Robert Merton on the Causes of the Financial Crisis

Last Updated Apr 20, 2009 2:33 PM EDT

Harvard Business School professor and Nobel Prize winner Robert Merton believes the economic crisis was caused by financial engineering innovations that unleashed forces that we really didn't understand or predict.

"We've created instruments for manipulating financial risk without a thorough understanding of the underlying engineering," Merton tells the Wall Street Journal.

For example, prediction models did not adequately comprehend the interrelatedness of financial institutions and how these close ties could propogate risk throughout the system and quicken the destruction of the sub-prime crisis.

WSJ columnist L. Gordon Crovitz notes that innovation often goes down this road, where the value of the innovation is so high that we put it into practice without really knowing the ramifications of doing so.

The lesson isn't to punish the innovators, but rather to learn from their mistakes. "We now know that our complex markets need better models, which should include more humility, acknowledging that some risks are still too uncertain to measure and should be avoided," Crovitz writes. "Instead of vilifying modern-day elevator engineers, we should challenge financial engineers to find fixes for what's broken."

  • Sean Silverthorne

    Sean Silverthorne is the editor of HBS Working Knowledge, which provides a first look at the research and ideas of Harvard Business School faculty. Working Knowledge, which won a Webby award in 2007, currently records 4 million unique visitors a year. He has been with HBS since 2001.

    Silverthorne has 28 years experience in print and online journalism. Before arriving at HBS, he was a senior editor at CNET and executive editor of ZDNET News. While at At Ziff-Davis, Silverthorne also worked on the daily technology TV show The Site, and was a senior editor at PC Week Inside, which chronicled the business of the technology industry. He has held several reporting and editing roles on a variety of newspapers, and was Investor Business Daily's first journalist based in Silicon Valley.