The New Financial Order: Risk in the 21st Century

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The New Financial OrderRisk in the 21st Century

• Prof. Robert J. Shiller
• Yale University

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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

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1. Technological Progress and the Democratization
of Finance
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Progress in Finance

• Theory of diversification and pooling
• Theory of moral hazard and how to limit it
• Theory of derivatives pricing
• Behavioral finance

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Behavioral Finance

• Psychological framing
• Framing of gains versus losses, Kahneman and
  Tverskys Prospect Theory, Econometrica 1979
• Framing of ones self image, Sherman JPSS 1980.
  Psych. Lab student and volunteeers
• Anchoring
• Risk as feelings
• Desire for consistency and cognitive dissonance
• Reciprocity and ultimatum game

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Progress in Information Technology

• Database technology
• Technology of exchange
• Identification devices
• Encryption devices
• Decline of underground economy
• Increased complexity and enforceability of
  contracts

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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

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

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Winner-Take-All

• Stars created by movies, phonographs, television
• Advanced information technology may do the same
  for many occupations

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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

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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

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Uncertainty of Future

• Extent of future inequality is unknown
• The fact that inequality hasnt sharply worsened
  since the Luddites is no proof it wont happen in
  next century
• Risks are still insurable

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3. Six Ideas for a New Financial Order
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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 lifes
  decisions, makes for more risk taking

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• 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

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II. Macro Markets

• Long-term (perpetual) claims on major income
  flows, Shiller Macro Markets 1993
• Short ones own country, investing in world
• World portfolio (Athanasoulis and Shiller Rev.
  Fin. Studies 2000)

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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

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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

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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

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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

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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

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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

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

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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
  Michelins main markets decline to specified
  levels

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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

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IV Inequality Insurance

• Framing change redefine progressive tax system
  by Fixing after-tax Lorenz curve
• Each individuals 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

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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.

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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

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Antecedents to Risk-Sharing International
Agreements

• EU Structural Fund and Cohesion Fund
• Commonwealth of Nations informal aid conventions

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4. A Model of Radical Financial Innovation
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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

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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

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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

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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

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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)

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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