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Pride and Prejudice: Contrarian Speculation on Wall Street’s Future

Thursday, April 21, 2011

Why Larry Summers’s experience on Wall Street is cause for hope.

It is a truth universally acknowledged that Larry Summers is really, really smart. All discussions regarding Summers start with bloodlines: He’s the son of two distinguished economists, and the nephew of not one, but two Nobel laureates in economics (Paul Samuelson and Kenneth Arrow). That said, Summers made the most of genetic good fortune, whizzing through the Massachusetts Institute of Technology and Harvard University, becoming at the age of 28 one of the youngest tenured professors in Harvard’s history. Working in a variety of fields in economics, he quickly rose to the top of the profession, and in 1993 was awarded the John Bates Clark Medal, awarded every two years by the American Economic Association to “that American economist under the age of forty who is judged to have made the most significant contribution to economic thought and knowledge.” Perhaps even more impressive is the fact that in 1987 Summers became the first social scientist to win the National Science Foundation’s Alan T. Waterman Award, made in recognition of “ the talent, creativity, and influence of a singular young researcher.”

This story isn’t intended as a paean to Summers—he hardly needs a testimonial from me—so I’ll not tarry over his long career in public service or his shorter career as president of Harvard. Suffice it to say that, all things considered, no economist in the world can match his résumé. In light of his background and achievements, it was hardly surprising that shortly after vacating the presidency at Harvard he assumed a part-time position with a financial house, in this case the D.E. Shaw investment group in New York. The surprising thing was the way he was recruited, which is what I’d like to focus on here.

As part of the screening process, the folks at Shaw actually asked Summers—one of the world’s greatest economists—to solve math puzzles!

First, a word or two about Shaw. Almost from the time of its establishment in 1988, D.E. Shaw has been pushing the boundaries of computational finance, in so doing, developing a reputation as perhaps the geekiest quantitative investment house in New York, a financial nerdistan populated by scores of brilliant PhDs in math, computer science, economics, and engineering. Since April 2009, when reports first surfaced that Summers pocketed over $5 million in his last year at D.E. Shaw before joining the Obama administration as director of the National Economic Council, the media, when mentioning Summers and Shaw in the same story, have seldom missed an opportunity to highlight the economist’s earnings at the firm. Louise Story’s April 6, 2009, piece in the New York Times, entitled “A Rich Education for Summers (After Harvard)” is somewhat exceptional in this regard, for she focuses as much or more on the knowledge and insights Summers gained by working in such a stimulating environment.

One little tidbit in Story’s article is worth a closer look, for it gives me at least a margin of hope about our much beleaguered financial community going forward. According to Story, as part of the screening process, the folks at Shaw actually asked Summers—one of the world’s greatest economists—to solve math puzzles! Talk about meritocracy (the firm, by the way, is said to accept only 1 of every 500 applicants). Equally impressive to me is the fact that Summers didn’t tell his grand inquisitors to take a hike or just walk out of the interview. He accepted their challenge, solved the math problems posed, and was offered a job. Tell me, where else in America, or, indeed, in the world, would a senior person with Summers’s track record be asked to bring it in this way? Nowhere.

Failure is indispensable to successful design. Problems virtually always arise when engineers innovate.

Now cynics reading this piece might suggest that this story is apocryphal or at the very least made up of cloth almost whole. I had the opportunity to speak with Summers last November when he was down at the University of North Carolina-Chapel Hill for an event sponsored by the UNC’s Global Research Institute, which I direct. While he was down here, we talked a bit about his hiring at Shaw and he confirmed that things occurred pretty much as outlined above. That’s when I started thinking about writing this article.

The financial industry certainly has its problems and it deserves its fair share of the blame for the onset of the Great Recession. Moreover, quants and the innovative financial products they “engineered” were at the center of many of the problems that arose. But quants are human (more or less!) and engineering innovations of all types have always been prone to problems early on. Although one can take the analogy too far—obviously, the innovations produced by financial engineers are not based on physical laws in the same way that innovations in construction, electrical, or chemical engineering are—in all of these areas it is humans doing the innovating. And humans, being mortals, sometimes misjudge, miscalculate, and make mistakes.

To fully realize the potential of recent financial innovations, we need to develop more sophisticated models of financial markets, learn how to evaluate risk more accurately, and better understand the complexities of human behavior.

A quarter century ago, in his classic book To Engineer is Human, Henry Petroski demonstrated rather convincingly that failure is indispensable to successful design. Problems virtually always arise when engineers innovate—think here of collapsing bridges, exploding engines, and crashing airplanes—and, once problems are exposed, engineers have generally set to work on such problems and been able to surmount them over time. In so doing, they have enhanced efficiency and improved people’s lives in many, many ways.

A similar process will likely occur in financial engineering as well. In the past, other types of financial innovations—the discounting of bills of exchange, the creation of futures markets, the advent of non-investment grade (“junk”) bonds, etc.—have had rocky starts and have faced plenty of opposition. Over time, such innovations have generally proved their worth. The same may well hold true even for many of the so-called exotic financial instruments created in recent decades; certainly, some forms of securitization have already shown their value. To fully realize the potential of recent financial innovations, though, we need to develop more sophisticated models of financial markets, learn how to evaluate risk more accurately, and better understand the complexities of human behavior. We will need to make sure that we get right the context in which financial innovation occurs, whether through more effective regulation, better incentive structures, or more training in business ethics, if not all of these things.

But I’m confident that we can do what is necessary, and I’d place my money in particular on places such as D.E. Shaw (which, admittedly, has been having a tough time of late), where brilliant people work and merit rules. Paul Volcker’s line about the ATM being the most important financial innovation of the past 25 years is a good one, but it might not be accurate if Wall Street’s meritorious quants can be tamed. Don’t bet against them.

Peter A. Coclanis is Albert R. Newsome Distinguished Professor of History and director of the Global Research Institute at the University of North Carolina-Chapel Hill.

FURTHER READING: Vincent Reinhart recalls Larry Summers and Tim Geithner “When They Were Young” and discusses “Getting Lehman Profoundly Wrong,” and Arnold Kling reviews “Regulation and the Financial Crisis: Myths and Realities.” Peter Wallison writes “Roots of Crisis Buried Deep after Inquiry,” John Makin says “Tighten Your Seatbelts: 2011 Could Be Worse Than 2010,” and Alex Pollock explains “The Political Finance of Covered Bonds.”

Image by Rob Green/Bergman Group.

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