Guest Post
Team Player: Robert Shiller on Finance as Panacea
Book Review by John Staddon
Shiller, Robert J. Finance and the Good Society. PrincetonUniversity Press. 2012. 304 pp.
Yale professor Robert Shiller is one of the most influential economists in the world. Co-inventor of the oft-cited Case-Shiller index, a measure of trends in house prices, he is author or co-author of several influential books about financial crises. He shared the 2013 Economics Nobel with Eugene Fama and Lars Peter Hansen.
In 2012 Professor Shiller published a full-throttle apologia for plutocracy: Finance and the Good Society. FATGS is a reaction to the hostility to finance provoked by the 2007+ crisis. But rather than being an effective defense, FATGS just underlines what is wrong with present arrangements.
Shiller sees the solution to our still-unfolding problems not as less financial invention, but more: “Ironically, better financial instruments, not less activity in finance, is what we need to reduce the probability of financial crises in the future.” He adds “There is a high level of public anger about the perceived unfairness of the amounts of money people in finance have been earning, and this anger inhibits innovation: anything new is viewed with suspicion. The political climate may well stifle innovation and prevent financial capitalism from progressing in ways that could benefit all citizens.”
Is he right? Is financial innovation always good? Have the American people turned into Luddites, eager to crush creativity and settle into a life of simplistic poverty, uncorrupted by the obscure and self-serving creations of financial engineering?
Yes and yes, says Professor Shiller, who applauds what others deplore in the rise of ‘financial capitalism’ which Shiller describes as “a system in which finance, once the handmaiden of industry, has taken the lead as the engine driving capitalism.”
Finance capitalism, a new name but an old idea, has been unpopular for years. In the 1930s, especially, right after the Great Depression, the big finance houses, like J. P. Morgan were seen as conspirators against the public interest. Goldman Sachs, the ‘great vampire squid’ of Rolling Stone’s Matt Taibbi, plays the same role these days.
Some of Shiller’s defense of the financiers is simply puzzling because it is pretty obvious nonsense. This is what he has to say about securitization – the bundling of hundreds of mortgages into layered bonds that have been sold all over the world:
Securitized mortgages are, in the abstract, a way of solving an information asymmetry problem—more particularly the problem of “lemons.” This problem…refers to the aversion many people have to buying anything on the used market, like a used car.1
The claim that securitization solves the information problem is paradoxical to say the least. How can removing a mortgage from the initial lender improve the buyer’s knowledge of the borrower? Surely the guy who actually originates the loan is in the best position to evaluate the creditworthiness of the borrower?
Ah, the answer is apparently the rating agencies: “Bundling mortgages into securities that are evaluated by independent rating agencies, and dividing up a company’s securities into tranches that allow specialized evaluators to do their job, efficiently lowers the risk to investors of getting stuck with lemons.”
Really? Not everyone agrees. Here’s a comment about rating agencies from Michael Burry, who was one of the few to spot the eroding quality of sub-prime mortgages in the years leading up to the 2007 crash. Burry’s conclusion was that the proportion of demonstrably bad loans in MBSs increased over the years, but the credit scores remained the same! So much for the credit-rating agencies which were, in effect, captives of (and paid by!) the bond issuers. Shiller concedes that securitization “turns out not to have worked superbly well in practice,” but he blames optimism about house prices (and where did that come from?), not the built-in opacity and erosion of responsibility of securitization itself.
Securitization can only justify its name if several underlying assumptions are true. A key assumption is that mortgage default rates differ from place to place. Things may go bad in Nevada, say, but that will have no effect on default rates in New York. The risks associated with individual mortgages, scattered across the country, might have been more or less uncorrelated, before securitization. But afterwards, “[r]ather than spreading risk, securitization concentrated it among a group of electronically linked investors subject to herd-like behavior.”2 Mortgages now rose and fell in synch: bubble followed by bust. The attempt to reduce individual risk leading (after some delay) to increased systemic risk – what I have called the malign hand.3 Securitization rested on an assumption that was as false as it was convenient.
So what’s good about financial capitalism? Well, FC is democratic, says Shiller.
[T]here is nothing in financial theory that specifies that control of capital should be confined to a few ‘fat cats.’ Think of the broadly democratic proliferation of insurance, mortgages, and pensions—all basic financial innovations—in underwriting the prosperity of millions of people in the past century.
There are a couple of problems with this. First, by seeking universal security, finance has instead arrived at collective instability – as the pensions and credit crises of recent years have proved. All too often, illusory individual security has been achieved only at the cost of systemic breakdown.
The second problem is Shiller’s assumption that democracy, vaguely defined, is a always good. Well, there are many forms of democracy; some work well and others badly. Some preserve the rights of minorities; others degenerate into tyranny of the majority. The ‘financial contagion’ involved in bubbles looks more like the latter than the former. The fact that many people are involved in something is no proof of its virtue. It’s also hard to ignore the eye-watering compensation awarded to Wall Street’s ‘masters of the universe’ in recent years. Finance doesn’t look very democratic to me.
Most people think the financial sector is too big, admits Shiller, who disagrees. Well, just how big is it – and how big should it be?
Financial activities consume an enormous amount of time and resources, increasingly so over the years. The gross value added by financial corporate business was 9.1% of U.S. GDP in 2010…By comparison it was only 2.3% of GDP in 1948. These figures exclude many more finance-related jobs, such as insurance. Information technology certainly hasn’t diminished the number or scope of jobs in finance.4 (emphasis added.)
So, yes, the financial industry has grown mightily. But why hasn’t IT reduced its size – made it cheaper – in relation to the rest of the economy, just as mechanization reduced the number of people involved in farming? If any sector should benefit from pure computational power it is surely finance. Many clerks and human computers should have been made redundant as digital computer power has increased and its cost has decreased. But no: computation has not been used to increase the real efficiency of the financial industry. It has been used to create money – in the form of credit (leverage) – through ‘products’ that have become increasingly hard to understand. Many trace the recent instability of financial markets in part to derivatives and other complex products made possible by the growth of financial IT. But Professor Shiller sees these things as creative innovation and contributors to general prosperity. Creative they may be, but the evidence is that expansion of finance is associated with slowed growth of the economy as a whole.5
So, how big should finance be? Professor Shiller makes a comparison to the restaurant industry. “People in the United States spend 40% as much (3.7% of GDP) eating out at restaurants as the corporate financial sector consumes. Is eating out a wasteful activity when people could just as well stay home and eat?” Is finance comparable to eating out? Hardly. Eating out is end-use, of value in itself. Shiller seems to think that finance can create wealth directly, like the auto industry or farming. But finance exists only to allocate resources efficiently. A bond or a swap has no value in and of itself. It’s value is its contribution to building ‘real’ industry. Yet now finance seems to consume more than the resources it allocates. In 2002 it comprised a staggering 45% of US domestic corporate profits, for example, a huge increase from an average of less than 16% from 1973 to 1985.6 Shiller is right that no one knows, or can know, exactly how big the financial industry should be. But when it makes almost half of all profits, even its fans may suspect that it has grown too great.
Shiller’s vigorous defense of a controversial industry made me uneasy, but it took some time to discover just what it is in his philosophy that is so disturbing. Here is a paragraph which makes the point quite clearly:
At its broadest level, finance is the science of goal architecture—of the structuring of the economic arrangements necessary to achieve a set of goals and of the stewardship of the assets needed for that achievement… In this sense, finance is analogous to engineering.”
What’s wrong with that, you may say? People have goals and surely the purpose of our social arrangements is to help achieve them? Well perhaps, but contrast Shiller’s comment with this from Steve Jobs: “people don’t know what they want until you show it to them.”7 Who has what goal in Jobs’ world? Not the consumer, who doesn’t know what he wants until he sees it, and not even Apple, which works on each new product until it just seems right. Much of the creativity of capitalism is bottom-up – the goal emerges from the process. It’s not imposed from above. But for Professor Shiller, the goal always comes first. His ideal is command from above, not the kind of “spontaneous order” that Friedrich Hayek and other free-market pioneers have identified as the secret of capitalism’s success.
Another problem is that Prof. Shiller thinks that financial engineering is, well, engineering.8 Engineering is the application of valid scientific principles to achieve a well-defined and attainable goal. Financial ‘engineering’ certainly employs valid mathematics, but it is not based on a set of established principles that are both necessary and sufficient. The desired objective may or may not be possible – no one can prove that Prof. Shiller’s equity insurance is not destabilizing, for example. Financial engineering is to real engineering as astrology is to astronomy.
Finally there is the problem of risk itself. The finance industry accepts without question that shedding – sharing, distributing – risk is always a good thing. And risk itself is treated as a thing, like a load – of bricks, say – that can usefully be split up and shared. Like a load of bricks, its total amount doesn’t change when it is split up. Nor do individual bricks get heavier or lighter with each change of carrier.
But risk is not a thing. It is a property of an economic arrangement. As the arrangement changes, so does the risk. The bricks do change as they pass from one carrier to another. Both the total mount of risk (if that even means anything) and, more importantly, who exactly is at risk, change as the arrangement changes – as we move from individual mortgages to mortgage-backed securities, for example. The concept of ‘sharing risk’ is a very bad, and very dangerous, metaphor.
Robert Shiller’s impassioned defense of the evolutions of finance is an accurate reflection of the belief system of an industry that has lost a firm connection to reality: Risk is treated as a thing instead of a property. Financial ingenuity can and should reduce risk whenever possible. It should be possible to insure against any eventuality, if we are just clever enough. The more people are involved in finance, the more ‘democratic’ it becomes. Ingenious packaging like securitization, shares risk without increasing it. All these beliefs are more or less false. Yet they are at the heart of modern finance.
So have the American people in fact turned against the financial industry, as Prof. Shiller fears? Well, people are upset and alarmed by what has just happened. They probably would turn against finance if they could. But their unhappiness will have little effect because their leaders are captive to finance. “Wall Street Is Still Giving to President” headlines the Wall Street Journal9 . The President talks the talk: “President Barack Obama called Wall Street executives ‘fat cats,’ criticized their bonuses and tried to raise their taxes. The financial-services industry, in turn, has directed a stream of complaints toward the administration, fueling perceptions of a rift between the president and a key 2008 donor group.” But it’s all theater. Money is what really talks and the industry knows it has little to fear from either party so long as it can both bribe and scare them into following its lead. Almost nothing has been done to curb the profitable instabilities of finance and, so long as present arrangements continue, nothing will be done. The team, and Professor Shiller, can relax.
John Staddon is Professor Emeritus in the Department of Psychology and Neuroscience at Duke University, and a Honorary Visiting Professor at the University of York.
- 1Finance and the Good Society. P. 54.
- 2The Death of Capital, Michael E. Lewitt (John Wiley, 2010)
- 3John Staddon The Malign Hand of the Markets, New York: McGraw-Hill, 2012.
- 4FATGS, p. 12.
- 5The Malign Hand, location 3390 (Kindle edition)
- 6Simon Johnson The Quiet Coup, The Atlantic, 2009: http://www.theatlantic.com/doc/200905/imf-advice
- 7http://www.businessweek.com/archives/1998/b3579156.arc.htm
- 8See, for example, FT June 8, 2012: Science in banking helped cause the crisis. From Richard Lesmoir-Gordon.
- 9WSJ, July 3, 2012
