The New Financial Order

Risk in the 21st Century

Robert J. Shiller

• Publisher: Princeton University Press
• Year: 2009
• ISBN:
  9781400825479
• Topic: Negocios y empresa
• Subtopic: Finanzas

In his best-selling Irrational Exuberance, Robert Shiller cautioned that society's obsession with the stock market was fueling the volatility that has since made a roller coaster of the financial system. Less noted was Shiller's admonition that our infatuation with the stock market distracts us from more durable economic prospects. These lie in the hidden potential of real assets, such as income from our livelihoods and homes. But these ''ordinary riches, '' so fundamental to our well-being, are increasingly exposed to the pervasive risks of a rapidly changing global economy. This compelling and important new book presents a fresh vision for hedging risk and securing our economic future.
Shiller describes six fundamental ideas for using modern information technology and advanced financial theory to temper basic risks that have been ignored by risk management institutions--risks to the value of our jobs and our homes, to the vitality of our communities, and to the very stability of national economies. Informed by a comprehensive risk information database, this new financial order would include global markets for trading risks and exploiting myriad new financial opportunities, from inequality insurance to intergenerational social security. Just as developments in insuring risks to life, health, and catastrophe have given us a quality of life unimaginable a century ago, so Shiller's plan for securing crucial assets promises to substantially enrich our condition.
Once again providing an enormous service, Shiller gives us a powerful means to convert our ordinary riches into a level of economic security, equity, and growth never before seen. And once again, what Robert Shiller says should be read and heeded by anyone with a stake in the economy.

Part One

Economic Risks in an

Advancing World

ONE

What the World Might Have

Looked Like since 1950

VISUALIZING THE MAJOR economic risks of the future is difficult. Because such risks are only hypothetical—at least until we have concrete evidence of their imminence—most people do not feel easily convinced of the benefits of any new measures against them. We tend instead to be distracted by little day-to-day problems that are already clearly revealed. We seldom think about how we should be dealing with deep and fundamental risks.

In contrast, the dangers that have dominated the past are well known to us. Thus, let us consider, as a thought exercise, risks that have already come to pass. Let us imagine how history since 1950 might have been different if it had somehow been possible to implement some of the new financial ideas that are developed in this book. This exercise will lend some concreteness to our evaluation of the potential for financial innovation.

We will assume for this exercise that the relatively undeveloped state of information technology in 1950 had imposed no obstacles to the adoption of radical financial innovations. We will also assume quite a bit more financial sophistication among governments, businesses, and the public than was in fact common in 1950. And we will ignore the complexities of the changing world political situation since 1950: We will focus on the possible benefits of risk management technology, assuming that they could have been applied.

This is an exercise in alternate history, which seeks to illustrate what might have happened from a given date forward if some crucial fact of history were changed. Alternate history has been criticized by some mainstream historians: The complexity of history is such that any conclusions are highly conjectural. Other historians, however, believe that alternate history is useful as a mental exercise, alerting us to significant facts and details about our world that might otherwise have escaped notice.¹

Reconstructing History since 1950 with Better Risk Management

In 1950 the Marshall Plan (the European Recovery Program authorized by the U.S. Congress) was in full swing, helping to offset the devastation and disruption caused by World War II. The total sum transferred during the life of the program, from 1948 until 1951, from the United States to European countries (Austria, Belgium, Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, The Netherlands, Norway, Portugal, Sweden, Switzerland, Turkey, and the United Kingdom) was thirteen billion dollars, most of which was transferred as outright gifts. This would appear to be an impressive example of spontaneous charity.

From another perspective, however, this magnanimous gesture still amounted to only 1.3 percent of U.S. GNP for those four years. While the Marshall Plan is widely regarded as a significant factor in European recovery, in fact it amounted to a relatively small sum of money. If one considers the situation in Europe, where in some places the population bordered even on starvation after the war, thirteen billion dollars would not seem an adequate amount of assistance envisioned from Rawls’s original position.

Nor was the Marshall Plan really charity. Secretary of State George C. Marshall’s proposal for a costly plan to repair Europe initially received a skeptical reception from the U.S. Congress, until it was pointed out that the dollar value of the Marshall Plan would be no more than 5 percent of the amount that the United States spent for all of World War II, and that unless this additional expenditure were made, all of the war effort might have been for naught and Europe could yet fall to fascist, communist, or other unwanted influences (as had happened after World War I).² The supporters of the Marshall Plan framed it as the successful completion of the war effort. There is a natural human urge to complete tasks that have been started, and the psychological framing of the Marshall Plan tapped into this urge.³ Had it not been framed this way, the United States might have left war-damaged Europe almost entirely to its own resources. Hardly an example of altruism, the Marshall Plan at best showed that the United States could summon the political will to make substantial payments abroad when it deemed them important.

Now comes the thought experiment: Let us imagine that most European people and governments had made fundamental risk management contracts before World War II to protect their livelihoods: livelihood insurance, macro markets, income-linked personal loans, and international financial agreements between governments (mentioned in the introduction and developed later in this book). The reader may still be puzzled by these terms at this point, but for now suffice it to say that these contracts reduce major risks to incomes and that if they were understood before 1950, many of them would not have cost much to set up.

Had these arrangements been made before the war, then they might well have transferred much more money than did the Marshall Plan. In other words, it is quite possible that the United States (and other countries) could have turned 10 percent of GDP or even more to damaged countries after the war in fulfillment of their financial obligations as defined by risk management contracts signed before the war. The benefits would have been enormous: To the undamaged United States, a 10 percent loss in income would have had relatively modest impact, while the effect on war-battered Europe of these same resources would have been huge.

What about the doubts that risk management contracts can survive war? In this case, it seems clear that most of the Marshall Plan countries would have had their contracts honored, since most of the damaged countries were not antagonistic to the United States or its allies during the war. Beyond that, the very fact that even conquered Germany and Italy received Marshall Plan support after World War II shows that the bitterness of war does not necessarily obviate responsible actions. Most likely, Germans and Italians would have benefited from their risk management contracts, had they been arranged earlier.

During the same post-war period, nothing comparable to the Mar-shall Plan was authorized for Asian countries, even though many areas were also devastated by World War II. U.S. President Harry S. Truman’s Point Four Program for the rest of the world (so-called because it was the fourth point in his 1949 inaugural address), as implemented between 1952 and 1954, appropriated only 6 percent of the total spent in the Marshall Plan.⁴ Why did the United States favor Europe for its beneficence? Presumably, this decision reflects the same pattern of foreign aid that we see today: feelings of kinship mixed with a sense of political expediency. The United States saw Asia differently from Europe.

But if we can imagine that governments and individuals understood risk-sharing opportunities well enough before the war to take some of these steps to manage income risks in Asia, then it is reasonable to surmise that many Asians would have been successful in protecting their interests. As a result, Asia would not have remained so economically devastated after the war. Finance is impersonal—unlike foreign policy. It seeks out the highest return wherever it can be found, regardless of nationality. Asia would then have received substantial help after the war through the macro markets, livelihood insurance, or other contracts arranged before the war. If such risk management measures had been undertaken, the Japanese economic miracle of the 1960s and the economic miracle of many of the Asian countries might have been moved forward into the 1950s, and similar advances might have occurred in yet other countries that are only emerging today.⁵ An entire generation might have led better lives.

Even if no such risk management had been in place before 1950, in Europe or Asia, the immediate tragedy of the war could have been reduced after the war if the war-damaged countries around the world had sold claims on their own future GDPs to raise money for recovery. Rather than borrowing in U.S. dollars, they might well have raised more money through macro markets—massive claims on national income, occupational income, or other income indexes—because the risk properties of such debt would have been more advantageous for both sides. U.S. investors who were optimistic about a European economic recovery might well have been attracted to making such loans, seeing a chance to make a lot of money with risk that they could have limited by diversifying it among the rest of their investments. European borrowers needing development funds might have been more inclined to borrow, since they would not have to worry about the risk that an anemic European recovery would have made it difficult to pay the debt back. Had risk management contracts been available in Eu-rope in 1950, they would have helped offset the effects of uneven recovery from the war.

Now suppose that economic risk management treaties had been undertaken by African countries and their European patrons when Africans received their independence beginning with Ghana in 1957. Governmental agreements could have been written to exchange unexpected African-country per capita GDP growth for unexpected European-country per capita GDP. The relationships between these African countries and their European patrons were strained at that time, but one can still imagine that a sense of self-interest might have prevailed among these countries if the financial concepts of risk sharing had been firmly established at the time.

Governmental risk-sharing contracts negotiated in 1960 would have forced European countries to think in risk management terms that would have been utterly uncharacteristic of the time. In designing the international agreements, they would have had to talk openly about the expected prospects of the African economies. In addition to the possibility that the African economies would do worse than expected and receive payment from the European countries, parties would have had to consider that the African economies might also have done better than expected, and thus would have had to pay their European patrons according to the terms of the agreements.

In fact, the history of much of Africa since 1960 has been quite disappointing. For example, Nigeria’s real per capita income at the time of its independence in 1960 was $1,054. Thirty-eight years later, in 1998, its real per capita GDP had in fact declined slightly to $1,025.⁶ One might have expected greater success for the newly independent oil-rich country. Nigeria could not have paid with cash for insurance in 1960, but it could have agreed to pay in the future out of these expectations, agreeing to pay substantially if its economy did better than expected. It might seem hard-hearted for the other country in the agreement to require payments from such a poor country under any circumstances, but such an agreement would have been enormously beneficial to Nigeria. As we now know, the outcome would have been that Nigeria would not have paid at all and would have obtained a great deal of money to offset its disappointing performance.

If Europe and Africa had made such risk management contracts in 1960, then many countries in Africa today that today are suffering enormously from poverty and resulting problems of crime, ethnic warfare, and disease would instead be getting large financial payments from their colonial patrons. Millions who died from AIDS and other afflictions might be alive today. Medical researchers studying such tropical diseases as malaria, Nile fever, and sleeping sickness might have had the greater economic impetus to find solutions. Moreover, with the higher living standards made possible by these risk management contracts, a better response to the African problem of high birth rates and consequent high increase in population might have been possible.

Suppose also that similar risk management contracts had been made between the developed countries of the world and the nations of the former Soviet Union when it dissolved in 1991. The economic near-disaster that we saw in the 1990s in the poorer regions of these former- Soviet countries would have been automatically ameliorated by large payments from the developed countries. If these payments had been contractual, they might well have been vastly larger than the meager foreign help that flows to these countries today.

Had former Soviet Bloc countries done all of their borrowing in terms that were linked to their GDPs, then these countries might not have found themselves in such economic doldrums after independence. We might not have seen the 1998 financial crisis, marked by the fall, far away in the United States, of Long-Term Capital Management because the feared default in Russian debt would have been prevented.

By the same token, suppose that less-developed country (LDC) debt to foreigners could have been indexed to a country’s own GDP starting in 1950. We can then reasonably suppose that events like the LDC debt crisis of the early 1980s, the Mexican crisis of 1994, the Asian crisis of 1997, the Argentine crisis of 2001, or the Brazilian crisis of 2002 might have been less severe. The real value of these countries’ debts would have fallen at the time of the crisis. Because investors and bankers would have known that this safety valve was in place, they would have been less likely to exacerbate the c...

Table of contents

• Table of Contents
• Preface
• Acknowledgments
• INTRODUCTION
• Part One Economic Risks in an Advancing World
• ONE What the World Might Have Looked Like since 1950
• TWO The Hidden Problem of Economic Risk
• THREE Why New Technology Creates Risks
• FOUR Forty Thieves: The Many Kinds of Economic Risks
• Part Two How Science and Technology Create New Opportunities in Finance
• FIVE New Information Technology Applied to Risk Management
• SIX The Science of Psychology Applied to Risk Management
• SEVEN The Nature of Invention in Finance
• Part Three Six Ideas for a New Financial Order
• EIGHT Insurance for Livelihoods and Home Values
• NINE Macro Markets: Trading the Biggest Risks
• TEN IncomeߞLinked Loans: Reducing the Risks of Hardship and Bankruptcy
• ELEVEN Inequality Insurance: Protecting the Distribution of Income
• TWELVE Intergenerational Social Security: Sharing Risks between Young and Old
• THIRTEEN International Agreements for Risk Control
• Part Four Deploying the New Financial Order
• FOURTEEN Global Risk Information Databases
• FIFTEEN New Units of Measurement and Electronic Money
• SIXTEEN Making the Ideas Work: Research and Advocacy
• Part Five The New Financial Order as a Continuation of a Historical Process
• SEVENTEEN Lessons from Major Financial Inventions
• EIGHTEEN Lessons from Major Social Insurance Inventions
• EPILOGUE A Model of Radical Financial Innovation
• Notes
• References