Figure 1: Even brilliant economists can gamble away money.

“Source: Edwards, F. R. (1999). Hedge funds and the collapse of long-term capital management. Journal of Economic Perspectives, 13(2), 189-210.”

Introduction

My preparations for the review of the book Money Magic by Laurence J. Kotlikoff led me to sink into a Wikipedia rabbit hole. Especially the time in which I tried to grasp the ideas behind the Merton–Samuelson theorem led me to consult the Wikipedia pages of Robert C. Merton and Paul Samuelson for hours and hours, impressed by their huge contributions to economics as a science. However, one instance in the life of Merton interested me in particular: his involvement in the hedge fund Long-Term Capital Management (short: LTCM), whose collapse in 1998 almost led to a global financial disaster. Curious about the matter and not fully satisfied with the corresponding Wikipedia page, I fortunately found the well-written article Hedge Funds and the Collapse of Long-Term Capital Management by Franklin R. Edwards. The article not only describes the timeline of the LTCM collapse in an interesting fashion, it also explains the functioning of hedge funds and why they can fail. So let’s dive into it.

“I once asked a roomful of economists — all of whom were gathered to discuss household personal finance — to answer, on the fly, the consumption-smoothing question for a hypothetical forty-year-old. I gave them the pertinent information and watched their faces. They weren’t happy. They knew they were about to produce a very wrong answer. Right then and there, they seemed to realize that even financially literate people like themselves couldn’t make proper financial decisions via introspection.” (p. 6)

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