The Non-Friedman

There's a curious flurry of interest in the late Yale economist James Tobin on the blogs tonight, triggered by a backgrounder from Bloomberg: curious not so much do to the quality of the intro (which is high) but because it seems to receiving so much attention. Maybe it is the endorsement from Paul Krugman; or maybe just the idea that team Obama needs a counter-guru to fill the gap left by the abrupt disappearance of Milton Friedman. In a way, Tobin is an unlikely candidate: aside from the fact that he is dead, he had nothing like Friedman's nack for achieving celebrity. But his was an extraordinarily fertile mind, and he left his fingerprints on any number of subfields in economics.

Indeed, here is one Tobin idea that nobody seems to be saying much about tonight: the "Separation Theorem." To summarize: Harry Markowitz kicked off the revolution in modern finance with the invention of his amazing money machine--the notion that you may be able to increase the return on your portfolio without increasing risk if you properly diversify (or reduce risk without reducing return). Tobin swiftly carried the idea to a whole new dimension: Tobin showed how, if Markowitz was right, then all sensible investors would want to hold just one portfolio--the so-called "market portfolio." If the market portfolio was too risky, they could reduce risk by putting some of their money in risk-free securities; if they wanted more risk than the market, then they could leverage up by borrowing at the risk-free rate.

From this, naturally follows "the index fund," and, pretty quickly the other innovations that make up the story modern finance. Markowitz published in 1952 (Tobin in '58). From that time to this, finance theory has been pretty much a narrative of triumph. No, strike that: from that time to last year, when it all fell apart. If you were going to round up all the culprits, Tobin would have to be one of those making the perp walk.

*Snide Alert: I kid, I kid. Actually, I think Tobin's theorem is briliant in its simplicity and elegance, and an idea that looks no worse today than it did a year ago. But you'd have to admit that he is in pretty bad company.