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13 September 2017 Financial Analysts Journal Book Review

Pioneers of Financial Economics, Volume 2: Twentieth-Century Contributions (a review)

  1. Martin S. Fridson, CFA

In this volume of financial history, a variety of authors describe how science and practice evolved in the 20th century—the approaches that triumphed and the paths not taken. This fascinating book is an indispensable reference for practitioners and scholars.

The history of financial economics belies the myth that science inevitably evolves along a single, true path.  Pioneers of Financial Economics, Volume 2: Twentieth-Century Contributions  illustrates this point repeatedly.1 For instance, contributor Elton G. McGoun (Bucknell University) demonstrates that today’s nearly universal identification of risk with historical probability distributions is the outcome—not the uncontestably correct outcome—of a battle that raged up until the 1940s. Even more startling is the demonstration by Gabriel Hawawini (INSEAD) and Ashok Vora (Zicklin School of Business, Baruch College) that the standard yield-to-maturity approximation presented in finance textbooks is the least accurate of several formulas derived since 1855.

Geoffrey Poitras (Simon Fraser University), assisted by Franck Jovanovic (Université du Québec à Montréal), has compiled a collection of articles on financial history of far more than historical interest. For example, Bucknell’s McGoun points out that the inherent problems of gauging probabilities by historical distributions are as severe as ever, even though mainstream researchers no longer debate the question. In particular, for many types of events to which investors would like to assign probabilities, no “reference class” of previous, relevant observations exists. For practitioners who sense the problem and seek a way out of the intellectual confines of historical probabilities, it is immensely helpful to realize that eminent economists once considered alternative modes of analysis more fruitful than using historical probabilities.

Paul Davidson (University of Tennessee) documents a similar triumph by a single, not necessarily superior, approach to a broad segment of economics. Influenced by a circle of mathematicians who began publishing under the pseudonym “Nicolas Bourbaki” in the 1930s, quantitatively oriented economists came to define “rigor” to mean consistency with a set of autonomous,  abstract  axioms rather than axioms that reflect the physical world. Deliberate rejection of real-world constraints came to dominate mathematical economics largely through the work of Bourbaki disciple Gerard Debreu. Even Debreu’s collaborator on foundational work involving equilibrium, Kenneth Arrow, has acknowledged that forward markets do not exist for most goods in the real world, which renders a general equilibrium system inapplicable to the actual economy.

The second volume of  Pioneers of Financial Economics  also includes an excellent history of a doctrine that, to the great benefit of intellectual inquiry, has not been deemed resolved for all time, the efficient market hypothesis. Kian-Guan Lim (School of Business, Singapore Management University) details statistical testing of equity prices in the decade preceding Eugene Fama’s 1965 declaration in the  Financial Analysts Journal  that stocks follow a random walk.2 In a separate article, assistant editor Jovanovic reproduces the stirring words that Fama wrote in the  FAJ :

[T]he only way the chartist can vindicate his position is to  show  that he can  consistently  use his techniques to make better than chance predictions of stock prices. It is not enough for him to talk mystically about patterns that he sees in the data. He must show that he can consistently use these patterns to make meaningful predictions of future prices. (“Random Walks in Stock Market Prices,” p. 59)

Lim continues the story through the 1990s and the establishment of journals devoted to the behavioral finance counterreformation.

Another highlight of the volume is a long-overdue rehabilitation of economist Irving Fisher (1867–1947), now remembered by investors exclusively for proclaiming, just prior to the Stock Market Crash of 1929, that stocks appeared to have reached “a permanently high plateau.”3 As Robert W. Dimand (Brock University) recounts, the man whom Nobel Laureate Paul Samuelson has called “the great Irving Fisher”

  • presciently warned that “risk-free” government bonds were highly vulnerable to inflation, which, in fact, ravaged the debt of several European countries after World War I;
  • introduced purchasing power–stabilized bonds 60 years before the British government “invented” inflation-indexed obligations;
  • developed the expectations theory of the term structure of interest rates; and
  • championed prudent portfolio diversification, in opposition to the leading practitioners of his day.

As for Fisher’s supposed forecasting blunder, Dimand cites modern research that found the 1929 crash could not have been predicted even with today’s statistical techniques. 4

Numerous other delights await readers of Poitras and Jovanovic’s fascinating book. They will learn, for example, about mathematician Edward O. Thorp, a pioneer in the study of both gambling strategies and financial markets. In the cause of science, Thorp unwittingly imbibed coffee laced with knock-out drops while playing baccarat at a mob-controlled casino. Hal Varian (University of California, Berkeley) writes:

It has been seriously suggested that there should be a Journal of Negative Results which could contain reports of all those regressions with insignificant regression coefficients and abysmal R-squares.

Additional highlights of  Pioneers of Financial Economics, Volume 2 , include profiles of selected Nobel laureates in economics by financial economists prominent in their own right—of Merton Miller by René M. Stulz; of Robert C. Merton and Myron S. Scholes by Robert A. Jarrow; and of Fischer Black by Robert C. Merton and Myron S. Scholes.

Not surprisingly for such an ambitious work, minor errors creep into the text. One author implies that American Telephone & Telegraph (AT&T) was a predecessor of ITT, an unrelated company. Another uses the heretofore unknown Latin phrase “ sine que non. ” A discussion of economic first principles alternates between “axiomization” and “axiomatization,” nowhere indicating that the terms are anything but synonymous. By the same token, editor Poitras corrects a longstanding error by noting that fixed-income pioneer Frederick Macaulay was Canadian by birth, not Scottish or British as reported by sources as eminent as the Society of Actuaries.

Taken as a whole,  Pioneers of Financial Economics, Volume 2 , is an indispensable reference for practitioners as well as scholars. It covers 20th century innovations thoroughly, and its prose generally meets a high standard of clarity. Above all, the book proves that history written with a point of view can furnish insights of extraordinary practical value. To evaluate where a field of study stands, knowing whence it came is invaluable.


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