TCS Daily

Elvis and Fischer Black: Analyzing Perfect Capital Markets

By Arnold Kling - July 25, 2005 12:00 AM

"Cause Elvis is a perfect being.
We are all moving in perfect peace and harmony towards Elvisness"

-- Mojo Nixon, Elvis is Everywhere


To economists, Fischer Black is like Elvis Presley. Both were legendary, and both died relatively young. Black's untimely death from cancer clearly cost him the Nobel Prize, which is never awarded posthumously. A Nobel went to Myron Scholes, whose sole claim to fame was co-authorship of an important paper with Black on option pricing. Black, for his part, produced a number of other memorable and stimulating analyses beyond the option pricing formula.


Thanks to an outstanding new intellectual biography by Perry Mehrling, I have been reminded of Fischer Black's distinctive perspective on finance and economics. I want to use that perspective as the reference point for a series of essays on how capital markets and financial innovation affect the economy. There is a widespread but uninformed belief that modern financial markets create risk and moral hazard, with government regulation the necessary antidote. The reality, as Fischer Black understood, is more nearly the opposite.


From Another Planet


Fischer Black was very committed to the analysis of perfect capital markets. In such markets, everything is an asset, every asset is tradable, and almost any risk is diversifiable. Most importantly, you are not "stuck" holding most of your portfolio in a particular form of human or financial wealth. Instead, you can hold a combination of a risk-free asset and the market portfolio, which offers higher average returns than the risk-free asset for the least possible increase in risk.


When the context is limited to liquid, tradable assets, such as common stocks, the theory of perfect capital markets implies that the most efficient way to accept more risk in exchange for higher expected return is to hold a broad market portfolio (often referred to as index fund investing), rather than to concentrate on a few stocks. If you want to reach for higher returns than a typical investor, you should put less than the average investor into short-term interest-bearing investments (such as bank deposits) and more into the market portfolio, but you should not switch from the market portfolio to a narrower group of stocks. This implication of the theory of perfect capital markets is called the Capital Asset Pricing Model (CAPM). CAPM pre-dates Fischer Black, and is due to a number of authors, including Nobel laureates Harry Markowitz and William Sharpe but also John Lintner and -- Mehrling points out -- Jack Treynor, an early mentor to Black.


Many economists, myself included, adhere to CAPM as a model of the stock market. However, Fischer Black took seriously the theory of perfect capital markets and CAPM as extended to the economy as a whole, and in going that far Black had little or no company.


When he was alive, I was among those economists who had difficulty accepting Black's view of the economy as a whole. His ideas were very provocative, and they had solid internal logic. But Black's theories sounded like they came from some other planet. An interesting planet to visit, certainly, this planet with perfect capital markets. But surely, the rest of us felt, no one would mistake Earth for the planet Fischer Black was describing. Once, in an attempt to market his ideas to the "rational expectations" school of economic thought, Black wrote a paper in which he described his theory as one in which we may assume that every participant understands how the entire economy works. My reaction to this assumption was to comment that "the fact that there are agents in the economy who fail to understand its operations is evidenced by the paper under discussion."


I still believe that it is tough to sell the idea of perfect capital markets as an approximation of the economy as it exists today. I find it more useful to think of it as an ideal to which we may be headed, by trial and error, stumbling and groping. We are always moving slowly in the direction of the ideal -- "towards Elvisness," as it were. It is in viewing financial markets as evolving very gradually toward the perfect capital markets ideal that Fischer Black's economics provides a useful perspective on issues of financial regulatory policy.


Overview of the Story


This is the first of several essays that I will use to try to provide TCS readers with a framework for thinking about financial regulation. Like Perry Mehrling, I am attempting in these essays on Perfect Capital Markets to provide some of the flavor of modern financial economics, which is a highly technical subject. This introduction is the first essay. Here is the plan for the rest.


2. To talk about financial regulation, you have to begin with a theory of why financial markets exist in the first place. In the next essay, called "Learning, Risk, and Time," I propose to describe the economy metaphorically as a restaurant or food court, with economic growth consisting of coming up with new recipes. Research and testing of new recipes takes time and involves risk. Suppliers and demanders of consumption-deferral and risk-taking must find one another, which gives rise to the need for capital markets.


3. Uninformed opinion, which we might term "folk finance," sees risk as something that is created by Wall Street out of thin air. In contrast, the economic view is that risk is inherent in the process of economic growth -- what I call the process of searching for new recipes. Modern finance begins with something called the Modigliani-Miller (MM) theorem. MM challenged the view that firms alter the risk-return profile with leverage (borrowing heavily to finance investment). Instead, MM showed that financial leverage is like a chemical reaction, in that risk and return are neither created nor destroyed. The third essay, "Slicing the Pizza," explains the MM argument, which led economists to replace "folk finance" with something more sophisticated.


4. The most important implication of modern finance is that in perfect capital markets multiple prices for risk disappear. With perfect capital markets, there is just one price of risk. In the fourth essay, "One Price for Risk," I attempt to explain the logic of the Capital Asset Pricing Model. Note, however, that of all of the ideas in economics that I consider important, CAPM is the one that I feel least able to drive home convincingly without using math.


5. The real world is filled with idiosyncratic and segmented risk premiums. Because the theory of perfect capital markets tells us that this should not happen, these risk segments are an indicator of the underdeveloped state of real-world capital markets. In the fifth essay, "Financial Innovation," I suggest that many financial innovations can be thought of as efforts to correct mis-pricing of risk, reducing the frictions caused by idiosyncratic risk premiums. That is, one way to view financial innovation is as a process that tends to gradually break down the market imperfections that make Fischer Black's planet seem so remote from our own.


6. In the final essay, "Regulatory Misconceptions," I list several common rationales for financial market regulation. In view of the financial economics of the first five essays, two of the common rationales for financial market regulation are unsound. One rationale is that regulation serves to reduce risk. However, risk is inherent in the economy, and financial innovation, not regulation, is what lowers the cost of risk-bearing. Another rationale is that financial regulation addresses moral hazard. However, privately-developed financial contracts work better than regulation at addressing moral hazard. Other rationales for regulation, such as protecting irrational or poorly-informed consumers/investors, are more difficult to dismiss. However, they fail to justify financial regulation as currently structured and performed.



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