Shiller’s underwhelming innovations

September 30, 2009
James Kwak has a great response to Robert Shiller's FT op-ed about financial innovation. But his line at the end about how "for the sake of argument, I am willing to concede that these are useful innovations that would make people better off" has been misconstrued, and it's worth pointing out that in fact they're not useful innovations that would make people better off.

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James Kwak has a great response to Robert Shiller’s FT op-ed about financial innovation. But his line at the end about how “for the sake of argument, I am willing to concede that these are useful innovations that would make people better off” has been misconstrued, and it’s worth pointing out that in fact they’re not useful innovations that would make people better off.

Why not? Mainly because, at heart, they’re all variations on the theme of doing-clever-things-with-as-yet-uninvented-derivatives. But that’s a theme which really shouldn’t have survived the financial crisis.

In 2003, Alan Greenspan famously said that ““what we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” But, as it turned out, they weren’t. Lots of people wanted to transfer risk, and precious few were genuinely willing and able to take it on: even hedge funds generally prided themselves on being lower-risk than the stock market as a whole.

The result was a system where derivatives were used to hide risks, and shunt them off, unseen, into the tails. A system where hidden risks turned out to be much more dangerous than if they’d all been out in the open all along.

In each of Shiller’s examples, you start with a risk that an individual wants to lay off: the risk that home prices will fall, or that the market will plunge just before you retire, or that inflation or healthcare costs will kick in after you retire. And in each case, the individual tries to lay off that risk elsewhere.

Shiller simply takes it on faith, however, that a nice liquid market can and should spring up to provide two-way prices in such risks, solving lots of problems at a stroke; he doesn’t stop to consider that maybe the reason such markets haven’t sprung up is precisely that there’s no real demand from anybody wanting to take on those risks. In reality, Shiller should know that better than anyone: his much-vaunted house-price derivatives have gone nowhere, partly because no one ever really had any need or desire to go long.

Shiller’s first proposed innovation is an attempt to deal with the regrettable move, in recent years, towards a “popular reliance on housing as an investment”. Only except for suggesting the obvious — moving people away from the idea of housing as an investment, and towards good old-fashioned renting — he comes up with a complex mortgage with all manner of embedded options. As with any derivative, those options will be a zero-sum game, and you can be sure the homeowner is going to end up on the wrong side of it. But Shiller still seems to think it’s a good idea for homeowners to buy them, instead of simply getting a plain-vanilla, easily-comprehensible mortgage, with payments which are set over the life of the loan and which are entirely predictable.

Shiller’s second innovation is target-date mutual funds: I’m almost surprised that he didn’t suggest some kind of principal-protection scheme, involving derivatives, instead. (Maybe because that would have sounded too much like portfolio insurance, which caused the 1987 crash.) But target-date funds are widely misunderstood, and in 2008 some 2010 funds contrived to underperform the S&P 500. They’re a mess, and they’re expensive, and it’s not obvious that they do any good. So color me unconvinced on this front.

Finally, Shiller dreams of annuities which would pay out a set amount of money per month for life, after adjusting for inflation, and which on top would include all healthcare costs. Nice dream, Bob. But there’s a good reason such things don’t exist: no insurer wants to take on a large amount of those kind of risks, and nor would any self-respecting insurance regulator allow them to do so. There isn’t a long-dated derivatives market in future health-insurance costs, but if there were, very few people would have any reason to sell protection against those costs rising, at any price. Sure, a few hedge funds might dabble in the market. But they could never satisfy demand. And in any case, as with the mortgages, the buyer of the annuity would generally lose out, just because of the zero-sum nature of derivatives. Since the cost of the embedded options would be hidden in the price of the annuity, the insurer would have a license to charge through the nose for it, and the buyer of the annuity would never know.

Simplicity and transparency are good things, and Shiller’s innovations go the other way instead. That’s nothing to get excited about.


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