Limiting the Risk -- and Pain -- of Capitalism

THE NEW FINANCIAL ORDER

Risk in the 21st Century

By Robert J. Shiller Princeton University -- 366pp -- $29.95

Irrational Exuberance secured Yale University economist Robert J. Shiller's reputation for boldness. Published in March, 2000, when stock prices were nudging the cirrus clouds, it argued -- complete with italics -- that "the present stock market displays the classic features of a speculative bubble." That seems obvious now, but it was highly controversial in the glory days of such books as Dow 36,000 by James K. Glassman and Kevin A. Hassett. Shiller took heat from legions of market boosters for needlessly frightening investors.

Now, Shiller has proved even bolder than we thought. He's not satisfied with being known as the geek from Yale who called the top of the bull market: His ambitions are global and systemic. Shiller wants nothing less than to inspire and guide the redesign of the world financial system. The New Financial Order: Risk in the 21st Century is not so much narrative as blueprint -- a step-by-step description of what should be done to limit the damage done to people, and even entire nations, by capitalism's creative destruction.

Inside Shiller beats the heart of a social reformer. He argues that today's institutions don't protect people from some of the biggest financial risks they face. The risk, for instance, of choosing a profession that will be rendered obsolete by technological change. The risk of buying a house in a neighborhood or region that will go downhill. The risk of living in a country that will underperform. So he has invented institutions and arrangements that could allow people and countries to insure themselves against these risks and others.

Shiller argues persuasively that new risk-sharing mechanisms would save people from "gratuitous, random, and painful inequality." Less obviously, they would give people the confidence to take risks that might benefit society as a whole. His example is a young biochemist considering a specialty in adenoviruses, which cause respiratory and eye infections. Society needs more adenovirus experts. But the biochemist might shy away from such a narrow specialty for fear that science might take a different direction and the costly education would be wasted.

Shiller's solution? "Livelihood insurance." Create a futures market in professions, with trading based on people's guesses about what will happen to the average income in various professions. Hedging in such a market, an insurer could sell a policy that would pay the biochemist an annual sum if the study of adenoviruses turned out to be a backwater. To discourage shirking, the policyholder would receive nothing if his or her own pay was low but average pay in the specialty was high.

Shiller has ideas for the government, too. He would reengineer the Social Security and income tax systems to share risks between segments of society. Instead of being locked in, Social Security payments to retirees would be tied to the incomes of working people. If workers' wages rose slowly, retirees would have to share their pain. Under his income tax plan, the degree of inequality between rich and poor would not be allowed to grow. So if the top 1% of the population earned a bigger share of national income than today, the tax rates it faced would rise, while rates on others would fall. He would also tie the interest on loans to borrowers' incomes.

Thinking even bigger, Shiller proposes that nations strike risk-sharing agreements with one another under which countries that fare better than expected will pay money to the ones that do worse. If South Korea and Argentina had made such a deal in 1965, Shiller argues, Argentina would today be getting large payments from Korea that would ease its plight. Likewise, "macro securities," which Shiller conceived with a former student, Allan Weiss, would let people hedge themselves or make bets on broader chunks of economic activity than they can today. Instead of buying, say, 100 shares of IBM, they could buy (or short) 100 shares of Portugal, or Western Europe, or even the world. Shiller even has a solution for distortions caused by inflation: state prices in inflation-adjusted units. He credits this idea to Chile, where people have been quoting rents, house prices, and taxes in stable unidades de fomento since 1967.

Shiller admits that many people will find his ideas "unnatural, even unworkable." So he strives to define them in appealing terms. Take the international risk-sharing agreement, for example. If it's framed as a tax on success and a reward for failure, it won't fly. But he thinks it will work if framed as a risk-management contract, since contracts are considered inviolate. He notes that poor India routinely honors its contracts to pay interest on debts to the rich U.S.

An even bigger obstacle is that many of Shiller's ideas, such as livelihood insurance, have intrusive side effects. Frighteningly, he suggests that holders of disability insurance could prove they're not malingering -- and thus lower their premiums -- by accepting "electronic scrutiny of their purchases and sales, of their Internet activity, and of biometric identification systems that track their economic activities." Yikes!

Shiller sees his inventions as being in the risk-sharing tradition of social security, workers' compensation, and unemployment insurance. "If we can achieve but one of [the inventions], in some form, it would be a major improvement," he writes. You might say he's guilty of irrational exuberance. But what inventor isn't a little crazy?

By Peter Coy

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