Arnold Kling  

Perry Mehrling, Fischer Black, and Elvis

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In this essay, I continue to praise Perry Mehling's biography of Fischer Black.


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.

If your inclination is to reject market theory any time you see a difference between theoretical ideals and actual markets, then Fischer Black is not for you.

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.

For Discussion. Black might have argued that even if it is only an approximation, the assumption of perfect markets is the most logical approximation with which to start. Agree or disagree?


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COMMENTS (7 to date)
spencer writes:

Before you can answer that question you have to ask what one means by perfect markets.

Is a perfect market always correct?

Does a perfect market reflect everthing that is currently known about a security?

Does a perfect market just reflect the price that clears the market?

Or does it just come close enought to these three conditions that for pratical purposes you are close enough?

Which one of these answers would you pick? Or would you offer another answer? After I know that I can discuss the perfect market with you.

Ian Lewis writes:

I imagine that we do need to start from a "Perfect Market". If we didn't, we would need to start from some imperfect market. As far as I can tell, there are infinite imperfect markets but only one Perfect Market.

Whether it is right or wrong, it seems like the best place to start from.

Matt McIntosh writes:

"Perfect markets" (whatever sense you mean this in) can be useful as a simplifying assumption in order to demonstrate underlying economic principles, but as a working assumption for practical policy direction it's not realistic. Don't confuse theoretical physics with engineering.

spencer writes:

My own bias is that major financial markets are close enough that the perfect market is a close enough approximation to start with.

However, when I look at other markets I have always wondered if the profession has made a major mistake to focus on the perfectly competitive assumption and that we would have been better off is we had made Chamberlins "imperfect competitive" the center of our studies.

paul writes:

I think one of Fischer's best papers was "Noise" journal of finance 1986. It's not that markets aren't perfect but given the current state of nature, they are just "very" noisy. I think he had a profound appreciation for the level of precision (or lack there of) of empirical research. That’s why he focused on the theory.

eddie writes:
Don't confuse theoretical physics with engineering.

Don't confuse policy direction with engineering either.

As long as its all guesswork anyway (guesswork accompanied by reams and reams of data, but guesswork nonetheless) we might find ways of making better guesses if we find better theoretical foundations.

llld writes:

A clear definition of perfect markets is required to answer the question.

Without financial markets, where would moral hazard come from? Some government regulation may increase moral hazard, but it is financial markets that allow for the separation of ownership from control. Where do we get moral hazard without that separation, and, hence, without financial markets.

The "widespread but uninformed belief" that you refer to is more a result of the lack of understanding of the benefits of financial markets. They are crucial for creating liquidity, and hence flows of capital from savers to investors with longer time horizons. The government's role in all this is far more ambiguous than you make out.

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