Book: Finance and the Good Society
Author: Robert J Shiller
I met economist Robert Shiller, famous for the Case-Shiller home price index, at a breakfast in London in 2009 to mark the publication of his book Animal Spirits, co-authored with George Akerlof. He explained how financial innovation might be used to limit the volatility of 'animal spirits', a bold claim after an economic collapse often attributed to an excess of financial innovation. I suggested what we needed was financial de-innovation; simpler, not more complex financial systems. Shiller looked puzzled.
In Finance and the Good Society, he looks forward to a rapid increase in the scope of financial services to create a more prosperous, stable and equal society. At its analytical heart lies the conviction that financial innovation is the road to 'complete' markets - markets for all possible desired contracts. Thus it can move the actual market system closer to the ideal market system envisaged by economists such as Arrow and Debreu, despite the absence of the perfect rationality and perfect information that those theorists considered necessary for Pareto efficiency.
Indeed, it is the absence of these conditions that justifies ever more extensive financial engineering, because, if they existed, trades would always be priced correctly, on average, and one would need no financial system at all!
It is the object of financial innovation to make 'previously untradable risks tradable'. Shiller shows how financial inventions (eg, limited liability, stock markets, securitisation, insurance, pensions, mutual funds) have contributed to human wellbeing, and offers his own ideas about how they may continue to do this. For example, the housing market could be made less risky by having continuous work-out mortgages. Instead of issuing debt, governments could issue shares - 'trills' - in the nation's GDP. Tax rates could be set to provide 'inequality insurance'.
Shiller is particularly keen to incentivise good causes. 'Benefit corporations' could specify objectives other than maximising profits; there might be different levels of tax deductibility for various kinds of philanthropic giving; there could be 'participation non-profit organisations', purchase of shares in which would count as charitable contributions, and so on.
As these examples show, Shiller does not rely on markets alone to discover and serve human needs. Government has a vital role in both facilitation and regulation.
Four years after the Great Collapse, a book in praise of finance and its practitioners has an air of both defiance and innocence. But Shiller argues his case skilfully and persistently, and with a wealth of quirky and interesting examples.
The first part, based on lectures to his finance class at Yale, can be highly recommended as a handbook for investors and money managers, as well as for explaining the mysteries of the financial system.
Apart from this descriptive section, Finance and the Good Society is an invitation to argument. First, Shiller ignores the possibility that financial innovation may be subject to diminishing social returns. At the macro level there is no clear correlation between financial intensity and the overall rate of economic expansion. Many countries achieved rapid growth in the period of 'financial repression' from 1945 to the 1970s. Nor have trend growth rates risen after the financial liberalisation of the 1980s. Such considerations have led Adair Turner, a former regulator, to argue that the benefits of financial innovation may vary by stage of development.
Second, Shiller's expectations for finance are closely bound up with his view of why markets fail. His explanation is behavioural. Over large swathes of their lives people act irrationally; their decision-making is subject to wide mood swings ('animal spirits') and herd behaviour. On this view, more 'complete' insurance markets, made possible by information technology, can limit the bad consequences of the erratic flight of the human butterfly. But it may be that our problem is epistemological: there are bound to be too few insurance markets, because much of the future is uninsurable - we don't and cannot know enough about it. If this is so, the programme of salvation through better 'risk management' may be misconceived.
Finally, one is left wondering what Shiller means by the 'good society' of his title. He implies that it is one in which all people have the maximum chance to achieve their goals; indeed, 'finance is the science of goal architecture'. On the content of these goals he has little to say. But, without being more specific about the goals, it is impossible to say how much or what kind of finance, or financial innovation, a society needs.
- Lord Skidelsky's latest book, How Much is Enough? (Allen Lane), co-authored with his son Edward, is out this month.
Finance and the Good Society
Robert J Shiller