The popular literature about the world of investment in the 1980s carries titles that reflect those events: Bonfire of the Vanities, Barbarians at the Gates, The Predators' Ball, and Liars' Poker. The main characters are arrogant, greedy, cynical, and shady. The movie Wall Street summed it all up: "greed is good", the address by corporate raider Gordon Gekko to a crowd of investors, is the claim that came to epitomize the zeitgeist.
But what if the real heroes of the stock market frenzy were not those pathetic figures that generations of MBA students tried to emulate? What if the unsung heroes of the times were instead the professors and ivory tower academics who wrote those students' textbooks? Finance professors are usually not held in very high esteem: their economics colleagues won't share office space with them, their practically-minded students deride them for not practicing what they are teaching, and the general public considers any accident on the stock market as proof of the flaws in their theories.
Peter Bernstein's book pays due respect to their profession. It focusses on a small group of innovators who created finance as an academic discipline, and transformed Wall Street and the world along the way. Published in 1992, Capital Ideas starts and ends with two turning points in the history of modern finance: the crisis of October 1974, which saw the culmination of the worst bear market in common stocks since the Great Crash of 1929, and the stock market crash of October 1987, in which hundreds of billions of dollars were wiped out in a few hours.
Financial innovation was blamed on those two occasions, and finance specialists were castigated as sorcerer's apprentices. But for Bernstein, finance is more a solution than a problem, and the answer to the risk of innovation getting out of control is still more innovation. Had it not been for the crisis of 1974, few financial practitioners would have paid attention to the ideas on portfolio selection and risk management that had been stirring in the ivory towers for some twenty years. And putting the blame of the 1987 crash on portfolio insurance, as the commission chaired by Nicholas Brady did, is compared by the author to a proposal to slow down the train, when efforts should focus on improving the quality of the roadbed.
Finance had difficulty establishing itself as an academic discipline. It was taught mostly in business administration departments, not in economics faculties. Even in business schools such as Harvard, the investment course in the 1950s attracted so few students that it was taught at noontime so that it would not take up precious classroom space at prime time. Finance attracted marginal individuals, the kind of persons that would be described nowadays as nerds, with a taste for crunching numbers and dabbling with computer mainframes. Only a few of them had formal training in economics. The discipline flourished in only a handful of US universities where the talent of a few individuals made a difference and where business school professors did talk to their colleagues in the economics department: Chicago, MIT, and a few other places.
The body of knowledge that forms the core of the discipline-what Bernstein refers to as Capital Ideas- was conceived in the space of only twenty-one years, from 1952 to 1973. In short, it is contained in Harry Markowitz's work on portfolio selection, Franco Modigliani's and Merton Miller's revolutionary views about corporate finance and the behavior of markets, the Capital Asset Pricing Model developed by Sharpe, Treynor and a few others, Eugene Fama's explication of the Efficient Market Hypothesis, and the option pricing model of Fischer Black, Myron Scholes, and Robert C. Merton.
When the discipline was developed, many economists regarded the stock market as a side-show in the economic system, not worthy of serious attention. Even Milton Friedman, who sat on Markowitz's dissertation committee, reflected the prejudices of the profession when he declared: "Harry, I don't see anything wrong with the math here, but I have a problem. This isn't a dissertation about economics. It's not math, it's not economics, it's not even business administration." And it was something completely new and unrelated to previous work: Markowitz's seminal paper on Portfolio Selection, that brought him fame and a Nobel Prize, lists only three references to other works in its bibliography. One of the most fundamental paper by Jack Treynor, that laid the groundwork for the CAPM, wasn't even published.
There were some exceptions. The most famous was Paul Samuelson, known for his textbook first published in 1948 and who made so many contributions to the economics discipline that the Nobel jury had trouble highlighting only a few when they awarded him the prize in 1970. Although Samuelson was Keynes' most distinguished disciple, he rejected Keynes' own view of the market as little more than a casino, and he saw the stock market as a central institution as well as a source of fascinating intellectual puzzles. Another economist with a keen interest for financial markets was James Tobin, who spent most of his career at Yale except for a brief stint at he Council of Economic Advisers that began with the following dialogue when President Kennedy offered him the job:
- I'm afraid you got the wrong guy, Mr. President. I'm an ivory-tower economist.
- That's the best kind. I'll be an ivory-tower president.
- That's the best kind, Mr. President.
The book is very rich in anecdotes and personal details on the academic founders of modern finance, most of whom were interviewed at length by the author. It requires no prior knowledge of the field, although knowing one's betas from one's alphas will help the reader go through the material. My own exposure to theoretical finance has been very limited, but having done the maths once on the CAPM or the Modigliani-Miller theorem helped me get through the relevant chapters, whereas the last chapters on option pricing theory or continuous time finance are way beyond my grasp and could only be understood metaphorically. But the Capital Ideas and the difference that they made are just too important to be left ignored, and Peter Bernstein has made a great job of explaining them to the general public.
