‘Finance and the Good Society,’ by Robert J. Shiller

15 january 2013

Robert J. Shiller made his name in 2000 with “Irrational Exuberance,” a book that drew on behavioral economics to explain why financial markets overshoot. Shiller concentrated on the boom-bust cycle in technology stocks, but a later edition published while real estate was taking off correctly anticipated the popping of that bubble, too. With his latest volume, “Finance and the Good Society,” Shiller is coming at us from the opposite direction. Quoting Walt Whitman, who found “the eternal meanings” in muscular commerce, he celebrates finance’s “genuine beauty” and exhorts idealistic young students to pursue careers in derivatives, insurance and related fields.

Shiller’s main line of argument is an extension of Kenneth Arrow’s classic 1964 article, “The Role of Securities in the Optimal Allocation of Risk Bearing,” which emphasized the importance of markets for protecting against risk. If firms and individuals cannot insure themselves against bad outcomes, they will be necessarily cautious; the economy will grow more slowly than it should. A company will not invest in a new factory if it cannot hedge against swings in exchange rates that might render its investment unprofitable. An individual will not consume to the full extent of his capacity if he cannot insure his house or health. By connecting the ranks of insurance seekers with specialists who pool risk and so reduce it, finance liberates animal spirits and boosts prosperity.

Shiller’s book is a lament that nearly 50 years after Arrow’s article, many forms of risk remain hard to buy and sell. This is most obviously true in poor countries. The tragedy of the Haitian earthquake of 2010 was that so few buildings were insured there. This meant not only that homeowners faced financial ruin; it meant that far more people died, since the absence of insurance deprived Haiti of an industry with an incentive to police compliance with building codes. As a result, at least 50,000 Haitians perished, whereas an earthquake of comparable force in Northridge, Calif., in 1994 resulted in just 33 deaths. However loudly critics yell that the financial sector is bloated, the world needs more insurers.

Rich countries may not lack standard insurance, Shiller says, but other markets for risk remain underdeveloped. For example, ordinary families have no easy way to protect themselves from the risk posed by sharp moves in house prices. If convenient markets in house-price futures existed, a young couple expecting to need a bigger home with the arrival of children could hedge the risk that house prices in their area might climb into the stratosphere. An older couple expecting to downsize as kids head off to college could hedge the risk that their nest egg might lose value. If the first family could buy a house-price future from the second, both would have their risk reduced. Such is the magic of financial markets.

Newfangled mortgages have earned a bad name, but Shiller would like to make them even more complex. The standard home loan obliges the borrower to pay back a fixed amount, and obstinately ignores the truth that if the economy or real estate market tanks, the borrower won’t do so. Far better, Shiller says, to equip mortgages with “preplanned workouts,” so that the amount to be paid back automatically declines if the economy collapses. Preplanned workouts would avoid the absurdity of a family buying a $300,000 home, defaulting on its $275,000 mortgage when the home’s value falls to $250,000 and eventually buying an equivalent home at the new price and with a smaller mortgage. Vast amounts of transaction costs, uncertainty and suffering could have been prevented if the mortgage had been reduced pre-emptively and the family had stayed in its original home. Indeed, Shiller goes so far as to suggest that flexible mortgages might have averted the 2007-9 crisis.

The same sort of innovation might also work for government finance. Rather than raising capital by issuing fixed-value bonds and then defaulting if times get tough, governments could issue shares in their economies. Each share might represent, say, one-trillionth of a country’s G.D.P.; these “trills” would pay dividends whose value would depend on the performance of the economy. If the Greek government had raised money in this form, its financial obligations would have fallen with the onset of its troubles — which might have headed off a full-blown crisis. Just as with mortgages, intelligent contracts could improve risk sharing between providers and users of capital.

Shiller applies similar thinking to other policy challenges. Like mortgages and sovereign debt, government pension promises are specified as fixed entitlements. But the needs of the elderly must be balanced against the ability of younger generations to foot the bill; so Shiller suggests that pensions could be indexed to some indicator of taxpayer ability to pay, G.D.P. being one obvious metric. What is more, the world faces a rising challenge of inequality. Why not agree, in advance, what level of inequality a society is prepared to tolerate, and then devise variable tax rates that will deliver that target?

The big point is that despite the popular revulsion at Wall Street, society needs more financial innovation, not less. But what is holding innovation back? Here Shiller offers two answers. New financial instruments are attractive only if they can be bought and sold easily; they have to be widely adopted before people will want to adopt them widely. Shiller would like to solve this chicken-and-egg problem with government-supported tax incentives for market makers who kick-start trading in new instruments. One gulps at the prospect of yet another subsidy for too-big-to-fail banks. But Shiller’s proposal is logical.

The second reason for the shortfall in financial experimentation is that society has grown suspicious of it. New smartphone apps are celebrated in the popular culture; new derivatives for hedging risk are reviled as tricks to enrich hucksters. Shiller devotes a large part of his book to the assertion that this prejudice against finance is wrong. Psychologists have established that the key to happiness lies not in riches but in social esteem; therefore, Shiller says, financiers face powerful emotional incentives to balance profit seeking with a social conscience. “The futility of conquest in business mirrors the futility of conquest in war,” he writes. Just as it is impossible to extract much wealth from conquered countries, so it is impossible to extract much happiness from wealth earned unscrupulously.

Some readers may suspect that Shiller, a Yale professor, underestimates the materialism of Manhattan and Greenwich. Others may be frustrated by his meandering style. Reading his book is like wandering through an interesting garden. We learn that Israel and Brazil have more lawyers per person than the United States. We are urged to believe that Washington lobbyists “are probably more public-spirited than most” people. We read chapters on the history of business schools and the theory of public goods that do little to advance the main argument. But the best passages in this book make a persuasive case for a fresh view of an industry that is too glibly demonized. The most promising way to promote the good society, Shiller says, is not to restrain finance but to ­release it.