June 27, 2003

With a prescient stock market call in his 1998 work Irrational Exuberance, Yale economics professor Robert Shiller captured the limelight and the grudging admiration of the denuded investing public.

In The New Financial Order: Risk in the 21st Century, Shiller performs an even more spectacular feat. Using concepts from risk management and psychology, Shiller dresses up the rotting corpse of communism as the free-market, financial technology-based solution to all the world's problems.

Shiller's masterful performance pivots around the concept of "framing," which describes how the presentation of a choice affects the subsequent decision.

For example, suppose you are a deposed potentate with a secret offshore account. Only one of the two compliance officers at your private bank will reliably cover your tracks. The other will disappear with your money if he can, so using the bank is a fifty-fifty gamble.

You want to make use of $100 million of your nation's heritage. Do you spend $50 million bribing government mandarins to get the remainder in your hands, or try getting all of your hard-earned booty in a single shot? Most ruthless strongmen would take their chances.

Now, let's say an associate wants to wire you $100 million. Do you risk losing it all by having it forwarded offshore, or do you have it laundered into $50 million in liquid assets? Here, the discriminating dictator opts for the sure thing.

Answers to problems of this type depend on whether the situation is framed as a gain or a loss, even when the two are logically equivalent. To avoid losses, people take risks that they would otherwise shun when protecting gains.

Shiller extends this concept to raising government revenues. Instead of paying taxes on your gains, how about if a portion of your paycheck went towards (mandatory) "inequality insurance"? The "insurance" moniker gently frames what actually represents the polar opposite of a flat tax: Pool national income, subtract national spending, and then allocate the remaining funds back to individuals such that income inequality does not increase from current levels.

So if Mr. Gates doubles his holdings, his "insurance premium" would automatically redistribute all of his new, unnecessary wealth. Or, if Mr. Buffett were to overtake Mr. Gates, he could only keep just enough to put him as far ahead of everyone else as Mr. Gates had been before. The results would be no less perverse for the average citizen. If you kept your job while those around you were losing theirs, your effective tax rate would creep higher and higher. In return, your net worth could never fall below about one-millionth that of the richest person-who would get poorer by the year.

Wouldn't other countries overtake the U.S. economy as a result of this policy? No problem! Shiller expects governments to enter into GDP-growth swaps, by which economies booming above prior expectations would make payments to those failing to meet growth targets.

In Shillerville's private sector, markets would be encouraged to offer futures contracts on macroeconomic indicators, regional home prices and occupational incomes. Pricing these contracts would require extensive government-sponsored risk databases that track prices throughout the entire economy along with each person's financial status.

Then, financial institutions could underwrite new policies such as livelihood insurance. So if your college-bound son wants to play the tambourine, he could promise a percentage of his future income to pay for his tuition and his livelihood insurance. Then, if the average income for tambourine men falls, he would receive compensatory payments.

For extra money, he could take out an income-linked loan from a bank-if he has any human capital left to sell.

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Economics Imitates Art

Robert Shiller's New Financial Order brings to mind Thomas Pynchon's Vineland (1990), in which Zoyd Wheeler, an "official mental degenerate," receives a government stipend for crashing through plate glass windows in an annual display for the television news. When he instead tries to carve up a tavern with a chainsaw, the proprietor of the establishment warns him off:

"...it's become your MO, diving through windows, you start in with other stuff at this late date, forcing the state to replace what's in your computer file with something else, this is not gunno endear you to them, 'Aha, rebellious ain't he?' they'll say, and soon you'll find those checks are gettin' slower, even lost, in the mail..."

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Hey bankers, what would you do with a portfolio of non-performing human capital loans? Write to ischneider@cmp.com

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