WHY THE RICH STAY RICH, THE POOR STAY POOR

Author: By David Warsh, Globe Staff

Date: Sunday, December 8, 1985
Page: A1
Section: BUSINESS

Now observe the working-class neighborhoods of the old industrial cities, and the tumbledown buildings of Chelsea and Roxbury. This wide disparity between rich and poor has remained much the same, decade to decade.

Why and how does this state of affairs persist? How much of this wealth is earned and saved during the lifetime of the well-to-do? How much of it is inherited? How is it that the rich seem to stay rich, generation to generation? Beyond these fundamental questions lie the answers to pressing problems of public policy: Is the current level of government borrowing harmful to our economic future? Does Social Security impinge on investment? Are we in danger of eating our seed corn?

Franco Modigliani, who will receive the Nobel Prize for economics in Stockholm Tuesday, is the leading specialist on how these questions are formally asked and answered. The 67-year-old scholar at Massachusetts Institute of Technology is the principal author of what economists call the ''life-cycle" hypothesis - itself now nearly 35 years old.

Modigliani summed up his basic idea with disarming if somewhat misleading simplicity as the proposition that most people behave according to the maxim ''save it when you need it least; have it when need it most." Today, it underlies most economists' thinking about how savings and consumption decisions are made.

But as if to confirm the worst fears of those who think that economics is an undercooked science, the award cloaks much controversy about what exactly is implied by the life-cycle hypothesis. At a meeting last summer to celebrate the lifetime accomplishments of Modigliani, his friend and former close collaborator Albert Ando (along with Arthur Kennickell of the Federal Reserve System) asked how much support there was for dominant interpretation of the life cycle in household data for the United States and Japan.

There was not much, they concluded. Attempts to use it to explain very large-scale empirical studies must be judged "a complete failure," they wrote in a survey of the published work. "We started with one of the most elegant theories in economics, and we could not find a way to fit abundant bodies of data into its neat framework," they concluded. (A cheerful Modigliani immediately set to work defending his hypothesis at the meeting, of course.)

Somewhat more generally, the University of California's Thomas Mayer wrote a decade ago, "Of all the many tests which have been undertaken by friends of the (life-cycle) hypothesis, not a single one supports it . . . I therefore conclude that the . . . hypothesis is definitely invalidated."

So, are the Swedes honoring a guy who made a bad guess? Of course not. It is well over three centuries since Francis Bacon noted that the fundamental tenet of modern science is that "truth emerges more readily from error than confusion," and if Modigliani's work did not pin down, once and for all, the reasons for observed patterns of economic growth, savings and wealth, his conceptual breakthrough did make possible the formulation of efficient questions about these topics on a new level of concreteness.

The Nobel Prize "should have come sooner," says Mayer, the critic of a decade ago. "Super-well-deserved," says Harvard's Lawrence H. Summers, who perhaps has done more than any other scholar to controvert Modigliani's findings, at least on one level. "The crucial idea was that you should look at utility maximizing through time, and that consumption smoothing was an important part of savings decisions," says Summers.

But the funny thing is that Modigliani has got himself crosswise with most of the rest of the profession over the way this forward-looking behavior on the part of people actually works itself out in life. Modigliani thinks that most people save only for themselves - and not for their children.

"Franco thinks that the only substantial bequests that are left are left by people who are caught by surprise by the grim reaper, people who haven't yet spent all that they intended to spend," says colleague Robert Solow. ''Many other economists don't think that, and there is plenty of controversy on that point."

What is the evidence? Summers lists some of the reasons for arguing that bequests are an important part of savings decisions. For one thing, he says, there was savings behavior before there was retirement. "In 1900, there was much less retirement, and life expectancy was shorter, but there was a higher savings rate," he says. The implication: that people save even when they know they'll go on earning.

Then, too, it is difficult to find evidence that wealth declines the way it is supposed to in Modigliani's view. "The key thing in the old theory is that you decumulated wealth in retirement," says Summers. "But in fact, the data tend to suggest that the savings rate among 80-year olds is positive."

Still another skein of evidence involves the observation that the demand for annuities, reverse life insurance products, is far less than the life- cycle hypothesis would predict. "Circuit breaker" programs, which permit the elderly to postpone their property taxes until after they die, at which time the tax bill is paid out of proceeds of sale of a house, are not popular either.

But the most persuasive points are the most fundamental, according to Summers. One is that the inequality of wealth is very much greater than the inequality of earnings. Bequests are a natural explanation for the fact. Moreover, consumption patterns don't look the way a simple life-cycle story says they should. "It's not true that most of the earnings come early in life, and that consumption comes late in life, as the hypothesis suggests."

None of which has persuaded Modigliani. When Summers and Lawrence Kotlikoff published a paper concluding that up to 80 percent of existing wealth has been inherited, Modigliani checked their algebra, changed a few definitions and concluded that only 20 percent of wealth came in the form of bequests. His old friend Ando says Modigliani still calls up at intervals to argue that bequests are not of very great importance. Even his close associates sometimes wonder aloud why Modigliani insists on the unimportance of inheritance.

But none doubt that he is his own best exemplar. Upon learning of his Nobel award, which carries a stipend of more than $200,000, Modigliani said he would do what his theory predicted. With one eye on the time horizon of his life, he bought airplane tickets for a grand European tour for a dozen members of his family.

WARSH ;12/03,09:45 NKELLY;12/09,19:47 WARSH08