Thought for Thursday
Jason Soon linked to Alan Woods’ review of Shiller’s The New Financial Order a little while ago, so I thought I’d post mine, published a couple of weeks ago in the Fin. I can’t resist bragging that Shiller said it was the best review of the book he had read. It’s much longer than my usual so I’ve put it in the extended entry below.
The subtitle of a book is often more informative than its title. Robert Shiller’s subtitle Risk in the 21st Century captures an important truth. If Îglobalisationâ was the big idea of the 1990s, Îriskâ is set to take its place as the central idea for the early 21st century. As anyone who has thought about the issue knows, risk is both an exceptionally elusive concept and an ever-present reality. Terrorist attacks and viral epidemics remind us of the riskiness of life as does the (diminished but ever-present) possibility of a nuclear cataclysm.
Although this risks are always in the background, economic risks loom larger in our day-to-day lives. Will that seemingly secure job still be there next year? Will the return on my savings be sufficient to finance my retirement?
For a brief period during the long boom that followed World War II, Western societies seemed to have economic risk under control. Keynesian macroeconomic policies stabilized the aggregate economy, and guaranteed near-full employment, while the social-democratic welfare state cushioned its citizens against the vicissitudes of age, ill-health and the inequality of market incomes.
In reaction, there emerged a vogue for critics of the ‘riskless society’ such as Aaron Wildavsky. Many of Wildavsky’s key ideas were anticipated in Kurt Vonnegut’s 1961 science fiction story, Harrison Bergeron, in which the Office of the Handicapper General acts to even out all of life’s chances.
But with the breakdown of full employment, the erosion of the welfare state, and the repudiation by employers of the implicit contracts that effectively guaranteed lifetime employment for the core workforce, the riskless society has gone the way of that other mirage, the problem of excessive leisure. Whatever criticisms might be made of today’s society, a shortage of risk would surely not be among them.
Another important development has been the emergence of large body of literature dealing with the problems of risk and uncertainty and with the properties of social and economic institutions designed to manage those risks. These institutions include financial and insurance markets, social welfare systems and (particularly in less developed countries) a range of informal and customary institutions based on small communities or extended families.
At first, the tendency of this literature was to tame and domesticate risk, pointing out the analogies between risk management and other kinds of economic activity. The expected utility model developed by John von Neumann and Oskar Morgenstern in the 1940s showed how, given well-defined probabilities and seemingly innocuous assumptions about individual preferences, problems involving risky choices could be managed using the same economic logic already developed for the riskless case. In work that subsequently earned them both the Nobel Prize, Kenneth Arrow and Gerard Debreu showed how, with sufficiently well-developed markets, a market economy could produce an equilibrium with a perfectly optimal allocation of risk.
These ideas have been developed with ever-increasing sophistication over the sixty years since the expected utility model was formulated. Unlike many economic theories, moreover, they have been applied directly in the real world, leading to the creation of ever more complex financial instruments, generically referred to as derivatives. Underlying all of this has been the belief that financial markets price assets and allocate risks better than any possible alternative institution, a claim that is commonly referred to as the Îefficient markets hypothesisâ.
At the same time, however, a powerful countercurrent has emerged. One strand begins with the father of modern general equilibrium theory himself, Kenneth Arrow. Having proved that the existence of sufficiently well-developed markets would guarantee an optimal equilibrium, Arrow went on to point out that the number of markets required would be inconceivably large. The analysis of incomplete financial markets has shown that, in most cases, risk will not be spread appropriately.
A second challenge began with another Nobel Prizewinner, Maurice Allais who challenged the behavioral assumptions underlying expected utility theory. Allaisâ critique was taken up and expanded by Daniel Kahneman and the late Amos Tversky. Again the Nobel committee took note, awarding the 2002 prize to Kahneman (jointly with Vernon Smith) and posthumously mentioning Tversky. Among other things, Kahneman and Tversky pointed to the importance of Îframingâ in problems involving choice under uncertainty.
The classic example involves a medical decision problem, in which doctors are asked to compare two treatments for a population of 600 patients. One treatment would save 200 of the patients with certainty, while the other would have a 50 per cent chance of saving all 600 patients, but a 50 per cent chance of saving no-one. When the problem is framed in this way, many respondents prefer the Îlow riskâ option of saving 200 patients for sure. On the other hand, if this option is framed by saying that 400 patients will certainly die, and the alternative by saying that there is a 50 per cent chance that none will die, but a 50 per cent chance that all will die, the great majority of respondents prefer the risky alternative.
The work of Kahneman and Tversky, among others, has inspired the growth a new Îbehavioral financeâ school, which aims to focus on describing the actual behavior of participants in financial markets, rather than deducing the implications of theories of optimal risk management. Thus far, however, behavioral finance has been primarily a critical theory focusing on the detection of anomalies in the standard model rather than the development of a comprehensive alternative.
A third challenge was posed at the empirical level, most notably by Robert Shiller of Yale (who is himself high on most lists of likely future Nobelists). Shiller pointed out, among other things, that the volatility of stockmarkets was far greater than was consistent with the idea of rational market participants adjusting prices only in response to new information about future earnings. Shiller followed up his academic work with the bestseller Irrational Exuberance, which correctly called the late-90s stockmarket boom a bubble at a time when many others (most notably Alan Greenspan, who had earlier popularised the phrase Îirrational exuberance) saw it as the dawn of a new era.
Shiller has now turned from diagnosis to prescription. His latest book is primarily concerned with the advocacy of a range of financial innovations which would, he argues, improve both public and private risk management. A striking feature of Shiller’s argument is the way he combines an incomplete markets analysis along the lines pioneered by Arrow with the insights of behavioral finance theory. In proposing potential innovations, Shiller considers the most appropriate framing of each proposal. As a simple example, Shiller points out that the adoption of the term Îlife insuranceâ in place of the older, and more accurate Îdeath insuranceâ was a crucial factor in the success of this 19th Century financial innovation.
Shiller also gives a careful account of the informational requirements for implementation and argues that advances in information technology have greatly expanded the range of feasible innovations. He argues that the deployment of Global Risk Information Databases (GRIDs) will greatly enhance the feasibility of risk-reducing financial innovation.
Of the specific innovations proposed by Shiller, three are of particular interest in the light of recent Australian debates. The first is that of home equity insurance. Shillerâs idea is to provide homeowners with the option of purchasing insurance against declines in the value of a house price index calibrated to match the location and quality of their own home. This idea may be compared with the proposal for home equity partnerships put forward by the Menzies Research Centre and examined in detail in a recent report by the Prime Ministerâs Home Ownership Task Force.
The insurance proposal has the advantage of being based on an index rather than on the value of a particular home, which should reduce transactions costs, and increase the attractiveness of this instrument to financial markets. On the other hand, while insurance provides protection against declining prices, it is not usually available as a put option, allowing homeowners to trade away the benefits of future appreciation in prices in return for a payment up-front. Hence, unlike the equity partnerships idea, it provides no assistance in resolving the affordability problem. Both proposals have advantages and disadvantages and it remains to be seen which, if either, will be successful in the marketplace.
The second idea of interest is that of income-related loans. The basic idea, which Shiller traces back to Milton Friedman, is that loans for purposes such as education should be repaid, not in fixed instalments as in a standard loan, but in payments fixed as a percentage of the individualâs income. Australian readers, especially graduates will instantly recognise this as the basic principle of the Higher Education Contribution Scheme (HECS).
The success of this scheme is such that it has largely displaced all competitors in the field of higher education financing. Despite its ideological preference fees, the Howard government has converted most fee-based courses to the HECS principle. More recent proposals have gone beyond higher education to cover such disparate policies as drought relief, financial assistance for homeowners, and even fines for criminal offences.
Unlike many American writers on policy topics, Shiller has generally done an excellent job in looking at international as well as US experience. In this case, however, he does not cover the Australian experience with income-related loans, focusing instead on small-scale US initiatives. Perhaps a second edition will address this deficiency.
Shillerâs third proposed innovation is referred to as inequality insurance. As he observes, this is a framing device to focus attention on the risk management aspects of what would normally be seen as a specific form of tax indexation. Shiller proposes automatically adjusting tax rates in response to changes in the total revenue required and the distribution of income. The object of this adjustment would be to maintain a stable level of inequality in the distribution of after-tax income.
This is certainly a relevant suggestion in considering the current debate over the possibility of a return to tax indexation, either formally or through annual discretionary changes in tax brackets. As in the United States, though not to so great an extent, most of the gains in income over the past decade have gone to those in the top 20 per cent of the income distribution. Within that group, the top 5 per cent, and even more so, the top 1 per cent, have benefited disproportionately.
If Shillerâs suggestion had been adopted a decade ago, it would have implied an increase in the progressivity of the tax system to offset the increasing inequality of pretax income. In reality, particularly in the United States, changes in the tax system have favoured the rich and acted to reinforce the growing inequality of market incomes.
The prospect of having the wealth gains of the 1990s stripped away will no doubt appal the political right. On the other hand, such a policy would permanently rule out the traditional left strategy of redistributing income through union action to raise wages at the expense of profits. The key idea of the risk perspective on public policy is that both sides would be better off settling on an agreed distribution than taking their chances on unpredictable future developments. Whether this reasoning will prove sufficiently convincing to produce a settlement the long struggle over the distribution of income remains to be seen.
Other issues covered include insurance against changes in the relative earning power of different professions, insurance for countries against fluctuations in economic growth and improvements in the intergenerational risk sharing provided by the Social security system.
A notable feature of Shillerâs book is that it is addressed more or less impartially to the private and public sectors. Some of the innovations he proposes involve the private creation of new financial instruments to be traded in financial markets. Others relate purely to the redesign of government policies such as income taxes, and others still involve a mixture of public and private activity. Shillerâs impartial enthusiasm for risk reduction of all kinds is unusual in this field, where many participants are strongly committed to the proposition that lightly regulated financial markets provide optimal management of all kinds of risks, and others are equally committed to the proposition that only governments can handle this task.
If there is any criticism to make of this book, it is that the implicit account is one of inexorable progress towards better risk management, as financial innovation in both the public and private sectors expands the range of instruments available. In the broad sweep of history this is an accurate picture. Life has been greatly improved by the range of risk management tools that have been developed over the centuries. But history is also littered with financial innovations that have failed, taking investors and taxpayers money with them.
Moreover, there is a close link between financial innovation and the cycle of speculative bubbles and catastrophic busts that has been the cause of much economic and social misery. Given that (more or less by definition) all previous bubbles have burst, every new financial bubble requires a story to explain why Îthis time it’s differentâ. Most commonly, some combination of technological and financial innovation forms the basis of this story.
Shiller alludes briefly to the dangers of financial innovation, as exemplified by the collapse of Enron. However, he downplays the problem, focusing on the egregious examples of fraud within Enron rather than on the general decline of standards of financial probity that characterized the 1990s bubble as a whole.
All of this is surprising in the light of Shiller’s earlier work, which demonstrates convincingly that financial markets can get things very badly wrong, with disastrous consequences for the real economy. And, of course, the problems are not confined to the private sector. Many financial crises can be traced to attempts by governments to protect citizens and corporations against risk, without taking full account of the costs involved.
The New Financial Order is essential reading. But keep a copy of Irrational Exuberance handy as well.
Shiller, R. (2003), The New Financial Order: Risk in the 21st Century, Princeton University Press, Princeton, pp 366 +xvi