Forerunners of Modern Financial Economics: A Random Walk in the History of Economic Thought, 1900-1950

Published by EH.NET (November 2005)

Donald R. Stabile, Forerunners of Modern Financial Economics: A Random Walk in the History of Economic Thought, 1900-1950. Cheltenham, UK: Edward Elgar, 2005. viii + 173 pp. $85 (hardcover), ISBN: 1-84542-101-9.

Reviewed for EH.NET by Geoffrey Poitras, Faculty of Business Administration, Simon Fraser University.

Book reviews tend to say more about the reviewer than the book. It is possible to find fault in the most innovative contributions and to find kernels of value in misguided, pedestrian efforts. This short, delightful book by Donald Stabile is a case in point. While it is possible to criticize the numerous minor inaccuracies and inconsistencies in the presentation, this is to be expected from a book without equations dealing with the inherently mathematical subject matter of modern financial economics. Similarly, there is a decided lack of cohesion in the individuals selected for presentation — such as Thorstein Veblen, Irving Fisher and Benjamin Graham. Given the absence of studies on the intellectual antecedents to modern financial economics covering the 1900-1950 period, this lack of cohesion is understandable. Those seeking deep insight into important themes, such as the study of investment risk by economists will be disappointed. Achieving this objective is too much to expect from a small book that covers so much ground.

As exemplified by Rubinstein (2003, p. 1041), purists of modern financial economics maintain that “the moment of birth of modern financial economics” is the publication of Markowitz (1952). Stabile (p. 9) uses this assessment to define the goal of his book: “to document the efforts of a small number of economists who had discovered what Markowitz made conventional: stock market price changes can be treated as a random variable to be analyzed with statistical tools.” With the statistical element in mind, Stabile recognizes the important distinction between Bayesian and frequentist approaches to statistics. Throughout the book, Stabile aims to trace the intellectual foundations of modern financial economics to those that used Bayesian methods to analyze financial markets, even if such individuals are not typically recognized as Bayesians. This theme is so central to the book that, after an introductory chapter, the second of nine chapters is dedicated to developing the progress of Bayesian analysis within economics.

Recognizing the superiority of the Bayesian over the frequentist approach in analyzing financial markets is an excellent avenue for exploring the distinction between risk and uncertainty — a topic that is addressed at various points in chapters 5, 7 and 9. Because this distinction plays no substantive role in modern financial economics, a useful connection is made to the subject of chapter three: Irving Fisher’s theory of capital under both certainty and risk. Though Stabile makes a half-hearted attempt to argue that Fisher was in the Bayesian camp, the story is not much affected whether he is a frequentist or not. The essence of Fisher’s seminal contribution to laying the foundations of modern financial economics is ably, if somewhat superficially, developed. In the process, various interesting stories and anecdotes from Fisher’s life are provided. Because Fisher was a leading academic who had the misfortune of unsuccessfully seeking recognition from the vernacular side of finance, these stories will be of inherent interest to sociologists of intellectual history.

The stories and anecdotes about the various forerunners of modern financial economics are one of the desirable features of this book. For example, the personal investment strategies of both Keynes, in chapter 7, and Fisher, in chapter 3, are examined in detail to reveal that in making personal financial investment decisions neither was close to being an adherent to the diversification principle. The large number of forerunners identified in the book provides a number of stories to draw upon. In addition to Fisher and Keynes, the list of forerunners examined includes: Frank Knight, Benjamin Graham, John Burr Williams, Alfred Cowles, Edgar Lawrence Smith, Frederick Macaulay, Wesley Mitchell, and Herbert Davenport. The latter two names are motivated by the inclusion of a most unlikely forerunner: Thorstein Veblen. As Veblen’s contribution is afforded a whole chapter, the only individual other than Fisher to warrant a complete chapter, this odd selection requires considerable justification. While the justification provided is rather thin, Veblen does provide a connection to alternative approaches to financial economics that would not otherwise surface.

Despite recognizing Veblen, the possibility of providing a less conventional view of the history of modern financial economics goes largely undeveloped in this book. Undoubtedly, Veblen would be very uncomfortable with the mathematical world populated by the homogeneous rational investors portrayed in modern financial economics. Veblen is closer to modern sociologists than to modern financial economists such as Markowitz or Fama. Along this line, sociologists of intellectual history, such as Preda (2003), employ a distinction between vernacular and academic theories of finance. This distinction could have been used to establish incongruence between the vernacular views of the ‘old finance,’ as reflected by Benjamin Graham, and the academic theories of modern financial economics. Instead of viewing Graham as a forerunner of modern financial economics, the conflict between the academic and the vernacular approaches, identified in Haugen (1999) and Poitras (2005), could have been properly situated.

In the end, Forerunners of Modern Financial Economics is a short book with a number of attractive features. The subject is treated in an introductory fashion and the text is pleasant to read. Various fascinating intellectuals from the 1900-50 period that contributed, in some significant fashion, to financial economics are identified. Interesting anecdotes and stories from the lives of those examined offset the somewhat questionable and loosely conceived interpretation of the different contributions. The weakest aspect of the book is the unquestioning acceptance of the claim that modern financial economics begins with Markowitz (1952). If correct, this claim is restricted to the academic realm. No attention is given to identifying the practical or vernacular impact of the key elements of modern financial economics: “the efficient markets theory, the belief that stock price changes are random, and the study of investment risk” (p. 4). But exploring this comment further risks saying more about this reviewer than about the book.

References:

R. Haugen, The New Finance: The Case against Efficient Markets (second edition), Upper Saddle River, NJ: Prentice-Hall, 1999.

H. Markowitz, “Portfolio Selection,” Journal of Finance (1952): 77-91.

G. Poitras, The Early History of Financial Economics: 1478-1776, Cheltenham: Edward Elgar, 2000.

G. Poitras, Security Analysis and Investment Strategy, Oxford: Blackwell Publishing, 2005.

A. Preda, “Informative Prices, Rational Investors: The Emergence of the Random Walk Hypothesis and the Nineteenth Century ‘Science of Financial Investments’,” History of Political Economy (2003): 351-86.

M. Rubinstein, “Great Moments in Financial Economics: II. Modigliani-Miller Theorem,” Journal of Investment Management (2003).

Geoffrey Poitras is a Professor of Finance in the Faculty of Business Administration at Simon Fraser University, Burnaby, BC, Canada. He has published widely in the areas of derivative securities, security analysis, and risk management. He is also the author of The Early History of Financial Economics, 1478-1776 (2000) and is editor of the two volume Pioneers of Financial Economics to appear soon from Edward Elgar.