A Cautionary Tale

It was a somber August day in 1995 when Fischer Black died of cancer. He was 57 — not so much an athlete dying young (“Eyes the shady night has shut/Cannot see the record cut,” A.E. Houseman) as an explorer engaged in a fruitless search for El Dorado. Black was a general partner at Goldman Sachs and the father of four daughters. Had he lived, he almost certainly would have shared in the Nobel Prize given two years later for the Black-Scholes option pricing formula — “a new method to determine the value of derivatives,” as the Swedes described it. He left behind a volume of passionate jottings, lists and reading notes entitled Exploring General Equilibrium.

A couple of years later, Perry Mehrling, a Columbia University economist and historian of monetary thought, went to work on a biography.  Fischer Black and the Revolutionary Idea of Finance appeared last year, clearly a labor of love. The picture of Black that emerges is of a remarkably smart man, a very successful inventor and a strangely genteel crackpot, as opposed to a successful economist.

Though he rose steadily through the centers in which finance emerged as the engineering subsidiary of economics during the 1960s and ’70s — Arthur D. Little, Wells Fargo Bank, the University of Chicago, the Massachusetts Institute of Technology, Goldman Sachs — Black never really succeeded in entering the community of technical economics, even though he had solved a problem that economists had recognized as crucial. He never persuaded others to see the world the way he did.  He never knuckled under to them.  And never quit trying to make a dent.

The story of what Black did is fairly well-known by now, a famous advertisement in intellectual circles for the intellectual soup-pot that is the high end of life in Cambridge, Massachusetts. How the young applied mathematician from Harvard took a job at Arthur D. Little in 1965 instead of a post-doc in operations research. How he learned finance from fellow-consultant Jack Treynor, a Harvard MBA whose thinking about risk, time and share prices would lead to an early version of the Capital Asset Pricing Model. How in 1969 Black, while trying to relate the value of a stock option to the underlying price of its shares, wrote down a differential equation that he could not solve.

How, within a year, the equation, describing the relationship between the stock’s volatility, the option’s shelf life and the riskless rate of interest (meaning the rate the government paid on Treasury bills), had turned out to be a form of a well-known equation describing the diffusion of heat. How a research partnership with a young MIT economics professor named Myron Scholes led the pair to solve the equation and recognize the significance of what they had found as something much more than a prospecting tool for bargain-hunting investors — a “universal financial device” relating the present to the future, in Peter Berstein’s phrase. How MIT’s Robert Merton mapped their discovery into the larger tapestry of economics.

Well- known, too, is the brief but intense uphill battle that Black and Scholes fought before their paper was accepted by the Journal of Political Economy. Most great papers are resisted at first.

Much less well-known is the decade-long frontal assault that Black then made on the twin temples of technical economics, the University of Chicago and MIT, and this Mehrling covers in great depth.  Black’s successful investigations of options pricing brought him an invitation to visit Chicago, as Treynor’s earlier semi-discovery of the Capital Asset Pricing Model had brought an invitation to visit MIT.  Unlike his mentor, though, Black stayed in the academy for fourteen years, five of them in Chicago, in order to engage in a prolonged argument with Milton Friedman over the nature of money; nine more at MIT, in order to argue with Paul Samuelson, Robert Solow and Franco Modigliani about the origins of business cycles.

In neither case did he succeed. Economics rejected him completely. It wasn’t personal, according to Mehrling: “Indeed, it is fair to say that the mainstream of economics hardly even noticed him.”  The problem was that Black had had no formal training in economics. He understood its puzzles well enough, but couldn’t confidently manipulate its concepts. His papers were humiliatingly rejected. He published them himself eventually in a book.

So in 1984 he quit MIT and moved to Goldman Sachs, where then managing partner Robert Rubin hired him to scout out subtle forms of mis-pricing in the markets, the first “quant” to join a firm whose reputation to that point had been made in investment banking (though trading by then had become a second big business for the firm). One of the first memos Black wrote identified a potentially lucrative tax arbitrage using derivatives known as term-structure swaps.  A year later the firm voted him a partnership. Before long, he had attracted a group of practice-oriented finance intellectuals to Goldman that collectively rivaled the faculty at all but the very best business schools.

What was so heterodox?  Black maintained that the ups and downs of the business cycle were largely unpredictable, “because of basic uncertainty about what people will want in the future and about what the economy will be able to produce in the future.” If future tastes and technology were known, he wrote in his principal essay on the topic, “profits and wages would grow smoothly and surely over time.” But they weren’t known; instead they evolved in essentially unforeseeable ways. (The world was non-stationary, in econometricians’ jargon.)  So a boom was simply a period when technology matched well with what people wanted from it, a recession was a period of readjustment, and there was almost nothing the government or its central bank could do about either except to seek to stay out of the way. “The word got out that Fischer was absolutely first rate in the more specialized subfield of finance, but quite out of his depth when it came to general economics,” writes his biographer.

In his personal life, Black was even more unorthodox.  Mehrling delicately chronicles the successes and failures of three marriages in which Black participated with the all the zest of a man who believed that the CAPM model of riskless short-term borrowing was as reliable a guide to professional services as to financial assets. “An elegant and always meticulously groomed man, he loved women and often they loved him back, and it wasn’t all always about sex,” writes Mehrling. He was a doting father, too. He poured orange juice on his breakfast cereal, engaged in many health food fads, and was a most peculiar conversationalist. In the middle of a conversation, he would begin scribbling notes and cease talking until he was done.

Summing up: “He was the man from Mars, who looked at finance, and economics, through fresh eyes. He was the Zelig who always managed to be in the center of the intellectual action, even as that center moved from the world of business into academia and then to Wall Street. He was the visionary prophet who saw how the new ideas in finance would lead to a sea change, not just in the world of practical finance but also in our everyday lives.  And he was the extraordinary man who lived his life as if that sea change had already happened.”

When Black was named “Financial Engineer of the Year” in October 1994 by finance professionals, he chose as his topic “Doctoral Education, the Business School and the University.” He told the audience that had chosen him, “I see our university system as similar to the former Soviet empire, and as having similar problems… teaching and research are too uniform. They do not respond quickly to shifts in tastes and technology. (In fact, they try to make this into the virtue of preserving traditional values and avoiding fads.) And, most important, teaching and research simply cost too much…. In my view, the basic problem with research in business (and economics) is not that it’s too theoretical, or too mathematical, or too divorced from the real world (though all of these are indeed serious problems). The basic problem is that we have too much research, and the wrong kinds of research, because governments, firms, foundations and generous alumni support it.”

A few months earlier, while having trouble fastening the collar button of his shirt, he had joked with his wife that perhaps the problem was a tumor. Instead of going to doctor, however, he plunged into reading up on the possibilities — “research,” he called it. And when he finally got the diagnosis of the throat cancer that soon would end his life, Mehrling relates, “he burst into spontaneous laughter.”