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In Defense of Finance
Robert Shiller has become one of the media’s favorite economists in the past decade, and for good reason: He presciently declared the dramatic stock market rise in the late 1990s a bubble just before it exploded, and foretold the messy aftermath that would ensue. A few years later he warned that the U.S. real estate market had become a speculative bubble as well, this time combining his warning with a new financial-market index that gave investors — and everyone else as well — a measure of the size of the property bubble across the country. Liberals have construed Shiller’s message to be that the market is invariably prone to excesses and can’t be trusted, and that a healthy dose of government is a necessary ingredient to achieve “sustainable” growth. However, Shiller’s newest book, Finance and the Good Society, is at odds with the “Shiller as market-slayer” caricature lionized by so many. Shiller is above all else a contrarian — and a wildly accurate one at that — and this time he comes not to bury financial markets, but to praise them. His message is that what financial markets do best is help us reduce or avoid risk. No one would dream of putting all of their wealth into one company: Stock markets allow us to diversify. Banks allow us to buy peace of mind and a measure of return by pooling depositors’ money, lending it out to a wide variety of concerns, and (ideally) diversifying in this way. The securitization of mortgages was a brilliant innovation that allowed banks to diversify their portfolios of home loans away from their own communities, dramatically lowering their default risk should the local economy falter. When one entity pays another to assume the risk inherent in an investment, it’s not necessarily the case that the second party is, in fact, assuming risk — often it is merely using that risk to offset the risk elsewhere in the portfolio. The transfer of risk from one party to another is often a positive-sum transaction. What the financial collapse revealed is that our markets are not nearly as good at providing financial insurance or offsetting risk as we had thought — and that’s bad for economic growth. If it is more difficult or costly for entities to lower their risk, we see less capital available, fewer investments made, and ultimately slower economic growth. Shiller’s call to action is a contrarian one: He concludes the book by arguing that we need more bright college graduates going into finance. The world is less predictable than people tend to think, and we need people to develop innovative ways for people to invest and have peace of mind, or we will all pay a price, regardless of the state of the world. In reality, the world is plagued with a surfeit of leptokurtosis, a 25-cent word that describes a distribution where extreme events occur more regularly than should be the case if we were observing a normal distribution. Hundred-year floods happen more regularly than every 100 years, and the stock market can still rise and fall at dizzying speeds in reaction to world events, or nothing at all. People want to be guarded against their homes floating away and they’d rather not have the stock market plummet 20% the year before they retire. Thus, they willingly pay handsomely to guard against either possibility. Measuring these risks and finding a way to help people insure against them would genuinely benefit society as well as millions of individuals. Despite the wealth of talent already in the finance industry, we’re still not too good at doing either one.