Finance in America:
An Unfinished Story
by Kevin R. Brine and Mary Poovey
University of Chicago Press, 2017, 528 pages
Remember auction rate securities? For decades, financial institutions hosted “auctions” of these fixed-rate instruments for buyers and sellers. They were considered so safe, and the auctions (where the interest rate would be “reset” depending on the level of interest in the securities, among other factors) so routine, that auction rate securities became an alternative to money market funds for those wanting a short-term, interest-bearing investment.
Until they weren’t. In a kind of prelude to the mortgage crisis, the auctions began “freezing up” in 2008 and “failing”—that is, sellers could not find buyers. Financial institutions had implicitly agreed to backstop the auctions by buying up excess supply, until they too simply stopped, leaving holders of auction rate securities (ARS) without a ready market. For years afterward, significant amounts of almost worthless ARS rattled around financial firms and customer inventories.
The ARS debacle is one of the few financial events of the last century that Finance in America: An Unfinished Story does not mention, but it illustrates several themes that Kevin R. Brine and Mary Poovey present as central to their study in this truly magisterial history of the American financial system. Finance in America will be the textbook for a generation or more, for those wishing to understand what has become one of America’s most prominent economic sectors. Brine and Poovey weave their themes through a detailed narrative that examines developments in corporate organization, accounting, finance, and economics from the late nineteenth century through the 2008–9 financial crisis. The book is artfully comprehensive, examining topics such as stock analysis and valuation, economic forecasting, the development of stock indices, the increased importance of data and mathematical economics, portfolio theory, Keynesianism and monetarism, and econometrics, among others. Brine and Poovey place well-known giants such as Benjamin Graham, David Dodd, and Milton Friedman in context alongside the many other contributors to the American financial system and related scholarly areas. The book is also archivally rich, drawing from textbooks, conference papers, accounting materials, and other almost forgotten material. Despite the technical nature of the subject, the book is clearly written, and its readership need not be restricted to professionals or academics.
The Mathematical Turn in Economics and Finance
Central to the story of American finance is the “mathematical turn” in economics, beginning in the twentieth century. The book features an in-depth look at the contributions of economist Irving Fisher, in particular, whose works in the early part of the twentieth century, such as The Nature of Capital and Income (1906) and The Theory of Interest (1930), brought a new focus to the study of finance. Fisher is important for a number of reasons, including the fact that his 1891 doctoral dissertation introduced the concept of marginal utility into American economic analysis. Fisher led the way in turning economics away from its relationship with philosophy and ethics toward mathematics. His definitions of “capital,” “income,” “wealth,” and “risk” were oriented toward expectations about future income, in contrast to the more static picture of value presented by neoclassical economists. Brine and Poovey also explore everything from the econometric analysis of Norwegian economists Ragnar Frisch and Tryvge Haavelmo to work done in statistics and econometrics during World War II. They then trace the subsequent transfer of these developments to financial markets through a series of conferences in the 1940s, as the nation reverted to peacetime.
But finance is not simply math. Financial economics may be able to achieve a level of theoretical precision, but as this account shows, it is not a science in the way physics is. The book acknowledges “the consolidation of finance as a gradual, uneven process without losing sight of the heterogeneity of its components or the capaciousness of what it has now become.” How one defines a balance sheet, what to include as a “capital good,” and the creation of indices or stock valuation techniques are not questions with objective answers independent of time or context. Indeed, the discipline of “finance” on this account is largely a graft onto other disciplines such as mathematics and economics, and it also served (and continues to serve) political purposes.
In a surprisingly gripping section, Poovey and Brine recount the development of the concept of “gross national product” (GNP) in the 1930s and 1940s. As the authors show, the development of this concept came with serious methodological and conceptual challenges. For one thing, the principles of corporate accounting could not be perfectly applied to a nation; a nation’s tax revenue is not “income,” and consumption is not really national “cost.” Nevertheless, in the 1940s, economist Milton Gilbert wanted to see if consumer demand would hurt the war effort, or if the war was hurting national economic well-being; he would resolve these in the negative, arguing that using gross national product rather than net made more sense. But in doing so, Gilbert really focused on the health of government.
Others, like Simon Kuznets, had collected data on national income and production on the assumption that “the end goal of economic activity is the consumption of real goods and services; and the purpose of constructing national aggregates is to measure economic welfare.” Gilbert crucially departed from Kuznets by including a measure of expenditure as well. Gilbert’s model “implicitly equated the growth of government (expenditures and costs) with growth of the nation’s economy. . . . When the growth of government was equated with the growth of the nation, the policy tool the national accountant provided could be used to justify government growth—and the national accountant became, de facto, an apologist for—as well as an indispensable measure of—the government he measured.” For example, Gilbert added taxes back into the gross national product, but did not include payment of interest on government debt to the cost side. This analysis supported Roosevelt’s economic proposals during the war (as Poovey and Brine note, Roosevelt proposed a budget that allocated over half the nation’s “income” to defense spending). Gilbert needed to come up with an analysis that would avoid inflation as the nation purchased goods, especially those related to the war effort, at a faster pace. This analysis, however, also drove “the policies that shaped many Americans’ experience of the war: heavy taxation, the growth of U.S. debt in the form of Treasury bonds, price controls, and the rationing of some consumer commodities.”
Indeed, ordinary Americans’ general involvement with the financial system came about in World War I, with the government’s promotion of Liberty and Victory Bonds. The authors conclude that “the first stage of the democratization of the U.S. capital markets was a function of wartime necessity, patriotism, and ‘celebrity marketing,’” a combination which Brine and Poovey imply is still very much with us.
For examples like these, at our particular economic and cultural moment, a history of finance is crucially important. Finance in America shows just how finance is affected by cultural, political, and conceptual assumptions. Kuznets and Gilbert had both developed approaches to answer questions about the national economy, but Gilbert’s was better suited to answer the question then facing the nation. This, however, implies that our understanding of economic measures inevitably changes as the critical political questions change. By including taxes for the practical reason that this was what the government had spent to win the war, GNP would naturally expand as long as taxes grew. In the run-up to 2008, and to some extent even today, the nation perhaps suffers from a different distortion: the mindset that the stock market and those companies that dominate it simply reflect the objective state of the American economy. If the “market” does well, in other words, then the nation does well. But that is not necessarily the case. This mindset, so established among both right- and left-leaning commentators, is premised on certain neoliberal presuppositions, which are more assumed than proven.
Efficient Markets and Rational Choice
Finance in America also demonstrates the periodic failures to account for irrationality in financial decision-making. As the larger events of 2008–9 unfolded, a market panic of sorts spread to the ARS market, which was not the same as the mortgage market that was suffering a loss of confidence. Nevertheless, customers sought to dump their ARS holdings because of nervousness about their creditworthiness. Other investors, for the same reason, decided not to buy ARS as they typically would. But the buyers, sellers, and the ARS themselves were largely the same the day before auctions started to freeze as they were the day after; the investors simply stopped believing in the auction market itself. This pattern recurred in other areas of the markets. Even before defaults, some market participants decided that mortgage-backed securities simply were not worth what the financial models said they were. Once that happened, the brokerage houses that had relied on the value of those instruments as collateral to finance their operations could no longer do so, leading, in part, to a downward spiral. In the abstract, every credit matches a debit. But it is best not to look down from the ladder of debt. When that happened in 2008, as John Lanchester recounted in the London Review of Books (July 5, 2018), “people suddenly started to wonder whether these assets (which by this point had been sold and resold all around the financial system so that nobody was clear who actually owned them . . .) were worth what they were supposed to be worth.”
One way to look at the financial crisis is as a blow to the “efficient market” thesis, which received increasing attention beginning in the 1950s. In 1959, Harry Markowitz published his Portfolio Selection. Drawing on the work of earlier economists and finance theorists, Markowitz posited the “rational man” as a key component of his theory of portfolio diversification, and the book (along with the original 1952 article from which it developed) is considered the origin of modern financial theory. Markowitz’s work focused on mathematics to assess correlation; that is, “the expected returns from the assets held in a portfolio are additive—the overall return is attributable to each asset weighted proportionally to its representation in the portfolio—but the variance of the portfolio and its standard deviation is not additive because noncorrelated assets go up and down in different patterns.” Yet to achieve this result, Markowitz had to disregard what he called the “first phase” of the analysis: how investors choose the initial basket of securities, “the process by which the investor forms ‘beliefs about the future performance of available securities.’”
The efficient market hypothesis also draws from studies of randomness by MIT management professor Paul Cootner and University of Chicago’s Eugene Fama in 1964 and 1965, respectively. As formulated by Fama, the hypothesis postulates market participants as individualized, rational profit-maximizers with near complete information and almost no ability to arbitrage. In this scenario, stock prices take “random walks.” Fama and Merton Miller’s 1972 textbook, The Theory of Finance, embedded these assumptions about market actors in business school curricula.
This was joined with the conceptual breakthrough of the Capital Asset Pricing Model (CAPM) developed by Stanford economist William F. Sharpe in 1963–4, which shared Fama’s assumptions and was used to price financial assets. CAPM dominated the financial markets in the 1960s—a period Brine and Poovey view as comparable to the 1920s for its enormous economic growth. But as history changes, so does finance: the oil shocks and stagflation of the 1970s (a period of both slack production and inflation) called into question CAPM’s assumptions about efficiency and rationality. Although never fully replaced, CAPM underwent a transformative moment that led to its undoing: “Instead of trying to model the behavior of individuals making choices under uncertainty, financial engineers began to model the structure of the financial market itself. Instead of simply pricing securities, they began to create new financial assets, which were derived from the primary securities and could be traded independently.” These new instruments were priced according to the Black-Scholes model devised in 1973. Combined with increases in quantitative computing at securities firms, it became conceptually possible to quantify and contain all risk. Thus began the rise of derivatives, whose ultimate goal was to hedge risk in every conceivable scenario—a goal that was ultimately thwarted by the complexity and costs of the financial system itself, as seen in the credit and mortgage market shocks.
By the 1960s, Brine and Poovey write, economists generally agreed that “the idea that choice is based on utility should no longer be anchored in the nineteenth-century idea of marginal utility but in an epistemology of axiomatized rationality.” This epistemology was informed by several waves of probability theory that tried to quantify risk balanced against uncertainty. That thesis, however, has since faced increasing skepticism, both as a result of theoretical attacks and in light of events such as the financial crisis. As it turns out, people are not completely rational, and information is not always completely and immediately available. Psychologists and others have tracked “irrational” market behavior. Even courts, which had enshrined a version of the rational choice hypothesis to assist in reviewing claims of securities fraud called the hypothesis into question. Economists and finance theorists of course knew they were abstracting from actual circumstances to assist in their theory; and to be fair, major pieces of the theory have helped create wealth and are still used profitably every day in both academic and financial settings. But the focus on an idealized rationality and intense interest in calculating the probabilities of results based on varied and changing expectations led, in part, to an increasing divergence between what Brine and Poovey call the “real” and “financial” sides of the economy.
The Separation between the Real Economy and the Financial Economy
ARS were almost completely the financial rather than real economy, and were only one example of a number of increasingly exotic financial products, including derivatives of various kinds and collateralized-debt obligations. They were financial instruments that lived and had value in their own autonomous realm, backed by other financial assets such as student loans. This is how the authors understand the 2008 crisis, as opposed to, say, the Great Depression, which they describe largely as a “monetary” crisis (because in that case currency deflation combined with the loss of easy credit and a weakening economy to create a depression). And money itself straddles both sides of the economy: “In the real economy, money functions as a unit of account and a medium of exchange. In a financial economy, money is also a medium of exchange, but, in addition, it is a particular kind of asset (a store of value), and a standard of deferred payment.” Finance in America explains how those two sides became more integrated through sophisticated modeling and other tools, as well as how the “financial” side eventually engulfed the real economy. The story is at least as old as the Pujo Commission of 1913, which examined financial concentration and led to a published defense of the concentration in the financial industry as a necessary complement to the nation’s growing economy in commodities and capital goods.
But these different economies did not start out separately. It is one of the ironies of the history of finance that the hedge fund managers and traders in London and on Wall Street are using techniques essentially developed from agricultural markets. Poovey and Brine explore the work of Henry A. Wallace and other agricultural economists in the 1930s and 1940s, working at land-grant colleges in the Midwest, particularly Iowa State. These economists drew on the statistical tools developed by others such as Henry Ludwell Moore to address real issues in supply and demand, such as corn-hog ratios (the price of a bushel of corn divided by the price of one hundred pounds of pork). George Stigler, for example, joined the Iowa State faculty in 1936. Iowa State also helped develop a computing laboratory, and its graduates and faculty exercised significant influence through contributions to journals such as Econometrica. Alfred A. Cowles, who founded Econometrica, also established a leading economics research institute. Through these institutions, Cowles acted as a middleman between the agronomists and the financial economy, both by funding research and through his own work on stock forecasting. As the authors note, Iowa State was “by a fortuitous conjunction, the conduit by which advanced statistical work was incorporated into the compilation of financial data.”
The more recent “credit” crisis—which originated almost wholly within the financial economy rather than the real one—arose in large part as a result of the excesses of financial engineering and the irrational assumptions about rationality that Brine and Poovey trace to the 1960s. For example, the first study of the interrelationship of financial institutions with one another appears in Money in a Theory of Finance, by John Gurley and Edward Shaw, which provided important data for Friedman’s Monetary History of the United States, published in 1963. For Brine and Poovey, each of these developments during what they call the “intercrisis period,” 1970–2008, set the stage for the events of the financial crisis.
In the 1980s, banking and finance became more closely linked through developments such as securitization, despite the strictures of the Glass-Steagall Act. The perception that the financial system really “was” the American economy emerged during these years, and this perception changed banking behavior. In earlier periods, banks responded to economic fluctuations by increasing or decreasing lending to borrowers. Beginning in the 1980s, they tended to respond by reducing exposure to risk and raising prices. Brine and Poovey attribute this to the transformation of the financial system into a “market-based” system. By this, they do not simply mean that financial firms were operating in a capitalist system—that much has always been clear. Rather, this new system reduced central banks’ oversight of the money supply and lending, and allowed banks to use their securities arms to compete in developing financially engineered products.
Brine and Poovey point to a number of developments within four broad categories: disintermediation and the creation of a shadow banking system, deregulation, financial engineering, and securitization. Disintermediation refers to the splitting up of the functions typically performed by banks, such as liquidity transformation, leverage, and certain credit risk functions, to other institutions outside the banking system proper (the “shadow” banking system). A disintermediated system is harder to regulate or even fully understand, as market participants discovered, to their chagrin, when unraveling the tangled web of credit derivatives trades in the wake of the financial crisis. The rise of securitized asset classes such as mortgage-backed securities partially hid the separation of money and finance from the larger American economy. Securitized assets and the range of derivatives and similar products, whose growth was spurred by the exponential increases in computing power and data, were ultimately more exposed to risk than old-fashioned lending overseen by central banking, even despite the use of sophisticated modeling. “Intermediation within the shadow banking system tends to use short-term liabilities to fund illiquid long-term assets and, while this may have reduced the cost of credit for some consumers, it also helped make the market-based system vulnerable to shocks.”
New global financial arrangements that arose around the same time also had significant impacts. In 1971, the United States delinked the dollar from gold, effectively ending the 1944 Bretton Woods Agreement. This move established the dollar as the world’s reserve currency, but it also meant that the United States faced global competition from more markets. This was not helped by a stock market decline in 1973–4 and the oil shocks of the early 1970s. There was increasing pressure to allow U.S. financial institutions to invest in products outside the jurisdiction of the Federal Reserve that allowed for higher returns, such as the Eurodollar market.
Brine and Poovey point to other developments, including the influx of “quants” into the major financial firms, who applied techniques borrowed from mathematics and physics to make investment decisions. They highlight the dominance of the dynamic stochastic general equilibrium (DSGE) model in the 1980s and into the 1990s, which worked as a theoretical construct for analyzing economic and financial systems. When applied to the real world, however, it had one flaw: the model “shifted the balance between . . . the model world and the world outside the model: instead of simply capturing a simplified aspect of the real-world economy, DSGE model creates a fictitious economy and makes propositions about it.” The authors contrast these models with the work of economist Hyman Minsky, who argued for decades that a financial economy is unstable by its nature and analyzed the economy using a framework that emphasized institutions rather than mathematics. Minsky’s reputation has experienced a revival since 2008, when his insights proved prescient. His writings deserve further study.
By 2008, the economy was primed for disaster. Poovey and Brine call this new system a “market-based financial system” to distinguish it from a period of more strenuous regulation and oversight by central bankers. Deregulation caused formerly private partnerships to become global public financial institutions, for example. This had a number of consequences, such as bringing these financial firms under the same pressures for “yield” as other firms, and allowing them to risk capital far in excess of their former partners’ wealth (which was previously the primary source of such capital). These moves necessitated further complexity of financial instruments, since in many cases they were the main product of these firms, which in turn further sped the separation of the financial from the real side of the economy.
Law and Financialization
For much of the book, the law hovers in the background, becoming somewhat more explicit as the present comes into view. This is not surprising, since the law in the securities and financial markets usually means public law, like the securities acts passed during the Great Depression, and the growth of the regulatory state. But as the narrative proceeds, the more visible hand of the state emerges. Let’s refer back to our friends the auction rate securities. The problem with a lot of these ARS contracts arose from badly worded provisions on whether banks would preserve the auction if it failed. Many contracts, for example, said that the bank “may” step in. Investors simply read that “may” as the banks “will” step in. When the banks did not step in, investors sued, despite the contractual language, and there was agitation to bring regulatory attention to the market. The regulators eventually got involved. What happened next was interesting: although there were some exceptions, a lot of financial institutions semi-voluntarily decided to buy back the auction rate securities from their customers, even when the legal language was in their favor. Others—less inclined to do so—eventually succumbed to regulatory pressure and settled. Whether this reflects a “market-based” financial system is debatable; more likely, the regulatory state applied pressure, and the financial institutions decided payment was better than litigation. This example illustrates the complex relationships at play between banks and regulators in today’s financial system.
Poovey and Brine isolate the Celler-Kefauver Act of 1950 as a critical component in their story, in parallel to the developments in financial analysis. Corporate power had been an issue of controversy since the nineteenth century, and the early years of the twentieth century had seen efforts, such as the passage of the Sherman Act, to reduce the power of large corporations. The characterization of the corporation as a “privilege” granted by state law had slowly receded, and corporate entities were increasingly seen as autonomous persons with legal rights and a duty to maximize profit for their shareholders. The Celler-Kefauver bill was along the same lines: it prohibited horizontal mergers of companies, that is, companies that sought to consolidate across the same industry. The law, however, had the unintended effect of promoting diversification—companies with money to spare or shareholders to satisfy diversified across industries. This opened up a new way to look at corporate growth: “Instead of managers whose expertise derived from knowledge of specific product lines, the managers of these new companies used knowledge about finance to evaluate and manage parts of the company that had little in common except their ability to generate short-term profit.” Just as an investor may have a basket of noncorrelated assets, such as stocks or bonds of different issuers, large corporate organizations would also have a basket of sometimes wildly unrelated holdings designed (in theory) to weather economic storms. The authors note that “treating the corporation as a collection of assets, managers—who were often trained in finance or accounting—began to use innovative financial techniques such as the leveraged buyout to increase profits and market share.” It is only a short step from here to the economic dominance of private equity firms, which buy various companies, increase leverage, make them more “efficient” (sometimes by offshoring or eliminating American jobs), and then sell the company again. This is not always bad—a smaller company that exists is still better than a bigger one that does not—but the effects of such an economic and legal structure are mixed. This replacement of managers, experienced in industry, with those knowledgeable about financial techniques was perhaps the clearest break with the “real” economy that led to the domination of finance over production. An astute administration or Congress would do well to take a look at that act to see if it still serves its purpose.
Our free-market masters tell us that we are a nation of “investors,” which is quite a different thing than a nation of producers, or even a nation of citizens. Finance in America, though not a polemical work, explains how we have come to think of ourselves in these terms.