TWAROWSKI: Hello and
welcome to the MIT 2016
Open House Distinguished
Lecture Series.
My name is Filip Twarowski,
and I'm currently
a junior in Courses 16 and 18,
which are Aerospace Engineering
and Math, here at MIT.
It is my pleasure to introduce
to you professor Robert Merton.
Dr. Merton is the school
of management Distinguished
Professor at the Sloan School of
Management here at MIT, as well
as university Professor
Emeritus at Harvard University.
He received his PhD from
MIT in Economics in 1970,
and his research includes
finance, finance theory,
life cycle and
retirement finance,
the dynamics of
institutional change,
and improving the methods
of measuring and managing
microfinancial risk.
In 1997, Dr. Merton received
his Alfred Nobel Memorial Prize
in Economic Sciences for
his work on new methods
to determine the
value of derivatives.
Please join me in
welcoming Professor Robert
Merton to begin.
[APPLAUSE]
Thank you so much.
MERTON: Well, thank
you very much.
Thank you for coming
out on-- whoops--
I don't know whether
I should wish
for a rainy day or sunny day.
It's been so
beautiful yesterday,
I think if we had that, the
room would be completely empty.
But in any case,
thank you for coming.
For my topic today, I was
going to, as you can see,
talk about the
role of innovation.
And of course we are at MIT,
in the university or Institute,
so we should talk about the
role of science in all of this.
And it's all in the end
relevant to the issues
of the impact on global
economics and development.
So-- by the way, I should
say about my slides,
I'm not a slide person.
They're going to be very
entertaining slides,
and in fact, some of
them are so crammed,
you're going to be
hard to read them.
If I was up there
with you, forget it,
but I'm not going to
rely on them very much.
I'll move them along,
just kind of do it,
but the way you should
think of these slides:
If you find anything you hear
this afternoon interesting,
you can get copies.
Then you're going to
be happy that they're
compact because they're not
so heavy to carry around.
So don't get
frustrated if you say,
"I can't even read this,
let alone comprehend it,
so I'm just confused."
But this is kind of
my agenda for the day.
And let's start by just talking
about something that is often
forgotten, you know,
that to have a well-
functioning financial system is
absolutely essential to growth
and economic
development everywhere.
Sometimes there's this
notion that there's
the real sector, Main
Street, out there,
and then there's another thing
called Wall Street, which
is the finance sector.
I have to tell you, I'm on the
Cheney's Academy of Sciences,
some committee that
involves finance,
so you can imagine when I looked
at the English translation
of the committee I was
on, I was on the committee
on the fictitious economy.
I said, "how did that happen"?
I think I don't know, but
I have a good suspicion.
If the real economy is
well, Main Street, then I
guess finance is unreal.
And you can imagine
going from unreal,
the translations in
Mandarin back to English,
and what's a synonym for
"unreal?" "Fictitious."
OK.
So that's my theory, anyway,
as to how I got that title.
But other than some
textbooks in macroeconomics
that are probably a little
aged, the idea that you have
dichotomy, that you
have the real sector
and the financial
sector, is a fiction.
And I hope to illustrate
that too, today,
by going through actual
examples and so forth,
rather than giving
you a lecture on it.
And in particular I can
give you some intuition
based on some research
that was done,
among others, by my
professor at one time, then-
colleague and good
friend Robert Solow,
who won the Nobel Prize in
1987 for his theory on growth.
And he made many contributions,
but basically one
of the most important,
or one best known,
perhaps, is that
when he examined
economic growth and
its determinants,
he found that least for the
19th and 20th century, that it
wasn't population growth,
having lots of children;
nor was it frugality,
high savings rates,
"now you save more,
you must invest more,
therefore you must
grow more"; in fact it
was technological progress.
And he both had the
theory, and then the data
seemed to support, or be
consistent, with that theory.
And that was kind of
a revolutionary way
of thinking of things,
compared to the way
people thought in the past.
So technology-- now
if you think about it,
we could have all this
fantastic technology,
which we do here
at MIT in the labs
and so forth, wonderful
ideas in every area.
But unless that technology
can be translated
into implementation in
the broad economy deeply,
it will never manifest
itself into growth.
You actually have to do it.
You can't just invent
it and find it.
You have to implement it.
You have to make it permeate
its uses throughout the economy.
And the process of doing
that is, essential for that,
is to have a well functioning
financial and legal system that
allows you to raise the
resources, manage the risk,
and do so efficiently,
effectively,
to get the implementation done.
So I just-- a fast pass-through.
This is not the
purpose of the lecture.
Just to say whatever
you've heard
in the-- even places
like the New York Times--
editorial anyway-- or
the Wall Street Journal,
or wherever-- many things you
may have heard about finance
in the last 10 years, a number
of them are true or accurate,
I think.
But what isn't
accurate is the idea
that this isn't very important,
or it doesn't matter, or at
very least, just contain
it from doing anything bad,
and that's good enough.
That isn't good enough,
as I hope you'll see.
So what I thought
I would do today
in taking you through
this is to say, well,
if as financial
says-- oh, I mention
Douglas North, another
Nobel Prize winner, who
sadly passed away about a month
ago, but at 90- something.
That's not so terrible.
That's what someone
at my age can
say, "when I get to be
90, if I'm so fortunate"--
maybe I won't quite
look at it like that.
But in any case, if you
think the financial system is
important, how do
you improve it?
You improve it by a thing
called financial innovation.
That's the process of
improving the financial system,
and a variety of
things drive that.
In particular the drivers
are finance science,
same as in any of
the other fields,
and it is indeed a science.
It has a set of principles,
relationships, series
of hypotheses, and
has rather good data,
and uses very sophisticated
statistical techniques
in an organized fashion.
Actually able to predict
things, and more importantly,
some of the things that you
work out from it actually work.
So we have finance
science as a driver.
We have, of course,
technology, computers,
all of that sort of
thing which makes
it possible to do things that
weren't even feasible five
years ago, let
alone 25 years ago.
And so that was critical.
And finally you have
something that's
very important to getting
it implemented: need.
You've probably all heard
the old saw about real estate
valuation, "What
are the three most
important things for valuation?
Location, location, location."
In getting innovation
implemented-- not creating
the ideas, finding solutions,
but actually getting
them implemented-- the three
most important ones, at least
in my mind and my experience
over a lot of net decades
of trying to do it and
occasionally succeeding,
is "need, need, and need."
Okay.
So those are the
drivers for the process.
So I wanted to start
off-- I'm going
to give you sort of
a quick historical--
though not to give you
the "history" history.
Because if I was going to give
you the history, for example,
of finance science, I'd
at least have to go back
to 1900 and Louis Bachelier.
Oh, I have to put
something out here
for anyone who is in finance.
A lot of the technical
stuff in finance, you see,
physicists and so forth
say, "Yeah, you're
a mathematical physicist."
They all say, "Well,
this is very good,
you're just using it, but
the mathematics you use
is just physics mathematics."
And I have to correct
that, you know.
MIT always has to try
to keep it accurate.
It's almost true, with
just a slight variation.
Actually Louis Bachelier,
at the Sorbonne in 1900,
in his thesis-- if there's
any PhD students in here--
there is his thesis.
Not bad.
He developed the mathematical
theory of continuous time,
stochastic processes.
And as was required at
the time, his application
of his mathematics,
was to option pricing.
Options are a thing
called derivatives.
That was in 1900, and his
mathematical derivation,
according to people
who I respect,
when compared to Einstein's 1905
famous Brownian motion paper,
five years later-- Bachelier's
was just as rigorous, at least,
as Einstein's.
So actually if you think
it was Einstein's that's
being used in
finance, actually it
was a finance problem,
option pricing,
that preempted it
five years earlier.
Okay, enough on
that sort of thing.
But I couldn't resist, this
audience, telling them that.
So what I want to do is take
you through a bit of history.
I'm going to go back
to a period, as you all
are aware, probably very
painfully so, 2008 - 2009.
The great financial
crisis, which we're still
hearing about and feeling
the reverberations of,
has often been compared back
to the Great Depression.
Except I think at least some
question-- I don't say issue
with that-- because
well, there are
some-- it happens probably
that, as measured by the NBER up
the street in Central
Square, the recession--
Great Recession-- lasted
longer than any other
since the Great Depression.
The difference of the two
is pretty substantial.
You would have known the
difference between the 1930s
and 2008.
And more to the point
for our purposes,
I want to take us back to a
more recent period perhaps
more relevant, the 1970s,
which I'm sure for most of you
seems like a long time ago.
But compared to the
1930s, it's not.
And in particular
in the 1970s, we
had many of the same
institutions we have today.
Not as sophisticated,
necessarily,
but we had safety nets
and all kinds of things.
And I want to show
you, through going
through a very quick
pass, some of the things
that happened in the 1970s in
the United States and Western
economies that were
pretty big too.
And I'm not going to be
like some of your parents
or grandparents who said to
you, "When I went to school
I walked uphill both ways
in the snow barefoot.
You have it easy today. " So I'm
not going to get into a process
of trying to argue with "the
1970s was a tougher time than
in 2008," and so forth.
I'll let you make your own
judgment from just what I
point out to you.
But it happened the 1970s
was a period in which there
was an explosion of
risks, big risks, that
hit the financial
system and the economy
pretty much-- I won't
say simultaneously,
but close to simultaneously.
I'll just give you a laundry
list in no particular order.
The first thing that happened
is the fall of Bretton Woods.
That was an arrangement
by which all the currency,
major currencies of the
world, were linked in price.
So you didn't have to look
at what currencies were.
They were always the same.
So basically nobody ever knew
what the currencies' exchange
rates were, because
it was pretty boring.
And that was established at
the end of World War II, about
1944, so for about 30
years, a generation,
nobody thought about that.
All of a sudden
that all came apart,
and suddenly all the
currencies of the world
started moving around, with a
missing generation of, even,
experience with it, let
alone anything else.
Okay, that's the first one.
The second one was
the first oil crisis.
We didn't know we
had that number,
but it turns out that we did.
That was whereas,
you may have read
about if you weren't there,
you had long gasoline lines.
Then the price of oil went
from $250 a barrel to $14,
and that was a pretty
big shock to the system,
and had impacts on
all kinds of things.
And we had a second one
before the end of the decade,
and of course, we've been
in and out of it ever since.
So that's a pretty big one.
What else did we have?
Double-digit inflation,
more than 10% inflation.
We had not seen that
in the United States
since the 19th century,
100 years, no experience.
Now it's hard, probably, for
you to believe, especially when
you're hearing about Europe
worrying about deflation,
whether they can get
enough inflation.
But we had more than
double-digit inflation.
And the impact of
that, particularly
on some of the MIT
retiree professors
and staff-- you know,
you get $100,000 a year
as your retirement when
you're in your first year.
Next, what do you get--
$90,000, then you get $81,000,
and in three years, you've
lost 28%, almost 30%,
of your retirement.
That's pretty exciting,
okay, in the "Chinese" sense
of the word.
And so we had
double-digit inflation.
At the same time, we had
very high unemployment, 9%.
Now if you think of the
processes-- you don't have
to be an economist-- you've
certainly, if you've read
or listened-- what did the
central banks of the world
try to do?
Mr. Bernanke, and now Janet
Yellen, and Mario Draghi--
another MIT graduate,
who runs the ECB--
what policies did they take?
They really pump
money in there, trying
to bring interest rates
down, pumping lots of money
in to try to keep
the economy going.
I don't think they
could have done that,
or would have done that,
if they simultaneously
had a 10% inflation rate.
So I want you to understand
that the '70s was
a strange period in which
you had very high inflation
and very high unemployment.
Which is not supposed to
happen, of course, according
to tradition.
It was called "stagflation,"
and it was Mother Nature's way
of telling us we had
the sin of hubris,
to think we had solved
all these problems.
Because what wasn't
supposed to happen, did.
Anyway, so we had that going on.
The stock market fell by
50% in the United States,
in real terms, in
an 18-month period,
and there was no mortgage money.
Why?
We had Regulation II, which
said that deposits in banks
could pay no more than 5%.
No more.
US Treasury's "full faith and
credit," short-term and longer,
were over 10%.
It doesn't take a deep
mind to think, "Why would I
put my money in
a bank at 5% when
full faith and credit
from the US government
pays me over 10%"?
So guess what?
There was no money
for a mortgage.
It had nothing to
do with your credit.
You could be whoever you wanted.
You couldn't get money.
All right.
So I don't want to go
through all of this,
but do you get a sense
of the flow here?
There was a lot of shocks
that hit the system
in pretty major ways, okay?
And we had a fairly
long recession.
Now what I wanted, to
take you through this,
was not for, "Hey,
don't feel so badly
about what you've been through."
That's not the point.
But rather, to say, "What was
one of the impacts of this"?
One of the impacts of this
was an extraordinary amount
of financial innovation
implemented, all in the 1970s,
into the '80s and beyond.
But it all started
there, and it's
hard to believe that it wasn't
caused in part by the shocks
of all these risks coming in.
And we're not a fixed system.
We're a reacting system.
So when something bad happens,
or something disturbs us,
we react.
There's feedback.
And one of the
reactions is to-- we've
got all these shocks of risk.
We may not be able to
stop them, any more
than we can stop hurricanes.
But we can try to devise
means by which we can
measure and manage those risks.
And that's very important.
So I just wanted to list for
you some of the innovations that
took place.
We created an options
exchange, which
is nothing more than
value insurance.
It's an instrument
you can buy that says,
if you have this
contract, you can
sell the asset you
own, at a fixed price,
on or before a given date.
It's just an
insurance policy that
says you can always be
assured of getting this price,
whether it's a share of stock,
a house, a bond, or whatever.
So an insurance market was
created, the first one.
Options have been around
since, thousands of years,
but in terms of an exchange,
this was the first time.
We've similarly created
financial futures markets
for trading risks in
everything from currencies
that now were floating around,
interest rates, and stocks.
We created the first
electronic stock exchange.
There are things like
money market funds
and a bunch of other innovation.
TIAA-CREF, which is now
called TIAA-- they just
rebranded themselves--
those of you from academia
may know who they are.
They were an
insurance company that
was created by Andrew
Carnegie for professors,
for their retirement,
very large,
and our Paul Simonsen
was on the trustees.
And they were the
first major institution
to internationally diversify
stocks as a regular policy
back in 1972.
Those of you who have
401(k)s, or 403(b)s,
or saving for retirement, or
just that you routinely as US
people invest outside the US,
it's very standard to have
funds all around the world.
It's taken for granted.
That didn't exist
prior to that time.
All the stock and other
kinds of investments
were essentially domestic.
And as you'll see
in a little while,
that's not a small event.
Okay.
So they had that.
We had ERISA, that's the modern
pension system in the United
States, was created in 1974.
All the pension
funds you see out
there, the trillions of dollars
and all that, all of that
was created in the 1970s
as well, in response.
You have May Day, which
happened on May 1st,
so it was a May Day-- in which
the cartel of the New York
Stock Exchange was
finito, so you have
what's called
"negotiated commissions."
It used to be, prior to that,
if I bought 100 shares of IBM,
I paid a commission.
If you as an institution
bought 100,000 shares of IBM,
you paid 1,000 times
the commission.
Sounds bizarre.
You couldn't even
imagine that today.
Systems wouldn't work today.
Nothing you see in finance
that you take for granted
could be done because it's
all become institutions.
And you're talking about costs
being brought down to levels
that are very, very low.
Okay?
Well, if you didn't
have this change--
and it took something
to get this change done,
as it often does-- you had the
creation of a national mortgage
market.
Prior to that, mortgage finance
came from your local thrift
institution.
And if you're in a growth
area, everybody moving in,
they all wanted mortgages.
Where do you get
the money for it?
Well, that's interesting.
Hope a lot of people
are saving in the town.
And what we did is,
essentially, created
so that anywhere in the
world can finance mortgages
for people in the US.
So I can be in
Holland, or in Tokyo,
and I could be
funding US mortgages.
Well, that wasn't possible
[? prior to this. ?]
And on top of that, that
transformed the whole industry
from a one-stop place, where you
had to depend on that one place
in town, if it had money,
and if it had the confidence,
and it had the
willingness to sell,
to highly competitive
systems where
you had people and entities
specialize in things
like processing mortgages, which
has nothing to do with finance.
It's a processing of
it, and decompose,
and transform the industry.
Now this illustrates
one of the points
I wanted to make by
going back to the 70s.
When you have a crisis, whether
in the 1970s or in 2008,
it's like a fire, and all
you cared about is survival.
You'll deal with the rest later.
And if you want a
metaphor, imagine firemen
arriving at a blazing fire.
What did they do?
Whatever they have to do,
first, to get people out,
and secondly to
put out the fire.
And that may mean ripping down
walls, and breaking windows,
and doing all kinds
of destructive things
which turn out, perhaps,
to be necessary to do it.
Of course after the fire is
over, you look at the mess
and you kind of say, well, I
wish we didn't have to do that.
And then there were times
when they really are lucky,
and they have figured
out a way to put out
the fire without knocking walls
down and breaking things up.
But once the fire is
out, the job's done.
That's it.
Here, the solution to the
1970s-- not "the", "a"
big part of the
solution-- in all
of this innovation
that I've listed here:
First, it wasn't
something that was
destructive like
the breaking down
of walls that would then have
to be fixed after the crisis
was brought to bear.
It wasn't even something that
worked, but then had no value.
All the things you see here
on this list exist today,
are the mainstream today,
40-odd years later.
And all of us, in all the
generations in this room,
have benefited from it.
In fact so much so, we
take it for granted.
There never has been a
time since the creation
of a national mortgage
market that there
wasn't mortgage money.
Yes, sometimes
credit is tighter,
the interest rates change,
but there was always money.
We take that for granted.
We say, hey, got paid
too much, or maybe we
think we should get more
than we should for our house,
but it's always there.
That was not true.
So when you hear about--
especially the younger of you,
you hear "In the
good old days when
we understood
things," and were--
they weren't "good old days."
That's one advantage of
having lived through them.
There were lots of bad things
like not being able to-- no one
could get a house financed.
That seems to be a pretty
fundamental problem.
And there were many
more, so don't always
listen to the rhetoric
of the survivors.
They're the only ones
that tell the stories.
The ones who didn't
survive are not
around to tell you
about it, okay?
So just keep that in mind.
But all of this innovation
is still working today.
Furthermore, this was
developed in the United States.
In the subsequent
years, every country
in the world-- even
just developing ones,
not just developed
countries-- have instituted
these same kinds of risk
markets, futures markets, swap
markets, option markets,
and have brought most all
of these technologies
into their system.
And by the way, it has
made it possible to have
a globally integrated system,
even though individual cities,
nation-state systems,
are heterogeneous,
with different rules, different
currencies, and everything
else.
So there's some evidence that
not only does this stuff work
good, but others who
didn't have to looked at it
and said, "That looks good
to us," and adopted it.
So these are facts that
you can find in the world.
And so I wanted to show you
how sometimes crisis can
breed a lot of good
things in response.
Not that I wish crisis on it,
but rather that crisis does
have that impact of getting
a lot of things done.
And as it happened
during this time,
the research of finance
science exploded.
Now there is no question
that finance science
had a big impact on finance
practice and innovation.
What is equally true is that
the extraordinary innovation
had a feedback effect
on the science,
that we were able to see
things, do things, learn
things, and get inspiration
for things that we wouldn't
have otherwise had.
So again, it turned
out to be, I think,
a pretty virtuous
feedback loop for that.
Okay, so this is
taking us through.
That's the lesson.
Now I'm going to pump
you 20 years later.
We'll eventually get
to today, and even
talk a little bit about
tomorrow before we're done.
Okay?
But I think it might be fun to
just take you through these.
So I'm going to take
you to the 1990s
and I'm going to leave
the United States
and go to Europe, to Germany,
which had just reunified,
East and West Germany.
As you're probably aware,
the economic status
of the two halves of Germany
were quite different.
Western Germany was very
industrialized, very
well developed,
and certainly one
of the economic
powerhouses, as Germany
is today, of Western Europe.
And East Germany was not.
And when they reunited,
one of the things
that wanted to
happen as a nation,
is to kind of bring
them together.
So I'm going to
tell you a story.
There's a real story,
yes, I mean I know it,
okay, I mean firsthand.
So I actually know it.
There was a city
in what was then
East Germany called Leipzig.
And the city of
Leipzig decided it
wanted to expand the
amount of electric power
it had in the city so it
could grow and develop.
And it turned out that
electric power was
generated by natural gas there.
So I'm just giving you facts.
So they wanted to expand
the amount of natural gas
they could get.
And remember who's
managing this city.
They don't suddenly, when
you have reunification,
throw all the
people-- the mayors
and the city managers--
out of the city
just because they reunified.
This isn't like, you
know, you throw out
all Republicans, or all the
Democrats, or replace them all.
So the same kinds of people,
often the same people,
were still there who were
there when it was East Germany.
But under East Germany,
what was the case?
It was a command
and control economy.
There weren't any
markets, there weren't
any real financial
markets, there
were no-- nobody used present
value or any tools like that.
It was, we need it
let's do it, or whatever
we think we should do.
And that's the
culture that they had
since the end of World War II.
Okay.
The reason this
is important: I'm
trying to show you the
practical elements of how
you get innovation really
done, not just hypothetically.
And the elements of
that were that if you're
going to present
them with a solution,
you know, something to
do, it can't be complex.
It can't even be as
relatively simple
as that we might give to a
first- year finance class here.
The students-- no
disrespect to students,
you're just starting out--
because they just wouldn't have
been able to make the judgment.
So that was part of
the design criteria.
It had to be really, really
simple for them to understand
and make a decision.
So here was the situation
as it stood at the time.
The city was
offered two options.
One, from the Russians,
was a consortium that said,
we'll get you the
gas, and the deal
is, we'll give you gas for
15 years at a fixed price,
you understand.
So they fix the price,
and for 15 years
will deliver so much, and so
many Deutsche marks for Mcf.
See, this is before the Euro.
Okay.
So the contract the
Germans were offering--
I mean the Russians
were offering--
were, say x Deutsche marks
per Mcf of gas for the next 15
years fixed.
Now to physically deliver it,
they had to build a pipeline,
and the pipeline was going
to cost $300 million.
Now I know in
today's dollars that
doesn't seem that
big for a pipeline,
but that's actually
pretty, a lot of money,
particularly to the
city of Leipzig.
And you know in that
fixed price they
have to pay for that
pipeline, right?
I mean, they're not doing
this out of their good heart.
And the other thing
is that you also
had the issue that you were
doing a deal with the Russians.
And some things don't,
haven't changed.
Nothing about people,
the individual people
personally, but
let's just say it
can be somewhat taxing at
times, as you see some more
modern versions, in the case
of the last five years Okay.
But that's the deal.
The alternative was to
take the gas from the West,
from the North Sea and so forth.
And that would require a much
smaller pipeline, $50 million,
and you didn't have, perhaps,
the same political risk.
But what was the problem?
The problem was, first
of all, that the market
price for that gas
fluctuated all the time.
Right?
I mean, it wasn't constant.
Now if the people of your
city, for the last generation,
have lived in a place
where prices are fixed,
there isn't a price system,
this is what you pay every month
and that's what you paid
every month independently
of anything.
And now you're going to
suddenly say to them,
by the way, this month your bill
is $30, or 30 Deutsche marks;
next month, it's
52; next month, 41.
Does that sound like
that's a likely thing
to have people doing?
People don't like that
here, even though we've
lived in market economies.
So the problem with
the Western solution
was that you'd have enormous
amount of price fluctuation,
and the risk of things
causing a price fluctuation
are multifold.
First it was, of course,
the price of natural gas,
but what else?
Natural gas as with
oil-- the currencies
of which that is denominated
is not Deutsche marks,
it's dollars.
And now the Deutsche
mark, of course,
was not fixed to the dollar,
so you had currency risks,
you had natural gas
risks, and so forth.
So you could imagine the city
managers scratching their heads
and saying, which do we pick?
This is like, which would you
rather do: freeze to death,
or burn to death?
How about neither?
Well now, the truth is at
that time, a very well-known
global bank got wind of this.
And they were in the
business, among other things,
they had a group that
did financial solutions,
called financial engineering.
This is a common term.
All right?
And they said, hmm,
here's a problem.
Can we come up with
a better solution?
And the answer is, they did.
And I'm going to
tell you how it was
presented to the city managers.
So think of yourselves as
the city managers, okay,
and then I'll tell
you how they did it.
So first, I'll show
you the outcome.
So they go to the city managers.
You're the city-- you're
all city managers,
but I'm going to look
at you because you're
right in front of me.
Okay.
And I say to you, look,
the Russians-- well, I'm
not going to talk about
the politics or anything,
but they're offering
you fixed-rate gas,
x Deutsche marks per Mcf
for the next 15 years.
AUDIENCE: [INAUDIBLE]
MERTON: You like that, huh?
AUDIENCE: Yeah.
MERTON: How do you like
it if, two years from now,
the price of gas that any
one can buy anywhere else,
is x over 2 Deutsche marks,
and you're still paying x?
So think of it, I'm paying
30 Deutsche marks per Mcf,
and the rest of the
world is paying 15.
You're the city manager.
How are you going to explain
that to the population
of Cambridge, I mean Leipzig?
AUDIENCE: [INAUDIBLE]
MERTON: Why are you paying
twice as much for the gas
that everybody else
can buy the gas?
That's the nature
of a fixed contract.
You're happy it's fixed.
This is not going to
vary, but you're not
going to be so happy if you have
to explain to people why you're
paying twice as much.
Easy if you're
paying half as much.
Then you can be a
big heroine or hero,
but when you're
paying twice as much?
So think about that from
the political point,
but I'll put that to the side.
But I bet that was on
her mind, because she's
the one that actually has
to explain to people when
they come storming
into the city hall.
She's the one who's going to
have to face them and explain
to them the
complexities of hedging,
and why before-the-fact
decisions have to be made,
and after the fact, you wish
you may not have made them,
but that's the decision.
But what's the deal
I'm going to offer you?
They are offering you x
Deutsche marks per Mcf.
Here's what I offer you.
First, don't take the
Russian deal, take the West.
Get your gas from the West.
So I'm telling you
where to get the gas,
but here's what
we'll do for you.
Just buy it in the market.
So hook up, do number one.
Oops, I pushed that button.
Luckily I was
informed in advance
that there's a button that
did that, otherwise I'd
be panicking that I
washed out all my slides.
Okay.
So just go buy your
gas at any price.
Whatever the market price
is, you pay the market price.
Any time that market price
is more than x Deutsche
marks per Mcf, any
time it's more,
we'll rebate the difference.
You understand?
So if you pay 1.5x,
we'll give you back 0.5x.
Anytime it's below, enjoy it.
So in simple terms,
think about this.
You're the city manager.
Which would you have?
Always pay x and
think of the political
when it goes the wrong way,
or never pay more than x,
but otherwise pay
the market price.
So you're paying what
everybody else in the world
is, except when you
get a better deal.
What's your decision?
Which one do you like better?
AUDIENCE: [INAUDIBLE]
MERTON: Well, that
was not by accident,
the way it was framed.
Actually you can laugh,
but that-- I mean,
I think it's obvious-- it
was obvious to them, when
you finally got it done.
But like so many
things in finance,
and in many other
areas, making it really,
really simple for the
customer or the client
often is very, very
complex for the producer.
In other words, to be able
to offer this contract
was a very complex
thing that required
a complex set of tools,
analysis, skills, and so forth.
So what was under the hood
of this simple contract
is in fact very complex.
So if you ever hear,
oh, we should go back
to the simple days in
finance, when all we
had was a stock
market, and bond market
and so forth, the answer is,
that wouldn't have worked here.
You couldn't have
done the solution.
But I was first going to
see what you were getting.
It's like when you buy the
car, you turn on the keys
and it goes, and you like it.
But you don't have to know
how an internal combustion
engine works, or all the
stuff under the hood.
But it's complex
in the engineering.
Now the first
question you should
have asked as the
manager is, wait
a minute-- if it's
too good to be true,
it's probably not true.
AUDIENCE: Yeah!
MERTON: Or, there
is no free lunch,
and how are you able
to offer obviously
a better deal than the Russians,
with the Russians giving us
a high value-- price?
Are they trying to-- the
answers may [? add, ?]
but that's not what the
Russians were doing.
So then you might say, well,
which of us is a better credit?
Maybe you promised to
do this for 15 years,
but how do we know you'll do it?
Just as the Russians
have promised
to pay you, give you
gas for 15 years,
how do you know they'll do it?
Well, it turned out that this
bank had a far better credit
rating than Russia.
It was AAA when, back
when that meant something.
Like Global Bank, one of
the most well-known banks
in the world.
And if you had to take a
choice of which credit,
you were actually better
off taking that bank
than taking Russia, okay?
So it wasn't a credit deal.
Where did it come from?
If you can't understand where
you're getting the free lunch,
it's probably not free.
The answer is here--
and I should go over--
here is that because you're
doing the Western thing
physically, you're getting
your gas from the West, what
are you not doing?
You're not building that
pipeline from Russia.
You're building a
much smaller one.
So instead of spending $300
million for a pipeline,
you spend $50 million.
That means it's $250
million real dollars, not
phony dollars, not
accounting dollars,
not shell game dollars--
real dollars being saved.
And that's the source of how the
bank was able to offer a better
deal to Leipzig.
And at the same time,
it's in business.
It has to pay for its people,
its risks, and everything else,
and make a profit.
So that's the answer to
how the magic worked.
We didn't have to
build a $250 million,
more expensive pipeline.
We built a smaller one
and it turned out roughly,
and that's roughly, about
half went to the city
and half went to the bank.
Not as profit to the bank
but risk, paying people, etc.
So Leipzig came out of
this with $125 million
more dollars, real
dollars to spend,
than it would have otherwise.
And it got rid of
a political risk
at various levels,
which is non-pecuniary,
but you wouldn't like that.
People, your neighbors, coming
in wanting to lynch you.
Okay?
So that's what happened.
Now how did they do that?
It was all done with contractual
agreements, derivatives.
Derivatives are contracts,
like options and futures, that
allow us to move risk around
without moving money around,
so there's no
investment, there's
no money, just
move risks around.
You've heard of capital flows
in and out of countries?
That's money, or cash.
You've heard of trade flows?
We also have risk flows.
And if we can move
the risks around,
we can have real effects.
It is not, as some people
have said at one point,
all they're doing is moving
the deck chairs around
on the Titanic.
It's all going down
anyway because they're not
getting rid of risk.
That doesn't understand
what's going on.
Where you put the
risk matters a lot.
And if you've never
thought about it,
think of a life
insurance policy.
If anyone that you had to
insure, anyone else's life,
you would not do that
for $1.50 per $1,000.
You would not insure someone's
life for $1 million for $1,500.
I doubt that.
You understand you get $1,500,
but if the person-- unlikely,
but if the person passes
away, you pay $1 million.
You can't do that.
But with the risk sharing done
properly, it's easy to do.
So these are real effects.
Remember, I started my
remarks by pointing out
that these are real.
They have real effects
on the economy,
they have real effects
on what we can do,
and they have real effects on
what people are willing to do.
If you can share the risks
and move them around properly,
then you can undertake projects
of every kind that would be too
risky, imprudent to undertake,
if you had to do it yourself,
or if you didn't.
But if you move the risks around
to make it prudent, it works.
My colleague, Andrew Lo, has
been giving stuff here at MIT
on how to use finance to
solve a case of cancer.
But what it's really
about is how do you
share the risks of
all of the development
in an efficient enough way that
you get all the great ideas
coming out of MIT, and other
places, on new molecules,
or ideas for cures.
How do you get those actually
looked at, and studied,
and put into trials,
if they deserve it?
And that's what it's about.
It's all about moving
the risks around.
These are real effects, okay?
Now the derivatives they had
back in the days in the '90s
were very, very crude
relative to today.
There were no heating oil
futures to hedge their risk.
Remember, they're
making a guarantee
to the city of
Leipzig for 15 years.
That's a long time.
They're guaranteeing that
anything above that price,
they're going to pay back.
They're guaranteeing
it in Deutsche marks
and everything was
traded in dollars,
so they were taking all kinds
of risk: currency risks, energy
price risks, etc.
Okay?
They did the best they
could with what they had,
and they executed.
Was it complicated?
Absolutely complicated, not
just mathematically complicated,
complicated towards
experience, knowledge,
being able to execute
the transactions.
Could you do it easier today?
Absolutely.
We have futures in natural gas.
The contracts there only
went out five years.
Now they go out 10 and 15.
So we have much, much richer
markets today, and knowledge,
than we had back in the '90s.
So there are things we can
really do in the real world,
in scale, that work, that
couldn't have been even
contemplated then.
This is 20 years ago.
Okay?
So I'm trying, if nothing
else, to get across,
you understand: This is
the world you are in,
at least in my little
patch of your world,
which is called finance.
All right.
And that's how
they pulled it off.
Now there's one more
point to the story.
You said, gosh, this guy is
taking us-- where's my watch?
I put it out so I made sure I
didn't talk beyond time here.
Okay.
We're going to be okay, I think.
So why did I take
you back 20 years?
Because first of all,
what was the benefit?
The benefit was Leipzig
ended up with $125 million
that they could use
for other projects.
Pretty important
to a city that was
making an emergence from,
you know, a pretty big one.
What else did it happen?
And that's very modern.
A pipeline was not built. A
nasty pipeline, nasty to what?
To the environment.
All pipelines are that way.
We do it because we have to,
or that we are willing to.
This was a pipeline that
would have been built,
a big one, all the
way from Russia.
And you can imagine
all this stuff
because you're living today.
It hasn't changed.
In fact, it was probably
worse then because we were
less sensitive, had less tools.
But every time you build
something like that, there's
an environmental cost.
This is green.
And this is not
the only example.
I'll give you another quick one.
The TVA, which is an
electricity cooperative created
in the United States, created
during the Great Depression,
okay, put out contracts
to all the Mom-and- --
it had to be only people
connected to the grid,
people actually
generating electricity.
But there's sort of
little Mom-and-Pop--
they're not
Mom-and-Pops, but they're
little places that generate
relatively small amounts of it,
but they're connected
to the grid.
They put out contracts,
there were buying calls
to buy electricity,
and selling puts,
guaranteeing the
price of electricity
to anyone who's
connected to the grid.
And they sold enough of
this stuff to all of them
that they didn't have to build
two nuclear power plants.
That's 35 conventional
power plant equivalents.
Why?
Because they reorganized what
was out there through markets,
through these securities,
which could not
be done by some central
brilliant committee who
sat down and looked
at all the grid
and tried to figure it out.
It can't be done.
But these instruments
allowed that to happen.
So part of the story
here-- I'm trying
to reach the
broadest of audiences
here-- is to see it
not only save money,
it was more efficient in
that sense, it was green.
Because if you manage things
well, if you manage risks well,
you can be more efficient,
you can avoid that.
IT It's one of the ways to have
sustainability work, and that's
a very modern ideal, not just
one of the 1990s, or the 1970s.
All right.
So this list is
some of the things
that derivative contracts do.
I know you've heard the
big D word, oh my god, you
have one of those.
Actually I should tell you
they've been around for half--
well, they've been around
since the time of the Bible,
but in terms of large-scale
use since the '70s, that's
when the explosion was
created, and they've
been adopted around the world.
They are a central part
of every financial system.
No financial institution
in the world,
including all the central banks
of the world-- the Fed, okay,
the Bank of England, ECB-- can
function without derivatives.
Now this is [INAUDIBLE].
Just telling you
when you hear people
say we ought to get rid
of them or something,
or we don't need them, that's
someone who has never actually
been out in the world, at
least this part of the world,
because that's not feasible.
And furthermore, they're benign.
They're tools.
They don't have a soul, no more
than a corporation has a soul.
They're tools we've designed
to help us to do things.
And like all tools, whether it's
a chainsaw or anything else,
of course.
Any tool that's very good
can be used very well,
or it can be misused.
And of course we have to
be careful about that.
So I'm not suggesting
that there aren't
issues that have been involved
that you've heard about.
But I'm just
pointing out to you,
you have to put
it in perspective.
The solution is, we can all
agree, I think, in this room,
in any field, not just finance.
How about we agree that
we want all the fools
and knaves to be gotten rid of.
We don't want fools and knaves
making decisions for us,
or getting paid by us.
How many people oppose that?
You do?
You oppose it?
Oh.
I was going to say, whoo!
Hey, you're the first one!
But you know, maybe you're--
I won't mention his name.
You're not PC, but
maybe that's okay.
But in any case, my point is,
we can all stipulate that,
but don't ever get confused
between a bad example
of a good thing, and something
that's just not a good thing.
Something's not a good
thing, we don't want.
Something that's a good
thing, but a bad example,
we want to fix the bad example,
not get rid of the good thing.
Just keep that in mind as
a general thought process
when you're listening to
people's prescriptions.
And yes, in the middle of a
crisis, like the firemen, all
you want to do is survive.
Yes, sometimes you have to
do a lot of tearing down.
But understand, that's
what you're doing.
And that a lot of things
we had to do in this crisis
were of that sort.
We're going to have to rebuild.
But that's okay.
We do that pretty well.
So these are lists of some
of the things-- I'm not
going to go through them
with you, given the time--
but I wanted to move us a
little forward to one example.
As you'll notice,
I've used examples
because-- I've tried to
use examples that are big,
meaning big
projects, big things,
so you don't think this is some
toy that somebody in some lab
somewhere, or someone found some
example in some exotic place.
These are mainstream things
going on all the time.
Looking forward, I
want to just give you
an example of
something else that you
might find kind of interesting.
And this is the notion of
"global diversification
as pays."
The term "a free
Alpha" is jargon,
so if you don't know what
that means it's okay.
But let me just tell
you there are really
three ways of managing risk.
You can diversify,
you know, buy 1/10
of 10 ships that you
insure, rather than
insuring one ship 100%.
Don't put all your eggs
in the same basket,
and you're unlikely to
lose the whole thing.
So that's diversification.
It's a classic way of-- and
the benefits of diversification
can be gotten for free.
You don't pay for
diversification.
You don't have to
pay anything for it.
Okay?
The second way is hedging.
That's simply saying,
I have something risky,
I sell it to him, and
invest in something safe.
So I've just got rid
of the good things,
and I got rid of the bad
things so a hedge is both ways.
I'm no longer exposed to the
risk either way, good or bad.
That's the second way.
That's also free.
The third way is insurance.
Insurance is, I keep this
thing, I keep the upside,
but someone else pays me
if I have the downside.
I like that, but guess what?
That isn't free.
Somebody has to
take the down side,
and they have to be
paid for that, just
like when you insure your
car, your house, or your life.
If they would give it to
you for free, I'd love that.
I'd buy a lot of it myself.
I don't know about you.
But unfortunately you
have to pay for it.
So the three ways.
All risk is managed by some
combination of these three,
and insurance is the
only one you pay for.
Now if you don't
diversify, or you
don't diversify as well as you
could, is feasible for you,
then you have given
up a benefit which
I can quantify for you here.
That's the point.
You've given up a benefit
which you had for free
because of diversification.
So here's something
that's available for free.
If you don't do it,
you've lost out on it.
Now let me illustrate that
in a context that-- I've
been in Asia, I've been
all around the world
on these things.
So let me just use
China, which is not bad.
It's either the first or second
largest economy, depending
on who you talk to, or how
those numbers that you measure
but it really doesn't make
any difference whether it's
number one or number two.
It's big and important.
It's important for itself,
it's important for Asia,
and it's important
for the world.
Because China, if it does what
it's likely to want to do,
and should probably do, is not
more than just a big country.
It's going to be, at least
in the economic world
as well, it's going
to be a superpower.
So it has great impact
and responsibility.
Now you're looking at this
graph saying, what in the hell
is this?
All right, let me
tell you very simply.
I looked at the question of,
if the best of us-- first,
let me tell you what the
best diversification is,
because I tell you the
ideal diversification.
That's your standard right?
That's your North
Star, your Nirvana.
And the closer you get
to that, the better
you are, in terms
of diversification,
not everything.
This is one dimension.
The best diversified
portfolio at the current time
is the world portfolio.
That means you hold every asset
in the world in proportion
to the amount outstanding.
There are theories
to explain that,
but the common sense
is, you hold everything
out there in the world.
That's the best diversification,
at least until we go to Mars
and we can extend.
But right now we're just
pretty much on Earth.
So that is the gold
standard of diversification.
So now we know what
the gold standard is.
It isn't really feasible,
but we can approximate,
and that's done.
So I've used an approximation.
MSCI is a particular company.
By the way I have
nothing to do with MSCI.
I do with other
companies, but not them.
So this is not a disguise.
There is no conflict
of interest,
or I'm not trying to sell you
anything, at least anything
commercial; obviously ideas.
And I looked at
the world portfolio
and that was a proxy for the
best diversified portfolio.
Do you understand?
This is pretty standard.
And I happened to pick the
period-- the lady who almost
was, the one person off in the
room here who put her hand up--
and she helped me
get all this done.
And we just picked
1993 because the data
happened to be on the table.
So there's nothing
special about 1993,
because I'm not trying
to literally use
the numbers to prove anything.
I'm trying to illustrate,
like an example,
but with real numbers.
So we just had '93.
But I want to take it
through the end of 2015,
bring it up to date.
So I just don't want you see
anything special about 1993.
It just happened to be
what was on the table.
It's 24 years or whatever.
So we looked at data
and we asked ourselves,
if we invested in the Chinese
stock market for that period,
we would have earned a
return, an average return,
of some amount.
All of these are measured in
the same currency, dollars.
We would have earned so
many, a rate of return,
just like you do in a bank
account or the US stock market.
There would have been an
amount of risk or volatility
around that average,
which is a measure
of the risk of the portfolio.
Does that make sense to you,
even if you're not in finance?
How volatile it is, up and down,
around, maybe way down, way up.
And we've seen a lot
of both of those.
So does everybody understand?
So there's some notion of risk
that we had during the period,
and there's some notion
of the average return.
The average return
is on the ordinate,
and the risk is on the abscissa.
And as you have been told, I'm
sure, there's no free lunch.
So in general, to get
higher expected returns,
not realized returns, you've
got to take more risk.
So that shouldn't surprise you.
If you want to go
higher up, you typically
have to go out to more risk.
There's no free lunch.
Everybody get the picture,
and with the script?
What are these pictures?
Well, that point up
there is actually
what the world portfolio did.
It earned about, let's call
it a little bit closer to 9%,
and had it 15 units of risk,
15% standard deviation.
It doesn't matter.
Just think of it as a risk unit.
So you took 15 units of risk and
you ended up with nine return.
Now here's what actually
happened to China
during the same period.
China was much riskier.
Here's the risk of
the world, around 15.
China had a risk of
about 35, and that
was its average return,
which is about nine, also,
maybe a little less.
We have the numbers,
but it's not the point.
But you had to take
much more risk in China
to get the same average
return after the fact.
Now we all know we don't
know what's going to happen.
This is what happened, but
it's very unlikely anybody
forecasted it, actually.
Well, there's 7 billion
people on the planet,
we might find somebody.
But the typical forecasts
would not necessarily
be what happened.
Typically what we forecast
isn't what happens.
We have an eventuality
before the fact,
we have probability
distribution,
and we have the outcome.
You buy a lottery ticket and
you have some expectation,
and you either win or
lose, and if you lose,
that wasn't what you
expected, or isn't what
you were hoping to get.
Otherwise you
wouldn't have done it.
And if you win at
such a high return,
you know it couldn't
have been expected.
So you understand
the difference.
So we do a correction for that.
I don't want to go through
the technical things.
We asked the
question, given what
happened to the world,
conditional on what happened
to the world in these
24 years, what would
we have forecast
China would've done,
not knowing what
China actually did?
You see the experiment?
I didn't show you China.
I showed you the world.
And I said, given what happened
to the world portfolio, what
would you have forecast,
conditional on that,
of what China would do?
That's not what an
investor knew back then,
because we know
what the world did.
Does everybody
understand "experiment"?
I tell you the world, what
do you think China did?
The beauty of that forecast is
that it is an unbiased estimate
of China, conditional on that.
That is to say, what
actually happened to China
was maybe bad luck.
In fact we can say it was bad
luck, in the sense that China
turned out to perform less well
than we expected it to, given
what the rest of the world did.
So the point here that says
China expected, the green?
That point?
That's what we thought China
would do if China had behaved,
neither bad luck or good
luck, conditional on what
the world did.
And we're just going
to take the world
as what it did, because
we're comparing the two.
Does everybody understand
the experiment?
Now remember, I
mentioned hedging
as a way of running risk?
If I have a risky
security of any type
and I have a risk-free
security, that's one sure thing.
If I can mix those
any way I want,
if I can put half in my money
in one, and half in the other,
3/4, right?
That's my choice.
Obviously the more I put in
a safe thing, the less risk
I'm taking, but if the
safe thing, as it does,
has a lower expected return,
I'm getting less risk.
These straight lines that you
see up there are the menu.
The They are the menu
of expected returns
you could have
gotten for how much
risk you were willing
to take by investing
in that particular risky
asset, or the risk-free asset.
Does everybody understand why?
I'm just telling you, that
menu is a straight line.
So that's like you're
in the restaurant.
You see three menus there.
Remember, with one,
this is expected return.
We all like that.
That's risk; we all
don't like that.
So let me ask you.
Take any level of risk,
like here, go straight up.
If you did it in
China, actually,
that's the return you got.
If you did it in
China, and China
behaved as it should
have, or as expected,
you would have gotten that.
But if you put it in
the world, you got that.
Which one do you like?
Blue, green, or red?
Red.
Yeah.
Now you've got it.
And now you can
pick at any point.
So you see, I didn't have to
know what your aversion to risk
was.
If you're very low risk
taker, you're down here.
If you're a big risk
taker, like investing,
you take the whole risk
of China, you're up there.
By the way, this line extends
all the way up to here.
You can go beyond the line.
All these lines can be extended.
So I can get eight-point on the
menu, right up to the ceiling.
That's really feasible,
not a hypothetical.
All right.
Does everybody understand?
So if you actually had
China, this is what you got.
If you bought China
beforehand, and China
behaved as you thought it
would, you'd have gotten this.
But if you had done
world for the same risk,
you'd be up here.
Do you get the message?
So what does it cost you
not to have diversified?
Or to put it differently,
if you are constrained,
either by psychology, what's
called home bias-- I only
invest what I know about,
and I live in China,
and the only thing
I know about is
China-- the rest of the world,
who knows what they're doing?
So if I restrict myself to China
behaviorally, or as is reality,
if you're in China right now,
you cannot invest all around
the world without limitations.
You can get some,
but it's limited.
At times it's been prohibited.
So it's not your choice,
it's what you can do.
You're not allowed to
go to this restaurant.
You've got to go to the green
restaurant, or the blue one.
So each, whatever one it,
is you can measure cost now
of not having taken the
free, it's called free Alpha.
Alpha is a measure of how
much better you get for free,
and that's what's there.
And what we see here is that
if we look at China, even
along there, it
underperformed even
what we expect it to
do, by over 3% a year.
Now to put that in context,
if you take the retirement
system of China, which
is just being transformed
to a great big fund called
NCSSF, from the provinces,
if you take that, the difference
between x is 3% a year.
In 24 years you'll have
twice as much money
for the whole retirement system.
I just want to scale it for
you, for 1.5 billion people.
So 3% a year is a
very big number.
It's very expensive to
give that up for a society,
or for a pension system,
or for a retirement system,
or for any system.
So the first thing
these numbers do
is indicate to people:
How expensive is it
to just be in China, to
restrict it to just China only?
Now China is a big country,
and it's growing, right?
This wasn't a bad period in our
heads, and yet the numbers are,
you gave up 3%,
300 basis points.
That's pretty inefficient,
since you can get that for free.
You don't pay for it.
People spend hundreds
of millions, actually
billions of dollars out there
in the financial sector,
to find smart people who
can help them get a higher
return for the same risk.
All these people
you hear about that
are multi-billionaires,
and so forth?
They are people who earned or
got that money because they
found ways, on huge scale,
to be able to provide
an extra 1% or 2%.
Because when you apply
that to trillions,
that's worth
unbelievable amounts.
Now they do all this work,
and spend all this money,
and then they do something
they could do for free
and don't do it?
That's almost a sin, right?
So I'm trying to show you
something really simple,
very basic, no
complex, fancy thing.
But I wanted to quantify
it for you, for the world.
Now let me show you one other
thing as we're getting here.
So you understand the story?
The story is, if we were talking
to China and we said, you know,
I'm not going to tell you
whether you should do this
or not, but do you know how much
this is costing the country?
Their institutions,
if they can't do it?
Now many Chinese
institutions are
permitted to invest
overseas, but individuals,
for the most part, are not,
and their pension system
is not clear.
The first thing
to say is that you
want to understand
what it's costing you.
Not to say you
shouldn't do it, but do
you understand this is something
that's costing you this amount?
Do you really want
to pay the price?
You might look at a Bentley
car parked down in the garage
and say, not a bad car!
Then I show you the price.
You say, well, maybe
I'll stick with a Camry.
Because 30,000 is a
lot less than 300,000.
But if they were all
30,000, I think most of us
would probably pick the Bentley.
So understanding
what something costs
is not independent of
the decision to do it.
And so part of this is just to
make clear to people in a very
objective way-- to, say, using
the data in standard analyses
to show them this
is what it costs.
But you can do better than that.
This is MIT.
Because a lot of
times, the government
will come back and say, yeah,
we're sorry, it's a big cost,
we agree, and we
didn't want to impose
this cost on the Chinese
people, or ourselves.
But we had other policies
we wanted to follow.
We wanted to protect
against capital outflows.
And if we open our borders
up to money going in and out,
we've got to worry about
that, and other things I
won't go into because
we don't have time.
Perfectly legitimate
policy issues,
and I'm not going to opine
on them because let's just
say they're legitimate enough
that someone could credibly
say, that's too important.
We're willing to
give up 3% a year.
Guess what?
Use financial
engineering, and we
can get rid of the
3% we're giving up,
and keep the policies.
That's like getting a drug.
You've seen him on TV right?
The drugs, where they
show people bouncing along
after getting their
drug, feeling wonderful
and the overvoice says,
of course, your liver
may be shredded by this.
You'll get a heart attack.
And don't take this if
you're pregnant, or thinking
about being pregnant,
or if you have
this, or that, and the other.
Why?
Because these are all
side effects of this drug.
That's a polite word--
they make you sick.
But we put up with it.
Why?
Because we get cured of
something, or at least
treatment for something
that's even worse.
So is using the argument, well,
if it costs the country 3%
a year, so be it.
The policy is more important.
If you can find
a way of offering
the drug without
the side effects,
with the same efficacy,
I think that most people
would prefer that.
I don't think anybody wants
to think about their liver
being at risk, and so forth,
or worry about if they happen
to be pregnant, taking it.
And that's what we
can do, and is done.
And I probably don't have time.
I'm probably running late.
Yeah, I can see I am, as usual.
So I can't quite go through this
because I have one more thing.
But just take this away: There
is a way, and we've done it,
and it's done.
So everything I've talked about
is market-proven technologies.
We've already done it.
So this is not some dream
from a finance professor
over in his office, or his lab,
"maybe by 2040 we can do this."
Everything here can be done with
market-proven technologies that
are well understood; in
fact, used all the time.
But it is a very simple
way, a noninvasive way,
to eliminate this
bad side effect
and maintain those policies
that take care of things
like capital controls,
and so forth.
No problem.
So you'll just have to
take my word for that,
or come back some
time, or sign up
for my class to find out more.
But just to finish, let me show
you one other country in Asia:
Korea.
Korea, as you can see
here-- the blue line, which
is what actually
happened to Korea--
is higher than the
green line, which
is what we expected to happen.
So unlike China--
which, after the fact,
underperformed
what we expected it
would have done, given what the
world did-- Korea outperformed
what we expected it to do, given
what happened to the world.
Do you understand how
to read the lines?
That's why the blue is
above the green here,
unlike the previous
one, you see.
The blue is below
green for China,
the blue is above
green for Korea.
Korea outperformed.
Now in 1993, nobody
had this information.
Nobody.
But imagine I could
have given you in 1993
the following piece
of information
for sure-- not an
estimate, for sure-- Korea
is going to be a better
performing country than anyone
expected.
Outperform; it's an
outperforming country
after the fact.
I'm giving you a piece of the
future, a very valuable piece
of the future.
I'm telling you it's going
to outperform by quite a bit.
And I'm telling
you that for sure.
You get the experiment,
even though we
couldn't have done it?
There's nobody on
the planet that
had that information
for sure, but I'm
going to give it to you.
Can you get a sense of
how valuable this is?
And by the way, this
is for a whole country,
so the scale at which you
could take advantage of this
is not one little investment in
some little rinky-dink-- excuse
me-- some little
startup from somewhere.
You're talking about a
whole base of a country.
I told you the whole country
is going to outperform
over the next 24 years.
That's an incredibly important
piece of information.
What might you have done with
that if I gave it to you,
and you really knew I gave it to
you, and you knew it was true?
You said, well what am
I going to invest in?
Korea, right?
Why would I invest
in anything else?
I know for sure it's going to
outperform its expectation.
Well, how would you have done?
The blue line,
remember, is actual.
You did do better than expected,
but let's look at right here.
So if you took this
amount of risk,
you expected to get
that return from Korea,
and you actually got that.
So you see how it outperformed?
But do you see it did worse
than my two sisters, who
are brilliant and lovely
people who couldn't care less
about finance, and all they did
put their money in a Vanguard
world portfolio or
MSCI world portfolio.
They knew nothing about
finance and surely
didn't know that Korea was going
to outperform its expectation
for the next 24 years.
And my sisters cleaned
the clock of you
with that information, which is
incredibly valuable information
I assure you, if you
could ever get it.
What happened?
You screwed up on the easy part.
The hard part was getting
the information about Korea.
I gave it to you.
What did you do?
You made the mistake of
using the information
in the wrong way.
You put it all in Korea.
You forgot about
diversification.
What you should do is
take the information
and optimally mix it
with the rest of things
to get diversification.
Then you would really have
done better than my sisters.
But if you didn't
do that simple thing
that I can teach in the
class, that anybody can do,
doesn't take something that
I can't teach in my class--
and that's a crime.
So I'm going to have to quit
on this, because you know,
it's easy for me
to stand up here,
hard for you to sit there
especially for the third time.
But what's the overall message
that I want to give you here?
One, I want you to understand
a little bit about finance,
understand that almost all
of what finance is about
is managing risk,
not forecasting
what's going to happen.
That's for macroeconomists.
Finance is all about putting
the risks in the right place.
If we didn't have
uncertainty, or if it was not
very important, we would
have an incredibly simple
financial system.
We'd have one kind of
security treasury bills.
Every security would
earn the same return.
There would be no insurance Why?
Because we know the future,
and we don't need insurance.
As an approximation
of course, it's not
even close for approximation.
The world is an incredibly
risky place, and complex.
And managing that risk and
placing it in the right places
has, I hope you'll
come from this,
had really big real effects.
If you manage risk better,
it's not just being safer.
It means that you can
make prudent risks that
weren't prudent.
If I can manage the
risk better, then we
can do things which
have benefits.
It would not have been
prudent otherwise.
So don't think of looking
after risk as very important,
but it's a safety thing.
It's for growth.
Because we can take
on projects with high
expected growth rates if we
can manage the risk right.
Just as my colleague
Andrew Lo shows,
that if you are going
to do one molecule where
the expected return-- you
have a cancer drug just going
into the first phase, maybe
a 5% chance of getting
commercial success--
19 out of 20 failures.
If you look at the pricing, of
the cost of developing a drug,
the expected return on
that is about 4%, expected.
The risk if you do one molecule,
don't diversify, is 430%.
Nobody's going to
take a 430% risk
for the compensation of 12%.
But if you use
diversification, you
could turn that 420 into 34.
So drugs, growth, development,
all of these things
can't be done.
It's my first opening remark.
The financial system is critical
to getting the technology
and things
implemented, therefore
actually having an
effect on growth.
You have to actually do it.
To do it, you've got a mandate.
You have to get the resources.
But it's not just enough to put
savers together with investors.
That would be all we need if
we had a world of certainty.
We are not in a
world of certainly,
in case you haven't noticed it.
That big little thing,
or little big thing,
is the difference between all of
what you see in the structures
around the world, the
financial systems and not.
That's how you get things done.
That's how you get growth done.
And that's why
countries that have
well-developed financial
systems grow fatter,
and I want to say, succeed more,
in a material way, not just
an add-on way.
Thank you very
much for your time.
Appreciate your coming,
and let's all celebrate
100 years in Cambridge.
[APPLAUSE]
