By John Kay
The American economist Robert Shiller successfully called the peak of the economy boom. Irrational Exuberance, published in 2000, became a best seller. Prof Shiller has done more than any other mainstream economist to emphasise how psychology influences markets. Early in his career he demonstrated that fluctuations in asset prices are far larger than can be explained by economic, or any other, concept of rational behaviour.
And yet alongside Prof Shiller’s Dr Jekyll can be found his Mr Hyde. This alter ego believes that many economic problems would be solved by creating new speculative markets. He favours tax breaks for market makers who create still more exotic financial instruments.
One side of him recognises that these instruments may be used more often to gamble than to hedge. But the other applauds not just mortgage securitisation but the process of dividing and repackaging securities.
Shiller Jekyll acknowledges, with a degree of understatement, that the idea “turns out not to have worked superbly well in practice”.
Shiller Hyde has long been anxious to promote liquid markets in real-estate derivatives. In the night hours he is co-author of the Case-Shiller index of US residential house prices, created to facilitate these markets.
Prof Shiller has long understood the difficulty of reconciling the two arguments. “There is really no inconsistency, however,” he claimed in 1996. “I have never advocated the elimination of any financial market, so there is no reason why I should oppose the establishment of new such markets.” He repeats this statement in his latest book, Finance and the good society.
But this is persuasive argument only to those who have never heard the maxim “too much of a good thing”. No one should starve: that does not mean people should eat as much as possible. A country without a financial system would be – is – an impoverished place. It does not follow that the larger the financial system, the more prosperous the country.
A better response would echo the mantra of America’s National Rifle Association: guns do not kill people, people do. Derivative securities and other complex financial instruments can serve useful purposes. If they create instability it is because they are misused.
But should we, as the US would do, look for the solution in better people? Or should we, as most of the rest of the developed world does, think that if instruments are dangerous when abused their use should be tightly controlled? For many Americans, the fear of restrictions on the liberty of honest citizens is so strong that they are willing to accept the collateral damage of a high homicide rate and the incarceration of large numbers of bad young men. For Europeans, the loss of the ability to own a gun is a trifling price to pay for safer streets. There are similar transatlantic differences over the scope and merits of financial innovation.
Michael Albert, the writer, identified the twin origins of insurance: the mutualisation of risk in a Swiss village, and the pleasure English gentleman drinking in Lloyd’s coffee house derived from speculation on the fate of ships at sea. For Europeans in the Swiss tradition, the serious risks of everyday life are managed by social institutions. Americans, who inherited a different ethos and have not learnt to love a national health service, engage in a healthcare debate on issues that in Europe are not even open to discussion. Yet experience around the world is that only the rich can buy physical or economic security for themselves. Others must look to the state, more successfully in Sweden than Somalia.
Prof Shiller’s Mr Hyde can be reconciled with his Dr Jekyll only through an implausible faith in the power of markets. Ever since the days of alpine enclaves and wagers on the tides, insurance has been a mix of the socialisation of misfortune and the animal spirits of the professional gambler. But too often the speculative motive has tended to overwhelm the risk motive, and active markets have been a source of instability rather than security. As they were in the last financial crisis.
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