To me Krugman seems to be in love with "smart people" especially economics types. I'm sitting in an elementary seminar on options pricing and I can tell you with regard to applicability to the real world the published theory mainly because of false idealizations has holes you can drive a truck through. A Nobel prize is neither necessary nor sufficient mark of a successful and accurate theory. For example, the no arbitrage assumption is simply false, to a significant degree and it is the linchpin on which most of the Financial Trading Theory is based. This is not to say the private variants used by the traders isn't better but one shouldn't assume much in this case.
The contradiction may have been that in the best of all worlds if they made their investment more carefully truely hedged they would have diminshed their return to the point where big money would not have been interested. That nobody knew or announced the true risk is understandable and falls along the lines of Krugman's argument.
Interestingly enough it is by no means obvious that after the firm was recapitalized that as it liquidates its positions it won't be closed out as a profit. Evidently Warren Buffet was willing to recapitalize the firm along with Goldman Sachs so at least some very unnaive smart money thinks LTCM was doing something right. The difference between the Fed negotiated pot and Buffets was an extra 350 million for the partners
--mike -- Michael Cohen mike at cns.bu.edu Work: 677 Beacon, Street, Rm313 Boston, Mass 02115 Home: 25 Stearns Rd, #3 Brookline, Mass 02146 Tel-Work: 617-353-9484 Tel-Home:617-734-8828 Tel-FAX:617-353-7755