Financial Markets (2011)

ECON 252 (2011) - Lecture 23 - Finding Your Purpose in a World of Financial Capitalism

Chapter 1. The Course and Its Major Themes in Retrospect [00:00:00]

Professor Robert Shiller: All right. This is the concluding lecture for ”Financial Markets.” And in this lecture, I want–oh, I titled this lecture, Finding Your Purpose in a World of Financial Capitalism–but I just want to give a lot of summary thoughts about the course and about your place in the world of business and finance.

So, we had two–well, we had the major textbook for this course was by Fabozzi et al., and it gave you a lot of detailed information about financial markets and institutions. Did you like it? I’m getting approval, I guess. I put you through something, because I thought you have to know that material. Finance is like a language. Well, it is a language. There’s a lot of jargon, and behind the jargon are concepts, and I wanted you to immerse yourself in that.

I also assigned my manuscript for my new book, which is tentatively entitled Finance and the Good Society. I’m still not sure that that will be the final title. Some of you have been offering me suggested titles, I appreciate that. You can never know what the title of a book will be before you publish it, because someone else can always grab the title, and then you’ve got to change it.

But that book was about–see, Fabozzi is more about all of the language of finance, and all of the technical details. I wanted to supplement it with something about the purpose of all this, and how it fits into our lives. So, it’s not done yet, as you may be well aware in reading it. My apologies. But I benefit from interacting with you about it. It’s a dynamic thing.

I have a number of themes. They’re all just kind of random thoughts about the major things in this course. But I mean, I’m really thinking this time about the kind of tools we’ve learned about, tools that are particularly useful for people who specialize in finance. But I think, this almost should be a required course for everyone. Maybe, I’m just too enthusiastic about it, but the way things get done in our society is through financial arrangements. And too many people talk in vague terms, not, how are we going to make something happen? And finance is about that, so, that’s why I think this course should be–there should be more students taking it than are.

I also said, that I think that finance is not a purpose in itself, it’s a tool. And that you should be building your life around some kind of purpose. There’s a million different purposes, so that’s something for you to create in your own mind. But that’s where the meaning of life comes from.

So, another thing I’ve emphasized in this course is, that finance is like engineering, so you have to design it. And once something is designed and it works, it gets copied all over the world. You all have learned how to drive a car. Is there anyone here who hasn’t driven a car? I won’t ask for–no one raised their hand. So, you have to know a little bit about mechanics to drive a car. Maybe not too much. But ultimately, what I wanted to do in this course is, maybe not teach you how to build a car, but how to drive a truck, something big and powerful, and get you beyond the simple things.

So, finance, what does it do? It does really important things. It helps allocate scarce resources, it incentivizes people to do good work, and it manages risks. And this is what makes for the developed world that we have now.

Another theme of this course is about information technology, which is something that’s rapidly expanding. I don’t have to tell you that. But I think that it will change the world of finance. The last 50 years have shown tremendous changes, the next 50 years will show even more dramatic changes.

Or anyway, more specifically, I have seven themes that I want to cover in today’s lecture.

The first one is just about the morality of finance. I’ve been talking about this here and again, but let me say a little bit more about that in concluding. My second theme is hopelessness. There’s a tendency for people to think, that, at some level, because of the world’s problems, it’s all hopeless, anyway. I don’t think it is. Well, I’ve come to–I’ll have to tell you what I mean by that. Then thirdly, I just want say something about financial theory. Then to come fourth, to come back to another theme, which is wealth and poverty, which I’ve talked about a lot. Then, the world of the next century. And I think, one trend we’ll see is the democratization of finance, that finance will become much more of an integral part of our lives in a new information-technology-enriched world. And then lastly, I’ll say something about your career, whether it’s in finance or in something completely different. But I’m thinking that a good chance it has something to do with finance.

Chapter 2. The Morality of Finance [00:06:48]

Let me start, though, with the first thing, which is about morality. I have–actually, the two optional readings I have on this part of the reading list are both about morality. And one is the book by Unger called Living High and Letting Die. I think it’s a dramatically well-written book, but on the first page of the book, he refers you to UNICEF, which–actually, his book was written before the web got popular. The book is 1994, I think. 1996. He could have referred to the web, but he gave the address. UNICEF is the United Nations–what does the I stand for? Children Educational Fund, but what’s the I? Can someone tell me? [Correction: United Nations International Children’s Emergency Fund ]They don’t actually emphasize, what it’s spelled out. It’s the United Nations fund for children of the world, and that’s their website.

So, he opens the book by saying, why don’t you get out your checkbook right now and mail in $100 to unicef.org, because the estimate, as of 1996, is, that UNICEF can save a child’s life for $3. So, you will save the lives of 33 children for your $100 check.

How can they do that? How can they save a life? I think, maybe he’s referring to things like vaccination programs, things that are really cheap, that some children are not getting. And so, statistically, you can save a child’s life for $3. So, he says, write out a check, but of course, I can tell you what to do, and that is, just log on to that and get out your credit card. And I don’t know if you can save 33 lives with $100, but maybe you can.

So, when I first read the book, I thought about that, and then I turned the page–because most of us do–and I realized later, a month later, that I never had written out $100 check. So, I finally did. I went on to unicef.org and I gave exactly $100, as he called for. Then, I started–that was thought-provoking to think about that, because why did I stop at $100? Why is it that most of us don’t do that? There are intellectual defenses we have–we think of ourselves as good people–but if you were to see a dying child, you would emotionally be driven to do something, if there was something you could do, right? But somehow, when they’re not visible to us, we don’t take action to make them visible. What the book consists of, Unger’s book consists of, is an analysis of all the excuses we give for not doing it, for not doing that sort of thing. So, living our comfortable lives and letting other people die.

And I think, it’s really an interesting book, because it is referring to a paradox of human behavior. I think of this as at the juncture of philosophy and psychology. And now, those two departments are starting to–I understand, I’m not in either one of them–are starting to come together, because they’re realizing that philosophical issues are related to psychological issues. So somehow, the human spirit is very empathetic and sympathetic in certain dimensions, but not so in others.

When you read his book, you get a sense of meaninglessness or loss of purpose. It’s not entirely comfortable to read it. He has a lot of examples of moral dilemmas. I don’t mean to find fault with his book, but when I think further about it, it seems, that maybe the book is a bit circumscribed by the kind of moral dilemmas that he poses. In some sense, moral dilemmas are–it’s almost like there’s a moral imperative for us to take action to do things. That’s sort of what he’s getting at. But there’s almost a moral imperative to be entrepreneurial to do things.

I mentioned before, Paul Allen, who was one of the top people in Microsoft, who made so much money and squandered some of it, apparently, on conspicuous consumption, but on the other hand, gives a billion dollars to charity. So, it seems to me that–let’s not conclude that people who don’t write the $100 check are evil, and let’s think of the many, many dimensionalities of morality.

The other book I had on this part of the course was by William Graham Sumner, and it was written over 100 years earlier–1883–called What the Social Classes Owe Each Other. And Sumner was actually Yale’s first real economist. Interesting person. He graduated Yale College in 1863, and he was hired by Yale as a tutor in mathematics in 1866, and became interested in economics and sociology. He has the distinction of being the first American professor to teach a course called Sociology, and in those days, there wasn’t the distinction between the social sciences that there is now. So, he could teach both sociology and economics.

So, in his book, I think, he started a Yale tradition of conservative economics that lasted until the 1940s. And then, Yale kind of drifted more toward the liberal end. But he writes, anyway, in 1883, “Is it wicked to be rich? Is it mean to be a capitalist?” And he says, first of all, it seems, if capitalists are just richer than other people–he asks, where’s the dividing line, when someone is rich? So, is it wicked to be above that line? But where do you draw the line? And if you learn from Unger, maybe we’re all wicked, because anyone who doesn’t write a $100 check every day to UNICEF, when children are dying around the world, is wicked.

What Sumner is saying, and it seems to be a theme that survives the centuries, in favor of capitalists. I’ll quote Sumner. “The great gains of a great capitalist in a modern state must be put under the head of wages of superintendents. Anyone who believes that any great enterprise of an industrial character can be started without labor must have little experience of life. Let anyone try to get a railroad built or to start a factory and win reputation for its products, and he will find what obstacles must be overcome, what risks must be taken, what perseverance and courage are necessary.”

I don’t know, that I entirely agree with Sumner, but he has a point, that part of our morality is to do good for the world by doing things like set up railroads, or Microsoft. And the kind of activities that that entails, will create opportunities for conspicuous consumption, but not necessarily make that the defining characteristic of someone who does it. Nobody is perfect, and it’s hard to judge people ultimately, but it seems to me that there’s almost a moral imperative to entrepreneurship.

Chapter 3. Hopelessness: Challenging Malthus’s Dismal Law [00:16:06]

Let me go on to the second theme that I said I would talk about, and that is hopelessness. A lot of people, from their education, get the idea that ultimately there’s nothing we can really do. This is one of Unger’s–Unger talks about rationalizations we give for not being moral, and he calls it futility is a rationalization. Ultimately, there’s always going to be starving people in the world, and I can try to help this child, but something’s going to get him later, and so there’s no point. If you have that kind sense of futility, it can justify any amount of hedonism.

But I think, that the classic article that lends most people to that sense of futility, and I assume you know about this already, but it’s Malthus, 1798, his essay on–well, the title of it is Essay on the Principle of Population. So, Thomas Malthus wrote about the population problem. It was such a celebrated essay, that he went through six editions of it, but I’m going to quote from the first edition, just to remind you. He said, in 1798, “Population, when unchecked, increased in a geometrical ratio and subsistence for man in an arithmetical ratio.” So, the population growth follows an exponential growth curve. He says geometric, but it goes like that. Whereas he said, at best, the increase of our ability to produce is linear. He calls that arithmetical. And so, the population will run off with all of our resources. There’s nothing we can do, population will continue to put pressure on our resources. He says and I’m quoting again from his 1798 essay, “Population, when unchecked, goes on doubling itself every 25 years. If you go through two 25 periods where there was no check on population growth, it is impossible”–I’m quoting him–“to suppose that the produce could be quadrupled. It would be contrary to all our knowledge of the qualities of land.” And he comes now to his dismal law of economics. He didn’t call it that, but I will quote him. “No possible form of society could prevent the almost constant action of misery upon a great part of mankind if in a state of inequality and upon all if all were equal.” So that the natural state of humankind is bordering on starvation and dying. The force of his argument was quite profound, because it was hard to argue against him, that there’s nothing you can do about it. That’s just it. And all the theorizing of people can only result in a world, where more people are suffering and dying.

If you want to think more about this, I suggest you might go to Robert Wyman, who is a professor here at Yale on Open Yale, which means it’s another of these courses open on the internet. Has of course called ”Global Problems of Population Growth,” where he spends a whole semester thinking about the Malthusian problem. One thing that he talks about in that course is that there’s a popular sense that the population problem is not so bad anymore, because many countries have introduced birth control policies. Notably, China has a one-child policy, supposedly. It’s not really a one-child policy, it’s not enforced that well. It’s more like a two-child policy, or people have even more than that. But other countries–India, certain regions of India have made great progress, we’re told, in birth control.

But still, despite that, Wyman estimates that the world adds a billion people every twelve years. So, that’s a problem, and our resources are limited. So, the problem is that people are crowding into the cities, because there’s no room for them on the land. They’re trying to get an education to push themselves ahead, but the sheer numbers of people make it impossible for them all to get ahead. So, I suggest that you might take his course. It’s a problem that people don’t want to face up to.

So, I’m sounding very dismal here, but actually, I think that the problem is not as bad as it may seem. This is my take on it. I tend to be a realist about these things. We have a population problem, it’s going to be with it us, but, hey, it’s been with us forever, going all the way back in history. So, it’s a tough world that we live in, because the human race is naturally procreating, and naturally creating population pressures and conflicts that lead to wars and famines. We’ve been going through a good run in the last few centuries, but I don’t know when the end–it’s not an end–when we’re going to see more severe problems, but that just seems to be right and inevitable.

I think, that the weakest part of Malthus’ argument is the last step, saying that it’s necessarily a dismal world that results. I wanted to put the bright side on Malthus’ dismal law, and that is, most of the time, everyone’s fine in the world. Most people–it’s famines and wars are intermittent events that reduce population. Between those big events, pretty much everyone is doing all right. So I mean, maybe it’s not as bad as you think. You know, you might get killed in a war someday, but you enjoy life until that happens. I mean, that’s very basic, but I think it’s true.

Moreover, I think that there’s a lot that we can do to make life better, even in the context of dismal law, even accepting the dismal law. And I think that civilization is improving, so that life is better, even though there are population pressures. And that’s why I think there is–maybe I’m saying the obvious here, but I want to say it anyway–that there are plenty of purposes and goals that people can fulfill, even taking as given Malthus’ dismal law.

I talked last period about nonprofit and charity, and government as well. There are a lot of people, who are doing specific things to make the world respond better to the dismal law of Malthus’. And I wanted to mention certain examples, just to make this clear. I think, that there’s work being done by governments of the world, there’s also work being done by individuals who don’t need government, they set up their own organizations. Specifically talking about the environment. This is what’s being threatened by population growth. And so, there are many foundations that deal with the environment. I’ll just mention a few. The Nature Conservancy, the Worldwide Wildlife Fund, the Wildlife Conservation Society. And there are specialized ones, like African Wildlife Foundation, the Jane Goodall Institute, the Diane Fossey Gorilla Fund. You know, you think the gorillas out there are wild, but there’s finance and support. They’ve collected money. Someone is managing an endowment for the gorillas, OK? This is creative finance.

A part of the problem with–you think about, what’s happening with the population pressures of the world, and is it bad or not? Well, in some sense, it’s good. Having 10 billion people out in the world would just make for a more interesting place, right? There’d be more arts and sciences, and fun things to do. Eventually, we’re going to colonize the Moon and Mars, and there’s going to be fun trips to do, so, I don’t know, if it’s a bad world we’re coming into, even if there are conflicts.

But I think there’s specific problems with that world, and one of them is the extinction of species. You think about that, we’re destroying habitat for species, and they’re going to be gone forever. But the thing is that those kinds of problems are problems that have sort of business solutions.

I wanted to talk about one particular foundation. It’s a nonprofit. I’ll just give this as an example, the Nature Conservancy. It was founded in 1951 in the United States, but it now operates in 30 countries. Its total assets are 5.6 billion, which makes it the third largest charity in the United States. And they have a principle of ”conservation by design.” The idea is, our purpose is to prevent extinction of species. Because extinction is forever. You know, these species have taken hundreds of millions of years to evolve, they get wiped out, they’re gone. As far as we know, they’re gone forever.

So, what they do is they get scientists who specialize in environment and biology, and they say, which species are endangered, and what can we really do to prevent their extinction? And one thing that the scientists have been telling them is that you have to preserve habitat for species, and you have to do it with purpose and clarity. What do these animals need? Some of them are migratory, for example, and they migrate over long distances, so you have to preserve a migratory route and stopping places along the way for them. So, it has to be done well.

So, the Nature Conservancy believes, also, that the way to protect habitat is to buy land, and put up fences around that to keep people out, and then have a forest manager run it, so that the species will have it, will have that land. They say that they have 500,000 square kilometers of land that they’ve bought around the world. I calculated, that there’s 150 million square kilometers of land on the earth, so they have 1/3 of 1% of the world’s land protected by their charity. That might seem small, but you know, that’s a big difference, right? Because, if it’s the last habitat, that might be enough to keep a lot of species’ diversity going.

So, that’s an example of what–this is really finance. We have portfolio managers managing portfolios and properties of land with a good purpose.

That’s where I say, the moral dilemmas are not so simple. You could take a job managing a portfolio for one of these foundations. Peter Unger, in his book, is talking always about, would you save a child who fell in the water or something like that? But that’s not the kind of moral dilemmas that we really face, that an energetic intellect would find. The moral dilemma is to prevent big, bad things from happening, and that takes a sort of entrepreneurship and big thinking to manage.

Chapter 4. The Endurance and Survival of Financial Contracts [00:30:05]

Another thought I had in this context is about wars. I was saying that population pressures are a fact of life, and I’m skeptical that anyone will change the basic nature of the situation. But I wanted, in this context, to emphasize that financial arrangements are capable of enduring and surviving wars and catastrophes.

I wanted particularly to make it clear, that there’s a tendency for people to think, that finance is something that the government runs. You can easily get that impression, because, when you go into finance, the first thing you have to do is get licensed, and you have to file some papers with either the government or a government-approved organization. And then, you will find, there’s a whole list of laws and regulations that you have to memorize, and forms that have to be filed with government agencies, and permissions to be granted. So, it sounds like this is just the government. But I think that’s the wrong view. I think that you should think of finance as people making arrangements with other people, and governments are helpful, and they enforce a contract, but they don’t determine them.

And in particular, I wanted to give you a few examples that clarify this. What do you think happened after World War I with financial arrangements? Germany lost the war. People were really angry with Germany. In the Versailles Conference after World War I, Germany was made to pay huge reparation payments, payments that some people thought were so heavy, that the country will never be able to do it. So, what do you think they did to financial contracts? Germany was at its knees, people thought they were evil, or many people thought they were evil. Well, there was talk about taking away–people who own stocks or bonds, let’s just confiscate them, and tell them, you were in the wrong country at the wrong time–tough on you. Well, they talked about doing it, but they didn’t do it. The reparations were obligations of the German government, and they were paid by taxing people. And they taxed people in an equitable–they didn’t actually pay them, by the way. The skeptics were right. Germany never was able to pay the reparations, but it tried to pay them by taxing people, not by confiscating. Because ultimately, when it came down to it, they thought, well, Germans are all different, and some of them supported the war, and some of them didn’t, and some of them saved all their lives, and they’ve got a big amount of money, so let’s not confiscate their shares. So, they didn’t. That’s my first example.

Second example. Iran. Remember, it was ruled by the Shah of Iran, who was a secular ruler, hereditary ruler of Iran. Overthrown by a people’s Islamic revolution, and the Ayatollah Khomeini became the spiritual authority for the new country, it became much more Islamic. All right. So, what do you think happened to financial contracts in Iran? In particular, the Iranian government under the Shah had a social security system, and they were paying, to government employees, pensions.

So, what do you think the Ayatollah did? A guy is working all his life for the Shah, we’ve overthrown the Shah–do you still get your pension? What do you think? They did. They didn’t cancel. I think, it’s like common sense. You come in, you are a totally different government, now you’re a radical Islamic government. Now, I don’t say, that they won’t do some things that you don’t like, but they see the basic financial contracts and they preserve them.

The other example I’ll give is South Africa. And that is, in 1994, the white apartheid government was replaced by a government that was elected by the black majority in South Africa. So, what do you think happened to their pensions or their insurance? Where they confiscated? No. So, I think that this is a principle in history.

Now, I can give other examples, of course, where things went badly. Vladimir Lenin wasn’t so kind to stockholders in Russia after this Russian Revolution. Lazaro Cardenas, in Mexico, nationalized the oil industry. Mao Zedong–you know who he is, in China–not kind to capitalists. Mohammad Mosaddegh in Iran nationalized the oil industry. Gamal Abdel Nasser in Egypt nationalized a wide range of industries. Even in India, Indira Gandhi did widespread nationalizations that were effectively confiscations.

Even the United States has in some sense been involved in those sorts of things. After World War II, the United States was not going to confiscate wealth of wealthy people in general, but in Japan, there were these wealthy families that maintained industries, called Zaibatsu. These were the family-owned businesses that dominated Japan before World War II. The big four, Mitsubishi, Yasuda–who else? Mitsui–and what am I thinking of? It’s not in my notes. [Addition: The big four were Mitsubishi, Mitsui, Sumitomo and Yasuda] But these big, wealthy families were thought to have supported the war and made Japan into more radical than it would have been. So, there was a lot of U.S. thinking that we had to break up the Zaibatsu.

So, what the United States did is force these families to convert their holdings of industry in Japan into yen-denominated government bonds. And then, the Japanese government had a huge hyperinflation and wiped them out. So, it wasn’t actually a confiscation. The U.S. government didn’t deliberately confiscate the wealth of the Zaibatsu, but they effectively did that. By the way, we still have Zaibatsu in Japan, but they’re not owned by those families anymore. The same industrial conglomerates still survive.

Chapter 5. The Importance of Financial Theory [00:37:41]

Third topic, I was saying I would talk about is–maybe I’ll be brief about this–importance of financial theory. I’m an advocate of two seemingly disparate things, and you know this from this course. One of them is Mathematical Finance. We spent some time on it, but not very much, because there’s another course–it’s also on Open Yale–that John Geanakoplos has on Mathematical Finance.

But the other side of it is Behavioral Finance, which is a particular passion of mine. And Behavioral Finance is the application of psychology and other social sciences to finance. And I think that the two actually work together symbiotically, and that we should consider them together. Some people in Mathematical Finance are very opposed to Behavioral Finance, because it kind of muddles their world, but in fact, I think, they should consider it their salvation, because without Behavioral Finance, they’re kind of bordering on irrelevant. You have to consider things in a broader context and think of the interruptions and problems that are caused.

Chapter 6. Welfare and Poverty [00:39:13]

I said, the next topic I would talk about today is–I’ve already been talking about it a bit–is about welfare and poverty. It seems to me, it’s fundamentally connected with our thoughts about finance, because–I’ve referred to this problem before, that people think, that people who go into finance are money grubbers. They want to make money, they don’t have human feelings or something like that. And there’s also the sense, that we’re living in a world that’s increasingly plutocratic, that the wealthy people are controlling the world. That was a theme that took a lot of impetus in the 19th century with Karl Marx, who said exactly that. And in some sense, it’s coming back–maybe in not such an extreme form.

So, Jacob Hacker, who’s in our political science department, and Paul Pearson, who’s at Stanford University, have a new book that just came out called Winner-Take-All Politics. And that book is about–they have a claim in that book, that the world is getting more polarized by the political power of financial institutions.

Basically, they have something, they call the ”30 years war.” What’s the 30 years war? You might think, it’s something that happened in the 17th century. Not for them. The 30 years war is the war against the people of the world, fought by the financial community in the halls of Congress and Parliament, by lobbying. So, they argue that the companies have gotten more and more sophisticated in lobbying governments to fulfill their ambitions, and so, the income inequality that we’re seeing increasing, particularly in the United States, but also elsewhere in the world, is a consequence of this.

So, Hacker and Pearson say–much of the literature on income inequality says, it has something to do with the information revolution, which is eliminating jobs for low income people, and the increasing importance of education, which rewards college graduates at the expense of uneducated people–but they say, that the real increase in inequality has not been between high school graduates and college graduates, it’s between the whole population and the top tenth of a percent. There is this small community of super rich people, that are developing, who are very adept at lobbying governments. This is a trend that’s developing.

Well, I think to some extent, they are probably right. I think, maybe they overstate that, but I think, it’s a concern, but I think, that we do have democratic institutions, and we can respond to that. So that I think, maybe, they overstate it, because I think that, I’ve met billionaires in my life, I have a sense, that they are not–I haven’t met enough of them to make generalities about billionaires–but maybe, they have a little bit of a self-serving mentality, but in some sense they seem not to care. They don’t want to be viewed as evil, they want to be–a lot of what drove them to become billionaires was a sense, that they would be a benefactor of some sort, and so they’re ready to give it away. Anyway, that may be a casual impression.

But one thing that angers people about wealth is the tendency of wealthy people to build monuments to themselves. So, I was thinking of that, when I was at the J.P. Morgan Library in New York, and also there’s something called the Metropolitan Club, which is another building that he built to himself, this huge mansion in Manhattan that he built. And I was thinking, is J.P. Morgan evil? I mean, people are starving in the world, and he’s building a mansion for himself. But then, I reflected further–here, I am having dinner in his mansion. He’s gone. And is it really so bad in the scheme of things? I guess you can view it in different ways. You can view J.P. Morgan as a great success, who ended up helping the world, or you can view him as a selfish monument builder.

His life overlapped with Karl Marx, that I told you, about. But one of Karl Marx’s themes was, that the system is unfair. That some people have capital, that was a theme of his book, Das Kapital, some people have capital, and they are wealthy as a result, and they will continue to be wealthy, and they’ll make their children wealthy as a result.

I actually have a quote from Karl Marx. “It is not, because he is a leader of industry that a man in is a capitalist. On the contrary, he is a leader of industry, because he is a capitalist. The leadership of industry is an attribute of capital, just as in feudal times the functions of general and judge were attributes of landed property.” That comes from his book, Capital, in the 19th century. So, Marx thought, that ownership of capital was like a key to the good life, and that the population was excluded from that. But I’m going to come back to the democratization of finance, but it seems like capitalism–it isn’t essential to capitalism that some social class dominates capital. We can have a capitalism that is divided up among–that is more people’s, it belongs to people, and it’s not a privileged class.

So, another thing I wanted to talk about is my concern. Marx was impressive–I think I may have said this before–he was impressive, because he read emerging sociology. And the sociology of his day was beginning to recognize, that people do form themselves into social classes, and they have a sense of loyalty to others in their social class. But I think, that anything he said is of limited relevance today–was always of limited relevance. Interesting, but wrong in many ways.

I’m thinking of the works of another important thinker, Robert K. Merton, who was a sociologist at Columbia. He is the father of Robert Merton, the economist, who helped develop option theory. But Robert K. Merton referred to, what he called the ”cosmopolitan class.” He was looking at social classes. He picked a small town in the United States, and interviewed a lot of people, and was trying to understand their class structure. You know, who do you identify with? Who are you loyal with?

He was a deep thinker, I think, and looked at what really seemed to separate people. And he decided, that, in this little town, that there were really two classes of people. He called them cosmopolitans and locals. So, the cosmopolitans had a very different worldview. They tended to not care about what’s going on in their town. They would talk about national or international things. He’d listen to what they say. They were focused outside, they thought the town was irrelevant, and they tended to have maybe higher-level positions.

The locals were people, though, who would talk all about their town, and they would talk about people they know. They seemed to value their connections within the town. And when you asked for opinions about the local town, the locals would tend to give almost loving expressions. This is a great town, we have a great people here. And the cosmopolitans would act totally indifferent, and they don’t know anybody. They don’t know who’s the head of the fire department, or who holds the–maybe they know the principal the school, because they may have their kid in the school, but beyond that, they don’t know anything about their town.

So, Merton wrote that over 50 years ago. I have a sense, that it’s developing further, this split between cosmopolitans and locals. And it’s developing on a world scale. There’s now a world cosmopolitan class, and with increased communications we’re kind of split that way. So, people around the world who are learning to speak English well, that’s the world language, people who travel around the world, and people who are finance savvy, are developing into a social class. And I think, that there are animosities and conflicts, but it’s a little bit harder, because the cosmopolitans are so scattered and they’re relatives of us, so it’s not as intense a social contrast.

But you know, I think, that the animosities that we are feeling now have to do with the fact that cosmopolitans know and understand finance, and they have lawyers and advisors. The rest of the population feels excluded from that.

Chapter 7. The Democratization of Finance [00:50:36]

So, that brings us to what I said was the democratization of finance. And this is a theme of my own that I’ve been emphasizing. So, the democratization of finance is sort of trying to make it move beyond the cosmopolitan class, OK? So, cosmopolitans know how to get things done, how to raise capital, and they know how to manage their risks, so they don’t get into trouble. Inequality is substantially due to a failure to manage risks. Right? I mean, some inequality is due to fundamental things, like someone is talented and can make more money. But it’s also due to random things that are not controlled.

Notably, in the current financial crisis, we saw a huge drop in home values. And we saw people who bought homes at the top of the market, and then they find that their mortgages are worth more than their homes are, and so they have a negative net worth. They’re in trouble, they would be bankrupt–maybe they’re not bankrupt yet, but they’re verging on that–they’re very unhappy. This was a failure, I think, of bringing finance to the people. So, it’s not democratizing finance–we haven’t finished democratizing finance.

So, it’s kind of chaotic, the way things work for most people. Most people who, a, do not have a lawyer, b, do not have a financial adviser, c, do not have an accountant. Or maybe they go to some storefront tax-paying service, but that’s as far as they go. And these people make a mess of their lives.

So for example, we have laws that allow people to go bankrupt and wipe off their debts. All you have to do, if you are in trouble, financial trouble, is go to a lawyer and say, can you help me file for Chapter 7 bankruptcy? I’d like to wipe out all my debts. But usually, you have to have $1,000 to pay the lawyer to help you do this, and these people can’t get it together to do that. So, what happens? What happens to this typical person, who is uneducated, has gotten deeply in debt? What do you think happens? Do they ever declare bankruptcy? No. What do they do? They stop answering the phone, because they’re getting these dunning calls from creditors.

And so, the creditors then–it’s called informal bankruptcy. They will go to court, and ask the judge to allow them to garnish the wages of the person who won’t pay and won’t answer the phone. So, they’ll take another deduction from the person’s paycheck, eventually. The person never figures it out. His paycheck just went down, he is paying off his debt. What a mess. But that’s because of the failure of financial institutions to handle things well.

So, Elizabeth Warren, who is at–I mentioned her before–at the Harvard Law School has written a couple of books about these problems that people face. And it’s a testimony to the success of our democratic government, that she managed to persuade Dodd and Frank to put it in their bill, the Consumer Financial Protection Bureau, which would create a government agency that would try to limit the abuse of lower income, less educated people. We were hoping that she would be made head of her bureau, but it turns out, that she’s only acting–I forget what her exact title is–transitioning into finding a head for the bureau. Because the lobbyists that I told you about, representing credit card or the mortgage industry, are adamantly opposed seeing her put on as head of the bureau. So, it looks like it’s politically impossible to put her in charge of it, but she’s at least involved in helping pick the person who would make that happen.

So, I think these are nice steps forward, but I wrote a book–let me just mention my own book–in 2008, called Subprime Solution. And so, I was trying to think of the future. Again, I’m trying to think creatively and expansively without thinking punitively, as Elizabeth Warren seems often to do. Her view tends to be that there are exploiters who need to be regulated. But I’m thinking, that maybe there’s something positive we can do.

So, I have various ideas. Also, I had–this was 2008–I also had another book, The New Financial Order, in 2003. I’m getting on toward 10 books now in my life, and I’m having trouble remembering which one is which. I was just commenting to my wife, it’s a little bit of a problem. But somewhere in these books, one of the ideas I had–actually, it’s in The New Financial Order–is for livelihood insurance that would help protect–this is a financial institution that would protect people’s livelihoods. I viewed it as an expansion of something that we’ve got already, called disability insurance. In fact, it’s been offered by the government in the United States as part of the social security system, but it handles certain insurance against certain specific kinds of risks to livelihoods, namely health risks. If you become paralyzed, if you become mentally ill, any of those things that a doctor can attest to, is insured already. Very important, because things like that happen to people and they can’t earn a living anymore, and it happens to young people.

And so, we have private insurance, the government has taken over part of disability insurance, but there’s also private disability insurance. But none of this covers the biggest threats to people’s livelihoods. Most threats to livelihoods are not due to medical events. It’s economic events that make you–you know, you’re 40 years old, you’ve trained for, let’s say, nuclear engineering, and then we have the Fukushima or the Sendai disasters, and then suddenly no government of the world wants to build nuclear plants anymore.

So, here you are, you’re 40 years old, you’re reaching your prime, you would normally be making a good, high income, but now it’s useless. No fault of your own. This is a risk that you cannot now insure, and it’s part of the thing that contributes to inequality. And so, I think that we can insure those things, and in the future, as finance develops, these are some of the missions that we have to do.

Another thing is home equity insurance. I mentioned before, that the crisis was caused by failure to insure against home price risk. I’ve been working on trying to get home equity insurance started. Some of my colleagues at Yale, Will Goetzmann and Barry Nalebuff particularly, have actually created an insurance policy that would insure homes against price declines in the city of Syracuse, New York. Didn’t really take off, so this is still not happening yet. But here’s the idea–you can buy insurance against your home burning down. That goes back 300 years. But how often do homes burn down? Not very often. What’s the real risk that you face? It’s the loss of economic value of a home. And so, that is not insured anywhere in the world. Why not? We could insure it. I think, these are things that would–developing home equity insurance or livelihood insurance would be positive steps.

I have one more example from this book Subprime Solution, something that I call a continuous workout mortgage, OK? In the financial crisis today, right now, there are 2.5 million households that are on the verge of defaulting on their mortgages–haven’t yet, but they are at risk of defaulting and being thrown out of their houses. So, that’s something like close to 10 million people. Big time event.

Why is it that they’re being thrown out? Well, because their home value has dropped, maybe they’re unemployed, their income has dropped–we still have 8.8% unemployment–and they can’t pay their mortgage. And maybe, they think it’s futile, because they’re paying a debt that is bigger than their wealth. So maybe, they don’t feel in a very good mood about it. They go back to the mortgage lender and ask for a workout, and the mortgage lender typically says no. The government has done a sequence of programs to try to encourage the servicers of mortgages to do work-outs, that means lower their payments or somehow make it easier. But it’s been disappointing. They haven’t succeeded in getting cooperation on these programs. It’s one of the big tragedies of the financial crisis.

So, what I proposed is, that we should think forward. I don’t know how we can solve this mess right now, but think about in the future, having mortgages that have a pre-planned workout. And the workout would lower the cost of–lower the payment on the mortgage. Continuously, not just–the other problem with workouts is, even when people get a workout on their mortgage, they default anyway, because things get even worse later. And you’ve got one workout, you go back and say, I’d like another workout. They say, you have got to be kidding.

And anyway, the government, like the HAMP program, that the Obama administration has promoted, has only one workout for each family. So, I think they should be continuous and automatic. And they don’t require anyone to apply for a workout.

Chapter 8. Advice for the Right Career [01:02:18]

So, how much time do I have? I think I’ll move to my last subject, which is your career. Because you are young people and you may be wondering what you want to do.

I think, I maybe have reflected on this before. You probably feel that you want to do something important, and you want a sort of perfect career, something that tells a story, makes a story of your life and ultimately serves for good causes. But when you read Unger, you don’t get an inspiration like that, right? You get–he says, write a check right now to UNICEF. Well, I can do that, but it seems unrewarding just to give to charity. I can just live like a monk, right? I could take a job at a hamburger joint, and then give all my money away to UNICEF. Somehow that doesn’t feel–I think, that you know, that you have abilities, and you want to see them flourish, and you want to–that’s why I think, you shouldn’t be flipping hamburgers and giving the money away. That’s not what you should be doing now. And instead, it would be learning things that make it possible to do good works.

What is the perfect career? I mentioned Paul Allen or Bill Gates. Bill Gates–I shouldn’t give you an example of dropping out of college, but he dropped out of college. And by the way, you should do that, if you have a Microsoft-size idea, but I think I’ve said this before.

I don’t know. What is the perfect career? I’ll give you another example. Mohammad Yunus. You’ve heard of him. He went to a Ph.D. program at Vanderbilt University, got his Ph.D. in 1969, became an assistant professor of economics at Middle Tennessee State University. But then, the big thing that he did is, he went back to Bangladesh and founded the Grameen Bank. The Grameen Bank, which specialized in making microfinance loans in Bangladesh, and that was in ‘76. [clarification: Mohammad Yunus started making microfinance loans in Bangladesh in 1976, but the institution of the Grameen Bank was not established until 1983.]

Grameen apparently means ”of the village” in Bengali. But what he did is he conceived of a new way of making loans to very low-income people. Banks before Yunus didn’t have much interest in lending to low-income people, because the costs of administering the loan seemed to be too high, relative to what you could get back. But he had a scheme for getting people to pay back the loans. Often, they would make loans to women in groups–impoverished women, but he would lend to the whole group and say, that the whole group is jointly liable to the debt, that’s the only way we’ll make it. And it’s for business, for starting a business, like getting a wheeled cart, where you could sell food on the street. Some simple, low business like that. You can’t do it, unless you get a little bit of capital, enough to buy the cart and buy the first food to start selling. And these women can’t get that capital, but when he makes it available to them as a group, they then interact with each other and enforce the good behavior of each other. And it’s a system that worked.

So, he won the Nobel Peace Prize in 2006. It was not the prize in economics, it was the prize in peace. So, that’s an example of the kind of careers that, I think, some of you might think about.

So, I think that in looking forward to your own careers, you have to think about the next five decades. You’re going to be working–I said this before, I think–but you’re going to be working for another 50 years, right? More, if you enjoy it. With modern health care, you might live to 100, but you won’t be working at 100, probably. You’ll probably retire by then. Maybe not. Maybe, you’ve got a century ahead of you. And I think, that the world will change a lot over this interval of time.

I think that, by the way, information technology will be changing so many things that we do in ways that we can’t see. And financial markets will be everywhere. So, I may be presumptuous to think that some of these ideas here are likely to come about, but I’ve come to start to think that they’re all inevitable, because we’ve already seen the past. We’ve seen how financial markets have captured more and more risks. And we have such an advance in our technology, that there really ought to be big changes that will come.

So, I guess, what you have to do is, maintain a century-long personal outlook. I mean, just think about how much happened in the last century, right? We had two world wars, we had the whole communism came and–extreme communism came and disappeared. Things like that are going to happen in the next century. And so, I think you have to reflect on your role as an agent, not to think of it as something that a remote government is handling. This is something that you have responsibility for helping develop, how the world will turn out in the next century. I was just saying that governments come and go, but financial contracts and institutions and the people who manage them continue.

I think that you face great career risks in this new environment. I mentioned before, the 40 year-old, who finds that his career is suddenly eliminated because of some random change. There’s evidence that, what happens to you in life, depends on random events. It’s really so much unforecastable. I’m thinking of myself, for example. What did I think I would be doing? I’m still–I just stay in the same place. I’ve lived in New Haven for almost 30 years and I’ve been a college professor. But when I was your age, I never thought that I would be doing public speaking the way I have been. I get–I’m all over the–I don’t mean to exaggerate, but I didn’t have the confidence. You know, I was on my high school debate team, and I didn’t particularly do well. I think you just develop, careers develop and random things happen, and you discover things about yourself.

I was going to point out studies that show how random events affect where you go. So Joshua Angrist, who’s an economist, did a study of the effect of the draft lottery on success of people in life. In 1969, during the Vietnam War, the U.S. government decided to use a lottery, based on birthdates, to decide who gets drafted into the U.S. Army and sent to Vietnam. And so, Angrist thought that was a good controlled experiment. Let’s compare the lifetime income of people who–they way they did it is, they drew out of an urn all birthdays–there’s 366 days, birthdays–they drew them out of an urn, and the first one who was drawn was the first one to go to Vietnam. And then, as it went down, the higher the number, the less likely it is that you would ever be asked to go.

And so Angrist–by the way, I got 362. I couldn’t believe it. What great luck. We were listening on the radio–I was a graduate student–we were listening on the radio for the lottery numbers, and we were drinking beer, and people were all excited, wondering who was going to get drafted. And I thought, you know, when it got into the 350s, 350, 351, 352, I thought, I must have missed my birthday. I can’t be this far down, but I got 362. And that’s part of my success story, because according to Angrist, people who were drafted, who got the low number on the lottery, ended up with lower lifetime earnings. That kind of random event affects your whole life. You know, the word career goes back to the sense, that there are random things that happen, opportunities that come, and lack of opportunities that hurt your life.

So, I think that you have to accept the fact that it’s a risky world, that you have to try to position yourself, maintain–I think one important piece of advice I like to think of is, maintain an orientation toward history in the making. That there’s a tendency for people to orient themselves in terms of their own life cycle. They think, what’s going on now? Well, I’m a junior at Yale, and I’m going to be applying to graduate school next year. You should be thinking, well, this is a time in history, when the Middle East is changing rapidly, that the emerging countries are developing new technologies, and thinking about the opportunities that are happening in the world.

That’s kind of what we got from Hank Greenberg in his lecture. Remember, that he said, that the founder of his company decided to move to China at the beginning of the 20th century, and founded a business because of what he saw was happening in Shanghai, which was an international city at the time. So, I’m going to go there, and I’m going to make a business. That’s kind of positioning yourself with history. And then, he moved out of China before Mao Zedong took over, and then moved back in. I mean, this is history awareness, and I think that it matters enormously.

But you still can’t completely eliminate the role of chance in your life, this is a time-honored principle. I was actually going to quote the Bible. Ecclesiastes was a book of the Bible written in–when was that written–around 500 BC or 600 BC. [Clarification: The reputed author of this book was Solomon, tenth century BC, but analysis of the language suggests to some biblical scholars that the book was actually written between the fifth and second centuries BC] And this is, you probably already heard this, “I returned and saw under the sun that the race is not to the swift, nor the battle of the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favor to men of skill, but time and chance happeneth to them all.” So, that’s a time-honored truth, that randomness–

I actually had this “time and chance happeneth to them all,” I actually had that inscribed in Latin when I had my office redone. It’s over my desk in my office at home, “tempus casumque in omnibus.” Chance plays a huge role in our lives and this risky world plays a sequence of events over your lifetime that we have to try to manage.

So, what I hoped to do in this course. This was really a course about managing risks as well as enterprise and creating a cooperative spirit. I wanted to try to convey to you that we have a technology for that, that should be a part of your life. All right, thank you.

[APPLAUSE]

[end of transcript]

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