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25 of 29 people found the following review helpful:
3.0 out of 5 stars
Real People, Real Markets, Real Ideas, May 5, 2003
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.
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by Robert J. Shiller
by Jeremy Siegel
