The New Financial Order: Risk in the 21 st Century

1. The New Financial Order:Risk in the 21st Century Prof. Robert J. Shiller Yale University

2. Outline • Technological progress and the democratization of finance • The largest economic risks facing us in coming decades and the prospect of Intolerable inequality • Six ideas for a new financial order • A Model of radical financial innovation

3. 1. Technological Progress and the Democratization of Finance

4. Progress in Finance • Theory of diversification and pooling • Theory of moral hazard and how to limit it • Theory of derivatives pricing • Behavioral finance

5. 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 • Anchoring • Risk as feelings • Desire for consistency and cognitive dissonance • Reciprocity and ultimatum game

6. Progress in Information Technology • Database technology • Technology of exchange • Identification devices • Encryption devices • Decline of underground economy • Increased complexity and enforceability of contracts

7. 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

8. 2. The Largest Risks Facing Us in Coming Decades and the Prospect of Intolerable inequality

9. 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

10. Winner-Take-All • Stars created by movies, phonographs, television • Advanced information technology may do the same for many occupations

11. 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

12. 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

13. 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

14. 3. Six Ideas for a New Financial Order

15. 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

16. 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

17. 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)

18. 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

19. 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

20. 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

21. 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:

22. Economic Derivatives MarketGoldman 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

23. 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

24. Case-Shiller Chicago Home Price Index and Macro Prices Monthly 1991-1-2002-4

25. Case-Shiller San Francisco Home Price Index and Macro Prices Monthly 1991-1 to 2002-4

26. 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

27. 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

28. Income-Linked Personal Loans • Yale Tuition Postponement Option 1971-78 • Yale Law School Career Options Assistance Program 1988-today • MyRichUncle.com, Vishaq Garg and Raza Kahn • David Bowie bonds, David Pullman 1997

29. IV Inequality Insurance • Framing change: redefine progressive tax system by Fixing after-tax Lorenz curve • Each individual’s tax is the change in the after-tax 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

30. 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.

31. 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

32. Antecedents to Risk-Sharing International Agreements • EU Structural Fund and Cohesion Fund • Commonwealth of Nations informal aid conventions

33. 4. A Model of Radical Financial Innovation

34. Radical Financial InnovationExample: Life Insurance • Invented in 1600s with notion of probability, life tables, slow to take hold among public • Morris Robinson Mutual Life of NY 1840: highly-paid salesmen • Henry Hyde Equitable Life Assurance Society 1880s: large cash value • Viviana Zelizer: challenging God and tempting fate

35. Radical Financial Innovation Example: Altersversicherung • Extensive public discussion of inequality • Principle of insurance (Gustav Schmoller) • Role of new information technology • After favorable outcome, imitation around the world

36. 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

37. 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

38. 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)

39. Involvement of Existing Institutions to Promote Change • Insurance companies • Exchanges and investment banks • Banks • Databanks and econometrics firms • Governments • Pension plans • Labor unions • Professional organizations • Benevolent organizations