| The Subprime Solution |
| Robert Shiller, Princeton University Press, 2008, 208 pages, £9.95. |
| This is an important book from a distinguished academic. Not long ago it might have seemed alarmist, but now, in the wake of nationalizations and the demise of the American investment banking model, it looks remark-ably prescient. The argument is straightforward, the prose clear and concise. |
| The sub-prime disaster, says Shiller, is an epochal event, on a par with the Great Depression. It has the potential to change the nature of our social and economic relations forever. We face a choice: do nothing and the economic devastation that follows could destroy our faith in the capitalist economy; or, follow Roosevelt’s example and, with enlightened institutional reform, the world can end up a better place. This, then, is the modern economist as saviour. |
| He rightly emphasizes the importance of the housing bubble: |
| “The view that the ultimate cause of the global financial crisis is the psychology of the real estate bubble ... has ... been expressed before. But ... accounts of the crisis often ... place the ultimate blame entirely on such factors as growing dishonesty among mortgage lenders, increasing greed among securitizers ... or the mistakes of ... Alan Greenspan.” (p 4) |
| Bubble psychology is part of the human condition. In placing irrational, herd-seeking behaviour at the centre of his explanation, Shiller makes a decisive break with the dominant intellectual tradition: he is Keynes to Merton’s Pigou. Bubbles and the swing from greed to fear and back again define financial market history. Policy cannot therefore be based on models that axiomatically rule out the possibility of irrational bubbles. The first step must be to recognize that bubble psychology is endemic, and that institutions must be established to deal with this. |
| But before we get to the long run, we must deal with today’s mess. Here, Shiller is an unapologetic proponent of bailouts. He believes the govern-ment will ultimately have to take all toxic mortgages onto its balance sheet. |
| In discussing long-term solutions, the narrative takes an unexpected and interesting turn. In short, financial markets are part of the solution, not the problem. Ideally, individuals should be able trade a much wider variety of risks, using plain-vanilla instruments like futures and options, through simple, government-regulated retail products. These risks include labour income risk and house price risk, and he advocates new products such as ‘continuous workout mortgages’ where payments are linked to short-term ability to pay. |
| Governments will have to regulate standards and provide a much higher level of financial education than hitherto – a public good that the private sector will not provide. The answer is not an overweening regulatory bureaucracy, but a set of market-enhancing institutions that will radically change the way we conduct our lives. They will manage and diversify financial risks more effectively and in doing so democratize the access to finance. Well-designed institutions, coupled with proper regulation can overcome individual irrationality and abolish the boom-bust cycle. |
| But can they really? No matter how well informed, will individuals be prepared to run short positions on the value of their house that stay ‘under water’ for years at a time? Will new institutions overcome the logic of the ‘Black Swan’: that people are incapable of quantifying extreme risk? And can these new institutions abolish moral hazard and adverse selection? Experience suggests insurance markets go missing just when we need them most. |
| More prosaically, will these proposals fly? I fear not; they may be too radical. Market-based solutions jar too much with the zeitgeist for politicians to risk promoting them. But the ideological battle is just beginning. There is a danger that the pre-1980s world of credit rationing will return. This book offers a coherent alternative to policy makers. They should consider its recommendations very seriously. |
| Shamik Dhar |
| Fathom Consulting |
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