When innovation is the only remedy

The Subprime Solution
By Robert Shiller
Princeton, $16.95

Yale University’s Robert Shiller is one of the world’s outstanding economic thinkers and intellectual innovators, with a record of foresight that is the envy of his profession. Against the run of expert commentary, he correctly predicted the bursting of the stock market bubble at the start of this decade. Again in a small minority, he accurately forecast the collapse of the US housing market. His short, snappy and surprisingly far-reaching book on the subprime crisis is as interesting and indispensable as you would expect.

The Subprime Solution is an ambitious little volume: if anything, too much so. It covers a remarkable amount of ground in less than 200 (small) pages. In its second half, the proposals for reform arrive at a furious pace, and are presented too tersely to be entirely convincing. Yet the book’s broad framing of the issues is novel and valuable, and its arguments are always stimulating.

It starts with some historical context, focusing on lessons from the previous great US housing meltdown during the Great Depression. Shiller explains how that gave rise to a comprehensive programme of public and private institutional reform: the Federal Home Loan Bank system, a new bankruptcy law, the Home Owners’ Loan Corporation, the Federal Housing Administration, the Securities and Exchange Commission and so on. He argues that the current crisis calls for a similarly radical and encompassing response, as yet unforthcoming. He says that the measures adopted so far are inadequate to the scale and likely persistence of the subprime problem and its related ills.

Shiller’s central point is that remedies should not be organised around regulation, which aims to stifle or reverse financial innovation. Instead, his long-term remedy is more innovation in the correct institutional context. Meanwhile, in the shorter term, he calls for a greater willingness to arrange bail-outs of various kinds.

Governments are usually reluctant to call a bail-out a bail-out, but the book argues that there is no need to be em­barrassed. Sometimes they are necessary, and what matters then is to design them carefully, fund them adequately and act promptly. The fundamental purpose of a bail-out should not be to shore up inflated house prices or stock prices but to avoid a loss of confidence in economic institutions and maintain a sense of fairness. “The Federal Reserve has been bailing out troubled banks since it opened for business in 1914,”Shiller writes. “The Bank of England has been doing the same for hundreds of years. We must face up to the fact that we have not been able to avoid bail-outs in the past, and we cannot do so today.”

In the longer term, the goal should be to create what Shiller calls “financial democracy” – that is, extend the benefits of financial innovation to the widest span of society. In principle, mortgage securitisation aimed to do that, but the process was incomplete. The institutional foundations were missing and the information infrastructure, as the book calls it, was weak. Shiller’s principal focus is on how to improve the flow of information so that financial markets and financial innovation can foster financial security.

Shiller makes six proposals to improve the information infrastructure. First, ensure the supply of comprehensive, subsidised, fee-only financial advice to everyone. Second, create a financial product safety commission analogous to the one that oversees consumer products. (The US Treasury’s blueprint for reform envisages such a body.) Third, develop default-option financial plans – “authoritative assertion of new standard boilerplate for common contracts such as mortgages”.

Fourth, demand better financial disclosure; mortgage-backed securities were mispriced because of a lack of information about underlying loans. Fifth, develop new financial databases; this would allow the development of better measures of ability to pay in mortgage restructuring or “workouts”. Sixth, the most far-reaching idea, en­courage the indexation of contracts to inflation; homebuyers formed false ex- pectations of the return from ownership chiefly because of confusion over decades between real and nominal prices.

Shiller wants new markets as well: for instance, in house-price derivatives (allowing a bubble market to be stabilised). Building on better information and new markets, he calls for new risk-management technologies for everyman: continuous-workout mortgages (whose terms change month by month as circumstances alter); home equity insurance; and more comprehensive occupational income insurance.

Shiller, as you see, is an ardent financial-technology optimist, and his book is a torrent of fascinating ideas. Anybody interested in the subject must profit from reading it.

The writer is an FT columnist

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