Shiller front

oping countries. This experimentation is potentially valuable for the
world at large because it proceeds in varied environments and tradi-
tions and is supported by an eagerness to try different approaches.
Such experimentation is likely to inform new innovations that will
someday be copied elsewhere.
Psychology, Behavioral Finance, and Framing
If society is truly to democratize finance, business must make financial
devices and services easy to use by ordinary people and not just by fi-
nancial experts. People are not computers; they are not capable of do-
ing endless calculations and pinpoint analysis of self-interest, despite
what conventional economic theory has said for many years. Practical
finance has always known this, but academic finance is only just com-
ing to grips with the facts of human nature.
Most people are not comfortable with financial risk management
principles or the contraptions needed to apply these principles. More-
over, many people do not have a solid appreciation of their risks, nor
do they even know that they ought to reduce their risks. Gratuitous in-
come inequality is hard to control since many people may not take ba-
sic steps to control it, even when they can.
In light of these realizations, the theory of finance underwent a fun-
damental transformation starting around 1990 with the development
of behavioral finance, the application of principles of psychology and
insights from other social sciences to finance. Behavioral finance cor-
rects a major error in most mathematical finance: the neglect of the hu-
man element.
10
A particularly important lesson from behavioral finance is that psy-
chological framing matters enormously for risk management. Framing,
as used by psychologists Daniel Kahneman and Amos Tversky, refers to
well-documented patterns of human reactions to the context, reference
points, mental categories, and associations that influence how people
make decisions.
In designing new financial products, appearance and associations
not only matter but are fundamental. Some of the ideas for a new fi-
nancial order that follow have framing at their very core, and our un-
derstanding of the power of psychological framing is an important part
of the reason to expect that real progress in risk management can be
achieved in the future.
the promise of economic security
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Potential Problems with Financial Innovation
Financial progress has repeatedly encountered several significant prob-
lems in the past, which might frustrate our efforts to innovate in the fu-
ture. First is the problem of excessive speculative activity, which can in-
duce great volatility in financial markets. Notably, as I discussed in
Irrational Exuberance, the stock market boom in the late 1990s, peak-
ing in early 2000, encouraged wasteful corporate investments, ac-
counting trickery, and risky investment decisions by individuals. After
this boom, most of the stock markets of the world fell dramatically. The
real inflation-corrected Standard & Poor’s Index fell by half by mid-
2002
. Some other countries’ markets fell even further. The amount of
wealth that was wiped out in the stock market declines between 2000
and 2002 is measured in the trillions of dollars. In the United States
alone, the dollar value of this economic loss from this stock market
crash is roughly equivalent to the destruction of all the houses in the
country or the razing of many thousands of World Trade Centers. Even
though the stock market loss may one day be restored by another bull
market, the markets generate ever-present risks.
I have been frequently asked, when giving talks, what should be
done about such stock market volatility. I have always been at a loss to
give an answer that satisfies my questioners. In fact, the best thing
that we can do to reduce such risks is to expand our financial technol-
ogy so that we can use this technology to cushion against unnecessary
instability.
Despite the volatility we observe in speculative markets, no one
should conclude from any of my or others’ research on financial markets
that these markets are totally crazy. I have stressed only that the aggre-
gate stock market in the United States in the last century has been driven
primarily by psychology and fads, that it has shown massive excess
volatility. But many markets for subindexes relative to the market do not
show evidence of excess volatility, and the market for individual stocks
shows substantial evidence supporting the notion that prices in these
markets do carry genuine information about future fundamentals.
11
A second problem is that financial innovation sometimes encourages
secret dealings, deception, and even fraud. Secretive firms such as
Long-Term Capital Management have misled investors and then
blown up, mismanaged firms such as Metallgesellschaft have pursued
perilous financial strategies at the expense of shareholders, and un-

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ethical firms, such Enron, have committed malicious fraud that harmed
many people.
12
But this should not be viewed as evidence against im-
pressive progress in the field of finance. New technology, with all its
power, is always dangerous, and accidents will happen as our society
learns how to control it. In the early age of steam, many people were
killed by boiler explosions, in the early age of air travel, by airplane
crashes. Eventually, technological advances sharply reduced such acci-
dents. So too the challenge in economics is to advance and democra-
tize our financial technology, not reverse progress.
Third is the problem of disruption of government authority. Finan-
cial arrangements can be simply canceled or otherwise frustrated by
changing governments, and history suggests that long-term financial
arrangements have to confront political instability. But financial con-
tracts have usually survived changes in governments. Indeed, they have
usually survived the complete transfer of power to hostile forces as a re-
sult of war and revolution. The Hague Regulations, adopted at an in-
ternational peace conference in 1899, specify that victors in war must
respect the property and rights of individuals.
13
And, indeed, even after
World War I, despite Germany’s total defeat and such anger on the part
of the Allies and Associated Powers that extensive reparations were re-
quired from her government, German nationals were allowed to keep
their investments in Germany and abroad as well as their insurance and
pensions.
14
In Iran, after Ayatollah Ruhollah Khomeini displaced the
shah in 1979, the new radical Islamic government, despite its pro-
foundly revolutionary rhetoric, made good on the pensions that gov-
ernment employees under the shah had earned.
15
In South Africa in
1994
, after a fundamental turnover of the government from whites to
a black majority at a time of great bitterness due to a history of repres-
sion and apartheid, financial securities, insurance, and pensions were
not confiscated.
Of course, one can also find examples of broken financial contracts.
Although the world is no longer so impressed by the socialist theory
that allowed Vladimir Lenin, Lazaro Cardenas, Mao Tse-Tung, Mo-
hammed Mossadegh, Gamal Abdul Nasser, Indira Gandhi, and other
leaders to justify major confiscation of property and nullification of fi-
nancial arrangements, theories justifying such irregularities have not
been forgotten. Financial contracts will not always survive disruptions.
But history suggests that they usually will and that risk sharing con-
tracts usually are upheld.
the promise of economic security
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