Cancer Foundations

interviewer: today isdecember 5, 2011. i'm chris boebel. as part of the mit150 infinitehistory project, we're talking with professor andrew lo. professor lo is the harris &harris group professor of finance at the mit sloan schoolof management and the director of mit's laboratoryfor financial engineering. his wide-ranging researchinterests include financial

asset pricing models, financialengineering and risk management, trading technology,computer algorithms and numericalmethods, financial visualization, hedge fund riskand return dynamics and risk transparency, and evolutionaryand neurobiological models of individual risk preferencesin financial markets. his awards include-- toname just a few-- the alfred p. sloan foundationfellowship, the paul a samuelson award, a guggenheimfellowship, and multiple

awards for teachingexcellence. he is a former governor of theboston stock exchange and currently a research associatefor the national bureau of economic research, a member ofthe nasd's economic advisory board, and founder and chiefscientific officer of alphasimplex group, llc aquantitative investment management company. professor lo received a ba ineconomics from yale university in 1980 and a phd in economicsfrom harvard in 1984.

professor lo, thanks verymuch for coming in to talk to us today. lo: thanks for having me. interviewer: so let's juststart at the beginning. where were you born, andwhere did you grow up? lo: i was born in hong kong. and shortly after, i moved totaiwan for about five years. and then, when i was fiveyears old, i came to the united states.

and i grew up innew york city. interviewer: tell me a littlebit about that transition from a cultural perspective, thateducational perspective. lo: well, it was a fantasticexperience in many ways. so i grew up in a single-parent household in new york. and my mother worked pretty hardto put the three of the kids through school. we went through public schoolsthroughout, and the new york

city public school systems areamong the best in the country. certainly, they were at thetime, and so i feel i got a great education, and met somereally, really interesting people during my time there. interviewer: so you were anurban kid for most of your-- lo: i was. we lived in queens, and icommuted to the bronx. i went to the bronx highschool of science. i'm very proud of that.

i love that school, and ilearned a great deal from my classmates. it was a lot of fun. interviewer: so do youhave very early memories from taiwan? or does your consciousnessstart in new york city? lo: no, we have some memories. i've got a number of thingsthat i remember well from those days: playing withfireworks was one of the

favorite activities in taiwan,but for the most part, my childhood was reallyin new york. interviewer: so when did youstart developing an interest in economics, math? i'm sort of interested in yourentree to your field. were there early signs? lo: well, actually, startingin high school. i had always been interestedin science, of course. in third grade, my third gradeteacher, mrs. barbara

ficalora, was wonderfullysupportive, and made me the class scientist. and so i got an earlyintroduction to doing experiments. it wasn't until high school thati became exposed to real serious scientific reasoning,and also to the field of economics through a course thati took in social studies, where we read heilbroner'sworldly philosophers. and that really changed mythinking about the idea that

you could apply interestingmathematical principles to problems in economics. interviewer: bronx science isobviously kind of a legendary high school. can you talk a bit more aboutyour experience there? what were your careerambitions at that point in your life? and what kinds of thingswere you really studying in high school?

lo: well, for me, bronxscience was a really transformative experience,because, up until then, the junior high school andelementary school that i went to was really just local, kindof community schools, where you had a wide mix of kids, someof whom are interested in academics, but most of whomwere probably not. and so in that kind ofenvironment, to be doing well in school was to be abit of an outcast. it wasn't until i got to bronxscience that it became cool to

actually do well in school andto be interested in academics. so for me, it was reallylike an awakening. i had tremendous friends andactivities in bronx science that i really couldn't haveaccess to in any of the schools that i wentto before that. also, for me, it was a littlebit of an interesting experience in terms of themathematics at bronx science. right around that time, bronxscience instituted-- as all new york cityhigh schools--

the so-called new math. and if you know the historyof it, the new math was an absolute disaster from theperspective of the majority of the students. but for me, it was actuallytransformative as well, because up until then, i had aparticular learning issue, a slight case of dyslexiathat we didn't know until much later on. and so for the longest time,i had difficulty with

mathematical concepts,multiplication, and really basic things that other kidshad no issues with. i had a hard time memorizingthe multiplication table. it wasn't until i got to bronxscience that, because of the curriculum in mathematics-- it was transformed from thebasic algebra, geometry, trigonometry to sets, rings,fields, abstract algebra-- that i turned from a c studentto an a student in math, so for me, that was really animportant experience.

interviewer: that's kindof an amazing story. lo: i was one of the lucky onesthat benefited from the unfortunate aspects of the newmath that was perpetrated on new york city highschool students. interviewer: at leastthere was one. so you mentioned yourthird grade teacher. were there other mentors,significant teachers, experiences you had in highschool or before that time that really pushed you ina certain direction?

lo: oh, a number. one of the things that hasalways struck me is how important teaching is, because agood teacher can have such a positive influence on astudent for the rest of his or her life. and similarly, a bad teacher canhave tremendous negative consequences for that student. and so i've been very fortunatein that, during the years, i've had some goodteachers, many good teachers,

a few bad ones. so i have a good understandingof what's involved. and my third grade teacher,mrs. ficalora, stands out. in high school, i had anumber of teachers. bronx science is filled withreally extraordinary faculty. in fact, we don't thinkof them as teachers. we think of them as faculty. mrs. mazen, my calculusteacher. i learned more from her aboutcalculus than i think most

college courses would teachtheir students. so there are a number of verytalented instructors that i was very pleased andlucky to have. interviewer: what were yourcareer aspirations at that point, just before college? lo: well in high school, i thinkthat most of my friends and i were interestedin science and math. so at the time, my presumptionwas that i would go into one of those disciplines.

being the youngest of threechildren, and having an older brother and sister that werealso academically inclined made it relativelyeasy for me. my brother is a mathematicianat the jet propulsion lab at caltech. and my sister is a biologistat the university of pittsburgh. so they both followed veryacademic careers. and in my household, one had toget a phd just to measure

up to the older siblings. so from high school on, i wasvery much interested in following some kind of a careerpath in academia, although my interests weresomewhat on the more applied side, as opposed to purelytheoretical kinds of issues. interviewer: you mentioned asingle-parent household. was your mother at allacademically inclined? was it your motherthat you were-- lo: yeah, my mother was verymuch academically inclined,

from the perspectiveof what she valued. she felt that the life of ascholar was among the most important and prestigious. she was a lawyer by training. but she had-- as most, i think, chinesefamilies did-- a deep and abiding respect for academicachievements. and so it was pretty clear, fromthe kinds of things that she talked about and the valuesthat she held, that

developing new knowledge wasreally important to her and ultimately to allof the children. interviewer: so at that point inhigh school when you had to really start seriously thinking about the next steps-- going to college, whatyou might study-- tell me about thatdecision process. you ultimately went to yale. and then talk a bit aboutyour experience there.

lo: well, i was a littleconfused about what i wanted to do. my sister went to mitas an undergraduate. my brother went to caltech. and so when i talked with mymother about where i ought to go for college, she said, well,maybe you ought to think a little bit more broadly aboutthe kind of things that you're interested in. and so rather than pursuing asomewhat more technical career

path, i thought that maybeapplying to a general liberal arts college wouldbe a good idea. and i was thinking at that timethat i might want to do a combination of mathematicsand biology. i did a science projectas a senior. i was a westinghouse finalist. intel, i guess, now iswhat they call it. and i was very much steeped inmolecular biology at the time. and so yale seemed to have agood compromise in very strong

humanities, but also verygood science programs. so i ultimately decided thatthat would be, really, the best compromise. i visited the school,and i was really enthralled with the campus. new haven wasn't so great. but yale, itself,was a wonderful physical space for students. and so it was a pretty easydecision, after i had gone

through and looked at allthe various different possibilities. interviewer: you mentioned thewestinghouse competition. it's amazing how many of ourinterviewees have a story about westinghouse andparticipating in that. lo: well, it's a wonderfulactivity, and obviously not for everybody, but at bronxscience, most of the students that i interacted withreally got into it. and we learned somuch from it.

i still remember, to thisday, every aspect of the experiments that i conductedon the infective pathway of bacteriophage t4. and i actually corresponded withan mit faculty, who, at the time, i didn't know. but jonathan king actually hadsome strains of bacteriophage that i was interested in and wasvery generous in sharing it with me. so it was a wonderful experiencein getting me to

understand how research isconducted, and, really, what the academic style ofinteractions might be. interviewer: so youchose yale. you decided that that wasthe place for you. tell me a little bit aboutyour time there, how your academic and career interestsdeveloped, and just sort of what the experience was like. lo: well, i had a greattime at yale. it was a really remarkableexperience in a number of

different ways. when i arrived, i had thoughtthat i was going to be doing math, biology, maybe appliedsciences of some sort. but i ended up taking anintroductory economics course that was completely differentfrom anything that i had seen before. there was a substantial amountof mathematics involved. but yet the ultimateapplications were really quite relevant to day today experience.

and that's quite differentfrom math or physics, particularly at theundergraduate level. so i got very excitedabout that. the other thing that i foundremarkable about yale was that, really, for the first timesince i started getting interested seriouslyin academics-- for the first time, i actuallymet people at yale that i considered to be really smart,but who had no abilities to do mathematics.

in high school, certainly atbronx science, you very often equated intelligence withtechnical abilities. you're good at math,physics, biology--- you were smart. at yale, i ran into a numberof individuals that were extremely intelligent but weresimply not numerate. their form of intelligence ifound really different and fascinating. and that is sort ofthe beginnings of

my interest in economics. i realized that mathematicswas not the only way of understanding interactions in avery deep way, and that yet you could actually put the twotogether in some interesting fashion to come up withsome new insights. interviewer: so was it sortof an immediate click? you mentioned the introto economics class. lo: no, it wasn't. i was very confusedfor a long time.

what ultimately decided it forme was a teacher, a professor, sharon oster, who taught afantastic intermediate microeconomics class. she was spellbinding. she provided intuition,developed some very rigorous mathematical models, and madeit all relevant and really interesting. so i found her to be anenormously inspiring teacher. and from the moment i took hercourse, i took every other

course she ever taught, andultimately asked her to be my undergraduate advisor. and i was a research assistantfor her, and ultimately wrote my senior thesis with her andsome other faculty at yale. it was a tremendousexperience. and so i think that's reallywhat ultimately made me focus on economics as the fieldthat i went into. interviewer: some of thoseearly ideas you've talked about, the relationship or thetension between mathematical

models and human behavior, arestill present in a lot of what you are interested in, whichwe'll talk about later. but that's an interestingkind of continuity. lo: well, it is. and i think it's also a part ofmy interests even back in high school, with the worldlyphilosophers, but also from the science fictionperspective. i, as a high school student,read isaac asimov's foundation trilogy.

and the notion of usingmathematics to predict the course of human evolution, ifound completely captivating. and i didn't know it at thetime, but economics was probably the closest field tothis fictitious psychohistory that asimov talks about. and so i suspect that thathad something to do with it as well. but all of these pieceswere really amorphous to me at the time.

and only with the benefit ofhindsight does some of it seem to make sense. interviewer: it's funny. i just randomly, for somereason, over the weekend had picked up the firstfoundation, the first of the trilogy. i had read it years ago. were you a sciencefiction fan? was that something thatkind of drove

your interest in science? i read a lot of thingsin that genre as a high school student. but mostly arthur c. clarke. he was one of my favoritewriters, robert heinlein. but isaac asimov was a favorite,not so much because of his writing style. i actually found asimov'swriting style not nearly as pleasurable as arthurc. clarke.

but the range of ideas thatasimov had in his books were just astonishing, from i, robotto the foundation to all of the other short stories thathe wrote, his field of vision was really tremendous. and so that got me verymuch excited about the possibilities of science. and many of his ideas of sciencefiction have actually become science fact over thelast couple of decades. interviewer: so like so manypeople at mit, you had an

early interest in sciencefiction and science. but you chose to really movein kind of a different direction in college. was it difficult to saygoodbye to science? it's not saying goodbye. maybe that's the wrong term. lo: well, that's just it. you see, i actually didn't thinki was saying goodbye to science, although in manyrespects, i think

i should have been. and we can discuss that later. but my thinking was thateconomics could be as rigorous a science as the physicaland biological sciences. and i remember having manydinner conversations with my elder siblings, who, of course,were scientists, and who, of course, as eldersiblings do, spent a fair bit of their time torturingme, asking me to justify my existence.

and so i've actually spent afair bit of time thinking about whether or not economicsis or is not a science. i, of course, think it is. and when i was in college, myinterest in mathematical economics was probably motivatedby that drive. the ability to use formalmathematical and statistical models to make precisestatements about economic phenomenon was what ithought i was doing and studying in college.

and it wasn't until grad schoolthat i had a bit of a rude awakening to that effect. interviewer: we'll move on tograd school in just a moment. i just thought i would ask,were there other very formative or importantexperiences in college that pushed you in a particulardirection or helped form your ideas? lo: a couple. one was another professor,herbert scarf, who taught a

graduate course in economics,microeconomics, and economic theory. and game theorists, pradeepdubey and martin shubik, i took their courses as well. and during those courses, itbecame clear to me that using formal models to study humanbehavior was both a bit of a treacherous exercise-- thereis a lot of behavior that doesn't fit neatly intothese models. but at the same time, those werethe heydays of general

equilibrium analysis. and tremendous progress wasbeing made in developing mathematical theorems thatwould demonstrate the existence and uniqueness ofeconomic equilibrium. so it was a heady timefor the literature. and as an undergraduate, i gotexposed to some of it through the faculty. yale's economics program isreally tremendous in that they do expose the undergraduatestudents to graduate level

courses if and when they'reready and they're interested. and because they also allow foropportunities to write an undergraduate thesis, youactually can engage in research even at that level. so my senior thesis was on gametheory, and ultimately, i actually got it published. so that was a really fascinatingprocess that i enjoyed and it gave me a tastefor the academic and a sense that there's a lot that could bedone with relatively simple

mathematical tools. interviewer: you decided topursue graduate studies. you went onto harvard. you went immediatelyfrom undergrad on? or did you-- lo: i did. and in retrospect, that mightnot have been the best thing to do. but part of it was financiallydriven.

because we came from asingle-parent household and we didn't have very much in the wayof financial resources, i actually graduated fromyale a year early. and when i was thinking aboutwhat to do, i was actually choosing between law schooland graduate school. because i was also interested inapplications and seeing how these ideas could actuallyaffect reality in practice. but then i did a very simpleeconomic analysis. law school was three years, andthe tuition was however

many tens of thousandsof dollars. and graduate school was,for all intents and purposes, free. not only was it free, i foundthat they actually paid you to go to graduate school! they gave you a stipend. and so, to me, theanswer was clear. i have got to get a phd. that, and also the fact thatmy brother and sister were

phds, as i said, provided somemotivation for me to achieve that level of success froman academic perspective. so i think that ultimately idecided that going to grad school was the right decision. and given that my undergraduateadvisor, sharon oster herself, received her phdat harvard and spoke very highly of the program,that was a very easy decision for me. actually, mit and harvard werethe two choices that i had

considered. at the time, i reallydidn't have much of an interest in finance. i didn't know what financewas about. and so, really, for my interestin mathematical economics, i thoughtthat harvard would be a better choice. interviewer: did youknow boston at all? had you been here?

i was actually going to askif you had been to mit? you had a sibling whohad attended mit. lo: i have very fond memoriesof mit because when i was in junior high school, my sisterwas an undergraduate here. and so we would come upevery fall, and bring her up here by car. and i would stay here for acouple of days to make sure she got settled. and while here, i spent anenormous amount of time in the

student center playing, at thetime, pinball machines. i don't know if they have anypinball machines here now. but i spent a lot of time thereand roaming the campus. so i loved it. and i developed early onan affection for mit. interviewer: but you went toharvard, nevertheless. so tell me a little bit aboutyour graduate school years. again, i'm very interested in significant professors, mentors.

lo: harvard was a bitof a rude awakening in a couple of respects. probably the most significantwas that the faculty member that i was hoping to work withultimately ended up being on leave the year that iarrived, in 1980. so i ended up taking classesin micro, macro, and econometrics like all the otherfirst year students. and i was hoping that thematerial that i learned as an undergraduate would be expanded

upon in graduate school. i knew that the models that wedeveloped in undergraduate classes were relatively limited,and that with more mathematics and moreunderstanding of economic concepts we could developmore realistic models. so i was actually quitedisappointed when, after the first semester of my first year,i realized the models that we developed were prettymuch identical to what i had done at yale, and that therewasn't anything more.

it was a bit frustratingfor me. in addition, at the time theharvard economics program had some difficulties. they were going through atransition where some of their faculty were on leave. and the faculty that were thereat that time were not really supposed to be teachingin a first year core. so the core was somewhatuneven. and a number of us became quitefrustrated with that

experience. and so by the end of the firstsemester, i had actually filled out my applicationfor law school. i thought i had madea bad mistake. and it wasn't until i happenedto take a course in the spring semester taught by bob mertonin finance here at mit that changed my mind completelyabout graduate school. that was really the mostformative experience for me, realizing that you canactually apply very

sophisticated mathematics, butin very practical settings. and that was what was missingfrom general equilibrium theory and game theory. i didn't feel that themathematics really brought us to any closer understandingfor practical kinds of situations, whereas financeseemed exactly what i was looking for. so after that point,i realized i wanted to do finance.

interviewer: so for the trulyignorant, such as myself, what do you mean when yousay finance? i think people tend to glosseconomics, finance, even business into one bucket. talk about exactly what wasappealing and what it was. lo: sure. in fact, they're very closelyrelated, not surprisingly. finance started out as abranch of economics. but it has gotten to the pointwhere it has become so much

more sophisticated in terms ofthe models and methods that are applied that it has takenon a life of its own. so in a nutshell, finance issimply applying economic and mathematical principles to thestudy of money, investments, in a world of uncertainty. uncertainty is really the key,because, for the most part, economics is actually prettywell understood in the case of perfect certainty. if there is no randomness inthe world, we actually

understand a lot about supplyand demand and how individuals engage in various kindsof economic decisions. the sole aspect of the worldthat makes finance interesting and nontrivial is the factthat we don't know what's going to happen tomorrow. and uncertainty reallyunderlies all of what financial models are about. so in trying to model thedynamics of financial markets, banks, asset managementcompanies, hedge funds,

investment decisions,corporate financing challenges, all of those areproblems that ultimately involve economics, butfinancial economics. and because the tools offinance have evolved so rapidly and so differently fromother areas of economics, it has really become almost aseparate field unto itself. in fact, most finance researchis done in business schools. many economics departments,including harvard, have now hired a number of very talentedfirst rate financial

economists. but for the most part, themajority of the financial economists are actually inbusiness schools not economics departments. interviewer: so you had thisvery, very significant experience taking this coursewith bob merton. talk about how that influencedyour path in grad school. lo: well, it really changedit completely. up until then, my focus wasreally on mathematical

economics and game theory. but once i took bob merton'scourse on introductory finance, i realized that thereis so much more applications of genuinely substantivemathematics to problems that cannot be solved in any otherway, and that yet can bring tremendous insight thatultimately affects practice. that's not something that gametheory or general equilibrium theory has reallybeen able to do. so once i took bob merton'scourse in finance, i basically

took every other finance courseoffered at the time at the mit sloan school. fortunately, at the time, andeven to this day, harvard and mit have a very collegialrelationship, where students from one university can cross-register, and almost seamlessly take classes inthe other university. so it worked out beautifully,where i was able to take all of my courses infinance at mit. and when it came time for me totake my qualifying exams at

harvard, i petitioned to createa special field which was finance. at the time, they didn'thave a field called financial economics. so i had to petition, and,fortunately, was able to get one of the economics faculty atmit to examine me in that discipline. interviewer: so the research youwere interested in taking on as a grad student, just talkabout it for a bit in

light of this new interest thatdeveloped in finance. lo: one of the things that istarted out with thinking about in economicswas investments. i was fortunate to have as oneof my main advisers professor andy abel, who currentlyis at wharton. but at the time, he was a juniorfaculty at harvard. and andy had been working oninvestment theory, the idea of how capital in the unitedstates and elsewhere get created from various kinds ofeconomic considerations.

when you buy a machine, and youinvest in it, you plan to use it for many years. what makes you decide to buy amachine, versus renting or postponing? this kind of investmenttheory fascinated me. but i couldn't understand howthe kind of investment in machines translatedto investments in the stock market. i knew that the twohad to be related.

we both use the word investmentin those contexts. and yet, the kind of modelsthat were developed seemed really different. my finance courses seemedvery different from my macroeconomics coursesin that respect. and so i spent a good part ofmy graduate days trying to reconcile the two. i remember talking with fischerblack during his office hours and asking him howcould it be that, as an

economist, we use the wordinvestment to mean purchasing physical capital, whereas infinance, when we think about investment, we talk about purchasing shares of a company? those two activities ought tobe related in some very fundamental way,shouldn't they? and fischer black said,yes, they should. and i said, well, but there'snobody who's working on that. how do we reconcile the two?

doesn't this bother you? and he replied that when he runsinto contradictions and inconsistencies, that actuallydelights him. because he realizes that meansthat there is work to be done! and so that was a big insightfor me, that i shouldn't get frustrated. i should actually be thankfulthat there was a thesis topic that was emerging. and ultimately, that's what ispent my years working on in

my thesis, integrating real andfinancial investments in a mathematically consistentframework. interviewer: one thing that imeant to ask you before-- i don't want to getsidetracked. but i'm just curious. maybe you can sort of put itin the context of the work that you're taking on. what is general equilibriumtheory? and what are what you sawas its shortcomings.

lo: general equilibrium theoryis a fascinating idea that was developed centuries ago byfrench mathematician, leon walras, and others. and the idea sounds so simple. but actually, it's quitecomplicated to work out. the idea behind generalequilibrium is that when you look at an economy, you haveto focus on all the various different markets that exist,each one corresponding to a different commodity or good.

and within each market, you'vegot individuals that demand a good and individuals thatsupply the good. and in each market, ultimatelythe intersection of supply and demand determines the so-calledequilibrium price for that market. well, the fact is that all ofthese markets are going on at the same time. and so instead of looking atwhat happens in one market, in order to truly understand how aneconomy changes over time,

you actually have to ask thequestion, how do all the markets equilibrate together? general equilibriumdoes exactly that. it says that, given a collectionof individuals that all consume certain commodities,and given a set of businesspeople that producethose commodities, there have to be a set of prices for allthe goods that are traded in that economy so as to equateall the supply with all the demand across all the markets.

now that seems like a reallytall order, to expect that this kind of an equilibriumwould occur across all of these different venuesand settings. and the idea behind generalequilibrium is to determine the conditions under which sucha general equilibrium across all these marketscould actually occur. some beautiful mathematicsare involved in this. and not only are thereinteresting mathematics about the existence of equilibrium,there's additional mathematics

that say something about whetherthe equilibrium is unique, and what happens whenyou're outside of an equilibrium, and how you reachan equilibrium, how you move from one to the other. so it's an endlessly fascinatingseries of questions that actually relieson some very deep mathematics to understand. but the problem with theseso-called theories is that they have become so general,they are so abstract, that

they've become divorcedfrom reality. because in fact, in practice,you actually don't see general equilibrium occurring. in fact, in many cases, as we'veseen over the last few years, markets are oftenin disarray and in disequilibrium. prices are moving aroundall the time, trying to equilibrate. and unfortunately, themathematics and the direction

of the literature on generalequilibrium hasn't really focused as much on thetransitions, the dynamics from one to the other, as opposedto what occurs at an equilibrium. and so in that sense, i thinkfinance has become a much more relevant discipline, becauseit actually has testable implications that have somevery, very practical applications. interviewer: to return to yourgraduate work just for a

moment, you develop mathematicalmodels to sort of compare investments in stocks,bonds, with goods or machinery, and so on. i'm no mathematician. but can you talk aboutwhat kind of relationships you found? and again, if you use yourmathematical models it will not mean much tome, i'm afraid. well actually, it's prettystraightforward.

the results that i developed inmy thesis really focused on what kind of investment policiesof a corporation would be necessary in order tosupport the kind of real business activities thatit engaged in. and the answer is actuallypretty simple, and hearkens back to some research that wasdone by mit economist, franco modigliani, years ago. in a market where there are nofrictions, there's no cost to engaging in issuing stockor issuing bonds--

in a frictionless market anda market with no taxes, the answer is that the real economyand the financial economy are prettymuch separable. it doesn't matter how you wouldfinance a purchase of a new machine-- whether you use debt financingor equity financing-- because in a costless worldwhere markets are perfect all the time, you can shiftfrom one to the other pretty easily.

and therefore, the financialside is almost an afterthought. but the problem is that as soonas you introduce market frictions, that changescompletely. and really, it's the frictionsthat make things interesting. you have to understand where thefrictions are coming from and how they relate to the different sources of financing. and with market frictions, withtaxes, it turns out that

there actually is an optimalcombination of equity and debt financing that will support thekind of growth that a real business activity entails. and so working out themathematics of it is really what i did in my thesis. and it was done in a dynamiccontext, so it was not just a static, one-shot kindof a perspective. it was really couched in theframework of a company that was engaged in multipleprojects over

the infinite future. and so that really gave me adeeper understanding for how to integrate the real andfinancial sides of the economy, and gave me anappreciation for why it is that frictions reallyare at the core of what we do in economics. so much of economic theoryis the frictionless case. and those are important cases,because you have to understand the frictionless case beforeyou can start seeing how

frictions matter. but we often forget thatfrictions do matter-- because we get so enthralled with africtionless case, given that the mathematics areso beautiful-- that we don't go to the nextstep, which is to say, let's make it messy again by buildingin these frictions. and frankly, that's what i'vebeen working on ever since. interviewer: you mentionedrobert merton. were there other significantmentors, influences during

your graduate years thatwe should talk about? i think you've actuallymentioned a couple of others. lo: absolutely. jerry hausman was a criticalfigure in my intellectual development. jerry is an economist atmit, an econometrician. and it turned out that i got toknow him because i took an econometrics course withhim at harvard. he was on sabbatical from mit,and he decided to spend the

year at harvard. and so he taught a graduateeconometrics course that i took and i did well in. well, enough that he hired meas a research assistant that summer, and then hiredme to ta that course the following year. and i really enjoyed it andenjoyed working with him. and ultimately, hebecame one of my principal thesis advisors.

he was the one who gave me theidea that you could actually use rigorous econometrictechniques to apply financial concepts to the data and learna great deal about how these theories actually workedin practice. and so the field that iultimately spent most of my early career on, financialeconometrics, grew out of my interactions with jerry, andcountless conversations, and free lunches and dinners thatjerry treated me to very generously, during the timethat i was his student.

interviewer: we tend to thinkof graduate students, particularly at places likeharvard and mit, as being involved within thisall-consuming research quest for knowledge. were there other things goingon in your life that were really important to youor significant? or did you find yourselfgetting really sucked into the work? lo: well, no doubt, graduateschool was very intense.

but it was a fun intense, in thesense that it was, for the first time, an experience wherei was surrounded by people that were all interestedin the very same relatively narrow fieldthat i was. so that was a new experienceand a very enjoyable one. at the same time, i was alsoworking as a research assistant and as a tutor,because financially, it was a bit challenging for my family. and so i learned about the realeconomic life of making

money for supporting myself. i was also dating a girl whoultimately i married. my wife, who, at thetime, was an undergraduate at yale still. and so we had a long distancerelationship for my days at harvard. and i remember spending enormousamounts of money on phone bills. and it was really then that igot into the habit of staying

up late at night, becauseafter 11 o'clock, the rates went down. and even so, had we been ableto avoid these long night phone calls, we probably couldhave purchased two cars by the end of my graduateschool days. so that was probably the mostsignificant other activity that i was focused onduring that time. interviewer: so you'rea newly minted phd. what's next?

lo: well, when i went on thejob market, my wife--- my girlfriend at the time---was a graduate student in a phd program in finance at thewharton school at the university of pennsylvania. so i was fortunate enough tobe interviewed by them. and they flew me out to give ajob talk, and made me an offer the next day. and i accepted thenext day after. so by the middle of januaryi was actually done with

recruiting because my girlfriendwas there. and so it was pretty easy. also, the wharton school isrenowned in the area of finance, and it was a bit of anew thing at the time for an economist to be hired bya business school. at the time, most businessschool faculty were hired from business school phd programs. and there was some crossover,but not a lot, and certainly not a lot of crossoverin finance.

finance was really a field untoitself at the time: that was really more a businessschool activity. and economics departments wereonly really beginning to start thinking about offering classesin finance, never mind concentrations in that field. so when wharton madean offer, to me, it was an ideal situation. my girlfriend was there. it was a bona fide and verywell respected finance

department. and my only fear was whether ornot i was going to be able to measure up to a financedepartment where i was an economist, an outsider. interviewer: did you ever thinktwice about pursuing an academic career, as opposed towall street or other options? lo: well, i did a littleconsulting when i was a grad student because the summerbetween college and grad school i was a summerintern at a

company called data resources. it's a software companystarted up by some harvard faculty--- otto eckstein, dale jorgensen,and others--- and at dri, i actually wasworking on developing software for engaging in a varietyof economic analysis. maximum entropy spectralanalysis was my project that summer. and so i did a bit of consultingfor dri during my

years as a grad student. so i thought a little bit aboutgoing into industry. but because i was so fascinatedby the kind of questions that came up in mythesis and i wanted to continue on, and, i think,because the family upbringing that i had clearly valuedthe academic lifestyle-- my brother and sister were bothacademics at the time-- it really was clear tome that i wanted to follow an academic path.

interviewer: let's talka little bit about your years at wharton. what were your researchinterests? what kinds of things wereyou engaged in? and also talk a bit aboutteaching as a young faculty member. lo: it was a very interestingmix of experiences that i had, even in my first yearat wharton. when i started in wharton in1984, i was 24 years old,

which is relatively youngfor a business school faculty member. in fact, i remember very clearlymy very first day of class, i was clearly youngerthan most of the students in that introductoryfinance class. there must have been 100people in the room. wharton has quite alarge program, and they have big classes. and before i actually beganlecturing, literally the very

first day of class, a studentraised his hand. and so not knowing any better,i called on him and the student said, professor lo,before you begin, we just have three questions. and i should have known rightaway, when they use the royal we, this could not havea good ending. he said, first, can you tellus whether you have ever taught this course before? second, can you tell us whatkind of consulting experience

you have in this area? and third, can you tellus how old you are? and not knowing any better,i answered the questions. i said, no, this ismy first year. i've never taught thiscourse before. i have no consultingexperience, really, to speak of. and i'm 24, at which point literally halfthe class got up and walked

out of the room, because theydecided that they wanted to go to another section with moreexperienced faculty. and i guess i can'treally blame them. they're paying a lot of moneyfor their tuition. but that was a soberingexperience. and it only went downhillfrom there. so i was baptized in fire,in terms of mba teaching. and so that was a very importantexperience, a formative experience for me.

but on the bright side, theexperience at wharton was tremendously productive for meand the other junior faculty, because it turned out that inthat year wharton hired nine assistant professors just in thefinance department, so i was one among nine. and the good thing about it wasthat because we came in en masse, we became very close veryquickly, the nine of us, socializing with each otherafter hours, basically hanging out all the time, because asan assistant professor,

there's not much elseto do anyway. none of us had familiesat the time. some of us had girlfriendsor wives. but we didn't haveany children. so we spent a lot oftime together. as a result, the departmenthad to get used to us more than we had to get usedto the department. and that was an incrediblyimportant experience because it allowed us to ask reallyinteresting research questions

without the concern that sometenured faculty member would disapprove. because frankly, the tenuredfaculty members weren't even around to interact with us,given their priorities and activities. so we spent a lot of timeinteracting with each other, challenging each other, talkingwith each other about ideas, and ultimately oneof the most fruitful collaborations that i had in mycareer started in that year

with craig mackinlay, who wasanother assistant professor from the universityof chicago. interviewer: presumably, yourexperience with the students got better from thatlow point? lo: it did get better. and as i said, i learned veryquickly that mba students are very demanding, andwith good cause. they are spending a lot of moneyon their tuition, and they obviously have to startthinking about paying it back

in many cases with studentloans afterwards. it became clear to me thatrelevance was really key. but, more importantly, thatthere was a certain impatience among mba students with respectto abstract theories that may or may not lead to somevery specific practical implications. and in time i learned toappreciate that perspective, and begin to take it moreseriously myself. not to say that academictheories are devoid of

practical consideration. but there is a veryimportant divide between theory and practice. and i don't think thatacademics necessarily appreciate that as much asperhaps they might or that they would if they, themselves,were placed in kind of a practicalenvironment. interviewer: how did yourresearch interests evolve as a young faculty member?

lo: that was a wonderful thingabout wharton: it's that we didn't really have anyparticular directions that we were expected to takeas junior faculty. and so we were pretty much freeto think about whatever it is that appealed to us. and my thoughts as a firstyear faculty member were really in the direction ofthis notion of market efficiency, and the abilityfor the real and financial sides of the economy to engagein pretty much separate kinds

of directions. as an econometrics student injerry hausman's econometrics course, one of the things thati looked into was the ability of testing the random walkhypothesis using a particular statistical procedure. really, it was just an exerciseat the time to see whether or not one could usefancier statistical methods to test the age-old idea of whetheror not you could use past stock market pricesto predict future

stock market prices. one of the foundations ofefficient markets hypothesis is the notion that all theinformation about the future of a company is actuallycontained in its current price. and if that's true, that meansyou can't use past price realizations to forecast future directions of the market. and as a student in jerryhausman's econometrics course,

i developed an idea for using astatistical test to capture that hypothesis. so when i got to wharton,i started talking with craig mackinlay. he and i had lunch prettymuch every day. and over lunch i would tellhim about these ideas. and he would say, well, we canactually take it to the data. in my thesis, i spend a lot oftime testing various ideas, but i hadn't really donemuch with stock

market data at the time. so he and i beganto work on this. and shortly thereafter, wecame up with a rather startling conclusion. using the tests that wedeveloped and applied to the data, we came to the conclusionthat us stock market prices actually don'tsatisfy this random walk hypothesis. stock prices aren't actuallypurely random.

and at first, we thoughtthat we had made a programming error. but in fact, after severalrepeated attempts to explain away these findings, we came tothe conclusion that this is exactly what the datahad to say. and so we tried to get the paperpublished, and when we presented it at a conference wewere completely trashed by our much more senior andwell-respected discussant who simply didn't believethe results.

his view was that markets couldnot possibly be that inefficient, and that somehowyou must have made a programming error, which in ourbusiness, is worse than calling your mother afour-letter name. so we got very excited andagitated, and went back to our computers and reprogrammed,and looked at the results. and ultimately, we werevindicated in the sense that this really was a feature of thedata and from that point on, for about a period of 10years, craig and i wrote a

number of papers to try toexplain this anomaly, and ultimately published a bookthat collected all of our papers to try to understandthis phenomenon. interviewer: how longwere you at wharton? and then how do you ultimatelymove on and come to mit? lo: i was at wharton for fouryears, from 1984 to 1988. in 1988, my wife graduated. she finished her phd; she gota job in boston, and so we were able to move.

that same year, i gave a talk atmit and the faculty offered a position to me. given my interests and the rolethat bob merton played in my career, and jerry hausman,it was a very easy decision. i accepted the offer prettymuch immediately. and we moved up toboston in '88. interviewer: let's talk a littleabout mit in 1988 or the late 1980s. your experience obviouslystretched back before that as

a graduate student. what was it like then? have you seen significantchanges-- in either the study of financeor in the student body-- in the culture of the place? lo: well, certainly somethings have changed. but i think a number of thingshave stayed the same. and the things that have stayedthe same are really the reasons that drew me to mit.

i guess probably the mostimportant draw for me was that i believe that modern finance,finance as a scientific endeavor--- really began at mit. it began decades ago withpaul samuelson. his interest in finance sparkedthe interest of one of his most productive and mosttalented students, paul samuelson's student bob merton,who joined as a graduate student in 1969, andbecame immediately paul's

close companion in rewriting theentire corpus of finance theory from the ground up. to me, that was just atremendous draw and the mit finance tradition that developedsubsequently. and the many other facultymembers that were drawn to this environment, includingstew myers, fischer black, myron scholes, francomodigliani, john cox, any number of-- steve ross.

we have tremendous faculty herethat have really built the edifice of modernfinance theory. so for me, it was aneasy decision. what's changed over time isthat we now have a deeper understanding of the kind oflimitations that the early theories exhibit, and are nowmore and more aware of and open to alternatives to explainthose departures. the '70s, '80s, and '90s werea terribly exciting time for mit for the traditional financeparadigm: efficient

markets, rational expectations,and all of the various ideas and products. the multi-trillion dollarderivatives industry really came out of ideas thatsamuelson, merton, black and scholes, cox andross pioneered. and so that was an incrediblyexciting time for that literature. but over the course of thelast decade or so, we're beginning to see the emergenceof some new ideas that really

demonstrate that not only arethere limitations to the existing theories, but there areways of extending them so as to be able to develop a morerational, more internally consistent perspective on howmarkets succeed and fail in different circumstances. interviewer: turning now to yourresearch interests, as i mentioned at the beginning,there's a very almost intimidating array of topicsthat you've tackled. but there are also someconsistent themes throughout

that we've already touched on. thinking specifically aboutthe work that you've done since coming to mit, what aresome of the most important themes, from your perspective,that you've attempted to grapple with? lo: i think that there'sactually a pretty clear direction and evolution in myresearch agenda, which really grew out of the work thati did as a grad student and at wharton.

and that's really to try tounderstand the dynamics of financial markets. when i got to mit, i was stillvery much in the midst of this notion of a random walk andwhether or not one could create profitable tradingstrategies from historical information. and it took me quite a few yearshere at mit to try to understand exactly what all thenuances are of the various different types of activitiesthat financial

investors engage in. and ultimately, i came to theconclusion that, really, you could not explain a way theseanomalies as simply being exceptions that provethe rule. there were just toomany of them. and they were too stark andsignificant from both a statistical and economicperspective. and so that got me to try totake a little bit more seriously the kind of departuresfrom rationality

that people in the industryobserve all the time. what made it frustrating,though, was that the alternative to the traditionaleconomic and financial paradigm of rationalexpectations and market efficiency was so-calledbehavioral biases that psychologists and experimentaleconomists documented. the problem is that, in my view,it takes a theory to beat a theory and the anomalies literature,which was really just getting

off the ground at the time,doesn't constitute a theory. they're a collection ofcounterexamples, and very important, by the way, butthey're not really an alternative to the traditionalparadigm. so really, much of my work afterconcluding that markets really don't follow random walksand that you have to take these exceptions as veryserious challenges to the received wisdom, much of mywork has been trying to understand how to reconcilethese two contradictory

schools of thought. interviewer: and howdo we do that? lo: interviewer: well, itactually took me a while to come up with the answer. in fact, at first i thoughtyou couldn't. you just had to pick. pick your favorite flavor,and then stick with it. but ultimately, because i spentmore time thinking from a number of differentdisciplines and perspectives--

including psychology, thecognitive neurosciences, and evolutionary biology-- that i've actuallyfinally come to a reconciliation of the two. and in a way, it seems almostsimple to me now, even though to this day it's certainly notreceived wisdom, by any means. it's still fairlycontroversial. the reconciliation that i cameto is the recognition that economic phenomenon and economicinstitutions are

creations of human activity inmuch the same way that an ant hill or a beaver dam arecreations of living creatures that are adapting to aparticular set of challenges in their environment. and viewed from a biologicalperspective, everything is different, everythinglooks different. rather than arguing aboutwhether or not behavior is rational or irrational, a muchmore productive perspective is to ask what kind of adaptationshave emerged in

the face of certain societal,cultural, economic, and social challenges. and so it's really theconfluence of evolutionary biology with the revolutionthat we've had in the cognitive neurosciences that hasbeen able to allow me to put together these differentpieces because, ultimately, we're focusing onhuman behavior. that, i think, is the key. it's that all of the differentdisciplines that i've

ultimately ended up learningabout-- in order to answer the question, why do people behavethe way they do in economic contexts?-- are studying the same thing:human behavior. we may be focusing on differentelements of it, but we're all studying humans. and because of that, ourtheories should be mutually consistent. they may not be focusing onthe same thing, but as the

great evolutionary biologist,e. o. wilson, wrote in his book, consilience, these factshave to be mutually consistent with each other, because we'reexplaining the same phenomenon. and so, really, that's what myrecent work has been about. it has been about usingdifferent aspects of human behavior to try to understandthe whole, to create an integrated theory of humanbehavior that spans the various different contexts andactivities that we are likely

to engage in. interviewer: let's drill downjust a little bit and maybe focus on some examplesor an example or two. interviewer: i'm aneconomic actor. we all are. i make irrational decisionsall the time. i'll confess. what's the theoreticalexplanation for that? why would i make really, reallybad investments that

can be sort of demonstrativelybad, or make bad financing decisions? lo: to answer that question, weshould first ask the prior question, which is, howdo decisions get made? or how does behavior emerge? and obviously, we trace muchof behavior to the brain. so we need to spend a littlebit of time talking about neuroanatomy, and ask thequestion, what are the components of the brain thatneuroscientists have been able

to identify that are linkedto specific actions? well, we know a few thingsat this point. we know, for example, that thereis a part of the brain that is relatively primitivefrom an evolutionary perspective, the so-calledmidbrain or the amygdala, and the structures surrounding it. this part of the brain is reallyfocused on relatively instinctive kinds of activities,so-called fight- or- flight response, fear,greed, sexual attraction,

and we know that this part ofthe brain focuses on those activities through imagingtechniques that neuroscientists haveconducted. so that describes oneset of activities. another set of activities thatneuroscientists have also deduced as focusing on adifferent part of the brain is higher thought functions thatwe would normally associate with humans uniquely; thingslike language ability, mathematical ability, logicaldeliberation.

that part of the brain is,from an evolutionary perspective, the newest part,and it is given the name neocortex to indicate that. one of the things that we knowfrom the neuroscience literature is that these twocomponents, the amygdala versus the neocortex, in manycases they work together. they're obviously connectedin many different ways. but in other contexts they workantagonistically, to the point where when an individualis faced with very strong

emotional response that willactually physiologically restrict the flow of bloodto the neocortex. i illustrate this with mystudents by asking them to think back to periods in theirlives when they were dating, and they were trying to meetvery attractive partners, that ultimately they concocted arelatively staged kind of a scenario in which to talk withthem for the very first time and ask them out on a date. and when that accidental meetingarrives, you would

think that they'd be able tocharm this other individual into going out on adate with them. but more often than not, whenthe moment occurs, we end up becoming tongue tied, hopelesslyand embarrassingly inarticulate, and unable toimpress this individual. why does that happen? well, it happens because strongemotional stimulus--- which includes sexualattraction--- can actually reduce the flowof blood to your neocortex.

it makes it harder for you touse that part of your brain. for all intents and purposes,love makes you stupid! and that's an example of aconstraint, a biological constraint, that has some veryreasonable evolutionary underpinnings. obviously, when you aregetting chased by a saber-toothed tiger, it's moreimportant for you be scared and run like heck than foryou to be able to solve differential equations,even if you're at mit!

and as a result, these kindsof neurophysiological constraints have a verystrong implication for financial markets. when we are subjected to strongemotional stimulus, we will react in predictableways. we will have difficulty in usingthe logical faculties that, for the most part,we're able to make use of for other decisions. but under extraordinarycircumstances, those mental

faculties are notavailable to us. and this has to do with anotherbasic evolutionary principle about diversity. typically, when we think aboutmarkets in general-- the journalist, jamessurowiecki, wrote a book describing them as the wisdom ofcrowds, the idea that when you have a crowd, and ifthe crowd is relatively independent in its thinkingand evaluations, then by pooling the collectiveevaluations of this crowd, you

get some very, verywise decisions. for the most part, financialmarkets, and most economic markets work in that manner. two things can violatethis principle of the wisdom of crowds. one is if you don't have acrowd: small number of individuals. but second and most importantly,if the crowd is not independent, if they allthink alike, if we all think

exactly the same way we don'tget the wisdom of crowds. we get the madness of mobs. and the distinction betweenthe two is really one of diversity--- diversity of thought. if we are all thinking exactlythe same thoughts, if we all want to get out of a crowdedtheater because of a fire, we know that the exits are goingto be a real constraint. that's going to createproblems.

if we are all thinking alike,and we want to get out of the stock market at the same time,that's going to create a stock market crash. and so the key to understandingperiods of financial market dislocation andso-called irrationality-- and that's a very loaded term. it's not at all clear that it'sirrational to get out of a crowded theater ifyou smell smoke-- the fact is that those periods,when we all think

alike, when we don't have thewisdom of crowds, but we have the madness of mobs, we reactvery differently. and economic theory, the way ithas been developed, really goes out the window. we need to develop a bettertheory that takes into account these periods of coordinationand correlation, and i think that that can be done throughunderstanding a bit more of the neurophysiology of decisionmaking and then some of the evolutionary dynamicsof diversity.

this is one of the reasons whybiodiversity is such an important part of theenvironmental movement. it's because having a diverseset of species will allow you to be much more resilient inchanges to the environment. that same principle,literally--- the same principle--- applies to thought. by having a diverse group ofindividuals, diverse in their thinking, we are much morelikely to survive changes in

our economic environment andbe able to move on in a somewhat more rational manner. but without it, without thatkind of diversity, we are risking the same kind ofpunctuated equilibrium that we see in evolutionary biology. interviewer: you mentioned acouple of minutes ago that love can make you stupid. is the idea that money canmake you stupid too? lo: in a different way,yes, that's right!

so again, neuroscientists havedone experiments where they've imaged to individuals' brainswhile they receive certain kinds of monetary reward. they play certain games wherethey win small cash prizes. and what they've identified isthat the neural mechanisms for financial gain are verymuch the same as for drugs like cocaine. your brain is stimulated toreleasing dopamine into the nucleus accumbens, the pleasurecenter of the brain.

certainly not as much, and notas intensely, as when you are on a drug like cocaine, butnonetheless, the mechanisms are actually one and the same and so it's easy to see how,over periods of great prosperity, during bull markets,people can get addicted to that kindof an experience. the more money you make, themore money you want. you would think that afterearning $10, $20, $30 million that should be enough.

but in fact, it has nothingto do with the amount. it has to do with the experienceand the kind of pleasure it generatesin the brain. and so all of these elementsactually come to play in developing ideas about howeconomic decisions get made. it's not just pure mathematicaldeliberation that will guide individuals in theirdecision making; it's a much more complex amalgam ofdifferent decision making components.

and by understanding how thecomponents work together-- sometimes in tandem, sometimesantagonistically-- we have a better chance ofcoming up with a more realistic theory of financialmarket dynamics. interviewer: i was veryinterested in preparing for this interview, also, to readsome of the things that you've written about risk anduncertainty and how that drives human behavior, or howhuman behavior changes in those circumstances.

can you talk about that a bit? first of all, let me explainthat by most dictionaries and thesauruses, riskand uncertainty are considered synonyms. but in fact, from theeconomist's point of view, frank knight--- the universityof chicago economist--- distinguished the two by callingrisk the kind of randomness that one canparameterize, for example, mortality tables for lifeinsurance or the odds of

winning in a lottery. what he called uncertainty wasthe kind of randomness that you actually couldn'tput numbers on, that you couldn't quantify. and he argued originally thatuncertainty really explained why it was that certainentrepreneurs, like bill gates would become multibillionaires,whereas others who don't take that kindof bet, actually, only end up earning normal economicprofits, nothing nearly as

outsized and grandiose. but there's a very importantemotional underpinning to this distinction that knight reallydidn't focus on, but now, with the benefit of decades ofresearch in the cognitive neurosciences, we understandmuch better and that really has to do with fear. the fact is that the most potentform of fear is the fear of the unknown and so ifwe can't put a statistical probability on certain events,if we can't quantify them in

some manner, then we areactually not dealing with well-defined randomness,namely risk. we're dealing with completelyunknown kinds of outcomes and so as a result, people tendto be much more averse to uncertainty than theyare to risk. the case in point is the recentexperience that we've seen in the stock market. clearly, people are happy totake on the riskiness of the stock market because, for manyyears, the stock market has

done just fine with a certainlevel of volatility and a certain level of expectedreturn. but over the last five years,the stock market has been extraordinarily erratic. and erratic particularly interms of its level of volatility, because during thefourth quarter of 2008, when lehman brothers went under, thevolatility of the us stock market hit a spike of somethinglike 60 percent per year, and on an intradailybasis even higher.

at that level of volatility,most investors would say, cash me out, i really don't want tobe part of this anymore! and the fact is that thevolatility of volatility in the us stock market has beentremendous over the last few years to the point where we'reseeing a lot of individual investors having taken most oftheir life savings out of the stock market and putting theminto cash, which is ultimately not a very successful way toplan for their retirement. but that's an example of thefear of the unknown.

if you don't know what the rulesare, if you don't know whether the house is goingto confiscate all of your earnings at any point in time,then your simple decision will be not to play. and i think we're seeing thatplayed out now on a much bigger stage over the courseof the last few years. interviewer: so obviously here,nearing the end of 2011, these kinds of conversationsare not just academic. we witnessed the financialmeltdown in 2008.

we're now seeing a reallysignificant crisis brewing in europe. talk about these kinds ofmassive crises that sweep through the markets, through thesort of global financial structure, in terms of some ofthese things that we've been talking about. lo: well, i think that's partof a much larger theme that one can only really see fromthe perspective of evolutionary biology, and thatis that i think crises of all

sorts are the manifestationof the combination of technological advancesand human behavior. in particular, over the courseof the last 12,000 years, the human population has grownreally dramatically. if you take a look at typicalestimates of population during that time period, and you plotit on a graph, you see that the prototypical hockey stickexponential growth applies perfectly to the populationof humans. the way that we've been able toreproduce so successfully

in an otherwise hostileenvironment is through technology--- through the collectiveintelligence that we've been able to develop over hundredsof thousands of years of evolution to tame ourtechnology to our physical needs. and those technologies-- whether they're agricultural,or information technologies, or manufacturing technologies,or financial technologies--

they often have unintendedconsequences. for example, ddt was atremendous technological advance for agriculture, butit led to birth defects. automobiles were a wonderfulinvention, but they led to air pollution. and of course, industrialactivity now seems to be responsible for climate change,global warming. and i would argue financialtechnologies-- things like securitization,insurance contracts,

derivatives-- are wonderful inventions,wonderful advances in technologies that also canlead to unintended consequences. and these unintendedconsequences really are the result of the fact that thetechnologies provide us with much greater power incertain domains. but the greater power oftentimesis not controlled properly because human behaviorhas not changed that

much in the last 60,000 years. we are still very much wired thesame way we were back at the time when we first becamefully sentient, and our neocortexes developed intowhat they are today. and as a result, the fact thatwe're dealing with, in many cases, relatively ancient,hard-wired brains, but we're dealing with technologies thatallow us to do things that we were never intended to do in ouroriginal environment, has led to some challenges.

those challenges canbe dealt with. but the way that we're goingto deal with them is by developing smarter technologies,more advanced technologies. humans may not have been meantto fly the way that we fly now, but air traffic control andsafety measures allow us to do so relativelysafely today. and i think that we are nowat a stage where financial technologies have become soadvanced that we can now do

things that we werenever able to do. we need to develop the safetymechanisms to prevent us from doing the things that we oughtnot to do with those powerful interviewer: are you saying thatit's a bit-- and i don't know if this analogycaptures it, but-- sort of this idea that we allcrave things like sugar, salt, saturated fats, that we'veevolved to crave. and they end up killingus, because they're no longer so scarce.

and we just take toomuch of them. lo: exactly! so for example, certainly sugarwas present in the diets of humans 60,000 years ago. but they were fewand far between. occasionally, you wouldrun into a fruit tree. and you would have apear or an apple. and that was enormouslyattractive, but it came on occasion.

that's very different from beingable to eat deep fried twinkies every other day, whichi don't believe we were adapted to do. now maybe if we keep doing that,over the course of the next 50,000 or 100,000 years,we will have the ability to process that kind ofa sugar intake. but our current biologies arenot wired to engage in these kinds of activities. and a good case in pointis the internet.

the internet is really arelatively new invention, just a matter of a coupleof decades. and if you think about what wecan do now on the internet-- well, for one thing, at thispoint in time we are able, with a click of a mouse, towipe away half of our retirement investment in abad investment decision. that has never been possiblein the history of financial markets; it is possible today. and so if you think about thepower that individuals have to

do good and to do harm, they'reboth magnified by technology. and so we need to develop theguardrails, the safety mechanisms that will preventus from doing the kind of damage that we are now able todo with the very advanced technologies that we haveat our disposal. interviewer: so let's talk abit about those guardrails, because i'm very interestedin asking you about the relationship between these kindsof theories, this kind

of thinking, and policy making,and prescribing solutions for some of theseintractable problems. what do you see as your role? and how do we goabout doing it? lo: i have to admit that formuch of my early academic career i wasn't interestedin policy at all. in fact, i was much more focusedon the dynamics of private markets, and reallynever even thought about what was going on in the publicarena, simply because my

presumption was that policy wasbeing formulated by the experts in policy making, andthat the challenges, the intellectual challenges, werereally in trying to understand the dynamics of privatemarkets. it didn't occur to me untilrelatively recently that there are challenges in the policyarena that are at least as great and if not greater interms of affecting a much larger group of individuals. and so over the course of thelast 10 years, i've spent more

time thinking about theinterplay between policy and private activity. the first thought that i'vebeen spending time on is really the underpinnings ofpolicy making to begin with. economists and policy makersformulated a number of policy prescriptions with the implicitassumption that individuals, and thereforeinstitutions, are rational actors. the efficient markets hypothesisor rational

expectations have been appliedto macroprudential regulation as well as to financialmarkets. and the first observation thati think needs to be made is that the same limitations thatwe found to the kind of investment theories that privatefinancial markets exhibit really have tobe applied to more general policy settings. in other words, the kind ofmadness of mobs that we see in financial markets have to beapplied much more broadly to

economic settings informulating policy. and there are a number ofpolicymakers now that do have that perspective, butnot nearly enough. and certainly not enough toreally affect yet the direction of policy. i think that's the firstinsight, to begin with. and from that point on, allother policy implications will follow very readily. and changes in policy, moreimportantly, will be suggested

by this kind of a differentperspective. if we look at markets not asstatic, stable, physical systems that have underlyinglaws that are immutable, but are actually biologicalinstitutions that can evolve over time and as a function ofmarket conditions, i think we're much more likely toformulate policy prescriptions that are themselves adaptiveand much more likely to succeed in a variety ofdifferent environmental conditions.

interviewer: it's obviously avery hot political issue right now, just what exactly therole of governments are in all of this. what's your view on that? lo: in my view, government is,itself, an evolutionary adaptation. without a doubt, the institutionof government is critical for resolving a numberof challenges that we face as a society becausemarkets cannot work perfectly

by themselves. they do break down fromtime to time. and actually, implicitly,i think we already recognize that. for example, in this studio,there are a number of laws governing the fact that therehave to be sprinkler systems, there have to be well-lit exitsigns, the fact that there have to be certain protectionsfor all of us, in case of fire.

why do we institute suchexpensive features of this particular setting? it's because we recognize thatwe can't leave it to the discretion of the builders ofany institution to put these in place, because, left to thechoice of a real estate developer, they will almostnever choose the more expensive option ifthey can avoid it. the probability of fireseems relatively low. and if you allow people tochoose whether they want to

build a building with fireprotection versus another building without, they willchoose the cheaper alternative, unless there's anabsolute demand for the more expensive one. and for most days, there isn'tan absolute demand. that absolute demandoccurs right about when there's a fire. of course, by that timeit's a little late. we know this about ourselves.

we know human nature. we know that we will not gladlypay a higher rent for a facility that has fireprotection if we are given a choice. and so after a number of verysevere fires with many, many casualties, we as a societydecided to institute a law by government that says that allbuildings have to have fire protection if theyhave a particular function to the public.

and so this is an example ofhow laws and how government takes into account humanfrailties in a very explicit way. well, if we understand thisabout something as basic as fire protection, it has now cometime to make that same leap of understanding for allsorts of contexts, including financial ones. we now have to build infinancial protections that prevent us from doing the thingsthat we know we're

going to want to do,particularly after extended periods of prosperity. after many, many decades of theeconomy growing rapidly and financial markets generatinglots of value added for all the market stakeholders,at some point, we're going to say to ourselves,you know what, we don't really need asmany protections as we had in the past. it's time for us to perhapsloosen up some of these

protections that have beenreducing the growth rate of our economy. we don't need seatbelts anymore. we don't need leveragerestrictions anymore. we don't have to haveconstraints. that's a natural reaction fromdecades of no car accidents or no big financial meltdowns. and that kind of human tendencyis something that we have to recognize.

we do recognize it in limitedcontext, like fire protection. we don't yet recognize itin economic settings. interviewer: libertarians seeall of this, of course, in terms of maximizing individualfreedom, as opposed to restricting or regulatingthat freedom. what's your thinking or yourresponse to that kind of approach, which seems to bevery, very different? lo: well, in fact, i would saythat individual freedoms are absolutely critical.

and one of the unique aspectsof homo sapiens is the fact that we can actually choose howwe wish to live our lives. and i think that that's anabsolutely fundamental aspect of human society. there are very few societiesthat are so regimented across the board that willactually last-- even totalitarian regimes willultimately fall, because humans want to be free. however, freedom doesn'tnecessarily mean that any

action and activity should bepermitted; because of a very important aspect of humansociety, which is what economists call externalities. if my activities have negativeconsequences for you and your family, then we havea problem. we have a challenge thatwe have to resolve. and so because of the successof population growth, we are now at a point where a numberof activities that we have previously engaged inhave externalities,

or spillover effects. when the economy is relativelysmall the kind of spillover effects that we're talking abouttoday are really remote. but when the economy gets bigenough, when human society gets to where we are today--seven billion people, as of the end of this year-- these externalities becomemuch more significant. so we have to balance the humandrive for libertarianism with the acknowledgement thatindividual actions very often

have much broaderconsequences. and ultimately, that's reallythe political process. that's what we really rely onpoliticians to resolve. they haven't been doing sucha great job lately. but eventually, they will andthey must be able to come to terms with these verydifficult decisions. and ultimately, by understandingthe dynamics, the spillovers, theexternalities, we actually have a better chance of creatinga much more palatable

solution for all stakeholdersinvolved. interviewer: i also wanted toask you about financial education for, i guess, whati'll call the layperson. i am a relativelyunsophisticated investor. how much education should aperson who's not a business person, not particularlyinterested, frankly, in those kinds of issues have? and what is the role of makingpeople more sophisticated and more aware of these things?

lo: i have to confess thatto someone with a hammer everything looks like a nail. so if you're going to ask anacademic how much education they should have, the answeris, lots and lots. but i think that this isactually part of a much broader trend that we see acrossall aspects of our existence today. life has gotten more complicatedin many ways. it's obviously also gottensimpler in yet other ways.

but the fact is that, withvarious advances in the sciences, we now know a lot moreabout all aspects of our day- to- day existence. and therefore, we can makemore informed choices. take for example, diet. in the 1950s, the advice thatmost people received from their parents was eat toyour heart's content. there was no discussion ofcholesterol, or carbohydrates, or various kinds of healthissues that we now understand

to be quite significant andthat we can do quite a bit about by watching our diets. and so the advances that themedical sciences have offered have, in many cases, madeour lives simpler. we now can take a flu shot andbe assured that there will be relatively minor consequencesof a bad flu season. but it has also made our livesmuch more complex in that now you have to decide how muchfiber you're going to have, how much protein, how muchcarbohydrates and are you

taking enough vitamins andminerals each day? so we have each had tobecome a little bit more expert in diet. by that same token, i believethat we have been given tremendous opportunities toengage in a variety of different investment activitiesthat would have been impossible to useven 10 years ago. now you can buy an etf thatinvests in many different countries, whereas in the past,you would have had to go

to various different brokersto engage in those kinds of transactions. so in that respect,our financial lives have gotten simpler. we have had more access toinvestment opportunities. but those additionalopportunities mean that we have more complex decisionsthat we have to make. so i think that in the shortrun investors really should spend a lot more time thinkingabout their investment

portfolios. typically, an investor willthink about their portfolio maybe four times a year, oncea quarter, certainly once a year when they haveto do their taxes. but if you think about thatlevel of attention to your financial health, that'sactually a pretty limited amount of time that you spendcompared to how much time you spend on your physical health. you have a check-up of annually,but you'll have

other visits that involvevarious different specialties. so we spend more time nowthinking about our physical health than we do before,because we know more. by that same token, we need tospend more time thinking about our financial health thanwe have before. i believe that over time aseconomists, particularly financial economists, makegreater strides in taking into account human frailties invarious different financial products, eventuallywe'll be able to

develop smarter products. in the same way that an iphonealmost eerily knows what you want to do when you want to doit and makes it simple for you to do, we need an investment-kind of an iphone device that will allow us to reach ourultimate financial goals without having to spend too muchtime thinking about it. we're not there yet. and until we get there, weneed to spend more time understanding how financialinvestments work and how they

may or may not be consistentwith our ultimate goals. interviewer: i know thatteaching is, in fact, a very important part of what you doand a big part of your life. talk a little bit about that. and also, how do youbalance it all? lo: teaching is important. and i have to say that early on,because of my experiences in third grade with mrs.ficalora and throughout, i realized the benefits andtremendous costs of having

good and bad teachers. having an inspiring teachercan open your life to an amazing series of discoveriesand pleasures that would never have been possible. and similarly, a bad teachercould close a mind forever to a subject, which i thinkis just a crime. i think that teachersare underpaid-- particularly at the elementary,middle school, and high school levels--

because if we could measuretheir impact on society, if we could really measure the impactof having a good 11th grade trigonometry teacher onwhat that individual does 15 years from that point on,we would pay these teachers a lot more. we would be a lot morecareful about tenure. we would be a lot more focusedon developing good teachers at that level because that's whereminds are opened and where minds are shut.

so to me, teaching is one of themost important activities that we can do because that'sthe way that we replenish the stock of intellectual capitalin our society, the way that we encourage collectiveintelligence, and frankly, the way that we're going to solvethe challenges of society for the next few decades. the future scientists, andengineers, and economists that cure cancer, and fix globalwarming, and find new sources of energy, they are ourstudents today.

and so if we think in thoseterms, i think we'd take teaching a lot more seriouslythan we do now. interviewer: what's it liketeaching mit students? lo: that has just beena real pleasure. one of the constants that drewme and many of my colleagues to mit is the quality ofour students here. and it's really noticeable. i really view teaching ourstudents here as a privilege, not a burden.

we all like teaching studentsthat are good students, that are excited to learn, and thathave a certain degree of creativity and energy. well, mit students havethat tremendously. they are not only creative,but they have this entrepreneurial spirit thatreally makes them extraordinary students to teachbecause they don't take concepts for granted. they will take an idea andwork out five different

implications, and reallychallenge the teacher to really think about these ideasfrom a much deeper level. so i have to say that i'velearned more from the students here than i think i've taughtthem because of the challenges that they've thrown out, thecreativity that they bring to the process, and ultimatelythe energy that they have for learning. our students are absolutelyhungry for knowledge. and they drink it upat an amazing rate.

so it's really a tremendousenvironment for faculty. interviewer: speaking ofentrepreneurial spirit, i also wanted to shift gears a littlebit and ask you about some of your forays into that world. talk about that a bit. and why has it been importantfor to do it? lo: as i mentioned, when istarted in economics my interest was very muchon the applied side. i love seeing ideasput to work.

and one of the fascinatingthings about isaac asimov and the foundation series was thatsome very abstract mathematics was applied to some verypractical situations. and so from the very beginning,my interest was in seeing ideas implemented. and so during the period where iwas studying the dynamics of financial markets, the randomwalk hypothesis, it nagged me to no end that here we wereteaching our students that markets are efficient, it'simpossible to beat the market,

you should focus on risk andreward, and i had actually never taken any of theseideas that i had developed into practice. i had never tried to see howit is that these investment ideas did or did not workin actual settings. and so in 1999, i decidedto start my own investment company. i took a two- year leave ofabsence from mit, and worked with some of my former studentsand consulting

colleagues, and created acompany to try to undertake some of these ideas from amore practical setting. and over time, i've learned anenormous amount about how markets really work from tryingto use these ideas in practice, and seeing how theysucceed and fail over various different kinds of marketenvironments. interviewer: maybe just tofollow up, what kinds of things have you learned? i can imagine that that mightseem like an obvious question.

lo: well, there are few thingsthat i think i discovered quite to my surprise. one is that it's very painfulto lose money. but it's a lot more painful tolose other people's money than to lose your own. that aspect of human nature, ithink, is something that we don't really spend enough timetalking about in our investment classes. i do now.

but before i engaged in thisactivity i didn't realize just how important that emotionalaspect is, and why it's so important for investors toengage in third party financial advisors. in a way, it's much like themedical practice of never allowing a doctor to operateon his or her own family members, because you're tooemotionally invested. and in many respects, managingyour own wealth can be a very challenging activity, unlessyou are trained to think

somewhat more remotely, somewhatmore objectively about these kindsof decisions. managing other people'swealth has that very same feature to it. you don't want to disappointothers. you don't want to engage inpractices that are too risky. but at the same time, you arestewards of their wealth. and so they're expecting youto be able to make good investment decisions.

so the processes by which youcan provide that type of stewardship and the emotionaltoll that that can take on an individual is something thati learned about firsthand. and i found it very valuable. and ultimately i think it'sreflected in the research that i've done and what i teach mystudents now about how they might engage in these kinds ofactivities somewhat more productively and with somewhatmore preparation for the kind of challenges.

interviewer: thinking a bit moreabout mit, as we sort of start to wind down, themit economics, finance departments-- it's obviously a legendarya group of people. we've touched on someof your colleagues over the last 20 years. who are some of the otherluminaries that you would like to talk about? and are there any reallyinteresting stories that we

could gather? lo: there are so many. one of the things about mit thati love-- but it's also something that one hasto get used to-- is that there are so manysuperstars that are here that nobody really feels like theyneed to be catered to or treated any differently. this kind of an egalitarianethic is actually very different and unique,i believe, to mit.

i have been a student atharvard, a student at yale, a faculty member at wharton. i have visited most of the majorbusiness schools and economics departments over thelast few decades giving talks. and i have to say that mit isreally unusual in the ethic that has developed over theyears, particularly in the economics department andin the sloan school. and the ethic is really thatwe are all part of the same college of ideas

and you're judged by the clarityof thought and the creativity of your research. it's really that kind ofmotivation that keeps us young, and it keepsus thinking. and there's very little in theway of formalism that we engage in so we interactin a very open and collegial manner. that's one of the things thati value most about mit. in that setting, i have to saythat there are a number of

individuals that i've learned agreat deal from in a variety of different departments. one of the things that idiscovered early on was that mit is really like, for me,the world's biggest candy factory in that there are somany different interesting things going on in differentdepartments. in particular, in addition tothe sloan school and the finance group, i've interactedwith individuals in the economics department, with thebrain and cognitive sciences

department, with electricalengineering, and computer science, with the ai lab, yearsago when it was called the ai lab, and now the csail,the computer science and ai lab together. all of these individuals, ithink, have really contributed to a better understanding ofhuman behavior from my perspective. so it's hard for me to name anyone or two individuals. but certainly in the pantheon ofgreats, paul samuelson, bob

merton, franco modigliani,patrick winston, noam chomsky, marvin minsky, and tommypoggio, all of these individuals, i think, i'velearned tremendous amounts from over the years. and many more who havecontributed to my education. interviewer: that'squite a list. lo: there are a lot ofimpressive people here at mit. interviewer: so thinking aheadjust a little bit, maybe just give us an assessment, as wewind down, on what you feel

your impacts might have been asa researcher, as a thinker in finance. and where do you wantto take your work? obviously, the world is fullof challenges right now, in particular, in this area. and where do you want to go? lo: in terms of where i've been,let me start with that, and then talk about wherei hope to go. the early phase of my career wasreally focused on applying

rigorous concepts ofeconometrics and statistics to financial models to developthe field of financial econometrics. and i believe that thatfield is now very healthy and well- developed. and we now understand thatit's critical to use the proper methods of inferencefor understanding the empirical anomalies that weidentify in financial circumstances.

those empirical anomaliesleave a lot of room for innovation and creativitybecause they illustrate that the traditional paradigm issimply not satisfactory. there are missing piecesof the puzzle. and over the last 10 years of mycareer, i focused on trying to fill in those pieces of thepuzzle by bringing ideas from evolutionary biology and theneurosciences to provide a deeper and more nuanced understanding for human behavior.

where i think i'd like to goover the course of the next decade or so, if i'm luckyenough to continue being active, is to take those ideasand work out their implications for humanbehavior writ large. in other words, i'd like todevelop a complete theory of human behavior. and by complete,i mean one that applies across all contexts-- social, cultural, political,and economic.

because we are not socompartmentalized that on one day you're an economist, onanother day you are a psychologist, on another dayyou're a biologist, in terms of the way you act. we're talking about humans. and human behavior cuts acrossall of these siloed disciplines. and so what i've been spendingtime on recently is trying to understand how to integrate allof these different silos

in a more complete theory ofhuman behavior to the point where we understand so muchabout human behavior that we can actually createit artificially. this might seem like a programin artificial intelligence. but in fact, it's muchbroader than that. i think it was marvin minsky whosaid that he didn't want to create a computer that hecould be proud of; he wanted to create a computer thatcould be proud of him. and i think that that's a veryimportant insight because it

says that the notion of behavioris something much deeper than simple actions. we can now automatelots of behaviors. there are wonderful factoriesthat have very few human actors and are extraordinarilyefficient. but somehow we don't considerthem to be human. and the behaviors, frankly, arevery stupid in the sense that they're highly stylizedand they are not robust to changing environments.

going forward, what i'd like tobe able to do, what i think we now have the wherewithal todo, is to develop a theory of behavior that allows us toreplicate human interactions, human decision making inthe way that humans actually make them. so the turing test is awell-known idea, pioneered by alan turing, who said, thatif at some point by typing messages back and forth withanother party, you can't distinguish between theresponses you get from that

individual and the responsesthat you get from a human, then that computer is forall intents and purposes intelligent and human. i actually think that that's arelatively low threshold for what we need to achieve. i actually think that a muchmore relevant test for whether we have achieved anunderstanding of human behavior is to create a computerthat can engage in activities to such an extentthat seems to replicate humans

that, at some point, if someonewere to decide to terminate that machine, a numberof us would object on moral and ethical grounds. that, to me, is the ultimateturing test of human behavior. if we can create behavior thatcan actually mimic not just the look and feel of humanbehavior, but actually the mechanisms by which behavioradapts to new settings and can develop its own type ofcreativity, at that point i think we will have achievedsomething spectacular.

interviewer: so this hasbeen really wonderful. is there anything else you'dlike to add that we haven't talked about? lo: it's been very completeand wide-ranging. social responsibility? interviewer: sure. we have a few minutes,if you'd like to-- lo: the financial industry hasobviously undergone a great amount of turmoil overthe last few years.

and it has received many blackeyes at this point in terms of the behavior that wehave observed. but i think that we are at therisk now of throwing out the baby with the bath water whenwe start to engage in regulations that will ultimatelyhamper financial market development. because ultimately, while theremay have been excesses and even crimes that werecommitted during the financial crisis, the fact is thatfinancial markets are critical

for all aspects of society, andthat some of the biggest challenges that we havein front of us-- things like cancer or globalwarming or the energy crisis-- ultimately, those are going tobe challenges that we will face collectively. and we're only going to be ableto overcome them if we can unite in some coordinatedfashion. and one of the most importantaspects of that kind of unity is to be able to createproper incentives.

the financial system is designedto do just that. i believe that to some of thebiggest challenges of society can be addressed with theright kind of financial structures, and that they willbe virtually impossible to address without them. so we need to have more andsmarter individuals involved in the financial sector. we certainly should notrelegate that to the financiers because we know whatthey might do with it,

and we know that excesseswill occur. instead, we need to spend moreresources studying these issues, becoming much morenuanced in how we construct the appropriate financialstructures to be able to support innovation. and i think that if we can dothat, if we can find the right structures to create thewisdom of crowds and to support the kind of innovationthat we desperately need, we can face virtually anysocietal challenge

successfully with thosekind structures.