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The Birth of Modern Finance

As MIT Sloan celebrates the 100th anniversary of the founding of Course XV, we have taken the opportunity to produce a commemorative book that captures the significant and lasting contributions of our faculty, students, alumni, and staff to the fields of management and management education.

Here, we share an excerpt from the book chapter entitled, “Economics, Finance, and Accounting.” We hope that you will want to read more. If so, please visit: http://mitsloan.mit.edu/100years/book.php to order your copy.

Franco ModiglianiFranco Modigliani



Many scholars and industry leaders agree—the birthplace of modern finance is MIT. The Institute lays claim to pioneers like Fischer Black, Stewart Myers, and John Cox, as well as Nobel Laureates Paul Samuelson, Robert Merton, Myron Scholes, and Franco Modigliani. Formed in the 1960s, long before many business schools recognized finance as a distinct field of study, the MIT Sloan Finance Group is responsible for research breakthroughs that helped shape finance theory and practice over the last 40 years—and continue to do so today.

The modern intellectual history of finance begins with Paul A. Samuelson, who started his lifelong career at MIT in 1940. The Department of Economics named him assistant professor when he was 25 years of age and a full professor at 32. In the 1960s, Samuelson became interested in finance and wrote several seminal papers on topics including asset allocation and the fallacy of time diversification, and, of course, on the pricing of warrants and options, which would become the start of something much bigger. In 1970, he was the first American to win the Nobel Prize in Economics. John Kenneth Galbraith wrote in 1977 that, “Generations of students have learned their economics from Paul Samuelson, the pre-eminent teacher of his time.” Economic historian Randall E. Parker calls him the “Father of Modern Economics,” and the New York Times considered him to be the “foremost academic economist of the 20th century.”

Samuelson’s legacy is certainly far-reaching. He attracted many talented collaborators and mentees to MIT, including Robert Solow, Paul Krugman, Franco Modigliani, and Joseph Stiglitz, all of whom went on to win Nobel Prizes. Following Samuelson’s lead, the two departments—Economics (in the School of Humanities, Arts, and Social Sciences) and Finance (in the School of Industrial Management)—forged a lasting bond that made each stronger. In 1952, when the School of Industrial Management moved into the newly acquired Sloan building at the east end of campus, the Department of Economics left the Hayden Library, where social sciences was located, and joined their management colleagues, a sign of their close relationship.

What Dean Penn Brooks wrote in his last Annual Report in 1959 is still true today:

The area of economics has particular significance for the field of management, and the strength of the School has always been magnified by our faculty’s close working arrangement with MIT’s distinguished Department of Economics and Social Science. The collaboration is not only in the design of the teaching programs, where members of that Department contribute substantially to our program, but also in the close personal research relationships that exist between members of the two groups.

Robert MertonRobert Merton

One of Samuelson’s most significant contributions to the field of finance, however, was mentoring a rather unlikely PhD candidate in 1967—an applied mathematics student from Caltech who had no prior economics training and who was rejected from every other economics program to which he applied. That young maverick was Robert Merton. Yale, Harvard, Berkeley, and Stanford didn’t want him—the MIT Economics Department welcomed him with open arms. Then-Dean William Pounds advised Merton to skip the traditional finance courses (because he’d get bored quickly and leave) and enroll in Paul Samuelson’s mathematical economics course. Merton showed up the first day of registration, walked into Samuelson’s open door, and didn’t leave for three years. “The rest was history,” says Merton. “I lived in his office from the end of that class on campus.”

Paul SamuelsonPaul Samuelson

Samuelson once described Merton as “your average American boy next door, fond of baseball and taking autos apart.” Merton bought his first stock (GM) when he was 10 years old. He regularly balanced his mother’s checkbook and set up a “bank” with money from neighbors and family. At an early age, he read the stock tapes and began trading. Baseball was his first passion— the Brooklyn Dodgers—but at around age 11, that passion turned toward cars. On his bedroom wall, he put a large sheet of paper covered with more than 1,800 numbers. He crossed one out each day, counting down until he would be old enough for his driver’s license. At 15 he rebuilt his first car. It wasn’t long before he realized his real passion was applying math to economic problems.

What Francis Walker and Davis Dewey did for economics at the turn of the century, Paul Samuelson and Bob Merton did for the field of finance near the end of the century. At the time, they didn’t realize they were helping to create a new discipline—after all, finance was still part of economics in those days, not yet considered a serious academic subject in its own right. Plus, Merton had his sights set on becoming an economist. In fact, when he graduated in 1970 with a PhD in economics and applied for jobs in academia, Merton interviewed only with economics departments, no business schools. It was Franco Modigliani, with a joint appointment in economics and finance, who convinced Merton to stay at MIT and teach finance.

MODIGLIANI-MILLER THEOREMS

Around the same time that Samuelson was writing his dissertation, Modigliani, a young Italian economist, was developing a theory based on an examination of individual behavior—how people save for retirement. His theory, the life-cycle hypothesis (1953), would later provide important predictions for the economy as a whole, and win him a Nobel Prize in Economic Sciences in 1985.

Modigliani’s research with Merton Miller at Carnegie Institute of Technology (now Carnegie Mellon University) laid the groundwork for the field of corporate finance. No single work had prompted such widespread and revolutionary changes as the Modigliani-Miller (MM) Theorems. The influence of the MM (1958) propositions on capital structure and the (1961) theses on dividend policy pervades almost all aspects of financial economics to this day—opening the door on a new era in modern finance. The theorems introduced rigorous economic thinking to the anecdotal world of 1950s corporate finance. “Franco’s work is timeless,” said MIT economics professor James Poterba. “The issues he worked on are the big questions. They are as important today as when he wrote his papers.”

Modigliani also built, along with economist Albert Ando, a large-scale model of the U.S. economy to test the impact of monetary policy. “We learned enormous amounts about individual sectors of the economy,” said Poterba. “No part of the economy was safe from Franco’s microscope. It was tremendously influential.”

Stewart MyersStewart Myers

THE FOUNDING FATHERS OF FINANCE

With Modigliani in the lead, the Finance GroupStewart Myers, Gerry Pogue, Myron Scholes, Bob Merton, and Fischer Black—coalesced into a small but influential collection of researchers. Finance departments at other schools were larger—such as those at Chicago and Wharton—but in terms of productivity, MIT’s during this period was equally, if not more, important. “It was a wonderful band of scholars,” recalls Myron Scholes. Assisting Modigliani and Merton Miller at the University of Chicago, Scholes found infectious their “joy of getting results, and asking the next questions.” Upon meeting Black his first summer at MIT, Scholes became fascinated with options, insurance, and distributions of portfolios. Since Modigliani, then the Finance Group’s senior faculty member, was preoccupied with large macro projects, and Sidney Alexander, the unit head, was not a hands-on overseer, this new cohort of talented intellectuals was left to its own devices. What followed was a decades-long era of intense collaboration and creativity that transformed the academic field and the landscape of real-world finance.

“It was a rare and wonderful experience,” recalls Merton. “Our group was marked by a diversity of thought, a quality of mind, and a genuine affection for each other. We had passionate intellectual disagreements, but still had a great respect and affection for each other. We were blind to everything but talent, productivity, and skill. The research flowed so fast for us, and the students, there wasn’t enough time to do it all. That doesn’t happen everywhere.”

OPTIONS PRICING

Fischer BlackFischer Black

The 1970s was a decade steeped in financial strife. Interest rates ballooned into the double digits. Inflation was the highest it had been since the Civil War. An OPEC oil embargo caused gas prices to soar and shortages created long lines at the pumps, despite the rationing system that was hastily implemented. The stock market fell, unemployment was high, and with the end of Bretton Woods, foreign currency shifted from fixed to floating. The country was in crisis, and traditional solutions weren’t working. All this economic risk and uncertainty set the stage for tremendous innovation.

Myron ScholesMyron Scholes

In 1970, Black and Scholes solved the problem of valuing options and derived their now-famous formula. At the same time, Merton was working on this problem, but took a different approach, using Ito calculus to model the randomness of financial markets. Conversations with Scholes helped him reframe his ideas. With the publication of his paper on “Rational Option Pricing,” Merton took finance into uncharted waters, developing new tools and models that changed the course of modern finance. Leaders in the field see it as the dawn of a new era; Merton attributes it to good timing. “When it comes to innovation, the most important factors are need, need, need,” he says. “If this work had been published in the 1960s, it would have sat on the shelf.”

Merton and Scholes won the Nobel Prize in Economic Sciences in 1997. Black would have joined them in the honor, if not for his death in 1995. The impact of their formula was staggering, but they did not devise it from scratch. They built their seminal theory on the shoulders of their senior colleagues, including Samuelson, and his earlier work on valuing warrants, and Paul Cootner, who edited in 1964 The Random Character of Stock Market Prices. The formula was groundbreaking, but it did not win the Nobel Prize. Black-Scholes was just one example of a replicating methodology; it provided a way to evaluate the risk and production cost of a new instrument. And because it is flexible and can be applied in thousands of situations, it has been a workhorse for more than 40 years.