Lessons of the Fall: A Stunning Collapse and Weighty Morals to the Story

The collapse of Long Term Capital Management was a wonderful event, comparable in its enlightening powers to, say, the Great Crash -- but without the pain and privation, the bank runs, bank closures and bankruptcies that followed that earlier disaster.

What did we learn?

First, LTCM punctured the jewel of Chicago, the efficient capital markets theory. How? By proving that the event that should not have happened, did happen. Yields diverged when they should have converged. What should have been a safe bet proved catastrophic. And then, too, LTCM demolished the reputations of the professors, the authors of the efficient markets theory, who had lent themselves to the enterprise. They were exposed for what they were: Alchemists.

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True, LTCM's actual bets had little basis in the Merton-Scholes options-pricing formula. How could anyone judge the probable distribution of outcomes (and hence appropriate options pricing) in the Russian GKO market, which had only existed for a few years? But this is secondary. When the Nobel Prize is deployed as a marketing device, the underlying theory becomes subject ineluctably to the criterion of commercial success. If the Nobelists did abandon their own guidelines, as they apparently did, one may fairly presume that they did it because the guidelines weren't bringing in the money.

Second, LTCM seems to have produced an upheaval inside the establishment that awards the Nobel Prize in Economics. Amartya Sen, an economist of genuine distinction who contributes to important subjects such as the economics of famine, won the prize last year. We shall soon see if the improvement continues.

Third, LTCM rescued us from a shallow view of the Asian crisis. "Crony capitalism" had been the early war cry of the business press, and some economists too, including Paul Krugman (though Paul redeemed himself by quick advocacy of capital controls for Malaysia). But what could have been more emblematic of cronyism than the $100 billion of bank loans that found their way to LTCM? Or the chummy way the New York Fed stepped in to rescue ex-Fed man David Mullins? If the LTCM rescue was in some sense necessary to save the system (and I am prepared, on balance, to believe this), then it also showed that cronyism is endemic to capitalism. The Asians were therefore not some alien breed, but rather, just like us, lacking only the backing of the Federal Reserve and the refuge of the God-almighty dollar.

Fourth, LTCM exposed the free-market folly that led to the collapse of Russia. This was an ecumenical business, in which economists from Harvard helped to demolish Soviet institutions, putting nothing in their place, while economists from Chicago profited from the pyramid scheme on which the Russian government was then forced to function. When the latter collapsed, both sorts of economists lost their reputations. And the political damage will rightly now extend right up the chain in the Clinton Administration to Albert Gore, indeed to all who were told that Russia was in reckless -- even criminal -- hands, and who chose to do nothing about it.

Fifth, LTCM was reassuring, once the dust had settled, in regard to the stability of our own capital markets. This was not because it showed they are efficient, but because it showed they are liquid. Fed Chairman Alan Greenspan contained the crisis with three swift interest-rate cuts. No pyramid of unsustainable prices collapsed here in the U.S. -- which raises the question of whether or not what we are experiencing here (outside of the Internet stocks) is, in fact, a bubble. The easier conditions that followed for a year also helped some of the Asian countries, notably interventionist Malaysia and Korea, to stabilize their own situations.

A lesson for the future? LTCM showed that the past is not a reliable guide to the future. You can't get rich, reliably, by estimating the distribution of asset-market returns. The ergodic hypothesis (that changes in asset returns follow a bell curve) is a loser. It's time to reread Benoit Mandelbrot on the Pareto-Levy distribution with its infinite variance and his theory of self-similarity in the time scale of changes in asset pricing. If you don't know what I'm talking about, get the Fractal Geometry of Nature and start reading at the back.

Implication: It is also a fallacy to read the future of today's stock market from the history of past returns. For instance, price-to-earnings ratios. Is the exuberance rational or irrational? I don't know. Neither does Alan Greenspan. And no policy should be based on knocking up or down the Dow Jones per se. But lending pyramids and Ponzi schemes -- the great destroyers of liquidity -- are to be avoided, and government vigilance, ex-ante as well as ex-post, is essential for this task. Hence my call for higher margin requirements under Regulation T.

As the great economist Paul Davidson has said, markets that are efficient are not liquid, and markets that are liquid are not efficient.

Q.E.D., LTCM.

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James K. Galbraith does not own individual stocks, neither buys nor sells, and observes the markets from the safety of a tenured position and a highly diversified pension fund. He has no connection to Chicago. He does have an undergraduate degree from Harvard, but his economics degrees (M.A., M.Phil. and Ph.D.) are all from Yale, a department which seems to have learned from Irving Fisher's losses in the Great Crash of 1929 -- and is not known to be implicated in any current financial scandal.

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