Bài giảng Financial Markets - Lecture 3: Technology and Invention in Finance

Lecture 3: Technology and Invention in Finance Economics 252, Spring 2008 Prof. Robert Shiller, Yale University Change and Information Technology • Financial markets have shown rapid change in the past • Information technology is an important factor in the change, and portends important changes in the future • Other changes are due to simple invention, and slow public acceptance of new information Comparison with 1970 • In 1970, there were no organized options markets • No financial futures markets • No swaps • No strips • No electronic trading • Transactions costs precluded much trading Basic Themes of this lecture • Long run risks still not managed well • Invention of new risk management techniques, like other invention, proceeds fitfully, then spreads, never regresses • Proper psychological framing important for properly “human-engineered” risk invention • New information technology opens up many avenues for new risk management technology in the future Risk Theme • Biggest risks are long-term nonfinancial risks, currently poorly managed by available institutions • There are substantial uncertainties about future income distribution • Risk management broadly interpreted, includes tax and welfare system Framing Theme • Variability of economic actions in response to framing changes is fundamental lesson from psychology for economics • Framing is determined by language, institutions, convenient comparisons • Standards and units of measurement are frames, and incorporation into institutional infrastructure matters Invention Theme • Invention is important in institutions for risk management • Ideas, once developed, are then copied around the world • Human engineering is important in invention • Framing is critical part of risk inventions • Associated inventions, as with information technology, open up new possibilities • New technology (Internet, Turbo Tax, etc.) create new opportunities for risk management invention Long-Term Risks • For most people, labor income dominates • Labor income undiversified, unhedged • Gradualness of changes, absence of market- revealing prices of present values, obscures risks Inflation is an Important Long Term Risk • The difference between 2% per year inflation and 3% per year inflation, over 30 years, amounts to a difference in real value of 30% • Many people are locked into long-term nominal contracts. • E. g., Fixed income securities in US amount to over $7 trillion • Fixed-income pensions still important in US today Tax and Welfare System’s Importance in Risk Management • Harsanyi-Rawls view of tax and welfare system as risk manager • Because of declining marginal utility of income, the impact of any risk management system should be measured primarily by how it prevents very low incomes • Therefore, tax and welfare system dominates in any discussion of risk management Framing and the History of Taxes • Cognitive biases exploited by lawmakers who see need for higher taxes and wish to disguise them from public: loss aversion, salience • Highest marginal tax rate most salient • Lawmakers raise highest rate during wars, when salience is lowest, apply only to highest incomes • Lawmakers exploit the framing, slowly cutting tax rates postwar, which people frame as gains Framing and the History of Taxes, Continued • Lowering the income at which higher rates kick in is less salient than raising rates • Disallowance of important deductions, such as income averaging, is easy to do after the lobbying effort for them has dispersed – Edward McCaffery, “Cognitive Theory and Tax” in Sunstein, Behavioral Law and Economics, 2000 Frames versus Beliefs • Frames are categories of thought, not opinions. • Frames connected with language and culture. John Locke: “taking words for things” • Coordination problems in changing frames, often requires government coordination • Units of measurement are an extreme case, sometimes affecting actions. E. g., lots are divided into even fractions of acres. Language Categories • Named concepts receive special attention • Recession, bear market, stock price index • Units of measurement Loss Aversion – Kahneman Tversky • People very sensitive to small losses, kink in value function • Hence framing a financial product so that potential for loss is not perceived enhances desireability The Importance of Invention in Economic History • Technological Advance occurs at random places and is copied around the world • Automobiles and airplanes • Risk management institutions as inventions Insurance as an Invention • Elements of insurance concept are as complex as the elements of other inventions, such as engines or motors • Insurance contract, corporate or mutual form for insurance company, excluded claims to circumvent moral hazard, co- insurance, actuarial tables, public regulation, capital adequacy standards, etc. Changes in Patent Law • For most of last century, US Patent office rejected patents for business methods • Patentable inventions had to have a physical component • Inventors started claiming computers were that physical component. Merrill Lynch CMA Accounts, Priceline.com patent • Starting around 1998, patent law has been changed, allowing financial patents, and resulting in a flurry of financial patents 19th Century Advances in Information Technology • Paper machine, hence cheap paper • Carbon paper • Typewriter • Standardized forms • Vertical filing cabinets • Bureaucratic management techniques First US Income Tax • First federal US income tax enacted 1861, took effect 1862, 3% on incomes over $800 • 1862 3% on incomes over $600, 5% over $10000, deductions for rental housing, repairs, other taxes • Compliance initially was fairly high, attributed to wish to support war effort Failure of First US Income Tax • After Civil War, compliance declined, estimated that in 1872 only 10% of eligible taxpayers actually paid. • Failure attributed to “incapacity of the lower officers and dishonesty of the higher ones.” (Harry Smith, The United States Federal Internal Tax History from 1861 to 1871, 1914. 94 282-96. • Tax rescinded 1872 Bureaucratic Difficulties 1860s • Costly to run audits on taxpayers, lacking inexpensive and rapid travel, communications • Costly record copying, inadequate filing systems • Monitoring for government officer corruption difficult for same reasons • Inadequate civil service professional development Withholding of Income Taxes • Important human engineering element of income tax system • Endowment effect Thaler • Fairness issues • Underground economy flourishes where withholding is impossible. Tracking Stocks • Tracking stocks are claims on a division of a corporation • Increased use of computers in businesses allows greater facility for tracking individual lines of businesses • Tracking stocks are likely to grow in importance, and with them a host of related risk-management tools The Corporation • David Moss points out that a law requiring that all corporations have limited liability was tried as an experiment in New York State in early 19th Century, • Moss points out that limited liability was not obviously a good idea: it created agency problems for stockholders, who might pursue risky strategies at bondholders’ expense. Moreover, in fact unlimited liability hardly ever caused serious problems in practice. • But, New York experiment was obviously successful, and eventually all states copied it. Moss’ Theory why Limited Liability Corporations were so Successful • Investor overestimation of miniscule probability of loss beyond initial investment discouraged investment (weighting function) • Lottery effect: with limited liability, an investment in a corporation was a throwaway item, like a lottery ticket (prospect theory) • Allowed for investors to hold a highly diversified portfolio (not a concept that framers of corporate law were comfortable with then). Inflation Indexed Debt • History shows many examples of nominal debt being wiped out in real terms by high inflation • Indexed debt first attempted in Massachusetts, 1780, to help finance Revolutionary War • Shay’s rebellion 1786, sparked by apparent unfairness of other nominal contracts (e. g., soldiers’ pay) being worthless while indexed debt was not • Indexed bonds did not appear again in the United States until 1997. Still today no private indexed debt Barriers to Inflation-Indexed Debt • Strong tradition of nominal framing of contracts, so that nominal contracts stand alongside indexed ones • Mistrust of indexation formulae • Need a thoroughgoing indexation, such as that afforded by the Unidad de Fomento (UF) of Chile • New information technology makes indexation more of a possibility Real Estate Risk Management Devices • Value of homes is a major source of risk Macro Markets • My book, 1993, urges creation of markets for long-term claims on aggregates such as GDP of countries, incomes by education level, occupational incomes • Such assets would create prices for long- term claims on incomes, reframing attentions toward long-term values Conclusion • Advancing information and other technology will create vast changes in financial markets in next twenty years • Many opportunities for innovation