Fifteen years after the Global Financial Crisis: Recessions and Business Cycles in the History of Economic Thought

On how processing power shaped finance

Vergara Fernandez Melissa, Erasmus University Rotterdam

According to Eugene Fama, finance is “is the most successful branch of economics in terms of theory and empirical work, the interplay between the two, and the penetration of financial research into other areas of economics and real-world applications.” Whether finance is indeed ‘the most’ successful branch is surely a matter of debate. What’s not is how significant empirical work has been in shaping the field. In this paper I shall suggest that this is partly due to the opportunities the computer brought to finance scholars and practitioners to process data. Indeed, processing power has arguably shaped the field of finance as we know it today. I’ll focus on three aspects: First, the empirical foundation of the Efficient Market Hypothesis EMH). Second, the theoretical developments on asset pricing, particularly the Capital Asset Pricing Model (CAPM). And third, the finance industry, in particular the rise of index funds. Regarding the empirical foundation of the EMH, the arrival of “the first reasonably powerful computers” to the university of Chicago gave impetus to an empirical programme on the question of the behaviour of stock prices. Regarding the CAPM, it was not the advancement of processing power but rather the limitations of this power which, remarkably, had a major impact on finance’s theoretical development. The CAPM by William Sharpe was based on Harry Markowitz’s theory of investment decisions. Markowitz’s theory stipulated that investment decisions should be made on the basis of the calculation of the correlations between all stock prices. The practical impossibility of carrying this out (partly in terms of processing power and partly in terms of availability of stock price data), led Sharpe to consider a market index to which the correlation of every stock could be calculated. This simplified the practical task and proved important for developing a CAPM in which there was a single source of risk—market risk. Finally, regarding the finance industry, the role that John McQuown, an engineer hired to lead Wells Fargo’s Management Sciences Division, played a significant role in giving impetus to the creation of the first index fund. McQuown arrived at Wells Fargo due to his use of the IBM 7090, the biggest commercially available computer at the time (1962-1963), to distinguish cheap from expensive stock. He was an advocate of the same quantitative methods being developed by Chicago economists, bringing them in to consult for Wells Fargo. The most salient result of this Chicago University-Wells Fargo collaboration is the impetus given to index funds at the end of the 1960s.

Area: Eshet Conference

Keywords: Finance, Financial Economics, Computer, Asset Pricing, Efficient Market Hypothesis