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Financial innovations soften capitalism's bite

By Robert Shiller

Friday, Jun 06, 2003, Page 9

ILLUSTRATION: MOUNTAIN PEOPLE

Advancing technology has driven some of the biggest changes in human history. In finance and information technology, new developments soon promise to bring deep and fundamental transformations to the world economy.

Capitalism is the world's engine of growth. But because of its dynamism, capitalism tends to produce great uncertainties. It works through a process of "creative destruction," whereby relatively unsuccessful firms are tossed aside to make way for better firms. Individuals who (often through no fault of their own) become economically less productive can also be "discarded" by the market -- their careers interrupted and their investments cut to a fraction of their previous value.

Capitalism's bumpy ride has been at the root of demands for the state to intervene and protect the individual against the market's mercilessness. Beginning with Bismarck's social security system in 19th century Germany, through the American New Deal of the 1930s, to the social-democratic policies of postwar Europe, many countries created a "mixed" welfare state in which governments control and temper market forces, providing an extensive "safety net" for individuals.

Notwithstanding its achievements, many people believe that the welfare state comes at too high a price in terms of dampening economic dynamism. The prospect raised by today's new technologies in finance and information is that some of the "market failures" at the root of state involvement in the economy may cease to exist. Indeed, the very capitalism that generates unacceptable risk to individuals is poised to deliver the means for tempering the risks incited by "creative destruction."

In fact, the most important capitalist mechanisms for blunting the impact of risk on individuals -- insurance,diversification, and hedging -- have been around for centuries. But broader application of these tools has accelerated with the advent of new information technology, which also allow us to apply these tools without adversely affecting the incentives people have to work.

Indeed, the world seems to be entering an age of financial capitalism in which the basic principles of finance, and related fields of insurance and public finance, will be integrated into the world capitalist economy, and our lives, in a more thoroughgoing way than ever before. Aided by advanced information technology, financial institutions will be democratized and made available to everyone, which will go a long way toward solving today's problems of increasing inequality and declining economic vitality.

An example of recent progress illustrates what I mean. For most middle-class people in developed countries, the home they own is their most valuable asset. Although the postwar population boom and heavy regulation meant that real-estate prices in many countries went up more often than down, a sudden collapse of the property market -- such as happened in Japan a decade ago -- may dramatically reduce the value of most people's savings.

Such a financial "hit" may affect their consumption patterns, complicate their retirement plans, even bring them to the brink of indigence. Yet, until recently, one could insure one's home against fire or other damage, but not against reduction in value.

That is changing. Without attracting much notice, two important events recently took place.

First, in October 2001, futures markets on home prices in the UK were created by the spread-betting firm City Index. Last month, the investment bank Goldman Sachs created options markets for home prices, both for the UK as a whole and for Greater London, both to be traded on the London Stock Exchange. Theoretically, homeowners can use these new instruments to protect themselves against their home losing value. But these instruments are rather sophisticated -- too sophisticated, in fact, for most homeowners to deal in.

Second, last July, the city of Syracuse, New York, in conjunction with the Neighborhood Reinvestment Corporation, the Yale School of Management and Realliquidity, LLC, created home equity insurance that pays out if an index of city home prices declines. It is also, for the time being, a limited development. Like the British home price options and futures, this novel insurance policy was made possible by the new information technology in the form of electronic databases of home prices and characteristics.

Someday, these two institutions will be brought together in one country. Regulators permitting, insurance companies will then be able to write policies against loss of home value for individuals, and then will be able protect themselves against the risk to which these policies expose them by taking offsetting positions in the futures or options markets. This should make them willing to offer such policies to millions of people in different localities.

Home equity insurance will clearly not solve all the problems of individual risks, but it will solve a very big one. Moreover, it is only one example of the democratization of finance now underway. Further advances along these lines will follow.

Many risks are gradually being added to the list of those that can be insured against. The types of risks traded on electronic marketplaces are steadily expanding. Trading platforms are being improved to allow more complex trading. Databases are rapidly improving in depth, with personal financial planning Web sites more deeply integrated with them. Even systems of taxation and social welfare are more sophisticated in using insurance, financial and information technology.

Our mechanisms for dealing with risks can become increasingly differentiated and complex. With modern computers and information technology, it will be possible to deal individually with a million different risks. The combined effect of many different financial innovations will blunt the impact of capitalist risk on our individual lives, helping reduce economic inequality.

Robert Shiller is professor of economics at Yale University and author of The New Financial Order: Risk in the 21st Century.

Copyright: Project Syndicate
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