A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

CHAPTER 10

COCKROACHES AND HEDGE FUNDS

When I attended graduate school at MIT in the late 1970s, the perfect market paradigm was fast emerging as a framework to analyze the financial markets. It had already revolutionized the study of economics, and for academics the perfect market paradigm promised, for the first time, to provide a rigorous mathematical approach to understanding and interpreting the financial markets. I became enthralled with this promise after taking a course from Bob Merton, one of those rare men who is both a brilliant researcher and a great teacher. I had embarked on my graduate work with the intention of changing the underdeveloped world through developmental economics, but ultimately the elegance of financial economics was more alluring. My dissertation turned to a subject area of mutual interest to finance and economics: the transmission of information through the markets, with Merton as one of my advisers.

The MIT campus at that time contained the preeminent economics department in the country. The cornerstone was Paul Samuelson, one of the first Nobel Prize winners in economics and the man responsible for bringing mathematical rigor and scientific analysis to the discipline. As an undergraduate at the University of Chicago in the early 1930s, with the country mired in the Depression, Samuelson moved from the study of physics to economics. The switch was propitious, as he quickly realized that the tools of calculus and the principles of maximization he ...