Brave new idea spurs David to harness Goliath

The New Financial Order
October 17, 2003

Amid grand schemes for world economic stability, Howard Davies finds food for thought for the insurance industry.

Volatile financial markets have been good to Robert Shiller. Building on his 1989 success with Market Volatility , in 2000 he hit the big time, and The New York Times bestseller list, with Irrational Exuberance , an analysis of the stock-market boom that had been under way for almost two decades.

His timing, of course, could not have been better. Alan Greenspan, head of the US Federal Reserve, coined the phrase "irrational exuberance" four years earlier, and suffered for his too-early anticipation of the crash to come. Shiller hit the button at just the right moment, propelling himself into the front rank of academic analysts and, indeed, onto the upmarket talk-show circuit.

But he is not content solely to analyse, to model or even to predict; his aim is far more elevated. In The New Financial Order , Shiller presents a manifesto for - well - a new financial order. Beginning from the premise that the boom and bust destroyed wealth on a massive scale, encouraged wasteful corporate investments and stimulated accounting trickery, Shiller thinks we must be able to do better. Far from complaining from the sidelines, bemoaning the collateral damage generated by wild market swings, he takes a positive tack. The answer he favours is not to seek to constrain financial innovation, or to dampen market volatility in a vain attempt to exert control over the risks we face. "In fact," he maintains, "the best thing we can do to reduce such risks is to expand our financial technology so that we can use (it) to cushion against unnecessary instability." David, in other words, must harness the force of Goliath.

So The New Financial Order is about how to take advantage of the technology of risk management to bring positive benefits to individuals and to society as a whole. It is an ambitious endeavour, and a sympathetic one. My reading is, therefore, indulgent. But no amount of indulgence can conceal the fact that there are massive obstacles in the way of implementing Shiller's more imaginative projects.

Shiller's headline thought is quite straightforward. The technology that allows financial risks to be diversified and offset could and should be applied to the risks that affect ordinary people throughout their lives.

This, is, in itself, not a revolutionary observation; it is what life insurance is all about. But the products on offer to individuals today are simplistic and do not offset some of the more significant risks we face.

So, to take a relatively straightforward example, it is not yet possible to buy home equity insurance, whereby homeowners could insure the value of their property against the impact of local or regional shocks: the closure of a major factory, or a significant deterioration in the terms of trade.

Shiller believes that if such insurance had been available, it would have helped to prevent the rapid decay of some major US cities.

This is an eminently practical notion, though the price of such insurance could be quite high, given the magnitude of price movements observed in, say, Pittsburgh or inner-city Liverpool. A second possibility, which begins to show up the difficulties of his strategy, is what he describes as livelihood insurance, whereby a violinist could buy a policy to protect her future income against the possibility that the relative wages of fiddlers might fall.

At this point, one begins to worry about the practicality of the policy, and indeed its incentive effects. There are good and bad violinists, after all. Yet the bottom end of stringed income would be held up irrespective of performance. And what if the availability of livelihood insurance increased the take-up for relatively attractive professions?

These incentive problems become more acute with Shiller's next, and most ambitious, pair of ideas, both of which are designed to offset growing income inequality within and between nations. His own words are important here to capture the scale of the ambition. He argues that "if the world is to manage its political and economic affairs effectively, society must prevent any substantial worsening of economic inequality among its citizens". To do this, "the government should set by legislation the level of income inequality, in most cases probably initially roughly equal to the level of inequality today, and create a tax system that prevents inequality from getting worse". The tax system would, in other words, be designed automatically to offset growing incomes at one end of the distribution.

Shiller explains that the after-tax Lorenz curve would be used to guide policy - which would aim to fix the "sag" in the curve, known as the Gini coefficient.

This policy seems unlikely to find favour around the brunch table in Crawford, Texas, and even Governor Howard Dean might find the New Hampshire primary rather stony ground on which to launch a platform based on stabilising the Gini coefficient. It is hard to know how a government would determine the optimal degree of inequality, and indeed defend it.

The same principle looks even more problematic when applied to nation-states. Shiller takes the example of the different growth paths followed by South Korea and Argentina over the past 40 years. In 1965 Argentinian gross domestic product per head was about five times that of South Korea. Today, the average worker in Seoul is perhaps 50 per cent richer than his counterpart in Buenos Aires. To Shiller, this is an unhappy outcome that policy-makers should seek to prevent. Suppose Argentina and South Korea, perhaps through the International Monetary Fund, had signed a contract with each other agreeing to share development risks? "The outcome," he argues, "would have had South Korea paying Argentina a large sum of money, substantially mitigating the economic disaster in Argentina."

Would this have really been the outcome? One might reasonably wonder whether such a contract would have been enforceable, and by whom? Even if it were, would the transfer payments involved have mitigated the disaster? If, as most observers argue, the cause of the Argentinian economic debacle can be sourced to a fundamentally unstable and corrupt political system, sending a large cheque to the Casa Rosada would have been unlikely to improve the lot of the average gaucho.

And yet, and yet. It is easy to carp and to pick holes in what is deliberately set out as an ambitious and thought-provoking agenda. Shiller has done us a service in asking whether the skills of financial firms and markets are being deployed in the service of the common weal. I agree with him that the general answer to that question is "no". I suspect some progress could be made on Shiller's less grand notions - and I hope the insurance industry is reflecting on them already. But there are limits to the power of financial instruments to offset economic and political forces, and at times Shiller has, I fear, left those limits far behind.

Howard Davies is director, London School of Economics.

The New Financial Order: Risk in the 21st Century

Author - Robert J. Shiller
Publisher - Princeton University Press
Pages - 366
Price - £19.95
ISBN - 0 691 09172 2

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