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 débâcle, 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 generisevent – 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. We are not talking about the Hollywood big shots, such as Steven Spielberg and John Malkovich, or the legendary baseball pitcher Sandy Koufax, depositing their money with the fraudster Bernie Madoff. While these people are among the world’s best in what they do, they may not necessarily understand finance. We are talking about the expert fund managers, top bankers (including some of the world’s largest banks, such as the British HSBC and the Spanish Santander), and world-class colleges (New York University and Bard College, which had access to some of the world’s most reputed economics faculty members) falling for the same trick by Madoff.
Worse, it isn’t just a matter of being deceived by fraudsters like Madoff or Alan Stanford. The failure by the bankers and other supposed experts in the field to understand what was going on has been pervasive, even when it comes to legitimate finance. One of them apparently shocked Alistair Darling, then British Chancellor of the Exchequer, by telling him in the summer of 2008 that ‘from now on we will only lend when we understand the risks involved’.[1] For another, even more astonishing, example, only six months before the collapse of AIG, the American insurance company bailed out by the US government in the autumn of 2008, its chief financial officer, Joe Cassano, is reported to have said that ‘[i]t is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of the [credit default swap, or CDS] transactions’. Most of you – especially if you are an American taxpayer cleaning up Mr Cassano’s mess – might find that supposed lack of flippancy less than amusing, given that AIG went bust because of its failure in its $441 billion portfolio of CDS, rather than its core insurance business.
When the Nobel Prize-winners in financial economics, top bankers, high-flying fund managers, prestigious colleges and the smartest celebrities have shown that they do not understand what they are doing, how can we accept economic theories that work only because they assume that people are fully rational? The upshot is that we are simply not smart enough to leave the market alone.
But where do we go from there? Is it possible to think about regulating the market when we are not even smart enough to leave it alone? The answer is yes. Actually it is more than that. Very often, we need regulation exactly because we are not smart enough. Let me show why.
Herbert Simon, the winner of the 1978 Nobel Prize in economics, was arguably the last Renaissance Man on earth. He started out as a political scientist and moved on to the study of public administration, writing the classic book in the field, Administrative Behaviour. Throwing in a couple of papers in physics along the way, he moved into the study of organizational behaviour, business administration, economics, cognitive psychology and artificial intelligence (AI). If anyone understood how people think and organize themselves, it was Simon.
Simon argued that our rationality is ‘bounded’. He did not believe that we are entirely irrational, although he himself and many other economists of the behaviouralist school (as well as many cognitive psychologists) have convincingly documented how much of our behaviour is irrational.[2] According to Simon, we try to be rational, but our ability to be so is severely limited. The world is too complex, Simon argued, for our limited intelligence to understand fully. This means that very often the main problem we face in making a good decision is not the lack of information but our limited capability to process that information – a point nicely illustrated by the fact that the celebrated advent of the internet age does not seem to have improved the quality of our decisions, judging by the mess we are in today.
To put it another way, the world is full of uncertainty. Uncertainty here is not just not knowing exactly what is going to happen in the future. For certain things, we can reasonably calculate the probability of each possible contingency, even though we cannot predict the exact outcome – economists call this ‘risk’. Indeed, our ability to calculate the risk involved in many aspects of human life – the likelihoods of death, disease, fire, injury, crop failure, and so on – is the very foundation of the insurance industry. However, for many other aspects of our life, we do not even know all the possible contingencies, not to speak of their respective likelihoods, as emphasized, among others, by the insightful American economist Frank Knight and the great British economist John Maynard Keynes in the early twentieth century. Knight and Keynes argued that the kind of rational behaviour that forms the foundation of much of modern economics is impossible under this kind of uncertainty.
The best explanation of the concept of uncertainty – or the complexity of the world, to put it another way – was given by, perhaps surprisingly, Donald Rumsfeld, the Defense Secretary in the first government of George W. Bush. In a press briefing regarding the situation in Afghanistan in 2002, Rumsfeld opined: ‘There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.’ I don’t think those at the Plain English Campaign that awarded the 2003 Foot in Mouth award to the statement quite understood the significance of this statement for our understanding of human rationality.
2
For a very engaging and user-friendly presentation of the researches on the irrational side of human nature, see P. Ubel,