Order this
book from the NABE Bookstore at Amazon.com
|
|
The heart of The
New Financial
Order by Robert
Shiller, Professor of
Economics at Yale
University, is a conviction
that: “ … w o r s e n i n g
conditions can develop even as technological
advances mark greater levels of
economic achievement. But new
risk management ideas can
enable us to manage a vast array
of risks—those present and
future, near and far—and to
limit the downside effects of
capitalism’s ‘creative destruction’….
this new infrastructure
would utilize financial inventions
that protect people against
systemic risks: from job loss
because of changing technologies
to threats to home and community
because of changing
economic conditions” (p. ix).
Professor Shiller picks “six fundamental
ideas” that the new financial
order will use to “protect people
against systemic risks.” Three private
sector ideas include insurance
for livelihoods and home values,
macro” securities and markets to
hedge incomes and real estate, and
income-linked loans to hedge bankruptcy.
Three public sector ideas
include income inequality insurance,
intergenerational social security,
and hedges against unexpected
changes in “per capita GDP or its
analogues” (p. 177). Overall, the “book presents ideas for a new
financial order, a new financial capitalism,
and new economic infrastructure,
and further describes how
such ideas can realistically be
developed and implemented” (p. 2).
For example, young people considering
careers they really love may
think twice if they fear salaries
might decline. They could buy
livelihood insurance just like life or
car insurance that would compensate
them if their preferred career
income dropped. Expecting, say, a
$80,000 salary they would purchase
an insurance policy with a floor
salary of perhaps $40,000 for a fixed
period of time. Insurers would diversify
these risks, develop procedures
to minimize moral hazard, and hedge
downside systematic risk by buying “down” macro securities in livelihood
macro markets.
A “down macro security” is one
of the pair of securities Shiller proposes
that would allow ordinary people
to hedge individual risks that
include reductions in their incomes
or home values, companies to hedge
business risks, and governments to
hedge macroeconomic risks. Buying
“up macro securities” can be an
investment in or a hedge against
price increases in the same trading
units.
For individuals the “down”
security is an alternative to livelihood
insurance with different performance
characteristics. They buy
and hold the “down” security to protect
against decreases in their profession
incomes. Later, if their
incomes fall, they are compensated
to some extent by an increase in the
value of the down security that is
based on a decline in aggregate
indices of their specific professional
incomes. When the income losses
occur, compensation is automatically
deposited to their macro security accounts that work just like their
employers’ electronic payroll
deposits to their bank accounts. The
fungible, dividend-paying “down”
security functions like a short
futures position or a long put with an
over-funded margin account that
obviates margin calls.
Similarly, families, fearing current
prices for their homes might fall
for reasons beyond their control,
could purchase home equity insurance.
If an index of local housing
prices for comparable homes fell,
home equity insurers automatically
would partially compensate them
with deposits to their down security
accounts. Those companies, like
livelihood insurers, could hedge
their systematic risk in real estate
macro markets with down securities.
Finally, governments should
develop international risk sharing
contracts among themselves to
hedge adverse changes in GDP per
capita or related measures of national
economic performance. If one
country has an unexpectedly lower
GDP per capita, the other countries
pay it an amount specified in the
contract to offset its loss. Think of it
as an organized insurance market or
macro market for foreign or emergency
aid. A similar pension idea
was proposed in “International
Pension Swaps” by Zvi Bodie and
Robert Merton, published in March
2002 in the Journal of Pension
Economics and Finance. They
claimed that “By diversifying across
world markets, there is significant
improvement in the efficient frontier
of risk versus expected return” (p.
78).
The New Financial Order is a
great read that has a less technical
but broader vision than Professor
Shiller’s 1993 Macro Markets. He
successfully describes issues in
designing the new financial order for non-technical readers unfamiliar
with macro markets and risk management
practices, but he also suggests
research topics for the further
study of macroeconomic risk management
and the design of standards-
of-living financial instruments
for specialists. I eagerly look forward
to his next book and research
papers. However, I respectfully suggest
to readers that his design of
macro securities and markets and
choice of six fundamental ideas raise
some questions.
First, he believes macro markets
must include “a mechanism
whereby anyone who wants to supply
these securities can,” not just the
“government or the few large entities,”
and must “offer a simple and
user-friendly way of managing large
risks” (pp. 126 &128). To supply
these securities, investors must buy
a complete set of “up” and “down”
securities that, respectively, serve as
long and short hedges. Since most
individual investors only want downside
protection for, say, home values
and incomes, they can buy the complete
set, keep the “down” security,
and sell the “up” security, which
adds to the work and expense of
establishing the hedge. In the event
there are no local markets for “up”
securities, Shiller bundles them
from each city for distribution as a
single, global security for all cities
(U.S. Patent 5,987,435, p.13,
www.uspto.gov). However, this
explanation is vague because the
bundled market also may be incomplete.
The worst case is individuals
who just want a “down” security get
stuck paying for the “up” security
that increases the total cost of the
“down” security.
Alternatively, individual investors
will just buy and hold the “down” security. They will balance
attractive features such as dividends and user-friendly buy and hold procedures
against less attractive features
such as potential difficulties of
selling-off “up” securities in illiquid
markets and the opportunity cost of
high balances in margin accounts
with no margin calls, discussed next.
Investors could buy “down”
securities that “will not be subject to
any margin calls and have no need to
buy or sell securities through time.
Thus, macro securities offer a simple
and user-friendly way of managing
large risks” (p. 128). Readers should
understand that the securities are
“designed to have a high initial margin
that allows “for a reasonably
well-functioning hedging vehicle
without margin calls” (U.S. Patent
5,987,435, p. 9). There are no margin
calls because the formula to
adjust the “up” (“down”) share price
when the “down” (“up”) share price
changes requires excess capital in
margin accounts above Federal
Reserve margin call levels. A welcome
follow-up publication would
be a comparative analysis of the
expected transaction costs of buying,
selling, and holding macro securities
and other derivatives.
Ironically, macro securities are
not necessary to establish the new
financial order. What’s truly important
about them is that they allow
long-term hedging, which can also
be accomplished by developing
long-dated derivatives instruments
for forty to fifty years into the future
using current derivatives instruments
and techniques. Hedgers will
use macro securities and/or longdated
derivatives just as exchangetraded
and/or over-the-counter
(OTC) derivatives are used now—
based on convenience, affordability,
and other hedger needs. Hedgers
will decide between macro securities
and long-dated derivatives in
some instances just as car owners decide between Fords and
Chevrolets.
Second, why these six fundamental
ideas? Many other large
risks could have been selected.
Professor Shiller says: “Despite all of our research, we
will never know for sure how to
design risk management devices
on abstract principles alone. No
one has a theoretical model of
risks and of moral hazard that is
so well defined that we can know
how to build devices to work perfectly
the first time we try. Over
the years, businesses have conducted
experiments, and their
observations of the outcome have
led to their business models. The
same process must take place
with radical financial innovations
that transform our economy.
We must begin with various small
experiments” (p. 272).
He explicitly says he would
describe “how such ideas can realistically
be developed and implemented”
(p. 2). He successfully develops
principles of macro securities and
some key features of macro markets
like “democratization of finance”
but hardly shows how to implement
them, in my opinion. I infer he
believes that “various small experiments”
are not just inevitably present
in implementing the new financial
order, but they are his implementation
strategy because there is
no well-defined “theoretical model
of risks and of moral hazard.” An
epilogue titled, “A Model of Radical
Financial Innovation,” further elaborates
on how to make risks more
obvious, to more clearly define
them, and to experiment with them
(pp. 269-276), but this is still not an
implementation strategy.
The weakness and strength,
respectively, of The New Financial
Order are that it is an excellent, relatively relatively
comprehensive vision of how
to design six potential instruments of
the first-generation new financial
order, without a draft blueprint for
launching it. His six ideas are six
mostly unrelated, but nonetheless
compelling, characters in search of
the same play.
To guide implementation, however,
he should have ranked the six
ideas, picked the top one or two, and
then summarized the why, when,
where, who, how, and next steps to
commercialize them with at least as
much detail that he provided to
develop them. Which macro markets
should be implemented first and
why? Reasonable people can disagree,
but I suggest starting with
Medicare, followed closely by Social
Security for two reasons.
First, the missing “theoretical
model of risks and moral hazard” quoted above will be developed in
proposals to use derivatives to
finance, hedge, and reduce the costs
of intermediated social insurance
programs. Second, Medicare, Social
Security, and other social insurance
programs are easily cross-hedged in
a few rather than many derivatives
because their tax and/or benefits
cash flows are usually highly correlated.
The launch of health and pension
macro markets could be based
on the auction, secondary, and government
securities derivatives markets
that exist today, thus capturing
the benefits of the greatest single
success and most widely understood
application of modern financial risk
management. Government securities
derivatives have traded in the
United States since the 1970s and
are now supported worldwide by
many national governments. From
current government securities derivatives
markets it is one step up to
hedging GDP and related aggregates, one step down to hedging
social insurance programs, and two
steps down to hedging individual
risks with macro securities and/or
other long-dated derivatives. |
|
Review by James A. Hayes,
Albuquerque, New Mexico |
