Economic Principals

There's never been an American war quite like this one. With oil prices soaring and the economy seemingly fragile, it is striking just how greatly the situation resembles that of 1991, on the eve of the Gulf War. There are plenty of differences, of course, but the similarities are greater. One of these is likely to overwhelm all the others in the history books.

This is the only modern war in which a son has undertaken to carry through to completion what his father before him had failed to achieve.

With that in mind, let me tell a seemingly-unrelated story of intergenerational competition and cooperation, one which is continuing to unfold in a very different realm, just at the edge of the news. The idea is to get some feel for how these father-son successions can work.

Begin with the current issue of Harvard Business Review. There Zvi Bodie, of Boston University's School of Management, and Robert Kaplan and Robert Merton, of Harvard Business School, come out about as strongly as it is possible to do so in favor of estimating the cost to companies of the stock options they grant to favored employees, in order to carry them on their books.

Since the generous issue of options is thought to have done much to pump up the recent bubble in stocks, it is a matter of much controversy.

Currently, the authors note, options are not recorded as an expense on companies' books -- meaning there is little effective brake on the practice. This one form of executive and employee compensation is thus favored over all others. But the arguments for this special treatment don't stand up, they say. "Let's end the charade. The time has come to end the debate."

This is a remarkable brief, and it appears just as the Financial Accounting Standards Board is about to begin a final round of hearings before making a new ruling on the practice. Bodie, Merton and Kaplan -- two finance professors and an accounting authority -- list four fallacies among current arguments.

Options-jockeys claim that stock options do not represent a real cost; that their cost cannot be estimated; they their cost already is adequately disclosed; and that expensing them will hurt young businesses.

All wrong, say the professors. They marshal one argument after another to show why -- beginning with Warren Buffet's cheerful offer last year to take options in lieu of cash in return for the goods and services his companies sell to other corporations, prima facie evidence if ever there was that those options represent a real, calculable cost to issuers.

There's something of the last word about this piece. It brooks little dissent, especially from those who have trooped to the editorial pages of The Wall Street Journal in the past year to defend the current practice. They included former American Express CEO Harvey Golub and economists William Baumol and Burton Malkiel. Bodie and Merton's original piece appeared there as well.

Part of the authority with which they write is personal. It derives from the fact that it was Merton himself who, along with Fischer Black and Myron Scholes, devised the options-pricing formula in 1973 that stimulated the enormous growth in markets for options of all kinds.

Those markets in turn facilitate the widespread use of options grants to compensate executives and employees. Ten million persons received stock options in 2000, up from one million a decade earlier. The current rule governing the reporting of executive stock options dates back to 1972, the year before the Black-Scholes formula appeared.

Yet the main force of the Bodie-Kaplan-Merton argument derives from the essentially gladiatorial nature of the contest. These are questions to which there are right answers, not two or three different ways of looking at the problem, as for example, the significance of budget deficits. The case for expensing options is "overwhelming," they say. In effect, they dare others to take issue with them; they invite dissenters to duel.

The Nasdaq Stock Market has weighed in on behalf of current practices, gauzily comparing stock options to the Homestead Act, invoking Hernando DeSoto's The Mystery of Capitalism. But no one, least of all the accountants, want to do away with options altogether. All recognize the device is a powerful tool for motivating managers and employees and aligning their interests with those of their investors.

So, when the smoke clears, you can confidently expect that "prepaid compensation expense" to be a new category on income statements and balance sheets. Complicated? Yes. It will be another matter for experts, decided by experts.

Now as it happens, Merton's father died of lung cancer last Sunday, not long after the article appeared. He was 92, at the end of a remarkable career as a Columbia University professor. But he was not an expert at anything, at least not in the sense his son is. He was a sociologist, and an old-fashioned one at that, meaning one who was content for the most part to be smart.

Robert K. Merton was born poor in Philadelphia in 1910. At 14, he abandoned his birth name, Meyer Schkolnick, in the pursuit of whole-hearted assimilation. Who was going to hire an aspiring free-lance magician named Schkolnick? He availed himself of the many public institutions of that Quaker city to win a scholarship to Temple University. Thereafter he traveled to Harvard University, where he wrote a dissertation on the rise of science in 17th-century England for Pitrim Sorokin in the newly-organizing department of sociology.

He later recalled, "An abundance of monographs dealt with the juvenile delinquent, the hobo and saleslady, the professional thief and the professional beggar, but not one dealt with the professional scientist."

During World War II, with a deceptively short and simple paper called "A Note on Science and Democracy," Merton became the prime mover in a sweeping redefinition of science as the carrier of a particular social structure. Just as Reinhold Niebuhr adduced the existence of a "Judeo-Christian ethic" in a series of scholarly studies in those years in order to present a united front against potted Nazi doctrines of the origin of Western ideals, so Merton emphasized the ethical content of science as an alternative to totalitarianism.

It consisted largely, he wrote, of four imperatives -- universalism, communism, disinterestedness and organized skepticism. That is, Merton wrote, science acknowledged no national loyalties higher than to the truth. It aimed to create public knowledge, meaning the scientist could not hope to benefit until he had published his results, in effect giving them away (today in computer software we call this "open source" development). Because of its internal checks and balances, it was virtually devoid of fraud (a finding that occasionally has been bitterly challenged over the years as being excessively complacent). And it purposefully rewarded doubt and devalued "school spirit."

Merton had little to say about how science proceeded -- the ever-thinner slicing, the shrug in the face of complex problems in favor of the simpler ones that are susceptible to solution. But the effect of the spotlight he put on its normative structure was to elevate science to a higher moral plane just as thousand of European refugees arrived from Europe to take positions of responsibility in American institutions. The basic tenets of American democracy were reaffirmed in a surprising and effective fashion. "Melting pot" ideals were reinforced.

Merton's work and that of others who joined him became the organizing core of a vibrant sociology of science that flourished after the war. But gradually university sociology swept around Merton and others like him on its way to becoming more narrow, more various, more precise -- and much more critical of existing institutions.

Merton, meanwhile, didn't seem to care. He extended his interests further and wider, establishing with his friend Paul Lazarfeld the Bureau of Applied Social Research, where the focus-group concept originated, writing studies of integrated communities that became part of the underpinning of the government's brief to the Supreme Court in Brown vs. Board of Education.

By 1960, the year he was lionized by journalist Morton Hunt as "Mr. Sociology" in a profile in The New Yorker, he was on the verge of becoming "Mr. Irritating" to insiders -- a little like Joseph Schumpeter or John Kenneth Galbraith among the economists. Catchy phrases tumbled from his typewriter -- "self-fulfilling prophecy" is the best remembered -- but new works of galvanizing interest to the profession eluded him.

Moreover, in 1962 physicist-turned-historian Thomas Kuhn extensively reorganized the field with a book he called The Structure of Scientific Revolutions. Soon, departments dedicated to the history of science were sprouting in the best universities; sociologists were shouldered into the background. Merton later gave a good account of some of the circumstances surrounding this birth of a new discipline in a book called The Sociology of Science: An Episodic Memoir.

Then in 1965, Merton published his best-known book, On the Shoulders of Giants: A Shandean Poscript, a garrulous and playful meditation on the nature of scholarship in the form of a history of Isaac Newton's famous epigram -- "If I have seen farther, it is by standing on the shoulders of giants."

"The strange thing about RKM is that he is held in such greater regard outside sociology than within the field," says his old friend and editor Peter Dougherty. "Economists who know his stuff just love it. Sociologists have been writing him off for at least two generations.

"They always wanted to minimize his influence; put him in a smaller patch than he deserved. But he sprouted outwards beyond the constraints of sociology -- in economics, history of ideas, science, applied social research, literary analysis -- marketing, for goodness' sake. Some young sociological whippersnapper will have to reinvent Bob, I guess," says Dougherty.

Meanwhile, Merton's son -- he has two daughters as well -- had begun studying mathematics, first at Columbia, than at Caltech. In 1967, he enrolled as a graduate student in economics at the Massachusetts Institute of Technology, studying with his father's old friend Paul Samuelson. Before long the two were working on warrant pricing. It would be hard to exaggerate how different was the work of the son at that point from that of the father -- tight models described in abstruse calculus instead of "theories of the middle range."

In 1973, the younger Merton published "The Theory of Rational Option Pricing" in the Bell Journal of Economics, almost simultaneously with the famous Black Scholes paper in the Journal of Political Economy, whose submission had preceded it. The two approaches to valuation reinforced each other and turned out to be of enormous practical significance. Huge new markets in "derivatives" arose on the basis of them. And in 1997 Robert C. Merton and Scholes shared the Nobel Award in economics the year after Fischer Black died, for the new method they had devised.

In short, Robert C. Merton became everything that Robert K. Merton had not been -- a scientist's scientist, a founder of a field that never would fade away. And yet, whatever cross words passed between them in the brief period of youthful rebellion in the 1960s, the two men became each others' best friends, a mutual admiration society practically without equal in the social sciences.

The father continued to be influential in learned circles, but at a certain point he began signing himself "father of the economist." His wife, the sociologist of science Harriet Zuckerman, in 1977 wrote a well-received study of American Nobel laureates, Scientific Elite.

The forced liquidation in 1998 of Long Term Capital Management, the enormous hedge fund in which Robert C. Merton was a principal, put a dent in this happy story, mainly insofar as it damaged his credentials as a reformer of financial markets, espousing "functional finance," following in his father's footsteps. So did the end of a long marriage.

Otherwise, a fat pink cloud hung over the Merton family. Robert K. Merton continued to work on a book on serendipity, a subject long close to his heart. He completed it. It was published in Italy and its US publication arranged. Even when he died last week, there was a sense that nothing more could have been asked of life except that there should be more of it. But then as the old proverb has it, there is always more time than life.

So what's the point? What about the impending war in the Middle East? The businesses of the Merton and Bush families couldn't be more different -- scholarship vs. politics. What's the moral? What do Dubya and RCM have in common -- besides the fact that they carry their father's names?

Just this. The relationship between father and son takes precedence over almost everything else in this story. Sure, there's a crucial point of differentiation. Robert C. Merton's choice of mathematical economics involved a rejection of his father's path. And George W. Bush's populist Texas Ranger act contrasts sharply with his father's patrician Establishmentarianism. So does his history of elective rather than appointive politics. And his preference for go-to-hell tax cuts on the eve of war is in sharp contrast to his father's prudent budget-balancing.

But in almost every other sense, the younger Bush is following in his father's footsteps. His administration regards a shaking-up of governments in the Middle East as a necessary pre-condition to establishing a new post-Cold War stability there. Equally clearly, the White House regards a strong foreign policy as being the key to a durable economic recovery.

The Wall Street Journal last week reported the existence of a draft "roadmap" to a Palestinian state within a year. It was drawn up in December at the President's request by a shadowy "Quartet" of planners consisting of representatives from the US, the European Union, Russia and the UN, according to reporters Neil King Jr. and Jeanne Cummings. The draft document calls for a freeze on Israeli settlement activity and Palestinian elections within six months -- as long leadership is acting decisively against terror.

Depending how the showdown with Iraq turns out, the plan could be firmly on the tables of Israeli and Palestinian leaders by the fall -- with a good deal more action to follow, in international oil markets, domestic budget negotiations and all the rest. Mideast leaders don't much like the scheme, the Journal reported. But then if Saddam Hussein is forcibly removed from Baghdad, the calculus of power in the region will have changed again dramatically.

In the face of an audacious and hard-to-assess gamble, it probably makes sense for the near term to sit tight and pay attention. That is what the story of the Mertons, RKM and RCM, would suggest about how to think about the Bush family.