Myron Scholes Canadian-born American financial economist is photographed in Toronto, Ont. Sept. 15/2010. (Photo by Kevin Van Paassen/The Globe and Mail)Kevin Van Paassen/The Globe and Mail
Myron Scholes predicted in 2007 that banks would have to recapitalize, and the month before Lehman Brothers imploded in 2008 he said that there would be a global recession.
Mr. Scholes, a Timmins, Ont., boy who has spent most of his life in the U.S., rose to fame in 1997 when he and Robert Merton won a Nobel Prize for creating the Black-Scholes model of pricing options. Mr. Scholes was also one of the creators of the hedge fund Long-Term Capital Management, which blew up in 1998 as a result of bets that turned sour because of Russia's default, forcing the U.S. Federal Reserve to orchestrate a bailout.
Mr. Scholes was in Toronto Wednesday to speak at a risk-management event hosted by SAS Canada. Afterward, he sat down with The Globe and Mail to talk about the financial crisis and the state of the economy.
What's the most important thing we should learn from the financial crisis?
The tiger looks as though it's tame - it ain't. Globally what happened is that all of us, whether it's the consumer who borrows on their credit cards, the student who gets student loans, the home-buyer who [decides to buy a house based on the notion it's value is appreciating] the retiree who didn't save, or the private equity firms who levered their positions, there was this penchant for taking greater risk. That's because things were calm. Macro policy was working, the government was telling us from their side that we should take more risk, the government through regulation in the United States was encouraging sub-prime lending. We need to create enough volatility in our economy that people are cautious.
Where are we now in the economic cycle?
My view is that this is not a typical Keynesian recovery or recession model. Keynesian modelling relies on marginal propensity to consume and marginal propensity to invest. The idea that if we give more money to the poor, they have a propensity to consume that's much higher than the wealthy, though I wish they would talk to my wife about that, she seems to have a propensity to consume. But the idea is that transfer payments create a multiplier effect where a dollar spent creates $1.80 or $1.85 of actual consumption to re-stimulate the economy. The problem I see with that is that this is a structural change. We've had a large wealth effect. We have to rebuild our balance sheets and rebuild our flexibility, and that takes time. So the stimulus was put in place to encourage consumption at a time when people want to build their savings. ... I hope we can create policies that encourage investment.
Are regulatory reforms moving in the right direction?
I worry. In the United States the Dodd-Frank Bill had 2,039 pages. With the increased uncertainty as to what the regulations are going to constrain and what they're going to provide going forward, I think it does affect the provision of financial intermediation services in the United States and potentially around the world. The question I have is if we have to have a bill that was 2,039 pages as a result of the crisis, why didn't we have some of these regulations put into place prior to the crisis? And if it takes 2,039 pages to do something, do the regulators actually understand what the problem was? I looked at the bill, and there was very little on the housing market in the United States.
Do you think rating agencies will be less important ?
I do see a decreasing role for rating agencies. The rating agencies themselves have not had enough competition, and I think we will see alternative ways in which people and entities can rate. Given greater data availability and given understanding of how to model, I think that to the extent the SEC in the United States allows more competition to come in, there will be more forms and the rating agencies that we've seen in the past will really evolve to something quite different.
Derivatives have essentially become a bad word in many circles. Are we rushing to judgment?
Everything's derivative, it's how we name things. Things that went bad at the time of the crisis, we called those derivatives. Returns on securities are derived from fundamental instruments, we just call them different names. A futures contract is a derivative, but the futures exchange doesn't call them derivatives, they call them futures. So it's true that certain contracts did cause difficulties and blow up. The question I have is what were the mistakes made in the pricing, what were the mistakes made in the modelling?
Are you a fan of mark-to-market accounting rules?
I think that we should have mark-to-market. It causes entities to be more cautious of the types of assets they hold; stale inventory in financial institutions comes and rears its head because the prices are marked down. In many entities where you seem to be making income on stale inventory - because you're garnering the income each period but not marking down the paper at all - you're really not. What I would look at is can we have a combination system? During times that are not chaotic, we have mark-to-market, but then we would suspend mark-to-market when we have liquidity shocks, and later reinstate it when liquidity returns.
How will economics have to evolve now?
I hope we learn from the crisis. We had thought about things like the great moderation or the idea that we now understood macroeconomics, and we could use interest rate policy in a way to guide the economy forward. To do that, if you're inflation-targeting as an example, and in the U.S. required to also stimulate growth, then it leaves aside the question of what is inflation. Do we look at asset-bubbles or asset-price effects of trying to control the inflation rate? If we only try to control the consumer inflation rate and ignore the prices of assets, that could have consequences on the future growth of the economy. ... Additionally, we've ignored exchange rates. We've said let's let the inflation rate go where it may and don't worry about how it affects the economy.
Did we fail to learn lessons in the late '90s, and from Long-Term Capital Management?
The experience of the '90s, whether it's the '94 peso crisis or the '97 crisis in Asia, the '98 crisis, even the 2001 crisis, is that we recovered pretty readily. There wasn't great consequence.
His comments have been trimmed for length