There’s a slight whiff of delusion around some of Professor Robert Merton’s comment in his interview with the FT.
With the greatest respect to the Nobel prize-winner, some of his comments seem a little strange to us mere mortals. Perhaps we just don’t understand them.
In particular, there are his thoughts on LTCM:
The causes of the hedge fund’s collapse, though, are widely misunderstood, says Robert Merton. While some observers blamed events on the faith that the fund placed in financial models - founded on a belief in rational markets - Prof Merton says the real problem was the way that LTCM’s counterparties behaved.
When the fund started to suffer losses, the counterparties did not behave as proponents of finance science - or rational markets - predicted. Instead, they sold assets in a seemingly indiscriminate panic, triggering market swings more violent than anything Prof Merton expected.
So it was everyone else’s fault. And the problematic belief wasn’t in rational markets, it was in rational people.
He also adds in the interview that derivatives have been misunderstood and that when things go wrong, it should not be blamed on these instruments per se, but on the way they are used.
“Derivatives are like anti-lock brake systems in a way - there is no question that they can make things safer, but only if people choose to use them that way. Often they don’t - they might choose, for example, to drive faster in worse weather. Often we have chosen to use these tools not to decrease risks but to increase the benefits of taking the same risks,” says Prof Merton in the interview.
So derivatives are safe, in and of themselves. Again it’s people that are the problem - the ones that drive too fast, drink too much, bet more than they can afford to lose and smoke.
Does anyone find that reassuring?
