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Fixing American finance

By Arvind Subramanian
September 17, 2008 13:02 IST
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First, Bear Stearns, Freddie and Fannie, now Merrill Lynch and Lehman Brothers, and possibly the American insurance giant AIG soon to come. American finance is having a great fall. The President's men are trying to put it together again. And, on occasion, the Sheikhs' men have ridden to the rescue too. Who could have guessed that the departing, lasting legacy of George W Bush's conservative administration would be the divvying up of the icons of American financial capitalism between Uncle Sam and foreign, mostly autocratic, governments?

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The tragedy, of course, is that tragedy was not inevitable. The fall of finance did not sneak up on the world, under cover of darkness. It was predictable and predicted. Among the many who did so, the most analytical Cassandra was Robert Shiller of Yale University. His "beware the bubble in the housing market" sounding was prescient strike two.

Strike one was his early warning about the outrageous stock market valuations that led to the bursting of the tech bubble in 2000. That warning and its memorable translation into euphemism - "irrational exuberance" - were embraced, even appropriated, by Alan Greenspan, even as he did little to prevent the bubble from inflating as Fed Chairman.

Lehman falls, Merrill sold, AIG tottering. What next?

But a flawless record in dire prediction is the lesser of Shiller's achievements. What sets Shiller apart - brilliantly apart - from other analyses of the housing bubble are the sharpness of his diagnosis and the creativity of his solutions. These are the core of his excellent new book, The Subprime Solution: How Today's Global Financial Crisis Happened and What to Do about It.

Why did house prices get so out of whack? The litany of explanations and the associated cast of culprits are long and familiar. Aggressive and sometimes unscrupulous lenders pushed mortgage loans out to complacent, gullible, and often uncreditworthy (subprime) borrowers, on terms that seemed enticingly low upfront.

When the real estate-backed loans were repackaged and sold to investors as securities, rating agencies routinely and irresponsibly graded them as high quality. Regulators looked away.

This binge of borrowing and re-borrowing was facilitated by cheap money at home and plentiful money abroad. And Americans were in collective denial that wealth cannot be created by selling the same asset-homes-to each other in part because the whole business had the conscience-assuaging egalitarian veneer of promoting homeownership, especially for low-income blacks. Life, liberty and the pursuit of happiness in the new millennium required not just the SUV but also a home, preferably a McMansion.

Shiller's contribution here is to view all these elements as important but not the real deal. The ultimate cause, according to him, was simply bubble psychology, the collective belief that had taken hold that house prices could only head in one direction, a belief reinforced by the observable reality that house prices were indeed steadily accelerating for several years.

Why is this diagnosis appealing? Because all the culpable actions - lazy home appraisals, regulatory neglect, dubious ratings and even the Greenspan "put" - were ultimately sustainable only because of the "social contagion," as Shiller aptly puts it, that house prices would not come down.

Shiller's focus on the fundamentals then naturally leads to his creative and original remedies. Caught up in the tangled web of proximate causes and multiple suspects, most mainstream analysts see the remedy largely in terms of better regulation.

Leave aside how this is achieved in practice, history shows with depressing regularity that regulation alone is unable to prevent speculative bubbles in assets whether they are tulips, art, stocks, or land.

Bubbles, alas, spring from some deep human hard-wiring that produces greed, avarice, denial, and complacency. Along comes Shiller, whose goal is nothing short of addressing this hard-wiring, and whose preferred method is to create a financial democracy, so that all financial consumers are empowered and educated to make sound financial decisions, reducing their key and inherent vulnerability - and hence that of theĀ  financial system - to bubble psychology.

To Shiller the solution is not a choice between markets and regulation but more of both in order to harness the true potential of finance while minimising its vulnerability. Trust should finally be reposed not just in regulators or markets but in financially literate and discerning consumers.

Some of the more innovative ideas include providing subsidised financial advice to customers, and setting up a financial product safety commission that would oversee financial product quality just like its consumer safety counterpart.

Two proposals are particularly appealing. Borrowing from the insights of behavioural finance, Shiller suggests the creation of default options for mortgages. These would be simple and geared for the average consumer to prevent him from succumbing to enticing but bad choices involving teaser interest rates, zero interest financing and other fancy financing arrangements whose complexity would elude most customers.

Defaults can be over-ridden but that would require a much greater degree of understanding that only the most sophisticated would possess. The creation of default options has acquired broader appeal in recent years and is in the spirit of the apparently oxymoronic principle of "libertarian paternalism": the paternalism arises because people have to be nudged away from making bad and self-defeating choices which they tend to out of myopia, inertia, or laziness. But the arrangement is libertarian because people retain the right not to chose the default option if they so wish.

Another suggestion is to create and popularise units of account called "baskets" so that all consumers can distinguish changes in the real values of assets from changes that merely reflect inflation. Even more radical ideas call for creating new financial markets for home equity insurance and insurance against occupational loss.

Finance is a problem, Shiller seems to acknowledge, but stresses that the problem is finance as we know it, and asserts that more finance, more innovative finance, and finance under an improved institutional setting is definitely the way forward.

As cries of Armageddon echo through Wall Street, cries that no longer sound unduly alarmist, it is worth pondering Robert Shiller's offering: a brilliant and radical but not implausible perspective on putting the Humpty Dumpty that is American finance together again.

The author is Senior Fellow, Peterson Institute for International Economics and Center for Global Development, and Senior Research Professor, Johns Hopkins University.
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