When Genius Failed
Irving Fisher, like many others beside him, lost pretty much his entire fortune in the stock market crash of 1929. That's not the story of Irving Fisher, though... his is much more complicated. You see, more than 20 years earlier, in 1906, he wrote The Nature of Capital and Income, one of the first books to ascribe reason and scientific order to markets. Fisher's work has had a great deal of influence on economics in academia over the years, and his work is part of the foundation of complex financial mathematics and instruments we see on Wall Street today. In a recently released book, The Myth of the Rational Market, Time magazine editor-at-large Justin Fox tells the story further:
He is perhaps not the father, but certainly a father of modern Wall Street.
Hardly anyone calls him that though. Economists honor Fisher for his theoretical breakthroughs, but outside the discipline his chief claim to lasting fame is the horrendous stock market advice he proffered in the late 1920s. Read almost any history of the years leading up to the great crash of October 1929, and the famous Professor Fisher serves as a sort of idiot Greek chorus, popping up every few pages to assert that stock prices had reached a "permanently high plateau."
Well, if by "permanently high plateau," Fisher meant "about to fall drastically, plummeting the country into a prolonged depression," he was spot-on.
The book we have for you today, Roger Lowenstein's When Genius Failed, is a more recent example of academic faith in the rationality of markets going disasterously awry. It tells the story of Long-Term Capital Management (LTCM), a hedge fund started by John Meriwether that lured the best and brightest minds of American academia to Wall Street—Nobel Laureates of economics Myron Scholes and Robert C. Merton among them.
As Todd write in his review in The 100 Best: "'You're picking up nickels in front of bulldozers,' a friendly money manager warned..." Roger Lowenstein knows the stories of Wall Street—and knows how tell those stories—as well as anyone. In the last two decades, he has covered "the street" for America's two premier newspapers, the Wall Street Journal and The New York Times. And, when Conde Nast decided to put out a business magazine—the sadly defunct Portfolio—they went out and got Lowenstein to write them book reviews, a feature that obviously held our attention here. As he writes of LTCM in the epilogue of When Genius Failed: If only they had looked to the example of Irving Fisher, who had himself tried to pull off a similar move from the halls of academia to the pits of Wall Street almost a century earlier, believing evangelically in the rationality of the market and the soundness of his own mathematics. And, if only we could have taken the collapse of LTCM more seriously, perhaps we could have avoided much of what has come to pass recently... what with the liquidity crisis and the bailouts and the panic and the job loss. We have 25 copies available.
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Scholes had described the small amounts of money made on each trade to investors during the fund-raising like "vacuuming up nickels that others couldn't see." The only way to make large sums of money was through leverage, through taking on incredible amounts of debt to make the thousands of trades needed to earn substantial profits. This was both the genius and, as it turned out, the flaw of the strategy.
When Genius Failed, Page 102
LTCM was founded by Meriwehter in 1994. By 1998, when it failed, it had become so integrated in the machinations of Wall Street that the Federal Reserve Bank of New York found it necessary to organize a bailout of the institution to the tune of $3.625 billion to avoid a wider crisis—presaging some of the more recent, much larger government bailouts of Wall Street institutions. ... Uncertainty, as opposed to risk, is an indefinite condition, one that does not conform to numerical straitjackets.
The professors blurred this crucial distinction; they sent their mathematical Frankenstein gamely into the world as if it could tame the element of chance in life itself. No self-doubt tempered them; no sense of perspective checked them as they wagered such staggering sums.
Sigh... as Lowenstein writes:On Wall Street ... few lessons remain learned.
