They themselves point to a much earlier claim, similar to Fama's, by Scholes and Merton in response to the fact that, when the Chicago Board Options Exchange opened in April 1973 (prior to the widespread adoption of the Black Scholes Merton formula by traders), actual prices turned out to be inconsistent with it (a not surprising fact given that, as Fama points out, the assumption on which the formula was based - the EMH - was false).
“Black, Scholes, and Merton’s work was, however, theoretical rather than empirical. In 1972, Black and Scholes tested their formula against prices in the pre-CBOE ad hoc options market and found only approximate agreement. For example, as against the model, “contracts on high variance securities tend to be underpriced, and . . . contracts on low variance securities tend to be overpriced” (Black and Scholes 1972, pp. 414–15). Nor did the opening of the CBOE immediately improve the fit. Mathew L. Gladstein of Donaldson, Lufkin and Jenrette Securities Corporation contracted with Scholes and Merton to provide theoretical prices ready for its opening:
‘The first day that the Exchange opened . . . I looked at the prices of calls and I looked at the model and the calls were maybe 30–40% overvalued! And I called Myron [Scholes] in a panic and said, “Your model is a joke,” and he said, “Give me the prices,” and he went back and he huddled with Merton and he came back. He says, “The model’s right.” And I ran down the hall . . . and I said, “Give me more money and we’re going to have a killing ground here.”(Gladstein interview)’” p. 121
The formula has also proved immune to falsification by subsequent events (such as the 1987 stock market crash and the 1998 collapse of LTCM).
Scholes, for instance, has blamed mistaken use of the mathematics by financial market participants for the most recent crisis, thus, like Fama, ignoring that the EMH assumes that financial market participants can and do form and act on rational expectations. "From that idea [the EMH] powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well- informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them. And trying to beat the market was a fool’s errand for almost everyone. If the information was out there, it was already in the price. ...
“The EMH, to be sure, has loyal defenders. 'There are models, and there are those who use the models,' says Myron Scholes, who in 1997 won the Nobel prize in economics for his part in creating the most widely used model in the finance industry—the Black-Scholes formula for pricing options. Mr Scholes thinks much of the blame for the recent woe should be pinned not on economists’ theories and models but on those on Wall Street and in the City who pushed them too far in practice." http://www.economist.com/displaystory.cfm?story_id=14030296
The MacKenzie/Millo article also illustrates, however, a related problem with the “social constructionism” on which it is itself based.
It claims that markets became “rational” and hence "efficient" in the sense of the EMH when the latter, in the form of the Black Merton Scholes formula, actually came to dominate market decision making, i.e. it claims that, when a formula based on the assumption that prices in financial markets express rational expectations formed by market participants using existing information to rationally predict all future phenomena relevant to present valuations was itself made the basis of valuations, the assumption became true.
“With the aid of economic theory, of technology, and of much else, a passable version of homo oeconomicus can be and has been configured cognitively, so to speak [‘in financial markets’]” p. 141
Thus, in response to the 1998 collapse of LTCM, MacKenzie claimed in the London Review of Books (where he is a frequent contributor on financial markets) that:
“LTCM’s fate has provoked some anti-intellectual nonsense. Mathematical finance is part of the infrastructure of the modern world. The techniques developed out of the research of Black, Scholes and Merton continue to work perfectly well in millions of transactions daily, and to abandon them would be unthinkable folly.” http://www.lrb.co.uk/v22/n08/donald-mackenzie/fear-in-the-markets
More recently, reviewing Gillian Gett’s Fool’s Gold in the LRB in April of this year, he again implicitly claimed that the financial market practitioners of “mathematical finance” have contributed to “efficiency”; they have been "technically innovative" in a positive sense. The real problem revealed by the crisis was the stupidity of the financial market participants who set up “a mortgage CDO assembly line” (this having had nothing to do, apparently, with the EMH - nothing to do, for instance, with David Li's "Gaussian copula function"). “At its heart, Tett’s tale is a moral one. She believes that the history of the J.P. Morgan credit derivatives team shows that banking can be technically innovative while remaining responsible. Her readers may fear that the anthropologist has gone native, but I don’t think so. I have met a good number of the people she is writing about, and have studied many of the same events, and I largely share her judgment. In particular, J.P. Morgan’s decision not to set up a mortgage CDO assembly line has saved the bank from the catastrophic losses so many of its peers have suffered; unlike theirs, its solvency has never been in doubt. It is too easy just now to condemn all of those who work at the heart of the financial system as either rogues or fools. Tett is right to emphasise that despite all the pressures and all the temptations, prudent banking was still practised – sometimes – even at the centre of history’s largest ever credit bubble." http://www.lrb.co.uk/v31/n12/donald-mackenzie/all-those-arrows
Ted