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Excerpt: 'The Subprime Solution'

Chapter Six:
The Promise of Financial Democracy

The key to the subprime solution, to preventing future crises like the current one, as well as mitigating its aftereffects, is democratizing finance—extending the application of sound financial principles to a larger and larger segment of society, and using all the modern technology at our disposal to achieve that goal.

Doing this will reduce the long-run incidence of speculative bubbles like the housing bubble that we have just experienced. And to the extent that such bubbles still occur, it will establish a rational context for responding to them, instead of the after-the-fact scurrying for quick fixes that we have seen since the onset of the subprime crisis in 2007.

There used to be tremendous instability in the banking sector. For example, there were severe U.S. banking crises in 1797, 1819, 1837, 1857, 1873, 1893, 1907, and 1933. Those problems were largely fixed by a number of institutional changes over the years, notably the creation of the Federal Reserve System in 1913 and the New Deal reforms of the early 1930s. But effective reforms haven't reached all segments of our economy, especially the household sector, which continues to limp along with practically medieval financial insight. Unless we think more broadly about financial reforms that will encompass the majority of households, we will continue to experience crises.

As the events leading up to the subprime crisis make plain, it is remarkable that the imperfections of our basic economic institutions have not been more widely discussed. While markets bubble and burst, most people have only minimal protections against their biggest economic risks, hold dangerously undiversified portfolios, and risk ruin when they lose their jobs or fall ill.

These problems are regarded as inevitable features of the system, and the system itself is considered impervious to reform, as if it were a product of nature. But successful institutional reform efforts such as those of the New Deal era belie this widely held orthodoxy. Basic institutional reform is not only possible but necessary.

The subprime crisis has revealed a poverty of imagination on the part of leaders in initiating the reforms needed to build the new institutional foundations for a more secure economic environment. This chapter suggests ways of beginning just such an institutional reform initiative.

It's the Technology

Institutional reform starts with understanding the available technology. Information technology is the story of our time. It is key to the subprime solution. The continued growth of computers, data collection and processing capabilities, "smart" technology, and rapid, inexpensive communications all provide dramatically effective tools to implement the subprime solution—to correct some of the egregious faults in the economy's institutional foundation.

Along with this expanding information technology, there has been over recent decades a magnificent development of our knowledge in the field of mathematical finance. The field has captured the imaginations of mathematically inclined people, from traditional economics departments, to mathematics departments, to management schools, and now to engineering schools with their new financial engineering programs, and to numerous quant groups at investment banks and hedge funds. This theory, as part of economics, in turn allows us to harness the full potential of risk-management technology—especially when it is implemented on a sufficiently large scale, as our information technology now allows. The theoretical advances are important, for they tell us where and how to look for opportunities to use financial technology to advance human welfare.

Mathematical finance theory helps us understand how both sides of a financial contract can benefit from the contract, and it suggests how we can optimize the participation of the two sides so that human welfare as a whole is enhanced. We must rely on such theory if we are to avoid inconsistent and erratic policy proposals to deal with crises, such as capriciously awarding bailouts to some without properly considering the context, the appropriate incentives, or who is on "the other side," paying for the bailouts.

Modern financial theory has as an important component in agency theory. Agency theory explains how to motivate agents to behave as much as possible in the interests of all parties to a transaction, not just themselves. It is a theory that explains how to keep moral hazard under control by structuring financial institutions with just the right balance of incentives.

In a similar vein, the human sciences—psychology, sociology, anthropology, and neurobiology—are increasing our understanding of the mind by leaps and bounds, and this knowledge is now being applied to finance and economics. We have a much better grasp of how and why people make economic errors, and of how we can restructure institutions to help avoid these errors.

There has been an important revolution with the development, in the past few decades, of the field of behavioral economics, including behavioral finance. This discipline incorporates insights gained in other social sciences. For that reason, many financial theorists of the old school have resisted this revolution, for they fear that it renders their mathematical models useless. On the contrary—it opens up their models to far richer and more successful applications.

Denying the importance of psychology and other social sciences for financial theory would be analogous to physicists denying the importance of friction in the application of Newtonian mechanics. If one is permitted to apply Newtonian mechanics only in realms where friction can be completely disregarded, then one is confining its application largely to astronomy. Once we add a theory of friction, Newtonian mechanics can begin to be applied to earthly problems as well, and it becomes an essential tool for engineers who are designing devices to improve our daily lives. We have a comparable opportunity today with the advent of behavioral economics, which has the potential to facilitate exciting advances in financial engineering.

New institutions can be developed to solve many of the world's fundamental risk problems. But, as noted previously, this can be achieved only if the institutional foundations are retrofitted to produce greater economic growth through steadily expanded asset ownership—especially homeownership.

What follows is a package of proposed reforms that leaders—government, civic, and business, both here and abroad—can forge into a new institutional foundation for the housing market and other asset markets. Taken together, these proposed measures resonate with the spirit and letter of the reforms introduced during the New Deal era as a response to the financial failures of the 1930s, and with other institutional reform initiatives, such as the Basel II reforms deployed to secure today's international banking system.

Since these proposals in some cases represent significant departures from established practice, there will be those who will doubt that they can ever be put into practice. But we have to remember that the history of finance is one of periodic major breakthroughs in method and form. These breakthroughs have often happened at times of financial crisis, just as the innovations of the New Deal era occurred during the Great Depression. And the time for further institutional innovations is now right.

The changes proposed here are significant, but a number of them have been tried on a smaller scale, and all are distinctly within the realm of possibility. The net effect of this package of reforms would be to stress-proof the whole economy, building greater ballast into the institutional framework so that buyers and sellers are better able to conduct business with confidence rather than through desperate speculative moves.

Excerpted from The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It by Robert Shiller Copyright © 2008 by Robert Shiller. Excerpted by permission of Princeton University Press. All rights reserved.

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