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April 10, 2003

Novel Ideas for a Risky World

By HAL R. VARIAN

UNEMPLOYMENT is up. Housing sales are weakening. Oil prices continue to fluctuate, and the stock market remains volatile. There's no doubt we live in risky times, yet our tools for managing risk are limited.

We can do something about the stock market: those with low tolerance for risk can put their money in investments with more stable returns. There are also ways to manage the risk from oil-price fluctuations: buy or sell oil futures to lock in a particular price.

But what about unemployment risk or housing price risk? There are financial markets that help us manage fluctuations in corporate profitability and commodity prices. But there are no markets to help manage risks from fluctuations in labor markets and housing markets, even though these have a much bigger impact on most peoples' financial security.

How could we design markets to help manage such risks?

This challenging problem is examined in Robert J. Shiller's book "The New Financial Order" (Princeton University Press, 2003).

Mr. Shiller, a professor of economics at Yale, is well known for his previous book "Irrational Exuberance," which forecast the demise of the 1990's bull market. In his new book, Mr. Shiller turns to the role of financial institutions in managing risk.

Why is it that I can buy insurance against my house burning down, but not against my house price declining? One difficulty comes from what economists call moral hazard. Suppose I were able to buy "house price insurance." Once I had it, why should I bother to repaint, or fix that hole in the roof?

True, the peeling paint and leaky roof would lower the resale value but, hey, I'm insured, why should I care?

One solution to this sort of moral hazard is to base housing insurance on something outside a homeowner's control, like an index of house prices in that ZIP code. This way homeowners can be insured against fluctuations in local prices, but still have incentives to invest in keeping their own house marketable.

Such insurance has been offered, as an experiment, in certain neighborhoods in Chicago and Syracuse. Mr. Shiller, by the way, does not confine himself to ivory tower speculations. He has founded a company with his colleague, Allan Weiss, to offer tools to manage home price risk.

Similar ideas can be used in labor markets. One could sell financial securities linked to average compensation in various occupations. If you wanted to go to dental school, but were worried about the market for dentists when you graduated, you could buy "dentist income insurance," tied to average wages in this profession. Such insurance would protect you against the risk of labor market fluctuations, but still give you an incentive to work hard at your chosen occupation.

Moving from micro to macro risks, Mr. Shiller also offers novel ideas for markets in risks in a given country. Suppose you could buy or sell a security linked to a country's gross domestic product. Now you can buy shares only in stock issued by companies based in particular countries, but stock market growth is only loosely related to G.D.P. growth. Such "macro markets" could be an attractive way of managing risk and financing investment.

This year exports from Argentina are booming, driven by a cheap peso; perhaps this export growth will pull the country out of its three-year slump. Those who think so could buy shares of future G.D.P. in Argentina. Argentine businesses that produce exports could, in turn, sell shares tied to future G.D.P. to raise money for needed investments.

A particularly intriguing section of the book deals with risk sharing in Social Security programs. The current arrangement in most countries offers retirees monthly payments based on lifetime income, age at retirement and the inflation rate; these payments, in turn, come from a payroll tax on those still employed. Retirees get a fixed, inflation-adjusted payment, while all the risk from fluctuations in nominal income is borne by workers.

Suppose that, instead of receiving a fixed amount taken from workers' paychecks, Social Security recipients received a fixed share of those paychecks, where the share was determined by the fraction of the population that was retired. (This is now about 11 percent.)

The risk of fluctuations in nominal labor income would then be shared between workers and retirees. Those who preferred not to bear such risks, whether they were retired or working, could sell off some of that risk using the other markets Mr. Shiller describes.

These are intriguing ideas. They are only partly fleshed out in the book, but Mr. Shiller and his colleagues have investigated these ideas in greater depth in their academic work, some of which is available at www.newfinancialorder.com.

But would these markets really work? Housing equity insurance sounds feasible. Intergenerational risk sharing for Social Security also appears attractive; we would certainly be in a much better position today if the system had been set up in that manner. But Mr. Shiller's proposal faces the same problem all Social Security reforms face: How do we get from here to there?

Occupation insurance seems problematic. It's easy enough to decide the definition of a "dentist," but what, exactly is an "auto worker"? The Department of Labor has been trying to standardize occupational titles for a long time, but they change so rapidly that it's a losing battle. Think about trying to buy occupation insurance for "webmasters" a few years ago, or for "nanotechnician" a few years from now.

If such problems could be solved, occupation insurance would no doubt be a popular wedding present: "Good luck in your marriage to that economist, but here's some occupation insurance, just in case."

It is said that behind every successful man is a surprised mother-in-law. If so, there could be quite a large market for such securities.


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