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WALL STREET, along with the City of London and other world financial centers, has served as the liveliest laboratory for new ideas in all of capitalism. Modern finance-not only securities and banking but also insurance and public finance-grows out of powerful theories, both mathematical and psychological, and has produced economic inventions of the greatest utility. Despite some awful financial scandals that surface from time to time, these inventions really work, most of the time. The inventions work because the fundamental ideas are sound and because finance professionals have learned to apply them effectively to real people, with all their psychological biases and quirks.

The primary subject matter of finance is the management of risks. Finance looks at the various forms of human disappointments and economic suffering as risks to which probabilities can be attached. Finance poses arrangements that reduce these disappointments and blunt their impact on individuals by dispersing their effects among large numbers of people. Finance helps us realize our dreams by enabling creators and innovators to pursue their ideas without bearing all of the risks themselves and encourages them to take great risks for good purposes, as when entrepreneurs start new companies financed by venture capitalists.

Unfortunately, the insights of finance have been applied in only a limited way. Risk sharing has been used primarily for certain narrow kinds of insurable risks, such as stock market crashes or hurricanes, or for managing the risks of conventional investments, such as diversifying investment portfolios or hedging commodity risks, benefits that often accrue mainly to the already-well-off members of our society. Finance has substantially neglected the protection of our ordinary riches, our careers, our homes, and our very abilities to be creative as professionals.

We need to democratize finance and bring the advantages enjoyed by the clients of Wall Street to the customers of Wal-Mart. We need to extend finance beyond our major financial capitals to the rest of the world. We need to extend the domain of finance beyond that of physical capital to human capital, and to cover the risks that really matter in our lives. Fortunately, the principles of financial management can now be expanded to include society as a whole. And if we are to thrive as a society, finance must be for all of us-in deep and fundamental ways.

Democratizing finance means effectively solving the problem of gratuitous economic inequality, that is, inequality that cannot be justified on rational grounds in terms of differences in effort or talent. Finance can thus be made to address a problem that has motivated utopian or socialist thinkers for centuries. Indeed, financial thinking has been more rigorous than most other traditions on how to reduce random income disparities.

Equipped with modern digital technology, we can now make these financial solutions a reality. Right now we are witnessing an explosion of new information systems, payment systems, electronic markets, online personal financial planners, and other technologically induced economic innovations, and consequently much in our economy will be changed within just a few years. Almost all of our economy will be transformed within just a few decades. This new technology can do cheaply what once was expensive by systematizing our approach to risk management and by generating vast new repositories of information that make it possible for us to disperse risk and contain hazard.

Society can achieve a greater democratization of finance and stabilization of our economic lives through radical financial innovation. We must make this happen, given the economic uncertainty of our future at a time of global change and given the problems and inadequacies of today's financial arrangements. This book presents ideas for a new financial order, a new financial capitalism, and a new economic infrastructure, and further describes how such ideas can realistically be developed and implemented.

Incentives for Great Works without Moral Hazard

Financial arrangements exist to limit the inhibitions that fear of failure places on our actions and to do this in such a way that little moral hazard is created. Moral hazard occurs when financial arrangements encourage people to engage in destructive rather than productive acts, such as phony work done only to impress investors, wanton spending, or accounting malfeasance.

An entrepreneur may feel discouraged from starting an exciting new business because the risk of failure is too high. Modern financial arrangements can often solve this problem. For instance, this entrepreneur might find a venture capital firm that will agree to bear the risks, paying the entrepreneur a salary yet providing the entrepreneur some incentive for inspired work by offering shares in the upside if the company does well. The risk that might have prevented the entrepreneur from ever launching the business seems to disappear. Actually, the risk does not disappear, but its effects virtually disappear as the risks to the individual business are blended into large international portfolios where they are diversified away to almost nothing among the ultimate bearers of the risk, the international investors. International portfolio managers from Kabuto-Cho to Dalal Street to Piazza Affari to Avenida Paulista each take on some of this entrepreneur's risk, but as less than a millionth of their total portfolio-so small a part of their portfolios that they do not feel any of this entrepreneur's risk. The entrepreneur is now protected, at virtually no cost to anyone, and can launch an exciting new business without fear. Thus do financial arrangements foster individual creativity and achievement. This is the essential wisdom of finance and its principle of diversification.

As noted above, this inspirational effect of risk management on the entrepreneur can work very well if the venture capital firm is careful to avoid moral hazard, that is, incentives for the entrepreneur to burn down the plant or to pursue flashy opportunities that have only the appearance of potential for success, to postpone dealing with problems for fear of revealing them to others, or to continue too long in an enterprise that is clearly failing.

Finance has not been perfect in containing moral hazard-witness the recent Wall Street scandals in the United States. But it would be absurd to junk the system because of a few failures. We should instead adapt and extend finance's insights by applying its essential wisdom to the management of economic risks faced by everyone, and similarly spread the payoffs to everyone. Financial institutions can be strengthened to short-circuit fiascoes like that at Enron Corporation, where moral hazard escaped the controls, where top management, using some clever financial innovation as a foil, dishonestly ran off with the money at the expense of their employees.

Six Ideas for a New Financial Order

In this book I present six fundamental ideas for a new risk management infrastructure. The first three are intended primarily for the private sector: insurance, financial markets, and banking, respectively. The risk management concepts in these three ideas are the same, but they are applied to different risk management industries. Each industry-insurance, financial markets, and banking-has evolved its own methods of dealing with moral hazard, defining contracts, and selecting clients. At a time of fundamental innovation in risk management, it is prudent to build on these methods, respecting each industry's unique body of knowledge and extending and democratizing finance through them.

The next three ideas are designed primarily for development by the government, both through taxation and social welfare and through agreements with other countries. Government has a natural role in risk management because long-term risk management requires the stability of law, because most individuals have limited ability to construct appropriate long-term risk contracts, because fundamental institutions must be managed in the public interest, and because major international agreements require coordination with an array of government policies.

The first idea is to extend the purview of insurance to cover long-term economic risks. Livelihood insurance would protect against long-term risks to individuals' paychecks. In contrast to life insurance, which was invented at a time when deaths of young adults with dependents were much more common than they are today, livelihood insurance would protect against currently very significant risks-the uncertainties in our livelihoods that unfold over many years. Home equity insurance would protect the economic value of the home but would go far beyond today's homeowners' policies by protecting not just against specific risks to homes such as fires but also against all risks that impinge on the economic value of homes. In the form offered here, first proposed by my colleague Allan Weiss and me in 1994, the problem of moral hazard is dealt with by tying the insurance contracts to indexes of real estate prices.

The second idea for a new financial order is for macro markets, which I first proposed in my 1992 Clarendon Lectures at Oxford University and in my 1993 book, and that has been a campaign of mine ever since. It envisions large international markets for long-term claims on national incomes and occupational incomes as well as for illiquid assets such as real estate. Some of these markets could be far larger in terms of the value of the risks traded than anything the world has yet experienced, dwarfing today's stock markets. Even a market for the combined gross domestic products (GDPs) of the entire world, a market for the sum total of everything of economic value, should be established. These markets would be potentially more important in the risks they deal with than any financial markets today, and they would remove pressures and volatility from our overheated stock market. Individual and institutional investors could buy and sell macro securities as they do stocks and bonds today.

The third idea is income-linked loans. Banks and other lending institutions would provide loans that are contingent on incomes to individuals, corporations, and governments. The loan balance would automatically be reduced if income falls short of expectations. Income-linked loans would effectively allow borrowers to sell shares in their future incomes and in income indexes corresponding to their own incomes. Such loans would provide protection against the hardship and bankruptcy that afflicts so many borrowers today.

The fourth idea is inequality insurance, which is designed to address definitively, within a nation, the serious risk that income in the future will be distributed among people far less equally than it now is, that the rich will get richer and the poor poorer. It reframes the progressive income tax structure so that over time it fixes the amount of inequality rather than fixing arbitrary tax brackets.

The fifth idea is intergenerational social security, which would reframe social security to be more truly a social insurance system, allowing genuine and complete intergenerational risk sharing. Intergenerational social security's defining characteristic would be a plan to pool the risks that different generations hold, risks that today are primarily dealt with only informally and then only to a limited extent within the extended family.

The sixth idea is international agreements to manage risks to national economies. These unprecedented agreements among governments of nations would resemble private financial deals, but they would surpass such deals in scope and horizon.

Beyond these six ideas for risk management, this book proposes components of a new economic information infrastructure: new global risk information databases (GRIDs) to provide the information that would allow effective risk management, and indexed units of account, new units of measurement and electronic money for better negotiating risks.

Some Scenes from the New Financial Order

Picture vast international markets that trade major macroeconomic aggregates such as the total outputs of countries such as the United States, Japan, Paraguay, and Singapore, or indexes of single-family home prices both in cities-from New York to Paris to Sydney-and in regions, such as shoreline properties on the Riviera or agricultural property in the corn belt or the rubber plantations of Indonesia. Portfolio investors will be able to take positions in a wide array of such markets with little cost. International markets for human capital will emerge as well for occupations from medical and scientific professions to the careers of actors and performers to common labor. These markets will facilitate the creation of livelihood insurance policies on every major career and job category, and home equity insurance policies on the value of everyone's home. Massive electronic databases made accessible by user-friendly designs will enable people everywhere to engage these markets to manage their real risks.

As these markets transform our appreciation of risks, our concepts and patterns of thought will change accordingly. People will set prices in light of the prices in these markets; countries will make international agreements that parallel some of the risk management afforded in these markets and will similarly revise their welfare and social security systems. Our economies will run more efficiently because these markets provide the means to control our risks. The presence of these new markets will make it easier for firms to offer livelihood insurance, home equity insurance, and income-linked loans to individuals.

Our fundamental risks will thus be insured against, hedged, diversified, making for a safer world. By lightening the burden of risk, a new democratic finance will encourage all of us to be more venturesome, more inspired in our activities.

As a thought experiment, consider a young woman from India, living in Chicago, who wants to be a violinist. She finds it worrisome to borrow the money for her training given that her future income as a musician is so uncertain. But new financial technology enables her to borrow money online that need not be fully repaid if an index of future income of violinists turns out to be disappointing. The loan makes it easier for her to go into her favored career by limiting her risk because if it turns out that musicians' careers are not as lucrative as expected, then she will not need to repay as much of the loan.

Continues...

Excerpted from The New Financial Order by Robert J. Shiller Copyright © 2003 by Robert J. Shiller
Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.