Robert Merton on the Causes of the Financial Crisis

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."