RISK IN THE 21ST CENTURY

Outline
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Technological progress and the democratization of finance The largest economic risks facing us in coming decades and the prospect of Intolerable inequality Six ideas for a new financial order A Model of radical financial innovation

1. TECHNOLOGICAL PROGRESS AND THE DEMOCRATIZATION OF FINANCE

Progress in Finance

Theory of diversification and pooling Theory of moral hazard and how to limit it Theory of derivatives pricing Behavioral finance

Behavioral Finance

Psychological framing
Framing of gains versus losses, Kahneman and Tverskys Prospect Theory, Econometrica 1979 Framing of ones self image, Sherman JPSS 1980. Psych. Lab student and volunteeers

Anchoring Risk as feelings Desire for consistency and cognitive dissonance Reciprocity and ultimatum game

Progress in Information Technology

Database technology Technology of exchange Identification devices Encryption devices Decline of underground economy Increased complexity and enforceability of contracts

Democratization of Finance

Financial services once offered only to wealthy will be widely available

Online

auctions Online brokerages Personal finance sites Automation of tax collection

2. THE LARGEST RISKS FACING US IN COMING DECADES AND THE PROSPECT OF INTOLERABLE INEQUALITY

Lack of Public Appreciation of LongTerm Economic Risks

Little talk of long-term risks to standard of living Inequality around the world stands is dismissed as example of risk Human tendency to see economic outcome as proof of self worth Belief in a Just World: A Fundamental Delusion Melvin Lerner, 1980

Winner-Take-All

Stars created by movies, phonographs, television Advanced information technology may do the same for many occupations

Automation and Robotics

Spreadsheets replace accountants Industrial robots replace assembly line workers Fruit picking machines replace agricultural labor Computers replace translators Detection devices replace police

Risks of Globalization

Astonishing level of inequality across nations Communications technology: declining cost of telephones, introduction of e-mail, teleconferencing, reduce international barriers Multinational corporations English language

Uncertainty of Future

Extent of future inequality is unknown The fact that inequality hasnt sharply worsened since the Luddites is no proof it wont happen in next century Risks are still insurable

3. SIX IDEAS FOR A NEW FINANCIAL ORDER

I. Insurance on Livelihoods and Home Equity

Replaces life insurance in dealing with largest risks Livelihood insurance: long-term policies based on occupational indexes Repeated measures occupational indexes: Robert Shiller and Ryan Schneider Rev. Income and Wealth 1998 Powerful impact on conservatism in lifes decisions, makes for more risk taking

Risks to values of homes greater than risks by fire Oak Park Illinois, 1977 Chicago Home Equity Assurance Program 1988 Index-based insurance, Shiller and Weiss 1994 Yale-Syracuse-NRC program, 2002

II. Macro Markets

Long-term (perpetual) claims on major income flows, Shiller Macro Markets 1993 Short ones own country, investing in world World portfolio (Athanasoulis and Shiller Rev. Fin. Studies 2000)

Riskiness of Long-Term Claims on Incomes

Based on autoregression, data 1950-90, standard deviation of price change for GDPs is about half that of the stock market Occupational incomes, incomes by individual characteristic, riskier Digital revolution, robotics, suggest higher uncertainty in the future

GDP Warrants

GDP warrants grew out of oil price warrants issued as part of Brady-Bond refinancing for Mexico, Venezuela, and Nigeria Bulgaria issues warrants on GDP as part of Brady-Bond refinancing, 1994 Bulgarian warrants, inseparable from discount bonds, have not created salient price discovery for claims on Bulgarian GDP

Bulgaria GDP Warrants Data Surveillance

Citibank, 1994, Brady Bond underwriter, specified that GDP numbers would come from World Bank World Bank mission in Bulgaria is able to do some verification of GDP numbers Econometric models predicting GDP based on observables could enhance surveillance Observables are growing with information economy

Perpetual Futures (Shiller, Macro Markets, 1993)

Perpetual futures create both long and short sides of a perpetual claim on an indexed cash flow Daily cash settlement equals excess return between instrument that pays dividend proportional to index and riskless rate r:

Settlement t f t Index t (1 r ) f t 1

Economic Derivatives Market Goldman Sachs-Deutsche Bank

First Auction, October 2002, Nonfarm payroll Auctions in ISM Index, IFO Index planned Parimutuel Digital Call Auction (PDCA) Longitude, Inc., New York

Macro Securities

US patent #5,987,435 with Allan Weiss (Case Shiller Weiss, Inc.) would to create securities based on income aggregates or real estate prices in present environment Macro securities issued and redeemed by exchange only in pairs, one long and one short. Each member of pair has a cash account made proportional to some economic index by reallocating across accounts Each Macro pays dividends equal to interest on their cash account (NAV). Price of Macro should in equilibrium reflect market valuation of claim on cash flow

Case-Shiller Chicago Home Price Index and Macro Prices Monthly 1991-1-2002-4
Chicago
200 180 160 140

Dollars

120 100 80 60 40 20 0 1990

NAV Long Macro Long Macro Price NAV Short Macro Short Macro Price

1992

1994

1996 Year

1998

2000

2002

2004

Case-Shiller San Francisco Home Price Index and Macro Prices Monthly 1991-1 to 2002-4
San Francisco 250

200

150 NAV Long Macro

Dollars

100

Long Macro Price NAV Short Macro Short Macro Price

50

0 1990 -50

1992

1994

1996

1998

2000

2002

2004

Year

III. Income-Linked Loans

Milton Friedman, Capitalism and Freedom 1962: shares in future earnings, but feared irrational public condemnation But such loans should be based partly on income indexes, to reduce moral hazard

Michelin GDP-Linked Loan

Swiss Re New Markets and Societe Generale create bank and insurance company syndication for Compagnie Financiere Michelin, 2000 $1 billion 12-year subordinated loan facilities, with option to draw should GDP growth in Michelins main markets decline to specified levels

Income-Linked Personal Loans

Yale Tuition Postponement Option 1971-78 Yale Law School Career Options Assistance Program 1988-today MyRichUncle.com, Vishaq Garg and Raza Kahn David Bowie bonds, David Pullman 1997

IV Inequality Insurance

Framing change: redefine progressive tax system by Fixing after-tax Lorenz curve Each individuals tax is the change in the aftertax Lorenz curve between that individual and the next, times national income Effectively, automatic changes in marginal tax rates to fix the level of income inequality Possible great importance should inequality deteriorate more with new technology

V. Intergenerational Social Security

Social security should share risks between generations. Present system indexes retirees benefits to CPI, thereby pushing all risks to the working young Analogy to the family Ball & Mankiw, DeMange & Laroque, etc. Divide up national income between generations in such a way that retirees who contributed more get more.

VI. International Agreements for Risk Control

International agency such as World Bank would arrange very-long-term swaps among countries for GDP risks Could take form of parallel (back to back) loan agreements, indexed to GDPs Need to make long-term risk management a part of language and agenda of international agreements

Antecedents to Risk-Sharing International Agreements

EU Structural Fund and Cohesion Fund Commonwealth of Nations informal aid conventions

4. A MODEL OF RADICAL FINANCIAL INNOVATION

Radical Financial Innovation Example: Life Insurance

Invented in 1600s with notion of probability, life tables, slow to take hold among public Morris Robinson Mutual Life of NY 1840: highlypaid salesmen Henry Hyde Equitable Life Assurance Society 1880s: large cash value Viviana Zelizer: challenging God and tempting fate

Radical Financial Innovation Example: Altersversicherung

Extensive public discussion of inequality Principle of insurance (Gustav Schmoller) Role of new information technology After favorable outcome, imitation around the world

Risk Manifestation

Public does not focus attention on big risks Leadership must direct attention to risks Data must be refined and delivered to measure risks better Macro markets will add salience to risks Marketing campaigns that focus on risks

Robust Reframing

Importance of psychological framing

Altersversicherung

1889 Social Security contributions 1934 Portfolio Insurance 1980

Framing must be done correctly, so that changes are not needed later

Experimentation

Full consequences of economic inventions cannot be foretold Takes many years to evaluate Need to copy others inventions; many financial innovations occurred in times of stress or in less developed world (e. g. Futures markets in Tokugawa Japan, indexed units of account in high-inflation Chile)

Involvement of Existing Institutions to Promote Change

Insurance companies Exchanges and investment banks Banks Databanks and econometrics firms Governments Pension plans Labor unions Professional organizations Benevolent organizations