The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It
by Robert J. Shiller
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Manufacturer: Princeton University Press
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Binding: Hardcover
Dewey Decimal Number: 332.722
EAN: 9780691139296
ISBN: 0691139296
Label: Princeton University Press
Number Of Items: 1
Number Of Pages: 208
Publication Date: 2008-08-24
Publisher: Princeton University Press
Studio: Princeton University Press
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Customer Rating:
Summary: 3.5 stars-Shiller can't deal with uncertainty versus risk problem due to his allegiance to the SEU Rational actor model of
Comment: This could have been a major contribution to economic theory and history.Unfortunately,Shiller is unable to think outside the box of the basic neoclassical rational actor model of SEU(Subjective Expected Utility)theory ,and its extension in the form of the Tversky-Kahneman Prospect (Cumulative Prospect Theory )Theory that underlies the behavioral economics(finance)school of thought that has arisen since the late 1970's.Shiller makes it clear that he is an avid supporter of this school(Shiller,pp.117-120).SEU theory is actually a more advanced mathematical form of Jeremy Bentham's Benthamite Utilitarianism as expressed in his 1787 book, " Introduction to the Principles of Morals and Legislation".Bentham,the founder of neoclassical economics, asserted that all rational,and even some irrational, human decision makers are able to accurately calculate the outcomes of their actions .However,he failed to present a method describing how such decisions were made.Modern neoclassical economics filled this gap by combining the Ramsey-de Finetti-Savage subjective theory of probability,based on the premise that all probability calculations are precise,exact,accurate,unique,linear,additive,single number calculations, based on the laws of addition and multiplication of the probability calculus,combined with the expected utility theory of Morgenstern and Von Neumann,which claimed that all utilities can be shown to also be exact,precise,linear,additive calculations.Neoclassical economist Herbert Gintis gives a good summary of the neoclassical SEU theory :"...the model can be shown to apply over any domain in which the agent has transitive preferences " so that " there is a probability pi subscript,0<=pi subscript<=1 such that the agent is indifferent between Ai subscript and a lottery that pays A1 subscript with probability pi subscript and pays An subscript with probability 1-pi subscript.Clearly,these assumptions are extremely plausible "(Gintis,2004,Politics,Philosophy,and Economics,3,p.40).Unfortunarely,this is not the case.Gintis has presented an abbreviated summary of Savage's sure thing postulate that both Keynes(A Treatise on Probability,1921,p.315,ft.2)and Ellsberg showed required that the decision maker would have to be able to specify a complete information set.Keynes expressed this by the condition that the weight of the evidence,w,equalled 1.Elleberg expressed it by the condition that there was no ambiguity in the information base so that his variable ,rho,equalled 1.This problem ,of a complete information base ,showed
up in the 20 year exchange between L Jonathan Cohen and Tversky and Kahneman ,carried out primarily in
the pages of Brain and Behavioral Science journal between 1974 and 1994,over the blue -green taxi cab problem.Tversky had to come up with a Keynes/Ellsberg like w or rho variable,that he called s for support,in order to counter Cohen's point that Tversky -Kahneman were claiming that the experimental subjects
were irrationally using heuristics and rules of thumb,instead of the mathematical laws that a rational decision maker would use,rather than recognizing that the experimental subjects realized that their information
base was incomplete so that w and rho were less than 1.In cases of uncertainty /ambiguity ,where w or rho are less than 1,it is irrational to attempt to use the mathematical laws of probability which only work if w or rho are equal to 1.This was exactly the same point made in 1931 by Keynes in his review of Ramsey's subjective theory of probability.SEU theory can only deal with situations of
risk(w=1,rho=1).
Shiller constantly refers to the need to better manage risk through the risk models used by modern financial mathematical models .These risk models all result in the use of some sort of normal probability distribution(joint normal,cumulative normal,bivariate normal,multivariate normal,log normal).Benoit Mandelbrot
has demonstrated continuously for 50 years that none of the time series data supports the use of any type of normal distribution.The data supports the use of the Cauchy,Frechet,or power law distributions like the Pareto.Mandelbrot has correctly demonstrated that decision makers face the wild risk of the Cauchy and not the mild risk of the Normal.All 6 of the solutions proposed by Shiller on p.122 and discussed in depth on pp.123-169 can't deal with Keynesian uncertainty or Ellsbergian ambiguity or Mandelbrotian wild risk.The only way to deal with the uncertainty and lack of confidence created by the speculative and securitization behavior of the large Wall Street investment banks and the commercial banking system is a preventitive one-Prevent the speculators from getting their hands on the bank loans that they need to leverage their debt position in the first place.Thisis the solution arrived at by both Keynes and Smith(See Smith,WN,1776,pp.339-340;Keynes,GT,1936,pp.321-327,338-353,and pp,374-377).There is only one reference to uncertainty in this book.Shiller puts uncertainty in italics on p.103:"Right after the 1929 crash,the forecasters,although they did not predict the depression that was to follow,expressed unusual uncertainty(uncertainty is in italics for emphasis)about the economic outlook.Romer believes that it was this uncertainty that led to the sharp contraction in consumer spending that ultimately caused the Depression ".(Shiller,p.103,2008).Unfortunately,none of his solutions,based on the standard neoclassical SEU
risk models,that are taught universally in all economics and finance classes where Shiller teaches,can deal with the collapse in investor and consumer confidence because confidence
is a function of Keynes's w,which is assumed to always equal 1 in the SEU theory.Keynes gave the correct solution on p.158 of the General Theory-"A collapse in the price of equities,which has had disasterous reactions on the marginal efficiency of capital may have been due to the weakening either of speculative confidence or of the stste of credit.But wheras the weakening of either is enough to cause a collapse,recovery requires the revival of both(Keynes placed " both"in italics for emphasis).For whilst the weakening of credit is sufficient to bring about collapse,its strenthening,though a necessary condition of recovery,is not a sufficient condition."(Keynes,p.158,1936).None of Bernanke's current policies or of Shiller's recommendations on risk management will have any impact on confidence.
Shiller's position,in this book and the others he has written,is that the problem is one of irrational exuberance combined with information cascades.
"An information cascade occurs when those in a group disregard their own independently,individually collected information because they feel thateveryone else simply couldn't be wrong.(Shiller,p.47).Keynes had already shown that the reason this occurs is that each individual regards his w to be very low.This means that you are now dealing with uncertainty and not risk.Risk management techniques,no matter how mathematically advanced,will not be able to deal with this problem.
Shiller has correctly identified the problems of financial speculation and securitization.Unfortunately,his new risk management techniques would have no more of a chance of dealing with the wild risk of the Cauchy Distribution than an ice cube would have of not melting in the Sahara Desert.An ounce of Keynesian/Smithian prevention is worth more than a pound of risk management techniques build on the standard deviation of a normal probability distribution." Excessive Volatility " automatically means you have to deal with uncertainty as opposed to risk.
Customer Rating:
Summary: Audacious in its proposals
Comment: The first thing that can be said about this book is that notion of a financial bubble is not really explicitly defined. Instead its author takes it as a given that there was a housing bubble and it aggravated the current "credit crisis". One could perhaps debate the author's contention is this regard, if one examined for example the relatively stable housing markets in many areas in the country at the present time. His emphasis in the book is not on the quantitative analysis of financial bubbles but rather in what measures can be taken to alleviate the effects of the housing bubble. The study of these effects has taken on major importance in the last year, and much has been written about them. This book, although short, is interesting at least from the standpoint of the audacity of the solutions that the author proposes.
One of the best features of the book is the author's discussion of the importance of technology for the financial community. He looks forward to the integration of behavioral finance in the mathematical modeling of the financial markets. This is just getting started, and those involved can look forward to some very interesting developments along these lines. It is always refreshing to see new paradigms being used at a practical level, and behavioral finance shows great promise in more accurate modeling of the financial markets.
As part of a long-term solution, the author proposes the "democratization" of the financial markets but his proposals in this context are somewhat annoying since he, as do most other writers, frequently refers to the "general public" in a manner that implies a complete disrespect for the members of this group. It is interesting that no matter what the topic or ideology, its advocates always refer to the "general public" as some sort of class or entity that they do not belong to, but that is clearly lacking in intelligence and in need of their assistance. It is though every interest group feels that those outside of its political and intellectual logosphere need "enlightenment" or guidance of some sort. The author for example makes the statement that "the public, of course, does not understand this basic economic fact" when discussing why their ignorance resulted in a massive speculative bubble. Addressing "the public" (whoever that is) in this way only exposes the author's elitism. It does not help at all in elucidating the need for the "democratization" of the financial markets.
And assuming that this need is a valid one, it would be interesting to see just what actually would be made available for this purpose. For example, anyone who has worked in mortgage modeling knows of the need for more accurate data on house prices. Would the author be willing to make the Case-Shiller index available to anyone who wants it, without any financial compensation to the firm that currently has proprietary rights to it? When reading the book, it would seem that only financial tools produced as the result of government funding would be available without charge to anyone that was interested in using them. An immediate question arises as to whether these public tools are better than the ones developed by private firms or institutions. If they are, and they are recognized as such, then financiers and investors will use them instead, eliminating the need for the private tools. If they are not, then the people who use them are getting sub-standard advice, and this will aggravate or cause another financial bubble, since clearly the author believes that bubbles are caused by information of poor quality or wildly optimistic estimates of future prices.
The author is in favor of governmental bailouts, citing actions taken in the great depression as evidence, and the need for financial "stablity" (the latter undefined in the book). But the ability of the governmental institutions to fix the problems that arose out of the great depression is not apparent when reading this book or indeed many others on the same subject. Yes, these institutions were put in place because of the great depression, but this reviewer is not aware of any evidence that they played an actual role in ending it. Just because they were invented with the intent of solving the financial problems of the great depression does not mean that they actually did. Other factors may have played the major role, these factors not being known, with the result of a false imputation of success to these governmental institutions. Indeed, there are a few ideological groups who claim that it was the gearing up for the Second World War that effectively ended the depression.
If government is to be more involved in matters of economics, maybe a good start would be to pass what might be called a "Financial Courage Act", which would be a massive educational program to instill in all citizens a recognition and appreciation of the extreme volatility of the financial markets of the twenty-first century. This would not be a propaganda campaign waged to protect Wall Street economic interests, but instead a long-term project that would educate everyone on why the financial markets take the form that they now do and thus alleviate some of the anxiety associated with rapid change. This reviewer cannot see anything intrinsically wrong with financial bubbles, and if we all understand them as just another aspect of our financial deal making we will not be emotionally overwhelmed when they do occur. When Roosevelt made his speech on the debilitating effects of fear, he was correct, and that speech might have been his greatest contribution to the economic turmoil of his time. The citizens of his generation had the courage to face up to their difficulties and move on, and so there is no reason why everyone at the present time cannot do the same.
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Editorial Reviews:
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Customer Rating:
Summary: 3.5 stars-Shiller can't deal with uncertainty versus risk problem due to his allegiance to the SEU Rational actor model of
Comment: This could have been a major contribution to economic theory and history.Unfortunately,Shiller is unable to think outside the box of the basic neoclassical rational actor model of SEU(Subjective Expected Utility)theory ,and its extension in the form of the Tversky-Kahneman Prospect (Cumulative Prospect Theory )Theory that underlies the behavioral economics(finance)school of thought that has arisen since the late 1970's.Shiller makes it clear that he is an avid supporter of this school(Shiller,pp.117-120).SEU theory is actually a more advanced mathematical form of Jeremy Bentham's Benthamite Utilitarianism as expressed in his 1787 book, " Introduction to the Principles of Morals and Legislation".Bentham,the founder of neoclassical economics, asserted that all rational,and even some irrational, human decision makers are able to accurately calculate the outcomes of their actions .However,he failed to present a method describing how such decisions were made.Modern neoclassical economics filled this gap by combining the Ramsey-de Finetti-Savage subjective theory of probability,based on the premise that all probability calculations are precise,exact,accurate,unique,linear,additive,single number calculations, based on the laws of addition and multiplication of the probability calculus,combined with the expected utility theory of Morgenstern and Von Neumann,which claimed that all utilities can be shown to also be exact,precise,linear,additive calculations.Neoclassical economist Herbert Gintis gives a good summary of the neoclassical SEU theory :"...the model can be shown to apply over any domain in which the agent has transitive preferences " so that " there is a probability pi subscript,0<=pi subscript<=1 such that the agent is indifferent between Ai subscript and a lottery that pays A1 subscript with probability pi subscript and pays An subscript with probability 1-pi subscript.Clearly,these assumptions are extremely plausible "(Gintis,2004,Politics,Philosophy,and Economics,3,p.40).Unfortunarely,this is not the case.Gintis has presented an abbreviated summary of Savage's sure thing postulate that both Keynes(A Treatise on Probability,1921,p.315,ft.2)and Ellsberg showed required that the decision maker would have to be able to specify a complete information set.Keynes expressed this by the condition that the weight of the evidence,w,equalled 1.Elleberg expressed it by the condition that there was no ambiguity in the information base so that his variable ,rho,equalled 1.This problem ,of a complete information base ,showed
up in the 20 year exchange between L Jonathan Cohen and Tversky and Kahneman ,carried out primarily in
the pages of Brain and Behavioral Science journal between 1974 and 1994,over the blue -green taxi cab problem.Tversky had to come up with a Keynes/Ellsberg like w or rho variable,that he called s for support,in order to counter Cohen's point that Tversky -Kahneman were claiming that the experimental subjects
were irrationally using heuristics and rules of thumb,instead of the mathematical laws that a rational decision maker would use,rather than recognizing that the experimental subjects realized that their information
base was incomplete so that w and rho were less than 1.In cases of uncertainty /ambiguity ,where w or rho are less than 1,it is irrational to attempt to use the mathematical laws of probability which only work if w or rho are equal to 1.This was exactly the same point made in 1931 by Keynes in his review of Ramsey's subjective theory of probability.SEU theory can only deal with situations of
risk(w=1,rho=1).
Shiller constantly refers to the need to better manage risk through the risk models used by modern financial mathematical models .These risk models all result in the use of some sort of normal probability distribution(joint normal,cumulative normal,bivariate normal,multivariate normal,log normal).Benoit Mandelbrot
has demonstrated continuously for 50 years that none of the time series data supports the use of any type of normal distribution.The data supports the use of the Cauchy,Frechet,or power law distributions like the Pareto.Mandelbrot has correctly demonstrated that decision makers face the wild risk of the Cauchy and not the mild risk of the Normal.All 6 of the solutions proposed by Shiller on p.122 and discussed in depth on pp.123-169 can't deal with Keynesian uncertainty or Ellsbergian ambiguity or Mandelbrotian wild risk.The only way to deal with the uncertainty and lack of confidence created by the speculative and securitization behavior of the large Wall Street investment banks and the commercial banking system is a preventitive one-Prevent the speculators from getting their hands on the bank loans that they need to leverage their debt position in the first place.Thisis the solution arrived at by both Keynes and Smith(See Smith,WN,1776,pp.339-340;Keynes,GT,1936,pp.321-327,338-353,and pp,374-377).There is only one reference to uncertainty in this book.Shiller puts uncertainty in italics on p.103:"Right after the 1929 crash,the forecasters,although they did not predict the depression that was to follow,expressed unusual uncertainty(uncertainty is in italics for emphasis)about the economic outlook.Romer believes that it was this uncertainty that led to the sharp contraction in consumer spending that ultimately caused the Depression ".(Shiller,p.103,2008).Unfortunately,none of his solutions,based on the standard neoclassical SEU
risk models,that are taught universally in all economics and finance classes where Shiller teaches,can deal with the collapse in investor and consumer confidence because confidence
is a function of Keynes's w,which is assumed to always equal 1 in the SEU theory.Keynes gave the correct solution on p.158 of the General Theory-"A collapse in the price of equities,which has had disasterous reactions on the marginal efficiency of capital may have been due to the weakening either of speculative confidence or of the stste of credit.But wheras the weakening of either is enough to cause a collapse,recovery requires the revival of both(Keynes placed " both"in italics for emphasis).For whilst the weakening of credit is sufficient to bring about collapse,its strenthening,though a necessary condition of recovery,is not a sufficient condition."(Keynes,p.158,1936).None of Bernanke's current policies or of Shiller's recommendations on risk management will have any impact on confidence.
Shiller's position,in this book and the others he has written,is that the problem is one of irrational exuberance combined with information cascades.
"An information cascade occurs when those in a group disregard their own independently,individually collected information because they feel thateveryone else simply couldn't be wrong.(Shiller,p.47).Keynes had already shown that the reason this occurs is that each individual regards his w to be very low.This means that you are now dealing with uncertainty and not risk.Risk management techniques,no matter how mathematically advanced,will not be able to deal with this problem.
Shiller has correctly identified the problems of financial speculation and securitization.Unfortunately,his new risk management techniques would have no more of a chance of dealing with the wild risk of the Cauchy Distribution than an ice cube would have of not melting in the Sahara Desert.An ounce of Keynesian/Smithian prevention is worth more than a pound of risk management techniques build on the standard deviation of a normal probability distribution." Excessive Volatility " automatically means you have to deal with uncertainty as opposed to risk.
Customer Rating:
Summary: Audacious in its proposals
Comment: The first thing that can be said about this book is that notion of a financial bubble is not really explicitly defined. Instead its author takes it as a given that there was a housing bubble and it aggravated the current "credit crisis". One could perhaps debate the author's contention is this regard, if one examined for example the relatively stable housing markets in many areas in the country at the present time. His emphasis in the book is not on the quantitative analysis of financial bubbles but rather in what measures can be taken to alleviate the effects of the housing bubble. The study of these effects has taken on major importance in the last year, and much has been written about them. This book, although short, is interesting at least from the standpoint of the audacity of the solutions that the author proposes.
One of the best features of the book is the author's discussion of the importance of technology for the financial community. He looks forward to the integration of behavioral finance in the mathematical modeling of the financial markets. This is just getting started, and those involved can look forward to some very interesting developments along these lines. It is always refreshing to see new paradigms being used at a practical level, and behavioral finance shows great promise in more accurate modeling of the financial markets.
As part of a long-term solution, the author proposes the "democratization" of the financial markets but his proposals in this context are somewhat annoying since he, as do most other writers, frequently refers to the "general public" in a manner that implies a complete disrespect for the members of this group. It is interesting that no matter what the topic or ideology, its advocates always refer to the "general public" as some sort of class or entity that they do not belong to, but that is clearly lacking in intelligence and in need of their assistance. It is though every interest group feels that those outside of its political and intellectual logosphere need "enlightenment" or guidance of some sort. The author for example makes the statement that "the public, of course, does not understand this basic economic fact" when discussing why their ignorance resulted in a massive speculative bubble. Addressing "the public" (whoever that is) in this way only exposes the author's elitism. It does not help at all in elucidating the need for the "democratization" of the financial markets.
And assuming that this need is a valid one, it would be interesting to see just what actually would be made available for this purpose. For example, anyone who has worked in mortgage modeling knows of the need for more accurate data on house prices. Would the author be willing to make the Case-Shiller index available to anyone who wants it, without any financial compensation to the firm that currently has proprietary rights to it? When reading the book, it would seem that only financial tools produced as the result of government funding would be available without charge to anyone that was interested in using them. An immediate question arises as to whether these public tools are better than the ones developed by private firms or institutions. If they are, and they are recognized as such, then financiers and investors will use them instead, eliminating the need for the private tools. If they are not, then the people who use them are getting sub-standard advice, and this will aggravate or cause another financial bubble, since clearly the author believes that bubbles are caused by information of poor quality or wildly optimistic estimates of future prices.
The author is in favor of governmental bailouts, citing actions taken in the great depression as evidence, and the need for financial "stablity" (the latter undefined in the book). But the ability of the governmental institutions to fix the problems that arose out of the great depression is not apparent when reading this book or indeed many others on the same subject. Yes, these institutions were put in place because of the great depression, but this reviewer is not aware of any evidence that they played an actual role in ending it. Just because they were invented with the intent of solving the financial problems of the great depression does not mean that they actually did. Other factors may have played the major role, these factors not being known, with the result of a false imputation of success to these governmental institutions. Indeed, there are a few ideological groups who claim that it was the gearing up for the Second World War that effectively ended the depression.
If government is to be more involved in matters of economics, maybe a good start would be to pass what might be called a "Financial Courage Act", which would be a massive educational program to instill in all citizens a recognition and appreciation of the extreme volatility of the financial markets of the twenty-first century. This would not be a propaganda campaign waged to protect Wall Street economic interests, but instead a long-term project that would educate everyone on why the financial markets take the form that they now do and thus alleviate some of the anxiety associated with rapid change. This reviewer cannot see anything intrinsically wrong with financial bubbles, and if we all understand them as just another aspect of our financial deal making we will not be emotionally overwhelmed when they do occur. When Roosevelt made his speech on the debilitating effects of fear, he was correct, and that speech might have been his greatest contribution to the economic turmoil of his time. The citizens of his generation had the courage to face up to their difficulties and move on, and so there is no reason why everyone at the present time cannot do the same.
The subprime mortgage crisis has already wreaked havoc on the lives of millions of people and now it threatens to derail the U.S. economy and economies around the world. In this trenchant book, best-selling economist Robert Shiller reveals the origins of this crisis and puts forward bold measures to solve it. He calls for an aggressive response--a restructuring of the institutional foundations of the financial system that will not only allow people once again to buy and sell homes with confidence, but will create the conditions for greater prosperity in America and throughout the deeply interconnected world economy. Shiller blames the subprime crisis on the irrational exuberance that drove the economy's two most recent bubbles--in stocks in the 1990s and in housing between 2000 and 2007. He shows how these bubbles led to the dangerous overextension of credit now resulting in foreclosures, bankruptcies, and write-offs, as well as a global credit crunch. To restore confidence in the markets, Shiller argues, bailouts are needed in the short run. But he insists that these bailouts must be targeted at low-income victims of subprime deals. In the longer term, the subprime solution will require leaders to revamp the financial framework by deploying an ambitious package of initiatives to inhibit the formation of bubbles and limit risks, including better financial information; simplified legal contracts and regulations; expanded markets for managing risks; home equity insurance policies; income-linked home loans; and new measures to protect consumers against hidden inflationary effects. This powerful book is essential reading for anyone who wants to understand how we got into the subprime mess--and how we can get out.
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