The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1997
Robert C. Merton, Myron S. Scholes
Interview with Professor Robert C. Merton at the 1st Meeting of Laureates in Economic Sciences in Lindau, Germany, September 1-4, 2004. Interviewer is freelance journalist Marika Griehsel.
Professor Robert Merton, very welcome to this interview. It's a pleasure to have you with us. Today during your speech you outlined something that I found very interesting. You were saying that households and individuals have had, over the last couple of years, to take much more serious economic decisions about how their, for example, pensions would look like in the future and so on. Would you please tell us a little bit more about what the consequences have been and what consequences you foresee in the future, for example for households and financial institutions?
Professor Robert Merton: The trend has been, starting now in the Anglo-Saxon world but moving really to the rest of the world, as the ageing has taken place and retirement and pensions and so forth have become a much bigger issue. Recognizing that the structures that are used in the past, either from the Government or from corporations, of funding pensions in particular, have been just too costly. It's not that there's anything wrong with them, it's just it wasn't recognized how expensive they were. So there's been a move really over the last I would say 20 years of putting more and more responsibility on households to make major financial decisions; decisions that they hadn't had to make in the past. Decisions that they're not equipped to make at the moment, and with all respect for most households, I don't think they could be expected to become educated to make them in the future. Very much like you wouldn't ask people to perform their own medical services.
And as a consequence of that I see a shift, a trend, that's going to, I think, come, in which you're going to move from this sort of separate pieces, that everybody is asked to assemble their own financial plan or financial coverage, to more integrated solutions that are simpler for us to understand and do what we really want as individuals to do that. Now in particular, when you see the baby boomers coming to retirement, they're going to discover, many of them, that they do not have, with the combination of social security and their private savings, they will not have adequate savings in order to generate an annuity, which is what will look after them in retirement, adjusted for inflation, so that they don't have to give up their lifestyle as they age, that would be adequate to cover that. You know you can't get something from nothing. But one [INAUDIBLE] use of modern financial technology would be to develop instruments that get the most of what people do have for them. And one such instrument would be reverse mortgages. What that essentially allows the owner, who has accumulated wealth in their house, but wants to keep to live in as part of their living style, an opportunity to in effect be able to continue to live in their house throughout their retirement until their death, with no fear of being evicted because they couldn't repay the loans, but to be able to borrow out a substantial part of the value of the house and use that to purchase additional annuities so that they could live at a higher level. That's one such example.
Another would be combining treatment for long-term care and a life annuity in one package. And it just turns out, without getting too technical about it, that if someone has the need for long-term care, they're less likely to live as long, so by providing both contracts the provider, the insurance company or the corporate provider, can reduce its risk and therefore charge a lower fee than if they were sold separately. So we keep looking for use of financial innovations as a way to address in this case the retirement part of the lifecycle, but really to apply it throughout the lifecycle that all people in all places go through.
Could this be a way of reducing the risk in a way? I mean people have been quite upset, if you look at Sweden, for example. We're only now starting to realize that a large group of us will not have a pension that we thought we would have, because things have shifted and we were forced or made to believe that we had to make certain decisions. Do you think the risk for the individual will be less?
Professor Robert Merton: My hope, what I'm trying to build, so of course it's not finished yet, but which I think is quite feasible within the technology, is to develop instruments, tools, programmes and contracts that will make it possible for individuals to have a relatively risk-free economic retirement.
Does it mean that financial institutions need to become more risk-prone or more ethical about the way they do business, for example? You know who's going to change here?
Professor Robert Merton: I think part of it is the development of technology and more efficient allocation of resources, which doesn't require beyond that that either party gives something up. I think on the case of the institutions - they will have to work harder. They will either have to be more creative or they'll have to be at more risk or find ways to get risk-borne. From an economist's point of view that makes sense. It's much more sensible to expect institutions to find a more efficient way to distribute risk than to impose it on the individual person. So, I think we can make definite improvements there by moving in that direction. The ethical nature of things of course in every field and every profession sadly there aren't ethical things. But I think for the most part people who work in the financial services industry are really trying to do a good job and do the right thing.
You made a likeness between a car manufacturer, and you know you just can't have a car which has one door and looks the same color. So the financial institutions are going to have to be more, as you said, more innovative.
Professor Robert Merton: Yes, as it is now the institutions, by leaving the risk and the decision on the individual household, make life simpler for themselves, because the household's taking much more of the risk and they don't have to make the kinds of commitments. It opens it up, therefore, for many more people to be advisors on finance, because you don't really have to take that commitment. It is clearly more complex for the producer, so there's a kind of paradox. The easier, simpler to understand and more comfortable you make it for your customer, the more complex you make it for yourself.
And in the case of an automobile analogy, you know it's easier to make one door on a car rather than four, and if you produce all cars the same color you don't have to have as complex a painting choice or anything. But of course that doesn't take account of the needs of the actual customer. And in this industry, as well as the auto industry and the other industries, I think in the end they will find competitively they will have to do what's right for the customer. So, there is greater complexity, but I think on the whole it's a more efficient and effective system, and I really am quite hopeful that significant improvements will be made. And I wouldn't leave this by saying that over the last 20 years in many ways there have been very great improvements in what is offered in the financial services. It's just that there's been this underlying trend of putting more responsibility on the household for things that they really aren't in a position to make good decisions about.
The reverse mortgage, I just want to come back on that. Do you see that already in the United States?
Professor Robert Merton: There were versions of it. It often happens with an innovative idea, the first versions of that I think were rather poor. They didn't perform their key functions. So as I've described it there are no major providers here in the United States. There have been some sporadic places elsewhere. As with much of my work now I'm always looking to the next horizon rather than what's at the moment. But that said, there are no technological barriers to producing this. And in fact I hope to see it developed in the impending future.
I just want to go back a little bit in time and ask you something about your childhood, because you said you were looking forward all the time. When did you realize that you had a very good sense for economy and finance and, you know, the maths around it? Did you know that already as a child? I read somewhere that you liked baseball and you didn't really care that much for maths?
Professor Robert Merton: Well, I liked math as my academic subjects. But you're quite right, I think as a child I did the minimum amount of work I had to do in school; with the exception really of math – I enjoyed really. I liked baseball and other things. At the same time, when I was a pretty young age, I used to create fictitious companies, including a fictitious bank. I think it was called the RCM Dollars and Savings Company, of which I went and tried to get deposits and make investments. And at a relatively early age, ten or so, I invested my first share of stock. And I used to follow, look at companies and so forth. But throughout the whole period, and indeed right through my college years, while I was involved in the stock market, always interested in finance, I never thought of it as a full-time job. You know I always thought that was something for after hours. And it was really fairly late in my graduate study that I decided actually to move into economics.
I read somewhere that you said you wanted to do something that really mattered?
Professor Robert Merton: That was a big factor in my decision. As an undergraduate at Columbia, I went to the engineering school, I had a great deal of training in engineering and mathematics as well as subdiversified training. And then I went to the California Institute of Technology to do my PhD in applied math. And I went there and I took all the courses I needed and passed my qualifying exams. So I was really making a decision about doing research for my dissertations. So I finally came to the point where I really had to focus on what I was going to do. And I found myself ... two things happening: One: I was following the stock market and doing things before hours – not interfering with my studies but doing that.
And the other is I started to look at the range of problems that people were working on, using mathematics and the applied fields, and it ranged from plasma physics problems to water waves in a tank and fluid mechanics. And none of those really excited me too much. This was also in 1967, so middle-late part of the ‘60s. And we had had the view, at least we – I was not in a congress at the time – that we had solved macroeconomic problems; that we had the Council of Economic Advisors and under Kennedy and then Johnson there was a sense that we really had solved macro problems. And I looked at that and said, you know, "If you could do something in the field of economics," which intrigued me anyway, "you might have an influence, even if you did a little something, on an awful lot of people." And that's exciting. And so there was a combination of a sense that you really could do something, and then my idea that I sort of had a feel for the stock markets and things of that sort – economics, I had this mathematics training.
And then I'll confess there was a bit of serendipity or a bit of luck, I guess you would put it, I read a book on mathematical economics. I can't remember the author and as you'll see it's good that I can't. And I decided it was so terrible that I thought even I, if I went into this field with my mathematics, could probably do something. Had I read Robert Solow's or Paul Samuelson's mathematical works I might never have come into the field. So, it was a combination of all that that I made this complete break where I left Caltech, I applied to a number of economics departments, who of course I had no economics. All but one turned me down. The one that accepted me was MIT, which most would say was the best department in the world at that time. And they gave me a full fellowship so my decision was easy. And then I went to MIT.
Did your parents influence you? I know that your father is a highly acclaimed academic and I believe your mother also is in the academic field. In which way did they influence you? I'm sure in some way or another.
Professor Robert Merton: Well of course. I mean as we all have happen, being in a household with 10,000 books and things going on you absorb things that are not … But I think in the case of my father, in terms of the things that influenced me, he never pressed me to go into academics or pressed me to go to a field, and indeed my behavior was largely to move as far the other direction. I don't think that's uncommon with people with very successful parents. And so for a long time I think what I really absorbed from him was a sense of a work ethic; a sense that if you are going to do something it should be of top quality. And of course he being in a major academic environment, he himself being very eminent in a field, it just seemed standards that were set. I mean I was very comfortable. I met Nobel Laureates and their equivalents in the other fields and just, you know, listened. So there was that as background.
In my mother's case she taught me something, and one thing I often repeat to people is she gave me the dictum that I should do it their way, whoever they are who set standards, and do it so well that there's no question that I could do exactly what they were asking. And then once I did that, I had the right to do it my way. And I, to some degree, followed that for a good part of my life. But of course later my mother died, about 15 years ago, my father died last year, but my father and I were, you might say, best friends for the last 40 years. So we interacted; almost did some joint research.
He must have been very proud when you were given the prize?
Professor Robert Merton: Oh yes. And he was very happy. In fact he came to Stockholm with all of the rest of my family, but he was my significant other at the table. And he was very happy and he always signed his letters, even before the prize, as the ‘father of the economist'. I would sign as the ‘son of the sociologist'.
How did you react when you got a phone call?
Professor Robert Merton: That's a question there. I was actually leaving my apartment for an early flight to New York and the phone rang. And as we often do, the first moment was, "I better not answer it because I'll be late for the plane." Then I said, "Oh, I'd better answer it, you know, say I'm rushing." Well of course when the phone came and they said who they were and they said they had some interesting news for me I never left my apartment, I missed the plane. But after getting it I guess I just sat down. The phone started ringing and I quickly stopped answering. And I started thinking about it and it was just, you know, unbelievable. I guess the only feeling that came to mind was I said, "Well now I'm going to have to be a little more careful what I say, because I go downstairs now and whatever I say will be all over the world. And if it's something really dumb it's going to really reflect not on me only but also on my institution. It's going to cost the Nobel Foundation." And the committee had made their decision. So I felt a little more responsible of what I had to give when I said things.
Did you restrict yourself?
Professor Robert Merton: Oh, not really. It was the thought, but no, I think I felt a certain additional responsibility - it also created some - because people might actually listen.
The fields of economics is often to people from the outside very theoretical, but really it's about daily life. How is it possible to translate theory into daily life and explain it? You know it's so much part of our lives. How do you go about it when you meet people who might not have any knowledge when you explain a theoretical problem?
Professor Robert Merton: Well, as in every field there are some problems that only someone in the field can find interest in. They really are very technical. However, at the main stream of things, I think one should really be able to explain what's interesting and what's important about just about every aspect of economics. The trick is to find out the background of the person you're talking to and try to find a frame of reference. But if you really do understand the problems and what they're about I think there's no reason at all that you can't explain. At least the substance of it and why it's important. The execution may be more difficult to explain.
Has it helped you to move in these two worlds? I mean, you've done both academic work and you've done a lot of more practical work one could say as well, as a consultant, for example. How important is that, to be able to move between these two?
Professor Robert Merton: It turns out from a professional and a personal point of view it's been very important. As it happens, although I was at MIT on the faculty full-time for 18 years and then at Harvard for another 16, so I've always been in full-time an academia, I always found it was both beneficial for my research and beneficial for the other work to be involved in the practicing community. And I did some serious consulting when I was still a graduate student, but certainly within a year or two of my becoming a faculty member I became involved in practicing a very material way. And I could show in fact in the paper that was cited for the prize on option pricing, in that paper is a section I did which was an application of the technology we had developed to a thing called the "down-and-out" option, which was pretty esoteric. But it's turned out subsequently to be the prototype for a whole industry called exotic options, which are used all over the world and have been.
I wouldn't have known of the existence of that contract to put in my research paper, let alone solve it, how to price it and so forth, if I hadn't been involved in practice. So there really has been a feedback that, as a theorist the art of the science is making judgments about the abstraction from complex realities. When you build a model the world looks very complicated, so you have to simplify. And it's the art of how you simplify which I think, to a large extent, influences how people see your models and what you have developed. And I felt the confidence in my abstractions that – in the area I was working – that as a consequence of my being involved in practice I felt the confidence of being able to say, "This abstraction's okay. This is close enough to reality, this is the way it really happens. This isn't." And that, in no one specific case but as building the whole mosaic of models that you build and how you explain them and what's an interesting problem, I felt very influenced by having the practice.
On the more personal level it was stimulating to be working with world-class minds in academia; MIT, Harvard, you know, University of Chicago and so forth. And then be able to in some sense change clothes and go from Cambridge to New York, which is not a long distance in space, and be involved with very intelligent, interesting and motivated and talented people of a very different sort. And the combination of that just from a personal point of view is quite stimulating and still is.
Is there any field that you would like to advise young economists to go into if they are choosing the more academic side of it?
Professor Robert Merton: Well, I have to confess to a bias at my part of economics, financial economics. And I think this has, in the past, one of the great excitements about it is that doing the most complex mathematical theories, and empirical work, you could take that same work and it's turned out to have direct implications in practice. /?/ Direct implications in practice. So you could have sort of both. And that isn't traditional within economics actually. But it's true in finance or has been. Looking forward, I see the opportunities with that background, financial economics, to expand and grow what you can do with that. I think that the tools of financial economics are going to be more widely used in what are traditional macroeconomic fields, monetary theory, fiscal policies. If you want to end up running a central bank you'd better understand finance, you'd better understand the contracts. It's as important as learning about interest rates and the more traditional macro.
The opportunities: finance deals with risk. Risk permeates everything we do, and has always and it will continue. And the explicit understanding of risk, how to measure it and how to corral it or manage it, and designing instruments that make that possible, it is a very challenging thing but it's not going to go out of business. And finally, I would point out for the longer term that, you know, for someone starting a career, you're in a circumstance because of the evolving financial technology and physical technologies, that not only do the emerging market countries have to revise their financial systems and institutions, but so does Japan, the second largest economy. It completely has to redo it. It's not going to happen overnight of course. But so does Euro Europe, because while you have monetary union here you have not rationalized or designed the institutions that are going to permit that a true unification. No question that's going to happen. No question it's going to take rebuilding.
The excitement for the individual who's going into the field now, at least I see it, is that there's already enormous technology, market proven technologies, that can all be brought to bear to address these whole new problems. And, as I discovered in my own career, some ideas I had were adopted within a couple of years into mainstream practice. That was the options model. A second idea was related I had dealing with rescue debt. Took 26 years before it's now become widely adopted. The difference between the two was not somehow that people didn't recognize the good contribution in the second term, because they did. It was need.
Practice response to the things that are most needed. It doesn't have the luxury of looking at every idea and developing it. I believe that the need in the case of Eurolan, the need case of Japan and then of course all the emerging markets and whatever you want to define China to be, which is kind of in a class by itself, all point to both a need and the availability of the technology to expand and develop in whole ways that hadn't been done before. Really, if you want a metaphor for rebuilding the financial systems and the opportunities, in the past people had looked to the most successful economies and tried to model from them, adapt them. Whether it's the US or Britain and so forth. But in this rapidly changing environment of technology it's a little bit metaphoric. The same as if you were going to build a telephone system today because you had none, you wouldn't adopt the one that's in the United States with telephone calls. You would leapfrog the technology and build up a [INAUDIBLE], digital. And the same thing is true of financial systems. It's not that the US had a lousy phone system, in fact one of the ironies they had the best one. But because they had the best one it doesn't make sense to tear it all down and rebuild it.
So here, when you have this need of developing, of redoing these financial systems, the sort of bright light to it is because of all the technology that's evolved is the opportunity to leapfrog the best systems which exist today substantially; if you look at it the right way; if you're forward-looking not looking backwards, because if you're looking for help it's not in the past.
And this creates wonderful opportunity for young people coming along, whether in academia to do research. Just think of you know all the things that one could do. I mean, if I was starting over I'd be very excited. I'm excited now. I don't plan ever to retire. But if I was starting over I think it's a wonderful situation to be getting into. I mean because even though there may surely be delays, we know we sadly have wars and depressions – or at least recessions, that will dislocate changes. But if one of them looks at what has to happen over the next several decades, from a career point of view, both in terms of satisfaction and being in demand and having a chance to do something that could really influence a lot of people, you could look at it afterwards and say, "I was a part of that," not a bad feeling. There may be some others that you could name, but I think it has a great deal of opportunity. And that's what keeps me going now.
That's lovely. I just want to pass on the question about the third world and the developing world, which is really a continuation of what you've said. They have been going about financing and building up in a very old-fashioned way, taking risks that have not been at all profitable and of course having been so badly hit by war and conflict and natural disasters. But how do you see the developing world making the leapfrog, because it's certainly there, the natural resources, the human resources? The capacity is enormous and yet they are so far behind.
Professor Robert Merton: Of course it's a great challenge and to sit here and suggest it'll all take care of itself would be not the case. But that said, if we measure it in relative terms, relative to where we have been and what the opportunities or hope might be for the future, in my area of finance the new technologies, this new way of doing things, of being able to really much more efficiently distribute risk, to find ways which we've evolved of stripping risk and separating from the other qualities, of investment projects or a variety of other economic activities - gives us the opportunity to allow these countries to develop better the resources they have, because they can in effect take more risks, not for themselves because, that's one of the problems - they are not rich enough, wealthy enough, to be able to take much risk - so therefore you know that's where the rather poor, low return opportunities. The hope here is they're being able to distribute the risk elsewhere in the world, which it should be. Very much analogist to what I discussed moments ago about the households.
There are better ways to distribute lots of the risk than to impose them all on these smaller countries. So if we find ways, and there are ways, to distribute it that gives the opportunities for them to develop their resources, which inherently may have more risks, but they can shed them efficiently, and also have with them somewhat higher returns; that's one element. A second element is on the ongoing basis it's possible to substitute for the very concentrated risks, which are inherent in a small country. I mean there are only typically one or two major industries that can be developed or sources, whether it's agriculture or natural resources, oil even, that you can now get rid of those risks, those concentrated risks, while retaining the good parts of developing what are the comparative advantages in those countries? You could say, "What's different now?" Some technological difference. If you look at how countries, developing countries and certainly third world countries, get financed at all, it's been done by bank loans, it's also been done by governments and World Bank support and so forth, but to the extent you have private sector financing it's almost all been done by banks. It's been done as a consortium and it's typically been loans, loans in some foreign currency. Typically short-term loans, which is a prescription frankly for disasters. You know that may have been the best way to do it at the time, but it sets up a situation for a crises.
The idea here is by bringing financial technology, opening up the financial world, all the kinds of these new technologies [INAUDIBLE], financial contracts as we call them, and so forth that are [INAUDIBLE] derivatives and so forth, is it offers a multiple chance to these countries for getting rid of risks and for getting investment. So if one of the channels is clogged or something goes wrong with its banks, they have other channels; they're not shut off. Every country will benefit by development of this financial technology, but the smaller developing countries and the poorer countries actually will, I believe, benefit disproportionately because it gives them a potential seat at the table. Now it's true they need education – not of everyone, I mean education of people to be able to make use of these markets. But that's feasible. There is no reason at all that these countries can't have the best that they have.
I know the World Bank used to have a programme, which I think they still do, where they train them in how to deal with this. So you know it does require education. But the opportunity, the idea of having a place at the table of the world capital markets, without only being able to go through indirectly through the one channel which are banks, I think you know holds great hope in my mind. And so in a way it's going to be inevitable that at least the first beneficiaries of a lot of the technology are the more developed countries, because that's where the resources are, but ultimately I think the incremental percentage benefits are going to be much greater for these smaller countries and that's really a hope in my mind. It's a hope but it's a hope with some reason to be hopeful.
Great. Thank you so much for this interview and I wish you a great time here in Lindau.
Professor Robert Merton: Thank you very much for having me.
Professor Robert Merton: Thank you.
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