Trial and Error for Innovation

In Finance, Too, Learning Entails Risk
What if other innovators had given up?

By L. GORDON CROVITZ

Modern cities were built through trial and error. As architects reached upward, there was the trial of inventing a safe elevator so that buildings could become skyscrapers. Early contraptions were used in factories and mines, but when cables broke they plummeted to the bottom of the shaft. In the 1850s, Elisha Graves Otis developed a safety device to keep elevators from falling, eventually giving people the confidence to use them.

Our era may be losing the tolerance for the trial and error needed to make innovations successful. Consider the financial engineers whose mistakes led to today's financially led recession. They thought they were creating a more stable economy by applying mathematical models to markets, using new technologies of computing power and global trading. Even having lost fortunes, today they and their financial institutions are pariahs, subject to media frenzy and government regulation.

The innovators who thought up the elevator, the cotton gin and space travel didn't intend to kill or injure people as they perfected the technologies. Likewise, today's financial engineers never imagined their miscalculations could result in a global recession.

Perhaps the best person to illustrate this point is Robert Merton, the Harvard economist who won the Nobel Prize for his work that led to the options and futures markets of the 1970s that revolutionized financial markets. He was also a founder of Long-Term Capital Management, the hedge fund that became the poster child for mistakes in financial engineering in the 1990s.

Mr. Merton gave a fascinating lecture at MIT last month that deserves wider attention (the video can be viewed via The Business Insider Web site at http://bit.ly/MertonatMIT).

I asked Mr. Merton about the genesis of his talk. "There are plenty of fools and knaves in the unfolding story of the crisis," Mr. Merton said. "However, my focus was on providing some insights into what is happening in the financial arena, which are structural in their nature."

We need to figure out why the models failed. "Propagation of risk throughout the system, the potential dysfunctional elements of innovation, the limitations of models of all sorts, etc.," Mr. Merton told me, "all that would be there even if all involved in its development and management were competent, well-informed and completely ethical people."

In his lecture, Mr. Merton said this crisis was not a failure like the space shuttle Challenger disaster that could be blamed on the single factor of a faulty O-ring. Instead, many factors we're just beginning to understand, sparked by the housing bubble, led to the collapse. Risk grew across interconnected financial institutions as they bundled together assets such as mortgage-backed securities that collapsed together when volatility exceeded what the history-based models considered remotely possible. Government guarantees of deposits held by these banks, he noted, means "the government is writing a put option on a put option," making the plunge deeper.

Our fundamental problem is what Mr. Merton called the structural tension "between financial innovation and crisis." We know a lot about risk, information and probabilities, but not enough. "We've created instruments for manipulating financial risk without a thorough understanding of the underlying engineering." He compared innovations in finance to a new fast train running along tracks not yet redesigned for the speed. The value of the innovation, once perfected, outweighs the problems in the meantime.

It's easy to forget that financial derivatives have real value when applied with judgment. Businesses use them to hedge risks, from currency to the chances of a counterparty going out of business. Lenders can offer better terms by minimizing their risks, freeing up capital to support investment and economic growth. When the system seizes up, as we now see, pain spreads well beyond financial markets.

In a paper for the scientific journal of the Royal Society back in 1994, Mr. Merton warned that "any virtue can become a vice if taken to extreme, and just so with the application of mathematical models in finance practice." We know even better now that some risks can be calculated and thus reduced, while some unknowns cannot be turned into probabilities. "The mathematics of the models are precise, but the models are not, being only approximations to the complex, real world."

The measure of innovators is not in the mistakes they make, but in the lessons they learn. We now know that our complex markets need better models, which should include more humility, acknowledging that some risks are still too uncertain to measure and should be avoided. Instead of vilifying modern-day elevator engineers, we should challenge financial engineers to find fixes for what's broken.