A slight but nonetheless thoughtful book, "Reforming U.S. Financial Markets: Reflections Before and Beyond Dodd-Frank," (MIT Press, 2011) grew out of the fifth Alvin Hansen Symposium on Public Policy held at Harvard in 2009. At this symposium Robert J. Shiller and Randall S. Kroszner presented papers, which were then commented on by Benjamin M. Friedman (the editor of this volume), George G. Kaufman, Robert C. Pozen, and Hal S. Scott.
I assume those readers who watch CNBC are acquainted with Shiller and Kroszner, since both are frequent guests. Shiller, a professor of economics at Yale University, is probably best known for his book "Irrational Exuberance." He also developed, with Karl E. Case, the Case-Shiller home price indices that depress us month after month. Kroszner, a professor of economics at the University of Chicago’s Booth School of Business, is a former fed governor.
In this post I want to concentrate on a couple of points in Shiller’s more controversial paper, “Democratizing and Humanizing Finance,” described by Pozen as “almost philosophical.” (p. 102)
Shiller is a firm believer in regulation: “[m]arkets and government,” he writes, “are … inseparable.” (p. 14) Not surprisingly, he considers deregulation, a product of the conservative movement in both government and the halls of academe, one of the causes of the financial crisis. Deregulation not only wanted to get rid of all the referees in the financial “games,” a move that Shiller deems counterproductive: “Referees, and a good set of rules, prevent the rough play and cheap moves that would actually compromise the abilities of the best players.” (p. 24) It also rested on shaky theoretical foundations in the form of the efficient markets hypothesis.
Shiller quotes from the second (1984) edition of the popular finance textbook "Corporate Finance" by Brealey and Myers, written near the height of the popularity of the efficient markets hypothesis: “We recommend that financial managers assume that capital markets are efficient unless they have a strong, specific reason to believe otherwise. This means trusting market prices and trusting investors to recognize true economic value.” (p. 22) Bubbles, in brief, don’t exist.
A couple of devastating bubbles later, we might be inclined to agree with Shiller that “the efficient markets hypothesis is one of the most remarkable errors [or half-truths] in the history of thought, given its impact on our economic institutions and on the economy.” (p. 30) In its stead Shiller recommends relying on that faculty of the brain (theory of mind--ToM) “which formulates an assessment of the thoughts, incentives, and pretenses of others; that is, a faculty that looks into, and forms a judgment of, others’ minds.” (p. 6) ToM research is intriguing and echoes some early market wisdom (think Wyckoff), but it remains largely a work in progress.
Democratizing finance is a daunting task, and Shiller’s suggestions don’t seem particularly practical. He thinks that hedging markets, addressed to broad swaths of the population, should be encouraged. One such effort, the CME’s housing index futures launched in 2006, has been a flop. “The hope when this market was launched was that it would be the basis for creation of new retail products that would democratize finance by addressing the real risks that homeowners face.” (p. 32) So far this hasn’t panned out. Shiller also advocates subsidizing financial advisors for everybody and eliminating the wealth and income requirements for accredited investor status.
In posing the questions of how finance can be humanized and how it can be democratized Shiller assumes, of course, that finance should be both humanized and democratized. And I’m certain that many theoreticians and practitioners would line up on the other side of the divide. But I think the burden of proof lies with them. (This is a really cheap way of getting out of writing a treatise on the subject.)
Occasionally we should all step back from our daily routine and think about this slice of the world in which we try to earn our keep. Perhaps we could even help someone else understand what it is all about and how they might more fruitfully participate. Think about the possibilities of a volunteer domestic financial corps. That could be a form of grassroots democratization.