(The following, from SLATE, is pretty funny.)
This year's Nobel economists are too good for their own theory.
By Todd Porter
(posted Friday, Oct. 31)
The Nobel Prize in economics was
recently awarded to Myron Scholes and
Robert Merton. Their work has had
tremendous practical impact on the world
of finance. Yet their own lives call into
question a key assumption of economic
theory.
The issue is simple. One day in
1970, three hard-working associate
professors of finance scribbled down a
few equations on a blackboard, and
eureka! They had discovered a method for
pricing options. (The third man, Fischer
Black, died in 1995.) What did they do
with this extremely valuable information?
They gave it to the rest of us for free.
That is the problem.
The assumption that appears to be
in jeopardy is profit maximization. In
markets, particularly financial markets,
when profit opportunities arise, it is
assumed that savvy individuals will take
advantage of them in order to capture
profits. Some economists describe it this
way: No one leaves $500 bills lying on
the street. Indeed in finance
theory--including the Nobel prize
winners' own formula--the profit motive
is the engine that moves financial
markets from one equilibrium to another.
(Equilibrium being the place where
nothing really happens.)
Modern financial theory is highly
dependent on such strange theoretical
beings--greedy fortunetellers who can
compute the third derivative of their
utility function. For example, the
creatures assumed in the Capital Asset
Pricing Model, the keystone of most
academic finance, are assumed to care
only about risk and return. The people
trapped in the CAPM are assumed to apply
the equations provided by Sharpe,
Lintner, and Treynor (for which only
Sharpe won a Nobel) to pounce on the
slightest deviation from equilibrium in
order to get more. This greed is their
most important trait. If they aren't
greedy, the theory falls apart, as would
most other economic theories. Professors
Merton and Scholes have undoubtedly
assumed unbridled greed hundreds of times
in classrooms, academic conferences, and
cocktail parties. The question at hand is
whether our generous academics were
greedy enough to be consistent with their
own assumptions.
On that day in 1970, they surely
knew that they had discovered something
of great value. Why didn't they take
their solution and their measly academic
salaries and start trading options? With
the formula programmed into only their
calculators, they could have ruled the
emerging Chicago Board of Options
Exchange, taking the money of the hapless
traders who were still pricing based on
history, rules of thumb, or their guts (a
potentially substantial source of wisdom
here in Chicago). There is no way to know
how much money they would have made, but
it surely would dwarf the million bucks
they scored for the Nobel. They had the
key equation that now drives hundreds of
billions, if not trillions, of dollars of
annual trading volume in stock options,
futures options, mortgages,
over-the-counter currency options, and
most of the derivatives industry.
To be sure, these guys have made a
lot of money working for Wall Street
firms in recent years. They surely have
been adequately greedy in the rest of
their careers to satisfy their own
assumptions. But their youthful
charitable lapse must still be explained.
One possible explanation is that if
they had kept the formula to
themselves, the budding options market
would have been stunted. They would have
quickly taken all the money from the
suckers trading against them, and no one
would have been foolish enough to take
them on. Perhaps they actually have
maximized their income by settling for a
tiny piece of the huge pie that their
formula created? This explanation ignores
the underlying premise of the financial
markets: There's a sucker born every
minute. The market might not have grown
as big if they had hoarded their secret,
but they would have been able to dominate
it.
Another explanation is that they
may have feared some other finance
professor would ruin their monopoly.
There usually is a pathetic close second
for any theoretical breakthrough in
academia. That's the nature of the idea
market. Someone else eventually would
have stumbled onto the same formula. In
which case they would have had to cut the
spoiler in for half. Or even worse, the
spoiler might have given the formula
away, leaving our laureates with neither
fame nor fortune. Any claims that they
actually discovered it first, but kept it
to themselves, would have been met with
skepticism at the faculty club.
This leads us to a third possibility:
They couldn't trust each other.
Perhaps The Treasure of the Sierra Madre
was showing in Cambridge that weekend and
each economist realized that he would
always have to worry about the other two
guys. As any 10-year-old knows (and game
theorists can now elaborately prove),
three-person secrets are particularly
troublesome in this regard, because
nobody can ever pinpoint which of the
other two might have cheated. Thus, they
may have opted for full, public
disclosure because they knew that that
was the only way to ensure that they
shared equally in the spoils. (In the
end, they didn't share equally, though.
Scholes got his name on the formula and
the Nobel, Black only got his name on the
formula, and Merton only got the Nobel.)
Here's a thought: Maybe Black,
Scholes, and Merton were interested in
serving the public good, and the giveaway
was strictly for the betterment of
humanity! Before the guffaws start, we
should at least consider this
alternative. The formula was most
directly a gift to the options traders
around the world, which is not a group
that usually inspires charitable acts. So
these three weren't in the same league
with Mother Teresa. Scholes and Merton
reportedly are applauded when they appear
on the floor of the options exchange,
which shows that options traders are at
least appreciative, if not deserving, of
the rare charities that they receive.
However, the benefits of this formula do
extend beyond the pits. The efficient and
accurate pricing of options has helped to
make the economy more efficient. So we
all have benefited indirectly.
Another alternative is that our heroes
were pursuing the noble goal of
academics everywhere--tenure. Certainly
tenure was in the bag for these fellows
after coming up with the formula, though
it probably was likely for them anyway.
Or, if not tenure, their goal might have
been the eternal fame associated with
having your name on an important piece of
human wisdom. Economists are as guilty of
this hubris as are members of any
discipline: There's the Fischer Effect,
the Sharpe Ratio, the Miller-Modigliani
Theorem, Tobin's Q, the Laffer Curve (the
only one in which the name helps
characterize the discovery), and the
greatest of them all, Pareto Optimality.
Of these bits of academic immortality,
Black-Scholes is probably the most widely
used by nonacademics, so they have made a
good buy on the formula's fame value.
The first three explanations all
rely on various forms of greed or other
base human motivations that are close
enough to greed to be easily worked into
economic theory. The last three
motives--public good, tenure, and
fame--don't fit as well with the basic
assumptions of economics. It is possible
to fit them in by the economist's magic
trick of defining any behavior as
maximizing something called "utility,"
utility being defined as whatever you
choose to maximize. But plain old greed
should be adequate to explain nearly
everything in finance, because finance is
about making money. If the behavior of
people who are in the profession of
making money isn't well explained by the
motivation of making money, then it seems
a real stretch to apply it elsewhere--for
example, to nurses.
For straight cash greed, our Nobel
laureates fall woefully short of their
own standard. Someday a Nobel may go to
theoreticians in behavioral finance who
will be able to build a model that
explains their own behavior as well as it
does that of others.
Todd Porter, a former mutual-fund
analyst, is the associate editor of the
variable-annuities department at
Morningstar.
(from Slate. I'm sure they have it copyrighted, 1997)
Jim Devine
[EMAIL PROTECTED]
http://clawww.lmu.edu/1997F/ECON/jdevine.html
Academic version of a Bette Midler song: "you are the hot air beneath my wings."
