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Capital Ideas: The Improbable Origins of Modern Wall Street

Peter L. Bernstein

posted on 10 September 2001

reviewed by Joe McCauley


Poets are the unacknowledged legislators of the world....Let those who will, write the nation's laws, if I can write it's textbooks.
(P. Samuelson, quoted by Berstein)




Bernstein, the founder of The Journal of Portfolio Management (which contains many historically interesting papers on synthetic portfolio insurance) has written a fascinating book on the history of econometrics and finance, beginning with the origins of the Cowles foundation (''Science is Measurement''!) as the consequence of Cowles' personal interest in the question: Are stock prices predictable? This is also the origin of the journal Econometrica, where (so far as I can tell) no paper of any value whatsoever for understanding market behavior has ever been published. This book is all about heroes and heroic ideas, and Bernstein's heroes are Adam Smith, Batchelier, Cowles, Markowitz (and Roy), Sharpe, Arrow and Debreu, Samuelson, Fama, Tobin, Samuelson, Markowitz, Miller and Modigliani, Treynor, Samuelson, Osborne, Wells-Fargo Bank (McQuown, Vertin, Fouse and the origin of index funds), Ross, Black, Scholes, and Merton. The final real heroes (see ch. 14, The Ultimate Invention) are the inventors of (synthetic) portfolio insurance (replication/synthetic options): Rosenberg, Leland, Rubinstein, Cox, and O'Brien.



This book consists largely of a pre-LTCM (pre-10/98) cheerleading for option-pricing mathematics based on lognormality, and corresponding synthetic portfolio insurance. Osborne and Mandelbrot are mentioned, Osborne more than Mandelbrot. The largely unknown work by D. Duck, showing that market prices are exponential, is of course not mentioned. The book is, after all, written by an economist and, like all religions, economics prefers to praise its own high priests. Like most books the book is not error-free: e.g., Mandelbrot's ideas on stock prices are stated as being the origin of chaos theory (!), and Mandelbrot (of random fractals fame) is misportrayed as an 'articulate proponent' of chaos theory! Another error (page 182): ''..persistent forces are constantly driving the market toward (Modigliani-Miller) equilibrium.'' The evidence for the EMH is supposed to constitute the 'proof' for this nonsense. So much for 'proofs'. So ingrained is the false, misleading and inapplicable notion of ''equilibrium'' in the minds of economists that it is hopeless to expect to educate them out of their own morass. One can only wait and hope for a new generation with more open minds. Maybe in a thousand years. Even Black, who was educated as a physicist as an undergrad, did no better:




''When people are seeking profits, equilibrium will prevail.''
(F. Black, quoted by Bernstein)



Aside from the history of the EMH and econometrics, among the interesting and entertaining stories that are told are: the displacement of Graham and Dodd?s 'value theory' by the EMH, the revolutionary role played by Wells Fargo Bank in using the 'new finance math', and in creating index funds. The importance of the Miller-Modigliani 'theorem' which 'proved' that the (not-uniquely-defined) 'value' of a corporation is independent of it's debt. Then, there is the wild-haired idea of 'portfolio insurance', how to eat your cake and have it too (a free lunch, derived from the assumption that free lunched don?t exist). Here, one must take seriously enough the lognormal distribution of market prices and the corresponding risk-free prediction of Black-Scholes (who merely applied the CAPM to option pricing) to assert that a continually rebalanced portfolio of cash and risky assets is risk-free, i.e., 'insured'. in so many words. The idea is that risk-free implies that an option is equivalent to a .³³³risky asset plus an amount of cash, and it is this non-existent ('synthetic') option that 'insures' the portfolio. People did make money from it. Namely, brokers who benefited from the continual rebalancing. Of course, market prices are not lognormal, Black-Scholes is wrong), and no portfolio can be insured against all possibilities, especially those that occurred in 10/87 and wiped out confidence in LOR (Leland-O'Brien-Rubinstein Associates). But this failure of finance theory produces no crisis for Bernstein, whose book is the history of heroes, not villains. His last chapter, which can be ignored by the reader without loss, is states his ideology: free market über Alles. Or: equilibrium will prevail, even without restoring forces. I must confess, however, that I got something important from this book: the origin of America?s spend-spend-spend ideology in the Modigliani-Miller 'theorem'.




If the optimal portfolio is not risky enough, borrow to finance it?s purchase.
(Wells Fargo?s application of Tobin?s idea, quoted by Bernstein)





Next reviews to be expected from the keys of my Power Mac (''Get a REAL computer!'', my colleagues continually harass): the post-LTCM (post-10/98) anti-cheerleading books on option pricing and synthetic portfolio insurance, ''Capital Ideas and Market Realities'' by Bruce I. Jacobs and ''Inventing Money'', by Nick Dunbar.



price: $11.96 on