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Robert C. Merton, currently the John and Natty McArthur University Professor at Harvard Business School, shares the 1997 Nobel Prize in economics for his work on the Black-Scholes model for determining the value of a stock option–work that led to the creation of options and futures markets in the early 1970s, and thus to a revolution in financial markets around the world. Merton has also seen firsthand what a modern market crisis looks like: he was a founder of Long Term Capital Management, a hedge fund that saw enormous success followed by enormous losses in the mid-1990s, and which became a symbol of the limits of financial engineering.

Today’s financial crisis is often blamed on a system so complex as to be beyond the comprehension of even its practitioners. (See “The Blow-Up.”) We asked Merton what he thinks of complexity–and whether he thinks markets have too much of it.

Technology Review: Is it fair to say that the current financial system is too risky?

Robert Merton: Let me give you this analogy. If you’re driving in inclement weather, you’d say that a four-wheel-drive car is safer than a two-wheel-drive car. Now suppose that we observed that over the last 15 years, the number of passenger accidents per passenger mile driven hadn’t changed at all. And someone says, Now wait a minute: Has four-wheel drive made us safer? And the answer would be, Technically, no, because we’re having just the same number of accidents we used to have. So, was this all a waste, or were we wrong? I think you know the answer, as I do. What really happened is that people get something that will unambiguously make you safer if you behave the same way you did before. That’s the key element to understand first. The amount of risk we take personally, individually, or collectively is not a physical given constant. We choose it. What happens is, we look at some new, safer instrument and we say, Yes, we could be safer doing the same thing. Or, we could take the same amount of risk and do things that were too risky to do before. So with a four-wheel-drive car, you look out the window and see six inches of snow, and you say, That’s okay: I’m going to go over and visit my family. So the question to ask is not, Are we safer? The question to ask is, Are we better off?

TR: So do we have a better financial system than we did 10 years ago?

RM: Unambiguously. For example, I believe the people at almost every central bank are far more knowledgeable about the various financial markets than they were 10 years ago. Also, in general, we know how to measure and manage risk better than we did 10 years ago. And I think there’s more transparency than there was 10 years ago, in the following sense: One of the big areas with the current crisis is in credit. Bank loans are the prototypical, classic credit of the past. Bank loans were not repriced, like a mutual fund, due to market conditions. So when a crisis came, they were very opaque. There were loans sitting in these banks that had been sitting there for years, and nobody really knew what they were, and when a crisis came, all they know was that they were worth less. That’s not transparency–that’s opaqueness. Today, we have a credit-default swap market. On a daily basis, that market prices what sophisticated institutions were really willing to pay to guarantee the credit of probably 500 to 700 companies and virtually every sovereign country in the world. You can see that price every day. That’s a very big increase in transparency. Also, we have much more global diversification of risk. And look at mortgages. If you go back to the 1980s, virtually all mortgages were originated through thrift institutions. Today, you have a national mortgage market. Even in these tough times, mortgage money is available. It’s not that there aren’t problems, but as a technological matter and as an operating matter, those are all the pluses.

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Credit: Stuart Cahill

Tagged: Business, financial systems, financial markets, quants, market complexity

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