Capital Ideas. Bernstein Peter L.

becoming computerized. Even Latin America and Spain rely on computers to carry out trades, check customer credits, and post the transaction results for records and statements.2 In an article titled “The Wild, Wired World of Electronic Exchanges,” Institutional Investor magazine for September 1989 paints the scene: “Say good-bye to the heady roar of the exchange floor. Forget the terse shouting of two traders on the phone. The new sound of finance is the machine-gun clatter of fingers on a keyboard. And it can already be heard on thousands of trading desks in dozens of markets around the world.”3

      Financial markets are among the most dazzling creations of the modern world. Popular histories of financial markets from the City of London to Wall Street tell the story of panics, robber barons, crooks, and rags-to-riches tycoons. But such colorful tales give little hint of the seriousness of the business that goes on in those markets. John Maynard Keynes once remarked that the stock market is little more than a beauty contest and a curse to capitalism. And yet no nation that has abandoned socialism for capitalism considers the job complete until it has a functioning financial market.

      Simply put, Wall Street shapes Main Street. It transforms factories, department stores, banking assets, film producers, machinery, soft-drink bottlers, and power lines into something that can be easily convertible into money and into vehicles for diversifying risks. It converts such entities into assets that you can trade with anonymous buyers or sellers. It makes hard assets liquid, and it puts a price on those assets that promises that they will be put to their most productive uses.

      Wall Street also changes the character of the assets themselves. It has never been a place where people merely exchange money for stocks, bonds, and mortgages. Wall Street is a focal point where individuals, businesses, and even entire economies anticipate the future. The daily movements of security prices reveal how confident people are in their expectations, what time horizons they envisage, and what hopes and fears they are communicating to one another.

      The ancients left prediction to the Sphinx, to the Delphic oracle, or to those who could read the entrails of animals. Ecclesi-astes tells us that “there is no remembrance of things past, neither shall there be remembrance of things to come.” Dante reserved a seat in hell for anyone “whose glance too far before him ranged,” and twisted their heads back-to-front.4

      Today anticipating the future is a necessity, not an arcane game. Yet how do we make decisions when our crystal ball turns cloudy? How much risk can we afford to take? How can we tell how big the risk actually is? How long can we afford to wait to discover whether our bets are going to pay off?

      The innovations triggered by the revolution in finance and investing provide answers to such questions. They help investors deal with uncertainty. They provide benchmarks for determining whether expectations are realistic or fanciful and whether risks make sense or are foolish. They establish norms for determining how well a market is accommodating the needs of its participants. They have reformulated such familiar concepts as risk, return, diversification, insurance, and debt. Moreover, they have quantified those concepts and have suggested new ways of employing them and combining them for optimal results. Finally, they have added a measure of science to the art of corporate finance.

      Many of these innovations lay hidden in academic journals for years, unnoticed by Wall Street until the financial turbulence of the early 1970s forced practitioners to accept the harsh truth that investment is a risky business. This was the key insight that the academics brought to Wall Street. Waiting for one’s ship to come in is inevitably uncomfortable and uncertain, they declared, but there is no way to avoid the discomfort or to foretell just what the future holds in store.

      Wall Street responded to this urgent message by expanding the variety of mutual funds, by showing heightened interest in international investing, and by devising new instruments of corporate finance. Moreover, it discovered new sources of return in such risk-controlling techniques as options, futures, swaps, portfolio insurance, and other exotic measures.

      Some of these innovations produced unforeseen and undesirable outcomes. Financial markets, like many other creations of the human imagination, mix dangerous tendencies with wholesome impulses.

      Most economic crises, in one way or another, have originated from abuses in the financial system, which may explain why orthodox economists have traditionally shunned their brethren in the finance departments. Stocks and bonds, for example, by their very nature, invite speculation and even corruption. No one buys them with the lofty purpose of making the allocation of the nation’s capital more efficient. People buy them only in the hope of catching a ride on the road to riches.

      Because stocks and bonds are liquid, decisions to buy or sell them can be easily reversed. They change hands anonymously as their prices march across the computer screen. Because they move in response to information of all types, the player who gets the information first has an enormous advantage.

      They fluctuate in sympathy with one another, so that trouble in one place often spreads across the markets: chaos theory reminds us that the flutter of a butterfly’s wings in Mexico can turn out to be the cause of a tidal wave in Hawaii. Most important, the prices of stocks and bonds reflect people’s hopes and fears about the future, which means they can easily wander away from the realities of the present.

      There is no way to purge financial markets of these attributes. Efforts to do so – and regulation has come in many different forms – impair the efficiency with which financial assets perform the broad social function of serving as a store of value. Liquidity, low transaction costs, and the freedom of investors to act on information are essential to that function.

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      If individual investors had dominated the financial markets during the 1970s and 1980s, the revolution we have been describing would in all likelihood never have taken place; the ingenious journal articles would have stimulated more ingenious journal articles, but little change would have occurred on Wall Street. In any case, tax constraints and high transaction costs would have prevented individual investors from transforming their portfolios to accord with the new theories. Most individual investors work at the job only part-time and cannot undertake the long study and constant attention required by the application of innovative techniques.

      Instead, the revolution was augmented by the rise of institutional investors such as pension funds, which were able to change as their size and investment goals changed. In the 1950s, financial institutions were far from performance-oriented. When I first came into the investment management business in 1951, buy-and-hold was the rule and turnover in institutional portfolios was slow. One reason for this complacency was rationalized laziness in an environment in which competition played a negligible role. But in another sense it was perfectly logical. In the 1950s most stocks were owned by taxable individuals who had bought them during the 1930s and 1940s at far lower prices. I remember how impressed I was by the profits in the portfolios managed by my father’s investment counseling firm when I arrived on the scene in 1951. It made no sense to sell good companies and give Uncle Sam a disproportionate share of the winnings.

      It was about this time that everything began to change. The early 1950s were a period of great prosperity across all income groups. Yearly savings by individuals nearly tripled between 1949 and 1957. As the depression-haunted generation faded away, common stocks once again became an acceptable asset, even for trust accounts; New York State led the way by discarding a longstanding statute that had limited stock ownership to 35 percent of the total of personal trust capital.

      A great wave of new investors, with no share in the huge capital gains generated by the older portfolios, now acquired the habit of calling their brokers. Share-ownership doubled during the decade. By 1959, one in every eight adults owned stock, 75 percent of them with household incomes under $10,000 (the equivalent of about $40,000 in 1990 purchasing power). Individual savings flowed into the mutual funds even more rapidly than into the direct purchase of common stocks; mutual fund assets doubled between 1955 and 1960 and then doubled again over the next five years.

      Corporate pension funds developed from a novelty to an institution and became the primary clients of the investment management profession. Their assets increased more than tenfold during the 1950s, giving

2

Institutions yield sluggishly to technology. The Hong Kong exchange has a new trading floor filled with rows of people sitting at computing desks. With everything being done by the computer, a “trading floor” is no longer needed. But there always has been a trading floor, so there still is.

3

Hansell (1989).

4

I am grateful to McCloskey (1992) for the quotation from Dante.