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3. Financial Markets: Technology and Invention in Finance
Poziom:
Temat: Społeczeństwo i nauki społeczne
Professor Robert Shiller:
I thought I would just
remember a couple of highlights
from the first two lectures to
consolidate what we said then.
In the first lecture,
I talked about a lot of things,
but one theme that comes to my
mind is the theme of the moral
purpose and mission of the
finance community.
We talked about the sense that,
I think, young people have a
sort of prejudice against the
field and they think that
finance is a field that you go
into if you really value money
rather than people.
I want to reiterate again that
that's not the way I view the
field at all.
I was just yesterday--I gave a
talk in Montreal at the Caisse
de Dépôt,
et Placement du Québec,
which is the big wealth
management fund for the Province
of Quebec.
I met a lot of people there and
I never once got the idea that
anyone there was evil or
grasping.
I think they have a moral
purpose, which is to preserve
the livelihoods of the people of
the Province of Quebec.
You get a very different view
of things when you meet the
people.
I think our entertainment
industry likes to make movies
about people in finance,
but they are inevitably
portrayed as evil and I don't
know why that is.
I don't think there has ever
been a major motion picture
about a financial person who
ended up a philanthropist.
Why is that?
I just don't--people don't
like--people would rather
hate--I don't know why it's
something--it wouldn't be a good
movie theme, would it?
Anyway, you have to overcome
these--you have to think that if
you go into the field you would
probably--If you're
successful--you would probably
end up as a philanthropist;
but no movie will be made about
your life and you may encounter
hostility the whole way.
It's especially true right now
with the subprime crisis.
People are blaming the
financial community for our
troubles now.
It is true that we're seeing
some people thrown out of their
houses, in some cases,
because of some rather
questionable financial practices
that got people into mortgages
that they shouldn't have gotten
into.
But overall,
I think that the people in this
field are good people.
In the last lecture,
I talked about–In the
second lecture,
I talked about the pooling of
risks and the basic theme of
that lecture was that we now
have a mathematical theory,
probability theory.
When you look at this theory,
you realize that it suggests a
very important technology for
improving human welfare and that
is: by spreading risks.
The economy,
and technology,
and the weather,
and all sorts of factors create
risks.
But, the real technology
is--the technology that works to
eliminate risks is to spread
them out,
to pool them,
to share them among many
different people.
So, the idea that theorists
suggest--and it may be
unreachable--but the perfect
financial system would have all
of our risks pooled completely.
That is, nobody suffers alone.
If anything happens to me in my
livelihood, then it's spread out
over everybody and everybody
means the whole world.
Whatever happens to me,
when it's spread out over six
billion plus people,
it ends up divided by six
billion and it becomes
unobservable.
It becomes so small that it's
meaningless and that's the
ideal.
That's what,
in principle,
we can do and what I think is
the most important concept in
finance--this concept of risk
pooling.
We live in a world where people
suffer all kinds of misfortunes.
Of course, we can try to get
rid of these misfortunes.
We can do research on disease
prevention and weather
modification and global warming.
We can do research on all these
things, but there's another
technology, which is extremely
important.
That is, even leaving the risks
as they are and just sharing
them better.
So, I'll be talking more about
this.
The problem is that while the
principle of risk-sharing is
very simple and obvious the
practice requires technology.
It's just like you could say
some of the principles of
mechanics are very obvious,
but to make an engine that
operates in terms of those
principles is not obvious.
What I want to talk today about
is what I call technology in
finance.
I'll present my view of the
situation, but maybe it's a
rather idiosyncratic view that I
have.
But, I think--It's not so much
idiosyncratic,
but it's a different emphasis
that I put forth.
What I want to talk–There
are really three themes to
today's lecture:
a risk theme,
a framing theme,
and an invention theme.
I want to go over the history
of risk management and through
these three themes.
The first one is,
I might say,
a long-term risk theme.
Let me go over these three
themes.
The long-term risks are
dominant in our lives.
By that, I mean that everyone's
life is a sequence of shocks
that accumulate over your life.
I'm talking about economic
shocks.
When you start out young--We're
unequal at birth,
of course, because of our
parents and the advantages we
have, but relatively equal at a
young age.
As each year goes by,
you accumulate economic shocks,
shocks to your human capital,
shocks to what you own as you
get older.
You start--Your human capital
is your ability to do things and
your knowledge,
which is what you have to sell
in the marketplace.
As you get older,
your human capital evolves and
it has its ups and downs as you
age and you start switching from
human capital to other forms of
capital.
In other words,
you start saving and you own
stocks and bonds,
and real estate,
and other things.
Each of these suffers a
sequence of shocks that cumulate
over your lifetime,
so inequality gets worse and
worse as people age.
It is at its worst after
retirement when you are no
longer--you've exhausted your
human capital and you're living
off of all the accumulated
physical capital.
That's the life cycle story.
There's great inequality among
the elderly and that's a
problem.
Some of them are living very
badly and others are living with
great comfort.
That's what finance is about.
It's really about people.
We don't care at all about
corporations--we should make
that clear--except as they
contribute to individual
welfare.
I don't care what happens to
Citigroup or IBM,
except for the fact that there
are all those stockholders out
there and they're of all
different situations.
Some of them are absolutely
dependent on their holding of
these stocks.
That's what we have to think
about and it's a long-term
problem.
The problem with long-term
risks, also, is that anything
that we do to mitigate these
risks creates moral hazard.
That's another fundamental
theme of finance.
What is moral hazard?
That's a term that first
entered the English language
sometime in the mid-nineteenth
century, but of course the
concept goes earlier.
Moral hazard occurs when a risk
management institution
incentivizes you to do bad
behavior--to show bad behavior.
The classic example of moral
hazard is with fire insurance.
I get fire insurance on my
house and so I behave badly:
I deliberately burn the house
down to collect on my insurance.
That's moral hazard;
but it's not unique to that,
it's all over the place.
When you manage risks,
you create moral hazard.
That's why we need invention
and theory in finance to
minimize that.
The second theme for this
lecture is about framing.
By that I mean psychological
framing, and there are many
psychologists who talk about
this, but notably Daniel
Kahneman and Amos Tversky.
"Psychological framing" means
the tendency for people to view
things in a distorted way
depending on how they're
presented.
If I present things in one
frame, then you would react one
way.
If I present the same thing in
another context or background or
environment, then you react very
differently.
I will expand on this in a
minute.
The third theme is the
invention theme of this lecture.
That is--I mentioned this
before, but I want to expand on
it in this lecture--that the
history of finance is the
history of invention just as
much as it is in other fields,
notably engineering.
The idea that I want to develop
is that the history of finance
is a history of discrete
inventions.
Non-obvious ideas were
conceived of to solve these
problems of long-term risks and
to get around the psychological
barriers imposed by framing
biases and psychological biases,
in order to allow people to
actually manage the risk and to
get around moral hazard.
It's a difficult thing to do
these things and that's why we
need invention.
Another thing is that,
when once an invention is made,
it tends to be copied all over
the world.
So, the history of finance is
largely a history of copying.
That's what you have to do.
You may have to adapt it to a
particular environment,
but basically it is copying
other ideas.
Some people in less-developed
countries feel uncomfortable
that they are just slavishly
copying other,
more advanced countries;
but, they have to recognize
that is what everybody has been
doing all along.
We copy the good ideas and in
the process we adjust them and
make them a little bit better.
New ideas can come from
anywhere.
The basic thing,
though, is that every country
has to take the insights that
have been developed around the
world.
Let me come back now--I want to
go through these three themes.
Let me start with the long-term
risk theme.
I want to start with an
article, which--mention an
article by Backus,
Kydland,
and Kehoe--actually Backus,
Kehoe, and Kydland,
three economists [David K.
Backus, Patrick J.
Kehoe and Finn E.
Kydland, "International Real
Business Cycles," Journal of
Political Economy,
100(4):745-775,
August 1992].
One of these,
the last of the three,
Finn Kydland,
won the Nobel Prize a few years
ago.
In this article,
they talked about the
correlation of consumption
around the world.
What is consumption?
It's the amount that people
spend on consumption goods,
things that you buy for your
current use, like food,
shelter, clothing,
etc.
Every country computes an
estimate of how much is spent
each year on consumption by the
people who live in the country.
What Backus,
Kehoe, and Kydland did was look
at how much the consumption
correlates--the movement from
year to year--correlate across
countries.
If there were perfect
correlation, then it would be a
correlation of one.
That is, when one country's
consumption increases from one
year to the next,
every other country's
consumption increases from one
year to the next.
What they argued in this paper
was that, if we had perfect risk
management, then there would be
perfect correlation of
consumption across countries
because if we get rid of the
idiosyncratic risks,
then all that's left is
planet-wide risks.
If we had perfect financial
markets--and this is
intuitive--and I don't know how
obvious this is,
it's obvious to me,
but it's an intuitive point of
great importance--nobody would
suffer alone.
Anytime there's a risk that
hits one person or one country
the financial markets would
spread it out over everybody and
it gets very small.
What's left?
The only risks that are left
are risks that everyone shares,
so you would see planet-wide
risks expressing themselves in
consumption,
but nothing else.
Do you see that point?
We'd have perfect correlation.
Suppose the planet were hit by
a comet--this
happened--something like this
happened sixty-five million
years ago, so it could happen
again.
Maybe it won't now that we have
better plans to prevent things
like that, but suppose it did
happen.
We would see huge damage on the
impact site.
Let's neglect the fact that
some people would be killed by
the impact, suppose it was just
economic damage.
It would be a terrible--it
would be a problem all over the
world because the damage would
extend around the world;
but, you'd be much better off
if you were on the other side of
the world, not where it hit.
If we didn't have financial
arrangements,
then the people near the impact
would be in a terrible economic
situation and the people on the
other side would be much better
off.
If we had the proper risk
management institutions in
place, people would have
anticipated this risk and would
have made swaps or other
arrangements to protect
themselves against it.
What would happen?
The people near the impact
would not be harmed any more
than anyone else.
The world would suffer because
the damage is substantial and it
reduces our ability to produce.
So, the whole world--everyone's
consumption around the world
would go down.
You can't prevent that.
Anything that hits the whole
planet would be affected.
Backus, Kydland,
and Kehoe thought that that's
the situation we should be in
today.
There are things hitting the
whole world, like global warming
for example, and there are many
of them.
How well are we doing?
We're not doing well at all,
they concluded.
The correlation across
countries in consumption changes
is low.
In fact, it's lower than the
correlation of income changes,
which is surprising.
It means we really haven't done
anything--that's an
exaggeration--we've done very
little to manage risks that
individuals or that countries
face,
for that matter,
or even individuals face.
We've done a lot--I shouldn't
say we haven't done
anything--but we can do a lot
more.
The idea of risk,
that economic risks can be
pooled, is an intuitive one that
has occurred to people
throughout history.
It's very simple and obvious.
If we're living in--imagine
we're living in some remote area
and we're pioneers out there
with our cabins and there's no
government.
There's no one to protect us.
What do we instinctively do?
We kind of meet together and we
say, if anyone's cabin burns
down we'll all come over and
help.
It kind of feels like
generosity, but it's also a
self-interest that people
perceive.
It could be me that--my cabin
could burn down and I would
freeze to death in the winter.
So, people naturally and
spontaneously make arrangements
to share risks.
These kind of natural and
spontaneous arrangements are not
global, they're not big enough
and important enough.
I just want--one point of this
lecture is to try to emphasize
the real breadth of the concepts
of finance and how important
they are--how they reach out
into other things that you might
not think as associated with
finance.
I want to mention socialism.
This term really goes back to
Robert Owen, who was a British
thinker from 1771 to 1858,
who wanted to pool all the
economic activity in society.
What were the motivations for
doing this?
Well, I think he would say
inequality--hardship would be
reduced.
But, what was he really saying
in a sense?
You might say it was risk
management.
He wanted society to pool risks
and put things--put us together.
In his ideal society--socialist
society--all the consumption
would move up and down together,
just as in the ideal that
Backus, Kehoe,
and Kydland expressed.
Robert Owen wanted to create
this community.
He created finally--he
emigrated to the United States
and he set up a city called New
Harmony.
New Harmony was supposed to be
an inspiration.
Unfortunately,
it didn't work very well
because people started bickering
in his town and the New Harmony
became kind of a joke--it was
not a harmonious community.
So, he started to discover
moral hazard.
You put everyone together and
you say, okay all of your
economic fortunes are the same.
And what does someone start to
conclude?
Well, they start to get lazy or
they start to get irresponsible.
They think, it doesn't matter
what I do, I'm going to get the
same consumption as everybody
else,
so I'll just get lazy--a very
fundamental problem,
which you probably are already
aware of.
The socialist idea started to
lead to a number of experiments
in various countries around the
world that were pooling
risks--they might not have put
it this way.
One is the kibbutzim in Israel,
which were communities that
shared everything.
Originally, they were very
rigid about this.
They enforced complete sharing
and if you belonged to a kibbutz
you were completely stuck with
the common consumption.
It wasn't just in Israel--in
Japan, the Ito-En and
Yamaguchi-kai;
in the United States,
the Hutterites;
and there are many other
examples.
Joining one of these
communities has meant a real
change in your life.
It's complete sharing.
The problem is again the
ideal--they're trying to work
toward what I think of an ideal
that we see in finance--mainly,
the perfect correlation of
consumption and the elimination
of risk--we all help each other.
But, the problem they hit is
moral hazard.
I've heard a lot of stories
about a lot of bickering at the
kibbutz.
When someone gets a gift and
the other people at the kibbutz
say, "Well you can't have that
by yourself, we share
everything."
Some people say,
"I'd like to have my own
television set.
I don't want to go to the
common room and watch the same
set with everyone else.
I just, kind of,
want to be at home by myself."
So, nowadays kibbutzim have
loosened the rule.
I don't know these things
personally, but it's my
understanding that the whole
structure is suffering some
moral hazard problems and that
they're evolving and trying to
improve the institutions.
There's also a problem with
risk-sharing at that level.
That is, if you are one of
these commune communities,
then you're just a small number
of people.
The best you can do sharing
among yourselves is sharing your
own risk, the risk of your own
community;
but your own community goes up
and down and you're not sharing
widely enough.
The problem is that if you want
to do risk-sharing,
you're not, ideally,
sharing with someone who's just
like you--living in Israel,
working in a certain
agricultural industry--because
there are lots of risks that
you've already shared.
You should be sharing your
risks with someone who's
completely different--probably
living on the other side of the
world in a completely different
industry,
where the weather,
the institutions,
and the political situation are
completely different.
It doesn't work so easily to
share with those people along
the lines that these
communities--I think these
communes tend to emphasize a
social compact,
a feeling for each other,
a caring for each other,
which is a lovely thought but
it doesn't achieve risk
management on a big scale.
I think that what's happening
is these ideas--Everything is
evolving, so I'm actually
presenting here our modern
finance as the outgrowth of
socialism,
but that's not the usual way to
present it.
I guess it is that we care
about each other and we don't
want people to suffer alone.
We want to share things,
but we want to get more
scientific about how we share
things and that means--and we
want to be effective.
So, that means we have to
devise ways of sharing with
people that we've never met,
that we don't care about--I
mean, maybe we care about
everybody, but we don't have any
particular emotional ties to
them--and they're very different
people.
But, because of the logic of
risk management we have to make
a deal with them;
so, it becomes more formal and
impersonal.
That is what financial markets
do.
What's happening is:
we're seeing an evolution of
risk management.
You hear about it in various
terms that sound abstract.
We have private equity,
we have venture capital,
and we have employees getting
incentive options.
These are efforts to solve the
moral hazard problem and to
manage risks.
I believe that we're gradually
learning in our society.
This is maybe not widely
appreciated, but every decade
that goes by we do a better job
of incentvizing people and
preventing them from being
discouraged by risks.
It's a very complicated
situation because the kind of
economic risks that we face are
difficult for most people to
understand.
But they have to try to let
people manage their own risks
for themselves,
to some extent.
That means we have to expect
people to understand these
things somewhat.
I think we have an important
role for economic,
financial education.
Because of that,
each person is in a different
situation--it's a very
complicated world and we have
many different risks.
Continuing on the risk theme,
I mentioned one philosopher,
Robert Owen.
I could have also mentioned
Karl Marx--why don't I mention
him here.
He was a very important thinker
who had very low regard for the
financial community,
I think, unfortunately.
He wanted to kill them,
I think, or at least some of
them.
Nonetheless,
he shared certain things in
common with them.
Namely, that he was concerned
about inequality,
about some people doing badly,
and he proposed an economic
alternative that would pool
risks.
In fact, he actually emphasized
a concept that was first stated
by a French philosopher Louis
Blanc in the mid-nineteenth
century.
Blanc said the ideal society is
based on the principle of,
and now I quote,
"From each according to his
abilities, to each according to
his needs."
Have you heard that quote
before?
Karl Marx quoted Blanc,
but he didn't credit Blanc.
He didn't mention the name
because, I assume,
he thought everyone knew this
was Blanc;.but Marx was falsely
attributed to having made that
statement.
It's come around to us that
that was--a lot of people say
that was the core of his
communist philosophy.
That is complete risk-sharing,
right?
Some of us have high abilities
and we succeed,
some of us have low abilities
and we fail;
but we all get the same good,
we all have our needs
satisfied.
So that, I think--The communist
system is effectively a theory
of risk management and that's
not something you might think of
usually.
What was the big problem with
communism, as it was espoused by
Karl Marx?
The problem was that it had a
moral hazard problem and--I've
already been through it--it's
the same moral hazard problem
that you see at the kibbutzim
and the Yamaguchi-kai and other
places: that people don't work
effectively when their economic
interests are completely pooled.
Well, I suppose we've learned
from the Marx experience,
but we're, I think--Just about
every country of the world now
recognizes that it's a
complicated thing to get risk
management working well and we
have to design things more
carefully.
We can't just smash things and
start all over,
we have to design a system of
risk management.
That's what I think finance is
about.
I want to mention a couple
other philosophers who talk
about risk management.
One of them is the economist,
John Harsanyi,
who won the Nobel Prize in
Economics some years ago,
and another one is the
philosopher John Rawls,
who wrote the book Theory of
Justice, [John Rawls,
A Theory of Justice,
Cambridge MA:
Belknap Press of Harvard
University Press,
1971.]
which has become a classic.
I think of both of these as
incorporating--I would,
especially with Harsanyi,
but also with Rawls--as
incorporating some idea of risk
management into our basic
philosophy.
We have a philosophy that--most
of us--that some kind of
economic inequality is a bad
thing and that it's unjust for
someone who is,
for no fault of his or her own,
suffering economic hardship.
How to formalize this idea?
John Harsanyi was the first to
write about this.
[John Harsanyi,
"Cardinal Welfare,
Individualistic Ethics,
and Interpersonal Comparisons
of Utility" Journal of
Political Economy 63(4)
1955.]
He said that we should think
of--When we think about
distributional justice we can
think of it as a risk management
problem.
He said, imagine that we could
get people to have a big town
meeting for the whole world and,
he said, before they were born.
There's some space up in heaven
where all the unborn babies are
that will live in the future
and,
unfortunately,
they're not able to have a town
meeting;
but, let's suppose they could.
We're up there in heaven
thinking about our lives in the
future, as people,
and what would we do?
Suppose we don't know what
economic circumstances we'd be
born into and what kind of
contingencies we'd have in life.
What would we decide?
Suppose we were trying to
decide on a constitution for the
world in that state.
John Rawls expanded on this and
he called it the "original
position."
What would they do?
Well, they would probably agree
that we'd do some risk-sharing,
right?
Everyone who's thinking,
I don't know whether I'll be
rich or poor,
so I would like to have a world
in which risks are shared.
On the other hand,
what would you decide?
If you can imagine yourself in
that situation,
what would you decide about
inequality?
Would you decide to have a
world with absolute equality?
Well, you know somebody would
probably.
Suppose someone proposed that
up in heaven and someone else
might say, well that's not going
to work so well,
that's like a kibbutz--like one
of the kibbutzim.
It's not going to work,
we're not going to
enjoy--something's wrong with
that because it's going to
create a moral hazard problem
and we're not going to be as
productive.
Someone might also say,
you know a little inequality,
even a substantial inequality,
is not so bad as long as nobody
is really suffering.
As long as everyone has the
basic needs and they're--we can
all be happy.
You know, let's let some people
make big fortunes because that
provides spice in life and some
adventure,
something to look forward
to--that you might get this.
You could see saying,
we don't want to eliminate
inequality.
What Harsanyi and Rawls both
gave us was a system of justice
that, in my mind,
conveys a sense of financial
risk management.
I'm not going to talk a lot
about--Well, I'm going to move
also to framing here,
but let me at this point
mention something about public
finance.
This is not a course in public
finance.
It doesn't say--The title of
this course is Financial
Markets.
I guess when you put markets on
it that doesn't sound like
public finance but,
even so, it could.
Public finance is the financial
issues relating to governments.
Finance usually means the
private sector,
but the issues are much the
same in both cases.
Let me say something about
public finance here.
Public finance relates to the
tax and welfare system that we
have.
The government taxes people and
it takes some of the money and
redistributes it to people in
need.
This is essentially a risk
management system.
It's something that,
I suppose, Robert Owen and Karl
Marx would have said sounds like
a good thing.
But, of course,
they wanted to do much more and
be more comprehensive.
It's maybe something that has
evolved as something that
actually works.
You have a progressive tax
system that takes more money
from the wealthier people and
you have a welfare system that
looks at individual hardship and
pays out.
It does create moral hazard
problems--that's a problem with
it, but that's something that
we're learning about.
That's part of public
finance--is learning how to
modify the tax system so that it
works pretty well.
I want to start out by
mentioning taxes and welfare
because, I think,
that it's really the most
important risk management system
already in place.
Because the financial risk
management system that we have
is imperfect,
we aren't there yet.
The thing that's really doing
the heavy hitting on risk
management is really the tax and
welfare system.
That's because the most
important risk that individuals
face is the risk of major losses
of income.
If something really hits you
hard and you would be starving,
that would be really bad.
So, nobody starves in advanced
countries of the world today
because of this system.
Moreover, you might get hit by
an illness and then you could be
in desperate trouble that you
will die unless you get some
kind of emergency care,
which might be very expensive.
Every advanced country in the
world has a system that provides
for this, including the United
States, incidentally.
We don't have a national
healthcare system.
People say we don't--well,
we don't, but we do have an
emergency care system so that
anybody who is suddenly stricken
will be taken to a hospital and
taken care of.
It's not perfect,
but it is there.
What we do have we should be
thankful for,
it's very important.
I thought this would be a good
lead in to the second theme of
this lecture,
which is framing.
We have a good system in taxes,
but it's imperfect because it
hasn't been thought out
thoroughly in terms of risk
management.
Let's talk about framing and
taxes.
If you go to look at
congressional discussion of tax
rates, you won't see risk
management mentioned very often.
They seem to talk about it in
their own terms,
which to a public finance
expert is, I don't know,
very populist or
unprofessional.
I guess they're elected
officials and their voters are
not finance theorists and don't
think of this in these terms.
Edward McCaffery did a history
of taxes--I'm sorry,
spelled with two Cs--he's a law
professor in the United States
and asked about--based on issues
of framing and psychology.
We have a system,
which you say it really--The
progressive tax system is very
important but it's not
conceptualized right.
[Edward J.
McCaffery, "Cognitive Theory
and Tax," in Cass R.
Sunstein, editor,
Behavioral Law &
Economics,
Cambridge: Cambridge University
Press,
2000 398-422.]
What McCaffery points out is
that the only time the
government in the United States
has ever been able to impose
high taxes on wealthy people was
during wars.
If you look at the history of
U.S.
taxes, the very simple history
is World War One and World War
Two.
During World War One and Two,
our men were out dying in
Europe and people voted for
someone who said,
let's raise the taxes on the
rich, someone's profiting from
this war now.
It doesn't sound right when
other men are out there dying,
so they raised taxes during
World War One.
They did it again,
even more decisively in World
War Two, and that's how we got
progressive taxes.
I'm oversimplifying a little
bit but between wars the rate
tends to come down because
people think,
well the war is over.
They don't understand the risk
management function of it.
Politicians are reluctant to
cut taxes, but they do it
gradually.
That's a simple history of
taxes.
Actually, in the United States,
the income tax came in during
the American Civil War and it
was--the income tax came in
1861,
again during the war and it was
a progressive tax.
The tax, as of 1862,
was 3% on incomes over $600 a
year.
That sounds kind of low,
that was 1862.
Then they raised it to 5% on
incomes over $10,000.
It was a beginning,
but it didn't take because they
had technical problems.
I mention this tax example
because I want to stress that
framing and psychological
barriers are important problems
for creating financial markets.
The idea is that people don't
see this basic risk management
problem and they see things in
entirely different terms.
So Kahneman and Tversky talked
about how people view financial
gains and losses and they talked
about how people's actions are
very valuable depending on how
things are presented.
In one of their most famous
examples, they asked people the
following question:
Suppose you had bought
expensive tickets to a concert,
very expensive,
you paid $200 for each ticket.
You have two tickets,
$400 worth, and on the way to
the concert you lose the
tickets.
Now, you've arrived at the
concert hall and you're looking
through your pocket and you
realize they're gone--you've
lost them.
The question they asked people
is: would you go to the window
and buy another pair of tickets
for $400, having lost them?
People answered--most people
said, no, I'd be so annoyed and
angry with myself I'd just
leave.
But then they posed a different
version of the same question and
the different version was:
Suppose you had ordered tickets
to pick them up and pay for them
at the window at the concert
hall and you brought $400 in
cash in your pocket.
You arrive and you realize
you've lost your $400.
Now, the choice is:
you could--What are you going
to do?
Would you go to the ticket
window and use your credit card
to pick up the tickets or would
you just walk away in anger and
annoyance?
Well, most people say,
oh I would just go to the
window and buy the tickets.
Does that sound plausible that
you could see the difference?
But, in economic terms,
there's no difference between
losing the tickets and losing
$400, so why do you behave
differently?
Well, that's framing.
Because in your mind you're
putting tickets and cash in
different mental accounts,
the mental account "tickets"
generates an emotional feeling
and it changes my action--that I
lost in that account.
Unfortunately,
that's--unfortunately people's
decisions are biased by that
kind of thing.
So, we have to frame things
as--put things in the mental
categories--presentation
matters--so that people can
manage their risks right.
Kahneman and Tversky also--and
others have also talked about
insurance.
They've asked people a question
and then phrased it in two
different ways.
One of them was,
would you buy insurance against
such and such a risk?
The same question was rephrased
in another way,
without mentioning the word
insurance--they just described
it.
They said, would you sign a
contract that if you had this
loss the contract would pay you
a certain amount of money?
The percent of people who said
yes to that was lower because
they didn't put it in an
insurance frame.
We are accustomed to thinking
of insurance as a good thing.
If I talk about it in general
terms, they might not put it in
that frame and they might
not– Really,
an important example of framing
is how we deal with money and
indexation.
We have a "money frame" of
thinking and a "real frame."
The value of money changes
through time because of
inflation or deflation;
yet, most of our debts are
written in money terms.
That is, they're not indexed
for inflation.
If you wanted to have a real
frame, then you would index to
the consumer price index or some
other inflation index.
Most of us are accustomed to a
money frame, so most of us--when
we lend money to each other,
we do it in money terms.
You merely say--For example,
if your friend asked to borrow
$100 from you,
you would probably not say--you
might actually put interest on
this person,
so you could say,
alright, I'll do it with 5%
interest, pay me back in a year.
You would probably not even
think to say,
pay me 3% interest plus the
rate of inflation over the next
year.
That would be putting it in a
real frame and--wouldn't that be
more sensible,
because you would be specifying
the contract in real terms
rather than money terms?
Yet, most people just don't do
that.
Most of our fixed incomes,
as they're called--which are
assets that are denominated in
currency--Most of our debts are
written in money terms and
people can't get over this
framing in terms of money.
It's a powerful psychological,
you might say,
illusion--people think they
want money when,
in fact, they should want real
goods and services.
So, that's an example of a
framing issue.
Now, I want to move to the
third theme of this lecture,
which is invention.
As I said, progress in finance
requires an inventive process
and invention occurs in a milieu
of other invention,
notably information technology.
I said this is an earlier
lecture, but a financial device
is a complicated device like any
engine or any other thing that
they patent and develop to solve
some physical problem.
For example,
let's talk about an insurance
policy as an invention.
An insurance policy--the
concept is very simple,
we could talk about fire
insurance or life insurance.
Life insurance is designed to
protect–ideally,
it protects parents with young
children--that's the most
important application.
If one of the parents dies,
it creates hardship for the
family because the remaining
parent has the burden of caring
for children and earning a
livelihood to support all of
them.
It is very difficult,
so we have a policy that pays
them if one of them dies.
It's not easy to devise this
and the concept is very simple.
In order to devise an insurance
contact that does this job,
we have to have a contract
between an insurance company and
the insured.
The contract has to specify
what are the causes of,
let's say, death or a situation
in which one is covered.
We have to then realize that
there is a moral hazard problem.
We have to exclude certain
causes, like suicide,
in the case of life insurance.
In other kinds of insurance it
gets very complicated.
You have to exclude those
causes that generate moral
hazard problems for the
insurance to work;
otherwise, the whole system
will fail.
When they invented fire
insurance, in the 1600s,
there was a lot of skepticism
because anyone can burn down
their house.
They said, it's not going to
work because you have to decide
how much the house is insured
for and then anybody--If you
ever make a mistake and you
insure it for too much,
then the people who realize
they've got one on the insurance
company--they've insured the
house for more than it's
worth--they'll burn down their
house and collect the money.
Now, how can the insurance
company ever evaluate every
house properly to avoid that?
They had to work on that,
they had to devise--they had to
get an appraisal industry that
could appraise houses and get
some idea of what they're really
worth.
They had to get that all worked
out, it had to be done
accurately, and they had to
decide to keep a certain amount
of co-insurance.
In other words,
lower the amount insured below
the actual value of the house to
prevent moral hazard.
They had to develop statistics
of loss;
they had to know what the
losses were.
In the case of life insurance,
they developed actuarial tables
that require a collecting of
statistics.
Then of course,
there's the other problem that
the insurance company--how does
the insurance company reasonably
specify that it can come through
on this policy?
You have to have the insurance
company set up with a structure
itself that guarantees that they
have enough reserves to meet the
losses that they might incur.
That requires a theory of
capital and they're going to
have to invest the reserves in
financial assets.
Then you have to ask,
well how are the financial
assets going to behave over
time?
Then it becomes a theory
of--all of finance comes in as
well.
Moreover, beyond that,
how does one know,
in taking out an insurance
policy, that the insurance
company is going to be sound?
The insurance company has to
have some way of demonstrating
its soundness to the public.
Moreover, we have regulators
who have to regulate insurance
companies and make sure that
they have adequate capital.
So, it's a very complicated
industry.
Although, I said,
insurance was effectively
discovered or invented in the
1600s,
it has been slow to grow
because they didn't have the
well-defined--all of the
inventions yet.
I wanted to just give
some--often the inventions that
occur in finance,
they seem in a way obvious.
Some of the things I
said--you'd probably say,
well I should have known that
an insurance company would have
to do that, but it isn't.
What's obvious after the fact
is not what's obvious before the
fact.
One thing I'd like to stress is
that the history of technology
is sometimes a history of very
glamorous, unobvious ideas like
nuclear power.
That's amazing,
you can get atoms to smash
atoms and create a chain
reaction and create
power--that's a pretty amazing
invention.
But a lot of the inventions
that matter to us are extremely
simple.
They're kind of staring in your
face obvious.
Let me just give some example
of--sometimes people are very
slow to see the obvious,
or it seems so in history.
I'd like to talk about the
invention of the wheel--that's
the most famous invention,
right?
It's a cliché--People
say, let's not reinvent the
wheel here, so let's go back to
that.
Inventing the wheel--it seems,
what could be more obvious than
a wheel?
Well, it apparently is not so
obvious because in the Americas,
before Columbus
came--pre-Columbian
America--there were no wheeled
vehicles anywhere.
We had civilizations--Aztecs,
Mayas, Incas,
etc.--but no wheeled vehicles.
Now, the amazing thing is,
if you go to Mexico you can go
to museums that have children's
toys from pre-Columbian Mexico
with wheels.
They were little toys
that--they would be shaped like
animals or something and you
could roll them along the floor.
So, why didn't somebody think
of--you're sitting there with
your child playing with a
wheeled toy and then you're
going out to carry some heavy
stuff and you're dragging it
along the ground.
Why didn't you think of putting
wheels under it?
Well, it's apparently not so
obvious.
Some very obvious ideas are not
so obvious.
Some people today think,
I just can't imagine,
this history can't be right,
I don't believe that they
hadn't invented wheels in
America before Columbus.
To argue with them,
I point out an example,
which is more familiar.
Unfortunately,
you people are too young to
have experienced this,
but I've experienced this and
you can talk to your parents.
It used to be,
before 1972,
that suitcases never had
wheels.
You probably own a wheeled
suitcase, right?
Most of you do.
The idea of putting wheels on
suitcases goes back only to 1972
and it was Bernard Sadow who
invented--this is amazing,
right--the wheeled suitcase and
he got a patent on it.
He had a suitcase that--I don't
know exactly,
something like this--had a
strap that you'd pull it along
and it had four little wheels on
the bottom and it worked.
I had my student research
assistant find that guy,
let's call him up and ask him
about it.
It's so recent.
So my student called Bernard
Sadow up and asked him about his
invention and he said,
"Yeah, I was thinking,
why don't we have wheels on
suitcases?
So I just did it."
He said, "I had a lot of
trouble, I took it to department
stores and I said,
why don't you sell this?
I'm making it,
add it to your luggage."
He said he met a lot of
resistance.
The department stores said no
and so we asked,
why would they say no?
I mean, it's such an obviously
good idea.
He said, "They said people
won't buy it.
Anyway, they said,
look you go to any train
station and there are these red
caps or porters and they'll
carry your suitcase for you.
You don't need wheels."
That's what they told him.
But, it seemed like there was
kind of a way of thinking.
I think maybe people would be
embarrassed.
If you were the only guy with
wheels on your suitcase,
people would think you look a
little odd.
Anyway, it's interesting the
wheeled suitcase came in 1972.
The problem with Sadow's
suitcase--I actually had one and
you might have one in your
attic.
You can go up and look at it
because your parents probably
bought one and it's still up
there.
You can take it out and try
wheeling it along with that
strap.
It kind of works,
but it wobbles,
especially if you're hurrying
to catch your airplane.
That thing starts fish-tailing
and wobbling.
You've just got a strap you're
pulling it on--so obviously
there was a design defect.
Finally, it was Robert Plath,
who was an airline pilot who
invented a new,
wheeled suitcase,
which he patented in 1991.
This suitcase had--instead of
having four little wheels on the
bottom, it had two wheels on the
back.
You didn't pull the suitcase
lengthwise;
you pulled it widthwise,
so it gave you a stable base.
Moreover, instead of having a
strap he had this thing that--a
rigid thing--that you pull out
from this--you know what I'm
talking about?
He invented--he called it the
RollAboard.
He also had the idea that he
would make it narrow enough so
that when you're boarding an
airplane you can still roll it
down the aisle of the
airplane--it just fit perfectly.
So, that was the
RollAboard--that was 1991.
That's getting into recent
memory.
It's so obvious,
why didn't they have them
before?
Well, things that seem obvious
are not obvious and it has
something to do with--something
like framing.
We tend to think of doing
things in a certain
way--everyone else is doing
it--and we assume that that's
the smart way to do things.
That limits us and it's very
hard to get new ideas started,
but they do get started;
so, I think we'll get some
really obvious advances.
One thing about inventions is
that we have something called
patents.
The patent office grants patent
rights to inventions,
but traditionally
in--everywhere in the world,
really, financial inventions
were not considered worthy of
patenting because,
I guess, patent law came in
response to things like the
steam engine and the power loom,
which were physical inventions.
They didn't think of financial
inventions as worthy of patents.
Now, we're starting to see
patent offices accepting
financial devices.
It happened in the late 1990s,
in the United States,
that patent offices started to
accept financial patents.
Now there are several countries
that–-Japan,
Korea, and elsewhere--are
starting to see financial
invention as a serious
invention.
The last thing is information
technology, as a driver of
finance.
Now, I'd like to stress
information technology because
we are living in a time of rapid
advance, as you know--I don't
have to tell you this.
Computers are becoming more and
more a part of our lives and
this is something that is
transforming the world.
What is it that makes us
uniquely human?
You might say--or a good part
of--it is our ability to process
information.
We differ from lower animals
and our brains,
which are much more capable of
storing and processing
information,
but we're living in a time of
revolution when machines are
challenging or competing with
our brains.
This may create economic
dislocations that we will see
throughout our lives,
but also creates
opportunities--I want to stress
on the opportunities.
A lot of financial innovation
is co-evolved with information
technology.
A lot of simple ideas of risk
management are ideas that
require well-designed
information technology and we've
seen a lot of advances in the
last couple centuries that make
financial innovation possible.
I thought I would give you an
example from the nineteenth
century, which is very
important, and again it's public
finance.
I'm not going to stress public
finance so much in this course
but it seems--I'm going to give
the example of nineteenth
century information technology
and the nineteenth century
invention of social security.
Let's go back to the nineteenth
century, that's the 1800s,
that was a wonderful century
for information technology.
You probably don't think of it
that way because you say,
wait a minute,
the computer wasn't invented
until the 1940s.
Actually, you would be wrong;
the computer was invented in
the nineteenth century by
Babbage, but he didn't actually
make one.
He wrote down a design,
which was similar to what we do
now.
There were a lot of other
things that happened in the
nineteenth century that advanced
information technology and made
finance really powerful.
One was paper,
it sounds very simple.
At the beginning of the
nineteenth century,
in 1800, paper was handmade out
of cloth--that's the way they
made it.
Paper, therefore,
was very expensive.
So, if you bought a newspaper
it would be only two sheets
because it was so expensive--not
all the thick paper that we have
today--and it would cost
something like $10 or $20 in
today's prices.
It would only be wealthy people
who would buy that everyday.
They invented the paper machine
so they could mass-produce
paper--it didn't have to be
handmade anymore--and they
invented wood pulp paper so it
didn't have to be made out of
cloth anymore.
The price of paper fell and
created opportunity for
record-keeping,
which was very important
because that's what finance is
built--you need financial
records.
You can't have just one copy;
you have to have multiple
copies.
They also invented carbon paper.
Maybe you don't even know what
this--do you all know what
carbon paper--I guess you do
know what this is,
right?
It's obsolete.
Do you have any carbon paper
anyone, here in your room?
You do?
Okay, so it's not obsolete.
Anyway, it's just paper with
some black material on it.
You put it between two pieces
of paper, then you write on the
top one and it creates as copy
on the bottom one.
You can make multiple--you can
put three or four--the copy gets
worse and worse each time,
but you've got multiple copies.
That's information technology.
You really need that because if
you have only one copy of
something, you don't have a
backup;
so, you can store the one copy
separately.
Also, in the nineteenth
century, the typewriter was
invented.
Of course, that may be the core
idea of a computer.
Your computer looks like a
typewriter, but a typewriter
just speeds recording of
information.
Tests show in the nineteenth
century that people could type
four or five times as fast as
they could handwrite and there's
no ambiguity because it's very
clear what key was struck;
whereas, handwritten--fast
handwriting becomes impossible
to read--or difficult.
Another thing that
happened--they started
developing--it's not invented in
the nineteenth century,
but they started doing
standardized forms.
That is, there would be a
printed form on paper with
spaces to fill in the numbers or
other things.
That put us at,
sort of, organization on the
data entry that was unknown.
You have this standardized form
and you've got carbon paper
between them and you typed
it--all these really created
much more accurate techniques.
We also got better bureaucracy.
That means, we started to learn
management science in the
government, so that
government--and also in
corporations--so they could
manage effectively.
In the United States,
we developed the Civil Service.
It used to be that government
officials were all picked by
political patronage and they,
very often, were incompetent.
We set up--this is not a new
idea, this goes back to China
thousands of years ago,
but it started to be widely
done--a Civil Service exam that
established your competence.
So, you had competent people
with their typewriters and
carbon papers.
Also, the filing cabinet--that
sounds like a minor thing--was
invented in the 1890s.
Before that,
people used to put papers in
piles, tie them up in ribbons,
and put them on bookshelves or
in drawers.
The filing cabinet was much
more orderly and effective.
So, all those things developed
in the nineteenth century.
It just created a new world for
financial opportunity.
Things started to happen in
response to this and risk
management got better.
I want to talk about Social
Security as a risk management
technique that developed in the
nineteenth century and it
developed in Germany.
It is very interesting to me
because it's a discrete
invention that happened in a
point of time in response to
information technology.
This is 1889,
under the government of Otto
von Bismarck--although,
he has nothing to do with this,
it was other people--economists
in Germany that invented this
idea.
What did they do?
I should have also mentioned
another really important
information technology that
developed in the nineteenth
century was the Postal Service,
although we had mail before
then.
In the nineteenth century they
decided--it just got really good
at delivering mail.
In 1799, it would cost so much
to mail a letter--I don't know
exactly, something like $10 or
$20 to mail a letter at today's
rate--and it would take a long
time get there.
For most people it was
prohibitively--we're talking in
today's prices,
roughly speaking.
Most people wouldn't ever mail
a letter or get a letter--too
expensive, not to count only the
paper and everything was
expensive.
In the nineteenth century,
they developed the Postal
Service and it interacted with
the railroad.
They started having mail cars
on trains and they started
having postal sorting on the
train.
They were speeding the mail so
that it didn't have to wait to
sort it before it went on the
train--it was sorted while it
was moving on the train.
Germany was very effective in
these--they had advanced
bureaucracy, a good postal
service,
and they had a network of post
offices all over the
country--every little town had a
post office.
So, this was the internet of
the nineteenth century and it
really changed everything.
In 1889, the German Government
decided to use the postal
service as an information
network to create Social
Security.
They created a new law,
which said that every person
who works in Germany has to pay
the government a certain percent
of his income,
into the Social Security system.
In addition,
the employer has to match this
so that both the employer and
the employee have to do it.
Now, how in the world can
somebody actually make that work
for a whole country?
There were eleven million
workers in Germany at the time
and other countries looked on
this as,
this is ridiculous,
no government can actually
manage the system like this.
But, they did it through the
postal system.
You had to make--or your
employer can do it for you--they
take the money to the post
office and the post office would
give you stamps.
It was already the same
technology they used for the
mail.
You kept your Social Security
card and you pasted stamps on it
that proved that you paid it.
They kept a copy of that and
they filed it away,
so the government had a
complete record of your payments
into the system.
The design was that,
when you reached retirement
age, you would then get funds
from the government for the rest
of your life--your retirement
funds.
How did they decide how much?
Well, it was based on what you
contributed.
They would pull out your entire
life history of
contributions--they had it
because you had filed it all at
the post office and everything
was bureaucratic and
efficient--and they calculated,
according to a formula,
what you would get.
It was a real insurance system
and they would pay you in your
retirement.
The London Times,
in 1889, said this is going to
be a fiasco, there are going to
be so many mistakes,
and there are going to be so
many complaints that this whole
system is going to crumble and
fall;
but it didn't,
it actually worked.
Before long, the U.K. copied it.
The U.S.
was practically the last
country to copy this system
because, in the 1930s,
it didn't sound American.
We were kind of reluctant to
take on ideas from Germany,
of all places,
but we finally did.
We did that during the Great
Depression, when it suddenly
seemed like we really needed to
do something.
That's an example;
you see how information
technology created a Social
Security system.
Now, the really fascinating
thing is that we have the same
system today,
except we don't use the postal
service as the conduit anymore.
Now it's all electronic and
it's done by the Internet,
but it's the same thing.
You will see,
deducted from your
paycheck--and you already have
seen this--it says FICA and then
there's a certain amount,
a certain percentage of your
paycheck, and the employer
matches just like in Germany in
1889.
When you retire--you can
actually get it now,
electronically,
your entire employment history,
all your contributions--when
you retire, there will be a
formula--you can find it on the
Social Security system
website--which resembles the
formula that they did in 1889.
We're still doing the same
thing now.
This invention of social
security is well over one
hundred years old,
but I think that,
because of the rapid advance of
information technology,
we're going to see a lot more
progress.
Over your lifetime,
there are going to be a lot
more inventions like this.
So, that's why I think finance
will be an interesting field for
those of you who choose to go
into it.
Finally, I just want to say,
next lecture is January
twenty-eighth and we're going to
talk about portfolio
diversification,
which is one very important
application of the fundamental
principle of risk management,
as applied to securities.
It's more narrow than my very
broad discussion.
It's not public finance,
it's not insurance,
but it's one of the most
important fundamental theories
that underlies finance.
Then you have a problem set,
which is due on that day,
your first problem set,
and the problem set is up on
the website.
If you go to ClassesV2 and you
click on "Problem Sets," it's
Problem Set #1.
We're also going to--I'm going
to email you about review
sections.
Our first review section will
be in the week of January--with
your teaching fellows--will be
in the week of January
twenty-eighth and we're going to
have to ask you to sign up with
one of the teaching fellows.
We'll give you times and dates
when the sections occur.
I'll see you on January 28.
