Fiscal Studies

Robert Shiller, who shares this year's Nobel Prize with Eugene Fama and Lars Peter Hansen, is perhaps most famous for his ability to "predict the future." But he also has an impressive grasp of the past. As just one example, in my recent blog post on the history of inflation-protected securities, Shiller's paper on "The Invention of Inflation-Indexed Bonds in Early America" was the most useful reference. Shiller's ability to develop intuition from financial history has, I believe, contributed to his success in behavioral finance, or "finance from a broader social science perspective including psychology and sociology."

Rather than attempting a comprehensive overview of Shiller's work, in this post I would like to focus on "Radical Financial Innovation," which appeared as a chapter in Entrepreneurship, Innovation and the Growth Mechanism of the Free Market Economies, in Honor of William Baumol (2004).

The chapter begins with some brief but powerful observations:

According to the intertemporal capital asset model... real consumption fluctuations are perfectly correlated across all individuals in the world. This result follows since with complete risk management any fluctuations in individual endowments are completely pooled, and only world risk remains. But, in fact, real consumption changes are not very correlated across individuals. As Backus, Kehoe, and Kydland (1992) have documented, the correlation of consumption changes across countries is far from perfect…Individuals do not succeed in insuring their individual consumption risks (Cochrane 1991). Moreover, individual consumption over the lifecycle tends to track individual income over the lifecycle (Carroll and Summers 1991)... The institutions we have tend to be directed towards managing some relatively small risks."

Shiller notes that the ability to risk-share does not simply arise from thin air. Rather, the complete markets ideal of risk sharing developed by Kenneth Arrow "cannot be approached to any significant extent without an apparatus, a financial and information and marketing structure. The design of any such apparatus is far from obvious." Shiller observes that we have well-developed institutions for managing the types of risks that were historically important (like fire insurance) but not for the significant risks of today. "This gap," he writes, "reflects the slowness of invention to adapt to the changing structure of economic risks."

The designers of risk management devices face both economic and human behavioral challenges. The former include moral hazard, asymmetric information, and the continually evolving nature of risks. The latter include a variety of "human weaknesses as regards risks." These human weaknesses or psychological barriers in the way we think about and deal with risks are the subject of the behavioral finance/economics literature. Shiller and Richard Thaler direct the National Bureau of Economic Research working group on behavioral economics.

To understand some of the obstacles to risk management innovation today, Shiller looks back in history to the development of life insurance. Life insurance, he argues, was very important in past centuries when the death of parents of young children was fairly common. But today, we lack other forms of "livelihood insurance" that may be much more important in the current risk environment.

"An important milestone in the development of life insurance occurred in the 1880s when Henry Hyde of the Equitable Life Assurance Society conceived the idea of creating long-term life insurance policies with substantial cash values, and of marketing them as investments rather than as pure insurance. The concept was one of bundling, of bundling the life insurance policy together with an investment, so that no loss was immediately apparent if there was no death. This innovation was a powerful impetus to the public’s acceptance of life insurance. It changed the framing from one of losses to one of gains…It might also be noted that an educational campaign made by the life insurance industry has also enhanced public understanding of the concept of life insurance. Indeed, people can sometimes be educated out of some of the judgmental errors that Kahneman and Tversky have documented…In my book (2003) I discussed some important new forms that livelihood insurance can take in the twenty-first century, to manage risks that will be more important than death or disability in coming years. But, making such risk management happen will require the same kind of pervasive innovation that we saw with life insurance."

Shiller has also done more technical theoretical work on the most important risks to hedge:

"According to a theoretical model developed by Stefano Athanasoulis and myself, the most important risks to be hedged first can be defined in terms of the eigenvectors of the variance matrix of deviations of individual incomes from world income, that is, of the matrix whose ijth element is the covariance of individual I’s income change deviation from per capita world income change with individual j’s income change deviation from per capita world income change. Moreover, the eigenvalue corresponding to each eigenvector provides a measure of the welfare gain that can be obtained by creating the corresponding risk management vehicle. So a market designer of a limited number N of new risk management instruments would pick the eigenvectors corresponding to the highest N eigenvalues."

Based on his research, Shiller has been personally involved in the innovation of new risk management vehicles. In 1999, he and Allan Weiss obtained a patent for "macro securities," although their attempt in 1990 to develop a real estate futures market never took off.

"First, while low rates might encourage spending if credit were easy, it is not at all clear that traditional savers today would go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough money to retire. Given the terrible returns on savings since 2007, the prospect of continuing low interest rates might make her put even more money aside. 

Alternatively, low interest rates could push her (or her pension fund) to buy risky long-maturity bonds. Given that these bonds are already aggressively priced, such a move might thus set her up for a fall when interest rates eventually rise. Indeed, America may well be in the process of adding a pension crisis to the unemployment problem."

"In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small...

I have heard from various business contacts that the low interest rate environment is spurring institutional and individual investors to “search for yield.” This may entail taking on more credit risk than these investors are typically comfortable with in a reach for yields that may ultimately be illusive and result in losses they are ill-equipped to handle. Very low yields may also be distorting other investment decisions, inducing firms to undertake long-run investment projects that may prove to be unprofitable in a rising interest rate environment."

Both Rajan and Plosser fear that lower interest rates won't help the economy because either the income effect dominates the substitution effect or because low interest rates will cause "reaching for yield." My fellow Not Quite Noahpinion author John Aziz suggests:

"Savers looking for a larger rate of return should... take their money out of low interest savings accounts and out of the failed financial intermediation industry and invest it into quality economic projects that create jobs and growth. This could involve buying the stock or debt of large companies that wish to expand, or it could involve starting your own business, or investing in a startup or a mixture of these things. The easiest way to return to growth — and thus higher interest rates, and higher returns for things like pension funds — is for today’s savers complaining about low interest rates to turn into tomorrow’s investors seeking out and pouring money into quality projects that increase incomes, create jobs and create products that people desire and want to use."

The question is whether low interest rates have the beneficial effect on investment that Aziz describes, or the harmful reach-for-yield effect. Returning to Plosser, Krugman, and Rajan, it is interesting that the three economists seem to diagnose what is ailing the economy quite similarly (a "persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy"), but make different prescriptions. First, they differ in their opinions of unconventional monetary policy:

• Plosser: "The first step is to wind down our asset purchases by the end of the year in a gradual and predictable manner. As I said, I see little if any benefit from these purchases, and growing costs. The second step is for the FOMC to commit to its forward guidance on the fed funds rate path, that is, to begin treating the 6.5 percent unemployment rate and the 2.5 percent inflation rate in the guidance as triggers rather than thresholds."
• Krugman: "Unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried)."
• Rajan: "We really don’t know. Given the dubious benefits of still lower real interest rates, placing central-bank credibility at risk would be irresponsible."

They also differ in their general policy prescriptions:

• Plosser wants removal of fiscal-policy-induced uncertainty: "There remains significant uncertainty about the choices that will be made. How much will tax rates rise? How much will government spending be cut? U.S. fiscal policy is clearly on an unsustainable path that must be corrected. Efforts by Congress and the administration at the end of last year reduced some of the near-term uncertainty over personal tax rates. But the impact of the sequester, the debate over the continuing resolution to fund the federal government beyond this month, and the debt ceiling, which will once again become binding in the spring, all have clouded the fiscal policy situation. So, the resultant uncertainty will likely be a drag on near-term growth. In my view, until uncertainty has been resolved, monetary policy accommodation that lowers interest rates is unlikely to stimulate firms to hire and invest."
• Krugman thinks the fiscal multiplier is large, and fiscal retrenchment would be destructive: "the logic for a biggish multiplier and the logic of the crisis itself are very closely linked: times like these, the aftermath of a credit bubble, are precisely when you expect fiscal multipliers to be large. And that in turn says, once again, that fatalism — or worse yet, demands for fiscal retrenchment — in the aftermath of such a bubble are deeply destructive."
• Rajan looks to helping households refinance, and (somehow) improving workforce capabilities: "We cannot ignore high unemployment. Clearly, improving indebted households’ ability to refinance at low current interest rates could help to reduce their debt burden, as would writing off some mortgage debt in cases where falling house prices have left borrowers deep underwater (that is, the outstanding mortgage exceeds the house’s value)... But it is also important to recognize that the path to a sustainable recovery does not lie in restoring irresponsible and unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance... Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes."