01 Dec 1997
"Economists are puzzle solvers..."
An interview with Robert MertonTopics:
Two days after his Nobel Prize was announced, Professor Merton spoke with Bulletin editor Deborah Blagg in his Morgan Hall office, where imposing stacks of scholarly journals had been displaced temporarily by a garland of colorful balloons and numerous congratulatory floral bouquets.
Bulletin: What were you doing when you heard the news?
Merton: I was just about ready to leave for an early morning flight to New York. The phone rang in my apartment at about quarter to six. I could easily have been out the door. I answered the phone, and the secretary general of the Royal Swedish Academy introduced himself and said, "I have some interesting news for you."
Bulletin: Were you surprised?
Merton: I certainly was surprised, overwhelmed, and very happy. There are many people who have done remarkable work in this field. I am truly honored to have been chosen.
Bulletin: You have said that your father [Robert K. Merton, a National Medal of Science winner whose work in theoretical sociology at Columbia University has spanned fifty years] has been a strong influence in your life and your career. What did he say when you told him?
Merton: My father is the really serious academic in the family. He created the sociology of science; terms such as focus group, role model, and self-fulfilling prophecy are all familiar to us because of his work. He's 87 now, a university professor emeritus at Columbia, and a scholar at the Russell Sage Foundation. And we're very close; we've talked to each other every day for the last thirty years.
Anyway, when I called him in New York, he just was beside himself. When he later learned there would be a reception for me at HBS that day, he wanted to get to Boston as quickly as possible. He couldn't find a taxi to the airport outside his apartment, so he raced up a steep hill to Broadway, found a cab, and for the first time in his life he gave a driver a couple of extra bills with instructions to get him on the next shuttle at LaGuardia. He said his son had just won a Nobel Prize, and the cab driver made him spell the name Merton so that he'd have it right when he told the story.
Bulletin: Will your father be going to Stockholm with you when you accept the prize?
Merton: Yes, he'll be with me in December.
Bulletin: You mentioned how some of the concepts your father introduced have found their way into everyday vernacular. Are there applications of your own work that would be familiar to the average noneconomist?
Merton: In 1973, when the late Fischer Black, Myron Scholes, and I published the research recognized by this prize, option pricing was considered a fairly esoteric area. Myron and Fischer were working on a formula for option valuation. I looked at what they were doing and came up with an alternative - some say more robust - way to derive the formula that has since turned out to have very wide applicability. But at the time, the work only had direct implications for pricing over-the-counter options and some executive stock options.
The methodology we developed to solve that original problem, however, gave us an insight into solving a wide range of other problems. I think of the process of discerning other applications as a little bit like peeling an onion: once we gained the initial understanding, we began to see a whole world of possibilities open up. An option is a fundamental security now - whether linked to interest rates, stock indexes, currencies, commodities, or real estate. But that's only part of it. There are other financial things that have the same structure as an option and can thus be analyzed in the same way.
A home mortgage is a simple example of how our work is commonly applied. Most mortgages allow the homeowner the option to prepay the mortgage before its term is up. That option to prepay has a value, and banks need to know how much to charge for it up front. In order to determine that, they really need to be able to analyze what the chances are that the mortgage will be prepaid - in other words, what the risk is to them. What our analysis did, in addition to improving the means to price options, was to provide a way to measure risk exposure.
Bulletin: Why has the methodology been so widely used?
Merton: One answer is, simply, that it filled a need. It wasn't intellectual interest that made people want to apply it. In the 1970s, profit margins to options dealers were driven down, competition was going up, and options investors no longer could operate based on simple heuristics and guesswork. This theory enabled options transactors to take much bigger positions because they were hedged; they could be much more efficient, and they could control their risk much better.
If you look at the last 25 years of extraordinary financial innovation and institutional change - with structural changes in financial systems all over the world - it's easy to see why the ability to take financial securities and products, many of which never existed before, and analyze them both with respect to pricing and risk characteristics turned out to be a very powerful tool.
Bulletin: How do you present this theory to your students?
Merton: What the formula captures permeates many financial aspects of life. One way I present it in the classroom is to have the students design a security. We call it a squiggle. They ask, "What's a squiggle?" I say, "I don't know yet. You're going to design it for me." And in real time, they design the payoffs to the security.
Then I say, "Now, I'm going to show you how we price and analyze the risk of this just-created security." I take them through and apply the analysis, and boom - within a class session, we've worked out how this thing has to be priced. So they see that even with an instrument that never existed before they came into the classroom that day, the theory allows us to price it and measure its risk.
Bulletin: When did you first become interested in the field of economics?
Merton: I bought my first share of stock in General Motors (I've always been a car buff!) when I was ten. I can remember going with my dad to the stockbroker's and sitting there watching the NYSE and AMEX tapes, learning all the companies' symbols. And when I was in graduate school in applied mathematics at Cal Tech, I'd get up and go to the broker's at 6:30 (9:30 EST) to trade over-the-counter options and convertible bonds until I had to go to class at 9:00.
But it wasn't until I was contemplating the topic of my Ph.D. thesis that I started thinking about switching from applied math to economics. I had always been interested in financial markets, and I found myself thinking that unlike a career in applied math, where most of the work is pretty esoteric, if I could really make a breakthrough in economics, I might affect an awful lot of people.
So, much to the chagrin of both my family and my advisors at Cal Tech, I applied to a bunch of economics departments. Since I only had one undergraduate economics course on my transcript, all but one school turned me down.
Bulletin: MIT offered you a full fellowship?
Merton: Yes, and MIT had Paul Samuelson. My first semester there I took his course on mathematical economics and loved it. A paper I wrote for the course was later published, and Paul asked me to become his research assistant.
Working with him was critical to me, because he was one of the few economists at the time whose work really integrated sophisticated mathematics and financial economics. That real-world application of complex theory was very attractive to me, and when I realized that financial market problems could be a legitimate area for serious academic research, I was off and running.
One of the nice things about this award of the Nobel is that it further underscores the legitimacy of finance as a mainline field in economics. I get such a kick out of being able to bridge the highly mathematical world of formulas and the hands-on world of the markets.
Bulletin: Can you describe what it's like to work at this level of intellectual sophistication?
Merton: Economists are puzzle solvers, and some solve purely empirical puzzles, where you work long hours evaluating data one step at a time, trying every permutation, and after years of this, you hope to find something. That can be really fascinating and rewarding.
The research that I like best, however, typically starts out as theoretical and not empirical, but I always try to bring my financial common sense to bear on it. The art of theoretical model-building is to make good abstractions that also capture the essence of the world that you're trying to explain. That's the fun. That's the challenge. I've been doing this for close to thirty years, and I'm always excited when it really works. To have both intrinsic intellectual challenge and excitement and extrinsic application - it just doesn't get any better than that.
Bulletin: At 53, you are the second youngest economist ever to win a Nobel Prize. Where do you go from here?
Merton: In terms of research, for several years I have been working with colleagues in the HBS finance group on something called the Global Financial System Project. We are trying to understand the global financial system and the implications of institutional change.
Our conceptual framework to date is that because the institutions themselves are changing so dramatically - just look, for example, at the transformation of banks and insurance companies in the last couple of decades - we can't expect them to be our analytical anchors. Instead, we've decided to analyze the global financial system by looking at universal financial functions.
Bulletin: We spoke earlier of sophistication; this sounds like research based on very basic principles.
Merton: In a way, yes. All of us, whether we live now or a hundred years from now, in New York City or in Bali, are served by various financial functions as we go through life. We are born, we need to acquire shelter, we work, we borrow or lend money, we sell things, we retire, etc. Our group takes these functions as our unit of analysis and asks, "At any given time and place, with technology, geopolitical change, and a host of other variables factored in, what's the best way to structure an institution that performs those functions?"
The spirit of it is to try to devise a way of thinking about institutional change in an organized way in the global financial system. We're still at an early stage in this, but I'm finding it very exciting.
Bulletin: So you'll still have plenty to keep you busy when you come back from Sweden.
Merton: I have no thoughts of early retirement!