ECON 252: Financial Markets (2008)

Lecture 24

 - Making It Work for Real People: The Democratization of Finance


Professor Shiller, in his final lecture, reviews some of the most important tools for individual risk management. Significant inequality in domestic and international communities has created a need for social insurance programs, such as those created in Germany in the late 1800s. The tax system, bankruptcy laws, and government insurance programs are used to manage risk of personal wealth. However, each of these inventions must take account of psychological factors, such as moral hazard, in order to be effective without eliminating incentives to participate in the workforce, or other negative side effects. With regard to careers, including those in finance, young people should frame decisions with morality and purpose in mind, and with a broad perspective of both.

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Financial Markets (2008)

ECON 252 (2008) - Lecture 24 - Making It Work for Real People: The Democratization of Finance

Chapter 1. Sources of Financial Inequality [00:00:00]

Professor Robert Shiller: This is, as I said, my last lecture for this course and I’m entitling this lecture, The Democratization of Finance. I wanted to save this to the end because it’s really about looking at the broad purpose of our financial markets and our financial institutions. Ultimately, there’s only one purpose to all of this and that’s human welfare. It’s people. This should be obvious, but let’s not forget that corporations exist only for the benefit of people. Normally, we say for their owners, but we could also add other stakeholders. But, it’s people — individual people — that matter only, unless you want to add animals. We have non-profits that are aimed at animal welfare as well, so we’ll include them.

I’ve made it a theme of my recent books that finance is a powerful tool for improving human welfare and in my latest two books I emphasize what I call the democratization of finance. Maybe I should write this down because it’s a term that I like to use — democratization of finance — or you could say for short, financial democracy, but I mean something a little different. In the 1930s, people talked about financial democracy as the shareholders voting for the direction of a corporation. I don’t mean it — by that — by democratization of finance I mean bringing it to the people. There’s been a long trend towards democratization of finance that goes back centuries; that is, originally financial techniques were a value only to the very rich or the very sophisticated. In 1780, the President of Harvard College had his paycheck — I think it was President Lamont — indexed to inflation. [Correction: It was President Samuel Langdon.] I’ve been trying to figure out if anyone else in the world had ever had a CPI indexed labor contract and I’ve not been able to discover any other example. That was 1780. So, there was one person in the world who had an inflation index employment contract. Funny, who was it? It was the President of Harvard, so not a random person.

As time goes by, we have more and more spread of these concepts. I make it as a mission in two of my books, New Financial Order, which is on reserve, and my new book, which I’ll write here, Subprime Solution, which is not on reserve because I haven’t finished it yet, but it will be out in — it will be sometime this summer. It will be available in bookstores. Apparently, well — so, the theme is that — in both these books — is that a lot of our problems can be solved by extending — continuing this trend toward democratization of finance. We have problems with inequality — economic inequality. This is, I think, probably the most important issue facing advanced countries today — that is that we are not sharing income equally. There are a remarkable number of poor people and a small very elite group who are making hundreds of millions of dollars. In most countries of the world, inequality is getting worse. This applies both to the advanced countries like the United States and to the emerging countries like China and India.

It’s not altogether bad because part of the reason inequality is getting worse is that they’re suddenly getting rich people. If everyone’s getting better off, you could say, what’s the problem? In many ways that is the right answer, but I think that we can’t tolerate excessive inequality. The beauty of it is that the very same capitalism that has been generating inequality has solutions for it. Many of our venerable economic institutions that we already have are working against inequality, so I’ll mention just for example life insurance. That helps alleviate inequality by eliminating one important cause of inequality. A lot of poor people, traditionally, are people who’ve lost — families that have lost one of the two parents, either the mother or the father. Of course, that puts the family in stress because they have just lost half of their adults. If you have life insurance, that solves that.

Another source of inequality is solved by health insurance. An important cause of inequality is somebody gets sick, so they are unable to earn an income and they end up in disastrous economic situations. Another one is disability insurance. Disability insurance protects you against something like an accident that causes you to become unable to hold a job; that tends to be a lifetime thing. Disability insurance is a lifetime insurance contract; you pay for it while you’re healthy. If you become disabled, you get support for the rest of your life. These are just some examples of how inequality is already being dealt with through risk management institutions and why finance — I always lump insurance in — these are all insurance, but I lump that in with finance as risk management and why they’re so important.

We still see inequality getting worse, so I think that is a challenge toward improving risk management institutions. The subprime crisis that we’re in now is really substantially due to failures of our risk management institutions. Notably, we have had a failure to provide institutions to help people to diversify their own household portfolios. So, people who bought a house would have been in a highly leveraged position and vulnerable to risks of changes in home prices and to other risks. We need to go a lot further. Now, part of this theme of democratization of finance is that we have to pay respect to behavioral finance. That’s because people don’t — especially the less educated or less capable people — don’t always make optimal use of financial instruments like, for example, insurance. If people don’t make use of risk management contracts, then we have a problem.

What we have to do going forward in the future is design our risk management contracts to work better for real people. That requires what they call in the engineering department, human factors engineering, but I’ll add financial. Financial engineering is a term sometimes used in a disparaging term for people who invent things that are just a bit too complicated. But usually, the word financial engineering is used approvingly to refer to people’s efforts to make finance work even better than before — to make progress in our financial institution. One of the themes of my — of this book and this book — is that we have a lot of progress to be made, but I think it has to be taking account of our better financial institutions — knowledge of financial theory and behavior.

Chapter 2. A Call for Social Insurance: The Government’s Role in Risk Management [00:10:24]

What I wanted to talk about — actually, this lecture — I have several parts. I wanted to talk first about social insurance, which is not normally covered in a finance course. It seems to be so relevant that I want to talk about it. Social insurance refers to government programs that insure people against risk. I wanted to talk about the extremely important risk management programs that the government has instituted. I’m going to talk especially about bankruptcy and bailouts because they’re relevant right now, particularly relevant right now with the subprime crisis. Then I wanted to conclude this lecture with some thoughts about financial careers and about morality. I wanted — I talked about that in the first lecture. Maybe I should have talked more consistently about it.

Young people are thinking about careers and I think that, ultimately, I give you credit for wondering about the moral purpose of different careers. I think finance has a somewhat tarnished reputation, but I think that’s really undeserved. I guess people in finance get into controversial positions more so than people who are in other occupations that don’t put them in these moral dilemmas and sometimes they can behave badly. I don’t actually claim to have answers. You should take a philosophy course. I won’t give you answers to all these ethical questions, but what I want to do is at least raise them and think a little bit about how they relate to this course.

The first principle of — I want to come back now to what I said I would talk about — namely, the role of the government in risk management. I think it would be a mistake to ignore this because David Moss, who actually got his PhD in history from Yale and I talked to him when he was still here, wrote a book, When All Else Fails. It was a history of risk management in the U.S. This is about ten years ago this book came — or eight years — I forget exactly, sometime in the last decade. [David A. Moss, When All Else Fails: Government as the Ultimate Risk Manager, Cambridge: Harvard University Press, 2002.] He makes the argument that really every government — he focuses on the U.S., but every government has a risk management role. Much of what governments do is to do risk management, especially modern governments. That wasn’t maybe true so much before, before the end of the nineteenth century. The governments have gotten in increasingly into risk management.

The first example I would give is the progressive income tax or graduated income tax, as it was called by Adam Smith in 1776, in his book, The Wealth of Nations. He said that maybe we should have a tax on incomes and the tax on incomes should be graduated so that people with higher incomes pay a higher fraction of their income and that would help reduce inequality. Smith, although he raised it in that famous book in 1776, he then quickly dismissed it as unworkable. He said, if we had an income tax it would be, quote, “a tax on conscience,” meaning that only the honest people would pay it because it was impossible to verify anyone’s income; income is too complicated to measure. Maybe he was right. The first income tax — it was either the UK or Holland at the end of the eighteenth century. They had small income taxes and they were progressive, but they were a beginning. The U.S. experimented with an income tax in the 1860s and abandoned it. The original experiments were all only marginally successful, but the U.S. finally got an income tax in 1913 and at a very low level, but this is the U.S. It ultimately became very important. After World War II, the top marginal tax bracket rose above 90%, so it became a very significant redistributor of income. Ultimately, it’s gone way back down now; we’ve reversed it, but ultimately it’s a risk management device. What it means is that if you do very poorly, you don’t pay any taxes and you get benefits.

We also — I might add to it — we have a progressive income tax that finances education for everyone — universal education and other social services and public goods. So, that is a risk management device and it works despite limitations of human behavior because it’s automatic; it’s imposed on you, so nobody can forget about it. It becomes a universal risk management device. In some sense, it’s the most important risk management device of all because it deals at the very low level. Starting in around the — well, I guess you could go back to Milton Friedman, who was a conservative economist who started advocating a negative income tax in the 1940s. He actually, in his 1963 book, Capitalism and Freedom, he advocated it more strongly. That’s the usual source — that we should have a negative tax on low-income people to bring their income up to a good substantial level; so, that was the negative income tax. It sounded like a very negative tax on low income; it sounded like a very controversial crazy idea when he launched it, but crazy ideas have a way of eventually becoming standard.

The United States adopted — and it is now fairly significant — something called the Earned Income Tax Credit, which is a negative income tax for low-income families. It emerged from thinking — EITC — Earned Income Tax Credit. If you are a family with children with income very low, like under $10,000, you’ll get a substantial negative tax — several thousand dollars — and that is risk management. It means that anybody whose income falls below very low is — it’s kind of like an income insurance scheme run by the government.

The concern about all of these schemes, however, is moral hazard. If you have an earned income taxed credit — it’s kind of designed around moral hazard. Instead of having welfare, welfare is a less — that’s just a gift to someone who doesn’t have any job at all, who has no income. Then, that moral welfare tends to lead to a moral hazard problem. If the government says, if you don’t have a job we’ll support you, that encourages people to say, okay I don’t have a job. But, the earned income tax credit is different because it’s a negative tax rate on your income. You have to have income in order to get anything, so you have to get a job to get EITC. The more you earn, the more EITC, up to a limit for low levels of income — the more negative tax you get.

The thing that we’re — what we’re doing as time goes by is we’re getting a clearer picture of how to design risk management contracts for the general public. The EITC was invented in the ’70s in the U.S.; it was sponsored by Senator Russell Long. It is now being copied around the world; although, I guess there were earlier antecedents, but the U.S. was the first country to do EITC.

The other — I wanted just to remind you of the different kinds of risk management that the government offers. One important part of it is Social Security. I want to go back to the original Social Security system; it was in Germany under Otto Von Bismarck that the first Social Security systems were developed. It was considered a highly radical idea in the 1880s when — I’ll put this down in German, in case some of you can understand this — 1883 Krankenversicherung. Health insurance was founded nationally in Germany, so it was a government mandatory program; everybody in Germany had to contribute to health insurance. German words are very long; they run them together; I ran out of room to write Krankenversicherung. In 1884, Unfallversicherung — unfall means accident, like a fall; Versicherung means insurance. The government created an accident referring to workplace accident insurance and it was — the German government had it — it was an arrangement that made it mandatory for employers to buy insurance against injuries to people who worked there.

Then they had in 1889 Altersversicherung. This isn’t supposed to be a German lesson, but I like to put it this way because it suggests its origin. This was old age insurance; alter means old. So, old age insurance was generated for the whole country of Germany and, at this point in 1889, Germany was the only country to have a social insurance program. Shortly after the turn of the century, Lloyd George, who was Prime Minister of the UK, traveled to Germany and looked at their system and was very much impressed and thought — he said one thing he noticed about Germany, there are no beggars. Normally, in London you couldn’t walk down the street without seeing somebody who was sitting there holding out a tin cup who had no legs or mothers with children who were orphans. He said, it’s gone in Germany. So, he became convinced that the UK should follow the lead. This was copied over the whole word and it’s virtually everywhere now. Some less developed countries haven’t gotten there yet, but this is where they’re going.

I wanted to quote Gustav Schmoller, who is a German economist in the 1880s. In the early twentieth century, he wrote some memoirs about his life and the life of other economists in Germany. He said

“The triumph of insurance in every imaginable area was one of the century’s, [meaning the nineteenth century’s] great advances in social progress. It was an entirely logical development that insurance should spread from the upper classes to the lower classes; that it had to attempt as far as possible, to eliminate poverty and that the older charitable relief funds for the workers were more and more constructed on the sound principle of insurance.” [Gustav Schmoller, Charakterbilder, Leipzig, Verlag von Duncker, 1913, p. 57 (Shiller’s translation).

The problem with charity is that it tends to be whimsical and capricious. If you’re relying on charity to resolve problems of poverty, it’s going to be applied very unevenly and it would be salient examples of poverty. Like, if a child is suddenly stricken with some unusual illness and it gets written up in the newspapers, then generous contributions would come pouring into that child, but other children who are not so blessed get nothing.

Chapter 3. Social Security in the United States [00:25:50]

In the United States, we were about the last country to jump onto the bandwagon, begun in Germany — partly I guess because the U.S. is more free enterprise in its orientation. Maybe it doesn’t like to adopt ideas from Europe. It wasn’t until the Great Depression that the U.S. adopted Altersversicherung and we still haven’t adopted Krankenversicherung; we still don’t have a national health insurance. We have Medicare and Medicaid, but they don’t apply to everyone. We have about forty million uninsured Americans with no health insurance, so we’re still not there yet; maybe we’ll get there.

I wanted to talk about some of the important successes that — the Social Security System in the U.S. is our copy of the German system. Social Security started in 1935 — that was about fifty years after the Germans invented it. It’s remarkable how similar the idea that we have done is and it stays — we really have something like the 1889 German system in place today. What it did is it created a system of contributions to — right now, when you get a job, you have to pay 6.2% — that’s on your pay stub. 6.2% is taken out as your contribution to Social Security and then your employer pays another 6.2%. So, 12.4% of your income goes to Social Security and those are thought of as contributions to an insurance scheme for your — it has three components. It’s called OASDI; OA stands for old age, S stands for survivors, and DI stands for disability insurance. Well, they’re all insurance. You are — it’s mandatory; you are paying a lot into this system. You’re paying — the fact that your employer pays half of it is perhaps misleading, so it’s really like 12% of your income is forced to go into an insurance scheme; that’s big.

Now, there’s a cut off though. After you reach I think it’s around $95,000, [correction: $102,000 for 2008] you don’t have to pay anymore, but for most people it’s 12% of their income is going to Social Security. What do they get for it? They get a pension when they’re old and it’s guaranteed for the rest of your life and these other things a lot of people don’t even know about; you don’t even know that you’ve got them. Survivor’s Insurance is a life insurance program; this was actually added in 1939 with amendments. I guess maybe disability was added at that time too. What it means is, if you are under a certain age — I think it’s 18 — if your parents die, the government will — or one of your parents dies — the government will pay money to the family to support you. It’s life insurance offered by the government. Why did the government get into this? Well, the problem was — it’s behavioral finance again — that while wealthy people tended to get life insurance, the general mass of people were not because of some behavioral problem. They just didn’t see the value of it — didn’t understand it.

Disability insurance means that if you work and you have an accident, then you can no longer work; you start collecting Social Security. Normally, you don’t get the — old age until the age 62 or 65, but disability you can get at any age if you become disabled. It’s funny, I think a lot of people don’t even know they have this. These institutions operate so quietly, partly the government — they called this Survivors’ Insurance when they created it in 1939. I was wondering why don’t they call it life insurance, that’s what it is. Life insurance is something that pays the survivors of a family member who dies. I think they didn’t want to call it life insurance because they didn’t want to threaten the industry. There’s a whole life insurance industry. The government was going it in a big way to create a product, which was mandatory, but they didn’t want to upset the life — so they called it something different. You can get a life insurance salesman who will sell you life insurance and not even mention that you’ve got a policy already whether you want it or not; they would just be offering something to add to that.

What also they did starting in the 1930s — it was originally called Aid to Dependent Children, but they changed it to Aid to Families with Dependent Children and that was a separate program beyond these. The parents didn’t have to be disabled or old or anything like that to get this and that started in 1935. That’s our welfare system; it was for parents that couldn’t earn enough money — if you have a mother, a single mother with no husband and the husband — or the husband just can’t make any money, she would get aid for herself and the children. That, however, was abolished in 1996 because of moral hazard. The aid to families with dependent children was created in 1935 with little attention to the amount of moral hazard it might eventually create. There grew an increasing problem of welfare dependency. You would have families that had lived on AFDC their whole lives and their grandparent’s lives and their grandparent’s lives.

Public opinion turned against that and it was in 1996 and we had a Welfare Reform Act that abolished AFDC. It was a Republican bill, but it was signed by the Democratic President Clinton. That eliminated Federal — well, essentially they ended the welfare program started in the Depression. There still is some welfare, but there’s a lifetime five-year limit on actual welfare; after you’ve been collecting it for five years, you are disqualified. It denied welfare to immigrants who are not citizens and it limited food stamps to unemployed, childless adults. I think that as we move ahead we are becoming increasingly aware of how to design institutions around human glitches. So, the Welfare Reform Act — I don’t know if it was the right policy, but it was trying to eliminate a moral hazard problem. We have instead of — we’ve replaced the aid to families with dependent children with a more generous EITC. You see that it has very different moral hazard implications. To get Earned Income Tax Credit you’ve got to have a job and it can’t just be a token job because you don’t — it says the negative tax is a function of your income. I take this as signs of past progress that will continue in the future.

Chapter 4. Bankruptcy as a Risk Management Device [00:34:32]

I wanted to talk about bankruptcy briefly here because that is something that I mentioned is very important risk management device and it’s of relevance right now in time of financial crises. The United States did not have a bankruptcy law at the federal level, generally, until 1898. During the nineteenth century, there were repeated financial crises that led to temporary bankruptcy laws. What happened was, like what we’re seeing right now, there was some financial crisis and it caused people to lose their jobs for no fault of their own and they couldn’t pay their debts. Laws back then were often very harsh and they would send people to debtor’s prison. I think the enlightened view gradually developed — this is crazy; some person is trying hard; there’s a big financial crisis; makes bad investments; then, it can’t pay debts and we put this guy in jail. That’s crazy. In fact, there should be some other method that deals better with bankruptcy.

There were numerous bankruptcy laws but notable was the 1841 law, which for a temporary period gave — this is after a financial crisis — gave a fresh start. They said someone declaring bankruptcy can wipe out all debts and not go to jail and as long as they draw their wealth down to zero they could have a fresh start and go back to life normally. That kind of idea has gradually been — and it’s now — now it’s part of our general assumption about bankruptcies. I mentioned that 1898 was the landmark bankruptcy law. This is the first time that we had bankruptcy enshrined as an institution that lasts all the time. It’s not just during financial crisis; you can at any time declare bankruptcy as a way to protect yourself.

There was another landmark. This is a landmark bankruptcy law and there was another one in 1978 — another landmark bankruptcy bill, which made it even easier, much easier for people to declare bankruptcy. As a result, especially after 1978, bankruptcies became very commonly used ways to manage extreme outcomes in one’s finances. In fact, recently, since 1978, there are typically over a million bankruptcies — personal bankruptcies — a year. It’s a little known fact that there are more bankruptcies than divorces and you may wonder, well how can that be? I don’t hear about bankruptcies; you hear about divorces all the time. I think the reason you don’t hear about bankruptcies is that nobody needs to tell you. You don’t come across saying to — you ask someone, what’s new? Oh, I just declared bankruptcy. They don’t do that. They don’t do that about divorces either, but the problem with divorces is they can’t cover it up. Everybody knows you’ve gotten a divorce, so we hear a lot more about them, but bankruptcies are very important.

The other bill that is very important is 2005 and that reverses some of the 1978 bill. We’ve been pulling back; maybe 1978 was too generous, but I just wanted to give you some clue about what bankruptcy is. If you — there are three important kinds of bankruptcy and they refer to chapters of the United States Code. There’s Chapter 7 Bankruptcy — you should know this because half of you are going to declare bankruptcy some day — maybe not. We hope that you get an education in finance and few of you will declare bankruptcy, but some of you are going to be going through this. Chapter 11 and Chapter 13. Just so you’ll know in advance, before you actually do this, Chapter 7 is the liquidation form and this is where you say, this is it; this is the fresh start story. You give up everything you have to your creditors. The bankruptcy court will divide it up among the creditors and then you have a fresh start. It used to be in 1978 you could do this every six years. So remember, 2005 thought 1978 was too lenient, so they moved it to every eight years; so, that’s what you can do.

If you are in big trouble — you’ve gotten in more debt than you can handle — what you have to do is go to a lawyer and file for bankruptcy. Chapter 7 is often the favorite thing because it gives you a fresh start. However, the 2005 law said that you can’t do — as an individual — you can’t do Chapter 7 unless your income is below the median for your state, so I guess you have to forget Chapter 7. I’m assuming that most of you will be making more than the median income for the state you live in, so cross Chapter 7 — unless you’re really in a bad situation — cross Chapter 7 off. Chapter 7 is for — Chapter 11 — companies can also do Chapter 7.

Chapter 11 is for companies and it’s a reorganization rather than liquidation. For companies, it’s a system to help them get back on their feet. When a company files for Chapter 11 bankruptcy, what they’re saying is, hey we can’t pay; we’re out of money; and we have all these people coming to us that we owe money to and we don’t know who to pay first. We just don’t have enough money. It becomes a disorderly process and so they go to the court for protection. When a company runs out of money and it can’t pay its bills, then that can destroy the company immediately because people who were delivering things to the company that they need will stop delivering them. They say, I hear you’re bankrupt; you’re not going to pay us, so we’re going to stop delivering. That can destroy the company. The idea of Chapter 11 is to keep the company going so the court would impose some order and allow the company to continue in business and to hold off the creditors for now. It’s ultimately in the creditor’s interest if the Court does this because they’re better off in getting their debts paid if the company is still making money.

Chapter 13 is something like Chapter 11; it’s for individuals. That’s the one you’re going to be filing — let me put it that way. Some of you will be filing for Chapter 13 bankruptcy. What it is is that the court — the bankruptcy court — will make adjustments and a plan for you to pay off the debts. This is what we hope to see happen in increasing number of cases during the current crisis. So, if somebody has taken out a big mortgage, they’ve taken out car loans, and they were kind of profligate and now there’s a problem and they can’t pay on all these, they declare Chapter 13. They get a lawyer to represent them and the court can adjust their debts but not eliminate them. It says right now in Federal Bankruptcy Law that they cannot adjust the mortgage on your house, but they can adjust other debts. This is something that we’re talking about — the Congress is talking about — changing because the mortgage on the house is a big debt that bankruptcy ought to be able to adjust. It hasn’t happened yet.

I wanted to mention something else just so you understand what bankruptcy is. There’s something called informal bankruptcy. What’s the difference? With bankruptcy — bankruptcy is for people who have enough foresight to hire a lawyer and go out. If you are having trouble paying your bills, you know enough to go and hire a lawyer. The lawyer might demand a little money up front; the lawyer has to be paid. So, you should stop paying your bills and accumulate at least $1,000 so you can go to a lawyer and start Chapter 13 bankruptcy proceedings. A lot of people don’t have the ability to save $1,000 or to figure this out and they won’t call a lawyer. What is the common thing — somebody is running up too much in credit card bills, loses a job, creditors start calling — what do you think happens? They don’t get a lawyer; guess what they do? They stop answering the phone — very simple. I’ve run up all these debts, the phone keeps ringing, and these nasty people keep annoying me, so I just stopped using the phone. In fact, I left my whole phone bill lapse; I don’t pay my phone bill. I don’t even have a phone anymore, so no one can come and get — they knock on my door and I don’t answer the door.

What did courts do — what did creditors do? In the various states, they can go to a state court and appeal to the court to garnish your salary and you don’t have to do anything; you don’t have to show up. They go to — they find out who your employer is and then the State gives an order for the employer to take money out of your paycheck to help pay your debts. You never even figure out what happened. In fact, you might not even know it because you don’t read your pay stub and now some of your money is going through garnishment of your salary. That happens, but see this is the reality of bankruptcy. We are talking about another revision of the Bankruptcy Bill because we’re in a serious crisis and maybe 2005 pulled back too much. We keep waffling about how tight we want these, but ultimately bankruptcy law is very important in risk management because this is big time risk management. It has to be adjusted to deal with moral hazard and other things.

I just want to mention right now, there’s a bill being proposed by our own Senator Chris Dodd — here from Connecticut — and Barney Frank, which is not a bankruptcy bill. It’s a bill — a bailout. They don’t call it a bailout bill; they say it’s not a bailout, but I call it a bailout bill to help people who can’t pay their mortgages and they don’t have to declare bankruptcy. What they want to do is empower the Federal Housing Administration to guarantee loans — to work out loans and guarantee them — and then an FHA guarantee of loans. You don’t have to declare bank — you just have to go to your mortgage lender and say, I can’t pay; I’d like one of these FHA workouts. Then, if — this hasn’t happened yet. This is a bill, but if this bill passes, then there would be they said maybe several hundred billion dollars of mortgages would be guaranteed.

Here’s a typical story — might be, you owe $300,000 on your house — maybe that’s too big. You owe $100,000 on your house. They might lower that to $90,000 and give a different payment schedule and then the FHA will tell the bank that if you do this — to the bank — if you make these adjustments, we will guarantee the mortgage. So, this is another — that is that the federal government will pay back the mortgage if the individual doesn’t, so the government is getting into risk management; they’re managing the risks to the mortgage lenders.

In my — I’ll just mention one of the ideas in my book, Subprime Solution. I’m thinking that these things have happened in history so many times — we’ve had bankruptcy bills; we’ve had bailouts of one sort of another. They’re very controversial because people say, look there’s a moral hazard problem. If we’re bailing out homeowners who didn’t pay their mortgage, isn’t that a bad thing? Also, we’re doing it after the fact. Nobody explained this to the borrowers that they’d be getting this bailout, so isn’t it unfair to maybe other people who didn’t buy a house who are more sensible? What I am proposing in Subprime Solution is that we just have — these bailouts are important and we have to make them work better. So, I have something, which I call a continuous workout mortgage, which we should move to; this is my idea. So, I just mention one of the ideas in my book.

The way Dodd-Frank is proposing is that people who are in difficulty would have a single workout. It’s just like a bankruptcy; a bankruptcy is a single event and it occurs only once every eight years. So, people who are in big trouble get help from the government, but then it’s a one-time only, big event and only every eight years. Why don’t we do it continuously? What we want to do is have a mortgage so the balance or the payments adjust automatically for changes in home prices or incomes. That would make it — you get a workout every month. Now that sounds kind of radical and strange, but I don’t see why we shouldn’t do that, especially if we can get markets for home prices and incomes so that the lenders can hedge the risk. I’m talking about private institutions offering mortgages that build in the kind of workouts that we’re doing on an emergency basis from time to time. Once you recognize that workouts are needed, why don’t we make it part of the structure in institutions? Anyway, that’s just a little story about what I’m doing in my book.

Chapter 5. Balancing Morality and Psychology: Career Advice for Young Adults [00:50:30]

I said I would conclude this lecture with some thoughts and I have fifteen minutes for thoughts about finance. I wanted particularly to aim it at people at your stage in the lifecycle, younger people, because as I said at the beginning, there’s — I think people at your age are rightly concerned about purpose in life. You are launching out onto a whole lifetime career. I don’t know how you feel; I’m just guessing that a lot of the things that you might be doing seem possibly meaningless or at least not having enough meaning or purpose. I think that’s a good thing to worry about. Most of the time you’re taking a job, you’re taking a job to do some task that somebody wants done and it may be hard to see how it figures into some global picture; but, people want to do something that’s good. I wanted to come back, first of all, to a theme that I mentioned in the first lecture and that was — I think it’s a remarkable book; I’ll put it on reserve; I don’t think I actually got it on reserve yet.

Peter Unger is a philosopher and his book is called Living High and Letting Die — that was 1996. What it — this is a book about what we do in our lives — namely, that we tend to be wrapped up in ourselves. There’s — in advanced countries like the U.S., we’re living pretty well, but in other places people are starving or in desperate situations. One of the moral dilemmas that we seem to face is that you could save lives anytime you want by just giving to one of the appropriate charities. I’ll write this down; I said this on the first — I’m repeating it. I said this in the first lecture, but it’s worth repeating. On the first page of his book, he has down an address to mail, but you wouldn’t mail anymore. I’ll put it down again — — that’s the United Nations Children’s Fund — support/index.html — that’s their website. He is saying, why don’t you put this book down right now and send a check for $100 to UNICEF. He estimates that that will save thirty-three lives of children in the world. I actually got on UNICEF’s website this morning to check this out. They claim that they have — 9.7 million children die every year for preventable causes — for things that are preventable through vaccinations and improved water supply and things that they do, but they don’t have enough money to do.

The reason I write this down — actually, I don’t know what you would do, but when I was reading the book I was wondering, it’s kind of shock to put this down and think, I could save lives by just a check for $100. I didn’t do it and so I thought — that really made an impression on me because I just continued to read the book. I never — so, finally when I reread it the third time, I got on the website and I contributed $100. Then, I have this moral dilemma; why did I stop at $100? Because I could go way beyond $100 and if all these people that are dying, why am I not doing that? You start to think of justifications and excuses that come to your mind. Maybe you don’t want to read this book because he shoots them all down — all these justifications. One of the justifications is futility. You say, well these poor people in these less developed countries — you really can’t help them anyway because it’ll all get lost or the population will increase and there will be more dying people. Anyway, he dismisses that; you have to read it. It’s a rationalization that we don’t spend too much money — too much time on. We don’t dwell on it but we assume that it’s futile and so we ignore it.

Another one is that it’s very difficult to be a truly moral person. I would have to give — if I really thought about what was — the terrible things that were happening, I would have to give 90% of my income. That’s so — I’m not going to do that, so maybe I just won’t do anything. So, people make — what he illustrates in this book is, there’s a lot of casual thinking that we use to justify — to create an illusion of innocence that we feel that we’re innocent of any wrongdoing for not supporting the poor. This is an appeal for charity.

So, maybe you will donate or you probably — some of you have already done that. I wanted you to — because I think you’re launching out on careers and there’s something — there seems to be — moral dilemmas abound. I was impressed just looking at the New York Times this morning — the stories that suggested moral dilemmas for young people who are launching out on careers. One of them — they were reporting on the Pennsylvania primary, which incidentally you heard Hillary Clinton won 55 to 45, but that’s not what I was referring to. It was that they said the voters thought the most important issue is the economy — the U.S. economy — and I was thinking, well what about Iraq? And what about all the people that we are responsible — we’ve created the current situation there and people are dying everyday there and we’re concerned about the economy. Somehow, it seemed to be something — next thing on the news this morning, Rupert Murdoch will be buying Newsday, the sixth largest regional paper in the United States for $580 million. Somehow, there’s something bothersome about that story. This guy is super rich; he’s buying all the newspapers. He’s getting — I mean, he’s a finance person and he’s gaining control over — people read these newspapers as part of their recreation and relaxation and Newsday is kind of a fun paper, but it’s under control of this finance billionaire. I don’t know if that’s a moral issue.

Next thing in today’s paper — the U.S. has 5% of the world population and 25% of its prison inmates, so something is maybe wrong here. Another thing that was in today’s paper — South African dockworkers refuse to unload a Chinese ship with weapons bound for Robert Mugabe’s regime in Zimbabwe and that the Chinese ship may return to China without delivering. This may be — well, who are the dockworkers? This is not Rupert Murdoch; this is humble people loading the docks and they have a union and they said, we’re not going to do this; we’re not going to support Mugabe’s brutal efforts to suppress a free election. You start to wonder, are finance people moral or are they — I just give some — I think that — I don’t know how you think, but when I was your age, I somehow wanted a perfect career that was morally right and important.

So, who has as perfect career? I don’t know. I don’t have an answer and I’m not going to propose an answer, but let me just consider some names that come to mind. Bill Gates — now, he is a businessperson who runs a tight financial ship and you may be aware of how tight it is when you try to pirate one of his programs or something. So, he has a reputation for being a tough guy. On the other hand, he and Warren Buffett have set up the biggest transparently operated charitable foundation in the world and it has $38.7 billion dollars. How should we view — I wonder how Peter Unger would view Bill Gates. He does have a — what did he spend on his house? $35 million on his house. [News acconts now put current assessed value at around $200 million.] He does live a high style, but should he have started out giving away 90% of his income when he was your age? He wouldn’t be making any money if he did that, so I’m just thinking about — I’m not saying what’s right or wrong, but I wanted to give one other example that comes to mind.

Have you heard of this guy, Muhammad Yunus? He went to Vanderbilt University and got a PhD in Economics in 1969 and then he became assistant professor of economics at Middle Tennessee State University. It sounds like a very ordinary career so far — actually, it’s good being a PhD, but ordinary in a way; but then, he did something very important in 1976. He went back to his home country, which was Bangladesh — one of the poorest countries in the world. He founded a bank called the Grameen Bank. Does anyone speak Bengali here? What does Grameen mean? There’s no Bengali here. Well, I’m told it means “of the village.” What he did was create a bank that made loans to poor people; they’re called micro-finance. So, the typical loan was made to a young woman who was in desperate poverty and the loan would be enough to buy some small item that would start a business — for example, a push cart that could serve hot food so she could then go and stand on a street corner and sell some kind of food. That can be huge difference, having the money to buy a food cart, and can make her able to support her family. No banks before the Grameen Bank would do that sort of thing and they claimed that they couldn’t make money doing it, but he apparently succeeded. So, he won the Nobel — actually, the Nobel Peace Prize went both to Yunus and the Grameen Bank a couple years ago.

Those are examples of people who had kind of financey careers. If you looked at Muhammad Yunus in earlier years it might not look like a very morally, Peter Unger-type moral career. I don’t know what Peter Unger would say about Muhammad Yunus now. He never — we don’t ever have sense that he gave away 90% of his income to poor people, but look what he did. So, I don’t know the answer. I guess what I’m getting at is that I don’t know the answer to these moral questions, but I think that it’s kind of a mistake to think that a career in finance is necessarily immoral.

If you read Peter Unger you get the impression that just about everyone is evading the moral issues. Maybe we’re incapable of really behaving the way logical consideration of ethics would compel us to do. So, hardly anyone is giving 90% of their income. I don’t know where that leaves us exactly, but I guess what I want to do is leave open the possibility that a career in something related to risk management can be a very meaningful career path for life. I guess it comes back to the feeling that we live in a very risky world whose benefits are at this point shared very unequally. I think that it’s not — the simple idea that you should be writing checks to UNICEF is not necessarily the final answer, but what you should be doing with your life.

Somehow, what we see in these examples — I gave both of Bill Gates and Muhammad Yunus — and I’m not setting them up as necessarily examples, but it’s that a career that develops some idea that’s well motivated can be a source of great meaning and purpose in life. What these people do is, it seems to me, is they develop a career with some ultimate objective and somewhere along the career it may seem that they’re doing something unimportant or selfish, but you have to judge it in the big context. At times, I felt annoyed with Bill Gates when I had to pay for — when I bought my second laptop and I had to buy Windows again, but I think that what we really have to do is try to think of how — I guess one’s moral imperative might be — one view is it might be that you should develop some kind of human capital and some kind of long run plan for how you are going to apply your human capital. It doesn’t necessarily mean satisfying the demands of UNICEF along with way.

We are a people and we have a certain psychology. I think we can get above our psychology to some extent and get above the drives of our psychology in moments of inspiration and I think developing a career can be part of that. Anyway, I’ve — that was my inspirational conclusion to this. So, I don’t know what careers you will go into, but in the meantime, we do have two more lectures. I doubt that Larry Summers will be giving you advice about your careers, so I hope to see you again on Tuesday and Wednesday of next week.

[end of transcript]

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