NEW HAVEN – The basic principle of financial risk management is sharing. The more broadly diversified our financial portfolios, the more people there are who share in the inevitable risks – and the less an individual is affected by any given risk. The theoretical ideal occurs when financial contracts spread the risks all over the world, so that billions of willing investors each own a tiny share, and no one is over-exposed.
The case of Japan shows that, despite some of our financial markets’ great sophistication, we are still a long way from the theoretical ideal. Considering the huge risks that are not managed well, finance, even in the twenty-first century, is actually still rather primitive.
A recent World Bank study estimated that the damage from the triple disaster (earthquake, tsunami, and nuclear crisis) in March might ultimately cost Japan $235 billion (excluding the value of lives tragically lost). That is about 4% of Japanese GDP in 2010.
Given wide publicity about international charitable relief efforts and voluntary contributions to Japan, one might think that the country’s economic loss was shared internationally. But newspaper accounts suggest that such contributions from foreign countries should be put in the hundreds of millions of US dollars – well below 1% of the total losses. Japan needed real financial risk sharing: charity rarely amounts to much.
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Friday, May 27, 2011
Tuesday, May 10, 2011
Continuous Workout Mortgages
By Robert J. Shiller, Rafal M. Wojakowski, M. Shahid Ebrahim and Mark B. Shackleton
The ongoing crisis has exposed the vulnerability of the most sophisticated financial structures to systemic risk. This crisis—emanating from mortgage loans to borrowers with high credit risk—has devastated the capital base of financial intermediaries on both sides of the Atlantic. Its impact on the real sector of the economy has given rise to a fear and uncertainty not seen since the Great Depression of the 1930s.
The fragility of the financial intermediaries stems from the rigidity of the traditional mortgage contracts such as the Fixed Rate Mortgages (FRMs), Adjustable Rate Mortgages (ARMs) and their hybrids.
Read full paper [pdf]
The ongoing crisis has exposed the vulnerability of the most sophisticated financial structures to systemic risk. This crisis—emanating from mortgage loans to borrowers with high credit risk—has devastated the capital base of financial intermediaries on both sides of the Atlantic. Its impact on the real sector of the economy has given rise to a fear and uncertainty not seen since the Great Depression of the 1930s.
The fragility of the financial intermediaries stems from the rigidity of the traditional mortgage contracts such as the Fixed Rate Mortgages (FRMs), Adjustable Rate Mortgages (ARMs) and their hybrids.
Read full paper [pdf]
Saturday, April 30, 2011
Needed: A Clearer Crystal Ball
THERE were relatively few persuasive warnings during the 1920s that the Great Depression was on its way, and few argued convincingly during the last decade that the most recent economic crisis was near. So it’s easy to conclude that because we didn’t see these events coming, nothing could have been done to prevent them.
In fact, some people view the recent crisis as just another “black swan event,” one of those outliers, as popularized by Nassim Taleb, that come out of the blue. And it’s clear that a lot of smart people simply didn’t see the housing bubble, the instability of our financial sector or the shock that came in 2007 and 2008.
But the theory of outlier events doesn’t actually say that they cannot eventually be predicted. Many of them can be, if the right questions are asked and we use new and better data. Hurricanes, for example, were once black-swan events. Now we can forecast their likely formation and path pretty well, enough to significantly reduce the loss of life.
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In fact, some people view the recent crisis as just another “black swan event,” one of those outliers, as popularized by Nassim Taleb, that come out of the blue. And it’s clear that a lot of smart people simply didn’t see the housing bubble, the instability of our financial sector or the shock that came in 2007 and 2008.
But the theory of outlier events doesn’t actually say that they cannot eventually be predicted. Many of them can be, if the right questions are asked and we use new and better data. Hurricanes, for example, were once black-swan events. Now we can forecast their likely formation and path pretty well, enough to significantly reduce the loss of life.
Read full commentary
Saturday, April 2, 2011
Economists as Worldly Philosophers
By Robert J. Shiller and Virginia M. Shiller
In his influential 1953 book The Worldly Philosophers: The Lives, Times And Ideas Of The Great Economic Thinkers, Robert Heilbroner gave an inspirational account of what economists do, an account that was assigned as supplemental reading to countless beginning economics students over decades. Heilbroner wrote that he chose the term “worldly philosophers” because of the breadth and moral depth of economists’ inquiry. The appellation stuck, and for many years it was common to refer to economists as worldly philosophers. The inspiration of that book has contributed to the desire for many to go on to become economists, and to productive lives as researchers.
But, while the volume of research turned out by economists is most impressive, there are questions whether “worldly” and “philosophical” are represented as much as they should be in economic research. Has economics as a profession substantially lost sight of the idealism that existed in earlier decades? Has the strong impulse to pursue narrow specialization in order to propel research to the frontier led to some loss of moral perspective?
Read paper
In his influential 1953 book The Worldly Philosophers: The Lives, Times And Ideas Of The Great Economic Thinkers, Robert Heilbroner gave an inspirational account of what economists do, an account that was assigned as supplemental reading to countless beginning economics students over decades. Heilbroner wrote that he chose the term “worldly philosophers” because of the breadth and moral depth of economists’ inquiry. The appellation stuck, and for many years it was common to refer to economists as worldly philosophers. The inspiration of that book has contributed to the desire for many to go on to become economists, and to productive lives as researchers.
But, while the volume of research turned out by economists is most impressive, there are questions whether “worldly” and “philosophical” are represented as much as they should be in economic research. Has economics as a profession substantially lost sight of the idealism that existed in earlier decades? Has the strong impulse to pursue narrow specialization in order to propel research to the frontier led to some loss of moral perspective?
Read paper
Tuesday, March 22, 2011
Bubble Spotting
NEW HAVEN – People frequently ask me, as someone who has written on market speculation, where the next big speculative bubble is likely to be. Will it be in housing again? Will it be in the stock market?
I don’t know, though I have some hunches. It is impossible for anyone to predict bubbles accurately. In my view, bubbles are social epidemics, fostered by a sort of interpersonal contagion. A bubble forms when the contagion rate goes up for ideas that support a bubble. But contagion rates depend on patterns of thinking, which are difficult to judge.
Big speculative bubbles are rare events. (Little bubbles, in the price of, say, individual stocks, happen all the time, and don’t qualify as an answer to the question.) And, because big bubbles last for many years, predicting them means predicting many years in the future, which is a bit like predicting who will be running the government two elections from now.
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I don’t know, though I have some hunches. It is impossible for anyone to predict bubbles accurately. In my view, bubbles are social epidemics, fostered by a sort of interpersonal contagion. A bubble forms when the contagion rate goes up for ideas that support a bubble. But contagion rates depend on patterns of thinking, which are difficult to judge.
Big speculative bubbles are rare events. (Little bubbles, in the price of, say, individual stocks, happen all the time, and don’t qualify as an answer to the question.) And, because big bubbles last for many years, predicting them means predicting many years in the future, which is a bit like predicting who will be running the government two elections from now.
Read full commentary
Saturday, March 19, 2011
Economic View: Share the Risk and Share the Harvest
NOT so very long ago, most Americans lived on farms, with three generations under one roof: grandparents, parents and children.
Farming was — and still is — a risky undertaking. Sometimes, you have good weather and abundant crops, sometimes bad weather and meager crops. How did our forebears manage their risks, which were as significant for them as the booms and busts of our 21st-century economy are to us?
In good times, all three generations consumed a lot. In bad times, all three consumed less. The risks were spread among the extended family. This is risk management at its most basic level. It is called sharing.
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Farming was — and still is — a risky undertaking. Sometimes, you have good weather and abundant crops, sometimes bad weather and meager crops. How did our forebears manage their risks, which were as significant for them as the booms and busts of our 21st-century economy are to us?
In good times, all three generations consumed a lot. In bad times, all three consumed less. The risks were spread among the extended family. This is risk management at its most basic level. It is called sharing.
Read full commentary
Saturday, February 5, 2011
Housing Bubbles Are Few and Far Between
WHAT’S the outlook for home prices over the next decade? It’s not easy to tell. We need to confront the basic fact that near the beginning of the 21st century, the market for homes in much of the world suddenly became more speculative than ever.
This enormous housing bubble and burst isn’t comparable to any national or international housing cycle in history. Previous bubbles have been smaller and more regional.
We have to look further afield for parallels. The most useful may be the long trail of booms and crashes in the price of land, particularly of farms, forests and village lots. Those upheavals may give some insights into the present situation, and some guidance for the next decade.
Read full commentary
This enormous housing bubble and burst isn’t comparable to any national or international housing cycle in history. Previous bubbles have been smaller and more regional.
We have to look further afield for parallels. The most useful may be the long trail of booms and crashes in the price of land, particularly of farms, forests and village lots. Those upheavals may give some insights into the present situation, and some guidance for the next decade.
Read full commentary
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