Subprime Solution

A few months ago I stumbled across academicearth.org, which has videos of full courses in a wide variety of areas, mostly from Yale professors. I worked my way through Robert Shiller’s course on financial markets. He’s most well known for his work in behavioral finance, which applies concepts from psychology to analyzing decision making in financial markets.

The course was very similar to the upper-level finance elective I took in college, except more interesting and less dry. So when I saw Shiller’s new book, “The Subprime Solution,” available for $3 at the local used bookstore, I immediately jumped on it. I wasn’t disappointed, even if I took issue with some of his arguments.

Shiller’s prognosis of the crisis is that no one expected to see home prices decline, which led to a massive bubble in home prices. This led to people doing all sorts of silly things, like taking out mortgages that they couldn’t pay off or creating financial products that were riskier than they appeared.

As important as the “bubble mentality” is when explaining the current situation, I think he spends too little time analyzing the microeconomic conditions that formed this mentality to begin with. He seems a bit too taken by his own work in behavioral finance, and I was surprised to see no discussion of the perverse incentives faced by ratings agencies (http://www.econtalk.org/archives/2009/02/cochrane_on_the.html), the political pressure on Fannie and Freddie, etc.

Moving on to part two, Shiller’s solutions center around a.) short run bailouts to prevent a panic in the near/intermediate term and b.) a “democratization” of finance to guard against speculative bubbles in the future. I’m still skeptical about the argument for short-term bailouts, though I still think that there is a powerful case to be made for them. I’m more thoroughly skeptical about his arguments on how to make the financial system more transparent and accessible, however.

Some of them, such as making financial advice tax deductible, seem patently unrealistic. 3rd party financial advice will never be completely free of bias, and it’s not difficult to imagine financial planners taking advantage of a newfound market of uneducated people. His idea to create a sort of financial products safety commission seems equally uncompelling—It’s difficult to see why bureaucrats in a government agency would have better knowledge of the risk and return profiles of new products than people who invest in them. Some of the other ideas, such as a liquid futures market for housing market indices and “livelihood insurance” indexed to a people active in a certain occupation over a given area seem more sound, though the cynical libertarian in me wonders why these products have not been able to get off the ground by now.

Thankfully, he doesn’t jump on the populist “throw the CEO’s in jail and stab demon finance right through the heart,” which is quite refreshing to hear from someone who I (vaguely) associate with the left.

This book is well worth reading, even if Shiller is a bit too in love with his own work in behavioral finance to look at some of the other causes of the bubble. Not al of his diagnoses seemed realistic, though his analysis cogent and it was all certainly good food for thought.