Is Economics Dead?
Has the Discipline and Profession of Economics run its course? If it has its death occurred in the late 1990s in the United States of America. The event that signaled that death was the demise and rescue of a private equity firm known as Long Term Capital Management. LTCM failed and it was bailed out. Much could be said about the behavior of the public officials associated with the affair. U.S. Federal Reserve Bank Chairman Alan Greenspan, New Federal Reserve Bank Chairman Timothy Geithner, Treasury Secretary Robert Rubin, Rubin’s second at Treasury Larry Summers, and President William J. Clinton all deserve a great deal of scrutiny for their roles.
The actions of these officials signaled to the business world that a whole new business model had been established. The well connected and influential need not worry. They could engage in the most risky behavior imaginable and they would be protected. The lessons were learned and we are living with the consequences. But the most disturbing aspect of the whole incident was two of the partners in LTCM, Myron C. Scholes and Robert C. Merton. They were fresh off winning the Nobel Prize in Economics for their work on “a new method to determine the value of derivatives”.
The mathematics involved in their model was impressive, and perhaps for that they deserved a medal, but it was the topic and use of that mathematical power that laid bare the complete moral and intellectual bankruptcy of their profession. Economics had flat-lined.
Derivatives pose as an investment product but are actually a form of misdirection. Misdirection is used by magicians, pick-pockets and other con men to capture your attention while they’re performing their trick or robbing you. I’ll let you guess in which category Derivatives belong. Just as Alan Greenspan saw “irrational exuberance” as the cause of the 2007/08 crash, Scholes and Merton saw the exotic working of Brownian Motion in the derivatives markets. I cannot say for sure whether the long con being worked here by Merton and Scholes involved enough self-delusion to convince themselves that they were actually saying something about the workings of the economy or just playing with themselves. I’ll leave that for history to tell but the begged question in the entire process that took Scholes and Merton to such mathematical heights was, why didn’t they just look at the money flows?
A narrative that describes the participants in the derivative markets and a strict accounting of the money flows would tell most of the story. It’s true that most of the money in the derivatives market is borrowed money, but then just follow the money back to the people that lent it. The lenders obviously had a clear motive for the loans they made, and we’re talking Billions upon Billions here. Maybe these sleuth economists could have found a clear pattern. This type of analysis would explain everything far more clearly than using a very strained Algebra and the Calculus. But then someone one else might have gotten the Nobel Prize.
Scholes and Merton could have followed the money trail to the banks; after all, “That’s where the money is”. At the banks the trail might have gotten a little complicated. The banks were surely the source of the money that fueled all participants at almost every level in the Derivatives Market. But the curious thing was that though the money came from the banks, there was seldom, if ever, anyone’s account debited for the loans. It was almost as if the money appeared out of thin air. And it did.
Obviously Merton and Scholes ran in circles that would have a bit of difficulty discussing openly the actions and motivations of the people who ran the banks, but another Nobel Prize winning economist would not. Maurice Allais has made the clear and unambiguous explanation of where the banks get the money they loan out in the modern era; they create it out of thin air. As Allais notes, the entire process is indistinguishable from counterfeit.
Just as Alan Greenspan sought to use “irrational exuberance” to hide his own and others culpability in 2007-08, Merton and Scholes used higher mathematics to further confuse an intentionally confused process. The new and exotic investment instruments, derivatives among them, were designed to confuse and no amount of mathematics will change that. Never has the cultural and scientific legacy of the world been used in so low an endeavor. That the profession saw it as laudable is revelatory.
Had Merton and Sholes faced up to the fact that the Derivatives Markets were designed to separate the foolish from their money this episode could be seen as a blip on the radar. But they are still around, still promoting the political and economic milieu that made the whole thing possible.
The identification and exploration of the deep pockets that fueled the derivatives market is important because money is important. We live in a monetized world in which every dollar or peso or ruble is in competition with every other dollar, peso or ruble in the world and by proxy with every other person in the world. If Merton and Scholes had bothered to ask why anyone would lend money to the risky venture known as Long Term Capital Management they would have found that no one was willing to lend money to them.
Long Term Capital Management was a high stakes player in the Big Casino of Modern Capitalism. But they weren’t playing with their own money. They weren’t even playing with anyone else’s money. They were playing with money that was conjured into existence. I’m not sure that all the high powered mathematics in the world could have given any insight into the 24/7 adrenaline parallel dimension that was the Derivatives Market.
The economy is on a gurney on its way to emergency surgery. Do the doctors in that operating room have the tools to get the economy going again? This question is worth answering. But the answer must also contain a testable hypothesis. To give Merton and Scholes credit they did test their hypothesis, and failed in an embarrassingly public manner. But they seemed completely unaware that there was another group piggy-backing on their experiment with Long Term Capital Management. These people were asking a different question. “Can we design a set of products that will hoover up every available dollar in world capital markets until our bets go sour and then get the rest of the world to bail us out?” That experiment was a shining success. Now that’s something worthy of a Nobel Prize. They chartered the path for the biggest con in human History. Now there’s something to be proud of.