depreciated or obsolete capital, and as a result increases aggregate production, shifting the aggregate supply curve, SS (described in macroeconomics) to the right.  In contrast, economies decline when the levels of investment expenditures are not sufficient to replace depreciated or obsolete capital. In such a case, there is often a decline in the capital stock and the level of aggregate production.

 For the U.S. and other industrial countries, the twentieth century is a testament to how economic growth occurs through the savings, investment, and capital formation process: From the 1910 model-T Ford to the 2023 Mercedes, from the Wright brothers’ first flight to the Space Shuttle, from Royal typewriters to laptop computers, from Alexander Bell’s first telephone to the cell phone. Solow’s growth model captured this relation. In his sixth edition of Economics (1964), Samuelson added a new chapter on growth theory based on his colleague’s work, making economic growth a major focus for understanding economics.  In the early 1960s, MIT became known as the home of the growth economists.  Solow’s work also influence the works of Nobel laureates Paul Romer and Robert Lucas, Jr., who subsequently extended Solow's neo-classical growth model.

 Robert Solow was very dedicated to his students to the point where he made teaching a priority over research. Solow's past students include 2010 Nobel Prize winner Peter Diamond, as well as Michael Rothschild, Halbert White, Charlie Bean, Michael Woodford, and Harvey Wagner. One notable student was Mario Draghi who became the prime minister of Italy. In 1987, Robert Solow won the Nobel Prize in Economics for his analysis of economic growth.  

Conclusion

 The 1950s marked the period when the economics of Keynes began to take off. As History of Thought scholar, Mark Skousen, noted, this surge was led from the “other Cambridge”—Cambridge, Massachusetts: “The American advancement of Keynesian economists represented a subtle but clear shift from Europe to the New World. Before the war, Cambridge and London had shaped the economic world.” After the war it was Cambridge, Massachusetts— MIT— that took center stage, led by Samuelson, Modigliani, and Solow.   

Videos

·       Modigliani, Samuelson, and Solow

·       Paul Samuelson

·       Robert Solow

·       Franco Modigliani Part 1

·       Franco Modigliani Part 2

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