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8 September 2017 Financial Analysts Journal Book Review

An Engine, Not a Camera: How Financial Models Shape Markets (a review)

  1. Jerry H. Tempelman, CFA

This superb account of the development of the theory and practice of financial economics in modern times details certain profound changes in financial market practices that have occurred since the early 1970s and chronicles the emergence of the academic field of financial economics since the early 1950s.

An Engine, Not a Camera: How Financial Models Shape Markets , by University of Edinburgh sociology professor Donald MacKenzie, tells two stories. First, it details certain profound changes in financial market practices that have occurred since the early 1970s. Second, it chronicles the emergence of the academic field of financial economics since the early 1950s. MacKenzie’s thesis is that the new theories caused the changes in practices: “Financial economics . . . did more than analyze markets; it altered them.” The new theories were “prescriptive, not descriptive: [they] told rational investors what to do, rather than seeking to portray what they actually did.” Prior to introduction of the concepts of financial economics, which emerged from academia, investment methodologies had been developed largely by practitioners (e.g., MacKenzie traces the dividend discount model to the writings of Robert G. Wiese of Scudder, Stevens & Clark in 1930).

MacKenzie offers a richly detailed history of the new financial theories, such as Modigliani and Miller’s irrelevancy propositions, modern portfolio theory, the capital asset pricing model, the efficient market hypothesis, and the Black–Scholes model of option pricing. These theories initially met with resistance from both academic economists and investment practitioners.

In academia, financial economics was initially taught in business schools rather than in economics departments. Most mainstream economists thought of the new theories as applied mathematics rather than economics. But the “mathematicization” of finance eventually was paralleled in economics. For example, MacKenzie points out the “affinity” between the rational expectations theory and the efficient market hypothesis. Indeed, by the 1990s, financial economics had become one of the “central topics” of economics. The milestone event in this journey was the awarding of the 1990 Alfred Nobel Memorial Prize in Economic Sciences to Harry M. Markowitz, Merton H. Miller, and William F. Sharpe.

At the time the new theories began to be developed in the early 1950s, the two dominant approaches among investment practitioners were technical analysis and fundamental analysis, which the new theories proclaimed to be, respectively, “spurious” and “of little or no direct practical benefit.” MacKenzie’s discussion of the  Financial Analysts Journal ’s 1969–81 editorship by Jack Treynor is particularly enlightening in this context. Practitioners, driven in part by the bear market of the late 1960s, became interested in the new theories only in the early 1970s. The most direct application of the new theories was the introduction of index funds, but financial economists’ ideas also came to be applied more subtly in the form of “covert index tracking” by ostensibly active investment managers.

MacKenzie explores the new theories’ impact on two major financial crises—the October 1987 stock market crash and the 1998 failure of the hedge fund Long-Term Capital Management (LTCM). He convincingly argues that current market participants greatly underappreciate how close to the brink of collapse the financial system came in 1987. He attributes the narrow escape to the fact that, unlike its 1929 predecessor, the 1987 stock market crash was not followed by a major depression. Still, institutional memories of the more recent crash live on in the form of the “skew” in option pricing, which constitutes a deviation from prices derived by applying the Black–Scholes model and which did not exist prior to October 1987.

MacKenzie’s explanation for the failure of LTCM is not reckless risk taking on the part of its principals or a blind faith in their financial models. The cause is not even ascribed to the degree of leverage used by LCTM, which at 27:1 was no greater than the average ratio of the five largest investment banks at the time. Rather, MacKenzie blames the widespread imitation of LTCM’s positions and investment methodology by other market participants. This imitation led, in effect, to a “superportfolio” that started to unravel once holders other than LTCM began to unwind positions in a flight to quality following the August 1998 Russian debt default. MacKenzie has previously called this process the “sociology of arbitrage.”

These stories have been told before, but MacKenzie adds to them with primary research that contains a wealth of detail. He offers an extensive bibliography and even an original translation from the French of Jules Regnault’s  Calcul des chances et philosophie de la Bourse  (1863), which laid the foundation for stochastic models of price behavior. In addition, MacKenzie unearths some highly illustrative episodes through interviews with dozens of financial economists and practitioners. He opens  An Engine, Not a Camera  with an account of the 1987 stock market crash that includes a truly riveting conversation between key market participants. The account of Milton Friedman’s opposition to awarding Markowitz a Ph.D. in economics because his dissertation should have been, in Friedman’s opinion, in mathematics has been told previously. But Friedman’s subsequent role in gaining regulatory approval for the trading of financial derivatives on the Chicago exchanges is less well known. MacKenzie tells the story through quite humorous recollections of three meetings between key officials. (Incidentally, the book’s title is a paraphrase of Friedman’s famous 1953 essay on methodology in economics.)

The level of detail may make  An Engine, Not a Camera  seem on the tedious side at times, notably in the chapter that recounts how pit trading in Chicago was conducted prior to the use of the Black–Scholes option-pricing model. On the whole, however, the book offers a superb account of the development of the theory and practice of financial economics during the second half of the 20th century.


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