Financial Analysts Journal Volume 69 Number 1 2013 CFA Institute

P e r s pec t i v e s

Capitalism and Financial Innovation

Robert J. Shiller
At the 2012 CFA Institute Financial Analysts Seminar, held 2327 July in Chicago, Robert J. Shiller discussed his view that capitalism must be constantly updated through innovation in order to be successful in its purpose of achieving societys goals. Three recent innovationsthe benefit corporation, crowd funding, and the social impact bondare good examples of how finance and financiers can contribute to attaining these goals.

ith the worst financial crisis since the Great Depression just behind us, many people are angry and believe the crisis was a product of something fundamentally wrong with the financial system and the people who compose it. They believe that financiers were supposed to help guard and defend against such crises. They believe that financiers either dropped the ball or purposefully aggravated the situation for their own benefit. Further to this point, recent polls show that support for capitalism is falling all over the world. Therefore, my message here is a plea for capitalism and the need for change. Capitalism is a complex invention that changes all the time. As capitalists, we have to innovate and keep up with the times. Because we are living in the digital age, the future is going to be radically different from the past, and it is arriving at a rapid pace. I teach a class on the financial markets at Yale University. Some of my students are really young, just 18 years old. They havent figured out life, or much of anything about their long-term goals, although theyre certainly intelligent. When I wrote my latest book, Finance and the Good Society,1 I had my students in mind. I wanted to help them focus on values, purpose, and personal responsibility as an important part of their future career in finance. If present and future investment professionals can more thoroughly embrace this aspect of their role in society, I believe that the finance industry can meaningfully improve on and possibly reverse the publics negative perception of financiers. Robert J. Shiller is the Arthur M. Okun Professor of Economics and a professor of finance at Yale University, New Haven, Connecticut.

The ideas I posit are basically an appreciation of financial innovation. Today, cynicism and skepticism regarding financial innovation abound. Even former Fed chairman Paul Volcker contributes to these views. A couple years ago, he famously said that he couldnt think of any useful financial innovation within recent memory besides ATMs. What Volcker says gets a big audience, but I couldnt disagree with him more. Our civilization is built on financial innovation. Finance begets and supports almost all activities; it makes the world turn in a modern and civilized way. Innovation is necessary if finance is to remain relevant as a means of achieving societys goals. Perhaps what I have to say will help the finance community defend itself better and encourage finance professionals to assume personal responsibility for their role in making markets more efficient. Some say that I am too apologetic for evil financiers. I offer no apology or excuse. My intent is to explain that we all have strengths and weaknesses, regardless of our walk of life. The human being is a collection of emotions and impulses that modern neuroscience is helping us to better understand. We have circuits in our brains that are activated under certain circumstances. We have an altruistic side and a selfish side. This dichotomy is programmed into our brain. The key concepts of finance and the structure of financial institutionsfor example, ownership rights, subdivision of assets into shares, price discovery, employee incentives, and risk managementare all part of a system that aims to coordinate participants activities so that the right circuits in the brain will be triggered and that fraud, mismanagement, and unethical behavior will be limited.
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The Bubble Phenomenon

In my view, bubbles and crises occur less frequently than they otherwise would because of the structure of markets and the community of financial professionals, even though the most recent crisis was caused by a bubble, mostly in the housing market but also in the stock market. The bubble phenomenon, however, is not unique to the financial markets. One example of a nonfinancial speculative bubble is the collectivization in the Soviet Union from 1929 to 1933. Stalin decided to aggressively collectivize agriculture, and he did it without any markets, analysts, or professionals. The result was that millions of people died of starvation. A second example is the Great Leap Forward in China from 1958 to 1961, when Chairman Mao created a collectivization program and an industrialization program without the help of any financial markets or institutions. Over 30 million people died of starvation in that experiment. The Soviet collectivization and the Chinese collectivization were supported by great enthusiasm in some parts of the population. Propaganda accompanied both: The Soviet and Chinese governments promoted the belief that these programs were going to modernize their respective countries and that all citizens would become much better off from collectivization. The result was that peoples behavior in response to the programs was similar to the behavior of participants in speculative bubbles in the financial marketseven to the extent of an ensuing crisisand financiers were not involved in any way.

The Potential of Recent Financial Innovations

Over the last two years, the community of financial professionals has promoted three new innovations the benefit corporation, crowd funding, and the social impact bondthat jointly or singly may have a positive and lasting impact on society and societys goals. Any financial innovation is an experiment, and these three havent been around long enough to fully evaluate their viability or contribution, but each is noteworthy in its potential to improve the lives of many. The Benefit Corporation.A benefit corporation is a class of corporation required by law to create a general benefit for society as well as for its shareholders through profit maximization. A benefit corporation is charged with creating a material positive impact on society and with considering how its decisions affect its employees, its community, and the environment. A benefit corporation
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must publicly report its social and environmental performance using established third-party standards. It is essentially halfway between a for-profit organization and a not-for-profit organization. In 2010, Maryland was the first U.S. state to pass benefit corporation legislation. Ten more U.S. states have since followed Marylands lead. Moreover, a not-for-profit organization called B Lab evaluates the activities of companies in the service of the public and certifies those that meet certain standards as B Corps. One example is a company called Growers Secret, which manufactures fertilizer. The company states that it wishes to improve the NPK (nitrogen, phosphorous, and potassium) balance of the planets oceans. Fertilizers are believed to be running off the land into the ocean and causing chemical effects that are damaging to the ocean. The companys goalin addition to making moneyis to address this problem. The idea that we should bifurcate charity and profit is, in a way, inherently appealing. Why should organizations have any charitable mission at all? Life is simpler for corporate directors if they do not. For over half a century in the United States, the tradition has been that the board of directors of any for-profit corporation has a duty of loyalty to the shareholders. If the shareholders then want to distribute their dividends to charity, thats their business and not the corporations business. This concept has been the keystone of financial thinking about the U.S. corporate sector, but people are starting to doubt that that extreme is ideal. It may run afoul of certain aspects of human behavior. People like to think of their employers, and investors like to think of their investments, in terms of adhering to some principles and purpose other than profit. Its an empirical issue, and we should experiment with benefit corporations. The financial markets are already engaged in ethical investing, but we have to continue to tinker with financial institutions to try to better understand what motivates people and how they can be encouraged to pool their information in order to work together effectively. Crowd Funding. Another recent financial inno vation is crowd funding, which is the funding of a company by selling small amounts of equity to many investors. It is a new kind of investment banking that takes the form of a website that allows small investors to buy a small stake in a company. It allows the small investor to be, in effect, a venture capitalist. Crowd funding essentially democratizes finance. In the classic book Road to Serfdom,2 written in the early 1940s, the Austrian-born economist and philosopher Friedrich von Hayek asserted that a critical error of thought at that time was that
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scientists and central planners knew everything. Hayek argued that they didnt and that knowledge is, in fact, dispersed over millions of people; for an economy to be successful, it must activate that knowledge. Crowd funding is one vehicle for doing just that. Hayek was right: Knowledge is really all over the place. Thats why we have thousands of analysts. I think crowd funding is an exciting idea, but its also dangerous. Any innovation is dangerous because it could be used to abuse people, so we have to evaluate innovations as they are applied and be ready to make adjustments. Constant updating and improvement is a fundamental requirement of successful innovation. The Social Impact Bond.The social impact bond is the third financial innovation that has been introduced within the last two years. The first proponent of the social impact bond was New Zealand economist Ronnie Horesh, who floated the idea in 2000. Not until 2010, however, was such a bond issued. A social impact bond is not a bond in the conventional sense. It operates over a fixed period of time but does not offer a fixed rate of return. Repayment to investors is contingent on the achievement of specified social outcomes. The idea is to let the free enterprise system solve a social or even an environmental problem. The bond proceeds are used to create a financial market that will encourage and incentivize private vendors to find practical solutions for social concerns. In 2010, the U.K. not-for-profit organization Social Finance arranged a social impact bond for the U.K. Ministry of Justice to finance a group of activities that they hoped would help solve the recidivism problem of the U.K. prison system. Social Finance raised 5 million from 17 social investors who would make a profit only if the recidivism problem were ameliorated by a metric defined in the contract. The Ministry of Finance picked a prison outside London called Peterborough Prison, which had a history of high levels of recidivism. The proceeds of the bond issue went to social sector organizations that the investors thought were capable of improving the recidivism rate. Its still too early to determine if the bond has met its goals. In the United States, Massachusetts and New York City are currently experimenting with social impact bonds, and interest in this type of funding is spreading quickly to other municipalities. According to Ronnie Horesh, the Peterborough Prison bond is not marketable and cannot be shorted. Thus, it lacks a primary element of Horeshs original plan: Investors should be able to get out of a very long-term bond or project long before it reaches maturity or completion. For example, a bond could

have a 100-year payout, but an investor could have an exit strategy based on whether the program was working. The price of the bond would reflect the success of the project. As far as I know, that aspect of Horeshs plan has never been tried.

Securitization
The three recent examples of financial innovation are capitalism at workmaking opportunities for people with the right knowledge to use that knowledge for profit. Historians have pointed out that what may appear to be a sudden breakthrough or innovation, such as Alexander Graham Bells invention of the telephone and Thomas Edisons invention of the phonograph, is often really a series of many small innovations. When we talk about the innovation of crowd funding, we are really talking about a new method of securitization. Securitization was an innovation that blew up in the latest crisis because the process was fraught with errors. The most notable error in securitization was in real estatethe subprime loan securitization, which blew up because people didnt appreciate the risk that home prices would fall. As a concept, however, securitization will survive because it is a means through which a large number of people benefit. Securitization is an innovation designed to solve an asymmetric information problem. In the case of the mortgage market, mortgages and thus mortgage-backed bonds require a lot of analysis that many investors are unable to do, so without securitization, those investors would forgo investing in this market. By securitizing mortgages, tranches of similar credit quality are created, allowing a large swath of the general investing population to buy mortgage-backed bonds that they otherwise would not buy. Thus, mortgage securitization creates a financial market that allows many people to buy homes that they otherwise might not be able to buy, and it also lowers mortgage rates. The theory of finance involves asymmetric information as one of the elements that financial professionals have to engineer and design around.

The Economic Model of Human Nature

It seems to me that the view of human nature that has dominated economic thinking over the last half century, during the efficient markets regime, is a bit oversimplified and inaccurate: People are viewed solely as consumers. That model of human nature and decision making never felt right to me. People want to be loved and admired; they seek status and do not want to be shamed. Now, finally, the economic model of human behavior is beginning to
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change in order to embrace the true complexities of human decision making. As teachers, we have a tendency to dogmatize and oversimplify. But the world is not simple; it cannot be reduced to a simple framework. One important needed advance relates to the state of investment advice. People need good, solid financial advice. The complexities of a financial system require that investors be educated, but that alone is not enough. Serious deficiencies exist in modern financial society, and the average person needs financial guidance from a real personnot a website. That good information can be found on the internet is a big step forward, but the problem is that most people wont seek the information they need and wont read the information given to them. They need someone to actually talk to them. People benefit immensely by having a trusted adviser with a fiduciary duty to represent them. This situation is somewhat analogous to physicians advice in the 19th century, when most people did not have a personal physician. People learned about medicine through advertisements for Dr. So-and-Sos miracle remedy. The U.S. Food and Drug Administration had not been established yet, and they had no way to get advice from someone who didnt stand to make a profit selling them a drug. I think the situation has improved a lot in medicine. Now, we need to make similar progress in financial advice.

Trills: The Next Big Financial Innovation?

Weve discussed three interesting financial innovations of the last two years. Now, let me propose an innovation that I would like to see developed in the next couple years. I proposed it in 1993 in my book Macro Markets,3 and recently, a Canadian professor, Mark Hamstra, independently came up with the same idea: The U.S. government should sell shares of U.S. GDP to the public and make the shares marketable. Hamstras idea is to call the shares trills because a trill would be a one-trillionth share of GDP. In 2011, U.S. GDP was about $14.5 trillion, so a trill would have paid a dividend of $14.50 for the year. The trill owners claim would be a perpetuity; the government could get out of its obligation to the trill owner only by buying back the trill. The trill dividend would be paid in the local currency. Other governments could also issue trills. Canadian GDP, for instance, is about one-tenth of U.S. GDP, so in 2011, a Canadian trill would have paid US$1.81 (but in Canadian dollars), which is one-trillionth of Canadas 2011 GDP. I would like to see every nation selling its own trills.
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The price of a trill would fluctuate in the market on the basis of the anticipated GDP of the issuing country. The concept is similar to a country issuing equity instead of debt. Trill issuance is a type of risk management for the country. For instance, the European financial crisis likely could have been avoided if European nations had been selling trills. The crisis arose when the European nations had to roll over their short-term debt. So much debt was being rolled over that investors began to panic and interest rates rose rapidly and dramatically. Raising funds by issuing trills would avoid the vulnerability of having to refinance debt. Moreover, in an economic crisis or a recession, GDP tends to fall. The existence of trills might have mitigated the economic crisis to some extent, but at the very least, government payments to investors would be going down, not up. Currently, 30-year U.S. Treasury InflationProtected Securities (TIPS) are priced to yield 40 bps. Remember that TIPS pay a flat ratea fixed payment in real termsfor 30 years, and then, the payments stop. The value of a trill would probably grow at close to 3% a yearthe rate at which GDP has grown over the past century. Therefore, it is reasonable to assume that the dividend yield on a trill would be close to 10 bps, which is practically nothing. The U.S. government could begin to solve the budget crisis today by refinancing maturing debt into trills. If this were to happen, it would be the investment to end all investments. If every country were to issue trills, investors could buy a diversified portfolio of trills and would essentially own a share of the world. Owning a nations trill would be far superior to owning the nominal debt of that nation. A nation can destroy the value of its nominal debt by inflating its currency. Nominal debt is subject to the whim of a nations central bank: The bank simply has to adopt an easy money policy, which causes inflation to rise, and the holders of the debt have no recourse. A trill, however, is a promise to pay the investor a share of the nations GDP. There is some interest in trills and their analogues; notably, the Greek government issued GDP warrants in 2012 as part of their stressed debt refinancing. If the U.S. government would experiment with true trills, it could lead the way for the rest of the world while sheltering the nation from the risk of its present unparalleled levels of debt. I do not see how anyone could argue against this innovation because it is exactly the same mechanism that successful corporations use to finance their needs: They sell equity and manage their debt. The United States has heavily leveraged itself, and so has Europe.

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Conclusion
Capitalism doesnt make sense unless we have a philanthropic basis for it. Social psychologists have discovered the principle of reciprocity. On the one hand, people like other nice people and they behave nicely to people who they perceive are being nice to them. On the other hand, people can be vengeful and have a desire to hurt those who they perceive are hurting them. We have to have a caring society. How does that mesh with capitalism? It means that capitalism has to be designed in a way that encourages reciprocity: Finance should benefit society.

Essentially, our financial system of capitalism is an invention that has to be updated and changed constantly in accordance with our understanding of human behavior. The capitalist system has been designed to coordinate the activities of human beings who are themselves inherently problematic because of the potential for a certain percentage to act unethically and commit crimes. As teachers and investment professionals, we must educate ourselves and the public about the critical role that financiers play to help achieve social goals and mitigate social ills so that capitalism can thrive.
This article qualifies for 0.5 CE credit.

Notes
1. Robert J. Shiller, Finance and the Good Society (Princeton, NJ: Princeton University Press, 2012). 2. Friedrich von Hayek, Road to Serfdom (Chicago: University of Chicago Press, 1944). 3. Robert J. Shiller, Macro Markets: Creating Institutions for Managing Societys Largest Economic Risks (New York: Oxford University Press, 1993).

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