Customer Reviews

The New Financial Order: Risk in the 21st Century

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1 star:		(4)

 

 

Bob Shiller, economics professor at Yale University, is a shoe-in for a Nobel Prize in Economics within a decade. The reason: capital markets are at the center of today's global world, and Bob Shiller, perhaps more than anyone, understands them.

Talk about timing! His previous book, Irrational Exuberance (echoing Fed Chair Alan Greenspan's famous 1996 phrase), hit the book stores in mid-March 2000 -- six days after the NASDAQ peaked at 5,100 and the new-economy bubble burst. In it he explained why misperception of risk and our abysmal mismanagement of it brought stock prices far above sustainable levels. Of course, he wrote that long before the rest of us (except for Alan Greenspan) started to lose sleep over it.

His new book appears, again perfectly timed, when most of us feel more insecure than ever. There is no argument that with globalization the world has become a riskier place. The same opportunity that let the hedge fund Long Term Capital Management speculate and arbitrage globally also threatened the entire world, when at one point its liabilities were said to approach 10% of America's annual GDP. I co-authored a case study of a leading investment bank that pioneered a new state-of-the-art approach to risk management (known as value-at-risk) -- and was bankrupted by it.

Have we learned our lesson? I doubt it. A popular Silicon Valley bumper sticker says: "Oh Lord -- please, just one more bubble". Based on history, the prayer will be answered -- there will be many more bubbles. And more economic crises, because every economic crisis in history began with financial collapse.

Economists are great at diagnosing problems, but generally poor at solving them. But in The New Financial Order, Shiller offers a brilliant solution to our dismal inability to deal with risk and uncertainty, written in a style ordinary people can understand. His book is about "applying risk management technology to the major problems of our lives". In the words of his publisher Peter Dougherty, this is economics that tries to improve the culture. Here is Shiller's basic argument.

In the 1980's economic theorists played with an idea known as 'missing markets' -- the notion that if only there were markets for everything, including every kind of risk, we would all be far better off and the economy would function smoothly. In inventing the 'missing markets', people who hate risk find those willing to bear it, at an appropriate price. The mechanism of supply and demand finds that price of risk-bearing (insurance) that makes both risk-buyer and risk-seller happy and better off. But despite the boom in derivatives -- the market for a variety of exotic risk-bearing assets -- most of the risks ordinary people encounter cannot be insured.

Consider Joseph Q. Public. Joe wanted to study philosophy in college, but his mother persuaded him to became a mechanical engineer instead, because as a philosopher he might not make a living. He owns a three-bedroom Colonial in suburban Newton, MA., but worries its value will decline. He works for a small quality-assurance company and worries, in this global downturn, that he may soon be out of work. If he loses his job, he also loses his family's health insurance. All these risks are uninsured, because no such insurance exists; there are 'missing markets'. The irony is that, like a majority of Americans, Joe is heavily over-insured for the least worrisome or likely of all risks -- death. He has $700,000 worth of life insurance, even though, as a non-smoking 42-year-old who jogs, the chances he will die this year are less than one in five hundred -- far less than the chance of losing his job, picking the wrong career, or seeing his home equity tank.

How can Shiller's insights help Joe Public and the world in general? By devising markets that insure risks that really matter -- markets big enough, so that risk is widely spread and broadly diversified, minimizing the chance any single risk-bearer will go broke. Such as livelihood insurance -- the chance I may not make a living. Home equity insurance -- the chance my house will drop in value. Income-linked loans -- contingent on my having enough income to pay them pack. Inequality insurance --insurance for the risk income inequality will create too many poor people. Intergenerational social security -- pooling risks held by different generations, some of them who work, some who are supported by those who work. And a huge database that supports these new markets, with new indexes and units of measurement that quantify the risks so they can be bought and sold and efficiently insured.

Even if only a few of these new markets for risk existed, Joe Public could sleep a lot more soundly. It is time for banks, insurance companies, governments and the World Bank to invent them.
People love to ask economists like Shiller, if you're so smart -- and understand capital markets so well -- why aren't you rich? And if you know the solutions, why don't you do something?
Well, in fact, he is! And he does. In 1991 Shiller and partners founded Case Shiller Weiss Inc., to facilitate devices to manage the risks to our homes. This is done by the Case Shiller Home Price Index, a repeat-sale home price index that enables people to insure against a fall in home values. The company was sold at a high but undisclosed price to Wisconsin financial services firm Fiserv in 2002. Shiller has now founded a second firm, Macro Securities Research LLC, to create new risk management vehicles.

As a pioneer in what is now known as 'behavioral finance' -- the application of psychology to understanding behavior in capital markets -- Shiller has a secret weapon, his wife Virginia, a child-clinical psychologist. I suspect he and I had the same experience -- discovering that our wives knew far more about economic behavior than we did, because while we studied equations and numbers, they worked with, and helped, real people, every day.

In the last two decades fascinating developments and innovations have occurred in the field of finance. Now called financial engineering, the techniques used therein are dependent on highly sophisticated constructions in mathematics. Risk analysis has been a large part of this drive for innovation in finance, and is the subject of this book. The author proposes some "radical" innovations for risk management, and it is fascinating reading. Those who welcome new ideas and proposals in finance should find the book interesting, but the book is addressed to a non-technical general audience, and so most of the mathematical justification behind the ideas is left out. However, references are given for the author's work and others he has collaborated with for the reader who needs a more quantitative approach. There are some philosophical threads in the book that are somewhat troubling, for those who do not agree with the political and moral philosophy of John Rawls (who the author uses as a "foundation"), but the substance of his ideas can still be accepted even if this philosophy is explicity rejected.

The author proposes six ideas for what he calls a "new financial order": livelihood insurance, macro markets, income-linked loans, inequality insurance, intergenerational social security, and international agreements. He also proposes the development of massive databases, what he calls GRIDS, standing for "global risk information databases", in order to provide the information that allows effective risk management, and "indexed units of account", which is a new "electronic money" that serves to optimize the negotiating of risk.

All of part three of the book is devoted to these six ideas. The author proposes 'income indexes" as a way of hedging livelihoods and compares livelihood insurance with disability insurance. Those readers in the scientific profession will appreciate his ideas on livelihood insurance, due to the extreme risk in entering a specialized scientific field at the present time. Interestingly, the author compares this risk management device with academic tenure, believing that the latter is a good example of what could be done in society as a whole. He does not elaborate though on how universities reduce the "moral risks" in the tenure system, unfortunately. Optimizing productivity in individuals who are guaranteed lifelong employment is extremely difficult, and there are strong arguments against the institution of tenure for this reason.

The author's discussion of "macro markets" is very interesting, especially if read in conjunction with his research papers. Motivating it with a real world example of the Citibank loan to Bulgaria in 1994, the interest rate of which was tied to the growth rate of the Bulgarian economy, he proposes a few ways in which risks can be hedged for everyone, such as 'perpetual futures', and 'macro securities', the latter of which he prefers and discusses at length. These are securities that are automatically issued and redeemed on demand, but only in pairs. Based again on indexes, there is a macro whose price increases when the index increases, the other going down when the index increases.The author gives several examples of the forms which these macro securities might take.

Because of its philosophical orientation, the author's ideas on "inequality insurance" may be somewhat troubling, for it is the government who is to set legislation on the level of income inequality, and prevent inequality from getting worse. But the tax system will be "framed" so as appear to enforce a measure of inequality rather than the specification of tax rates. The author explains how the inequality insurance payments would be calculated using what he calls the "after-tax Lorentz curve", coupled with the "Gini coefficient", which is a measure of how much the Lorentz curve sags. Historical evidence though casts much suspicion on the government's ability to do anything of value in the economic realm. In addition, inequality, as meausured by the author, does not say anything of the history of what led to that inequality. The history must be known before any action should be taken to correct the inequality. Inequality in and of itself does not entail corrective action be taken to dissolve the inequality.

The biggest virtue of the book is the author's awareness, and subsequent discussion, of the role of technological advancement in economic affairs, particularly the role to be played by machine intelligence. However, in my opinion, I think he is wrong when he expresses the belief that low-income workers will be at higher risk for losing their jobs because of the advances in artificial intelligence. On the contrary, these kinds of jobs will probably be the most secure, since it will not be cost effective to have robots do the kinds of tasks involved in these jobs. The highest risk will be for those who are in middle management, for the tasks that must be done in these positions can be done much more effectively by intelligent machines. Indeed, areas such as accounting, information management, financial engineering, and other areas that are information-intensive will be run entirely by machines in the near future. The resulting massive loss of jobs could be dealt with by using financial innovations along the lines of what the author proposes in this book. The enormous wealth generated by intelligent machines could be used to alleviate the financial strain that will be experienced by the people who lose their jobs to these machines. And the machines themselves may have their own unique and clever methods to solve this problem and others that arise in the coming decades.

Shiller is a visionary economist. The problem with visionaries is that they do not always see the world the same way as everyone else.

This book outlines how Shiller believes a range of innovative risk management products could change the international financial system, and at the same time raise the living standards of ordinary people. Shiller wants to create derivative products which would allow people to use financial markets to hedge against loss of income, or the decline in the value of their house, for example.

Now this is pretty daunting stuff for the average reader, and I doubt that most of the people Shiller wants to help would fully appreciate the complexities of the things he advocates.

The other problem I have is that I simply don't believe all of Shiller's ideas are feasible. Moreover, even he would have to admit it is impossible to eliminate risk from life, yet that is what he tries to achieve.

I think it is a terrific book for those who want to ponder "what if." It can be a hard read though.

This is a big, big book. Although it contains only 276 pages of commentary, its scope envisions a brave new world we can only imagine and argue about. No doubt the outcome of the argument will weigh heavily on our future for years to come. Professor Robert J. Shiller needs no introduction. Whether by intent or luck, his "Irrational Exuberance" warning about our overvalued stock market was published around the time NASDAQ topped out just above 5000 (March 2000). The rest is history. And while I, as a former member of two options exchanges, certainly welcome any suggestion to increase the trading opportunities available to us today, the six innovative financial instruments he proposes to reduce/share risk leave a lot to be explained, both mechanically and philosophically. The book, though, rates five stars for its thought-provoking ideas and for the stature that Shiller brings to them. There's a lot in this book and nothing in it should be discarded without extensive study and reflection. One of life's hardest lessons to accept is that none of us, either individually or collectively, can ignore the dynamic world we live in. Sitting still is not an option because of the relative motion of everyone else in the world. Our only choices are, in the immortal words of Lee Iacocca, "Lead, follow, or get out of the way." Today's informational databases were sure to evoke something like Shiller's ideas. It is useless to turn our heads because it will happen. Therefore the intent of this book should be exposed to the largest possible number of people because what we decide will determine how we spend the rest of our lives. On the surface, Dr. Shiller would be creating a Dr. Pangloss world, but the devil would be in the details.
The most obvious aspect of Shiller's proposals is that he would use classical capitalistic markets to achieve classical socialistic goals. A most creative feat in and of itself. Insuring against risk, of course, is nothing new. Lloyd's of London dates back to Edward Lloyd's coffeehouse in the late 1680s. But not only does Shiller want to mitigate the risk of error in individual decision making, he also wants to insure "society" against the collective mistakes of all. It will be interesting to see which power groups line up on which side of the argument. Maybe he isn't proposing cradle-to-grave socialism, but certainly something close to young-professional-through-retirement risk sharing as administered/regulated by a combination of governmental/financial superbodies.
He convincingly begins his presentation with a short history of how new innovations are always refuted at first, then eventually work their way into our lives. This is a good start to set the stage for his own ground-breaking ideas.
There is no point in going over the mechanics of the proposals because they will see many different permutations before they ever become tradable entities, but more important are the goals and philosophy that pushes them all.
His first proposal covers personal insurance: livelihood insurance to reduce the risk of people embarking on a dead-end profession. He is inspired here by the very legitimate concern that society losses out on tremendous talent when gifted individuals steer away from professions that might not pay off in the future. He feels that if we insure them against this failure, their contributions will pay off in the long run. Also included in personal insurance is his proposal for home equity insurance to guard against a decline in your home's value. He's already put his money where his mouth is by incubating such a company and then selling it to a financial conglomerate.
Next is MacroMarkets. Here he envisions GDP futures to enable trading in national economies based on how they perform. One of the benefits here would be when a country's GDP begins to weaken, it would be a signal to the affected economy's leaders that something must be done to remedy the situation or else things will get worse.
Third, he addresses banking and income-linked loans. Interest rates on loans would rise or fall with one's income, region, or profession, and could be used to modify or eliminate current bankruptcy laws. However, could a bank stay solvent by lending money on fluctuating terms unless it could also pay interest on fluctuating terms? We've just lived through the S & L crisis borne out of this same scenario.
Fourth, he tackles his most inflammatory subject, that of income inequality. His basic fear here, along with Dr. Ravi Batra and others, is that increasing disparity of income leads to riots, revolutions, and war. But who decides what is fair and equitable? And would an earlier leveling effect have robbed us of the builders Carnegie, Rockefeller, and Ford up through Walton and Gates?
Fifth - Intergenerational social security. This is the most pressing problem today and will cause the most heated debates going forward. What is fair can be debated until we all die of old age.
Last, he would like to set up swaps between rich and poor, strong and weak nations based on their GDPs. But what happens when politicians are accused of "exporting jobs" like companies are today? They won't be in office very long. The IMF doesn't have a great record getting the masses to toe the line either when it comes to living up to prior agreements.
The scariest ingredient of all Shiller's proposals is the collection, retrieval and analysis of masses of amounts of information (GRID) needed to administer such an interconnected trading arrangement. Yet, the Internet is making us one people, and Shiller's financial instruments would make us one world, interconnected, co-dependent, and risk-sharing. If Clausewitz was right that war is politics by other means, then perhaps politics is economics by other means. Maybe the time has come for economics to supercede politics and maybe Shiller is showing the way. He does have a vision. Do we want to be part of it or not?

Economist Robert Shiller became a household name when he published his previous bestseller Irrational Exuberance just as the dot.com boom was peaking. In The New Financial Order, he capitalizes on his celebrity to put forward a thoughtful, detailed proposal for managing economic risks. This highly readable book portrays a future in which many serious individual financial risks are dispersed to savvy global investors, thanks to technology. Imagine violinists being able to insure their careers in addition to their Stradivarius instruments, developing countries securing generous loans from the first world by tying the repayment schedules to their future GDPs and a revamped tax system preventing the gap between rich and poor from widening. We suggest this book to risk-management professionals who want to step back and look at the big picture, as well as to anyone who has a stake in creating new financial products to meet twenty-first century needs.

Summary of opinion.
The risk management concepts developed by Shiller are far fetched. The likelihood of any being ever implemented is low. Thus, this book is not the best use of a reader's time. You are better off reading Shiller two earlier excellent books: Market Volatility, and Irrational Exuberance.

Abstract.
Shiller develops economic concepts to reduce important risks within our society. These include:

1) Livelihood insurance against poor career choices.
2) Home value insurance.
3) Income-linked loans for reducing the risk of hardship and bankruptcy.
4) Inequality insurance. Protecting the distribution of income.
5) Intergenerational Social Security: Sharing risks between Young and Old.
6) International Agreements for Risk Control.

Below I will briefly evaluate these concepts.

Livelihood insurance.
Workers could get coverage against the decline in income that workers in the same field have experienced. The decline in income for the workers in this specific field would be measured whether the worker has remained in this given field or not. Take a cohort of 100 professional violinists. If 50 exit the field, and make their living as bartenders, this cohort of 100 violinists income would really reflect the income of 50 professional violinists and 50 bartenders. By the end, what would this income index really tell you? Shiller underestimates the liquidity of our labor markets. Today, you can find as many astrophysicists in consulting firms, and investment banking. The same is true for engineers. Many engineers end up as consultants in fields often not directly related to engineering, instead of working for engineering firms.

Home value insurance.
Homeowners could buy insurance against the value of their homes. So, if the value of their homes went down, they would receive payments from the insurer. This product runs into two hurdles. First, if priced correctly, this product would be very expensive. Few homeowners would be willing to pay per year the several percentage points on the value of their homes to insure them against a decline in value of their homes for just a 12 month period. It is essentially the price of a Put option on the value of your home. Secondly, the brunt of this risk is not born by homeowners but by creditors. To conclude, this insurance product would be expensive to cover a risk that is mainly born by another party (creditors).

Income linked loans.

Borrowers would repay loans as a fixed percentage of their income. So, if their income goes down, the debt burden goes down, and vice versa. This product will never reach a critical mass because it is unworkable for banks. Banks try to match the cash flows from their assets with the ones from their liabilities. An income linked loan would have such an unpredictable cash flow that it could not be matched by any bank liabilities cash flow. You figure the deposits and bonds issued from banks are not income linked. As a bank depositor or a bondholder, you demand a very predictable cash flow stream, not one dependent on the income of the bank?s borrowers. Thus, I don't see income linked loans becoming part of "The New Financial Order."

Inequality insurance, protecting the distribution of income.
Here the tax structure would be automatically adjusted to maintain a predicated distribution of income. This would have horrendous implications for financial planning. You would be uncertain as to your ultimate tax burden at the end of the year when the distribution of income would be recalculated.

Intergenerational Social Security: Sharing risks between Young and Old.
This product would overhaul the structure of Social Security. Now, the Social Security system is structured as a pension system. Currently, social security contributions far exceed the payments. This is to build up the Social Security trust fund for when the large Baby Boomer generation retires, when payments will far exceed contributions. With Shiller, the income earned by active workers would be shared on a prorated basis with retirees. He states that currently retirees represent 11% of the population. So, the workers contribution would be 11% of their wages to support the retirees. But, this percentage will double in just a few decades. So, the 11% contribution will become 22%. This is unfair to the next generation. The current system of prefunding the social security trust to get set for higher social security payments in the future is better. It equalizes the burden of supporting retirees between current workers and their next generation. Shiller concept does the reverse.

International Agreements for Risk Control.
Countries would enter agreements that would hedge against their economies under performing in the future. So, let's say that India's GDP is expected to increase by 4% per year over the next 10 years. India would enter into a contract with a group of countries (U.S., UK, Germany, etc.). The group of countries would make a payment to India anytime India's GDP would grow by less than 4%. But, India would have to make very large payments to the group of countries whenever its GDP rose by more than 4% per year. It is unclear how India would come up with that extra money. Would it have to raise taxes on its citizen? The resulting counterparty risk associated with India making such payments would be unmanageable.

The NEW FINANCIAL ORDER outlines an ambitious plan for reworking the ways we control financial risk. Shiller "democratizes" the subject of risk by addressing, among other things, the vulnerability of "ordinary riches" like the value of our homes and our choice-of-career incomes. These risks are various, unpredictable, and unevenly distributed through time and geography. That unevenness (unfairness, Shiller might say) means the risks can be insured, securitized, and traded. The moral dimension to this is Shiller's intention to hedge inequality that is "gratuitous, random, and painful".

Changes in a nation's economy and the unknowable effects of technological advances are two long-term, systemic risks we all face. By comparison, the risk to an investor's wealth of a company's stock missing its projected quarterly earnings is small in measure to the seismic shifts in the net worth of a much broader base of homeowner stakeholders. Now, if the stock market is not an adequate proxy for the overall wealth of the economy, then why not create "macro markets" for securities that swap out the risk of one nation's aggregrate output (GDP) for another's. Some will argue that the stock markets in the U.S. and other developed countries are already proxies for their economic prospects. But given the thin liquidity and relative immaturity of many other markets, securities tied to a more fundamental metric such as GDP or all real estate values are a clear positive.

Shiller does a good job of suggesting the challenges government and the private sector will confront to implement a new risk infrastructure. There is an interesting anecdotal history in Part Five of how various financial and insurance plans came into being as with our social security system modeled after the German system in the 1880's. The development of sophisticated "global risk information databases (GRIDS)" will provide a resource for writing appropriate contracts in the future. Privacy advocates will shudder, but part of the point is that the ways we control risk have evolved over time and can be modified to work better. This is a provocative book because of the wealth of its vision. With this much innovative thinking it seems reasonable that additional studies will build on Shiller's work and pave the way for some of these ideas to be adopted.

By any standards, financial markets are behemoths, where trillions of dollars are traded daily in stocks, bonds, currencies or securities. But unlike common perception that values financial markets based on their profitability, their more important function is to manage risks: shares are sold to investors to spread out risk-if money is made in the process, all the better.

What is surprising is that despite the extensiveness and complexity of our financial nexus, many risks that people face are not currently covered: what happens, say, if your job is taken over by a computer? Or, if you spend seven years in school specializing in a field for which there is no market after you graduate? There is no protection against these threats. Yet, unemployment has a more adverse impact on welfare than any movement of the Dow Jones or the Euro/Dollar exchange rate. Financial markets can help people manage the latter, but not the former.

In this sense, risk management is limited. Extending its scope to manage more risks is the subject of Robert Shiller's book. Mr. Shiller, of Yale University, has put together his vision for the future: a New Financial Order where risk management can serve the people, not just investors who know the markets. "The New Financial Order" is an ambitious work, and although Mr. Shiller tries to show that baby steps have been made towards that vision, it is clear that he is thinking far ahead-decades, even more.

But what is this new order? Mr. Shiller's world is build around six pillars: livelihood and home values insurance, macro-markets where aggregate risks can be traded, income-linked loans, inequality insurance, intergenerational social security, and international agreements for risk control. These ideas are grand, as will be the markets needed to implement them.

This financial order is an attempt to reduce the effect of randomness on our lives. All these instruments, in different ways, will allow a more equitable and efficient sharing of risk, making people better off. If in the past few centuries, financial innovation led to economic prosperity, then the future of finance will be to create economic security. "The New Financial Order" is a blueprint towards that goal.

Goes well beyond current ideas of manageable risks to suggest concepts and tools for management of six categories of international, national and societal/personal risk that can and should be managed. The author also includes reflections on the nature of innovation in financial markets. The central theme is that current technology and databases permit the establishment of forms of risk management that would transform the our ability to achieve long term societal goals.

Separate chapters cover each of the six categories. They include:
* insurance for livelihoods and home values;
* income linked loans designed to cover individuals against hardship or bankruptcy
*insurance against increasing income inequality (between nations, groups or generations)

Although the book is written for a general audience, some of the concepts are quite difficult to grasp. An early chapter, which provides an 'alternative history' of the period from 1950 to 2000 if the risk management mechanisms had been in place, helps non-specialists to get a feel for what the author is proposing.

Some of Shiller's proposals, such as multiple indexes instead of or in addition to currency I can't see being accepted by the general public. It would be too confusing to have wages in one indexed amount and rent or mortgages in another, etc. How would anyone ever get a feel for where they stood, i.e. how much they had to earn to pay the rent? What if the wages index suffered more from inflation than the mortgage index or vice versa?

I think one indexed value for all long term contracts such as wages, rent, mortgages, credit purchases, savings/ investment accounts, etc. maybe even such things as magazine subscriptions and major goods like autos, and appliances would work, but I think people would still prefer to use hand currency values for day to day shopping, so they could compare what they want to spend to the currency value of their accounts. Otherwise it would be too much like flying blind.

Something that has puzzled me recently about academic and "serious" presses: where are the editors?

This book has an astonishing number of typos, bad or marginal grammar, doubled verbs, incomplete sentences, you name it. I constantly found myself having to back up and read a passage over again because I though I knew where it was headed only to find that the verb didn't match the subject, or what sounded like an idiomatic expression wasn't (it only coincidentally reproduced the idiom), etc. The extensive list of acknowledgements didn't include an editor specifically; the book reads like maybe some of the dozens of graduate students involved are ESL. Shiller really needed a good sharp eyed editor.