Nobel Laureates at Odds in Long-Term Capital Case

Joseph E. Stiglitz, who won the Nobel Prize in economics in 2001, testified Thursday that fellow laureates Myron S. Scholes and Robert C. Merton, both partners in now-defunct hedge fund Long-Term Capital Management, didn’t know economic substance when they saw it.

Stiglitz was testifying for the government in Long-Term Capital’s suit against the Internal Revenue Service, which claims the fund should pay about $75 million in taxes and penalties for using an illegal tax shelter. Long-Term Capital lost most of its $4.8 billion in capital in 1998 and prompted a Federal Reserve-orchestrated bailout to avert damage to securities markets.

Stiglitz, who won the Nobel Memorial Prize for his work on asymmetric information in economic transactions, agreed with the government that Long-Term Capital, founded by John Meriwether, had no reason to enter into a contested transaction except to save millions in taxes. He based his finding on logic.

“Economists are experts on rational behavior,” he testified. “We focus not on what people say, but what they do.”

Under questioning from Charles Hurley, the government’s lead attorney, Stiglitz, the former chief economist at the World Bank and now a professor at Columbia University, dissected the various pieces of the transaction, concluding that none added any economic value.

The Long-Term Capital shelter involved Onslow Trading & Commercial, whose partners were based in London. Onslow was formed to perform so-called lease-stripping transactions. In one case, it leased computer equipment from General Electric Capital Computer Leasing.

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Scholes, who won the Nobel Prize in 1997 with Merton for their work in determining the value of derivatives, testified earlier that the transaction had economic value. He estimated the fund’s partners could earn fees of up to $40 million from a $50-million investment made by Babcock & Brown Ltd., Onslow’s investment bank.

Stiglitz countered that Long-Term Capital, which structured its transaction with Babcock & Brown much like a loan, would have been better off borrowing the money itself and earning 100% of any of the returns.

“The fees don’t provide an adequate economic explanation,” he said.

Long-Term Capital’s lawyer, David Curtin, a partner at McKee Nelson, focused the judge’s attention on Stiglitz’s economic interest in being an expert witness for the government.

Stiglitz, Curtin said, earned $1,000 an hour for his work, which included writing a report for the government.