The New Financial Order:
st
Risk in the 21 Century
Prof. Robert J. Shiller
Yale University
Outline
1. Technological progress and the
democratization of finance
2. The largest economic risks facing us in
coming decades and the prospect of
Intolerable inequality
3. Six ideas for a new financial order
4. A Model of radical financial innovation
1. Technological Progress and
the Democratization of Finance
Progress in Finance
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Theory of diversification and pooling
Theory of moral hazard and how to limit it
Theory of derivatives pricing
Behavioral finance
Behavioral Finance
• Psychological framing
– Framing of gains versus losses, Kahneman and
Tversky’s Prospect Theory, Econometrica 1979
– Framing of one’s self image, Sherman JPSS 1980.
Psych. Lab student and volunteeers
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Anchoring
Risk as feelings
Desire for consistency and cognitive dissonance
Reciprocity and ultimatum game
Progress in Information Technology
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Database technology
Technology of exchange
Identification devices
Encryption devices
Decline of underground economy
Increased complexity and enforceability of
contracts
Democratization of Finance
• Financial services once offered only to
wealthy will be widely available
– Online auctions
– Online brokerages
– Personal finance sites
– Automation of tax collection
2. The Largest Risks Facing Us
in Coming Decades and the
Prospect of Intolerable inequality
Lack of Public Appreciation of
Long-Term Economic Risks
• Little talk of long-term risks to standard of
living
• Inequality around the world stands is
dismissed as example of risk
• Human tendency to see economic
outcome as proof of self worth
• Belief in a Just World: A Fundamental
Delusion Melvin Lerner, 1980
Winner-Take-All
• Stars created by movies, phonographs,
television
• Advanced information technology may do
the same for many occupations
Automation and Robotics
• Spreadsheets replace accountants
• Industrial robots replace assembly line
workers
• Fruit picking machines replace agricultural
labor
• Computers replace translators
• Detection devices replace police
Risks of Globalization
• Astonishing level of inequality across
nations
• Communications technology: declining
cost of telephones, introduction of e-mail,
teleconferencing, reduce international
barriers
• Multinational corporations
• English language
Uncertainty of Future
• Extent of future inequality is unknown
• The fact that inequality hasn’t sharply
worsened since the Luddites is no proof it
won’t happen in next century
• Risks are still insurable
3. Six Ideas for a New
Financial Order
I. Insurance on Livelihoods and
Home Equity
• Replaces life insurance in dealing with largest
risks
• Livelihood insurance: long-term policies based
on occupational indexes
• Repeated measures occupational indexes:
Robert Shiller and Ryan Schneider Rev. Income
and Wealth 1998
• Powerful impact on conservatism in life’s
decisions, makes for more risk taking
• Risks to values of homes greater than
risks by fire
• Oak Park Illinois, 1977
• Chicago Home Equity Assurance Program
1988
• Index-based insurance, Shiller and Weiss
1994
• Yale-Syracuse-NRC program, 2002
II. Macro Markets
• Long-term (perpetual) claims on major
income flows, Shiller Macro Markets 1993
• Short one’s own country, investing in world
• World portfolio (Athanasoulis and Shiller
Rev. Fin. Studies 2000)
Riskiness of Long-Term Claims
on Incomes
• Based on autoregression, data 1950-90,
standard deviation of price change for
GDPs is about half that of the stock
market
• Occupational incomes, incomes by
individual characteristic, riskier
• Digital revolution, robotics, suggest higher
uncertainty in the future
GDP Warrants
• GDP warrants grew out of oil price warrants
issued as part of Brady-Bond refinancing for
Mexico, Venezuela, and Nigeria
• Bulgaria issues warrants on GDP as part of
Brady-Bond refinancing, 1994
• Bulgarian warrants, inseparable from discount
bonds, have not created salient price discovery
for claims on Bulgarian GDP
Bulgaria GDP Warrants Data
Surveillance
• Citibank, 1994, Brady Bond underwriter,
specified that GDP numbers would come from
World Bank
• World Bank mission in Bulgaria is able to do
some verification of GDP numbers
• Econometric models predicting GDP based on
observables could enhance surveillance
• Observables are growing with information
economy
Perpetual Futures (Shiller,
Macro Markets, 1993)
• Perpetual futures create both long and
short sides of a perpetual claim on an
indexed cash flow
• Daily cash settlement equals “excess
return” between instrument that pays
dividend proportional to index and riskless
rate r:
Settlement t  f t  Index t  (1  r ) f t 1
Economic Derivatives Market
Goldman Sachs-Deutsche Bank
• First Auction, October 2002, Nonfarm
payroll
• Auctions in ISM Index, IFO Index planned
• Parimutuel Digital Call Auction (PDCA)
Longitude, Inc., New York
Macro Securities
• US patent #5,987,435 with Allan Weiss (Case Shiller
Weiss, Inc.) would to create securities based on income
aggregates or real estate prices in present environment
• Macro securities issued and redeemed by exchange only
in pairs, one long and one short.
• Each member of pair has a cash account made
proportional to some economic index by reallocating
across accounts
• Each Macro pays dividends equal to interest on their
cash account (NAV).
• Price of Macro should in equilibrium reflect market
valuation of claim on cash flow
Case-Shiller Chicago Home Price Index and
Macro Prices Monthly 1991-1-2002-4
Chicago
200
180
160
Dollars
140
120
NAV Long Macro
Long Macro Price
100
NAV Short Macro
80
Short Macro Price
60
40
20
0
1990
1992
1994
1996
1998
Year
2000
2002
2004
Case-Shiller San Francisco Home Price
Index and Macro Prices Monthly 1991-1 to
2002-4
San Francisco
250
200
150
Dollars
NAV Long Macro
Long Macro Price
100
NAV Short Macro
Short Macro Price
50
0
1990
1992
1994
1996
1998
-50
Year
2000
2002
2004
III. Income-Linked Loans
• Milton Friedman, Capitalism and Freedom
1962: shares in future earnings, but feared
“irrational public condemnation”
• But such loans should be based partly on
income indexes, to reduce moral hazard
Michelin GDP-Linked Loan
• Swiss Re New Markets and Societe
Generale create bank and insurance
company syndication for Compagnie
Financiere Michelin, 2000
• $1 billion 12-year subordinated loan
facilities, with option to draw should GDP
growth in Michelin’s main markets decline
to specified levels
Income-Linked Personal Loans
• Yale Tuition Postponement Option 197178
• Yale Law School Career Options
Assistance Program 1988-today
• MyRichUncle.com, Vishaq Garg and Raza
Kahn
• David Bowie bonds, David Pullman 1997
IV Inequality Insurance
• Framing change: redefine progressive tax
system by Fixing after-tax Lorenz curve
• Each individual’s tax is the change in the aftertax Lorenz curve between that individual and the
next, times national income
• Effectively, automatic changes in marginal tax
rates to fix the level of income inequality
• Possible great importance should inequality
deteriorate more with new technology
V. Intergenerational Social
Security
• Social security should share risks between
generations.
• Present system indexes retirees’ benefits to CPI,
thereby pushing all risks to the working young
• Analogy to the family
• Ball & Mankiw, DeMange & Laroque, etc.
• Divide up national income between generations
in such a way that retirees who contributed more
get more.
VI. International Agreements for
Risk Control
• International agency such as World Bank
would arrange very-long-term swaps
among countries for GDP risks
• Could take form of parallel (back to back)
loan agreements, indexed to GDPs
• Need to make long-term risk management
a part of language and agenda of
international agreements
Antecedents to Risk-Sharing
International Agreements
• EU Structural Fund and Cohesion Fund
• Commonwealth of Nations informal aid
conventions
4. A Model of Radical
Financial Innovation
Radical Financial Innovation
Example: Life Insurance
• Invented in 1600s with notion of probability, life
tables, slow to take hold among public
• Morris Robinson Mutual Life of NY 1840: highlypaid salesmen
• Henry Hyde Equitable Life Assurance Society
1880s: large cash value
• Viviana Zelizer: challenging God and tempting
fate
Radical Financial Innovation
Example: Altersversicherung
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Extensive public discussion of inequality
Principle of insurance (Gustav Schmoller)
Role of new information technology
After favorable outcome, imitation around
the world
Risk Manifestation
• Public does not focus attention on big risks
• Leadership must direct attention to risks
• Data must be refined and delivered to
measure risks better
• Macro markets will add salience to risks
• Marketing campaigns that focus on risks
Robust Reframing
• Importance of psychological framing
– Altersversicherung 1889
– Social Security contributions 1934
– Portfolio Insurance 1980
• Framing must be done correctly, so that
changes are not needed later
Experimentation
• Full consequences of economic inventions
cannot be foretold
• Takes many years to evaluate
• Need to copy others’ inventions; many
financial innovations occurred in times of
stress or in less developed world (e. g.
Futures markets in Tokugawa Japan,
indexed units of account in high-inflation
Chile)
Involvement of Existing Institutions
to Promote Change
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Insurance companies
Exchanges and investment banks
Banks
Databanks and econometrics firms
Governments
Pension plans
Labor unions
Professional organizations
Benevolent organizations