The New Financial Order: Risk in the 21st Century - Book Review

Business Economics, July, 2003 by James A. Hayes

By Robert J. Shiller. 2003. Princeton, NJ: Princeton University Press. Pp. 382. $29.95 cloth.

The heart of The New Financial Order by Robert Shiller, Professor of Economics at Yale University, is a conviction that:

   "... worsening
   conditions can
   develop even as technological
   advances mark greater levels of
   economic achievement. But new
   risk management ideas can
   enable us to manage a vast array
   of risks--those present and
   future, near and far--and to
   limit the downside effects of
   capitalism's 'creative destruction'.... this
   new infrastructure
   would utilize financial inventions
   that protect people against
   systemic risks: from job loss
   because of changing technologies
   to threats to home and community
   because of changing
   economic conditions" (p. ix).

Professor Shiller picks "six fundamental ideas" that the new financial order will use to "protect people against systemic risks." Three private sector ideas include insurance for livelihoods and home values, "macro" securities and markets to hedge incomes and real estate, and income-linked loans to hedge bankruptcy. Three public sector ideas include income inequality insurance, intergenerational social security, and hedges against unexpected changes in "per capita GDP or its analogues" (p. 177). Overall, the "book presents ideas for a new financial order, a new financial capitalism, and new economic infrastructure, and further describes how such ideas can realistically be developed and implemented" (p. 2).

For example, young people considering careers they really love may think twice if they fear salaries might decline. They could buy livelihood insurance just like life or car insurance that would compensate them if their preferred career income dropped. Expecting, say, a $80,000 salary they would purchase an insurance policy with a floor salary of perhaps $40,000 for a fixed period of time. Insurers would diversify these risks, develop procedures to minimize moral hazard, and hedge downside systematic risk by buying "down" macro securities in livelihood macro markets.

A "down macro security" is one of the pair of securities Shiller proposes that would allow ordinary people to hedge individual risks that include reductions in their incomes or home values, companies to hedge business risks, and governments to hedge macroeconomic risks. Buying "up macro securities" can be an investment in or a hedge against price increases in the same trading units.

For individuals the "down" security is an alternative to livelihood insurance with different performance characteristics. They buy and hold the "down" security to protect against decreases in their profession incomes. Later, if their incomes fall, they are compensated to some extent by an increase in the value of the down security that is based on a decline in aggregate indices of their specific professional incomes. When the income losses occur, compensation is automatically deposited to their macro security accounts that work just like their employers' electronic payroll deposits to their bank accounts. The fungible, dividend-paying "down" security functions like a short futures position or a long put with an over-funded margin account that obviates margin calls.

Similarly, families, fearing current prices for their homes might fall for reasons beyond their control, could purchase home equity insurance. If an index of local housing prices for comparable homes fell, home equity insurers automatically would partially compensate them with deposits to their down security accounts. Those companies, like livelihood insurers, could hedge their systematic risk in real estate macro markets with down securities.

Finally, governments should develop international risk sharing contracts among themselves to hedge adverse changes in GDP per capita or related measures of national economic performance. If one country has an unexpectedly lower GDP per capita, the other countries pay it an amount specified in the contract to offset its loss. Think of it as an organized insurance market or macro market for foreign or emergency aid. A similar pension idea was proposed in "International Pension Swaps" by Zvi Bodie and Robert Merton, published in March 2002 in the Journal of Pension Economics and Finance. They claimed that "By diversifying across world markets, there is significant improvement in the efficient frontier of risk versus expected return" (p. 78).

The New Financial Order is a great read that has a less technical but broader vision than Professor Shiller's 1993 Macro Markets. He successfully describes issues in designing the new financial order for non-technical readers unfamiliar with macro markets and risk management practices, but he also suggests research topics for the further study of macroeconomic risk management and the design of standards-of-living financial instruments for specialists. I eagerly look forward to his next book and research papers. However, I respectfully suggest to readers that his design of macro securities and markets and choice of six fundamental ideas raise some questions.