Many folks would agree that money is not the route to happiness. But, lets be honest, when some of your money is taken from you and just given to someone else – well now, that sure enough, has a way of pissing you off ! Such is a common refrain today, as taxpayer funds (your money) are used by Congress to bail out large banks and corporations, not to mention any number of people who irresponsibly bought mc-mansions they could not afford. Increasingly, there is a disconnect between what people “feel” and policy recommendations based on the cold, hard, complex, econometric, quantitative financial models used to justify these so-called bailouts. “It just feels wrong, but the experts tell us its for the best“. Strong medicine ? Hmmm.
John Maynard Keynes (pictured here) used the term ‘animal spirits’ to describe shifts in human mood that could have unpredictable effects on market behavior. In his recent podcast/lecture from the London School of Economics, Professor Robert Shiller opines further on these types of disconnects – those that exist between cold and dry economic models and real-life warm and fuzzy humans who inhabit a world constrained by these models that do not buffer against boom & bust cycles. Notably, Shiller, who is now highly in demand, was widely ignored during the last great disconnect – the one where people felt so good while the stock market and housing market inflated to levels that defied sound economic models (interestingly, he remains puzzled by our new Treasury Secretary, Timothy Geithner, who also never conceded that anything might be wrong with the financial system during the pre-bust years at the Federal Reserve Bank of New York – how could he miss it ?). Perhaps if we improved the economic models, then we could smooth-out the booming & busting ?
Shiller argues for a more flexible and sophisticated financial system that can better account for some of the emotional and social biases that make homo economicus such a greedy, panicky and yet often selfless and generous creature. Rather than static, fixed contracts, he suggests products that can function to hedge against what he calls, “psychological contagion”. Presently, he has created a number of such helpful products including securities which can hedge against the movement of house prices (via his Case-Shiller index) and newer securities (in development) that carry no counter-party risk and are somewhat less bubble-prone. He also advocates more research to connect financial engineering with behavioral finance which should help develop more advanced economic models that account and quantify discrete types of social and emotional biases that arise in the marketplace.
In any case, it is clear from listening to Shiller, and from his previous books, that financial engineering is best used as a tool to help everyday folks manage the inherent uncertainties of life over the long run (in contrast to financial engineering for the purposes of creating illusory wealth bubbles). I’m certainly a fan of Robert Shiller and wonder how basic brain science and behavioral finance might help his already groundbreaking work on the construction of financial instruments that factor-in the innate behavioral (sometimes irrational) biases that people have in assessing risk and making decisions based on long-term rather than short term outcomes. There must be many – and even some that are influenced by genetic factors. The new fields of neuroeconomics and its synthesis with behavioral genetics might, one day, even allow me to hedge against my own genetic risk (I carry 2 copies of the DRD4 7-repeat VNTR which, apparently, is associated with a 25-50% increase in risk taking).
My parents intuitively understood this somehow – they wisely gave me an allowance.