It's an old saw among historians of science that thermodynamics learned a lot more from the steam engine than the steam engine ever learned from thermodynamics. Indeed, steamboats were chugging up and down the Thames and Seine and Hudson long before Sadi Carnot and James Joule got around to the disagreement about engines' efficiency that produced the two laws of thermodynamics.
Nobody rides in steamboats anymore, and not many remember the Second Law very well, but everybody is affected by fruits of the quantum revolution in physics that followed in due course. They include, among other things, nukes and chips.
The point is that practitioners, practical men and women who never went to school, can learn to do some pretty fancy things all by themselves, without much help from theorists. But sooner or later, theorists begin to unlock the riddles of the art and are able to offer some very practical suggestions of their own in many instances.
That's more or less the situation in present-day financial economics, where abstruse theory has begun to make some very concrete contributions to the real world. It was underscored last week with the award of a Nobel Prize to three scholars -- Harry Markowitz, William Sharpe and Merton Miller -- who are far from household words, even in the homes of macroeconomists.
Ordinarily, the rise of modern portfolio theory would be just another story for business fans and investment buffs. But in this case, there is a broader point that is worth considering. It has to do with understanding the postindustrial world we live in now.
Some people like to assign a central strategic role to President Reagan's Strategic Defense Initiative -- Star Wars -- in changing the geometry of international relations during the 1980s. The Russians were intimidated into making peace, the argument goes, when the Americans threatened to leap far ahead in computer management of a battlefield dominated from space.
But in some deep sense, it was arguably American financial muscle, as much or even more than its lead in weaponry, that brought the Cold War to a decisive end. One of the reasons for this surge is the deep tradition of unfettered talk and untrammeled innovation in corporate finance.
Not that the American capital markets weren't a pretty remarkable achievement long before Harry Markowitz brought mean-variance analysis to bear on the problems of choosing an investment portfolio. The principle of diversification was intuitively well understood. Mutual funds had been invented and were beginning their phenomenal growth. Securities analysts labored to forecast earnings of various companies (and thus to implicitly calculate their rates of return).
There were elaborate rules of thumb about when corporations should issue common or preferred stock and when they should borrow money. Futures trading as a way of hedging against uncertainty dated back to 17th-century Holland, and the Butter and Egg Exchange in Chicago had been in business since before the Civil War.
What Markowitz, Sharp and Miller did was to build a deep and solid mathematical foundation under the analysis of investments of all sorts to bring a quantitative approach to thinking about uncertainty. Separately, their principal contributions are known among economists as portfolio theory, the capital asset pricing model and the Miller-Modigliani theorem. Together, they constitute the basis of a system for evaluating risks and the rate of return, usually against the benchmark of the performance of the overall market itself, of enormous generality and wide applicability.
In the 1950s and 1960s, their ideas were written down in esoteric equations; in the 1970s and 1980s, they were systematically translated by entrepreneurs into tens of thousands of jobs, a vigorous and bountiful new sector of the economy.
"The striking thing is that their work has permeated so much of financial activity, and in a fairly direct way," says Harvard Business School's Robert Merton. "Though there have been many modifications, you can recognize the original contributions in what people are doing now in practice.".
Like what? Well, the futures and options markets in Chicago are direct descendent of these ideas, says Peter Bernstein, a New York investment adviser who is writing a social history of the development of modern finance called "Capital Ideas."
Another example: Index funds with which investors buy baskets of securities that are representative of the market as a whole -- that's 10 percent of the holdings of pension funds already. And virtually every week, the authoritative International Financing Review brings a report of the introduction of some newfangled security that would be completely unfathomable without an advanced grounding in finance.
To be sure, there is a pessimistic view of the rise of modern financial technology, a view that often fastens on the role played by the markets in futures and options that are now spreading from Chicago to other centers of global finance.
Nobel laureate Merton Miller, a fierce defender of the industry he helped create, has distinguished between a "casino view" of markets as a zero-sum game of investors betting on price movement, and an "information view," in which speculative profits are the "bribe" that societies offer investors to assimilate information and to provide insurance against unexpected developments. There's not much doubt that the information view is more helpful.
Moreover, as more disciples of the new quantitative approach rise toward the top of money management, one hates to see the seat-of-the-pants crowd in eclipse. There is a sort of tough-minded, independent and plain-English gentleman, full of wisdom and good character, who typifies the old style of money management -- Ben Graham, Warren Buffett, John Templeton, T. Rowe Price. The newer generation hires more quants.
But the most interesting problem of all may have to do with new potential conflicts of interest between the universities and private enterprise that have arisen with the development of the new economic knowledge. Merton Miller, a University of Chicago professor, is a director of the Chicago Mercantile Exchange (the old Butter and Egg Exchange) and a defender against federal attempts at its regulation. William Sharpe retired early from Stanford University to make money by, among other things, advising the pension fund of American Telephone & Telegraph Co. Harry Markowitz worked for General Electric Co. and International Business Machines Corp. before a brief and somewhat checkered fling on Wall Street.
Private gain and public knowledge are sometimes difficult to reconcile, and redefining the ethical horizons is not going to be any easier in finance than it has been in medicine and biotechnology.
David Warsh is a columnist for the Boston Globe.