The New Financial Order: Risk in the 21st Century [Paperback]

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.

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.