Thursday, August 18, 2011

Now He Tells Us: Noble Prize Winner Says LTCM Was Doomed to Fail

A co-founder of Long-Term Capital Management said that the hedge fund was doomed to fail because of the leverage it used and the fact that its models don't work, reports FinAlternatives.

LTCM collapsed in 1998—a year after Myron Scholes won the Nobel Prize in economics for the models he created that caused the collapse.

“LTCM ran leveraged positions at too-high risk levels,” Scholes told Risk. “It was not a sustainable business in the longer run if you have to reduce leverage and seek extra capital at a time when risk transfer costs are high.”

Scholes also blamed an over-reliance on classic portfolio theory (my emphasis).
Capital models should give levels that are required to sustain the business at times of shock, and this is different for leveraged hedge funds because they can’t call for additional capital from investors. I believe capital models should not rely on portfolio theory, because the correlation structure is just not constant—in a crisis, you have intermediaries reducing risk simultaneously, so things that appeared to be independent clusters in the past become correlated, and diversification against those clusters does not provide staying power.
Austrian economists such as Ludwig von Mises have always taught that there are no such constants, long before LTCM was formed or exploded. In 1953, Mises wrote:
The positivist does not see that there are no constants in human action and that his postulate is therefore unrealizable.
In 1960, Austrian economist, Murray Rothbard wrote:

Indeed, the very concept of "variable" used so frequently in econometrics is illegitimate, for physics is able to arrive at laws only by discovering constants. The concept of "variable," only makes sense if there are some things that are not variable, but constant. Yet in human action, free will precludes any quantitative constants (including constant units of measurement). All attempts to discover such constants (such as the strict quantity theory of money or the Keynesian "consumption function") were inherently doomed to failure.
Bottom line, as Scholes seems to now admit, the Austrian economists are correct in adamantly stating that there are no constants in human action.

Scholes goes on to state:
The people who experienced the crisis we are in now will learn a heck of a lot because they experienced it. But people who didn’t experience it can’t understand because they weren’t there.
Well, Austrian economists decades before LTCM blew-up understood the LTCM problem.  Austrians also understood the current crisis well in advance (See here, here, here, here, here, here, here and here.)
So speak for yourself, Myron


  1. Exactly. All those hocus pocus math models look good on paper, but never work out in the real world. Hilarious that a nobel prize winning economist had a failure that bad. It shows how worthless nobel prizes and econometrics really is.

  2. Rothbard link is broken.