6/21/12 - the dangerous nobel prize in economics

In today's encore excerpt - academic orthodoxy can be a dangerous thing. In fact, any kind of orthodoxy can too easily segue into herd mentality. And in economics, academic orthodoxy coupled with advanced quantitative techniques can easily become uncoupled from sound reasoning and common sense. And so Robert Merton and Myron Scholes—who defined asset valuation orthodoxy with such work as the Black-Scholes financial option pricing model—were behind the spectacular multi-billion-dollar collapse of Long-Term Capital Management in 1998 after winning the Nobel Prize in economics in 1997:

"In 1997, Robert Merton and Myron Scholes were awarded the Nobel Prize in economics for their 'new method to determine the value of derivatives'. Incidentally, the prize is not a real Nobel prize but a prize given by the Swedish central bank 'in memory of Alfred Nobel'. As a matter of fact, several years ago the Nobel family even threatened to deny the prize the use of their ancestor's name, as it had been mostly given to free-market economists of whom Alfred Nobel would not have approved, but that is another story.

"In 1998, a huge hedge fund called Long-Term Capital Management (LTCM) was on the verge of bankruptcy, following the Russian financial crisis. The fund was so large that its bankruptcy was expected to bring everyone else down with it. The US financial system avoided a collapse only because the Federal Reserve Board, the US central bank, twisted the arms of the dozen or so creditor banks to inject money into the company and become reluctant shareholders, gaining control over 90 per cent of the shares. LTCM was eventually folded in 2000.

"LTCM, founded in 1994 by the famous (now infamous) financier John Merriwether, had on its board of directors—would you believe it?—Merton and Scholes. Merton and Scholes were not just lending their names to the company for a fat cheque: they were working partners and the company was actively using their asset-pricing model.

"Undeterred by the LTCM debacle, Scholes went on to set up another hedge fund in 1999, Platinum Grove Asset Management (PGAM). The new backers, one can only surmise, thought that the Merton-Scholes model must have failed back in 1998 due to a totally unpredictable sui generis event—the Russian crisis. After all, wasn't it still the best asset-pricing model available in the history of humanity, approved by the Nobel committee?

"The investors in PGAM were, unfortunately, proven wrong. In November 2008, it practically went bust, temporarily freezing investor withdrawal. The only comfort they could take was probably that they were not alone in being failed by a Nobel laureate. The Trinsum Group, for which Scholes's former partner, Merton, was the chief science officer, also went bankrupt in January 2009.

"There is a saying in Korea that even a monkey can fall from a tree. Yes, we all make mistakes, and one failure—even if it is a gigantic one like LTCM—we can accept as a mistake. But the same mistake twice? Then you know that the first mistake was not really a mistake. Merton and Scholes did not know what they were doing.

"When Nobel Prize-winners in economics, especially those who got the prize for their work on asset pricing, cannot read the financial market, how can we run the world according to an economic principle that assumes people always know what they are doing and therefore should be left alone? As Alan Greenspan, former chairman of the Federal Reserve Board, had to admit in a Congressional hearing, it was a 'mistake' to 'presume that the self-interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms'. Self-interest will protect people only when they know what is going on and how to deal with it.

"There are many stories coming out of the 2008 financial crisis that show how the supposedly smartest people did not truly understand what they were doing."


Ha-Joon Chang


23 Things They Don't Tell You About Capitalism


Bloomsbury, New York


Copyright 2010 by Ha-Joon Chang


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