Making Finance Visible, a review of Brine and Poovey
Brine, Kevin R. and Mary Poovey. Finance in America, an unfinished story. University of Chicago Press, 2017.
The authors of this book are respectively a non-academic Wall Street practitioner and a non-economist academic, but the text is nonetheless of considerable interest to economists and in particular to historians of economics since it represents an outsider reading and attempted synthesis of texts produced by them (as enumerated in the introduction, p. 23). The authors address their book explicitly to “earnest readers…whether they have formal training in economics or not” (26). Earnest readers themselves, the authors have apparently spent the years since the 2008 financial crisis sifting through the specialized literature, and here attempt to assemble the parts into an overarching narrative stretching from early 20th century to that crisis, with the goal of making finance “visible” to a non-specialist audience.
Why is that important? Because, according to the authors, the 2008 crisis arose precisely from the failure of economics and finance to make “visible” the centrality of finance since 1970, and in particular the emergence of a new market-based institutional form of finance, so-called shadow banking, here understood as money market funding of capital market lending (362). In their own words: “What we see in the decades between 1970 and 2008—which we call the intercrisis period—is an ever-widening mismatch between models designed to drive economic policies and the growth of the financial sector, in the United States but also abroad….The models economists used did not factor in many of the most basic components of finance, and the models used by financial engineers did not recognize that risk could be unknowable and systemic rather than subject to estimation and statistically manageable. The conditions were thus ripe for the rude awakening that occurred in 2008” (14).
The overall architecture of the story they tell is similar to that of a story I myself once sketched in “A Tale of Two Cities” (Mehrling 2010) without however getting any noticeable traction, and the reader is hereby warned that I am therefore favorably disposed to the book, and hope for them a better outcome. My story was about a shift “from the city of money to the city of finance, from the public Board of Governors in Washington to the private securities exchange in New York”, a shift reflected in concomitant methodological shifts in the treatment of risk, equilibrium and time, a shift pioneered (so I suggested) by Jacob Marschak.
All that is in their story too, but they put the emphasis somewhat differently. For them the key institutional changes were the rise of the corporation and big government in the first part of the century, and the rise of the market-based credit system in the last part of the century. And the key methodological shift was the rise of “modelling” as the preferred, indeed exclusive, method of economic inquiry and discourse. Chapter 7 “Models of Economies and Finance, 1930-40” places the origin of that methodological shift in the last years of the Great Depression, and so functions as a pivot point in the narrative, a pivot from the pre-war dominance of institutionalist economics, an empiricist project that sought to discover regularities in evolving economic practice, to “neoclassical” economics which preferred to study the properties of artificial constructions, “little model worlds”.
John B. Williams and Gerhard Colm emerge as pre-war pioneers of this shift toward formal modelling (Ch. 4.7 and 6.5), but it was peacetime spillover of the success of operations research in World War II more than anything else that drove the methodological future of both economics and finance (Ch. 8 and 9). Crucially, in both fields, “performativity constitutes an essential measure of the model’s success” (p. 10). The perceived failure of economics, specifically the Keynesian models of economic management that rose to dominance in the 1960 Kennedy administration, is contrasted with the manifest success of finance in the burgeoning industry that grew up around the new theories after 1970. The crisis of 2008 arose from both the failure and the success, as economics failed adequately to engage with the emerging new financial reality so leaving a gaping public policy vacuum that has yet to be adequately filled, and as finance focused narrowly on using increasingly advanced modelling techniques to produce new financial products for private profit, leaving aside the consequence of those new products for system stability.
As historians, the authors explicitly embrace a “genealogical approach”: “we treat the core ideas of finance as a composite of practices and theories that originated at other sites” (24). In effect, they search the past for the origins of the bits and pieces that got assembled into the constructs we know as modern economics and finance. The result of that strategy is that the first six chapters feel a bit disjointed, full of bits and pieces with no clear narrative, since the reason for including these particular bits and pieces only emerges in the last three chapters when we see what was made of them. Nevertheless, the overall effect is to make clear how economics and finance, presented in modern textbooks as a matter of the logical workings of a closed mathematical model, in fact arose not only in bits and pieces but more importantly in concrete practice. Irving Fisher is exemplary in this account not so much because of his early abstract work on general equilibrium modelling (following Gibbs), but rather for his later work pulling together the work of corporate accountants into a comprehensive worldview, “the financial view” (76-81). And the early Fed (specifically Allyn Young) is pictured not so much as applying pre-existing academic theories but rather pulling together the work of practical bankers in an attempt to develop a coherent strategy of monetary management for the new central bank.
A large part of the story they tell is about accounting, both corporate accounting and national income accounting, which arose from the practical need to make various aspects of the economy visible in order to guide managerial decision making, and only later entered economics. Indeed, the institutional economics of the early 20th century was largely driven by an attempt to make sense of the data being generated by the operations of large corporations and the government, and it is clear that the authors have considerable sympathy for that approach. Veblen was basically right to insist that “real” and “financial” are intertwined, so it is a mistake to build economic theories by focusing on the real and abstracting from the financial, and he was right also to insist on the evolutionary character of the system, so it is a mistake to build economic theories that focus on growth to the exclusion of institutional change. Similarly, Knight was right to insist on the importance of fundamental uncertainty, and to distinguish it clearly from quantifiable (and diversifiable) risk, and that means it is a mistake to build financial theories that treat only risk.
Starting in the 1920s, a large part of what was new, and needed to be understood, was financial, and clearly visible as such. Most important, the institutional apparatus that had been put in place during the world war in order to distribute the war debt of the state got repurposed after the war to distribute the bond debt of private corporations, and the result was the roaring twenties (128-129). Harold Moulton’s Financial Organization of Society (1921) pointed exactly to the importance of finance for supporting future economic growth and prosperity, and in due time Morris Copeland’s Study of Moneyflows in the United States (1952) would show how to capture the importance of finance in national accounts. Meanwhile however myriad popular accounts and investment manuals made finance visible, even too visible as the population at large got swept up in the speculative bubble that burst in 1929, ushering in the Great Depression. To Brine and Poovey, there is a direct analogy here with the hubris of the Keynesian growthmen in the 1960s, which ended with the collapse of Bretton Woods and the stagflation of the 1970s. The difference is that in the latter case the problem was the invisibility of finance in the models that had become the dominant mode of economic discourse. Gurley and Shaw’s Money in a Theory of Finance (1960), successor to Moulton and Copeland, was easily absorbed into the reigning Keynesian orthodoxy, and other successors like Hyman Minsky found themselves marginalized, “both out of synch and eerily prescient” (358).
Economists might well respond, indeed did respond at the time, that one has to start somewhere, and that’s what the embrace of modelling was all about. Marschak’s early work showed the way to include a financial sector in general equilibrium, and Tobin completed the task so constructing 1960s orthodoxy. The problem with this response, as the authors make clear, is that modelling makes some things visible, and other things invisible. Macroeconometrics and financial econometrics both made some new things visible, but also some old things invisible, old things that were perfectly visible to Veblen, Knight, and their students. Something was gained, but something was also lost, especially for the next generation as textbooks codified the new and left out the old. One value of an historical account such as this one is to reveal bits and pieces that have yet to be adequately incorporated into standard economics and finance. That is the sense in which the story is “unfinished”: “making finance visible will require the work of many hands” (374).