The Gurus

Five eminent economists gaze into the future.
S.L. MintzJanuary 1, 2000

Unless Y2K turned out to be a much bigger catastrophe than most experts predicted, this issue of CFO reaches readers with 1,200 months to go until year-end 2099. No one can say for sure, of course, what the heirs of today’s finance professionals will face by the next fin de siècle. But the future of the capital markets in the new decade certainly is fair game for informed speculation. And who better to weigh in than the intellectual pioneers who helped shape finance and investment in the 20th century? CFO invited thoughts from a select few, asking what senior finance executives face in the next 10 years. Responding were four Nobel laureates–Paul Samuelson, Harry Markowitz, William Sharpe, and Robert Merton–and the country’s preeminent economic historian, John Kenneth Galbraith. Happily, these great minds do not think exactly alike. Except for some tweaking from Galbraith, though, they generally express optimism about the finance world ahead.

Paul A. Samuelson

Besides fostering the development of static and dynamic economic theory, Paul Samuelson secured a place for rigorous analysis in the field of economics. For these far-reaching achievements, in 1970 Samuelson became the first American to receive the Nobel Prize in Economic Science. Now 84 years old, he is the Institute Professor Emeritus at Massachusetts Institute of Technology.

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FATE SOMETIMES CONTRIVES A SILVER LINING in the dark clouds. U.S. productivity fell in the early 1930s, and by 1940 was back only to our 1929 previous peak. That meant a whole lost decade. But as John Maynard Keynes predicted when he came to wartime Washington, D.C., there had accumulated during the depressed decade new but unused knowledge. It was proved that Keynes was near the mark when, by 1945, U.S. productivity had reached to as much above 1930 as 1930 had been above 1915.

I suspect a similar surprise may be in store soon for Euroland and Asia. If their slump is indeed behind them, then by 2005 they may find themselves at a level of living and a pace of progress that the pre-1990 trend statistics would have predicted to take place, in the absence of (1) the land bubble and the stock bubble that affected Japan so mortally, and (2) the post-1997 Asian flu.

There is no magic or miracle in this sanguine hypothesis. It rests only on good sense.

  • Persistent stagnation has been putting effective pressure on corporations everywhere to break out of the careless habits formed during the easy bubble years. Inefficient practices must be modified under the ruthless, competitive forces of the modern global economy.
  • A store of new technologies is constantly accumulating. When given a chance by a return of macro prosperity, that store will increasingly be drawn on.
  • Knowledge is spreading everywhere. People in still-underdeveloped regions have become clever importers of new knowledge wherever its origin.

The worldwide golden age I am envisioning for most societies depends on how well the macro global economy holds up in the next five years. Here, too, the objective signs look favorable.

None of what I am writing is guaranteed to happen. Economics is not a predictable science like the astronomical motions of the several planets. International recovery efforts could falter. A Wall Street collapse could ignite a turn-of-the-century global panic. The European Monetary Union could explode or implode.

The art of judgment in political economy is not to deal primarily with possibilities. Worst-case scenarios can always frighten. Probabilities and plausibilities are what prove useful in the long run.

Harry Markowitz

Harry Markowitz realized around 1950 that notions of expected return on stock constituted only a portion of the information investors require in an uncertain world. The need to account also for risk–the beta factor- -gave rise to his doctoral dissertation, the first building block in what is called modern portfolio theory. For demonstrating the link between diversification and investment risk reduction, Markowitz, who is now 72 and professor emeritus at City University of New York, shared the Nobel Prize in 1990.

I VIEW THE CURRENT STATE of portfolio theory with a sense of accomplishment and humility. On the one hand, thanks to the contributions of many, we have a much better understanding now of the sources of risk for a portfolio of assets and liabilities. On the other hand, there is no demonstrably correct way of estimating the inputs required for a risk- return or value-at-risk analysis. In particular, those responsible for financial risk control should periodically ask themselves whether there is some source of systematic risk that they are overlooking, and how this risk should enter their analyses and actions.

As to the future, the world is getting faster and no less risky. The need for risk analysis and control will not diminish. Certainly E- commerce is here to stay, and it will revolutionize many important aspects of our lives. But it will still be true, as before, that entrepreneurs will try to make money. Some will win, some will lose; it is just part of the free enterprise system.

Risk has been the same since the caveman. Modern portfolio theory has developed apparatus for risk evaluation and control. This apparatus, subject to further enhancement, will carry forward into the risk world of the future.

William Sharpe

Blame Stanford University Professor Emeritus Bill Sharpe for putting investment professionals on notice that portfolio risks can be measured and managed. The Nobel committee took note, and awarded Sharpe the prize in 1990, alongside Harry Markowitz and Merton Miller. Much as some critics currently question the relevance of Sharpe’s capital asset pricing model (CAPM), its underlying merits are as valid as ever, says Sharpe. Now 65, he keeps busy these days as a guiding force behind, an Internet- based service for managing and evaluating investment performance.

THERE ARE TWO KEY MESSAGES in CAPM, if you get down to the bedrock. One is that a broadly diversified marketlike portfolio is a very good thing to think about. That gave rise to the notion of the index fund. That is an important message, as strange and heretical as it seemed when we first started.

The other message is that to get a higher expected return, you have got to accept a higher beta value. There is also a broader version. What kind of risk do you expect to get rewarded for in the long term? Answer: the risk of doing badly in bad times. If there is a reward for bearing risk, it almost has to be that. Otherwise, the world makes no sense at all. The premium for bearing risk is related to the risk that just when you need it, you are going to be poor. If that kind of risk is not rewarded, then there is no reason to believe that there is a risk premium for stocks as opposed to putting your money in the bank. In the CAPM world, beta is the measure of how badly you do in bad times–high beta securities or portfolios are going to really tank if the market goes down.

Will a new theory come along eventually and blow out the lights? Undoubtedly there will be one. I haven’t the foggiest idea about what it will be or what area it will be in. If I did, I would be working on it.

Robert Merton

For his role in developing the means to determine option values, the celebrated Black- Scholes options pricing model, Harvard Business School’s Robert Merton shared a Nobel prize in 1997 with Myron Scholes. (Fischer Black died in 1995, at age 57). Although his name does not adorn the model, Merton, now 55 and Harvard’s John and Natty McArthur University Professor, was the First to recognize a practical structure for a theoretical solution.

IN A FUTURISTIC KEYNOTE SPEECH last spring, Enron Corp. president and chief operating officer Jeff Skilling explicitly made the case that his and his managers’ thinking across all facets of Enron’s operations is built around the integration of modern financial technologies and physical technologies. This integration strategy, made possible by the financial innovation and vast reductions in transaction costs of the last decade, is already causing fundamental changes in the industrial organization of the power and energy industries. Its application is likely to spread to other industries, with similar effects.

Thus, learning how financial-asset concepts can be applied to production decisions as with real-options analysis, and understanding financial contracting so that integrative strategies can be executed effectively, may become essential managerial skills for competitive success.

In this new financial environment, the “real” and “financial” parts of a firm’s activities become inexorably intertwined, as financial contracts sometimes substitute for, and at other times complement, physical production and distribution. This puts the CFO in the center of integrating decisions on capital structure, risk management, and strategic operations. That’s the way all CFOs must think if they want to succeed in the new millennium.

John Kenneth Galbraith

From his post as Paul M. Warburg Professor Emeritus of Economics at Harvard, the 91-year- old Professor Galbraith offers a bracing tonic for Finance executives who serve as fiduciaries to massive corporate pension funds and 401(k) plans. Seen from the ivory tower– Professor Galbraith’s, anyway–the recent boom owes more to serendipity than to investment wisdom. An economics adviser to President John F. Kennedy and the author of many acclaimed books on economic themes, Professor Galbraith rebukes Finance professionals enamored of their recent track records. By his lights, they seldom deserve the credit.

ANYONE SURVEYING THE MODERN financial world with a measure of detachment must marvel at the number of men and women who now guide investments. Corporate financial officers, managers of mutual funds, hedge funds, index funds, and a vast number of other free-market operators all make recommendations and take action–an explosion of financial talent. We talk much of the attraction of technology, the computer world. It is minor compared with the explosion in numbers in the world of finance.

All lay claim to one high professional qualification: a knowledge of what will happen in general, and what the prospects for specific firms are in detail. Only the depth of their competence goes unmentioned. That is unchallenged. And, of course, these advisers act on their expectations. The expectations, in turn, set the price of the particular security or securities.

If the view is generally favorable, this justifies the action that justifies the expectations. Prices go up. This attracts further attention. The process continues. Genius is affirmed by the market effect of the purchases so generated; truly, a wonderful thing. No deep intelligence is required; the higher price rewards the dimmest participant.

But how could there be a supply of intelligence sufficient to head all those mutual funds, hedge funds, index funds, and pension arms of corporations? The answer is simple: Some intelligence certainly exists, but it is not especially required.

Financial genius is a rising market, achieved by expectations of a rising market. Genius, as always, dissolves when there comes an end to illusion, and with the general rush to get out. So in 1929; so in later, lesser episodes; so in approximately 30-year intervals going back to Tulipmania, the exuberant commitment of sober Dutchmen to the wonderful financial prospect of the tulip bulb in 1637.

Joseph Schumpeter, an economist of impeccably conservative credentials, thought these recurrent episodes greatly desirable. They cleared the economic system of the naive, inadequate, and stupid. He called it “creative destruction.” I do not go that far; I am content to repeat that financial genius is, in unhappy measure, a rising market.

Maybe We’ll Try Again…Next Millennium
Asked to predict, one expert says he has no clue.

Brilliance does not always imply access to a crystal ball. Consider this reply from Milton Friedman, 1976 Nobel laureate for his outstanding work in consumption analysis and monetary history and theory. As it did with the other economists invited to contribute, CFO asked what ideas introduced in the 20th century would retain currency in the 21st. We also told Friedman and his peers they could go in any direction. “Instead of depicting the future,” we suggested, “a provocative question would give CFO readers something to think about.” Although disappointing, his reply may be enlightening.

In re your letter of November 5, 1999, about your forthcoming January 2000 issue of CFO, I am sorry to say that I am not prepared to contribute to the brief comments you are seeking.

I haven’t the slightest idea what are sensible answers particularly pertinent to financial executives to the questions you raise.

Appreciate your asking. Pardon my refusing.

Milton Friedman, Sr. Research Fellow
Hoover Institution, Stanford University

Regulation’s Foe
Von Hayek would warn that in the future, as now, controls will manage to stifle markets.

The question of regulation hangs over most discussions of finance in the coming decades. Is more needed, or less? The late Friedrich von Hayek (1899­1992) reached his conclusion a half-century ago: Regulation is crippling. Insights built around this thesis garnered a 1974 Nobel prize for von Hayek. To learn what this fierce opponent of regulation might say on the doorstep of the 21st century, CFO invited Edwin J. Feulner to speculate. Currently president of the Heritage Foundation, Feulner served from 1996 to 1998 as president of the Mont Pelerin Society, founded in 1947 by von Hayek.

Professor von Hayek was a major advocate of the market as a discovery process. The change in modern financial markets exemplifies the operation of the creativity and innovation of unhampered markets at work. The trial-and- error process known as competition generates constantly improving financial products. The system of profits and losses, which is an integral part of this process, rewards those who innovate successfully, while signaling those who have misjudged the market that they have erred in their judgment. The competitive market process utilizes the knowledge of literally millions of participants.

Professor von Hayek would oppose regulation of evolving financial instruments and markets. Such efforts would substitute the judgment of the few for the many, effectively undoing the chief advantage of a market economy. The argument for unregulated financial markets– and free markets, generally–is not that they always produce the “best” result. Rather, competition means that large errors are avoided. Planned economies and heavily regulated markets make all conform to one model. That was the route to wholesale economic failures in Soviet-style economic systems about which Professor von Hayek warned us in his book The Road to Serfdom.

Financial markets never flourish in heavily regulated economies. Indeed, even moderate regulation can stifle the development of financial markets. Chile’s system of capital controls–far from Draconian by global or historical standards–kept it from ever becoming a regional banking center. Even though these controls have been lifted, the threat of their being reimposed will likely prevent Chile from becoming an important banking or financial center in the future.

In the next century, as in the last, the maximum possible freedom in financial markets is the best route to both financial stability and prosperity.