From crisis to crisis: the manic masters of the universe

  • November 13, 2011

Capitalism & Crisis

Deluded by the idea that financial risk can be controlled through quantitative models, the Masters of the Universe keep running themselves into the ground.

From Crisis to Crisis: Theory and History of Capitalist Crises

Part I: Can Capitalism Survive?
Part II: Details Proliferate, Structure Abides
Part III: Is the Euro Today’s Gold Standard?
Part IV: The Manic Masters of the Universe

When the speculative hedge fund Long-Term Capital Management collapsed in the late 1990s, its elephantine demise should have sent alarm bells going off in capitals around the world. Here was a vast financial institution run on the basis of state-of-the-art mathematical models designed by Nobel Prize-winning economics, quite literally face-planting itself into financial oblivion.

One of LTCM’s co-founding Nobel Laureates, Robert C. Merton, had helped devise complex quantitative methods of risk analysis meant to maximize the fund’s returns while minimizing its risks. But rather than providing a stable pattern of revenues, Merton’s initially highly successful “risk engineering” helped contribute to the illusion that LTCM’s profoundly overleveraged and dangerously overexposed balance sheet was fundamentally sound.

In a piece in the London Review of Books, the Scottish sociologist Donald MacKenzie revealed the irony of the economist Robert C. Merton forsaking the lessons of his father, the sociologist Robert K. Merton, who once observed that “beliefs about social institutions are a constitutive part of those institutions.” Even more ironically, Merton Sr. used the self-fulfilling prophecy of a bank run as the perfect example of a situation where unquantifiable actor beliefs (rather than their quantifiable interests) are crucial to shaping outcomes.

But Junior failed to heed his father’s lesson. Ultimately, it was not Merton’s flawed quantitative models of risk assessment that were to blame for the collapse of LTCM, but rather the illusion of certainty that these models provided. The problem was not in the models — it was in the mindset of the traders, who considered themselves to be the ‘Masters of the Universe’, who could grasp even its most complex inner functioning through powerful computational techniques. This bullish mindset, instead of allowing the fund managers to control for risk, ultimately made them blind to it.

The modeling of complex systems – chaotic systems – does not lend itself easily to prediction. It may do so in times of calm, but we should know by now that, under conditions of free capital flows, financial markets never really tend to be calm for long. So ten years on, it happened again – only this time on an infinitely larger scale. Once again, complex financial products designed to disperse the risk of individual investors actually ended up amplifying the systemic risk of a total meltdown of financial markets. What goes up, must come down.

So why did we not heed the lessons of Merton Sr. and his “financial wizard” son? Perhaps we simply did not want to know. Back in 1987 already, the quants believed a stock market collapse to be so against-the-odds that even if the lifetime of the universe were to be replayed a billion times over, Black Monday would still be considered a “highly unlikely event”. And as John Lanchester pointed out in Whoops!, this bizarre belief was mindlessly replicated in the lead-up to the subprime mortgage crisis of 2007-’08, with investors believing that a 20 percent decline in house prices “was likely to happen only in a time frame many, many trillions of years longer than the history of the universe.”

Psychologists commonly associate such delusions of grandeur with schizophrenia and bipolar disorder. Perhaps this could help us understand the manic nature of financial markets today?

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Jerome Roos

Jerome Roos is a postdoctoral researcher in political economy at the University of Cambridge, and the founding editor of ROAR Magazine. For more on his research and writings, visit

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