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Team Player: Professor Shiller and Finance as Panacea

How big should finance be? How productive is the financial industry?

This is a new review of a relatively old book by a famous economist. The book seems never to have been critically reviewed, despite the eminence of its author. But as the financial industry looks forward to some kind of de-regulation, the issues covered here are returning to the front page.

Shiller, Robert J. (2012). Finance and the Good Society. Princeton University Press. Kindle Edition.

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 important books about financial crises - including Irrational Exuberance (2000) and (with George Akerlof) Animal Spirits (2009). 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.

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 [no kidding!], 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 fin-Luddites, eager to crush quant 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, the rise of ‘financial capitalism’: “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.

How does Shiller defend the financiers? What is so good about financial capitalism? What improvements may we expect in the future?

Some of Shiller’s defense 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, first given a theoretical explanation by George Akerlof, refers to the aversion many people have to buying anything on the used market, like a used car.[2]"

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 person 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 another comment about rating agencies. It’s 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 (this is a bit long, but bear with me):

"So you take something like NovaStar, which was an originate and sell subprime mortgage lender, an archetype at the time. The names [of the bonds] would be NHEL 2004-1, NHEL 2004-2, NHEL 2004-3, NHEL 2005-1, etc. NHEL 2004-1 would for instance contain loans from the first few months of 2004 and the last few months of 2003, and 2004-2 would have loans from the middle part, and 2004-3 would get the latter part of 2004. You could pull these prospectuses, and just quickly check the pulse of what was happening in the subprime mortgage portion of the originate-and-sell industry. And you’d see that 2/28 interest-only ARM mortgages were only 5.85% of the pool in early 2004, but by late 2004 they were 17.48% of the pool, and by late summer 2005 25.34% of the pool. Yet average FICO [consumer credit] scores for the pool, percent of no-doc [“Liar”] loan-to-value measures and other indicators were pretty static…. The point is that these measures could stay roughly static, but the overall pool of mortgages being issued, packaged and sold off was worsening in quality, because for the same average FICO scores or the same average loan to value, you were getting a higher percentage of interest only mortgages[3]."

In other words, the proportion of crap 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. (Just how critical will a rating agency be of a bond when it is paid by the issuer of the bond? Moral hazard, anyone?)

Shiller concedes that securitization “turns out not to have worked superbly well in practice,” but he blames optimism about house prices not the built-in opacity and erosion-of-responsibility of securitization itself. But optimism is much more an effect than a cause; otherwise it can be invoked whenever economists are asked to explain something for which they in fact have no real explanation. The malign feedbacks of securitization are a real explanation.

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 – are uncorrelated. 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”[4]. 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[5]. Securitization rested on an assumption that was as false as it was convenient. Securitization was anything but…

So what’s good about financial capitalism? Well, it's democratic, says Shiller. “there 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 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.

Shiller also seems to think that the ‘democratization of finance’ will lead to a more equal world – after taxes, at least. He would probably agree with Washington Post columnist Robert Samuelson that, despite all those K Street lobbyists, the rich pay most of the taxes and the middle class get most of the benefits: “In 2009, $2.1 trillion (60 percent) of federal spending went for ‘payments for individuals.’ This included 52.5 million people receiving Social Security; 46.6 million on Medicare (many of the same people); 32.9 million on food stamps; 47.5 million on Medicaid; 3.9 million with veterans’ benefits. Almost all these benefits go to the poor and middle class. Meanwhile, the richest 5 percent of Americans pay 44 percent of federal taxes. Does this look like government for the rich?”[6]

But these statistics are a bit misleading. The rich do indeed pay the lion’s share of taxes, but they also make more than a lion’s share of the income. In 2011, for example, the top 1% made 21% of the income and paid…21.6% of the taxes![7] That’s essentially the same fraction of their $1.37M average income as it is of the $67 thousand average income of the fourth 20%. When you get into the middle class and below, income taxes are not in fact very progressive. In further confirmation, the Gini index, a good measure of inequality, rose and fell in almost perfect synchrony with the rise and fall of the financial sector in the US economy from 1967 to 2005[8]. More finance has gone along with more inequality, not less as Shiller implies.

The tax issue is horribly complex, of course. These simple figures ignore income forfeited by tax-efficient investment via low-interest municipal and other tax-exempt bonds, double taxation of investment income, etc. But overall, the tax system is less progressive than it looks.

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.[9]" (my italics)

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 all the evidence is that expansion of finance is associated with slowed growth of the economy as a whole[10].

So, how big should finance be? Professor Shiller makes a comparison to the restaurant industry.

To some critics, the current percentage of financial activity in the economy as a whole seems too high, and the upward trend is cause for concern. But how are we to know whether it really is too high or whether the trend is in fact warranted by our advancing economy? …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. Its 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[11]. 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.

So what is the promise of finance? What benefits may we expect in the future? Shiller devotes a whole chapter to “Insurers”, tracing the expansion, which he terms “democratization,” of insurance to areas most of us would never have thought “insurable” at all.

Livelihood insurance is one possibility. This would be a long-term insurance policy that an individual could purchase on a career, an education, or a particular investment in human capital. One could choose to specialize far more narrowly than is commonly done today—say, on a particularly interesting career direction—developing the expertise for such a career without fear of the consequences if the initiative turned out badly.

Other examples that may surprise are futures markets in careers outcomes by occupation, long-term catastrophe insurance (e.g., against the possibility that hurricanes will increase in frequency over the next fifty years), and home-equity insurance (insurance against a loss in value of your home). Shiller concludes “Pushing the concept of insurance to new horizons can be inspiring work.”

Really? To me Shiller’s enthusiasm for insuring everything in a quest for a riskless society borders on the delusional. Risk is, after all, the main source of financial discipline. Render debt riskless and there is little to prevent it rising without limit.

And there are practical problems. Unless you think it a panacea that can potentially solve all problems, the first question about insurance, surely, should be how do you compute the odds? The answer for most of these novel insurables, is “guess” because there is no principled way to compute odds. For life insurance there are mortality tables and a reasonable expectation that the pattern from the past will hold in the future, or at least for a generation or so. Much the same is true for property insurance – the insurer knows historic fire, burglary and theft rates, and so on. But ‘equity insurance’? Who could have computed the odds on the recent property bubble collapse? Insuring against such an event is itself gambling on a planetary scale.

So what? Shiller might respond “no one can compute the exact odds on a horse race either.” Presumably many of the novel insurances he proposes would have to compute odds just based on the market – how many people want X amount of insurance on Y events? – just as the TOTE does on a racetrack.

What’s wrong with that, you might ask? Well, in a horse race, you at least know that there is going to be only one loss for the bookie (only one winner). But in a bet on a bunch of mortgages, the number of losers is uncertain. And betting on a horse race affects only the punters who, usually, are betting with their own money.

But betting on house equity, with borrowed money, has implications for the whole economy. Would equity insurance encourage house purchase? Yes. Would it make buyers less anxious about a possible decline in house prices? Sure. Would insurance have helped the housing bubble inflate? Almost certainly. So would insurance have added to the crash? And would it have been able to cope with the resulting losses? Yes – and no, it would not have been able to pay out to everyone. So how great an idea is equity insurance after all!

And finally there is the problem of feedback: it is usually dangerous to insure someone against a hazard over which they have control. If I take out insurance against failing in a career, for example, my incentive for working hard at it will surely be somewhat reduced and my tendency to give up correspondingly increased. Risk is a great motivator; eliminating risk must therefore impair motivation.

Similar misgivings arise for most of the creative financial products puffed by Prof. Shiller. They may benefit individuals, but at the cost of increasing systemic risk, which is borne by others - the malign hand again.

Shiller’s vigorous defense of a controversial industry made me uneasy, but it took some time to discover just what it is at the heart of his philosophy. Here is a paragraph which makes the point:

“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 Apple’s Steve Jobs: “people don’t know what they want until you show it to them.”[12] 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[13]. Engineering is the application of valid scientific principles to achieve a well-defined and attainable goal. Financial ‘engineering’ employs valid mathematics -- based on shaky assumptions. Its predictive powers are minimal. 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 rather 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. A load of bricks doesn’t change its total amount 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.

But Robert Shiller’s impassioned defense of the evolutions of finance accurately reflects 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. Insurance is always good. 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.

[1] A shorter version was published at…

[2] Finance and the Good Society. P. 54.

[3] Quoted by Michael Lewis in The Big Short, location 545 (Kindle edition).

[4] The Death of Capital, Michael E. Lewitt (John Wiley, 2010)

[5] John Staddon The Malign Hand of the Markets, New York: McGraw-Hill, 2012.


[7] Taxes—Who Really Is Paying Up, by Andrea Coombes. WSJ, April 15, 2012. See also…

[8] The Malign Hand of the Markets, New York: McGraw-Hill, 2012.

[9] FATGS, p. 12.

[10] The Malign Hand, location 3390 (Kindle edition)

[11] Simon Johnson The Quiet Coup, The Atlantic, 2009:


[13] See, for example, FT June 8, 2012: Science in banking helped cause the crisis. From Richard Lesmoir-Gordon.

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