Published by EH.NET (October 2007)

Geoffrey Poitras, editor, Pioneers of Financial Economics: Volume 2, Twentieth-Century Contributions. Edward Elgar: Cheltenham, UK, 2007. x + 244 pp. $130 (cloth), ISBN: 978-1-84542-382-7.

Reviewed for EH.NET by Ramon P. DeGennaro, Department of Finance, University of Tennessee, Knoxville.

Pioneers of Financial Economics: Volume 2 is arranged in three parts. Part I is titled “Early Contributions.” My favorite chapter in this section is Robert W. Dimand’s discussion of Irving Fisher and his students. This is partly because the chapter is so well done, partly because Fisher did so much, and partly because Fisher could be so audacious at times. Part II is titled “The Modern Finance Revolution: The Inside Perspective.” If forced to choose among the five fine articles in this section, Hal Varian’s article about Harry Markowitz, Merton Miller and William Sharpe would be a narrow winner. Varian is simply a gifted writer who successfully translates these Nobel laureates’ work into concise, clear language, using a graph and only a few equations. Part III is titled “Alternative Perspectives on the Revolution.” Here, my favorite is Donald MacKenzie’s contribution, “The Emergence of Option Pricing Theory.” This is entertaining because it conveys the process of discovery and the intellectual struggles that Black, Scholes and Merton endured. Getting from the idea to the famous Black-Scholes and Merton formula wasn’t easy, even for them.

I enjoyed the articles and recommend the book particularly to economic historians and sociologists interested in the evolution of ideas. Prospective readers should be aware that this book has an agenda, though. This agenda becomes clear as early as the introduction, which throws down the gauntlet between what it calls “traditional finance” (it sometimes uses “old finance”) and “new finance.” The dividing line is approximately Markowitz’s work or the Modigliani and Miller papers. There is no doubt which side the book favors and to its credit it makes no bones about it. It absolutely favors traditional finance. Part II, which in the context of this book champions new finance, contains four reprints and only one original contribution. The articles in the other parts of the book are new. This cannot be due to chance, especially given a revealing sentence about the reprints in the introduction: “Each of these chapters is an excellent example of the narrow interpretations of the intellectual history of financial economics and inflated claims for scientific significance common in modern financial economics” (12). Or this: “A key objective of Part II is to explore the process of prestige creation and reinforcement in modern financial economics” (8).

In short, a key reason for including the five chapters dedicated to new finance is to assert that those who write tributes to Nobel laureates within the field are making inflated claims, and to show that the prestige which the new finance enjoys is allegedly built on a house of cards. Readers will ask why, from among the tens of thousands of articles from which to choose, the book includes articles that it believes are deeply flawed, if not to grind the axe in a particular way?

If an attempt to frame Pioneers of Financial Economics as a contest between traditional finance and new finance must be made, and if a winner must be chosen between them, readers would find the result to be more credible if the playing field were not so obviously tilted. For example, the book makes no effort to conceal its distaste for modern portfolio theory. By way of support it correctly notes that many market professionals still perform security analysis, which the book treats as the purview of traditional finance. But it rarely if ever mentions mutual funds, which are a trillion-dollar counterexample highlighting the success of portfolio theory. The many studies showing that indexing beats active management, far more often than not, are apparently too trivial to mention. The book claims that, “One of the oddities of modern financial economics has been the success of this movement in securing the academic high ground in the finance curriculum of business schools despite proving relatively sterile in practical implications.” Such statements likely will persuade very few readers. They see that options and futures trading are booming, along with sophisticated risk management techniques. Banks and corporations routinely hedge using tools built on modern finance. Businesses design executive compensation contracts to include securities to align their incentives with other investors. Regulators invoke capital structure theory to require banks to issue securities designed to provide early-warning signals of financial distress. Investors hold mutual funds. Exchange-traded funds are growing rapidly. If the book wants to make a convincing case in a battle between old and new, it would do better to show that these innovations have their roots in traditional finance rather than simply to ignore them.

The choice of a post-Keynesian economist to write the final chapter is consistent with the book’s slant. I do not believe that I am alone in thinking it strange to select a post-Keynesian economist to write the final chapter of a book on the pioneers of financial economics. This in no way minimizes or denigrates Keynes’s contributions to the field of economics. They speak for themselves. The choice merely seems … strange.

Given the agenda, a different title would work better. In Defense of Traditional Finance would be just fine. Search engines would find the book for readers seeking such material, and casual library or bookstore browsers would know immediately what to expect when they pick up the book.

While I would have preferred that Pioneers of Financial Economics had chosen a more balanced approach to the perceived battle between old and new, readers would have been still better served not to cast it as a contest at all. This battle is over and everyone knows who won. The proponents of old finance are sure that they won, the proponents of new finance are sure that they won, and just about everyone is satisfied with this outcome. In truth, most of us have no time to take sides in battles outside of our specialty. Perhaps we would all benefit by borrowing from Kian-Guan Lim, who ends his fine chapter on the evidence in support of and against the Efficient Market Hypothesis by writing, “… we could also move on.”

Ramon P. DeGennaro is the SunTrust Professor of Finance at the University of Tennessee. He also conducts research as a Visiting Scholar at the Federal Reserve Bank of Atlanta. He has published more than thirty-five refereed articles on financial market volatility, the term structure of interest rates, financial institutions, and investments. His other publications include research reports, book chapters and book reviews. The opinions in this article are his own and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.