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Risk management for you, me and Argentina

In a new book, iconoclastic economist Robert Shiller argues for a new financial order that affects both individuals and nation-states. Is his brave new world a plausible one?

Robert J. Shiller trod on hallowed financial ground with the publication of his book Irrational Exuberance, which argued that the 1990s run-up in equities was a classic bubble due to burst. He cautioned investors to look before leaping. Serendipitously (at least for the author), the book came out in March 2000, the month Nasdaq hit its record high.

Now the Yale economist is back with another book, this time cautioning investors and noninvestors to think long and hard about the broader risks they face in life. Managing a person's economic well-being is not a matter of managing the person's portfolio, notes Shiller, but managing the other, largely "hidden" risks that create uncertainty about the future.

When a couple purchases a home, it faces the risk that its property may depreciate in value over the years. A woman who chooses to become an endodontist could be out of luck in 2030 if dentistry changes enough that the market for her talents disappears. A person living in a country whose GDP tanks could face even bigger problems.

In the book The New Financial Order: Risk in the 21st Century, Shiller argues that individuals should be able to protect themselves against a drop in the value of their homes or their livelihood. These are, as he puts it, "insurable risks," and the insurance industry should create products for long-term, heretofore unacknowledged risks. Not only would such products make financial sense, but also when risks are spread out across society, the result is that people overall are better off.

Instead of telling people how to make money, Shiller tells them how to avoid losing money and how to forestall a decline in their economic status.

At its core, The New Financial Order is a book of advice, but instead of telling people how to make money, Shiller tells them how to avoid losing money and how to forestall a decline in their economic status.

At the same time, Shiller's ambition is so sweeping--some may say sprawling--that his advice entails a top-down, left-to-right, wall-to-wall overhaul of the U.S. tax code, social security, the insurance industry, the securities markets, personal loans, international loans and financial agreements between countries and, oh yes, the introduction of new indexed units of account that can take the place of currency or can at least exist side by side. Living up to its title, Shiller's book boldly delivers a blueprint for a New Financial Order.

Shiller is an innovative, even visionary, thinker, but he acknowledges that most of what he writes in this book will be seen as pie-in-the-sky fantasy. His ideas are politically and practicably unworkable. Nonetheless, he makes the case that this is the direction in which nations and individuals should be heading--that "democratizing finance" by making risk-management tools available to individuals is a useful and socially productive goal.

A philosophical perspective undergirds this book--a perspective that falls broadly into the economics-is-not-the-same-as-selfishness school of thought. Shiller looks to the late philosopher John Rawls' theory of distributive justice to provide a moral framework for our economic relationships and expectations. He draws on the ideas of the late Nobel laureate and economist John Harsanyi, who interpreted Rawls to argue that a society's economic institutions and risk-management mechanisms should be designed to improve the prospects of individuals at all levels of society and, most importantly, to ensure that inequality in society does not increase.

Brave new world
In Shiller's universe, individuals will be able to insure against changes in the determinants of their future wealth. If inequality in our society threatens to rise, more money can be transferred to the poor through the tax structure without going back to Congress to beg for new funds and more entitlement programs.

Nations will be able to swap income streams based on the unanticipated portion of GDP performance, according to predetermined formulas, thus providing poor countries with a safety net if their economy underperforms expectations.

Shiller is a good, strong writer, and many parts of his book could be read as informative standalone essays, however radical their mission. The book is also well-organized. Part 1 surveys many of the risks that individuals face over the years, noting that although risk management and risk technology are designed to ameliorate traditional business risks such as interest rate or currency risk, they can find a firm footing in the retail industry.

The book then explores how technological progress can alter risk management in the future. Advances in information technology, database management and storage capacity make it possible to develop the risk-management information needed to create and hedge innovative products. Shiller also cogently explores the science of behavioral finance--the field that applies insights from psychology to the financial sphere. Much of this discussion pivots on the work of Amos Twersky, now deceased, and Princeton psychologist Daniel Kahneman, who won a Nobel Prize last year for his foundational work in this field. Shiller provides an excellent overview of "framing," "anchoring" and other concepts that describe how people make judgments and respond to risk.

The heart of Shiller's book lies in Part 3. This section spells out his six ideas for a New Financial Order--three geared toward individuals and three toward governments. In each instance, after explaining his idea, Shiller goes on to outline its implementation, sometimes rising to a Talmudic level of detail.

Regarding his first idea, insurance for livelihood and home values, he notes that insurers must create reliable indexes of the average income for individuals in given fields as well as single-family home values in geographic areas. In the case of the former, here's how the insurance might work: The endodontist enters into a long-term livelihood contract with an insurer, pays an annual premium for the policy and receives predetermined quarterly payments from the insurer if the average income in her field dropped below a certain level.

The problem of moral hazard--of the individual taking actions to improve the likelihood of a bigger payout--is thwarted by not having the payments tied to the policyholder's income, which might also be lower than the average because of inferior talent or laziness. The policyholder would, however, be protected against a general decline in the average income in her field.

One problem with this idea, judged by the risk-management standards that Shiller sets up, is that people cannot be forced into these contracts, so the benefits only accrue to those clever or prescient enough to take advantage of the insurance. If minimizing inequality in society, including future inequality, is a stated goal, then this scheme doesn't accomplish that. Shiller notes that employers or labor unions could provide livelihood insurance to workers, but that seems like a particularly tall order.

Shiller's second innovative idea is the creation of macro markets. These would be markets for new retail products that could be traded on exchanges and held in a portfolio along with traditional securities like stocks and bonds. There could be macro securities on the U.S. GDP, which would pay a quarterly dividend based on a specified fraction of GDP; macro markets could also exist on average or initial pay in different occupations, the unemployment rate, nonfarm payroll statistics or on almost anything that can be indexed.

These macro markets are potentially huge--much larger than current stock markets--and would enable people to trade "enormous risks that have never been traded before," writes Shiller. They would also enable ordinary individuals to speculate on a wider array of financial products--a right that they have but a prospect that already worries many national financial regulators.

An advantage of macro markets that Shiller touches on only lightly is the informational role of prices for these new securities. Since these securities represent potential claims in the future, their prices, like the prices of traditional futures contracts, would have a predictive function. A forward curve for endodontists, for example, would reflect the market's expectation of demand for employment in that field three years out, 10 years out, 20 years out, and so on.

A further advantage of macro markets, notes Shiller, is that they would implicitly encourage people to look at the risks that could affect their economic status as quantifiable and hedgeable, which would go a long way toward implementing the kind of risk-management infrastructure needed for risk-sharing on a massive scale. Shiller and a former student named Allan Weiss have a patent on macro securities. Two global banks are supposedly planning to launch a handful of macro securities in 2004, according to a talk that Shiller gave at New York University this past winter.

Shiller's third big risk-management idea is income-linked loans, in which the borrower's repayment terms are tied either to the average income among similar loan recipients or to the borrower's future income level. A version of this idea has been instituted by a number of universities, including Yale Law School, where since 1988, a portion of student loans is forgiven if the borrower takes a low-paying but "socially conscious" job after graduating. Shiller also asserts that the advent of income-linked loans will reduce the likelihood of bankruptcy and economic hardship.

Lifting all boats
Shiller's buffet of risk-management ideas for governments is bolder yet: inequality insurance, intergenerational social security and risk-based international agreements. All three involve a radical renovation of traditional risk-transfer mechanisms.

In the first case, Shiller proposes overhauling the tax system as a form of social insurance for taxpayers. Tax legislation would be redefined "in terms of the level of inequality (in society) rather than the level of tax rates," with annual tax rates shifting in response to the level of measured inequality among the populace. Such a system, he notes modestly, would require a good deal of framing and education to make it acceptable, but over a number of years this could be accomplished.

Similarly, Shiller would change social security to pay beneficiaries not fixed amounts every month, based on their contributions over the years, but amounts that fluctuated in response to the percentage of retired people in the population and the income base of current workers. If 11 percent of the U.S. population is retired, for example, working people would contribute 11 percent of their after-tax income to social security. This would shift the burden of old-age insurance to the elderly and the young, rather than requiring the young and future generations to shoulder the entire cost of this social insurance.

Shiller's sixth risk-management idea is the advent of international financial agreements that extend a safety net to poor countries. Let's say that in 1965, Argentina and South Korea entered into a contract in which they shared development risks, to use Shiller's example. If Argentina's economy, which had a per capita real GDP nearly five times that of South Korea's, did better than expected over the next, say, 40 years, it would make regular payments to South Korea; if it did worse, South Korea would send money to Argentina. The result would essentially be a form of insurance for whichever country fared worse than expected.

There are many obstacles to every one of Shiller's ideas, but he is dedicated in his effort to address them head-on.

There are many obstacles to every one of Shiller's ideas, but he is dedicated in his effort to address them head-on. Many of these contracts would be large and, ultimately, painful. People are not used to negotiating contracts that extend for years, especially not contracts that may require them to make higher payments than anticipated.

They might not honor the contracts. Poor nations may be reluctant to fork over to rich nations if their economies thrive rather than combust. Shiller concedes that it seems callous to expect poor countries to give up some of their GDP if they perform better than expected, but recognizes that without that promise there would be no incentive for the richer countries to enter into the agreements in the first place--agreements designed to provide cushions for the poorer countries.

After tooling through these radical risk-management concepts, Shiller doesn't sit back on his heels. He outlines the risk-management devices and institutions necessary to make all this happen. These include global-risk information databases, new units of measurement and electronic money. The global databases, for instance, would collect the tremendous amount of data needed for banks, insurers and others to set prices on contracts and to hedge their own risks.

These databases, Shiller assures us, would protect privacy while enabling "extensive public use of data pertaining to risks." Not a few people, however, will balk to read about the breadth of personal information, including genetic information, that these databases might legitimately store. Finally, Shiller offers an upbeat analysis of the evolution of financial markets and social insurance, explaining how the ideas in this book fit into the slipstream of that history.

The New Financial Order is a bold plea. Shiller argues passionately that our economic decisions and financial institutions should reflect moral concerns about the kind of society we want for ourselves--and not about mere incremental changes to the status quo. He hopes for more recognition of the risks that individuals face and the inequality within and between nations.

Getting there would clearly be an arduous task, but he believes we can train ourselves to look at risk-sharing as a form of insurance from which societies will ultimately benefit. In a post-bubble, post-9/11 world in which our vulnerabilities seem to be increasing, this is a wish that may have resonance. But it is no more than a wish.

To read more articles like this one, visit Knowledge@Wharton.

All materials copyright © 2003 of the Wharton School of the University of Pennsylvania.