WEBVTT 00:02.140 --> 00:06.310 Professor Robert Shiller: I thought I would just 00:06.307 --> 00:11.017 remember a couple of highlights from the first two lectures to 00:11.015 --> 00:13.635 consolidate what we said then. 00:13.640 --> 00:18.200 In the first lecture, I talked about a lot of things, 00:18.203 --> 00:23.473 but one theme that comes to my mind is the theme of the moral 00:23.469 --> 00:27.769 purpose and mission of the finance community. 00:27.770 --> 00:32.620 We talked about the sense that, I think, young people have a 00:32.621 --> 00:37.061 sort of prejudice against the field and they think that 00:37.061 --> 00:41.991 finance is a field that you go into if you really value money 00:41.994 --> 00:44.054 rather than people. 00:44.050 --> 00:50.440 I want to reiterate again that that's not the way I view the 00:50.444 --> 00:54.654 field at all. I was just yesterday--I gave a 01:03.838 --> 01:07.698 management fund for the Province of Quebec. 01:07.700 --> 01:12.080 I met a lot of people there and I never once got the idea that 01:12.083 --> 01:14.673 anyone there was evil or grasping. 01:14.670 --> 01:18.860 I think they have a moral purpose, which is to preserve 01:18.855 --> 01:23.345 the livelihoods of the people of the Province of Quebec. 01:23.349 --> 01:27.859 You get a very different view of things when you meet the 01:27.855 --> 01:30.625 people. I think our entertainment 01:30.626 --> 01:35.126 industry likes to make movies about people in finance, 01:35.129 --> 01:39.499 but they are inevitably portrayed as evil and I don't 01:39.502 --> 01:41.102 know why that is. 01:41.099 --> 01:46.299 I don't think there has ever been a major motion picture 01:46.300 --> 01:51.690 about a financial person who ended up a philanthropist. 01:51.690 --> 01:56.120 Why is that? I just don't--people don't 01:56.122 --> 01:59.472 like--people would rather hate--I don't know why it's 01:59.468 --> 02:03.198 something--it wouldn't be a good movie theme, would it? 02:03.200 --> 02:07.070 Anyway, you have to overcome these--you have to think that if 02:07.065 --> 02:10.285 you go into the field you would probably--If you're 02:10.286 --> 02:14.276 successful--you would probably end up as a philanthropist; 02:14.280 --> 02:19.050 but no movie will be made about your life and you may encounter 02:19.049 --> 02:21.049 hostility the whole way. 02:21.050 --> 02:24.100 It's especially true right now with the subprime crisis. 02:24.099 --> 02:28.299 People are blaming the financial community for our 02:28.295 --> 02:31.755 troubles now. It is true that we're seeing 02:31.755 --> 02:36.025 some people thrown out of their houses, in some cases, 02:36.030 --> 02:39.450 because of some rather questionable financial practices 02:39.448 --> 02:43.308 that got people into mortgages that they shouldn't have gotten 02:43.310 --> 02:45.050 into. But overall, 02:45.049 --> 02:50.409 I think that the people in this field are good people. 02:50.410 --> 02:53.780 In the last lecture, I talked about–In the 02:53.780 --> 02:56.940 second lecture, I talked about the pooling of 02:56.936 --> 03:00.946 risks and the basic theme of that lecture was that we now 03:00.953 --> 03:04.833 have a mathematical theory, probability theory. 03:04.830 --> 03:09.510 When you look at this theory, you realize that it suggests a 03:09.505 --> 03:14.335 very important technology for improving human welfare and that 03:14.340 --> 03:16.480 is: by spreading risks. 03:16.479 --> 03:19.099 The economy, and technology, 03:19.099 --> 03:23.659 and the weather, and all sorts of factors create 03:23.659 --> 03:26.929 risks. But, the real technology 03:26.925 --> 03:32.655 is--the technology that works to eliminate risks is to spread 03:32.662 --> 03:34.792 them out, to pool them, 03:34.794 --> 03:38.054 to share them among many different people. 03:38.050 --> 03:43.110 So, the idea that theorists suggest--and it may be 03:43.107 --> 03:49.197 unreachable--but the perfect financial system would have all 03:49.197 --> 03:52.807 of our risks pooled completely. 03:52.810 --> 03:55.690 That is, nobody suffers alone. 03:55.690 --> 04:00.370 If anything happens to me in my livelihood, then it's spread out 04:00.366 --> 04:04.296 over everybody and everybody means the whole world. 04:04.300 --> 04:09.470 Whatever happens to me, when it's spread out over six 04:09.465 --> 04:13.935 billion plus people, it ends up divided by six 04:13.936 --> 04:17.906 billion and it becomes unobservable. 04:17.910 --> 04:21.850 It becomes so small that it's meaningless and that's the 04:21.847 --> 04:23.257 ideal. That's what, 04:23.263 --> 04:26.223 in principle, we can do and what I think is 04:26.217 --> 04:30.297 the most important concept in finance--this concept of risk 04:30.295 --> 04:32.775 pooling. We live in a world where people 04:32.784 --> 04:34.464 suffer all kinds of misfortunes. 04:34.459 --> 04:36.859 Of course, we can try to get rid of these misfortunes. 04:36.860 --> 04:41.260 We can do research on disease prevention and weather 04:41.257 --> 04:44.187 modification and global warming. 04:44.190 --> 04:48.270 We can do research on all these things, but there's another 04:48.272 --> 04:51.302 technology, which is extremely important. 04:51.300 --> 04:55.200 That is, even leaving the risks as they are and just sharing 04:55.195 --> 04:59.595 them better. So, I'll be talking more about 04:59.603 --> 05:02.593 this. The problem is that while the 05:02.589 --> 05:06.929 principle of risk-sharing is very simple and obvious the 05:06.933 --> 05:09.463 practice requires technology. 05:09.459 --> 05:12.889 It's just like you could say some of the principles of 05:12.885 --> 05:16.675 mechanics are very obvious, but to make an engine that 05:16.680 --> 05:20.670 operates in terms of those principles is not obvious. 05:20.670 --> 05:27.290 What I want to talk today about is what I call technology in 05:27.288 --> 05:30.738 finance. I'll present my view of the 05:30.739 --> 05:35.829 situation, but maybe it's a rather idiosyncratic view that I 05:35.829 --> 05:39.209 have. But, I think--It's not so much 05:39.207 --> 05:43.057 idiosyncratic, but it's a different emphasis 05:43.058 --> 05:44.848 that I put forth. 05:44.850 --> 05:49.000 What I want to talk–There are really three themes to 05:49.002 --> 05:51.112 today's lecture: a risk theme, 05:51.114 --> 05:54.324 a framing theme, and an invention theme. 05:54.319 --> 05:59.189 I want to go over the history of risk management and through 05:59.187 --> 06:00.917 these three themes. 06:00.920 --> 06:03.050 The first one is, I might say, 06:03.052 --> 06:04.892 a long-term risk theme. 06:04.889 --> 06:07.249 Let me go over these three themes. 06:07.250 --> 06:20.920 06:20.920 --> 06:27.770 The long-term risks are dominant in our lives. 06:27.769 --> 06:32.609 By that, I mean that everyone's life is a sequence of shocks 06:32.605 --> 06:35.305 that accumulate over your life. 06:35.310 --> 06:38.580 I'm talking about economic shocks. 06:38.579 --> 06:42.109 When you start out young--We're unequal at birth, 06:42.105 --> 06:46.065 of course, because of our parents and the advantages we 06:46.071 --> 06:49.451 have, but relatively equal at a young age. 06:49.449 --> 06:53.279 As each year goes by, you accumulate economic shocks, 06:53.282 --> 06:57.562 shocks to your human capital, shocks to what you own as you 06:57.558 --> 07:00.848 get older. You start--Your human capital 07:00.851 --> 07:04.521 is your ability to do things and your knowledge, 07:04.516 --> 07:08.646 which is what you have to sell in the marketplace. 07:08.649 --> 07:12.769 As you get older, your human capital evolves and 07:12.767 --> 07:18.287 it has its ups and downs as you age and you start switching from 07:18.285 --> 07:22.135 human capital to other forms of capital. 07:22.139 --> 07:24.949 In other words, you start saving and you own 07:24.954 --> 07:27.124 stocks and bonds, and real estate, 07:27.115 --> 07:28.485 and other things. 07:28.490 --> 07:32.670 Each of these suffers a sequence of shocks that cumulate 07:32.667 --> 07:36.237 over your lifetime, so inequality gets worse and 07:36.237 --> 07:38.057 worse as people age. 07:38.060 --> 07:42.200 It is at its worst after retirement when you are no 07:42.196 --> 07:47.156 longer--you've exhausted your human capital and you're living 07:47.159 --> 07:51.129 off of all the accumulated physical capital. 07:51.130 --> 07:53.400 That's the life cycle story. 07:53.399 --> 07:59.189 There's great inequality among the elderly and that's a 07:59.188 --> 08:02.818 problem. Some of them are living very 08:02.820 --> 08:07.210 badly and others are living with great comfort. 08:07.210 --> 08:10.630 That's what finance is about. 08:10.630 --> 08:11.990 It's really about people. 08:11.990 --> 08:15.720 We don't care at all about corporations--we should make 08:15.723 --> 08:19.183 that clear--except as they contribute to individual 08:19.180 --> 08:22.180 welfare. I don't care what happens to 08:22.183 --> 08:25.833 Citigroup or IBM, except for the fact that there 08:25.830 --> 08:30.020 are all those stockholders out there and they're of all 08:30.022 --> 08:32.042 different situations. 08:32.039 --> 08:35.329 Some of them are absolutely dependent on their holding of 08:35.329 --> 08:37.929 these stocks. That's what we have to think 08:37.929 --> 08:40.139 about and it's a long-term problem. 08:40.139 --> 08:46.729 The problem with long-term risks, also, is that anything 08:46.730 --> 08:53.680 that we do to mitigate these risks creates moral hazard. 08:53.679 --> 08:56.079 That's another fundamental theme of finance. 08:56.080 --> 08:57.140 What is moral hazard? 08:57.139 --> 09:00.649 That's a term that first entered the English language 09:00.654 --> 09:04.444 sometime in the mid-nineteenth century, but of course the 09:04.440 --> 09:06.130 concept goes earlier. 09:06.129 --> 09:10.529 Moral hazard occurs when a risk management institution 09:10.534 --> 09:15.524 incentivizes you to do bad behavior--to show bad behavior. 09:15.519 --> 09:20.059 The classic example of moral hazard is with fire insurance. 09:20.059 --> 09:23.959 I get fire insurance on my house and so I behave badly: 09:23.963 --> 09:28.593 I deliberately burn the house down to collect on my insurance. 09:28.590 --> 09:31.510 That's moral hazard; but it's not unique to that, 09:31.506 --> 09:33.106 it's all over the place. 09:33.110 --> 09:36.060 When you manage risks, you create moral hazard. 09:36.059 --> 09:40.499 That's why we need invention and theory in finance to 09:40.502 --> 09:45.032 minimize that. The second theme for this 09:45.031 --> 09:48.321 lecture is about framing. 09:48.320 --> 09:51.820 09:51.820 --> 09:56.110 By that I mean psychological framing, and there are many 09:56.107 --> 10:00.157 psychologists who talk about this, but notably Daniel 10:00.161 --> 10:02.501 Kahneman and Amos Tversky. 10:02.500 --> 10:05.770 10:05.769 --> 10:11.839 "Psychological framing" means the tendency for people to view 10:11.838 --> 10:16.788 things in a distorted way depending on how they're 10:16.794 --> 10:19.724 presented. If I present things in one 10:19.716 --> 10:21.856 frame, then you would react one way. 10:21.860 --> 10:26.140 If I present the same thing in another context or background or 10:26.137 --> 10:29.377 environment, then you react very differently. 10:29.379 --> 10:33.819 I will expand on this in a minute. 10:33.820 --> 10:42.580 The third theme is the invention theme of this lecture. 10:42.580 --> 10:47.690 That is--I mentioned this before, but I want to expand on 10:47.691 --> 10:52.531 it in this lecture--that the history of finance is the 10:52.529 --> 10:58.279 history of invention just as much as it is in other fields, 10:58.280 --> 11:01.350 notably engineering. 11:01.350 --> 11:06.160 The idea that I want to develop is that the history of finance 11:06.162 --> 11:09.162 is a history of discrete inventions. 11:09.159 --> 11:13.999 Non-obvious ideas were conceived of to solve these 11:14.001 --> 11:20.131 problems of long-term risks and to get around the psychological 11:20.126 --> 11:26.446 barriers imposed by framing biases and psychological biases, 11:26.450 --> 11:29.380 in order to allow people to actually manage the risk and to 11:29.377 --> 11:30.687 get around moral hazard. 11:30.690 --> 11:34.660 It's a difficult thing to do these things and that's why we 11:34.657 --> 11:37.717 need invention. Another thing is that, 11:37.722 --> 11:43.002 when once an invention is made, it tends to be copied all over 11:42.996 --> 11:45.966 the world. So, the history of finance is 11:45.968 --> 11:47.878 largely a history of copying. 11:47.880 --> 11:50.070 That's what you have to do. 11:50.070 --> 11:53.740 You may have to adapt it to a particular environment, 11:53.737 --> 11:56.697 but basically it is copying other ideas. 11:56.700 --> 12:00.700 Some people in less-developed countries feel uncomfortable 12:00.703 --> 12:03.653 that they are just slavishly copying other, 12:03.653 --> 12:07.543 more advanced countries; but, they have to recognize 12:07.538 --> 12:11.018 that is what everybody has been doing all along. 12:11.019 --> 12:14.529 We copy the good ideas and in the process we adjust them and 12:14.534 --> 12:16.444 make them a little bit better. 12:16.440 --> 12:19.240 New ideas can come from anywhere. 12:19.240 --> 12:22.090 The basic thing, though, is that every country 12:22.086 --> 12:25.816 has to take the insights that have been developed around the 12:25.817 --> 12:26.447 world. 12:26.450 --> 12:31.560 12:31.559 --> 12:35.789 Let me come back now--I want to go through these three themes. 12:35.789 --> 12:40.799 Let me start with the long-term risk theme. 12:40.799 --> 12:48.929 I want to start with an article, which--mention an 12:48.928 --> 12:53.738 article by Backus, Kydland, 12:53.740 --> 12:56.010 and Kehoe--actually Backus, Kehoe, and Kydland, 12:56.013 --> 12:57.303 three economists [David K. 12:57.298 --> 12:58.188 Backus, Patrick J. 12:58.187 --> 12:59.027 Kehoe and Finn E. 12:59.028 --> 13:01.938 Kydland, "International Real Business Cycles," Journal of 13:01.944 --> 13:03.774 Political Economy, 100(4):745-775, 13:03.772 --> 13:05.762 August 1992]. One of these, 13:05.762 --> 13:08.192 the last of the three, Finn Kydland, 13:08.192 --> 13:10.902 won the Nobel Prize a few years ago. 13:10.899 --> 13:14.069 In this article, they talked about the 13:14.073 --> 13:18.023 correlation of consumption around the world. 13:18.020 --> 13:22.470 13:22.470 --> 13:23.830 What is consumption? 13:23.830 --> 13:28.820 It's the amount that people spend on consumption goods, 13:28.820 --> 13:33.530 things that you buy for your current use, like food, 13:33.534 --> 13:36.034 shelter, clothing, etc. 13:36.029 --> 13:41.269 Every country computes an estimate of how much is spent 13:41.266 --> 13:47.566 each year on consumption by the people who live in the country. 13:47.570 --> 13:51.000 What Backus, Kehoe, and Kydland did was look 13:51.004 --> 13:55.484 at how much the consumption correlates--the movement from 13:55.476 --> 13:59.066 year to year--correlate across countries. 13:59.070 --> 14:02.050 If there were perfect correlation, then it would be a 14:02.054 --> 14:03.264 correlation of one. 14:03.259 --> 14:06.489 That is, when one country's consumption increases from one 14:06.486 --> 14:08.636 year to the next, every other country's 14:08.636 --> 14:11.576 consumption increases from one year to the next. 14:11.580 --> 14:15.990 What they argued in this paper was that, if we had perfect risk 14:15.992 --> 14:19.762 management, then there would be perfect correlation of 14:19.764 --> 14:23.754 consumption across countries because if we get rid of the 14:23.749 --> 14:27.659 idiosyncratic risks, then all that's left is 14:27.664 --> 14:29.374 planet-wide risks. 14:29.370 --> 14:32.090 If we had perfect financial markets--and this is 14:32.093 --> 14:34.993 intuitive--and I don't know how obvious this is, 14:34.990 --> 14:39.980 it's obvious to me, but it's an intuitive point of 14:39.977 --> 14:44.657 great importance--nobody would suffer alone. 14:44.659 --> 14:48.329 Anytime there's a risk that hits one person or one country 14:48.330 --> 14:52.130 the financial markets would spread it out over everybody and 14:52.129 --> 14:53.609 it gets very small. 14:53.610 --> 14:56.810 What's left? The only risks that are left 14:56.813 --> 15:01.443 are risks that everyone shares, so you would see planet-wide 15:01.436 --> 15:05.036 risks expressing themselves in consumption, 15:05.040 --> 15:06.340 but nothing else. 15:06.340 --> 15:07.180 Do you see that point? 15:07.180 --> 15:09.010 We'd have perfect correlation. 15:09.009 --> 15:12.049 Suppose the planet were hit by a comet--this 15:12.050 --> 15:16.010 happened--something like this happened sixty-five million 15:16.011 --> 15:18.841 years ago, so it could happen again. 15:18.840 --> 15:21.820 Maybe it won't now that we have better plans to prevent things 15:21.816 --> 15:23.716 like that, but suppose it did happen. 15:23.720 --> 15:29.750 We would see huge damage on the impact site. 15:29.750 --> 15:32.610 Let's neglect the fact that some people would be killed by 15:32.610 --> 15:35.120 the impact, suppose it was just economic damage. 15:35.120 --> 15:39.860 It would be a terrible--it would be a problem all over the 15:39.855 --> 15:44.585 world because the damage would extend around the world; 15:44.590 --> 15:47.390 but, you'd be much better off if you were on the other side of 15:47.391 --> 15:48.771 the world, not where it hit. 15:48.769 --> 15:51.649 If we didn't have financial arrangements, 15:51.650 --> 15:56.120 then the people near the impact would be in a terrible economic 15:56.115 --> 16:00.575 situation and the people on the other side would be much better 16:00.579 --> 16:02.739 off. If we had the proper risk 16:02.741 --> 16:05.631 management institutions in place, people would have 16:05.625 --> 16:08.795 anticipated this risk and would have made swaps or other 16:08.798 --> 16:11.738 arrangements to protect themselves against it. 16:11.740 --> 16:13.080 What would happen? 16:13.080 --> 16:17.150 The people near the impact would not be harmed any more 16:17.148 --> 16:18.578 than anyone else. 16:18.580 --> 16:22.450 The world would suffer because the damage is substantial and it 16:22.450 --> 16:24.510 reduces our ability to produce. 16:24.509 --> 16:27.159 So, the whole world--everyone's consumption around the world 16:27.161 --> 16:29.591 would go down. You can't prevent that. 16:29.590 --> 16:32.470 Anything that hits the whole planet would be affected. 16:32.470 --> 16:35.870 Backus, Kydland, and Kehoe thought that that's 16:35.874 --> 16:38.754 the situation we should be in today. 16:38.750 --> 16:42.430 There are things hitting the whole world, like global warming 16:42.432 --> 16:45.012 for example, and there are many of them. 16:45.010 --> 16:49.250 How well are we doing? 16:49.250 --> 16:51.360 We're not doing well at all, they concluded. 16:51.360 --> 16:54.550 The correlation across countries in consumption changes 16:54.548 --> 16:57.188 is low. In fact, it's lower than the 16:57.187 --> 17:01.097 correlation of income changes, which is surprising. 17:01.100 --> 17:05.100 It means we really haven't done anything--that's an 17:05.103 --> 17:09.593 exaggeration--we've done very little to manage risks that 17:09.587 --> 17:12.707 individuals or that countries face, 17:12.710 --> 17:15.020 for that matter, or even individuals face. 17:15.019 --> 17:18.349 We've done a lot--I shouldn't say we haven't done 17:18.351 --> 17:20.921 anything--but we can do a lot more. 17:20.920 --> 17:25.080 The idea of risk, that economic risks can be 17:25.076 --> 17:30.296 pooled, is an intuitive one that has occurred to people 17:30.296 --> 17:32.516 throughout history. 17:32.520 --> 17:34.290 It's very simple and obvious. 17:34.289 --> 17:38.579 If we're living in--imagine we're living in some remote area 17:38.576 --> 17:42.786 and we're pioneers out there with our cabins and there's no 17:42.790 --> 17:44.970 government. There's no one to protect us. 17:44.970 --> 17:46.650 What do we instinctively do? 17:46.650 --> 17:50.330 We kind of meet together and we say, if anyone's cabin burns 17:50.326 --> 17:52.566 down we'll all come over and help. 17:52.569 --> 17:55.989 It kind of feels like generosity, but it's also a 17:55.986 --> 17:58.616 self-interest that people perceive. 17:58.619 --> 18:02.009 It could be me that--my cabin could burn down and I would 18:02.005 --> 18:03.935 freeze to death in the winter. 18:03.940 --> 18:08.940 So, people naturally and spontaneously make arrangements 18:08.943 --> 18:12.063 to share risks. These kind of natural and 18:12.064 --> 18:15.974 spontaneous arrangements are not global, they're not big enough 18:15.968 --> 18:17.478 and important enough. 18:17.480 --> 18:21.950 I just want--one point of this lecture is to try to emphasize 18:21.954 --> 18:26.434 the real breadth of the concepts of finance and how important 18:26.428 --> 18:30.898 they are--how they reach out into other things that you might 18:30.903 --> 18:34.113 not think as associated with finance. 18:34.110 --> 18:39.610 I want to mention socialism. 18:39.610 --> 18:43.780 18:43.779 --> 18:52.929 This term really goes back to Robert Owen, who was a British 18:52.929 --> 19:00.989 thinker from 1771 to 1858, who wanted to pool all the 19:00.992 --> 19:06.112 economic activity in society. 19:06.109 --> 19:08.229 What were the motivations for doing this? 19:08.230 --> 19:12.950 Well, I think he would say inequality--hardship would be 19:12.951 --> 19:15.201 reduced. But, what was he really saying 19:15.202 --> 19:17.152 in a sense? You might say it was risk 19:17.151 --> 19:22.151 management. He wanted society to pool risks 19:22.145 --> 19:26.745 and put things--put us together. 19:26.750 --> 19:33.000 In his ideal society--socialist society--all the consumption 19:32.998 --> 19:38.278 would move up and down together, just as in the ideal that 19:38.278 --> 19:40.828 Backus, Kehoe, and Kydland expressed. 19:40.830 --> 19:44.570 19:44.569 --> 19:51.159 Robert Owen wanted to create this community. 19:51.160 --> 19:54.700 He created finally--he emigrated to the United States 19:54.700 --> 19:57.560 and he set up a city called New Harmony. 19:57.559 --> 20:00.779 New Harmony was supposed to be an inspiration. 20:00.779 --> 20:04.129 Unfortunately, it didn't work very well 20:04.134 --> 20:09.704 because people started bickering in his town and the New Harmony 20:09.695 --> 20:15.075 became kind of a joke--it was not a harmonious community. 20:15.079 --> 20:19.009 So, he started to discover moral hazard. 20:19.010 --> 20:24.440 20:24.440 --> 20:28.410 You put everyone together and you say, okay all of your 20:28.412 --> 20:30.842 economic fortunes are the same. 20:30.839 --> 20:32.929 And what does someone start to conclude? 20:32.930 --> 20:36.980 Well, they start to get lazy or they start to get irresponsible. 20:36.980 --> 20:42.580 They think, it doesn't matter what I do, I'm going to get the 20:42.577 --> 20:46.027 same consumption as everybody else, 20:46.029 --> 20:48.199 so I'll just get lazy--a very fundamental problem, 20:48.200 --> 20:50.060 which you probably are already aware of. 20:50.060 --> 20:56.270 20:56.269 --> 21:01.689 The socialist idea started to lead to a number of experiments 21:01.688 --> 21:06.568 in various countries around the world that were pooling 21:06.565 --> 21:10.805 risks--they might not have put it this way. 21:10.809 --> 21:17.719 One is the kibbutzim in Israel, which were communities that 21:17.717 --> 21:20.097 shared everything. 21:20.099 --> 21:23.839 Originally, they were very rigid about this. 21:23.839 --> 21:29.799 They enforced complete sharing and if you belonged to a kibbutz 21:29.798 --> 21:35.178 you were completely stuck with the common consumption. 21:35.180 --> 21:44.320 It wasn't just in Israel--in Japan, the Ito-En and 21:44.316 --> 21:48.956 Yamaguchi-kai; in the United States, 21:48.957 --> 21:50.217 the Hutterites; 21:50.220 --> 21:54.250 21:54.250 --> 21:56.760 and there are many other examples. 21:56.759 --> 22:01.769 Joining one of these communities has meant a real 22:01.765 --> 22:04.055 change in your life. 22:04.060 --> 22:06.810 It's complete sharing. 22:06.809 --> 22:10.609 The problem is again the ideal--they're trying to work 22:10.609 --> 22:15.269 toward what I think of an ideal that we see in finance--mainly, 22:15.269 --> 22:18.089 the perfect correlation of consumption and the elimination 22:18.088 --> 22:19.768 of risk--we all help each other. 22:19.769 --> 22:22.649 But, the problem they hit is moral hazard. 22:22.650 --> 22:29.550 I've heard a lot of stories about a lot of bickering at the 22:29.550 --> 22:32.420 kibbutz. When someone gets a gift and 22:32.422 --> 22:36.092 the other people at the kibbutz say, "Well you can't have that 22:36.087 --> 22:38.307 by yourself, we share everything." 22:38.309 --> 22:41.169 Some people say, "I'd like to have my own 22:41.166 --> 22:43.466 television set. I don't want to go to the 22:43.467 --> 22:45.857 common room and watch the same set with everyone else. 22:45.859 --> 22:48.059 I just, kind of, want to be at home by myself." 22:48.059 --> 22:51.069 So, nowadays kibbutzim have loosened the rule. 22:51.069 --> 22:55.109 I don't know these things personally, but it's my 22:55.105 --> 22:59.725 understanding that the whole structure is suffering some 22:59.729 --> 23:04.769 moral hazard problems and that they're evolving and trying to 23:04.773 --> 23:07.383 improve the institutions. 23:07.380 --> 23:14.690 There's also a problem with risk-sharing at that level. 23:14.690 --> 23:18.450 That is, if you are one of these commune communities, 23:18.449 --> 23:21.629 then you're just a small number of people. 23:21.630 --> 23:25.770 The best you can do sharing among yourselves is sharing your 23:25.771 --> 23:28.791 own risk, the risk of your own community; 23:28.789 --> 23:32.959 but your own community goes up and down and you're not sharing 23:32.957 --> 23:36.077 widely enough. The problem is that if you want 23:36.076 --> 23:38.626 to do risk-sharing, you're not, ideally, 23:38.626 --> 23:42.676 sharing with someone who's just like you--living in Israel, 23:42.680 --> 23:46.550 working in a certain agricultural industry--because 23:46.553 --> 23:50.663 there are lots of risks that you've already shared. 23:50.660 --> 23:53.250 You should be sharing your risks with someone who's 23:53.246 --> 23:56.396 completely different--probably living on the other side of the 23:56.402 --> 23:58.732 world in a completely different industry, 23:58.730 --> 24:01.180 where the weather, the institutions, 24:01.176 --> 24:05.016 and the political situation are completely different. 24:05.019 --> 24:09.059 It doesn't work so easily to share with those people along 24:09.062 --> 24:12.332 the lines that these communities--I think these 24:12.325 --> 24:15.725 communes tend to emphasize a social compact, 24:15.730 --> 24:18.880 a feeling for each other, a caring for each other, 24:18.883 --> 24:22.233 which is a lovely thought but it doesn't achieve risk 24:22.229 --> 24:24.159 management on a big scale. 24:24.160 --> 24:29.530 I think that what's happening is these ideas--Everything is 24:29.525 --> 24:34.235 evolving, so I'm actually presenting here our modern 24:34.244 --> 24:38.134 finance as the outgrowth of socialism, 24:38.130 --> 24:41.690 but that's not the usual way to present it. 24:41.690 --> 24:45.080 I guess it is that we care about each other and we don't 24:45.080 --> 24:46.930 want people to suffer alone. 24:46.930 --> 24:49.440 We want to share things, but we want to get more 24:49.439 --> 24:52.539 scientific about how we share things and that means--and we 24:52.535 --> 24:53.865 want to be effective. 24:53.869 --> 24:57.179 So, that means we have to devise ways of sharing with 24:57.180 --> 25:00.510 people that we've never met, that we don't care about--I 25:00.510 --> 25:03.510 mean, maybe we care about everybody, but we don't have any 25:03.510 --> 25:06.670 particular emotional ties to them--and they're very different 25:06.668 --> 25:09.058 people. But, because of the logic of 25:09.062 --> 25:12.212 risk management we have to make a deal with them; 25:12.210 --> 25:14.620 so, it becomes more formal and impersonal. 25:14.619 --> 25:17.259 That is what financial markets do. 25:17.260 --> 25:21.710 25:21.710 --> 25:24.420 What's happening is: we're seeing an evolution of 25:24.415 --> 25:26.845 risk management. You hear about it in various 25:26.850 --> 25:28.220 terms that sound abstract. 25:28.220 --> 25:31.980 We have private equity, we have venture capital, 25:31.980 --> 25:35.980 and we have employees getting incentive options. 25:35.980 --> 25:39.990 These are efforts to solve the moral hazard problem and to 25:39.993 --> 25:44.753 manage risks. I believe that we're gradually 25:44.753 --> 25:47.843 learning in our society. 25:47.839 --> 25:52.389 This is maybe not widely appreciated, but every decade 25:52.387 --> 25:57.277 that goes by we do a better job of incentvizing people and 25:57.278 --> 26:01.738 preventing them from being discouraged by risks. 26:01.740 --> 26:09.080 26:09.079 --> 26:13.119 It's a very complicated situation because the kind of 26:13.124 --> 26:17.714 economic risks that we face are difficult for most people to 26:17.713 --> 26:21.503 understand. But they have to try to let 26:21.501 --> 26:25.771 people manage their own risks for themselves, 26:25.772 --> 26:28.832 to some extent. That means we have to expect 26:28.830 --> 26:30.890 people to understand these things somewhat. 26:30.890 --> 26:34.060 I think we have an important role for economic, 26:34.062 --> 26:35.582 financial education. 26:35.579 --> 26:39.659 Because of that, each person is in a different 26:39.656 --> 26:44.276 situation--it's a very complicated world and we have 26:44.275 --> 26:46.535 many different risks. 26:46.539 --> 26:55.009 Continuing on the risk theme, I mentioned one philosopher, 26:55.009 --> 26:58.719 Robert Owen. I could have also mentioned 26:58.721 --> 27:01.201 Karl Marx--why don't I mention him here. 27:01.200 --> 27:06.560 He was a very important thinker who had very low regard for the 27:06.561 --> 27:10.541 financial community, I think, unfortunately. 27:10.539 --> 27:13.809 He wanted to kill them, I think, or at least some of 27:13.811 --> 27:15.221 them. Nonetheless, 27:15.217 --> 27:18.887 he shared certain things in common with them. 27:18.890 --> 27:24.790 Namely, that he was concerned about inequality, 27:24.791 --> 27:32.101 about some people doing badly, and he proposed an economic 27:32.104 --> 27:36.984 alternative that would pool risks. 27:36.980 --> 27:45.900 In fact, he actually emphasized a concept that was first stated 27:45.903 --> 27:53.963 by a French philosopher Louis Blanc in the mid-nineteenth 27:53.962 --> 27:59.422 century. Blanc said the ideal society is 27:59.420 --> 28:04.470 based on the principle of, and now I quote, 28:04.474 --> 28:11.454 "From each according to his abilities, to each according to 28:11.454 --> 28:14.934 his needs." Have you heard that quote 28:14.933 --> 28:17.933 before? Karl Marx quoted Blanc, 28:17.928 --> 28:20.968 but he didn't credit Blanc. 28:20.970 --> 28:24.290 He didn't mention the name because, I assume, 28:24.289 --> 28:28.819 he thought everyone knew this was Blanc;.but Marx was falsely 28:28.815 --> 28:32.205 attributed to having made that statement. 28:32.210 --> 28:36.190 It's come around to us that that was--a lot of people say 28:36.194 --> 28:39.614 that was the core of his communist philosophy. 28:39.609 --> 28:43.259 That is complete risk-sharing, right? 28:43.259 --> 28:46.039 Some of us have high abilities and we succeed, 28:46.040 --> 28:48.760 some of us have low abilities and we fail; 28:48.759 --> 28:52.379 but we all get the same good, we all have our needs 28:52.380 --> 28:55.880 satisfied. So that, I think--The communist 28:55.875 --> 29:00.865 system is effectively a theory of risk management and that's 29:00.873 --> 29:04.603 not something you might think of usually. 29:04.599 --> 29:08.879 What was the big problem with communism, as it was espoused by 29:08.878 --> 29:11.898 Karl Marx? The problem was that it had a 29:11.904 --> 29:16.354 moral hazard problem and--I've already been through it--it's 29:16.348 --> 29:20.718 the same moral hazard problem that you see at the kibbutzim 29:20.717 --> 29:25.307 and the Yamaguchi-kai and other places: that people don't work 29:25.312 --> 29:30.662 effectively when their economic interests are completely pooled. 29:30.660 --> 29:35.990 Well, I suppose we've learned from the Marx experience, 29:35.992 --> 29:41.922 but we're, I think--Just about every country of the world now 29:41.916 --> 29:46.946 recognizes that it's a complicated thing to get risk 29:46.952 --> 29:52.482 management working well and we have to design things more 29:52.482 --> 29:55.902 carefully. We can't just smash things and 29:55.895 --> 29:58.285 start all over, we have to design a system of 29:58.294 --> 30:00.714 risk management. That's what I think finance is 30:00.708 --> 30:03.758 about. I want to mention a couple 30:03.761 --> 30:09.121 other philosophers who talk about risk management. 30:09.120 --> 30:13.830 30:13.829 --> 30:19.369 One of them is the economist, John Harsanyi, 30:19.371 --> 30:26.331 who won the Nobel Prize in Economics some years ago, 30:26.329 --> 30:28.619 and another one is the philosopher John Rawls, 30:28.620 --> 30:31.470 who wrote the book Theory of Justice, [John Rawls, 30:31.470 --> 30:33.510 A Theory of Justice, Cambridge MA: 30:33.506 --> 30:35.946 Belknap Press of Harvard University Press, 30:35.950 --> 30:40.190 1971.] which has become a classic. 30:40.190 --> 30:44.080 I think of both of these as incorporating--I would, 30:44.079 --> 30:47.879 especially with Harsanyi, but also with Rawls--as 30:47.876 --> 30:52.006 incorporating some idea of risk management into our basic 30:52.007 --> 30:56.717 philosophy. We have a philosophy that--most 30:56.724 --> 31:02.914 of us--that some kind of economic inequality is a bad 31:02.905 --> 31:08.725 thing and that it's unjust for someone who is, 31:08.730 --> 31:13.820 for no fault of his or her own, suffering economic hardship. 31:13.820 --> 31:17.840 How to formalize this idea? 31:17.839 --> 31:21.139 John Harsanyi was the first to write about this. 31:21.140 --> 31:22.270 [John Harsanyi, "Cardinal Welfare, 31:22.272 --> 31:24.062 Individualistic Ethics, and Interpersonal Comparisons 31:24.056 --> 31:25.836 of Utility" Journal of Political Economy 63(4) 31:25.839 --> 31:27.009 1955.] He said that we should think 31:27.006 --> 31:28.786 of--When we think about distributional justice we can 31:28.790 --> 31:30.540 think of it as a risk management problem. 31:30.539 --> 31:35.879 He said, imagine that we could get people to have a big town 31:35.878 --> 31:41.848 meeting for the whole world and, he said, before they were born. 31:41.849 --> 31:46.429 There's some space up in heaven where all the unborn babies are 31:46.426 --> 31:49.006 that will live in the future and, 31:49.009 --> 31:51.649 unfortunately, they're not able to have a town 31:51.652 --> 31:54.812 meeting; but, let's suppose they could. 31:54.809 --> 31:59.799 We're up there in heaven thinking about our lives in the 31:59.799 --> 32:03.609 future, as people, and what would we do? 32:03.609 --> 32:07.069 Suppose we don't know what economic circumstances we'd be 32:07.070 --> 32:10.840 born into and what kind of contingencies we'd have in life. 32:10.840 --> 32:12.370 What would we decide? 32:12.369 --> 32:16.749 Suppose we were trying to decide on a constitution for the 32:16.749 --> 32:18.439 world in that state. 32:18.440 --> 32:21.410 John Rawls expanded on this and he called it the "original 32:21.413 --> 32:25.353 position." What would they do? 32:25.349 --> 32:28.489 Well, they would probably agree that we'd do some risk-sharing, 32:28.485 --> 32:30.465 right? Everyone who's thinking, 32:30.469 --> 32:33.169 I don't know whether I'll be rich or poor, 32:33.166 --> 32:37.176 so I would like to have a world in which risks are shared. 32:37.180 --> 32:41.030 On the other hand, what would you decide? 32:41.029 --> 32:43.349 If you can imagine yourself in that situation, 32:43.353 --> 32:45.473 what would you decide about inequality? 32:45.470 --> 32:49.190 Would you decide to have a world with absolute equality? 32:49.190 --> 32:52.430 Well, you know somebody would probably. 32:52.430 --> 32:55.250 Suppose someone proposed that up in heaven and someone else 32:55.250 --> 32:57.730 might say, well that's not going to work so well, 32:57.730 --> 33:01.480 that's like a kibbutz--like one of the kibbutzim. 33:01.480 --> 33:04.180 It's not going to work, we're not going to 33:04.183 --> 33:07.813 enjoy--something's wrong with that because it's going to 33:07.810 --> 33:11.570 create a moral hazard problem and we're not going to be as 33:11.568 --> 33:14.028 productive. Someone might also say, 33:14.029 --> 33:17.469 you know a little inequality, even a substantial inequality, 33:17.466 --> 33:20.666 is not so bad as long as nobody is really suffering. 33:20.670 --> 33:23.440 As long as everyone has the basic needs and they're--we can 33:23.442 --> 33:26.262 all be happy. You know, let's let some people 33:26.262 --> 33:30.402 make big fortunes because that provides spice in life and some 33:30.398 --> 33:32.608 adventure, something to look forward 33:32.613 --> 33:34.163 to--that you might get this. 33:34.160 --> 33:37.490 You could see saying, we don't want to eliminate 33:37.489 --> 33:42.029 inequality. What Harsanyi and Rawls both 33:42.034 --> 33:48.254 gave us was a system of justice that, in my mind, 33:48.247 --> 33:54.457 conveys a sense of financial risk management. 33:54.460 --> 33:59.350 33:59.349 --> 34:04.859 I'm not going to talk a lot about--Well, I'm going to move 34:04.857 --> 34:09.207 also to framing here, but let me at this point 34:09.205 --> 34:13.355 mention something about public finance. 34:13.360 --> 34:15.920 This is not a course in public finance. 34:15.920 --> 34:18.490 It doesn't say--The title of this course is Financial 34:18.494 --> 34:20.904 Markets. I guess when you put markets on 34:20.904 --> 34:23.684 it that doesn't sound like public finance but, 34:23.683 --> 34:24.983 even so, it could. 34:24.980 --> 34:31.610 Public finance is the financial issues relating to governments. 34:31.610 --> 34:34.920 Finance usually means the private sector, 34:34.917 --> 34:38.967 but the issues are much the same in both cases. 34:38.969 --> 34:42.419 Let me say something about public finance here. 34:42.420 --> 34:53.000 Public finance relates to the tax and welfare system that we 34:52.995 --> 34:57.745 have. The government taxes people and 34:57.754 --> 35:04.434 it takes some of the money and redistributes it to people in 35:04.425 --> 35:08.555 need. This is essentially a risk 35:08.559 --> 35:10.919 management system. 35:10.920 --> 35:14.340 It's something that, I suppose, Robert Owen and Karl 35:14.340 --> 35:17.560 Marx would have said sounds like a good thing. 35:17.559 --> 35:19.939 But, of course, they wanted to do much more and 35:19.938 --> 35:21.178 be more comprehensive. 35:21.179 --> 35:24.459 It's maybe something that has evolved as something that 35:24.458 --> 35:27.348 actually works. You have a progressive tax 35:27.349 --> 35:31.429 system that takes more money from the wealthier people and 35:31.425 --> 35:35.855 you have a welfare system that looks at individual hardship and 35:35.858 --> 35:38.688 pays out. It does create moral hazard 35:38.686 --> 35:42.746 problems--that's a problem with it, but that's something that 35:42.746 --> 35:44.366 we're learning about. 35:44.369 --> 35:48.309 That's part of public finance--is learning how to 35:48.309 --> 35:52.659 modify the tax system so that it works pretty well. 35:52.659 --> 35:56.539 I want to start out by mentioning taxes and welfare 35:56.536 --> 35:59.786 because, I think, that it's really the most 35:59.793 --> 36:03.983 important risk management system already in place. 36:03.980 --> 36:07.610 Because the financial risk management system that we have 36:07.613 --> 36:09.953 is imperfect, we aren't there yet. 36:09.949 --> 36:13.489 The thing that's really doing the heavy hitting on risk 36:13.491 --> 36:16.771 management is really the tax and welfare system. 36:16.769 --> 36:21.599 That's because the most important risk that individuals 36:21.602 --> 36:25.632 face is the risk of major losses of income. 36:25.630 --> 36:30.670 If something really hits you hard and you would be starving, 36:30.665 --> 36:32.965 that would be really bad. 36:32.969 --> 36:38.179 So, nobody starves in advanced countries of the world today 36:38.176 --> 36:40.416 because of this system. 36:40.420 --> 36:45.360 Moreover, you might get hit by an illness and then you could be 36:45.358 --> 36:49.898 in desperate trouble that you will die unless you get some 36:49.899 --> 36:53.549 kind of emergency care, which might be very expensive. 36:53.550 --> 36:57.440 Every advanced country in the world has a system that provides 36:57.443 --> 37:00.893 for this, including the United States, incidentally. 37:00.889 --> 37:05.119 We don't have a national healthcare system. 37:05.119 --> 37:09.029 People say we don't--well, we don't, but we do have an 37:09.030 --> 37:13.530 emergency care system so that anybody who is suddenly stricken 37:13.530 --> 37:17.220 will be taken to a hospital and taken care of. 37:17.219 --> 37:20.209 It's not perfect, but it is there. 37:20.210 --> 37:23.380 What we do have we should be thankful for, 37:23.379 --> 37:25.079 it's very important. 37:25.079 --> 37:28.929 I thought this would be a good lead in to the second theme of 37:28.925 --> 37:31.035 this lecture, which is framing. 37:31.039 --> 37:38.179 We have a good system in taxes, but it's imperfect because it 37:38.182 --> 37:44.132 hasn't been thought out thoroughly in terms of risk 37:44.134 --> 37:48.484 management. Let's talk about framing and 37:48.480 --> 37:49.120 taxes. 37:49.120 --> 37:53.860 37:53.860 --> 37:57.440 If you go to look at congressional discussion of tax 37:57.439 --> 38:01.649 rates, you won't see risk management mentioned very often. 38:01.650 --> 38:06.680 They seem to talk about it in their own terms, 38:06.676 --> 38:12.146 which to a public finance expert is, I don't know, 38:12.149 --> 38:16.169 very populist or unprofessional. 38:16.170 --> 38:19.210 I guess they're elected officials and their voters are 38:19.212 --> 38:22.832 not finance theorists and don't think of this in these terms. 38:22.830 --> 38:29.210 38:29.210 --> 38:38.510 Edward McCaffery did a history of taxes--I'm sorry, 38:38.514 --> 38:49.874 spelled with two Cs--he's a law professor in the United States 38:49.866 --> 39:01.586 and asked about--based on issues of framing and psychology. 39:01.590 --> 39:03.720 We have a system, which you say it really--The 39:03.715 --> 39:06.165 progressive tax system is very important but it's not 39:06.172 --> 39:07.162 conceptualized right. 39:07.164 --> 39:08.964 [Edward J. McCaffery, "Cognitive Theory 39:08.959 --> 39:09.899 and Tax," in Cass R. 39:09.904 --> 39:11.794 Sunstein, editor, Behavioral Law & 39:11.793 --> 39:13.923 Economics, Cambridge: Cambridge University 39:13.919 --> 39:15.769 Press, 2000 398-422.] 39:15.771 --> 39:19.351 What McCaffery points out is that the only time the 39:19.349 --> 39:23.569 government in the United States has ever been able to impose 39:23.571 --> 39:27.151 high taxes on wealthy people was during wars. 39:27.150 --> 39:30.390 If you look at the history of U.S. 39:30.389 --> 39:33.829 taxes, the very simple history is World War One and World War 39:33.826 --> 39:36.246 Two. During World War One and Two, 39:36.248 --> 39:39.978 our men were out dying in Europe and people voted for 39:39.976 --> 39:43.066 someone who said, let's raise the taxes on the 39:43.070 --> 39:45.740 rich, someone's profiting from this war now. 39:45.739 --> 39:49.489 It doesn't sound right when other men are out there dying, 39:49.492 --> 39:52.392 so they raised taxes during World War One. 39:52.389 --> 39:55.339 They did it again, even more decisively in World 39:55.339 --> 39:58.539 War Two, and that's how we got progressive taxes. 39:58.539 --> 40:03.879 I'm oversimplifying a little bit but between wars the rate 40:03.877 --> 40:07.527 tends to come down because people think, 40:07.529 --> 40:09.869 well the war is over. 40:09.869 --> 40:12.319 They don't understand the risk management function of it. 40:12.320 --> 40:15.950 Politicians are reluctant to cut taxes, but they do it 40:15.948 --> 40:18.898 gradually. That's a simple history of 40:18.897 --> 40:19.467 taxes. 40:19.470 --> 40:33.430 40:33.429 --> 40:42.159 Actually, in the United States, the income tax came in during 40:42.161 --> 40:50.311 the American Civil War and it was--the income tax came in 40:50.310 --> 40:51.620 1861, 40:51.620 --> 40:58.310 40:58.309 --> 41:04.669 again during the war and it was a progressive tax. 41:04.670 --> 41:11.130 The tax, as of 1862, was 3% on incomes over $600 a 41:11.127 --> 41:13.787 year. That sounds kind of low, 41:13.791 --> 41:17.441 that was 1862. Then they raised it to 5% on 41:17.444 --> 41:19.464 incomes over $10,000. 41:19.460 --> 41:22.780 It was a beginning, but it didn't take because they 41:22.780 --> 41:24.440 had technical problems. 41:24.440 --> 41:32.720 41:32.719 --> 41:37.919 I mention this tax example because I want to stress that 41:37.918 --> 41:43.208 framing and psychological barriers are important problems 41:43.211 --> 41:46.521 for creating financial markets. 41:46.520 --> 41:53.550 41:53.550 --> 41:58.200 The idea is that people don't see this basic risk management 41:58.199 --> 42:02.769 problem and they see things in entirely different terms. 42:02.770 --> 42:09.810 42:09.809 --> 42:17.029 So Kahneman and Tversky talked about how people view financial 42:17.034 --> 42:24.384 gains and losses and they talked about how people's actions are 42:24.377 --> 42:31.007 very valuable depending on how things are presented. 42:31.010 --> 42:35.090 In one of their most famous examples, they asked people the 42:35.091 --> 42:37.981 following question: Suppose you had bought 42:37.976 --> 42:41.876 expensive tickets to a concert, very expensive, 42:41.881 --> 42:44.861 you paid $200 for each ticket. 42:44.860 --> 42:49.850 You have two tickets, $400 worth, and on the way to 42:49.854 --> 42:53.354 the concert you lose the tickets. 42:53.349 --> 42:57.149 Now, you've arrived at the concert hall and you're looking 42:57.154 --> 43:00.834 through your pocket and you realize they're gone--you've 43:00.825 --> 43:04.425 lost them. The question they asked people 43:04.425 --> 43:09.835 is: would you go to the window and buy another pair of tickets 43:09.844 --> 43:12.514 for $400, having lost them? 43:12.510 --> 43:16.580 People answered--most people said, no, I'd be so annoyed and 43:16.577 --> 43:18.987 angry with myself I'd just leave. 43:18.989 --> 43:23.499 But then they posed a different version of the same question and 43:23.501 --> 43:27.581 the different version was: Suppose you had ordered tickets 43:27.584 --> 43:31.884 to pick them up and pay for them at the window at the concert 43:31.881 --> 43:35.821 hall and you brought $400 in cash in your pocket. 43:35.820 --> 43:41.220 You arrive and you realize you've lost your $400. 43:41.219 --> 43:45.679 Now, the choice is: you could--What are you going 43:45.677 --> 43:48.257 to do? Would you go to the ticket 43:48.259 --> 43:52.649 window and use your credit card to pick up the tickets or would 43:52.646 --> 43:55.826 you just walk away in anger and annoyance? 43:55.829 --> 43:59.499 Well, most people say, oh I would just go to the 43:59.497 --> 44:01.757 window and buy the tickets. 44:01.760 --> 44:06.530 Does that sound plausible that you could see the difference? 44:06.530 --> 44:10.170 But, in economic terms, there's no difference between 44:10.174 --> 44:14.034 losing the tickets and losing $400, so why do you behave 44:14.028 --> 44:16.688 differently? Well, that's framing. 44:16.690 --> 44:20.050 Because in your mind you're putting tickets and cash in 44:20.048 --> 44:24.248 different mental accounts, the mental account "tickets" 44:24.251 --> 44:29.701 generates an emotional feeling and it changes my action--that I 44:29.700 --> 44:31.810 lost in that account. 44:31.809 --> 44:36.879 Unfortunately, that's--unfortunately people's 44:36.882 --> 44:42.072 decisions are biased by that kind of thing. 44:42.070 --> 44:47.830 So, we have to frame things as--put things in the mental 44:47.830 --> 44:53.170 categories--presentation matters--so that people can 44:53.172 --> 44:56.212 manage their risks right. 44:56.210 --> 45:01.550 Kahneman and Tversky also--and others have also talked about 45:01.553 --> 45:05.203 insurance. They've asked people a question 45:05.195 --> 45:08.735 and then phrased it in two different ways. 45:08.739 --> 45:12.219 One of them was, would you buy insurance against 45:12.217 --> 45:13.917 such and such a risk? 45:13.920 --> 45:17.720 The same question was rephrased in another way, 45:17.721 --> 45:22.431 without mentioning the word insurance--they just described 45:22.431 --> 45:24.671 it. They said, would you sign a 45:24.669 --> 45:28.359 contract that if you had this loss the contract would pay you 45:28.357 --> 45:30.137 a certain amount of money? 45:30.139 --> 45:34.759 The percent of people who said yes to that was lower because 45:34.761 --> 45:38.131 they didn't put it in an insurance frame. 45:38.130 --> 45:41.580 We are accustomed to thinking of insurance as a good thing. 45:41.579 --> 45:46.169 If I talk about it in general terms, they might not put it in 45:46.170 --> 45:49.690 that frame and they might not– Really, 45:49.690 --> 45:59.300 an important example of framing is how we deal with money and 45:59.298 --> 46:04.418 indexation. We have a "money frame" of 46:04.419 --> 46:07.809 thinking and a "real frame." 46:07.810 --> 46:12.810 46:12.809 --> 46:16.159 The value of money changes through time because of 46:16.160 --> 46:20.390 inflation or deflation; yet, most of our debts are 46:20.391 --> 46:22.721 written in money terms. 46:22.719 --> 46:25.449 That is, they're not indexed for inflation. 46:25.449 --> 46:30.429 If you wanted to have a real frame, then you would index to 46:30.432 --> 46:35.332 the consumer price index or some other inflation index. 46:35.329 --> 46:41.709 Most of us are accustomed to a money frame, so most of us--when 46:41.710 --> 46:47.370 we lend money to each other, we do it in money terms. 46:47.369 --> 46:51.439 You merely say--For example, if your friend asked to borrow 46:51.437 --> 46:54.587 $100 from you, you would probably not say--you 46:54.593 --> 46:57.893 might actually put interest on this person, 46:57.889 --> 47:00.029 so you could say, alright, I'll do it with 5% 47:00.027 --> 47:01.677 interest, pay me back in a year. 47:01.679 --> 47:04.929 You would probably not even think to say, 47:04.932 --> 47:09.652 pay me 3% interest plus the rate of inflation over the next 47:09.648 --> 47:12.708 year. That would be putting it in a 47:12.707 --> 47:16.557 real frame and--wouldn't that be more sensible, 47:16.559 --> 47:20.689 because you would be specifying the contract in real terms 47:20.694 --> 47:22.584 rather than money terms? 47:22.579 --> 47:28.019 Yet, most people just don't do that. 47:28.019 --> 47:32.109 Most of our fixed incomes, as they're called--which are 47:32.112 --> 47:36.732 assets that are denominated in currency--Most of our debts are 47:36.734 --> 47:40.684 written in money terms and people can't get over this 47:40.675 --> 47:43.095 framing in terms of money. 47:43.099 --> 47:46.239 It's a powerful psychological, you might say, 47:46.242 --> 47:49.312 illusion--people think they want money when, 47:49.313 --> 47:53.173 in fact, they should want real goods and services. 47:53.170 --> 47:56.900 So, that's an example of a framing issue. 47:56.900 --> 48:03.700 Now, I want to move to the third theme of this lecture, 48:03.696 --> 48:06.336 which is invention. 48:06.340 --> 48:14.720 48:14.719 --> 48:22.909 As I said, progress in finance requires an inventive process 48:22.910 --> 48:29.990 and invention occurs in a milieu of other invention, 48:29.991 --> 48:34.851 notably information technology. 48:34.850 --> 48:40.120 48:40.119 --> 48:47.319 I said this is an earlier lecture, but a financial device 48:47.324 --> 48:55.304 is a complicated device like any engine or any other thing that 48:55.300 --> 49:02.890 they patent and develop to solve some physical problem. 49:02.889 --> 49:10.359 For example, let's talk about an insurance 49:10.363 --> 49:14.923 policy as an invention. 49:14.920 --> 49:17.730 An insurance policy--the concept is very simple, 49:17.730 --> 49:21.020 we could talk about fire insurance or life insurance. 49:21.019 --> 49:25.149 Life insurance is designed to protect–ideally, 49:25.146 --> 49:29.596 it protects parents with young children--that's the most 49:29.596 --> 49:31.696 important application. 49:31.699 --> 49:35.449 If one of the parents dies, it creates hardship for the 49:35.452 --> 49:39.552 family because the remaining parent has the burden of caring 49:39.552 --> 49:43.312 for children and earning a livelihood to support all of 49:43.305 --> 49:45.815 them. It is very difficult, 49:45.818 --> 49:50.478 so we have a policy that pays them if one of them dies. 49:50.480 --> 49:56.950 It's not easy to devise this and the concept is very simple. 49:56.949 --> 50:02.259 In order to devise an insurance contact that does this job, 50:02.262 --> 50:07.572 we have to have a contract between an insurance company and 50:07.574 --> 50:11.064 the insured. The contract has to specify 50:11.059 --> 50:15.099 what are the causes of, let's say, death or a situation 50:15.099 --> 50:17.119 in which one is covered. 50:17.119 --> 50:21.309 We have to then realize that there is a moral hazard problem. 50:21.309 --> 50:24.249 We have to exclude certain causes, like suicide, 50:24.248 --> 50:26.248 in the case of life insurance. 50:26.250 --> 50:29.380 In other kinds of insurance it gets very complicated. 50:29.380 --> 50:32.890 You have to exclude those causes that generate moral 50:32.890 --> 50:35.920 hazard problems for the insurance to work; 50:35.920 --> 50:38.010 otherwise, the whole system will fail. 50:38.010 --> 50:41.050 When they invented fire insurance, in the 1600s, 50:41.053 --> 50:44.743 there was a lot of skepticism because anyone can burn down 50:44.744 --> 50:47.374 their house. They said, it's not going to 50:47.373 --> 50:50.793 work because you have to decide how much the house is insured 50:50.787 --> 50:53.917 for and then anybody--If you ever make a mistake and you 50:53.916 --> 50:57.026 insure it for too much, then the people who realize 50:57.030 --> 51:00.410 they've got one on the insurance company--they've insured the 51:00.409 --> 51:03.449 house for more than it's worth--they'll burn down their 51:03.451 --> 51:05.311 house and collect the money. 51:05.309 --> 51:08.239 Now, how can the insurance company ever evaluate every 51:08.237 --> 51:09.947 house properly to avoid that? 51:09.949 --> 51:12.539 They had to work on that, they had to devise--they had to 51:12.544 --> 51:15.284 get an appraisal industry that could appraise houses and get 51:15.277 --> 51:17.267 some idea of what they're really worth. 51:17.269 --> 51:20.019 They had to get that all worked out, it had to be done 51:20.021 --> 51:23.031 accurately, and they had to decide to keep a certain amount 51:23.031 --> 51:25.101 of co-insurance. In other words, 51:25.096 --> 51:29.336 lower the amount insured below the actual value of the house to 51:29.338 --> 51:30.978 prevent moral hazard. 51:30.980 --> 51:36.020 They had to develop statistics of loss; 51:36.019 --> 51:37.889 they had to know what the losses were. 51:37.889 --> 51:41.759 In the case of life insurance, they developed actuarial tables 51:41.763 --> 51:44.433 that require a collecting of statistics. 51:44.429 --> 51:47.799 Then of course, there's the other problem that 51:47.799 --> 51:52.519 the insurance company--how does the insurance company reasonably 51:52.516 --> 51:56.406 specify that it can come through on this policy? 51:56.409 --> 52:01.109 You have to have the insurance company set up with a structure 52:01.112 --> 52:06.052 itself that guarantees that they have enough reserves to meet the 52:06.046 --> 52:08.586 losses that they might incur. 52:08.590 --> 52:12.690 That requires a theory of capital and they're going to 52:12.691 --> 52:16.561 have to invest the reserves in financial assets. 52:16.559 --> 52:19.599 Then you have to ask, well how are the financial 52:19.597 --> 52:21.857 assets going to behave over time? 52:21.860 --> 52:26.100 Then it becomes a theory of--all of finance comes in as 52:26.100 --> 52:28.110 well. Moreover, beyond that, 52:28.107 --> 52:31.017 how does one know, in taking out an insurance 52:31.021 --> 52:34.931 policy, that the insurance company is going to be sound? 52:34.929 --> 52:38.619 The insurance company has to have some way of demonstrating 52:38.620 --> 52:40.530 its soundness to the public. 52:40.530 --> 52:45.510 Moreover, we have regulators who have to regulate insurance 52:45.510 --> 52:50.490 companies and make sure that they have adequate capital. 52:50.489 --> 52:52.959 So, it's a very complicated industry. 52:52.960 --> 52:55.650 Although, I said, insurance was effectively 52:55.648 --> 52:58.078 discovered or invented in the 1600s, 52:58.079 --> 53:01.879 it has been slow to grow because they didn't have the 53:01.880 --> 53:04.950 well-defined--all of the inventions yet. 53:04.950 --> 53:13.330 53:13.329 --> 53:17.059 I wanted to just give some--often the inventions that 53:17.059 --> 53:20.429 occur in finance, they seem in a way obvious. 53:20.429 --> 53:22.779 Some of the things I said--you'd probably say, 53:22.780 --> 53:25.920 well I should have known that an insurance company would have 53:25.915 --> 53:27.425 to do that, but it isn't. 53:27.429 --> 53:32.959 What's obvious after the fact is not what's obvious before the 53:32.955 --> 53:36.045 fact. One thing I'd like to stress is 53:36.050 --> 53:40.810 that the history of technology is sometimes a history of very 53:40.811 --> 53:44.701 glamorous, unobvious ideas like nuclear power. 53:44.699 --> 53:47.629 That's amazing, you can get atoms to smash 53:47.627 --> 53:50.697 atoms and create a chain reaction and create 53:50.697 --> 53:53.907 power--that's a pretty amazing invention. 53:53.909 --> 53:57.819 But a lot of the inventions that matter to us are extremely 53:57.822 --> 54:00.592 simple. They're kind of staring in your 54:00.593 --> 54:03.833 face obvious. Let me just give some example 54:03.827 --> 54:07.947 of--sometimes people are very slow to see the obvious, 54:07.952 --> 54:10.212 or it seems so in history. 54:10.210 --> 54:13.460 I'd like to talk about the invention of the wheel--that's 54:13.459 --> 54:15.489 the most famous invention, right? 54:18.591 --> 54:20.791 wheel here, so let's go back to that. 54:20.789 --> 54:24.599 Inventing the wheel--it seems, what could be more obvious than 54:24.604 --> 54:28.664 a wheel? Well, it apparently is not so 54:28.664 --> 54:34.234 obvious because in the Americas, before Columbus 54:34.231 --> 54:40.041 came--pre-Columbian America--there were no wheeled 54:40.035 --> 54:42.755 vehicles anywhere. 54:42.760 --> 54:46.290 We had civilizations--Aztecs, Mayas, Incas, 54:46.290 --> 54:48.980 etc.--but no wheeled vehicles. 54:48.980 --> 54:53.890 Now, the amazing thing is, if you go to Mexico you can go 54:53.885 --> 54:59.225 to museums that have children's toys from pre-Columbian Mexico 54:59.228 --> 55:01.888 with wheels. They were little toys 55:01.886 --> 55:05.416 that--they would be shaped like animals or something and you 55:05.416 --> 55:07.506 could roll them along the floor. 55:07.510 --> 55:10.780 So, why didn't somebody think of--you're sitting there with 55:10.776 --> 55:13.696 your child playing with a wheeled toy and then you're 55:13.704 --> 55:16.914 going out to carry some heavy stuff and you're dragging it 55:16.914 --> 55:18.214 along the ground. 55:18.210 --> 55:21.500 Why didn't you think of putting wheels under it? 55:21.500 --> 55:25.210 Well, it's apparently not so obvious. 55:25.210 --> 55:29.140 Some very obvious ideas are not so obvious. 55:29.139 --> 55:32.199 Some people today think, I just can't imagine, 55:32.201 --> 55:35.811 this history can't be right, I don't believe that they 55:35.806 --> 55:39.476 hadn't invented wheels in America before Columbus. 55:39.480 --> 55:42.530 To argue with them, I point out an example, 55:42.532 --> 55:44.352 which is more familiar. 55:44.349 --> 55:46.999 Unfortunately, you people are too young to 55:47.000 --> 55:50.300 have experienced this, but I've experienced this and 55:50.296 --> 55:52.426 you can talk to your parents. 55:52.429 --> 55:57.769 It used to be, before 1972, 55:57.768 --> 56:04.748 that suitcases never had wheels. 56:04.750 --> 56:07.330 You probably own a wheeled suitcase, right? 56:07.330 --> 56:12.150 Most of you do. The idea of putting wheels on 56:12.150 --> 56:19.350 suitcases goes back only to 1972 and it was Bernard Sadow who 56:19.349 --> 56:25.319 invented--this is amazing, right--the wheeled suitcase and 56:25.315 --> 56:27.155 he got a patent on it. 56:27.159 --> 56:29.759 He had a suitcase that--I don't know exactly, 56:29.761 --> 56:33.071 something like this--had a strap that you'd pull it along 56:33.073 --> 56:36.743 and it had four little wheels on the bottom and it worked. 56:36.739 --> 56:42.109 I had my student research assistant find that guy, 56:42.113 --> 56:46.613 let's call him up and ask him about it. 56:46.610 --> 56:49.200 It's so recent. So my student called Bernard 56:49.198 --> 56:52.218 Sadow up and asked him about his invention and he said, 56:52.224 --> 56:54.974 "Yeah, I was thinking, why don't we have wheels on 56:54.969 --> 56:56.639 suitcases? So I just did it." 56:56.639 --> 57:01.289 He said, "I had a lot of trouble, I took it to department 57:01.286 --> 57:05.016 stores and I said, why don't you sell this? 57:05.019 --> 57:07.419 I'm making it, add it to your luggage." 57:07.420 --> 57:09.690 He said he met a lot of resistance. 57:09.690 --> 57:13.540 The department stores said no and so we asked, 57:13.544 --> 57:15.604 why would they say no? 57:15.599 --> 57:17.639 I mean, it's such an obviously good idea. 57:17.639 --> 57:21.659 He said, "They said people won't buy it. 57:21.659 --> 57:24.079 Anyway, they said, look you go to any train 57:24.084 --> 57:27.434 station and there are these red caps or porters and they'll 57:27.432 --> 57:29.282 carry your suitcase for you. 57:29.280 --> 57:30.660 You don't need wheels." 57:30.660 --> 57:33.020 That's what they told him. 57:33.019 --> 57:35.469 But, it seemed like there was kind of a way of thinking. 57:35.469 --> 57:37.359 I think maybe people would be embarrassed. 57:37.360 --> 57:40.320 If you were the only guy with wheels on your suitcase, 57:40.319 --> 57:42.719 people would think you look a little odd. 57:42.719 --> 57:56.179 Anyway, it's interesting the wheeled suitcase came in 1972. 57:56.179 --> 57:59.399 The problem with Sadow's suitcase--I actually had one and 57:59.404 --> 58:01.424 you might have one in your attic. 58:01.420 --> 58:04.800 You can go up and look at it because your parents probably 58:04.803 --> 58:07.003 bought one and it's still up there. 58:07.000 --> 58:09.980 You can take it out and try wheeling it along with that 58:09.978 --> 58:11.568 strap. It kind of works, 58:11.567 --> 58:14.537 but it wobbles, especially if you're hurrying 58:14.535 --> 58:16.285 to catch your airplane. 58:16.289 --> 58:18.799 That thing starts fish-tailing and wobbling. 58:18.800 --> 58:23.840 You've just got a strap you're pulling it on--so obviously 58:23.836 --> 58:26.306 there was a design defect. 58:26.309 --> 58:30.719 Finally, it was Robert Plath, who was an airline pilot who 58:30.716 --> 58:33.186 invented a new, wheeled suitcase, 58:33.190 --> 58:35.510 which he patented in 1991. 58:35.510 --> 58:39.680 This suitcase had--instead of having four little wheels on the 58:39.683 --> 58:42.423 bottom, it had two wheels on the back. 58:42.420 --> 58:45.010 You didn't pull the suitcase lengthwise; 58:45.010 --> 58:48.360 you pulled it widthwise, so it gave you a stable base. 58:48.360 --> 58:51.880 Moreover, instead of having a strap he had this thing that--a 58:51.876 --> 58:55.276 rigid thing--that you pull out from this--you know what I'm 58:55.275 --> 58:57.915 talking about? He invented--he called it the 58:57.921 --> 59:00.131 RollAboard. He also had the idea that he 59:00.131 --> 59:03.341 would make it narrow enough so that when you're boarding an 59:03.344 --> 59:06.174 airplane you can still roll it down the aisle of the 59:06.170 --> 59:08.220 airplane--it just fit perfectly. 59:08.219 --> 59:11.409 So, that was the RollAboard--that was 1991. 59:11.409 --> 59:12.869 That's getting into recent memory. 59:12.869 --> 59:16.129 It's so obvious, why didn't they have them 59:16.133 --> 59:18.783 before? Well, things that seem obvious 59:18.778 --> 59:22.438 are not obvious and it has something to do with--something 59:22.441 --> 59:24.741 like framing. We tend to think of doing 59:24.739 --> 59:27.069 things in a certain way--everyone else is doing 59:27.074 --> 59:30.124 it--and we assume that that's the smart way to do things. 59:30.120 --> 59:34.820 59:34.820 --> 59:40.020 That limits us and it's very hard to get new ideas started, 59:40.019 --> 59:44.499 but they do get started; so, I think we'll get some 59:44.501 --> 59:46.571 really obvious advances. 59:46.570 --> 59:50.960 One thing about inventions is that we have something called 59:50.962 --> 59:55.932 patents. The patent office grants patent 59:55.932 --> 1:00:01.102 rights to inventions, but traditionally 1:00:01.097 --> 1:00:07.797 in--everywhere in the world, really, financial inventions 1:00:07.804 --> 1:00:12.174 were not considered worthy of patenting because, 1:00:12.170 --> 1:00:16.920 I guess, patent law came in response to things like the 1:00:16.919 --> 1:00:21.589 steam engine and the power loom, which were physical inventions. 1:00:21.590 --> 1:00:25.220 They didn't think of financial inventions as worthy of patents. 1:00:25.219 --> 1:00:30.739 Now, we're starting to see patent offices accepting 1:00:30.741 --> 1:00:32.951 financial devices. 1:00:32.949 --> 1:00:36.629 It happened in the late 1990s, in the United States, 1:00:36.632 --> 1:00:40.822 that patent offices started to accept financial patents. 1:00:40.820 --> 1:00:47.030 Now there are several countries that–-Japan, 1:00:47.027 --> 1:00:53.357 Korea, and elsewhere--are starting to see financial 1:00:53.362 --> 1:00:58.052 invention as a serious invention. 1:00:58.050 --> 1:01:09.530 The last thing is information technology, as a driver of 1:01:09.532 --> 1:01:11.622 finance. 1:01:11.620 --> 1:01:20.300 1:01:20.300 --> 1:01:23.870 Now, I'd like to stress information technology because 1:01:23.873 --> 1:01:27.993 we are living in a time of rapid advance, as you know--I don't 1:01:27.986 --> 1:01:29.736 have to tell you this. 1:01:29.739 --> 1:01:33.149 Computers are becoming more and more a part of our lives and 1:01:33.145 --> 1:01:36.085 this is something that is transforming the world. 1:01:36.090 --> 1:01:38.890 What is it that makes us uniquely human? 1:01:38.889 --> 1:01:41.999 You might say--or a good part of--it is our ability to process 1:01:41.996 --> 1:01:44.996 information. We differ from lower animals 1:01:44.995 --> 1:01:48.665 and our brains, which are much more capable of 1:01:48.668 --> 1:01:51.768 storing and processing information, 1:01:51.769 --> 1:01:55.089 but we're living in a time of revolution when machines are 1:01:55.087 --> 1:01:57.587 challenging or competing with our brains. 1:01:57.590 --> 1:02:02.130 This may create economic dislocations that we will see 1:02:02.129 --> 1:02:05.299 throughout our lives, but also creates 1:02:05.298 --> 1:02:10.178 opportunities--I want to stress on the opportunities. 1:02:10.179 --> 1:02:15.959 A lot of financial innovation is co-evolved with information 1:02:15.957 --> 1:02:20.107 technology. A lot of simple ideas of risk 1:02:20.110 --> 1:02:24.680 management are ideas that require well-designed 1:02:24.678 --> 1:02:30.738 information technology and we've seen a lot of advances in the 1:02:30.736 --> 1:02:37.386 last couple centuries that make financial innovation possible. 1:02:37.389 --> 1:02:40.809 I thought I would give you an example from the nineteenth 1:02:40.805 --> 1:02:44.095 century, which is very important, and again it's public 1:02:44.098 --> 1:02:46.928 finance. I'm not going to stress public 1:02:46.929 --> 1:02:51.199 finance so much in this course but it seems--I'm going to give 1:02:51.199 --> 1:02:55.049 the example of nineteenth century information technology 1:02:55.050 --> 1:02:59.320 and the nineteenth century invention of social security. 1:02:59.320 --> 1:03:04.860 Let's go back to the nineteenth century, that's the 1800s, 1:03:04.856 --> 1:03:10.486 that was a wonderful century for information technology. 1:03:10.489 --> 1:03:13.349 You probably don't think of it that way because you say, 1:03:13.352 --> 1:03:15.542 wait a minute, the computer wasn't invented 1:03:15.538 --> 1:03:18.408 until the 1940s. Actually, you would be wrong; 1:03:18.409 --> 1:03:22.139 the computer was invented in the nineteenth century by 1:03:22.142 --> 1:03:25.172 Babbage, but he didn't actually make one. 1:03:25.170 --> 1:03:30.160 He wrote down a design, which was similar to what we do 1:03:30.155 --> 1:03:32.365 now. There were a lot of other 1:03:32.370 --> 1:03:36.290 things that happened in the nineteenth century that advanced 1:03:36.290 --> 1:03:40.210 information technology and made finance really powerful. 1:03:40.210 --> 1:03:45.070 One was paper, it sounds very simple. 1:03:45.070 --> 1:03:48.360 At the beginning of the nineteenth century, 1:03:48.363 --> 1:03:53.073 in 1800, paper was handmade out of cloth--that's the way they 1:03:53.068 --> 1:03:55.548 made it. Paper, therefore, 1:03:55.549 --> 1:03:57.359 was very expensive. 1:03:57.360 --> 1:04:01.490 So, if you bought a newspaper it would be only two sheets 1:04:01.494 --> 1:04:06.224 because it was so expensive--not all the thick paper that we have 1:04:06.220 --> 1:04:10.060 today--and it would cost something like $10 or $20 in 1:04:10.059 --> 1:04:13.289 today's prices. It would only be wealthy people 1:04:13.294 --> 1:04:14.874 who would buy that everyday. 1:04:14.869 --> 1:04:18.689 They invented the paper machine so they could mass-produce 1:04:18.691 --> 1:04:22.241 paper--it didn't have to be handmade anymore--and they 1:04:22.244 --> 1:04:26.204 invented wood pulp paper so it didn't have to be made out of 1:04:26.199 --> 1:04:29.469 cloth anymore. The price of paper fell and 1:04:29.465 --> 1:04:32.175 created opportunity for record-keeping, 1:04:32.176 --> 1:04:36.026 which was very important because that's what finance is 1:04:36.028 --> 1:04:38.808 built--you need financial records. 1:04:38.810 --> 1:04:41.900 You can't have just one copy; you have to have multiple 1:04:41.899 --> 1:04:49.009 copies. They also invented carbon paper. 1:04:49.010 --> 1:04:51.640 Maybe you don't even know what this--do you all know what 1:04:51.635 --> 1:04:53.785 carbon paper--I guess you do know what this is, 1:04:53.791 --> 1:04:55.611 right? It's obsolete. 1:04:55.610 --> 1:04:59.120 Do you have any carbon paper anyone, here in your room? 1:04:59.120 --> 1:05:02.270 You do? Okay, so it's not obsolete. 1:05:02.269 --> 1:05:08.329 Anyway, it's just paper with some black material on it. 1:05:08.329 --> 1:05:11.789 You put it between two pieces of paper, then you write on the 1:05:11.789 --> 1:05:14.729 top one and it creates as copy on the bottom one. 1:05:14.730 --> 1:05:17.620 You can make multiple--you can put three or four--the copy gets 1:05:17.616 --> 1:05:20.406 worse and worse each time, but you've got multiple copies. 1:05:20.410 --> 1:05:22.290 That's information technology. 1:05:22.289 --> 1:05:26.379 You really need that because if you have only one copy of 1:05:26.384 --> 1:05:29.094 something, you don't have a backup; 1:05:29.090 --> 1:05:31.970 so, you can store the one copy separately. 1:05:31.969 --> 1:05:35.079 Also, in the nineteenth century, the typewriter was 1:05:35.076 --> 1:05:39.486 invented. Of course, that may be the core 1:05:39.486 --> 1:05:41.886 idea of a computer. 1:05:41.889 --> 1:05:45.969 Your computer looks like a typewriter, but a typewriter 1:05:45.971 --> 1:05:48.921 just speeds recording of information. 1:05:48.920 --> 1:05:52.490 Tests show in the nineteenth century that people could type 1:05:52.493 --> 1:05:56.253 four or five times as fast as they could handwrite and there's 1:05:56.251 --> 1:06:00.011 no ambiguity because it's very clear what key was struck; 1:06:00.010 --> 1:06:03.250 whereas, handwritten--fast handwriting becomes impossible 1:06:03.251 --> 1:06:04.641 to read--or difficult. 1:06:04.639 --> 1:06:07.499 Another thing that happened--they started 1:06:07.502 --> 1:06:11.442 developing--it's not invented in the nineteenth century, 1:06:11.438 --> 1:06:14.728 but they started doing standardized forms. 1:06:14.730 --> 1:06:18.870 That is, there would be a printed form on paper with 1:06:18.871 --> 1:06:22.771 spaces to fill in the numbers or other things. 1:06:22.769 --> 1:06:25.419 That put us at, sort of, organization on the 1:06:25.420 --> 1:06:27.270 data entry that was unknown. 1:06:27.269 --> 1:06:31.579 You have this standardized form and you've got carbon paper 1:06:31.584 --> 1:06:35.604 between them and you typed it--all these really created 1:06:35.600 --> 1:06:38.130 much more accurate techniques. 1:06:38.130 --> 1:06:41.100 We also got better bureaucracy. 1:06:41.099 --> 1:06:46.289 That means, we started to learn management science in the 1:06:46.290 --> 1:06:50.180 government, so that government--and also in 1:06:50.183 --> 1:06:54.913 corporations--so they could manage effectively. 1:06:54.909 --> 1:06:57.889 In the United States, we developed the Civil Service. 1:06:57.889 --> 1:07:01.529 It used to be that government officials were all picked by 1:07:01.532 --> 1:07:05.432 political patronage and they, very often, were incompetent. 1:07:05.429 --> 1:07:09.019 We set up--this is not a new idea, this goes back to China 1:07:09.016 --> 1:07:12.636 thousands of years ago, but it started to be widely 1:07:12.639 --> 1:07:17.269 done--a Civil Service exam that established your competence. 1:07:17.269 --> 1:07:20.049 So, you had competent people with their typewriters and 1:07:20.054 --> 1:07:23.784 carbon papers. Also, the filing cabinet--that 1:07:23.776 --> 1:07:28.986 sounds like a minor thing--was invented in the 1890s. 1:07:28.989 --> 1:07:31.619 Before that, people used to put papers in 1:07:31.619 --> 1:07:35.559 piles, tie them up in ribbons, and put them on bookshelves or 1:07:35.563 --> 1:07:38.723 in drawers. The filing cabinet was much 1:07:38.719 --> 1:07:40.969 more orderly and effective. 1:07:40.969 --> 1:07:45.129 So, all those things developed in the nineteenth century. 1:07:45.130 --> 1:07:55.070 It just created a new world for financial opportunity. 1:07:55.070 --> 1:07:59.760 Things started to happen in response to this and risk 1:07:59.763 --> 1:08:01.933 management got better. 1:08:01.929 --> 1:08:07.569 I want to talk about Social Security as a risk management 1:08:07.570 --> 1:08:13.210 technique that developed in the nineteenth century and it 1:08:13.211 --> 1:08:15.731 developed in Germany. 1:08:15.730 --> 1:08:19.240 It is very interesting to me because it's a discrete 1:08:19.239 --> 1:08:23.089 invention that happened in a point of time in response to 1:08:23.092 --> 1:08:24.952 information technology. 1:08:24.949 --> 1:08:28.459 This is 1889, under the government of Otto 1:08:28.460 --> 1:08:33.340 von Bismarck--although, he has nothing to do with this, 1:08:33.340 --> 1:08:41.450 it was other people--economists in Germany that invented this 1:08:41.453 --> 1:08:44.413 idea. What did they do? 1:08:44.409 --> 1:08:47.929 I should have also mentioned another really important 1:08:47.928 --> 1:08:51.578 information technology that developed in the nineteenth 1:08:51.581 --> 1:08:56.621 century was the Postal Service, although we had mail before 1:08:56.617 --> 1:08:59.457 then. In the nineteenth century they 1:08:59.458 --> 1:09:03.428 decided--it just got really good at delivering mail. 1:09:03.430 --> 1:09:07.220 In 1799, it would cost so much to mail a letter--I don't know 1:09:07.219 --> 1:09:11.069 exactly, something like $10 or $20 to mail a letter at today's 1:09:11.072 --> 1:09:14.232 rate--and it would take a long time get there. 1:09:14.229 --> 1:09:17.029 For most people it was prohibitively--we're talking in 1:09:17.030 --> 1:09:18.880 today's prices, roughly speaking. 1:09:18.880 --> 1:09:22.290 Most people wouldn't ever mail a letter or get a letter--too 1:09:22.291 --> 1:09:25.531 expensive, not to count only the paper and everything was 1:09:25.530 --> 1:09:27.780 expensive. In the nineteenth century, 1:09:27.782 --> 1:09:30.832 they developed the Postal Service and it interacted with 1:09:30.832 --> 1:09:33.552 the railroad. They started having mail cars 1:09:33.551 --> 1:09:36.961 on trains and they started having postal sorting on the 1:09:36.961 --> 1:09:39.491 train. They were speeding the mail so 1:09:39.490 --> 1:09:43.350 that it didn't have to wait to sort it before it went on the 1:09:43.345 --> 1:09:47.065 train--it was sorted while it was moving on the train. 1:09:47.069 --> 1:09:50.759 Germany was very effective in these--they had advanced 1:09:50.762 --> 1:09:53.342 bureaucracy, a good postal service, 1:09:53.340 --> 1:09:56.460 and they had a network of post offices all over the 1:09:56.463 --> 1:09:59.403 country--every little town had a post office. 1:09:59.399 --> 1:10:02.639 So, this was the internet of the nineteenth century and it 1:10:02.638 --> 1:10:04.228 really changed everything. 1:10:04.229 --> 1:10:08.269 In 1889, the German Government decided to use the postal 1:10:08.268 --> 1:10:11.868 service as an information network to create Social 1:10:11.865 --> 1:10:14.435 Security. They created a new law, 1:10:14.436 --> 1:10:18.576 which said that every person who works in Germany has to pay 1:10:18.584 --> 1:10:22.104 the government a certain percent of his income, 1:10:22.100 --> 1:10:25.070 into the Social Security system. 1:10:25.069 --> 1:10:28.549 In addition, the employer has to match this 1:10:28.550 --> 1:10:33.440 so that both the employer and the employee have to do it. 1:10:33.439 --> 1:10:37.039 Now, how in the world can somebody actually make that work 1:10:37.040 --> 1:10:38.430 for a whole country? 1:10:38.430 --> 1:10:42.040 There were eleven million workers in Germany at the time 1:10:42.036 --> 1:10:44.656 and other countries looked on this as, 1:10:44.659 --> 1:10:47.399 this is ridiculous, no government can actually 1:10:47.402 --> 1:10:49.232 manage the system like this. 1:10:49.229 --> 1:10:51.369 But, they did it through the postal system. 1:10:51.369 --> 1:10:55.009 You had to make--or your employer can do it for you--they 1:10:55.014 --> 1:10:58.794 take the money to the post office and the post office would 1:10:58.788 --> 1:11:01.118 give you stamps. It was already the same 1:11:01.121 --> 1:11:02.691 technology they used for the mail. 1:11:02.689 --> 1:11:06.109 You kept your Social Security card and you pasted stamps on it 1:11:06.111 --> 1:11:07.851 that proved that you paid it. 1:11:07.850 --> 1:11:11.090 They kept a copy of that and they filed it away, 1:11:11.093 --> 1:11:14.893 so the government had a complete record of your payments 1:11:14.889 --> 1:11:17.849 into the system. The design was that, 1:11:17.851 --> 1:11:22.281 when you reached retirement age, you would then get funds 1:11:22.278 --> 1:11:27.098 from the government for the rest of your life--your retirement 1:11:27.100 --> 1:11:31.430 funds. How did they decide how much? 1:11:31.430 --> 1:11:33.240 Well, it was based on what you contributed. 1:11:33.239 --> 1:11:35.729 They would pull out your entire life history of 1:11:35.731 --> 1:11:38.821 contributions--they had it because you had filed it all at 1:11:38.818 --> 1:11:41.528 the post office and everything was bureaucratic and 1:11:41.526 --> 1:11:44.736 efficient--and they calculated, according to a formula, 1:11:44.738 --> 1:11:45.788 what you would get. 1:11:45.789 --> 1:11:50.239 It was a real insurance system and they would pay you in your 1:11:50.236 --> 1:11:52.516 retirement. The London Times, 1:11:52.521 --> 1:11:57.261 in 1889, said this is going to be a fiasco, there are going to 1:11:57.262 --> 1:12:00.452 be so many mistakes, and there are going to be so 1:12:00.447 --> 1:12:03.487 many complaints that this whole system is going to crumble and 1:12:03.490 --> 1:12:05.240 fall; but it didn't, 1:12:05.236 --> 1:12:07.156 it actually worked. 1:12:07.160 --> 1:12:09.690 Before long, the U.K. copied it. 1:12:09.689 --> 1:12:12.539 The U.S. was practically the last 1:12:12.537 --> 1:12:16.897 country to copy this system because, in the 1930s, 1:12:16.899 --> 1:12:19.479 it didn't sound American. 1:12:19.479 --> 1:12:23.769 We were kind of reluctant to take on ideas from Germany, 1:12:23.765 --> 1:12:26.565 of all places, but we finally did. 1:12:26.569 --> 1:12:29.799 We did that during the Great Depression, when it suddenly 1:12:29.799 --> 1:12:32.509 seemed like we really needed to do something. 1:12:32.510 --> 1:12:35.370 That's an example; you see how information 1:12:35.372 --> 1:12:38.452 technology created a Social Security system. 1:12:38.449 --> 1:12:42.149 Now, the really fascinating thing is that we have the same 1:12:42.148 --> 1:12:44.938 system today, except we don't use the postal 1:12:44.938 --> 1:12:47.208 service as the conduit anymore. 1:12:47.210 --> 1:12:50.220 Now it's all electronic and it's done by the Internet, 1:12:50.215 --> 1:12:51.685 but it's the same thing. 1:12:51.689 --> 1:12:53.549 You will see, deducted from your 1:12:53.550 --> 1:12:57.270 paycheck--and you already have seen this--it says FICA and then 1:12:57.270 --> 1:13:00.620 there's a certain amount, a certain percentage of your 1:13:00.623 --> 1:13:03.913 paycheck, and the employer matches just like in Germany in 1:13:03.908 --> 1:13:06.168 1889. When you retire--you can 1:13:06.171 --> 1:13:08.801 actually get it now, electronically, 1:13:08.798 --> 1:13:12.978 your entire employment history, all your contributions--when 1:13:12.975 --> 1:13:16.335 you retire, there will be a formula--you can find it on the 1:13:16.344 --> 1:13:19.254 Social Security system website--which resembles the 1:13:19.247 --> 1:13:21.277 formula that they did in 1889. 1:13:21.279 --> 1:13:25.559 We're still doing the same thing now. 1:13:25.560 --> 1:13:28.920 This invention of social security is well over one 1:13:28.922 --> 1:13:31.532 hundred years old, but I think that, 1:13:31.529 --> 1:13:34.439 because of the rapid advance of information technology, 1:13:34.440 --> 1:13:36.650 we're going to see a lot more progress. 1:13:36.649 --> 1:13:38.989 Over your lifetime, there are going to be a lot 1:13:38.993 --> 1:13:40.423 more inventions like this. 1:13:40.420 --> 1:13:45.930 So, that's why I think finance will be an interesting field for 1:13:45.927 --> 1:13:49.477 those of you who choose to go into it. 1:13:49.479 --> 1:13:52.989 Finally, I just want to say, next lecture is January 1:13:52.991 --> 1:13:56.571 twenty-eighth and we're going to talk about portfolio 1:13:56.572 --> 1:13:59.452 diversification, which is one very important 1:13:59.450 --> 1:14:02.840 application of the fundamental principle of risk management, 1:14:02.840 --> 1:14:05.650 as applied to securities. 1:14:05.649 --> 1:14:08.999 It's more narrow than my very broad discussion. 1:14:09.000 --> 1:14:11.650 It's not public finance, it's not insurance, 1:14:11.649 --> 1:14:14.979 but it's one of the most important fundamental theories 1:14:14.976 --> 1:14:16.636 that underlies finance. 1:14:16.640 --> 1:14:20.040 Then you have a problem set, which is due on that day, 1:14:20.036 --> 1:14:23.296 your first problem set, and the problem set is up on 1:14:23.304 --> 1:14:26.474 the website. If you go to ClassesV2 and you 1:14:26.473 --> 1:14:29.763 click on "Problem Sets," it's Problem Set #1. 1:14:29.760 --> 1:14:33.960 We're also going to--I'm going to email you about review 1:14:33.960 --> 1:14:36.510 sections. Our first review section will 1:14:36.509 --> 1:14:40.109 be in the week of January--with your teaching fellows--will be 1:14:40.105 --> 1:14:43.285 in the week of January twenty-eighth and we're going to 1:14:43.288 --> 1:14:47.118 have to ask you to sign up with one of the teaching fellows. 1:14:47.119 --> 1:14:53.209 We'll give you times and dates when the sections occur. 1:14:53.210 --> 1:14:56.000 I'll see you on January 28.