Swimming Against the Tide; Robert Shiller’s Solution to the Credit Crisis

The Man Who Saw it Coming (Click on image to read article)

The Man Who Saw it Coming (Click on image to read article)

Robert Shiller is part of a handful of economists who had made dire predictions of the impending economic downfall that we are dealing with today. What differentiates him from the crowd is the fact that he had predicted the economic downfall for the right reasons.

“Long before the extent of the subprime-mortgage crisis was evident, Shiller predicted that home prices would fall more rapidly than any models had predicted and that financial markets globally would be upended as a result.”

Shiller is an expert in the management of risk; and in this capacity, “he recognized that the real-estate bubble in the United States and parts of Europe represented, above all, a failure to manage risk.”

Unlike the U.S. administration and the federal reserve who are in a mad rush to saturate failing banks and many other failing companies with billions upon billions of “rescue plan” funds, Shiller believes this is the wrong approach. “He argues that unless the central issue of risk is addressed, all the money that governments are pouring into financial rescues won’t prevent another, potentially worse financial crisis down the line.”

“In Shiller’s view, derivatives “are a risk management tool much the same way insurance is. You pay a premium and if an event happens, you get a payment.” His radical answer to our problems is that trying to leash financial innovation is hopeless, and that we should instead push forward into a brave new world where derivatives become as common as cash.”

Another quality that separates Shiller from the majority of economists is his lack of faith in the “efficient-market hypothesis.” Shiller instead believes, “that market prices reflect ‘animal spirits’ and popular passions, not perfect information.” This is why he is a strong believer in financial innovation and calculated government regulation. His ultimate solition is to, “use derivatives to allow home-owners—and, by extension, lenders—to insure themselves against falling prices.” In supporting his solution of using derivatives as a means of insuring themselves from falling prices, he makes the following argument.

“For stocks, because of the use of derivatives and options, money can be made when markets fall, which significantly increases the potential number of buyers and sellers at any given point. And more buyers and sellers—according not just to Shiller but to most finance scholars and traders—means that markets stay liquid and functional even under pressure.” This is truly a novel solution and one that should be boldly pursued, despite the opposition it may face due to the bitter taste derivatives have already left for a many investors.

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~ by maniebrahimi on June 14, 2009.

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