“The history of financial theory remains a rarely studied, and ultimately little-known, area.” (I, p. 169). Thus writes Franck Jovanovic in Volume I of this two-volume work which seeks to provide a representative selection of the range of work that has so far been done in this field, as a stimulus to budding historians who are looking for an under-researched area where they can make their mark. A number of the included articles have been previously published elsewhere, but the editors do a genuine service both in selection and in collection. Economists will almost certainly have missed the contributions by historians and sociologists, contributions that to my mind offer the most substantial stimulus for further work.

Why has the history of financial theory been such an intellectual backwater, given the obvious importance of finance for the current economic era? In his introductions to the two volumes, Geoffrey Poitras sketches the outlines of one possible explanation.

Modern financial economics—by which he means the amalgam of Modern Portfolio Theory (the Efficient Markets Hypothesis, Markowitz portfolio theory, and Sharpe-Lintner CAPM) plus contingent claims theory (Black-Scholes-Merton)—rose up as an explicit challenge to “traditional finance,” a challenge that was in one sense incredibly successful. Within a single generation, the New Finance not only forced its way onto business school faculties and curricula, formerly the territory of Traditional Finance, but also largely succeeded in pushing traditional finance out of academia. Says Poitras: “The emergence of modern financial economics in the 1950s is a textbook example of Kuhn's paradigm-transforming revolution” (II, p. 69). Such a rapid transformation had wide-ranging consequences. One consequence was a distinct lack of interest in the historical origins of the discarded set of ideas.

This was a mistake, argues Poitras, if only because it underestimated the continuing importance of the traditional ideas in actual financial practice. Indeed it could hardly be otherwise since traditional finance arose from attempts by practitioners to solve the practical financial problems posed by their business experience. As such, the history of what Alex Preda calls a vernacular science of financial markets (I, ch. 7) stretches back to antiquity, and shares roots with the history of actuarial science and mathematical statistics. Finance did not have to wait for Modigliani-Miller; in fact, it did not even wait for Adam Smith! It is a mistake not to recognize these roots as part of the history of financial economics, but it is an easy mistake to rectify and I doubt that today there would be many objections. Indeed, proponents of the New Finance have been eager to claim roots in earlier work, as for example the enthusiastic embrace of Louis Bachelier as a precursor to modern option-pricing theory, an enthusiasm ably chronicled by Dimand and Ben-El-Mechaiekh (I, ch. 10) even if shown to be excessive by Jovanovic (I, ch. 11) and Zimmerman and Hafner (I, ch. 12).

A more problematic set of intellectual roots for traditional finance involves the tradition of American institutionalist economics which was largely replaced in academia by a neoclassical economics emphasizing “mathematical rigor and empirical verification.” Hal Varian (II, ch. 5) quotes Robert Merton's description of traditional finance: “a collection of anecdotes, rules of thumb, and manipulations of accounting data.” Varian and Merton are referring here to the legacy of American institutionalism in the traditional field of finance. This is what the New Finance succeeded in replacing, and this is what Poitras thinks deserves greater attention by historians. Poitras's own chapter on the roots of modern fixed income analysis in Macaulay's work for the institutionalist NBER (II, ch. 4) proves by example what is lost by neglecting these roots, as also Witzel's chapter (II. ch. 2) on the roots of modern concern about corporate governance. We can perhaps excuse those who made the revolution in modern finance for ignoring these roots in their enthusiasm to make the field anew, but the historian should take a longer and broader perspective. There is clearly a lot more work to be done along these lines.

Volume I is primarily concerned with bringing to light contributions that trace the history of traditional finance, and with placing modern contingent claims theory within that stream. Volume II by contrast is primarily concerned with the remaining question of the history of Modern Portfolio Theory itself. Here there is a different problem. Since the challengers who brought us the New Finance presented themselves as doing nothing more than bringing standard tools of economic theory to bear on specifically financial topics, there would seem to be no pre-history of modern financial economics per se, as distinct from the history of economics itself. Such an attitude is clear in the insider points of view reproduced in the volume (II, Ch. 5–8). Similarly, Dimand (II, Ch. 3) does the best that can be done to trace the history of financial economics back to Irving Fisher and his students in the early years of the twentieth century.

But this story doesn't really work. If Modern Portfolio Theory is efficient markets plus mean-variance portfolio selection plus CAPM, then Fisher cannot be its father since he wrote in opposition to the essential idea of all three elements. Dimand himself makes clear that Fisher did not believe in efficient markets—in fact, Fisher thought he had a formula for predicting stock price movements. And as McGoun (II, ch. 12) makes clear, the problem is even worse than that. Fisher explicitly rejected the use of probability theory to analyze economic risk, a rejection that amounts to opposition to the analytical move that lies at the very center of MPT. McGoun quotes Fisher writing in 1930:

In 1930, as McGoun makes clear, Irving Fisher's position was not controversial. Frank Knight similarly distinguished between risk and uncertainty, and argued that the latter was more characteristic for economic problems (as also Keynes of course). But, over the next two decades, the accepted professional thinking about economic risk shifted to the exact opposite with a wholehearted embrace of probabilistic risk as the appropriate framework for economic problems. Arrow's 1951 survey article, “Alternative approaches to the theory of choice in risk-taking situations,” is taken to be the “end of the old era and the undisputed beginning of the new” (II, p. 207). It was thus Arrow, not Fisher, who prepared the ground for Modern Portfolio Theory. McGoun sees this analytical move as a bad thing for finance (on epistemological grounds), and Davidson (II, ch. 13) sees the same move as a bad thing for macroeconomics. But the historian is less concerned with passing judgment, and more interested in understanding exactly why the profession changed its mind from Fisher 1930 to Arrow 1951.

On that question this volume sheds little light. There is a lot of talk about a “sociological” explanation, which amounts to the suggestion that understanding of these matters was hijacked by elite high-status economists—academics bearing mathematics simply rolled over practitioners bearing hard-won wisdom—but I take such an explanation to be mainly a placeholder until we come up with a richer and more historical story. To pose the historiographical problem at its sharpest, let us suppose for the sake of argument that everyone agrees that non-probabilistic uncertainty is an ever-present and important feature of our actual experience. Let us suppose further that everyone also agrees that the economy as a whole is non-ergodic (as Davidson puts it) in the sense that the relative frequency of events experienced in the past is a poor guide to the relative frequency of events we will experience in the future. The question then is why an entire profession came to think that it might be useful to expand the theory of choice from an environment of certainty (as Fisher) to an environment of probabilistic risk (as Arrow), and even more why did that change of thinking happen in the two decades from 1930 to 1950, decades that included both the Great Depression and World War II? It cannot have been that people were simply lulled by stable times into believing in stable probabilities.

For a historian, the timing amounts to a big clue that the answer must have something to do with the enlarged role of government in making and implementing economic decisions, partly as a response to economic collapse in the 1930s and partly as a response to the exigencies of world war that followed. Decisions of all kinds had to be made, and science was pressed into service everywhere to help, including economic scientists. Irving Fisher's model of rational decision making under certainty was one place to start, but inevitably it had to be supplemented with intuitive judgment. Decision making under probabilistic risk seemed, from this point of view, simply a better, albeit also unrealistic, model that would also have to be supplemented by intuitive judgment. Why better?

The work of Judy Klein has shown how the roots of postwar models of economic decision making under conditions of probabilistic risk can be found in wartime decision algorithms for practical problems like ballistic targeting. Apparently Irving Fisher's pessimism about our ability “to express completely the laws which determine the path of a projectile when affected by random gusts of wind” proved to be excessive. We cracked the ballistics problem, and the confidence gained from cracking such a wartime problem then lapped over into peacetime economic problems (for better or for worse). The macroeconomic version of that confidence took the form of large scale econometric modeling directed toward economic stabilization (if not more thoroughgoing economic planning). The microeconomic version of that confidence took the form of Modern Portfolio Theory. In both arenas, the problem of decision making under the fog of war gave way to the problem of decision making under the fog of peace.

Clearly, such a line of explanation is no more than one possible line of historical inquiry, and it would need much more work before it could be taken seriously. I put it forward merely to suggest that a sociological story about elite neoclassical formalists driving out lower status historico-institutionalists is just too simplistic. Let us recall, for one, that John Lintner of Harvard Business School, an elite co-discoverer of CAPM, comes in fact from the institutionalist tradition and never rejected it. Second, as McKenzie shows (II, ch. 11), Fischer Black of Arthur D. Little, with no academic credentials in finance at all, developed the famous options pricing formula by using CAPM, knowing nothing at all about the supposed ancient intellectual roots of contingent claims theory.

These volumes make clear that the story of the history of financial economics is richer than the potted stories we tell graduate students about Bachelier and Fisher, valuable as those stories may be for pedagogical purposes. I suggest that the history is richer also than the sociological theory allows. The full richness remains to be revealed by future work.