Economist Robert C. Merton 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. 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. (…) 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. (…) We’re more willing to drive faster because of the better tools at our disposal.

{ MIT/Technology Review | Continue reading }

READ MORE >> ideas, technology, economics | June 18th, 2008