An Engine, Not a Camera: How Financial Models Shape Markets

This the text of a book review recently published in the Annals of Actuarial Science, Vol. 5, part 2, pp. 297–298

Robert Peston, the BBC’s Business Editor who broke the news of the Credit Crisis to the British public in 2007, has said that in the months leading up to the crisis he had tried to report on Collatorallized Debt Obligations but had not been able to find a banker who could explain them to him (see What is Financial Journalism for? Ethics and Responsibility in a time of Crisis and Change p 20). This point gets to the crux of the Credit Crisis, “no one” saw it coming and the responses of the US and UK governments was inadequate because there had been no public discussion of developments in finance, as there are of developments in, for example, energy, nano or genetic technologies. The result was society was completely unprepared for what would unfold in 2007-2008.

In writing An Engine not a Camera Donald MacKenzie, a sociologist working in ‘Science and Technology Studies’, hopes that there will be “richer conversations” about financial markets, and out of these discussions a better, and stronger, financial system will emerge. Science and Technology Studies examines how social factors affect technological progress and one of its pioneers was Robert K. Merton, father of one Robert C. Merton. While STS is not popular amongst many physical scientists who like to believe their knowledge is based on indisputable fact, there are numerous financial mathematicians who, following Poincaré (see The Value of Science especially Science and Hypothesis) , see facts in the context of theory, which is constructed in a social context.

The central thesis presented by MacKenzie is that modern financial markets ‘perform’ financial theory. That is, finance practioners have been trained by universities to believe a set of cohesive ideas which they then, on graduation, employ in the markets. Since the ideas are the same, whether presented in Europe or in salt-water or fresh-water universities in the US, the heterogeneity of countless individual agents is replaced by a single Homo economicus. The immediate consequence of this is the commoditisation of finance theory; models are ‘shrink wrapped’ and become ‘black boxes’ with the subtleties of their underlying assumptions are irrelevant. The more dramatic result is that, eventually, the ‘performed’ markets become so far removed from the reality of finance that that they collapse in an episode of ‘counter-performativity’. MacKenzie describes in detail two examples of what he sees as counter-perfomativity, Black Monday in 1987 and the failure of Long Term Capital Management eleven years later.

In support of this hypothesis MacKenzie discusses in detail how modern derivative markets emerged and how, alongside the evolving markets, modern finance theory was created. His history of the development of finance theory, between 1950 and the 1990s is possibly unrivalled being based on extensive interviews with pretty much everyone who has made a significant contribution, including Markowitz, Samuelson , Friedman, Merton, Scholes, and Harrison. Underpinning these narratives is a discussion of the relationship between the ‘practice’ of finance and the academic theory, and it is in this context that MacKenzie offers an explanation why Black-Scholes-Merton received the Nobel Prize while Thorp and Kassouf have been generally ignored in the university classroom.

While a reader may have an issue with MacKenzie’s core hypothesis, his account of how finance has developed makes the book is essential reading for anyone who is seriously interested in modern financial theory.

The book’s weakness is that it was written in the aftermath of the failure of LTCM, a time when the importance of the martingale approach to derivative pricing was only beginning to be understood. While the text does discuss the work of Harrison, Kreps and Pliska it does not go on to discuss the importance of the ‘Fundamental Theorem’ (that a market is arbitrage free if a risk neutral pricing measure exists, and complete if the measure is unique). Ironically for sociologists, the Fundamental Theorem is based on Black and Scholes's observation that it should not be possible to make a risk-less profit, which is almost a statement of commercial morality and so is socially constructed.

The strength of the book is that it highlights the dangers of adopting financial models as black-boxes rather than crafting solutions relevant to specific situations. This is highlighted in his analysis of the failure of LTCM, where MacKenzie rejects many of the popular explanations for the fund’s failure, making the observation that criticising hedge funds for taking on risk is rather like criticising aeroplanes for leaving the ground. While the events of 1998 may seem irrelevant in the aftermath of 2007, MacKenzie has undertaken a similarly comprehensive review of the Credit Crisis in the context of performativity and counter-performativity. Again the message he delivers is to employ fundamental skills that can question the received wisdom of the dominant models, a message that finance would do well to heed.

Isaac Newton: Financial Regulator

Alongside the stock market boom of the 1690s was rampant inflation, caused by the fact  that much of the coin circulating in England had been clipped and there was widespread counterfeiting. The inflation came about because, at the time, silver was an absolute measure of price. If English coins lost silver, more were needed to pay the foreigners, and so the importers would ask for more coin from their domestic customers. [Craig, 1946, p 8]

This, physical, process was compounded by the growth in banks’ lending, increasing the supply of  money chasing, pretty much, the same volume of goods, further depressing the value of money. The result was a collapse of confidence in the value of the coin that the English government was using to pay its debts. In 1696 the government decided that confidence would be restored only if the Royal Mint replaced all the silver coin in circulation with sound coin.

Almost simultaneously, and apparently not by design, Newton was appointed Warden of the  Royal Mint in April 1696. While the publication of Principia had made little impact during the last days of James II Stewart’s reign, when William III took up residence at Hampton Court, Christiaan Huygens, whose elder brother Constantijn Huygens was an adviser to William, introduced Newton to the new court. Another of William’s advisers was the English Puritan philosopher, John Locke, who had been a political exile in the United Provinces since 1683. Locke and Newton became firm friends and Locke took it upon himself to secure a lucrative post for Newton, who seems to have become bored with Cambridge after exposure the excitement around William’s court, filled with soldiers, statesmen, bankers and scientists [Levenson, 2009, p 44–46].

The period 1690–1695 proved difficult for Newton, his work gravitated to theology and he  developed an intense relationship with a young Swiss man, Nicolas Fatio de Duiller, which ended in 1693 and shortly after Newton appears to have had a nervous breakdown (He had had one in 1678 also) . In the aftermath, Locke and the President of the Royal Society, who also happened to be the Chancellor of the Exchequer, pulled strings and secured the Wardenship for Newton.

While Newton, along with everyone else, had been asked to give his opinion on what to do about  the coinage, it seems the initial appointment was more ceremonial than practical. The Warden was the monarch’s representative at the Mint and had historically been the most important post there until the crown stopped charging seiniorage, a fee for minting coins, in 1666. After that point the Master, the manager of the mint, became its most important, and best paid, employee [Craig, 1946, p 1–4].

The re-coining, by emptying the economy of coins, precipitated what has been described as “the  gravest economic crisis of the century” [Murphy, 2009, p 56], a century that included the devastation of the Civil War, the stop on the Exchequer and the boom and bust of the infant stock market. The government were not happy and, in time honoured fashion, pointed the finger at the Mint’s operations rather than blame their own policies.

Newton, as Warden, was called in front of the Parliamentary Committee on Mint  Miscarriages in 1696. One of the witnesses for the prosecution, appearing in 1697, was William Challoner who proposed a series of improvements for the Mint, which Newton  dismissed. The Committee of politicians preferred the advice of Challoner over that of the physicist and so Newton responded to this turn of events ‘rationally’, by locking Challoner in Newgate prison. Newton, as Warden could do this, but had to release Challoner  after seven weeks, at which time Challoner, as might be expected, stirred up a hell of a row.

Around a year after Challoner’s first appearance in front of the Committee, Newton was called  before it to justify his his treatment of the man. Newton had spent the intervening year, and £9 10s, investigating Challoner. It turns out that Challoner had started out as a labourer but through counterfeiting, theft, fraud and duplicity, become a wealthy gentleman. His whole ploy, it seems, had been to get appointed to the Mint, to support his criminal activities. Challoner was executed in March 1699 following a prosecution managed by Newton, who was ‘promoted’ to Master of the Mint at the end of the year [Craig, 1946, p  17–19].

Being Master gave Newton an average income some 16 times what he would have had as an  academic. Today an ‘average’ salary for a jobbing professor is around £60,000, and we could expect the Lucasian Professor at Cambridge to earn somewhat more than this. On this basis, the equivalent salary for Newton  as Master of the Mint is in excess of  £1 million [Levenson, 2009, p 239]. Newton no longer needed the security of his position in Cambridge and he resigned his Professorship at the end of 1701.

Newton is often presented as being difficult to get along with, for example a positive assessment  published by the Royal Society in 1995 gives the following summary

Isaac Newton was a humourless, solitary, anxious, insecure and private man with obsessional traits. He was poor at human relationship, such as the expression of gratitude [Keynes, 1995]

However this picture is at odds with the picture painted by Sir John Craig, who wrote about Newton’s work at the mint in Newton at the Mint in 1946,

Newton appears to have been a good judge and handler of men, and he had some magnetism which in many engendered an extraordinary regard and respect [Craig, 1946, p 119]

and “He had the tact to allow for political or human aspects”. Moreover,

he was a good bureaucrat, he insisted on the preservation of clear and exact records …[he had] care and restraint in considering new outlays of public money, with indifference to waste or extravagance that had become customary [Craig, 1946, p 120]

Craig's views are supported by the fact that John Maynard Keynes described Newton as “one of the  greatest and most efficient of our civil servants,” no small praise from the man who managed Britain’s  finances during the First World War.

Newton’s more anti-social behaviour is attributed to insecurity originating in Newton’s difficult childhood, an insecurity that seems to have remained with him throughout his time in science. However, Newton seems  to have taken to his role at the Mint like a duck to water, and maybe being able to see the broader  relevance of his intelect to the wealth of the nation, gave Newton the confidence to start enjoying life.

Newton did not completely abandon science, he became President of the Royal Society in 1703, holding  the post until his death, but his last significant work, Optiks, published in English in 1704, was based  substantially on research undertaken in the early 1670s. However, Newton played an active role in  finance for the rest of his life. One of his most significant acts was in setting the exchange rate between  gold and silver in 1717, an exchange rate that would shift Britain from the silver standard to the gold  standard.
 

English money had always been associated with silver, giving us the term ‘sterling silver’, this was in  common with much of Europe, India and China but different from the Middle East, who based money on gold. By 1710 Britain was running short of silver coin because the amount of silver in a coin was making it worthwhile to convert coin into dinner services. Newton’s solution was to reduce the amount of silver in a coin, a pound of silver should be used to make 64.5 shillings instead of 62 shillings. This was not popular with the government, as it was seen as devaluing the coin, and so would result in inflation. Therefore Newton, according to Craig,

translated the conclusion into the mathematically equivalent but impractical proposition that silver coin should retain its weight and be left to rise in value by force of scarcity [Craig, 1946, p 107].

This situation continued until in 1717 the government saw the solution as increasing the value of the Britain’s main gold coin. On Saturday 21 December 1717 the government asked Newton to fix the sterling silver exchange rate with the main gold coins used throughout Europe, in a report ‘blinding with science’ [Craig, 1946, p 108], the value of the British gold guinea increased from being worth only 20s of silver, to being worth 21s. The Law of Unintended Consequences kicked in, Newton had undervalued foreign gold coins. The result was described by Adam Smith in his Lectures some forty-five years later

As silver buys more gold abroad than at home, by sending abroad silver they bring gold in return, which buys more silver here than it does abroad. By this means a kind of trade is made of it, the gold coin increasing and the silver diminishing. Sometime ago a proposal was given in to remedy this, but it was thought so complex a case that they resolved for that time not to meddle with it. [Fay, 1935]

The direct consequence of this was that silver coin became increasingly unpopular, and in 1816, Gold was declared the “sole standard measure of value” [Fay, 1935], putting into the force of law what the markets had started doing a century earlier.

Shortly after defining the Gold Standard, Newton was caught up in the South Sea Bubble of 1720. Newton had been an early investor in the South Sea Company and in April, in the early days of the Bubble, he liquidated, doubling his money with a profit of £7,000 (roughly £700,000 in today’s terms). However, he was drawn into the mania again later that summer, and, according to his half-niece, the famously beautiful Catherine Barton, he lost £20,000 (roughly £2 million in today’s money!) [Kindleberger, 1996, p 28]. Craig notes that Catherine "was a hard woman”, and the ‘loss’ was never realised but rather the potential profit had Newton maintained his original holding and sold at the top of the market [Craig, 1946, p 112]. None the less, Newton was left to observe that

I can calculate the motion of the heavenly bodies, but not the madness of men.

References

   J. Craig. Newton at the Mint. Cambridge University Press, 1946.

   C. R. Fay. Newton and the Gold Standard. Cambridge Historical Journal, 5(1):109–117,
1935.

   M. Keynes. The Personality of Isaac Newton. Notes and Records of the Royal Society of
London, 49(1):1–56, 1995.

   C. P. Kindleberger. Manias, panics and crashes: a history of financial crises. Wiley, 1996.

   T. Levenson. Newton and the Counterfeiter: The Unknown Detective Career of the World’s Greatest Scientist

   A. L. Murphy. The Origins of English Financial Markets. Cambridge University Press,
2009.