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Nobel Laureates Trace How the Economy Began to Fall Apart

December 26, 2008 at 6:20 PM EST
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The subprime mortgage meltdown and subsequent downward spiral caught some officials and the public off guard. Yet there were some clear indicators of the impending crisis. Paul Solman speaks to two Nobel award-winning economists about how the economy began to unfurl.
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MARGARET WARNER: Two perspectives now on how the financial crisis began. They come from Nobel award-winning economists Paul Samuelson and Robert Merton.

Economics correspondent Paul Solman talked with them recently.

ROBERT MERTON, economist: I’m Rational Man, with a big “R,” big “M”…

PAUL SOLMAN, NewsHour economics correspondent: Speaking at Boston University recently, a pair of financial pioneers, Harvard Professor Robert Merton, who won the Nobel Prize in Economics for Finance a decade ago and his teacher, who won the Nobel Prize in 1970, MIT’s Paul Samuelson, now 93.

The so-called financial engineering these men helped create has been fingered as a key culprit in the economic crisis. But in separate interviews, teacher and student strongly disagreed on finance’s role in causing today’s scary downturn.

PAUL SAMUELSON, economist: People compare it with the Great Depression, but the Wall Street shenanigans this time are much worse.

PAUL SOLMAN: Well, what did Wall Street do this time that it didn’t do last time?

PAUL SAMUELSON: Fiendish Frankenstein monsters of financial engineering had been created, a lot of them at MIT, some of them by people like me.

Nothing like this was present in 1929 when Herbert Hoover and the secretary of treasury, the billionaire Andrew Mellon, were doing the wrong things. They didn’t encounter this problem at all.

PAUL SOLMAN: The problem of Samuelson’s so-called monsters, credit default swaps, say, or mortgage-backed securities, which, as we’ve explained in pieces now up on our Web site, could be used to protect an investment or to make huge bets in unregulated markets.

And, says Samuelson…

PAUL SAMUELSON: You not only can bet with them, but you can leverage to a degree that you don’t even know you’re leveraging.

PAUL SOLMAN: You can, in other words, borrow money with which to bet with them?

But to Robert Merton, financial engineering is an instance of successful innovation and, in its defense, he points out…

ROBERT MERTON: It is inevitably going to be the case that a successful innovation is going to be running ahead of the infrastructure to support it. By infrastructure, I mean the regulations, the oversight, the experience of markets.

And the reason is because it doesn’t pay to build a whole infrastructure to support every innovation in advance, because most of them fail. And so the ones that succeed, the ones we see, will be ahead.

It’s not unlike, in a physical context, if we design a high-speed train, one that can go 200 miles an hour. We’d love to have one between here in Boston and New York. Unless you built the track, the infrastructure to support it, you can’t prudently run it at 200 miles an hour. I think everyone would agree with that.

Housing market is main culprit

PAUL SOLMAN: Moreover, says the financial engineer, the economy went down the wrong track for a very simple reason: We had wild over-optimism in the housing market.

ROBERT MERTON: I think people have been saying, "It's all these fancy things that are going on." But my belief is, if you took all the mortgages that were out there, and the same amount that are out there, but we had no structures, no engineering...

PAUL SAMUELSON: So not pools of mortgages, mortgage-backed securities...

ROBERT MERTON: Not pools of mortgages...

PAUL SAMUELSON: ... none of that?

ROBERT MERTON: OK, we would have had losses as massive as we're seeing here. Some of these structures, the subprime, the almost-zero-level loans, all that kind of -- that's bad stuff.

But the crisis we're in now, because of the amount that real estate has fallen, is hitting ordinary mortgages, ordinary mortgages that were done at good levels, OK, and that people were respectable about.

PAUL SOLMAN: But it's possible, isn't it, that by creating these pools of debt and then selling them to people who have no connection to the people they're in essence lending the money to, through these different institutions, that we've created a disconnect which has enabled people to take on risks that they would not otherwise have taken on, and we're now paying the piper for that?

ROBERT MERTON: Absolutely. But I think, if you go back to the way things were done in the 1970s, before the mortgage market, you'd have less risk of one kind, but you'd have the other, which is you can't get mortgage money every time interest rates go above some level. And I think that most of us would not like to go back to a time when mortgage money wasn't available.

Change in regulation needed

PAUL SOLMAN: So, yes, fancy financial instruments, so-called "derivatives," like mortgage-backed securities, may have become Frankenstein monster-like, but they also mobilized the world's wealth to address worthwhile ends.

Merton became famous in 1997 by winning the Nobel Prize for a math-driven way to price options, a fairly straightforward financial instrument. He became famous again the next year when the hedge fund he helped create, Long-Term Capital Management, went under.

What did you learn from Long-Term Capital Management? Are you more humble with respect to your or anybody's ability to figure out what's going on?

ROBERT MERTON: I'd say it's more than humbling. I mean, it's very, very painful. And you wouldn't want -- I wouldn't recommend it to anyone.

So -- but if you're looking at it as a scientist, I think we find that, as hard as we work at things, that inevitably crises will occur, which almost by definition means that something that you didn't anticipate, and that's the nature of taking the risk of being in that kind of business.

Now, please don't hear what I'm saying as that the complex instruments that were created and so forth didn't contribute to it. Absolutely. And we absolutely have to do that, but I also think...

PAUL SOLMAN: "Have to do that," meaning regulate them?

ROBERT MERTON: No question in my mind we need to make changes in the rules, because it's failed. But the danger is that you create a new set of rules, with all good intentions, that actually have even more negative effects.

Teacher and student agree

PAUL SOLMAN: For years, Merton has made the case that managers should be required to learn more about the risks of fancy derivatives and financial engineering and, in the end, on this point, teacher and student agree.

PAUL SAMUELSON: I can tell you, because I serve on so many nonprofit boards, where half of us are academics and half of us are from Wall Street, that there's no CEO who understands at all a derivative. All they know is that somebody tells them in their organization, "We've got a wonderful profit center."

PAUL SOLMAN: With making good returns.

PAUL SAMUELSON: Good returns. And what your mother told you, if somebody comes and tells you there's a wonderful bridge that you can get at a great bargain, don't believe it.

PAUL SOLMAN: We spoke to your student, Robert Merton. And he said, look, innovation always brings with it certain risks. You don't kill innovation as a result.

PAUL SAMUELSON: I'm not speaking in favor of killing innovation. I'm speaking in favor of centrist use of the market, which involves necessarily a considerable degree of regulation. Markets by themselves will get themselves inevitably into inequality and into their own destruction. It will happen again and again.

PAUL SOLMAN: You're a lifelong Democrat.

PAUL SAMUELSON: I'm an incurable centrist.

PAUL SOLMAN: Do you feel that there was simply an ideological shift towards free-market fundamentalism, some people have called it, that got us inevitably onto this track?

PAUL SAMUELSON: Since 1980, yes.

PAUL SOLMAN: And that's your explanation for what happened?

PAUL SAMUELSON: Yes. And not only that, the economics profession, the guys I have lunch with and love, have, generally speaking, moved greatly rightward. I'm not sure that all of the fiendish stuff could have been picked up by centrist regulators, but you don't have to be perfect in anything in economic life. If you spent 70 years in economics, you'll understand that.

PAUL SOLMAN: So things could have been a lot less bad?

PAUL SAMUELSON: Yes.

PAUL SOLMAN: I once misquoted you to yourself by saying that you'd said when asked, "How come if you're so smart, you're not rich?" You'd said, "But I am rich."

PAUL SAMUELSON: No. What I say is, if you're so rich, how come you're so dumb?

PAUL SOLMAN: Paul Samuelson, thank you very much.

PAUL SAMUELSON: You're welcome.