Tuesday, October 15, 2013

Robert Shiller and Radical Financial Innovation

Robert Shiller, who shares this year's Nobel Prize with Eugene Fama and Lars Peter Hansen, is perhaps most famous for his ability to "predict the future." But he also has an impressive grasp of the past. As just one example, in my recent blog post on the history of inflation-protected securities, Shiller's paper on "The Invention of Inflation-Indexed Bonds in Early America" was the most useful reference. Shiller's ability to develop intuition from financial history has, I believe, contributed to his success in behavioral finance, or "finance from a broader social science perspective including psychology and sociology."

Rather than attempting a comprehensive overview of Shiller's work, in this post I would like to focus on "Radical Financial Innovation," which appeared as a chapter in Entrepreneurship, Innovation and the Growth Mechanism of the Free Market Economies, in Honor of William Baumol (2004).

The chapter begins with some brief but powerful observations:
According to the intertemporal capital asset model... real consumption fluctuations are perfectly correlated across all individuals in the world. This result follows since with complete risk management any fluctuations in individual endowments are completely pooled, and only world risk remains. But, in fact, real consumption changes are not very correlated across individuals. As Backus, Kehoe, and Kydland (1992) have documented, the correlation of consumption changes across countries is far from perfect…Individuals do not succeed in insuring their individual consumption risks (Cochrane 1991). Moreover, individual consumption over the lifecycle tends to track individual income over the lifecycle (Carroll and Summers 1991)... The institutions we have tend to be directed towards managing some relatively small risks."
Shiller notes that the ability to risk-share does not simply arise from thin air. Rather, the complete markets ideal of risk sharing developed by Kenneth Arrow "cannot be approached to any significant extent without an apparatus, a financial and information and marketing structure. The design of any such apparatus is far from obvious." Shiller observes that we have well-developed institutions for managing the types of risks that were historically important (like fire insurance) but not for the significant risks of today. "This gap," he writes, "reflects the slowness of invention to adapt to the changing structure of economic risks."

The designers of risk management devices face both economic and human behavioral challenges. The former include moral hazard, asymmetric information, and the continually evolving nature of risks. The latter include a variety of "human weaknesses as regards risks." These human weaknesses or psychological barriers in the way we think about and deal with risks are the subject of the behavioral finance/economics literature. Shiller and Richard Thaler direct the National Bureau of Economic Research working group on behavioral economics.

To understand some of the obstacles to risk management innovation today, Shiller looks back in history to the development of life insurance. Life insurance, he argues, was very important in past centuries when the death of parents of young children was fairly common. But today, we lack other forms of "livelihood insurance" that may be much more important in the current risk environment.
"An important milestone in the development of life insurance occurred in the 1880s when Henry Hyde of the Equitable Life Assurance Society conceived the idea of creating long-term life insurance policies with substantial cash values, and of marketing them as investments rather than as pure insurance. The concept was one of bundling, of bundling the life insurance policy together with an investment, so that no loss was immediately apparent if there was no death. This innovation was a powerful impetus to the public’s acceptance of life insurance. It changed the framing from one of losses to one of gains…It might also be noted that an educational campaign made by the life insurance industry has also enhanced public understanding of the concept of life insurance. Indeed, people can sometimes be educated out of some of the judgmental errors that Kahneman and Tversky have documented…In my book (2003) I discussed some important new forms that livelihood insurance can take in the twenty-first century, to manage risks that will be more important than death or disability in coming years. But, making such risk management happen will require the same kind of pervasive innovation that we saw with life insurance."
Shiller has also done more technical theoretical work on the most important risks to hedge:
"According to a theoretical model developed by Stefano Athanasoulis and myself, the most important risks to be hedged first can be defined in terms of the eigenvectors of the variance matrix of deviations of individual incomes from world income, that is, of the matrix whose ijth element is the covariance of individual I’s income change deviation from per capita world income change with individual j’s income change deviation from per capita world income change. Moreover, the eigenvalue corresponding to each eigenvector provides a measure of the welfare gain that can be obtained by creating the corresponding risk management vehicle. So a market designer of a limited number N of new risk management instruments would pick the eigenvectors corresponding to the highest N eigenvalues."
Based on his research, Shiller has been personally involved in the innovation of new risk management vehicles. In 1999, he and Allan Weiss obtained a patent for "macro securities," although their attempt in 1990 to develop a real estate futures market never took off.


  1. Good post. For anyone who's interested, Shiller's Open Yale course on Financial Markets is quite good.

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