THE DECLINE AND FALL OF THE U.S. ECONOMY Dr. Myron Scholes defined the Black and Scholes theory in a New York Times interview with Deborah Solomon on May 14, 2009: “It is an equa- tion that prices options on common stocks and provides a methodology to value options on securities generally. It can be used to measure risk and trans- fer risk.” When she followed with another question—“In retrospect, is it fair to say that the idea that banks could manage risk was a total illusion?”—Scholes responded: “What you are saying is negative. Life is positive too. Every side of a coin has another side.” I interpret Dr. Scholes’ evasive response to Ms. Solomon’s very clear question as a yes: it was a total illusion. The crash of 2008 was resounding proof. But it was an illusion born in the context of the times. So, before we go further with Black and Scholes, it is first necessary to set the stage for their work, to flesh out the cultural context of the times. They did not construct this stage, or create the culture. Rather, in the classic way of evolution, they merely adapted to it. The construction of that stage and the onset of a new culture celebrating debt began under the influence of Britain’s John Maynard Keynes, later to become Lord Keynes, to many, the most famous economist of the twentieth century. Keynes helped create a new economic context by inducing a paradigm shift from eighteenth-century classical to twentieth-century neo-classical economics. In so doing, Keynes single-handedly created a new discipline called “macroeconomics.” John Maynard Keynes made mathematical analysis of economic events aca- demically popular. His 1936 book, The General Theory of Employment, Interest, and Money was an abstract analysis of the Great Depression. That book was des- tined to be Keynes’s masterwork. It made Keynes the twentieth century’s most influential economist by far, according to many economists, among them Nobel Prize winner Paul Krugman, who holds Keynes as his idol. Briefly, Keynes argued that Say’s Law of Markets fails to apply in a slump. Say’s Law states that given flexible costs and prices, free markets assure full employment of all resources. In effect, if prices are not fixed, supply will create its own demand. More on Keynes’s critique later. Here we should note that Keynes made his case not on the basis of actual data of the Great Depression, but by mathematical logic applied to his assumptions. Like Ricardo and Marx before him, he let abstract logic trump actual data. (Keynes’s theory falls apart when applied to the actual data of that time. That data actually confirms rather than refutes Say’s Law. I developed this analysis in my 1995 journal article “The Great Depression Reconsidered and Its Implications for Today.”)1 We will look at this in more depth later. His General Theory was difficult to read and follow because, as we see later when we look at Black and Scholes’s famous equation, most of us bog down if confronted by thickets of algebra not of our own making. That is why it was not until about 1948 (after Keynes had died at a fairly early age) that Keynesian theory began to motivate economists to adopt his “macroeconomic” approach. (Macroeconomics did not exist until Keynes created it.) It was not just the passage of time, however, that led to this conversion. A good part of this shift occurred because of the wartime invention of the mainframe computer. As early mainframes improved and their software became more sophisticated, wannabe math majors by the hundreds began to shift to an economics major. (“Pure mathematicians” in those days looked down on powerful computers claiming that using electronic computers to crunch numbers by brute force would seduce mathematicians to grow lazy in thinking about the underlying mathematical logic.) (They actually had a point. Shortly before I retired from Boeing, the USSR imploded and the Cold War ended. For the first time, Boeing engineers could freely travel to Russia. Many were eager to go because Boeing engineers had learned that Russian mathe- maticians, lacking the easy access to computers of Americans, had made some major breakthroughs in basic math concepts important to engineers.) From about 1948, when Paul Samuelson first published his landmark text, Economics, people who liked math began shifting to economics without feeling guilty about using computers. It was just too tedious to create any complex mathematical or statistical model for economic forecasting. Even a simple least- squares trend analysis can be tedious and time consuming if done by hand. (With a computer and the right software, you can enter the data, then hit the button, and before you can blink, you have the R2 and trend line.) The big rush came after 1960, when Robert McNamara, after rising quickly up the ladder at Ford Motor Co. using quantitative methods, and just becoming president of the company accepted newly elected President John F. Kennedy’s invitation to become Secretary of Defense. McNamara introduced his quantitative methods at the Pentagon, where, already, during World War II, he had served the Air Force as a quantitative “whiz kid.” He insisted on expressing everything in numbers and using computer models to solve all problems. Many of his reforms were certainly needed; some were long overdue; and in the end, Pentagon opera- tions were markedly transformed. But McNamara disdained any wisdom that could not be expressed numerically. He was clear about all that. McNamara was a self-confessed neo-positivist, a school of philosophy claiming that if you cannot express your position numerically it has no useful meaning. McNamara was also clear that the mainframe computer made this level of quantification practical for the first time in history. He was convinced that the awesome computing power of the mainframe had finally made it possible to make detailed and accurate forecasts. Given the power to forecast accurately, it becomes logical and necessary to plan according to that forecast. In business, such plans include the scheduling of production, and that schedule calls for allocating money, men, and material according to that plan. Only top manage- ment can perform this job McNamara insisted. Having made the forecast and planned accordingly, management must issue the commands to implement pro- duction and then monitor for compliance by the use of controls to assure that the plans are followed. Forecasting, planning, command, and control became the name of McNamara’s computer-era game. Given all that, McNamara also felt that the burgeoning human relations school then prevalent in many univer- sity business schools and in some business firms, was just so much touchy-feely fluff. That “fluff ” came into being when researchers discovered in the now famous Hawthorne Studies at Western Electric that workers had far more influence over productive efficiency than the adherents of Frederick Winslow Taylor’s school of scientific management had suspected.2 For example, workers were routinely able to frustrate the “time and motion” studies designed to improve their productivity. Moreover, workers were easily able to bring pressure to bear on their peers either to enhance or retard productivity. The human relations school as such emerged when Harvard Business School pro- fessors took this and similar findings to heart and urged worker participation in decision making. They insisted that workers deserved far more respect than the time and motion studies ever considered necessary. People, in this new human relations view, were to be seen as a business firm’s most important resource and treated as such. McNamara did not put down human relations as crudely as I have suggested, but he thought the mainframe had made such thinking outdated and largely irrelevant. After all, if the top command has all the information needed to make the plans, what use is input from the lower levels who themselves have no access to such information except through top management?
Posted on: Tue, 11 Jun 2013 03:23:06 +0000
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