The Machine that Changed the World


The rivalry between Paul Samuelson and Milton Friedman continued to the 1970s, but it shifted to new ground – to developments in the rapidly-expanding field of finance.   Samuelson was an active contributor, both with the research he described as his “Sunday painting,” and as a market participant. Friedman was more reluctant convert, but still managed to have a major impact, as godfather to the Chicago risk markets. The new discipline was even quicker than the economics profession to adopt the Arrow tools and put them to practical use.

Developments in finance unfolded apace with growth of the computer industry. Of all the developments accelerated in the crucible of World War II, none more important than the digital computer, not just because of the many new analytic methods developed during the war. From the beginning, experts anticipated that computers would do many things besides simply crunch numbers. They would store data, control tools, operate factories, manage communications, generate images and sound, steer rockets, fly airplanes, drive cars.

One upshot, however, was completely unanticipated.  The speedy, sprawling growth of computer and communications technology over the next 75 years offered the world a master class in the sheer power of markets – their  vicissitudes, advantages and shortcomings.

If you were to choose the occasion on which the two great streams of enterprise, computers and finance, first flowed together, it might be May 1, 1975.  That is when the US Congress began to dismantle certain barriers to competition in financial markets that had been in place since the earliest days of the Republic. A process of innovation already was well underway. The effect of financial deregulation was to hasten it. Twenty-four years later, the last of the guardrails installed during the New Deal were removed. .By then the financial system was traveling along the edge of a cliff.

 .                                   The Oldest Dream

The story of finance properly understood is a story of innovation, but often it is told as a matter of outsmarting others in the money economy.

Take Aristotle’s Politics. In Book One,  the philosopher  advocates collecting “the scattered stories of the ways in which individuals have succeeded in amassing a fortune.”  He then relates the story of the philosopher Thales of Miletus who, sensing that it was going to be a banner year for olives, put down “small deposits” on the rental of all the olive presses in the neighborhood and made a fortune in the options trade ( thereby demonstrating that philosophers “can easily be rich if they like, but that their ambition is of another sort”). Another man in Sicily cornered the local supply of iron, and, though he raised prices only a little, tripled his money.  In both cases, says Aristotle, the key to riches lay in contriving a monopoly. Maybe so, but more interesting to us are those options contracts.

The story of modern finance has been well told; I’ll barely sketch it here. The first account, Capital Ideas: The Improbable Origins of Modern Wall Street, by long-time money manager Peter Bernstein, is still in many ways the best, because it is that of an eyewitness. Donald MacKenzie, of the University of Edinburgh, has reexamined to good effect the story at greater depth in An Engine, Not a Camera: How Financial Models Shape Markets.   The most recent account, Pricing the Future: Finance, Physics, and the 300-year Journey to the Black-Scholes Equation, by mathematical economist George Szpiro, recalls and explains in great tranquility. My favorite, from which most of the next four paragraphs are drawn, is Louis Bachelier’s Theory of Speculation: The Origins of Modern Finance, by Mark Davis, of Imperial College London, and Alison Etheridge, of Oxford University (Princeton, 2006). It is pure history of social science, and concludes with a chapter called “From Bachelier to Kreps, Harrison,and Pliska.”

Financial practice had become considerably more sophisticated by the time of the South Sea Bubble. In The First Crash: Lessons from the South Sea Bubble, Richard Dale describes the profusion of instruments available to London traders in the thirty years after the Glorious Revolution of 1688. They included futures contracts, options contracts known even then as puts and calls (or, in those days, “refusals”), insurance policies, even annuities tied to the longevity of personages such as the Prince of Wales. There was plenty of gambling, to be sure, but the instruments were mostly legitimate, developed by all kinds of people as means of managing the risks of their businesses — Japanese rice farmers, Dutch fishermen, Scottish traders.

As financial markets broadened, so did the opportunities. By the middle of the nineteenth century, William Makepeace Thackeray could write in Vanity Fair,

There is no town of any mark in Europe but it has a little colony of English raffs – men whose names Mr. Hemp the officer reads out periodically at the Sheriff’s Court – young gentlemen of very good family often, only that the latter disowns them; frequenters of billiard rooms and estaminets, patrons of foreign races and gaming tables.  They people the debtors prisons – they drink and swagger – they fight and brawl – they run away without paying—they have duels with French and German officers – they cheat Mr. Spooney at écarté– they get the money and drive off to Baden in magnificent britzkas – they try their infallible martingale and lurk about the tables with empty pockets, shabby bullies, penniless bucks…

That “infallible martingale” would be a betting system. There were dozens of variations, confided by one man to another as nothing less than a recipe for transmuting lead into gold. The term was borrowed from the strap of  a horse’s harness that connects from the nose to the girth and prevents the animal from throwing back its head. The strategy is simple: bet a dollar on a particular outcome and keep doubling until you win, at which point your losses are covered and you have made money. As described by Alex Preda, in Framing Finance: The Boundaries of Markets and Modern Capitalism, the second half of the nineteenth century became a landscape of charts and guidebooks and price-reporting device such as the ticker and the pantelegraph, a primitive chemical fax machine.

That was the background to Louis Bachelier’s successful defense of his thesis, Theory of Speculation, in March 1900. (Head of his committee at the Sorbonne was the great mathematician Henri Poincaré.) It was essentially a study of the behavior of share prices, in combination with the two sorts of forward-dated transactions often associated with them, futures and options contracts. Davis and Etheridge put his achievement this way:

… to introduce, starting from scratch, many of the concepts and ideas of what is now known as stochastic analysis, including notions generally associated with the names of other mathematicians working at considerably later dates. He defined Brownian motion – predating Einstein by five years – at the Markov property, derived from the Chapman Kolmogorov equation and established the connection between Brownian motion and the heat equation. The purpose for all this was to give a theory for the valuation of financial options.

And he almost did. Indeed, given his model of asset prices, he came up with a formula that was technically correct, the authors say – though not for the reasons given.  It didn’t matter.  Bachelier lived a long, mostly happy life, surviving service in World War I as a private in the French army, but his coup went all but unnoticed for more than 50 years.

It wasn’t until after World War II, with its advances in theories of statistical prediction, that economists became interested in stock prices – at the Cowles Commission, at the University of Chicago.  Alfred Cowles himself had been deeply interested in the topic; he was an investment adviser, after all. Among the bevy of economists, econometricians, mathematicians and statisticians gathered under Cowles aegis, there was  room for Harry Markowitz. He had completed his undergraduate degree in two years at Chicago and gone straight into economics. His topic: apply the new mathematical methods to the stock market in hopes of finding something. What he found was the basis of modern portfolio analysis – the fact that risk and return were intimately related, in ways that could be measured and mathematized.

When time came for Markowitz to defend his thesis, Milton Friedman, a member of his committee, demurred. As related in Capital Ideas, Friedman said, “Harry, I don’t see anything wrong with the math here, but I have a problem. This isn’t a dissertation in economics, and we can’t give you a PhD in economics for a dissertation that’s not economics. It’s not math, it’s not economics, it’s not even business administration.”  Former Cowles director Jacob Marshak, also on the committee, intervened, and Markowitz received his degree.  He went off to RAND.  Thereafter the finance and economics grew up under mostly separate roofs.*

* Thirty-five years later, Friedman remained unpersuaded of the connection to economics. He told news reporters that, as a finance professor, Markowitz wouldn’t appear on a list of the top 100 “most-likely” winners of a Nobel Prize.  Markowitz shared the award in 1990 with fellow finance specialists Merton Miller and William Sharpe.  On the fiftieth anniversary of the appearance of Markowitz’s “Portfolio Selection” in the Journal of Finance, Mark Rubinstein, of the University of California at Berkeley, wrote that the striking thing about Markowitz’s work was that in 1952 it had “seemed to come out of nowhere.”

.                           A Short History of Computing

Arithmetic machines were an old dream, too. The abacus, or counting frame, had been around for four thousand years.  John Napier introduced logarithms in 1614 as a means of simplifying complex calculations; Kepler dedicated his table of ephemeris to Napier. “Napier’s bones” and the slide rule followed.

Not until Charles Babbage conceived the idea of a steam-powered “calculating engine” in 1821 was the possibility broached in its modern form, and then mostly as a will-of-the-wisp. Babbage tried to build one and failed, Like Bachelier, his contribution was mostly forgotten. Maurice Wilkes, an electronic computer pioneer, wrote in 1971 that, “however brilliant and original, [Babbage] was without influence on the modern development of computing.”  His glamorous life did inspire a much-beloved counter-factual thriller, on the order of the equally fictional adventures of Sherlock Holmes, and today Babbage and his young and still-more-brilliant associate, Ada Lovelace, daughter of Lord Byron, are pillars of steampunk society.

It was the urgency of World War II that brought electronic computing into existence, a product of British and American research that took shape in Princeton and Philadelphia amid the desperate measure to design and assess the atomic bomb.  Especially influential in the design of the first machines was the polymath John von Neumann. His contribution to Theory of Games and Economic Behavior was complete by the end of 1942:  be began working on the bomb project and in 1945 he wrote a report on computer design “Von Neumann architecture” describes features of the first computers that remain characteristic of much computing  down to the present day. Commercial development of “mainframes” began soon after the war,

From the start, different ideas of how computers might work took root in the Servo-mechanism laboratory at the Massachusetts Institute of Technology.  Von Neumann machines were designed to be giant, lightning-fast calculators; the Servo Lab sought to build a “universal trainer” designed to simulate different aircraft depending on the program installed, and so invented the concept of “real-time” computing. In 1957 a onetime graduate student  in the Servo Lab named Kenneth Olson founded Digital Equipment Corp, which went on to become the second biggest computer company in the world, after IBM, confounding the conventional wisdom of the day that the new industrial state had replaced the lone pioneer.  For a good overall guide to developments, see Computing: A Concise Histoty, by Paul E. Ceruzzi.

.                                   Into the Business Schools

The Ford Foundation became the largest philanthropy in the world after the deaths of Edsel Ford, in 1943, and Henry Ford, in 1947. Seeking a mission, its directors decided that the nation’s business schools were ripe for change.  Previous Ford family philanthropy had been mostly devoted to exhibitions of the world that was lost when the motor car came into existence:  Dearborn Village and the Wayside Inn.  Now Henry Ford II looked to the future. The giant manufacturer had been influential in putting RAND Corp. into business. The Ford Foundation now hired one of its executives, H. Rowan Gaither.

There was at the time no more celebrated example of education reform than the transformation of American medical schools that followed Abraham Flexner’s 1910 report on education for medicine, advocating bringing science into the curriculum.  Gaither now borrowed from Flexner’s  playbook.  Ford would dedicate itself to bringing the recent advances in economics and behavioral sciences into management education. All this is described in The Roots, Rituals, and Rhetorics of Change: North American Businerss Schools After the Second World War.

Ford chose the Carnegie Institute of Technology in Pittsburgh as its showplace, largely because its Graduate School of Industrial Administration was newly-established and therefore especially receptive to innovation.  Founding dean Leland Bach, a University of Chicago PhD, hired imaginatively and devised a curriculum that put research at its core.  Three veterans of the Cowles Commission came aboard: Herbert Simon, William Cooper and Franco Modigliani.  The latter teamed up with his colleague Merton Miller to produce  an argument that, economically speaking, it doesn’t matter how  a firm finances itself, whether by selling stock or borrowing  Debt and equity were pretty much the same. The Modigliani-Miller theorem had profound implications for, among other things, corporate governance. The University of Chicago’s Graduate School of Business hired Miller in 1961; the MIT Department of Economics hired Modigliani the following year.

.                                       Making modern finance

These were the beginning of the The Go-Go Years, a buoyant period for markets, an even more buoyant period for academic finance. At RAND Corp, a graduate student named William Sharpe solved a portfolio problem that Harry Markowitz had given him far more simply than before.  Eugene Fama received a PhD from Chicago’s business school – now the Booth School of Business – for a thesis that concluded that stock prices were essentially unpredictable, that their behavior resembled Brownian motion.  It turned out that Paul Samuelson had been working along similar lines. The mathematics were identical to those of Bachelier fifty years before – Samuelson discovered the French scholar after a statistician sent him a post card – but now the tools were much better.  The goal had become the formula for pricing options, isolating risk, the recipe that had just eluded Bachelier. It developed into a three-way race  to solve the problem among applied  mathematician and consultant named Fischer Black, a young  MIT professor, Myron Scholes, and Samuelson himself. Samuelson narrowly lost – a tale told times since by Bernstein, MacKenzie, Szpiro, and, in greatest detail, by Black’s biographerPerry Mehrling, of Barnard College. Then Robert C. Merton,  of MIT, generalized the Black-Scholes options-pricing formula and located it firmly in the Arrow-Debreu-McKenzie tradition.

Stephen Ross, who in 1970 was one of Kenneth Arrow’s freshly-minted students at Harvard, announced when he arrived at the University of Pennsylvania’s Wharton School that he planned to work on finance, only to be told by a senior colleague that “Finance is to economics as osteopathy is to medicine.”  Decades later, Ross observed that they had given six Nobel prizes in osteopathy.

.                                           Into the Pits

The new ideas from finance were put into practice in Chicago in the ’70s. It happened there, and quickly,  for several reasons. The work had started in Chicago, at the Cowles Commission. Research had flourished in the competition between business schools: between the University of Chicago and MIT; between Chicago and its crosstown rival, Northwestern University. There were rival exchanges in Chicago, both of them dealers in commodities, thoroughly accustomed to forward trading, dominated respectively by Irish and Jews. And in the late 1960s, both were hungry for new business.

The Chicago Board of Trade, established in 1848, was the the oldest futures exchange in the world, a pillar of the city’s banking establishment.  Its frenzied trading pits had been celebrated by novelists Frank Norris and Theodore Dreiser. They were housed in what for decades had been the tallest building in the city – looking down on the financial district from the peak of its roof was a giant statue of Ceres, Roman goddess of the harvest.

Nobody much celebrated the Chicago Butter and Egg Board, located a few blocks away.  Founded in 1898, reorganized in 1919 as the Chicago Mercantile Exchange (CME), for many years it traded just two products, butter and eggs.  A scandal in onion futures in 1957 cost it a third. But the Merc had Leo Melamed, a  Polish refugee who had signed on as a runner in 1953 as a means of putting himself through law school. He became a lawyer, but he never left, borrowing $3,000 from his father to purchase a seat and become a trader.

By 1970, Melamed was chairman of the Merc.  He had moved the exchange out of its old headquarters to a new building a few blocks away. Now he was obsessed with currencies. The Bretton Woods system was slowly breaking down under competition among nations whose currencies were tied to the dollar.  Banks could trade currencies among themselves, but individuals had no access to markets. For centuries, futures trading had been confined to agricultural products and livestock.  Would such markets for financial products work?  Melamed consulted Milton Friedman, who agreed to write a paper supporting the idea.

The Merc didn’t need regulatory approval, but Melamed spent plenty of time in Washington, building support for the newly created International Monetary Market.  When he called on George Shultz, shortly to become Treasury Secretary, the former dean of Chicago’s Graduate School of Business signed off on the plan. To build consensus, Melamed invited Paul Samuelson to be keynote speaker at a gala two months before the opening of the exchange.  Samuelson turned out to be “somewhat of a downer” Melamed remembers, saying that the MIT professor, who had been named the second winner of the newest Nobel Prize eighteen months before, “didn’t give the idea of currency futures much of a chance.” Melamed complained to Friedman, who replied, “What did you expect?”

The new markets opened in May 1972, trading US Treasury bill futures, Swiss francs, British pounds, and Japanese yen, alongside pork bellies and live cattle.  Samuelson, it turned out, had meanwhile developed interests, including Commodities Corp., the quantitative hedge fund he had started with Helmut Weymer, a former student.

The older, more prosperous Board of Trade — wheat, corn, rye, barley and soybeans – had since 1969 been considering expanding its business to include options trading.  That was when Princeton economists Burton Malkiel and Richard Quandt argued in an article in the newly established magazine Institutional Investor that options’ reputation as the “black sheep” of financial instruments was undeserved, and that the informal markets that existed in New York did a poor job of meeting investors’ needs. Regulatory approval was required to trade options, however.  In 1973 the Securities and Exchange Commission finally gave its blessing.  The Chicago Board of Options Exchange opened for business.  The next year the Board of Trade hired Berkeley professor Richard  Sandor and went into the  financial futures business itself.

.                                  The Policy-makers

The New York markets were not oblivious to the commotion in Chicago; executives just didn’t think the new markets would succeed.  The New Yorkers similarly discounted the politicians in Washington.  The Justice Department in the Johnson Administration had sued the New York Stock Exchange under the Sherman Act, accusing it of anticompetitive practices.  But with Richard Nixon, Wall Street had a pro-business president – or so its investment bankers thought.

In fact the Nixon administration had a large number of free-market reformers, especially its financial team.  Attorney General John Mitchell pressed the antitrust lawsuit against the Big Board.  William Casey, appointed by Nixon to head the SEC, encouraged the Chicago futures markets. And Shultz, after he moved to Treasury from the Labor Department, was alert to the possibilities.  Once again, the group  around Friedman were the prime movers.

It happened this way. William Simon, Shultz’s  deputy, and a veteran bond trader at Salomon Brothers, commissioned Chicago Business School professor James Lorie to write a report on stock market practices. The year before, former Federal Reserve Board chairman William McChesney Martin had written a report highly favorable to the the time-honored restrictions of the stock exchange.  Lorie, in February 1974,  could hardly have been more negative: “The best regulator and protection of the public interest is competition,” he wrote.

By then the Watergate scandal was building towards it climax. Whatever  lines of appeal might have existed had been shut down.  Nixon resigned, William Simon became Treasury Secretary, President Ford refused to intervene,  and on May 1, 1975, Mayday, as it was known , the 180-year-old practice of prohibiting price competition by members and fixing the brokerage commissions they charged public investors was ended. Members would be forced to compete with one another for the privilege of channeling the savings of the public and profits of corporations into investments. They feared being attacked from all sides – banks, corporations, insurance companies, large institutional investors.

The year before, the Justice Department had brought suit against American Telephone and Telegraph, arguing that “the Bell System” that had been created under legislative oversight a hundred years before had turned out to be profoundly anticompetitive and was stifling innovation. Meanwhile, the Defense Advanced Research Projects Agency was funding all manner of computer networking technologies; a boom in minicomputers had begun; the first microprocessors were appearing.

The era of de-regulation had begun.


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