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What does Nobel Prize Laureate Robert Merton, professor of finance at Harvard Business School, think about the financial mess America has created, and is trying to clean up?

Here are some of his views, as told to Harvard Business School’s on-line magazine Working Knowledge:

University Professor Robert Merton, who received the Nobel Prize winner in economics in 1997, began his remarks by noting that in the current turmoil a large amount of wealth—between $3 and $4 trillion—has been lost without any offset in gains. Loss in wealth will be borne by house owners, those who finance them, and the general population to the extent that the government becomes engaged. “This is not simply a liquidity crisis or simply a problem of a messed-up financial system,” said Merton. Standard financial models remove some of the mystery about what has happened and make the financial crisis comprehensible, he continued. But his larger message to students in the audience was to highlight the relation between financial innovation and crisis. •“Is there a structural relation between innovation and crisis? I think there has to be,” Merton said. “Successful innovation will always outstrip the infrastructure to support it, at least for some considerable time. That’s true because most innovations fail, so it’s not practical to build a new infrastructure to support every innovation until you find out they succeed. So it’s inevitable they will be mismatched for some time. We have to have oversight. But if it is too strict we’ll never get innovation. There really is a tradeoff, and we have to be prepared for that.” Merton expressed concern about potential unintended consequences of efforts to confront the crisis. He reminded the audience that banks and insurance companies, the sources of some of these problems, are among the most regulated entities other than hospitals in the United States. While regulation is important and needed, “it’s not magic,” he said. Poorly done regulation could have a long-term negative effect. “I hope we’ll have careful analysis and pathology before we start to set the regulations,” Merton continued, suggesting the creation of the equivalent of the National Transportation Safety Board for examining financial crises in a technical, determined way. •Finance as a profession does not look bright, he acknowledged. It will be tough to get jobs on Wall Street. But the good news is that innovation will continue. 

“The financial functions of the system, whether providing for retirement or transactions, still have to be performed. This is a global and growing business, and it’s one that can have very significant impact on economic development and growth. •“Some commenters say, ‘We have to get financially sophisticated people out of the system.’ The worst is to say ‘financial engineer.’ I suggest it’s just the opposite. The problem, in part, is that senior managers, regulatory overseers, and members of boards of these financial institutions don’t have a good understanding of all of this. And it would be perverse if the solution was to dumb down or limit what the institutions can do in terms of what they develop, to fit the existing managers. I think the longer-run solution is that general managers have to become far savvier.”  The finance job market is global, and there remains a strong need for talent. People skilled in general management combined with highly technical training to develop a functional perspective are best equipped to navigate the changes ahead, Merton concluded.

Several brief comments on Merton’s views.

* History: remember Long Term Capital Management in 1998? The perfect storm (Asia collapse, Russian default) that at one point created potential losses of a trillion dollars? Only Alan Grenspan’s rapid bailout saved the world at that time. Merton was a co-founder of LTCM, together with Myron Scholes and John W. Merriweather. By gaining time, much of LTCM’s debts were unwound quietly. But an enormous financial collapse, like today’s, was very close. Greenspan had no authority for a bailout, because LTCM was registered as a hedge fund in the Cayman Islands. But he did it anyway. Today’s bailout engineers seem far less savvy than Greenspan was. (Incidentally Merriweather is now running a new fund, JWM, following precisely the same model that LTCM followed – and may again be in some trouble).

* The next crisis: As America struggles to clean up the current crisis, the seeds of the next crisis are sown.   Merton says so. In high-tech startups, a sophisticated technological innovation usually fails, with damage done only to the psyche of the founder. In finance, sophisticated financial innovations can destroy the world.  Merton wants financial innovation to continue. It will. I am already trying to puzzle out, what will the anatomy of the next financial crisis, in 5-10 years, be like?  

* More sophistication, not less: And Merton is right that the core problem is not the high level of sophistication in financial markets, that spawned complex hard-to-understand financial assets, but too little such sophistication. Even fund managers, even managers of huge pension funds, did not understand what they were investing in. They did not properly evaluate the risk entailed, only the return. Will we find ways to educate our financial leaders in the wild and wonderful ways of financial innovation – so that they at least partially understand the cat-in-the-sack they bought during 2001-7? And yes, we do need a far deeper level of financial education. Every general manager needs to know what today, only his or her CFO knows. Same for the board of directors and audit committee.

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America’s ship is sinking. But not because of what you think – the financial crisis, the $700 b. (5 % of US GDP), Lehman Bros. etc.

The real reason lies elsewhere, I believe.

Data in the American Psychological Association MONITOR (June 2008, p. 11) shows that for in the U.S., 311,600 undergraduate degrees were conferred on business majors; second was social sciences and history, then education, then psychology. Engineering was a very distant 7th, with only 78,600 graduates.  

Who will be America’s innovators in the future? The business majors, who invent such winning ideas as mortgage-backed securities, credit default swaps, auction based securities and contractual debt obligations?

Or the engineers, who combine empathetic insights into social needs with technology skills?

China’s top three universities alone match America’s total output of engineers. And India is a close second.  

NYT Columnist Tom Friedman says we have had too much American intervention in the world, which was bad, and now, in the future, we will have too little, which will be equally bad. I think America’s future is endangered less by its financial mess than by its inability to interest young people in technology. Remember Kennedy’s Aug. 1963 challenge: “We shall go the moon by the end of the decade”? The vision pulled many thousands of young people into science and engineering, whatever else the moon shot accomplished. 

Nothing parallel exists today. I think this is the real long-term threat to America.

Blog entries written by Prof. Shlomo Maital

Shlomo Maital
October 2008
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