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The New Financial Order

The New Financial Order: Risk in the 21st Century

Robert J. Shiller
Copyright Date: 2003
Edition: STU - Student edition
Pages: 384
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  • Book Info
    The New Financial Order
    Book Description:

    In his best-sellingIrrational Exuberance, Robert Shiller cautioned that society's obsession with the stock market was fueling the volatility that has since made a roller coaster of the financial system. Less noted was Shiller's admonition that our infatuation with the stock market distracts us from more durable economic prospects. These lie in the hidden potential of real assets, such as income from our livelihoods and homes. But these ''ordinary riches,'' so fundamental to our well-being, are increasingly exposed to the pervasive risks of a rapidly changing global economy. This compelling and important new book presents a fresh vision for hedging risk and securing our economic future.

    Shiller describes six fundamental ideas for using modern information technology and advanced financial theory to temper basic risks that have been ignored by risk management institutions--risks to the value of our jobs and our homes, to the vitality of our communities, and to the very stability of national economies. Informed by a comprehensive risk information database, this new financial order would include global markets for trading risks and exploiting myriad new financial opportunities, from inequality insurance to intergenerational social security. Just as developments in insuring risks to life, health, and catastrophe have given us a quality of life unimaginable a century ago, so Shiller's plan for securing crucial assets promises to substantially enrich our condition.

    Once again providing an enormous service, Shiller gives us a powerful means to convert our ordinary riches into a level of economic security, equity, and growth never before seen. And once again, what Robert Shiller says should be read and heeded by anyone with a stake in the economy.

    eISBN: 978-1-4008-2547-9
    Subjects: Finance, Economics

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-viii)
  3. Preface
    (pp. ix-xii)
  4. Acknowledgments
    (pp. xiii-xviii)
  5. INTRODUCTION The Promise of Economic Security
    (pp. 1-18)

    WALL STREET, along with the City of London and other world financial centers, has served as the liveliest laboratory for new ideas in all of capitalism. Modern finance—not only securities and banking but also insurance and public finance—grows out of powerful theories, both mathematical and psychological, and has produced economic inventions of the greatest utility. Despite some awful financial scandals that surface from time to time, these inventionsreally work,most of the time. The inventions work because the fundamental ideas are sound and because finance professionals have learned to apply them effectively to real people, with all...

  6. Part One: Economic Risks in an Advancing World

    • ONE What the World Might Have Looked Like since 1950
      (pp. 21-31)

      VISUALIZING THE MAJOR economic risks of the future is difficult. Because such risks are only hypothetical—at least until we have concrete evidence of their imminence—most people do not feel easily convinced of the benefits of any new measures against them. We tend instead to be distracted by little day-to-day problems that are already clearly revealed. We seldom think about how we should be dealing with deep and fundamental risks.

      In contrast, the dangers that have dominated the past are well known to us. Thus, let us consider, as a thought exercise, risks that have already come to pass....

    • TWO The Hidden Problem of Economic Risk
      (pp. 32-45)

      FOR ALL THE TALK about risk and finance, the critical economic risks that we face remain substantially hidden, almost as if they did not exist. We do not fully perceive the risks to individual careers, to the opportunities of the next generation, to our neighborhoods, to local industries, or to the economic success of countries. Individuals are aware of the economic risks facingthemselvesand theirownfamilies, but only intermittently and imperfectly. They do not really understand the nature of these risks or their breadth.

      Gaining basic perspectives on our long-term economic risks is essential if we are to...

    • THREE Why New Technology Creates Risks
      (pp. 46-57)

      FEW ADULTS who lived through the building and bursting of the “Nifty Fifty” technology bubble of the early 1970s or the dot-com bubble of the late 1990s would argue against the claim that our economic destinies, for better or worse, are tied to technology. But technology has even more fundamental economic impacts than these examples would suggest. To the extent that technology is ubiquitous in economic activity, any consideration of our future must take into account the risks associated with evolving technology, both for good and for ill.

      To secure and advance our economic prospects, we must work to enhance...

    • FOUR Forty Thieves: The Many Kinds of Economic Risks
      (pp. 58-66)

      DEALING INDIVIDUALLY with all of our separate risks is impossible because there are too many of them to comprehend. We can buy insurance policies on our house’s burning down, on having our laptop stolen, and on contracting a deadly disease. But if we imagine that such a piecemeal approach to risk management works well by itself, we are mistaken. Economic risks pervade life. Hence, we instead need to insure against risks to some comprehensive measures of economic well-being such as income itself—a theme of a number of the ideas for fundamental risk management to be discussed later in this...

  7. Part Two: How Science and Technology Create New Opportunities in Finance

    • FIVE New Information Technology Applied to Risk Management
      (pp. 69-81)

      ADVANCES IN INFORMATION TECHNOLOGY promise to serve us very well in achieving radical financial innovation. As hardware capabilities steadily advance, so too do software capabilities, and, with them, the structure of our human organizations. At any time of fundamental technological change, our concepts, our units of measurement, and our framing of issues change. With such technological and cultural ferment afoot, fundamental transformations in the nature and quality of our lives are possible through financial progress.

      Consider the development of some important information technology that has been around for quite a while that we generally take for granted—very simple technology,...

    • SIX The Science of Psychology Applied to Risk Management
      (pp. 82-98)

      THE LAST FEW DECADES have seen great progress in research in the science of psychology. Financial innovators can make use of this research to help them better understand how the human mind assembles its view of the world and better devise new risk management technology that can manage society’s biggest risks. These risks evolve over very long periods of time and thus any institutions developed to manage them require substantial long-run reliability and stability. Ultimately, these institutions must make sense to people—which means they must start from a firm psychological footing.

      While the new information technology makes many things...

    • SEVEN The Nature of Invention in Finance
      (pp. 99-104)

      THUS FAR, we have reviewed some of the largest economic risks that people face, as well as the information technology and science of psychology that can help us devise powerful new financial technologies that will improve our lives. In part 3, I will offer some ideas of the major directions that such innovations might take.

      Before getting into the specific ideas, however, a few brief reflections on the nature of invention in finance are called for. For some readers who are already involved with financial innovation, these reflections may be unnecessary. But many readers may be unaccustomed to thinking of...

  8. Part Three: Six Ideas for a New Financial Order

    • EIGHT Insurance for Livelihoods and Home Values
      (pp. 107-120)

      CONSIDER THE SITUATION of a young person who is considering seriously preparing for an ambitious and focused career, for example, a young man who is thinking of a pursuing an advanced degree in biochemistry with a specialty in recombinant DNA technology, writing his dissertation in a laboratory specializing in adenovirus vectors. Getting the degree would be an investment measured in years and would prepare him with highly specialized knowledge. As with the novice violinist in the introduction to this book, our potential biochemist is confronted with a personal dilemma that reflects a range of risks.

      Who knows what incomes of...

    • NINE Macro Markets: Trading the Biggest Risks
      (pp. 121-138)

      IMAGINE A MARKET for the entire U.S. economy made possible by a security that pays on each share a quarterly dividend equal to a specified fraction, say, one trillionth, of that quarter’s U.S. GDP. Each holder of a share would be entitled to receive this dividend each quarter indefinitely. The U.S. government or private U.S. entities who contract to pay these dividends could issue these securities.

      Based on the current U.S. economy, with a fraction of a trillionth of GDP, the dividend on one share would be about $2.50 quarterly, or ten dollars each year, and this dividend would subsequently...

    • TEN Income-Linked Loans: Reducing the Risks of Hardship and Bankruptcy
      (pp. 139-148)

      IT MAKES LITTLE SENSE, now that our information technology has improved so much, to subject borrowers to conventional fixed nominal interest rates on their debts. This old system deals with income uncertainty by letting financial problems build until they reach a breaking point, sometimes creating great distress, at which time borrowers can obtain some relief, at the expense of some humiliation, by bankruptcy proceedings. Far better would be the smooth adjustment of debts to new economic circumstances. Loans that are designed to do this could be the standard, the generic personal loan, to purchase houses, to upgrade houses, to provide...

    • ELEVEN Inequality Insurance: Protecting the Distribution of Income
      (pp. 149-164)

      IF THE WORLD IS TO MANAGE its political and economic affairs effectively, society must prevent any substantial worsening of economic inequality among its citizens. We will want to arrest any possible tendency for the fruits of our economy to be distributed much more unequally between rich and poor in the future.

      The idea for inequality insurance presented here is that the government should set by legislation the level of income inequality, in most cases probably initially roughly equal to the level of inequality today, and create a tax system that prevents inequality from getting worse. The idea is that if...

    • TWELVE Intergenerational Social Security: Sharing Risks between Young and Old
      (pp. 165-174)

      IN AN INFLUENTIAL 1994 REPORT,Averting the Old Age Crisis,the World Bank sounded an alarm for most of the world.¹ The report asserted that certain of our hopes for social progress, the reduction of the once-rapid world population growth and the improvement of life expectancy, have succeeded so well that they will create an unprecedented new problem: a rising number of elderly people as a fraction of the world’s population.

      According to the report, in 1990 there were five hundred million people in the world over the age of sixty. By 2030, there will be 1.4 billion. Either the...

    • THIRTEEN International Agreements for Risk Control
      (pp. 175-186)

      BETWEEN 1965 AND 1990, the economic fortunes of two countries on opposite sides of the globe—Argentina and South Korea—experienced a sharp reversals. In 1965 the per capita real GDP in South Korea was $1,754. That same year, the per capita real GDP in Argentina was $8,371, nearly five times as high. At that time, South Korea looked like a country that might humbly ask Argentina for foreign aid. But by 1990, twenty-five years later, South Korea’s per capita real GDP had risen to $10,087, while Argentina’s per capita real GDP hadfallento $7,158.¹ Now South Korea was...

  9. Part Four: Deploying the New Financial Order

    • FOURTEEN Global Risk Information Databases
      (pp. 189-201)

      PRESENT-DAY INSURANCE and financial systems, so vital to individual well-being and social welfare, would be impossible without data—from actuarial tables to corporation balance sheets, drivers’ records, employment information, credit and housing histories, tax records, and more. Data sources of all kinds allow for the effective estimation and pricing of risk and facilitate the smooth and continuous negotiation of contracts, claims, adjustments, and payments. If we as a society are to expand these risk management institutions to incorporate more kinds of risks, all of us—citizens, insurers, investment managers, bankers and government agencies—will need better, more encompassing databases and...

    • FIFTEEN New Units of Measurement and Electronic Money
      (pp. 202-221)

      THE FAILURE OF MONEY to serve as a stable and sensible unit of measurement for financial transactions has caused innumerable financial dislocations. The dislocations caused by inflation or deflation are so well known that the public in virtually every country of the world has become fixated on the uncertainties of the value of money.

      A computer search of English language newspapers in the late twentieth century shows that the word “inflation” was the most commonly used economic term of all; in fact, newspapers use “inflation” more than “sex.” All this public attention to inflation is not because of some inherent...

    • SIXTEEN Making the Ideas Work: Research and Advocacy
      (pp. 222-228)

      TO MAKE THE IDEAS for risk management work, we need more than has already been outlined. We need further research on risks, research that can be done in conjunction with information on the GRIDs, research to identify the opportunities for risk sharing. And we need broad advocacy by public groups and authorities who represent the interests of various segments of society.

      Risk identification means the discovery and measurement of opportunities for risk sharing. Learning where the large uncertainties lie is vital, as is identifying where different people have very different kinds of risks. Only when we deal with these large...

  10. Part Five: The New Financial Order as a Continuation of a Historical Process

    • SEVENTEEN Lessons from Major Financial Inventions
      (pp. 231-244)

      MOST FINANCIAL INNOVATION is accretive, that is, it builds in small ways upon past innovation. The steady improvement in financial technology that such accretion affords is important. Most of us, observing in our lives only the succession of small changes, are unfamiliar with the potential of radical financial innovation. Our unfamiliarity may lead us to underestimate the possibility of fundamental change, and to despair excessively that it will ever happen in the future.

      The history of some of the financial devices that we already have can shed light on the possibilities for the new technology that we are developing today,...

    • EIGHTEEN Lessons from Major Social Insurance Inventions
      (pp. 245-268)

      LET US NOW CONSIDER some of our most important social insurance inventions (risk management created for every member of a nation by its national leaders, usually members of the government), and their relevance to the future. Consideration of social welfare systems for risk management is especially important if one considers the risk posed by new technology, new information technology, automation, and the like, possibly in combination with other changed economic factors such as the “forty thieves” discussed in chapter 4—risks that could cause a major worsening of income inequality that lasts for decades or even centuries. This sharp increase...

    • EPILOGUE A Model of Radical Financial Innovation
      (pp. 269-276)

      IT REMAINS NOW to pull various ideas together into a model of really significant financial innovation, not just incremental innovation that has no larger direction or strategy, but innovation that can be transforming to our lives. We have already seen most of the basic elements of a model of radical financial innovation, with the various ideas for risk management institutions, the GRIDs and indexed units of account, the directions for research on risks and of advocacy for change. And we have seen some concrete illustrations of these principles in examples from history. But we need to distill from the analysis...

  11. Notes
    (pp. 277-324)
  12. References
    (pp. 325-350)
  13. Index
    (pp. 351-366)