Yale University economist Robert Shiller defends the social value of financial innovation, in a Vox Talks interview recorded in May 2012. He surprised me with a Panglossian response to the following two questions.
RV: You’ve described a couple of financial innovations [the benefit corporation and the social impact bond] that have a really pro-social motivation. But when a lot of people think of financial innovation they think of specific things like collaterised debt obligations and credit default swaps and the kinds of things that people think contributed to the crisis.
Shiller: Collateralised debt obligations are a source of problems because they were flawed and they did help worsen the crisis. But I think collateralised debt obligations are in the same category as the things I just mentioned. What they do is they make it easier for people to buy a house. What they do is they take mortgages and package them, and then they split them up into tranches, and they have a triple-A tranch which is thought to be safe. It wasn’t, as it turned out, but next time they’ll get the problems ironed out and it will be. So they ’re able to get investors investing in the mortgages. The ultimate thing is, and it’s kind of hard to see but it’s real, it ought to bring down the mortgage rate. And that means bringing more people into housing than there could have been. We don’ know who they are, but there are some families living in homes who otherwise couldn’t afford that if there weren’t collateralised debt obligations. I have nothing to do with these people who issue CDOs, and I don’ mean to sound like they did it right, but I don’ think it’s in a different category. I think it’s something that has a social benefit.
RV: In the wake of the crisis there’s also been talk about finance just being too complicated. Some of these innovations have been too complicated even for the organisations that have made them. So the kind of people who were running organisations, dreaming up new kinds of derivatives, didn’t really understand what was going on. That must be a real problem with financial innovation, that the people in charge don’ really understand the technology that they ’re using.
Shiller: That is a problem, and I would say that it’s a problem with technology in general. When someone designs an airplane, if it gets too complicated then the engineers don’ understand what’s happening. This is to do with systems, so if you ’re designing an air traffic control system and it’s too complicated, there’s going to be a catastrophe. But on the other hand I’ thinking that modern civilisation with modern computers can create some pretty complicated things. I’m thinking of, for example, the automobile. It’s got more and more complicated over the years and it’s getting harder and harder for the backyard mechanic who wants to fix the car. So you take it out to a dealer who has a computerised diagnostic system and so on. That’s the kind of society we’re living in. We always have to be mindful of some catastrophe that could result from our not understanding the complexity, definitely. But on the other hand I think we’re on a secure trend to more complexity, and computers are an important reason why we are. Life is going to get more and more complex and specialised, that’s pretty inevitable while civilisation advances.
“Finance and the good society“, Robert Shiller interviewed by Romesh Vaitilingam, Vox Talks, 27 July 2012.
I don’t understand Shiller’s comparison of the complexity of machines (computers, automobiles, airplanes) to the complexity of financial products. There is no need for me to understand how a computer or an automobile is constructed in order to make an intelligent purchase or operate a particular model. And there is no need for me to repair a malfunctioning computer or automobile. Nor do pilots need to know how a airplane is built, or how to repair it. Financial products have more in common with air traffic control systems. If they become too complex, they might have design flaws that are unknown to users. In the case of finance, there is the added problem that financial ‘experts’ can (and do) sell complex, flawed products to investors, enriching themselves at the expense of their unsuspecting clients.
Flaws in the design of complex automobiles, airplanes and computers quickly reveal themselves, so damage is kept to a minimum. Flaws in the design of complex air traffic control systems or financial products, in contrast, might remain hidden for years, with catastrophic consequences. Simplicity is thus a virtue for the latter, but not for the former type of product. This, at least, is how I see the problem.
Simplicity alone, however, will not correct a poorly functioning financial industry. Basic financial literacy is essential. Life insurance is not a particularly complex product; nonetheless, the vast majority of consumers pay far more than they should for protection, often in the form of “whole life” instead of term insurance. Reliance on the advice of financial experts (or insurance salesman) is not likely to produce good results for consumers.
There is much more in the full interview, and in Professor Shiller’s new book, Finance and the good society (Princeton University Press, 2012).
Tags: Robert Shiller