An Engine, Not a Camera: How Financial Models Shape Markets (review)

Starting in the 1950s, a group of economists created a new field of financial economics based on the notion that risk can be measured with statistical methods. MacKenzie presents an important and needed history of the development of financial economics.

The book's title refers to MacKenzie's view that the mathematical models of financial economics do not describe financial markets but enhance their performance. Consequently, his goal is to show that financial economics exhibited "performativity" by influencing financial markets. He derives the term "performativity" from sociology but also borrows ideas from economics, mathematics, and statistics. The result is a well-written history of financial economics and financial markets in the United States since the 1950s. Its overriding question is the extent to which the two histories are linked by the changes that financial economics brought to financial markets.

To address that question, MacKenzie focuses on the big theories of financial economics: Modigliani and Miller's theory of the irrelevance of dividends; Markowitz's theory of portfolio selection; Sharpe's capital-asset pricing model; Fama's efficient-markets hypothesis; and Black, Scholes, and Merton's option-pricing model.¹ These economic models all employ mathematics and statistics at a high level, but MacKenzie explains them well. His review of their development draws on written articles and on interviews with many of the practitioners of financial economics. The use of oral history gives insights into the development of financial economics not ordinarily available to historians.

The second part of the "performativity" thesis requires MacKenzie to provide a history of financial markets, for which he again relies heavily on oral history, with the assurance that he corroborates individual memories. The biggest changes that he highlights include the development of markets for derivatives—financial instruments such as options derived from an underlying security (stock shares, for one). Derivatives had a precarious existence in financial markets until the last three decades, when they began to be traded on the Chicago Board of Trade and the Chicago Mercantile Exchange. As an example of "performativity," MacKenzie cites how the option-pricing model gave legitimacy to option trading. Moreover, respectable economists were able to use their models to convince securities regulators that markets for derivatives were reasonable. The introduction of index funds also came from financial economics.

These illusions of how professionals used the models of financial economics in financial markets help MacKenzie to give a positive answer to his question of "performativity." He does not, however, overextend his claims for the validity of his answer. Just as he notes that many of the financial economists that he studied were well aware of the limitation of their models, he is aware that his answer is not conclusive. But he tells a good story that anyone interested in financial economics will find worth reading.