All Commentary
Monday, March 1, 1993

Capital Ideas: The Improbable Origins of Modern Wall Street

Bernstein illuminates the critical role financial markets play in economic development and growth.

Peter Bernstein documents in workmanlike fashion not only the unusual intellectual origins of many modern financial instruments and strategies, but also how financial economists have struggled to gain the full acceptance of their economic brethren. Finance was long neglected by economists. The author gently, yet at times unevenly, mixes personal anecdotes about individuals—including not only economists but engineers and physicists as well—with an interesting overview of their contributions to the theory of finance.

The genesis of modern financial innovations largely came from cloistered academics with little securities market experience, rather than from street-smart analysts and investors, for example. In fact, modern developments in finance spring from a central tenet not often accepted by such securities professionals. The overarching theme of Capital Ideas is that securities markets are efficient. Efficient financial markets seemingly present a conundrum for securities analysts and investors. On the one hand, market efficiency largely condemns the analysis profession to futility. That is, if markets are efficient, with prices immediately reflecting all information, one cannot regularly “beat the market.” However, without hard-working and talented securities analysts and investors seeking out new information, the markets would not be so efficient. Bernstein points out that efficient securities markets and the concomitant fact that most investors will do no better than average is actually “a compliment to the avidity and intelligence and self-interest that motivate informed investors. If more investors were to become less zealous in pursuit of their fortunes, the keen and the swift would find the market a lot easier to beat.”

Bernstein examines several innovations in finance theory, from Harry Markowitz’s development of the “Efficient Frontier” of securities portfolios to Hayne Leland’s idea for insuring such portfolios. James Tobin’s “Separation Theorem,” William Sharpe’s development of the “Capital Asset Pricing Model,” Eugene Fama’s “Random Walk Theory,” Modigliani and Miller’s assertions that the market value of the firm is independent of its capital structure, and Black and Scholes’ analysis of option pricing are all surveyed to varying degrees.

Two aspects of Bernstein’s book are particularly intriguing however. Ironically, the first is his closing chapter. All authors seek to neatly tie together the themes and ideas strewn throughout their books in the final chapter. Bernstein does so splendidly. He takes the many financial innovations explained in the preceding fourteen chapters and expresses their importance to everyday economic life.

Bernstein illuminates the critical role financial markets play in economic development and growth, a point of particular importance today as socialism continues its descent. In fact, the author unequivocally declares: “In socialist economies it is the absence of free and active markets for corporate ownership that deprives citizens of the goods they want, with the quality they demand, and at the prices they can afford.” Without functioning financial markets, resources are misallocated with “catastrophic effects on living standards, employment and economic growth.”

The importance of risk-taking does not elude the author’s purview. Bernstein observes: “Because the stock market makes diversification easy and inexpensive, the average level of risk-taking in society is enhanced.” And very simply, “Institutions that encourage risk-taking are essential if a society is to grow and raise its living standards.”

Bernstein also describes how theoretical innovations met specific, “real world” needs. For example, the “markets for futures and options allow dealers to hedge the risks they incur,” and the junk bond market “satisfied the needs of both the investors who bought junk bonds and the relatively small companies” seeking much needed capital for growth and job creation “that their banks either could not or would not supply.”

The second intriguing aspect of Capital Ideas is buried between the lines. Several of the economists Bernstein discusses, such as James Tobin, Paul Samuelson, and Franco Modigliani, are Keynesian macroeconomists. Yet, the truly interesting aspects of their life’s work have been accomplished on the micro level, for example, verifying the efficiency of securities markets and exploring its implications. One can only imagine what these individuals might contribute if they would finally let go of their fallacious macroeconomic analysis and prescriptions, such as fine tuning aggregate demand, and apply their intellects and microeconomic analytical tools to issues like economic growth, taxation, employment, and living standards. The dichotomy between the microeconomic and macroeconomic endeavors of such individuals is apparent to many, except themselves and others schooled in the failed Keynesian system. 

Raymond J. Keating is New York State Director of Citizens for a Sound Economy.