A Primer on Money,Banking and Gold

A Primer on Money, Banking and Gold

By Peter L. Bernstein

Publisher:- John Wiley & Sons,Inc

ISBN: 978-0-470-28753-3

Reviewed By:- Sanjukta Kar

In the current world, money is the medium of exchange. It is generally aligned with the quantity of goods produced in order to avoid inflation and deflation. Along with money, gold is another vital part of our financial infrastructure and is also a measure of wealth and prosperity. Historically it has been observed that mankind has shown poor money management skills

An increase in production or a rise in prices of existing goods should be equal to purchasing power of the people. If a country enters into an inflationary phase, then people may not be able to afford the increase in prices and will reduce their standard of living thus affecting the retailers selling goods and services, who in turn will cut down orders from wholesalers and wholesalers will ask manufacturers to cut down production. Manufacturers look into their own profit margin and cuts down employment. Similarly a business trying to increase production or trying to expand must find funds for this. But these extra funds needed for the expansion may not be available to the business and thus they might look to borrow. When such borrowing occurs, the business is actually spending beyond its current means of income.

People hold money for “precautionary motive” and to n invest this idle/extra cash to earn dividends and interests. The capital market facilitates the transfer of money from someone with excess cash to someone with low cash. However if there is no assurance of getting money back lenders will be more cautious in lending money and will charge a high rate of interest.

Money comes in two forms—coins and currency. The Government prints and mints coins and notes but cannot control the amount of money in circulation in the economy and in what form we want to hold money .When money supply rises all fingers point to the banks. If the bank pays money to Mr. X then Mr. X’s bank balance will increase without withdrawing from any other depositor. Total volume of the deposits will also increase.

But bankers themselves have the difficult task of matching withdrawals to deposits and always holds a reserve (some extra cash) when net withdrawals are increasing than net deposits. The banker forms a timeframe in his mind about the time of deposits and withdrawals. His next step is to increase the cash reserve of the bank. For this he carries a “ secondary reserve” Its likely for him to buy U.S. Treasury obligations with a short maturity so that he can get the money back in a short time . If he needs cash before maturity, he will try to find a buyer for these securities and will sell at a price higher than buying price. To ascertain a constant amount of money at his disposal, the banker will allocate resources between marketable securities and loans. He also compares the cost of maintaining a portfolio of securities to the cost of running a loan and credit department as his ultimate motive is to cover the bank’s operating expenses and also retain a profit for the bank’s stockholders. A bank can buy securities to earn interest whenever it has money to do so but it cannot obligate anyone to borrow money . Contrary to this, when loan demand is high bankers will refuse to buy securities. So both instruments are attractive in its own way. Usually the bank stops borrowing money when a recession sets in and people have low credit scores. Also it doesn’t loan money to people who cannot repay it back and reduce the bank’s deposits. The loans and investments of the commercial banks follow from its deposits and for the entire banking system deposits are created by loans and investments.

Following the banking crisis of 1907 the Federal Reserve system (Fed in short)was formed by the Congress in 1913. The genius of this system lies in serving both private and public interests. The Federal Reserve System regulates the quantity of reserves in proportion to deposits of the member banks and acts as a banker’s bank as they hold the cash reserves of commercial banks as deposits. The system facilitates the transfer of money from one bank to another without any physical transfer of funds. The Fed is also the main depository of the United States Treasury. The Treasury also carries Tax and Loan Accounts with commercial banks. These account take the social security taxes. With increase in taxes and balance the Treasury issues a “call’ and the balance of the commercial banks at the Fed will reduce and the balance of the Treasury will increase, the Treasury balance of the commercial banks will go down.

The Fed has direct control on the rate of spending in the economy. The Fed can prevent a situation of money panic (where everyone is a seller and no one is a buyer) and the situation of an inflation (everyone a buyer and no sellers). If a commercial bank is short on reserves the Fed can buy its securities to maintain the bank’s cash position. No other commercial bank in the economy loses any cash and the Fed gets the money back in the form of deposits by the bank gaining reserves. It also plays vital roles in the bond market, influences prices and business activities by persuading banks to hold either less cash and more securities or by holding more cash and less securities, depending on the prevailing economic scenario.

By 1935, the Banking Act entrusted upon the Board of Governors of the Federal Reserve System to change the member bank’s reserve requirements.

By 1967, the member banks of the Federal Reserve system were required to keep 16.5% of their demand deposits as reserves. The original use of reserve requirement was to make each member bank have adequate resources but later this became a tool for controlling the supply of money. The discount policies and open market operations also influence the total reserves. However, small city banks are more likely to hold excess reserves than reserve city banks. Although the free reserves change according to different business cycles it fails to provide any correct prediction of the trend in monetary policy. Past history shows that the Fed as the savior for reserve losing commercial banks. This is done by open market purchase of securities. But where does the Fed get the reserves? Does it not suffer from “negative excess reserves” like commercial banks? The answer lies in the Federal Reserve Act of 1913 when a paper currency called the Federal Reserve Note which are irredeemable obligations came into play which is constantly used by the Fed when Fed needed money. As for example in 1967, 9 out of 10 dollars were Federal Reserve Notes. The Fed never loses reserves while paying out currency.

Till 1968, The Federal Reserve Notes could not exceed 4 times the gold certificate holdings. These certificates were backed by gold held in the Treasury vaults at Fort Knox. However the original creators of the Federal Reserve Act lacked the foresight of an expansion supply of money and shrinkage of gold reserves and the law was altered to eliminate the need for gold certificate requirements. Previously government created money by printing gold certificates when he acquired gold. Since 1933, only the government is allowed to own gold. The government can sell gold to only foreign central banks. When a foreign government buys gold, it issues a check “for the order of the U.S. government”. The Fed reduces the foreign governments balance and increases the Treasury’s balance on its book but as the U.S. has lost some gold reserves some gold certificates will be cancelled and the Fed then holds less gold certificates. As a medium of exchange gold was unable to maintain its supremacy after the financial disasters of 1930s. By 1929, the Government stopped gold convertibility. The stock of gold at Fort Knox was gradually dwindling as the foreigners demanded more and more gold much above the fixed supply of this precious metal.

From 1938 to 1945 the economy was characterized by 4 periods: the pre- World War II years, the post war years, Inflationary years from V-J day to the Korean War and thereby an era of rising interest rates, tightening money and gold outflows. The war years were characterized by an excessive outflow of currency accompanied by the increase in interest rates .The post war years saw a rise in demand for consumer goods due to excessive money supply . The years from 1945 to 1948 faced widespread inflation with consumer prices rising 33% and wholesale prices rising by 51% whereas from 1942 to 1945 wholesale prices rose only by about 7%. By 1950 with the shortage of short term securities The Federal Reserve lost their control on money supply and was called the “engine of inflation”. However, The Korean War made things better. The Fed was relieved from buying the residual Government securities which led to the formation of the Federal Reserve “Accord” of April 1951. The main motive of the “Accord” was to avoid the creation of a redundant money supply to finance the spiraling price rises of the 1950’s. From 1958 to 1960 the rise in GNP was 10 times higher than the rise in money supply. Consequently, interest rates of long term bonds rose by 50% with increasing demand for money. With the rise in commercial bank borrowings they passed strict laws to restrict loans. By 1951 the excess reserves of the commercial banks reached a peak of $1 billion which was facilitated by the Fed’s ability to buy government securities and reducing the reserve requirements of member banks.

From 1965 to 1966 there was a decline in unemployment, banks lost their free reserves due to excess borrowing and the interest rates rose to 4.5% which was the highest since 1929. From 1962 to 1965 as a result of the Vietnam War defense expenses accelerated to $10 billion. The pressure on the money markets was led by two actions of the Fed: the yield on Government bonds were above 4.25% which led to a rise in the yield and quantity of Treasury bills. Secondly, the rising cost of Vietnam War was financed by selling assets of Export Import banks and the Federal National Mortgage Association which commanded for a higher rate of interest as these were less familiar than money market instruments.

The rise in corporate borrowing led to an increase in loans by the commercial banks. The Fed followed an expansionary policy and total reserves of member banks increased by leaps and bounds from 1965 to 1966 . In April 1966, the Fed through the Open Market Committee meetings set a brake to the expanding money supply. But the expanding money supply overcame all breaks with the increasing reserves of the commercial banks from April to October. Financial tensions were reflected in the interest rates with an increase of 1% from April to October for U.S. Treasury bills and the unchanged 4.5% rate of the commercial rates from 1960 to 1965 reached a staggering height of 6% during the first seven months of 1966. Borrowing rates of long term funds in the bond market were also at its highest since 1920. As short and long term securities of the Federal National Mortgage Association and other top quality organizations provided a higher interest rate people substituted their holdings of mutual savings banks, insurance policies for these security issues. At the backdrop of these developments residential construction showed a record decline at the beginning of 1966 since the World War II. Things turned around by the spring of 1967— borrowings from the Fed declined and there was monetary inflows into savings institutions and commercial banks. This was accompanied by a decline in interest rates of short term Treasury issues and long term Government bonds.

There are three main lessons that one can learn from tight money crisis of 1966 :- (1) Tight money creates a definite demand for money which is impossible to satisfy., (2) While tight money stops access from some sectors money is still available at a higher cost from other sectors., (3) Alternative means of safe investment at higher returns can divert public attention from investing in financial intermediaries.

History says cataclysmic instances of inflation are due to a shortage of goods and the inability to produce and distribute rather than an excess supply of money. A little bit of inflation is good as the postwar country by country analysis shows inflation is accompanied by high growth rather than with no inflation. Also the preservation of the dollar as an acceptable means of currency will entail less economic costs

The Price of Prosperity

The Price of Prosperity
A Realistic Appraisal of the
Future of Our National Economy
By Peter L. Bernstein
Publisher:JOhn Wiley & Sons,Inc
ISBN:978-0-470-28757-6

Reviewed By: Sanjukta Kar

Following the inflation period of 1946-1948, the postwar years saw an increase in pent up demand and increase in employment and consumer spending. During this time labor was in short supply, but new technology led to an increase in capital good production and by 1975 production grew threefold while population rose by less than 50%. The question then arises will the demand increase at par with output. There were predictions that unemployment will reach 10% by 1970 and 20% by 1980 if demand did not rise.

In such an unemployment scenario, some like J. M. Keynes believed that government spending should be undertaken when there is a lack of demand and should be reduced with an increase in private demand. Such spending will lead to purchase of goods and services thus creating employment. However, there is difference between government spending under democratic and autocratic government as pointed out by economist James Tobin. Our main focus in the context of either public or private spending is whether our well being or prosperity is increased or not. In other words, government spending does not add any burden to the private economy if the labor and resources are increased accordingly.

An increase in taxes promotes income and employment if volume of government spending with increased taxation is greater than the cut in private spending. If the opposite holds—increase in private spending due to cut in taxes greater than government spending the consumer demand should be a very strong driving force. Reduction of Taxes DO NOT decrease in corporate prices charged. Historically, higher taxes do not reduce people’s incentives to work less. United States showed a lower tax burden and a higher growth rate during the 1950’s than West Germany, Austria, Finland, Norway, France, Luxemburg, Britain, Netherlands and Italy.

The primary arguments against increased taxation are (1) Restricts our spending choice, (2) Stifles economic incentives and (3) Destroys growth by moving resources from private to public sector. But ee will all suffer without public services like toll roads, post office, parks . If the poorer citizens are charged according to their use they will face disaster as unlike the rich, the largest share of their income is spent in buying necessary goods.

Unlike private services public services sometimes run with a loss as it benefits the society. So the proposition of the Committee for Economic Development (CED) that people can achieve a better life without government spending and taxation is utterly meaningless.

The primary argument against government spending is that it is wasteful and inflationary. So taxes should be reduced so that private spending is increased. Let us focus on inflation which is caused by an increase in prices due to excess demand over supply. The high price induced inflation is due to the actions of union monopolies and corporate positions and not due to public spending and can be checked by utilizing the excess labor and resources in the economy which will increase supply in response to demand . Consumer demand can be constrained by levying taxes to curtail the excess demand, while full employment and utilization of resources are maintained.

The opponents of government spending points out that the creation of new money to finance investment caused inflation from 1955 to 1957 and as private investment increases consumer goods supply, these are not inflationary. But this view ignores the important public expenses that have to be incurred like improving roads, labor exchanges, defense goods etc.

Opponents of public spending also point out that it cannot cure cyclical unemployment, caused by changing business cycles. However, any attempt to increase output in the operating sector will have similar effect on the economy whether it is in the public sector or private sector. When it comes to structural unemployment, caused by technological innovation that eliminates certain jobs, relocation and retraining unemployed workers is important for the overall growth in the economy. If the private sector is growing slowly, it cannot absorb this

People realized the importance of a rise in public budget after a depression to restore order in the political and economic sphere. Though J.M. Keynes acknowledged the importance of public spending in the face of decaying private spending, Keynesian economists still points out the importance of withdrawal public spending when the private sector can support itself.

As opposed to a socialist economy (government determines more than its own needs for public services, decides prices of goods and services) a free economy like U.S. gives the private sector the full freedom to make its own pricing decisions. The government still regulates the economy by the introduction of antitrust laws like the interstate Commerce Commission, the Federal Trade Commission. Government intervention is still an important tool to provide relief to the poor. Government spending improves productivity, increases demand for goods and services and provides employment and adds to our economic freedom rather than curtailing it. As the government benefits the economy as a whole there is no reason to see any loss of individual freedom.

Capital Ideas: The Improbable Origins of Modern Wall Street

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein.
Publisher: Wiley, John & Sons, Incorporated
Pub. Date: June 2005
ISBN-13: 9780471731740

Reviewed by: Fahad Almudhaf







Bernstein traces the history of modern finance and provides an interesting summary of the developments in this field. It is common among people to think about academicians as “unrealistic” persons with strange beliefs and ideas which do not work in real life. However, this book shows many examples of applications in finance that are directly related to the great and seminal articles published in “academic” journals. The book gives a clear picture of how academic ideas had influenced the financial industry with the help of information availability and the computer technology.

The author traces the evolution of important concepts such as option pricing, portfolio insurance, efficient markets, diversification and portfolio theory. He shows that the concepts developed by scholars forced the financial industry to rethink its techniques and methods. It took some time but ended up changing the way of practitioners. Developments in academic finance had a great impact on Wall Street. Academics helped investors to be aware of risk and how to deal with it and better control it. The research of academic finance introduced many beneficial financial innovations. For example, Equity mutual funds which are linked to an index are one of the outcomes of academic finance.

The predictability of stock prices:
In 1882, Charles Dow thought that stock prices were predictable. However, in 1900, Louis Bachelier challenged Dow and argued that it is impossible to predict prices in capital markets. The random walk concept was described as “the path a drunk might follow at night in the light of a lamppost”. Eugene Fama is a strong proponent f this concept and argued that security prices follow a random walk movement.

Cowles doubts that stock market forecasters can be accurate in their forecasts. He provides evidence that the average practitioner underperformed the market. However, he states that naive investors would continue to ignore the negative findings of surveys showing that the buy-and-hold strategy beats the average of mutual funds and that analysts have no added value even if they were published every five years. Cowles says “It wouldn’t matter. People are still going to subscribe to these services. They want to believe that somebody really knows”. When will investors change this habit? A stronger effort needs to be done to spread the ideas of random walk and market efficiency. Bloom (1974) casts doubt about the market advice for a fee industry. If they really know, then why would they share their knowledge and not make money themselves!

In 1913, Cowles established an index tracking the performance of the stock market. This was the beginning of what we are all familiar with nowadays as the S&P 500 index.

Paul Samuelson, a Nobel laureate, once said “The non predictability of future prices from past and present prices is the sign, not of failure of economic law, but the triumph of economic law after competition has done its best”

Portfolio Selection:
“Nothing ventured, nothing gained” and “Don’t’ put all your eggs in one basket” are two old rules of investment. However, Harry Markowitz developed a method which helps investors to maximize expected gains while minimizing risk. He shows that we should concentrate on the “covariance” and how the assets in a portfolio perform relative to one another. “The riskiness of a portfolio depends on the covariance of its holdings, not on the average riskiness of the separate investments”. Markowitz includes both risk and return in his “mean variance analysis”

The Separation Theorem:
“Interior decorators” look at investors in a distinct way with unique requirements. However, James Tobin simplified Markowitz’s methodology and came up with the “Separation Theorem” which argues that security selection is separate from the decision of portfolio allocation and rejects the interior decorator approach. According to Tobin’s theory, all investors will choose the super-efficient portfolio which dominates all other portfolios on the efficient frontier regardless of their own styles or preferences.

The single index model:
William Sharpe developed a method to overcome the difficulties in the application of Markowitz’s theories of efficient portfolios and diversification. Sharpe developed the single index model which assumes that the returns of securities are related with a basic single underlying factor which is the market itself. This model helped in saving time by simplifying calculations required especially with the help of computers.

Sharpe was able to combine practical applications with theoretical innovations and showed that academic research can be applied successfully in real life. He discovered the central building blocks of capital market theory by introducing CAPM in 1964. Sharpe’s model concludes that the stock market is Tobin’s super-efficient portfolio. Buying and holding a diversified portfolio of stocks was the optimal investment strategy set forth by Sharpe.

The demon of chance:
Confirming the previous findings of Cowles, Holbrook Working found that price changes are random and unpredictable. Working and the traders themselves couldn’t distinguish between graphs of changes in random numbers and graphs of changes in commodity prices. Maurice Kendall didn’t find any structure in the long history of price patterns. This again confirms the findings of Working. Kendall states that “The best estimate of the change in price between now and next week is that there is no change”.

This was bad news to technicians who follow trends and charts and claim to be able to forecast the future based on such technical analysis. Harry Roberts argues that patterns of technical analysis could be generated by chance. In addition, Osborne argues that the movements of stock prices are not anymore predictable than molecules movements.

On the other hand, Alexander (1961) uses filter strategies and finds that a move in the stock market once initiated tends to persist. Professional investors were happy with such results. However, this good news didn’t last so long when Alexander himself came later with another study to find that such strategies do not work anymore and confirms that forecasters couldn’t predict stock prices.

The search for high Performance Quotient:
Eugene Fama analyzed the random behavior of stock prices. He started by reviewing previous research and said that “The chartist must admit that the evidence in favor of the random walk model is both consistent and voluminous”. He argues that analysts help to narrow discrepancies between intrinsic values and actual prices. However, we have many smart people in the market and it is hard to outguess them. He saw the market as “efficient” where prices reflect all available information. “An efficient market is one in which no single investor has much chance, beyond luck, of consistently outguessing all other participants”. Fama provides empirical evidence in favor of efficient markets hypothesis.

Financial advisors continued to believe that they will do better than the market by spending time on research. However, Peter Bernstein admits that “We fooled ourselves just as much as we fooled our prospective clients” (pg. 140)

Michael Jensen derived a performance measure which adjusts the returns for the level of risk taken. After adjusting for risk, Jensen found that only 26 out of 115 mutual funds outperformed the market! This evidence supports the efficient market.
There are several market anomalies when stock prices might be predictable. Calendar effects are a form of such anomalies. For example, average returns in January were found to be higher than other months especially for small firms. Stock prices tend to go down on Mondays and up on Fridays. Short term momentum is the strongest anomaly where a stock or fund is likely to perform well in the following year if it performs well this year. However, beating the market consistently remains a challenge.

The Best at the Price:
In 1938, John Burr Williams introduced the most influential method for determining intrinsic value which is the Dividend Discount Model. “A stock is worth only what you can get out of it”. The future cash flows (dividends) paid by the company are behind the value of the stock price. William argues that we need to discount future payments to account for uncertainty.

Warren Buffett is a student of Benjamin Graham who believed in fundamentals. Investors ought to base their decisions on intrinsic value which is “the value justified by the facts, e.g. the assets, earnings, dividends, definite prospects”. Graham emphasize on accounting data and not cash flows.

Bernstein argues that “If everyone is a noise trader, the market will be chaotic … the presence of intelligent investors is a necessary condition for a market that lends itself to systematic analysis and understanding … A little inefficiency goes a long way in making the game worth playing” (pg.161)

The Bombshell Assertions:
David Durand rejected the “Entity Theory” which asserts that the value of a firm is independent of its capital structure. However, Franco Modigliani and Merton Miller show that the market value of the firm is independent of its capital structure. Yes, indeed capital structure doesn’t matter.

Modigliani and Miller (MM) significantly contribute to the theory of finance by introducing the concept of “Arbitrage” which exists in imperfect markets where identical assets in two different markets are trading for different prices. In such cases, there is a sure profit opportunities (free lunch) with no risks. Arbitrageurs bring perfection to imperfect markets. MM also came up with their dividend irrelevance proposition which states that dividends will not affect the value of the firm. James Vertin refers to the work of MM as “bombshell assertions”

Risky Business:
Jack Treynor came up with a method for predicting the risk premium and to demonstrate its importance in the behavior of capital markets and portfolio selection. His performance measure relates the returns to the volatility of the portfolio.

William Sharpe divided the total risk into “systematic” (un-diversifiable) and “unsystematic” (diversifiable) components. Investors are just compensated for the taking systematic risk which is the risk of the market. Sharpe’s models helped portfolio managers to predict risk and expected returns. The performance measure helped to evaluate portfolio performance of mutual funds.

In 1976, Stephen Ross developed the Arbitrage Pricing Theory (APT) as an extension of CAPM. It measures how stocks prices will respond to changes in the “multiple” economic factors that influence them. APT avoids the unrealistic assumptions of CAPM and assumes multiple factors instead of a single factor o influence prices.

The Universal Financial Device:
The Greek philosopher Thales is the first one to use the financial instrument known today as an “option”. It gives the owner the right but not the obligation to take an action under specified conditions agreed to in advance. This gives investors an opportunity to hedge their risks. They can control how changes in the market affect their portfolios. Car insurance and prepayment in a mortgage are examples of “options”.

In 1950’s and 1960’s, Paul Samuelson, Cootner, and Kruizenga studied Warrant pricing. Fischer Black and Myron Scholes had great contributions in bringing the theory of option pricing. Black and Scholes came with the option pricing formula that is currently used in investment and corporate finance strategies.

The Constellation:
Wells Fargo Bank is a role model in adopting theoretical concepts into practical applications. Portfolio management revolution started at Wells Fargo. Portfolios in Well Fargo were structured around company size, industry breakdowns, and beta measure. In 1969, William Fouse recommended them to launch the first index fund to replicate the S&P 500. However, they rejected his idea in the beginning. The first index fund was born in 1971 and the indexing business has grown ever since. Wells Fargo switched from active management to passive products by the end of 1970s.

Vertin, McQuown and Fouse helped the academics to participate in Wels Fargo and the financial industry and be respected. Bernstein states that “they who truly brought the gown to town” (pg.252)

The Accountant for Risk:
Barr Rosenberg was successful in educating the practitioners with the ideas of Markowitz, Tobin, and Sharpe. Rosenberg came with the notion of extra-market covariance which added a new dimension to the single-index model of Sharpe. Rosenberg started “BARRA” which is a leading company in portfolio management strategies and measuring investment risks. This company came up with a program to predict a stock’s beta using many characteristics of the company. It also came up with a program called MULMAN (multiple manager risk analysis). Bernstein claims that this program “had changed the world” and described Rosenberg as the “accountant for risk” who advanced the frontiers of portfolio management (pg.264-266)

The Ultimate invention:
Hayne Leland thought of a financial instrument which works like an insurance policy for portfolios in the market and concluded that a put option is what will work as portfolio insurance. Then come Cox, Ross and Rubinstein with their option pricing model that became popular among practitioners.

The market for stock index futures is an active and highly liquid market which helps investors to protect themselves. Some argue that portfolio insurance is a major factor in the October 1974 crash. Therefore, portfolio insurance declined as an accepted investment strategy. However, other possible reasons could be the old infrastructure and trading rules of the financial markets which didn’t match the latest technology of investing. Problems of market liquidity are also a possible cause of the 1974 crash.

The View from the Top of the Tower:
The author ends up his book with a chapter where he shows the significance of stock markets to the economy. He refutes individuals who claim that stock markets are nothing more than regulated casinos or a playground for speculators! Bernstein presented arguments which we as finance academics should be aware about especially nowadays when we start hearing more complaints about the importance of stock markets. We need to have such valid arguments to defend our case that stock markets are vital to the economy. After reading this last chapter, you will be able to support the fact that “Wall Street shapes Main Street”.

My own thoughts and opinion:
I am totally satisfied with this book and have no doubt that this book is a great read. The author conveyed his story in a lively and entertaining way. He did a great job in presenting these theories in simple English. I like the fact that the author is a well respected practitioner in the field of investments. He is also the founder of the Journal of Portfolio Management. This journal seeks to link practitioners with the academic theories of portfolio management. This book fits both industry professionals and academics interested in finance.

Bernstein provided us with an overview of the concepts of thinkers who showed the world how finance ought to be. The author did not forget the pioneers who brought these ideas from academia and implemented them into Wall Street such as Vertin, McQuown and Fouse.
The book has interesting biographical details of the stars of Finance. You will know much more personal stories and interesting facts about the names who are consistently cited in well respected “rigid” academic journals of finance. You will start to put a picture along with the name and think about them as if you met them and did not just read the outcome of their interviews through the author. This helps us to understand the time when they wrote their dissertations and articles and encourages the young researcher to start observing the field and directing research in the areas which can probably have an impact on the real life.

I like the fact that Bernstein interviewed the stars of this story and provided the reader with their research motivation and their backgrounds. However, I did not like the fact that the people whose works are described in this book actually read drafts and contributed to Bernstein’s understating of the subject. This could be a reason behind the fact that the author seems biased in his presentation in favor of the efficient market hypothesis. He presents the failure of portfolio managers and stock analysts to consistently beat the market without taking more risk as if nobody published any studies contradicting the “Efficient Market Hypothesis” coined by Fama. He almost presented the results of one group (the proponents) as if the other group had no valid arguments or even any findings which support them or cast doubt about market efficiency. I wish to read much more than one paragraph talking about market anomalies. I would prefer to rather read more of the results of Behavioral finance academicians and leave the decision to the wise reader to support which group.

It seems obvious that Bernstein throughout the book clearly tries to convert more readers to believe in market efficiency and the fact that they should stop playing the game of beating the market because this mission is impossible! They can continue to do so for fun and as addicts to gambling or daily trading. Noise trading increases the liquidity of the markets. Actually their noise could be an important factor to ensure market efficiency through fundamentalists. Some would like individuals to continue daily trading using technical analysis and following the winners. This would give more and more support to the “truth” which I believe in that the markets are indeed efficient in the long run and not necessarily in all times. No one can neglect and ignore the behavioral and psychological factors.

My final word would be to thank the academics for introducing a number of beneficial innovations to the world of finance. Keep up the great work! The readers are advised to dig through the academic journals because they will better understand the way markets work and find the “best” strategy backed up with empirical findings and not just personal opinions. After reading this book, my answer to the best strategy in stock markets is to buy-and-hold and index which is a replica of the market. Do you accept my challenge to read this book and not end up being convinced with this point? Try it and let me know!

Bernstein, Peter L. (1970). Economist on Wall Street: Notes on the Sanctity of Gold, the Value of Money, the Security of Investments, and Other Delusions. New York: Macmillan.

Review by Hum Nath Panta

Understanding different aspects of market, economy and investment is very crucial to investors, practitioner, fund managers, portfolio managers, academicians and investment analysts. The book entitled “Economists on Wall Street” by Peter L. Bernstein is an excellent resource to all who have interest on investment, financial market and economy. The “Economist on Wall Street” is an excellent collection of articles of Peter Bernstein from 1955 to 1970. It includes author’s interesting observations on very important and relevant issues including priorities, stock market, inflation and its control, gold, the intricacies of monetary policy, the future of dollar, the dilemmas of household finances, developments in portfolio management, influence of institutional investors, rules of optimal mixes, and philosophy and fantasy.

Peter Bernstein is an author of many famous books in economics and finance. He has published countless articles in many professional journals. He worked as a professor and portfolio manager. He has published many best selling books including A Primer on Money, Banking, and Gold, and The Price of Prosperity including Economists on Wall Street. “Economist on Wall Street” is one of his best books. His role as an author of books on issues related to money and investment is very appealing to me due to his profound experience and knowledge on this field. He has the unique ability to synthesize various issues related to economic history and investment. “Economist on Wall Street” is an excellent example of the author’s ability to analyze and synthesize money and investment related issues precisely. Moreover, the inclusion of forwards by financial luminaries and new introduction provides fascinating picture of author’s best time in the Wall Street.

The author provides in-depth analysis of various aspects of stock market. In other words, he presents a detail insight about different topics related to investment especially on stock market. There are seven chapters and most of the chapters include several articles on related topics. The author starts from a simple introduction to priorities. In this book, the author extensively elaborates his experience on stock market and investment related issues. The second chapter includes several articles which give a detail insight about the stock market. Other important issues such as inflation and economy are discussed in detail in chapter three. Moreover, the author discusses about gold and balance of payments in chapter four, the economist as portfolio manager in chapter six and philosophy and fantasy in chapter seven. Thus, the author starts from very basic introduction to priorities and then extends his ideas on complex issues such as philosophy and fantasy. Although the author has organized his thought process in seven different chapters, the central issues discussed in each chapter is stock market and security pricing. The author presents his views precisely in each chapter concentrating around the stock market which is the central them of this book.

Among the chapters presented in this book, chapter two and three strike on the central them of the book. Chapter two presents author’s view points about stock market. It contains several essays which are relevant to understand stock market. For example, Fulbright hearings on the stock market provide very precise analysis of how a sense of perspective on the present can sharpen our ability to foresee about the future. According to the author, Fulbright hearings conclude the need for public education to protect the public against emotional and uninformed action in stock market. This is very relevant idea even today especially when we are facing a greatest financial crisis after the great depression of 1929. Moreover, this essay provides perspective through analysis of the nature of speculative excess and describes the disastrous consequences that can follow from it. The author also provides an extensive analysis on how stock price could fall 75 percent to 80 percent from their present lofty level and could extend over period of horizontal movement. Furthermore, the author shades light on important issues and concludes that current market trends are part of a dangerous speculative bubble or rather a sign of an important change. All these issues discussed in this book are very relevant these days. Thus, the author has put very accurate perspective on several issues related stock market.

With regard to institutional investors, the author believes that they run risk of becoming the victims of their own emphasis on short term performance and are indeed becoming to substitute speculative for investment. So their action can lead all investors across the threshold of danger. The influence of growing institutional share ownership may cause wider rather than narrower price changes in future. This book also provides an extensive analysis of bear market, its properties, importance of volume, introduction to growth and value stocks while explaining the feel of the market. Indeed, the author’s analysis on bear market is very informative and persuasive.

Although the author has covered a wide range of issues in this book, the central idea is about stock market and investing. The ideas presented in this book are vary relevant and practical. Through understanding of this book may help investors and portfolio managers to achieve their investment objectives. The author covers issues an investor or portfolio manager should know adequately. The most interesting chapter in this book is “The Feel of the Market”. This is the heart of this book. It provides very valuable information an investor or fund manager needs to know in the stock market. Through understanding of this chapter helps understanding stock market. For example, understanding of price movement in long run, institutional investing and institutional speculator, the anatomy of the bear market, volume, gold crisis and security market, and growth versus growth companies are core areas and investor or a fund manager must know.

The author precisely conveys his ideas. I want to include some extracts from the book which give an idea on how the author presents convincing points he wants to convey. In page 28, second paragraph he writes, “The old buy and hold investments philosophy no longer works and was in fact buried in the avalanche of 1962”. In page 29, second paragraph, he writes, “In our technology oriented economy portfolio management now requires more than college economies and a careful reading of the wall street journal. Furthermore, on the frontier of growth, change is rapid. The security analysts must be alert informed and willing to abandon old favorites for new ones”. In the last paragraph of page 181, he writes, “In investing the greatest disasters are really limited only to those investors who are forced to liquidate at moments dictated by external events”. These extracts give an idea how simplistically the author presents convincing points.

In conclusion, the issues presented in this book are descriptive and in chronological fashion. The author supports his arguments by example. This is the great part of author’s writing style. The author presents his case in very simple language and the ideas and evidences presented in this book are convincing and persuading. Therefore, I highly recommend that anybody interested in stock market and investing should read this book.

The Structure of Scientific Revolutions

Author: Thomas S. Kuhn
The University of Chicago Press, 1996, Third Edition
ISBN: 0-226-45808-3

Review by: Julio A. Rivas Aguilar

The purpose of this book is to give the reader a perspective of development of science. Science is evolving, and there have been scientific revolutions that have shaped the body of knowledge that mankind has nowadays. However, in order to reach this step, there has been a process of learning, understanding, proving, and accepting. Kuhn explains this process in several different stages.

First of all, the book explains the importance of paradigms. Paradigms are achievements that have produced firm discoveries, and have two main characteristics: they are sufficiently unprecedented, that means they observe new issues that haven’t been addressed before, and sufficiently open ended, giving practitioners material to work on new research. All sciences base their research in great paradigms, and if for some reason there’s no paradigm, all facts might seem relevant. In finance, this paradigm could be considered as the Capital Asset Pricing Model, since it’s the broadest theoretical framework that has inspired financial research during the last 40 years.

Paradigms will gain importance if they’re able to solve problems that the previous ideas were not able to address. Due to the fact that paradigms are open ended, there’s a big opportunity for scientist to do research in great depth. The paradigm only gives the general guidelines, and scientist will use those guidelines as paths for their future research. This research is called normal science. The process of normal science includes dealing with significant facts, matching those facts with the existing theory, and then articulate new theory.

Normal science per se is not characterized by being innovative. It is rather visualized as the one that solves the different puzzles in the paradigm. If for some reason normal science fails to prove a finding, these failures are used as a way to strengthen the fundamental paradigm. Sciences are puzzles, and normal science is the one in charge of finding the puzzle pieces and putting them together. However, this fate is not simple: there could be several potential solutions to different problems. The issue will then be on how to identify which alternative is the most suitable.

Paradigms have priorities by themselves. It could be considered that searching and finding a new paradigm is rather easy, compared with developing the rules that will guide this new paradigm. And, besides that, finding the rules of the paradigm is less appealing that the paradigm itself. However, rules are important and necessary, since they help to model achievements, and therefore increase the number of discoveries and strengthen the position of that particular paradigm.

However, paradigms are not permanent, and there are anomalies and new discoveries throughout the development of science. Discoveries are considered novelties of fact, and inventions novelties of theory. It is sometimes difficult to know when a discovery was made, since scientist could have made a discovery without even being aware of it. However, in order to consider an event as a discovery, it should have three characteristics. First, there should be a previous awareness of the existence of an anomaly. Then, there should be a simultaneous conceptual and observational recognition of this new fact. Finally, there will be a change of the categories and procedures inside a paradigm. This process is not smooth: it will encounter resistance from some practitioners.

On the other hand, when there are new discoveries, this could lead to a change in a paradigm itself. A new discovery by definition will discard some previous beliefs, and it will eventually lead to a modification of the original paradigm. Nevertheless, this new discovery should be strong enough, and should have very strong fundaments, in order to produce changes in theory. This is a consequence of a state of crisis, and this crisis must give any science a chance for retooling.

Whenever a crisis is present on any science, practitioners will find it difficult to renounce to their original paradigm. In order to do so, a paradigm should be compared with nature and with the old paradigm, and the new one should prevail. Discrepancies will arise due to these changes, and scientists will work to close the gap. These changes of paradigms involve a reconstruction that changes the basis of a science; it’s a complete change. However, it is important to note that new paradigms emerge before having a crisis; that is, whenever there’s crisis, the new paradigm was already created and strengthened.

Having this background, it is now relevant to talk about scientific revolutions. These will appear with non cumulative developmental episodes that will have as a consequence a replacement of an older paradigm with a new one. It is called revolution because it leads a new way to find things, and it implies a change in the previous incompatible modes of community life. New theories are generated, tested, and finally accepted. These revolutions will be a consequence of research performed by competing schools: the one that supports the new paradigm against the one that holds the older one.

Revolutions also imply a change of world view. Whenever a new paradigm emerges, scientist will need to have new instruments, look and observe different places, and therefore have a new perspective of the world. The methods of observation will change as well, since there will be a new paradigm. New phenomena will be analyzed under a new framework provided by the paradigm. Since the world is changing, and there is much information that hasn’t been analyzed, and this change in paradigm could imply the usage of that information.

Revolutions are also invisible. At the beginning, these revolutions only seem as an addition to previous scientific knowledge. However, these additions will often generate new knowledge, and it will have as a consequence a development in straight line that will eventually generate a revolution without being noticed. During this period, new theories emerge with facts and strengthen findings for the new paradigm, hence intensifying the revolution.

In order to resolve in favor of a new revolution, there should be a new set of practitioners in the area of study. Young people usually have new ideas and question older paradigms, hence motivating the search for newer alternatives. These scientists will then compare their new alternative against the previous one, and see which one prevails. The new paradigm has an advantage over the old paradigm: it will address problems that they were not previously considered. Hence, this important feature will resolve preferences in favor of the new paradigm.

Finally, it is important to know that the consequence of revolutions is progress. Science is dynamic, is transforming itself. By adding new practitioners, there will always be new problems to find, and new paradigms to propose. Therefore, science is always evolving, and this has a consequence of progress in any area of study. This is a cycle that repeats itself indefinitely, since there will always be new questions to solve, and new information to find.

It is important to note that both finance and real estate are sciences, and they have their own paradigms. It is then the duty of younger researchers to do normal science, and find new ideas to propose new paradigms. Behavioral finance, for instance, has emerged as a competing paradigm against efficient markets. There are still some other questions that haven’t been solved with any of those two paradigms. Therefore, observing, analyzing, experimenting, and proposing should be the route to follow in our new academic career.

Source for picture: http://upload.wikimedia.org/wikipedia/en/thumb/7/7d/Structure-of-scientific-revolutions-3rd-ed-pb.jpg/200px-Structure-of-scientific-revolutions-3rd-ed-pb.jpg

Against the Gods: The Remarkable Story of Risk

Against the Gods: The Remarkable Story of Risk
Peter L. Bernstein
John Wiley and Sons, New York, 1996
ISBN: 978-0-471-29563-9

Reviewed by Ramya Rajajagadeesan Aroul

Peter L Bernstein’s Against the Gods brilliantly presents centuries of mankind’s encounters with risk and uncertainty. This book enlightens the readers with the tale of thinkers and scholars whose astounding vision revealed how to put the future at the service of the present. The author in his pursuit for the understanding of the evolution of risk travels across various time periods and different continents and civilizations. It is definitely worth mentioning that this book is a comprehensive coverage of the history of risk. Another attraction of the book is the obvious passion with which Bernstein describes the many interesting people and alluring mysteries so peculiar to the mathematics of chance.

Bernstein concentrates on the history of numbers with fascinating insight. Bernstein walks that course through the laws of probability, decision theory, sampling, and utility theory and makes the entire exercise as enjoyable as a stroll in the woods. That stroll ends in the world of the stock market, forecasting, derivatives and chaos. The author’s approach is mostly historical and biographical. The five sections of the book cover the periods before 1200, 1200–1700, 1700–1900, 1900–1960, and 1960 to the present. The chapters in each part contain a series of one or more important contributors to the subject. The author not only provides an insightful history of the “science” of finance but also includes enthralling stories of people who drove the advance of modern finance. Many well-known names emerge—Cardano, Pascal, Fermat, Graunt, the Bernoullis, De Moivre, Bayes, Laplace, Galton, Keynes, and von Neumann.

Peter L Bernstein brings an extraordinary and novel perspective to his historical survey of the development of the mathematics of probability and uncertainty. In his journey of telling the tale of risk, the author also touches upon the persistent tension and unresolved controversy between the quantitative and subjective schools of thought. This aspect that the author deals with is of significant importance to researchers in understanding how much of the future can be predicted from the past patterns using mathematical modeling.

It comes to our surprise that the ancient Greek had little to do with the conception and advancement of the theory of risk. The author clearly provides nuances of the Greek era, their contributions and the reasons why they did not advance to the concept of risk. Modern thinking began when man discarded the idea that events are due to the whim of the gods and accepted the view that we are independent agents who can manage risks. In the case of ancient Greeks, they believed in the former view and to add to that they had an alphabet based numeric system that curtailed them from enabling more complicated calculations both of these did not let them venture into this area of risk management. Moreover, Greeks had little interest in experimentation; theory and proof are all that mattered to them. The modern conception of risk is rooted in the Hindu Arabic numeric system that reached the western world few hundred years ago. But the actual study of risk began during Renaissance as this was the time of vigorous approach to science and the future.

The 1654 correspondence between Blaise Pascal, a dissolute who became a religious advocate, and Pierre de Fermat, a lawyer whose genius was in mathematics signaled a very important event in the history of mathematics and the theory of probability. They constructed a systematic method for analyzing future outcomes. This definitely embarked the beginning of the theory of decision making. Decision theory is the theory of deciding what to do when the outcomes are uncertain and making that decision is the first step in the efforts of managing risk.

Foundations of modern decision theory were laid with the works of Daniel Bernoulli, a Swiss mathematician whose father and uncles were confirmed eighteenth-century geniuses. Bernoulli not only applied measurement to risk that cannot be counted for the first time in history but also defined the concept of utility intuitively. It was Bernoulli who identified every human being is different and has different risk aptitude which is one of the most pioneering breakthroughs in the theory of risk. Jacob Bernoulli, Daniel Bernoulli’s uncle was the first person to consider the relationship between probability and the quality of information through his Law of Large Numbers. He also draws the crucial difference between the reality and abstraction in applying the laws of probability.

DeMoivre came up with the new perspective of considering risk as a chance of loss and his greatest contribution of the introduction of normal distribution, mean and standard deviation to the field of risk management and statistics. Thomas Bayes extended Jacob Bernoulli’s Law of large Numbers further to come u with the concept of conditional probability. Thus Jacob Bernoulli, Abraham de Moivre, and Thomas Bayes showed how to infer previously unknown probabilities or uncertainties from the empirical facts of reality. Despite his lack of interest in risk management, Gauss’s achievements especially the Bell curve are at the heart of modern techniques of risk control. Galton’s innovation of analysis that led to the concept of correlation ultimately paved way for the emergence of today’s complex instruments for the measurement and control of risk in both business and finance.

Bernstein's last few chapters focus on the modern era of risk management including a complete review of the most important philosophers of the field. It makes immense meaning when the author while defining risk management states that “The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome”. Bernstein touches upon Chaos theory which is a more recent development based on the premise that much of what looks like chaos is actually a product of an underlying order. I would have preferred a more in depth analysis about chaos theory considering the importance of this theory especially after the advent of electronic computer.

It is in these few chapters that Bernstein focuses primarily on the stock markets. Bernstein interestingly notes that though Markowitz’s methodology in his famous 1952 Journal of Finance article on Portfolio Selection is a synthesis of ideas of Pascal, de Moivre, Bayes, Laplace, Gauss, Galton, Daniel Bernoulli, Jevons and von Newmann, he had failed to credit his intellectual forebears. It is rather probing to note that Markowitz himself had stated that he knew the ideas but not the authors. But what we as young researchers should take from Markowitz is the fact that he neatly draws on earlier theories like probability theory, sampling , bell curve, dispersion around the mean, regression to the mean and on utility theory to come up with a novel theory, the theory of portfolio selection. This is one such paradigm change that Thomas Kuhn talks about in his “The Structure of Scientific Revolutions”.

Bernstein familiarizes us with the many novel ways of inferring and measuring risk, and with the emerging field of behavioral finance, which recognizes and attempts to explain anomalies in finance, examples in which rational explanations fail. In this part Bernstein inclines himself to the fact that the assumption of rational behavior is a useful starting point, but it describes the real world only up to a point. "As civilization has pushed forward, nature's vagaries have mattered less and the decisions of people have mattered more," concludes Bernstein. The most attention-grabbing part of this discussion is Bernstein's presentation of the path-breaking work of Daniel Kahneman and the late Amos Tversky; they were experimental psychologists whose scholarly work, called "prospect theory," is often used by students of behavioral finance to explain a variety of financial irregularities.

With his appealing literary style, Bernstein explains the concepts of probability, sampling, regression to the mean, game theory, and rational versus irrational decision making. The final sections of the book hoist vital questions about the role of the computer, the relationship between facts and subjective beliefs, the impact of chaos theory, the role of the burgeoning markets for derivatives, and the looming dominance of numbers. The fact that the author clearly captures the various stages of the scientific revolution that was staged in the pursuit of risk management and control techniques is indeed the primary reason for me to state that this is one of finest books of this century. I could witness the paradigm shifts in the process of the evolution of various theories over the centuries. I could understand the art of theory building by just travelling with the author’s biographical nuances. Above all, as a young scholar I realize that I have to stand on the shoulders of other researchers to create new scholarly work and contribute to both the world of academicians and practitioners.

If I got to say about the book in one line, I would say that, Against the Gods: The Remarkable Story of Risk is an extraordinary book that turns the most scholarly and philosophical issues of our time into pure reading pleasure.