WEBVTT 00:00.910 --> 00:02.720 good morning. 00:02.720 --> 00:05.010 Today I decided not to use PowerPoint, 00:05.010 --> 00:07.070 I'm using index cards. 00:07.070 --> 00:11.190 This is traditional lecture style. 00:11.190 --> 00:13.630 I want to talk today about -- 00:13.630 --> 00:17.370 this is our third lecture for financial markets. 00:17.370 --> 00:20.940 I wanted to talk today about invention in finance. 00:24.680 --> 00:28.150 I think of finance, I don't know whether this will 00:28.150 --> 00:31.660 encourage you to be interested or not, but I think of it as a 00:31.660 --> 00:33.640 form of engineering. 00:33.640 --> 00:37.680 Finance is all about inventions. 00:37.680 --> 00:45.280 Devices that solve problems and that help people do things 00:45.280 --> 00:49.070 and get on with their purposes in life. 00:49.070 --> 00:54.360 And the inventions have many small details, 00:54.360 --> 00:56.070 just like any invention. 00:56.070 --> 00:57.220 Like an airplane. 00:57.220 --> 01:00.940 You look at an airplane, how many parts are in there? 01:00.940 --> 01:05.000 How many different people worked on the different parts? 01:05.000 --> 01:08.610 And it's so complicated that you might have disbelief that 01:08.610 --> 01:10.410 this whole thing is going to work, but 01:10.410 --> 01:12.270 somehow it does work. 01:12.270 --> 01:16.360 And another part that I want to emphasize in today's 01:16.360 --> 01:25.060 lecture is that engineering requires a human element. 01:25.060 --> 01:29.750 Engineers know that their devices will be run by people, 01:29.750 --> 01:32.190 and people are imperfect. 01:32.190 --> 01:36.070 And so, they have a course in engineering schools called 01:36.070 --> 01:38.500 Human Factors Engineering. 01:38.500 --> 01:42.870 And that's about designing machines, so that human beings 01:42.870 --> 01:48.740 won't mess up when they try to use them. 01:48.740 --> 01:52.260 That gets us into psychology. 01:52.260 --> 01:56.250 To me, when we talk about behavioral finance, which is 01:56.250 --> 01:59.260 going to be a theme of this course, human psychology and 01:59.260 --> 02:04.010 finance, it's fundamental to the inventive side of finance. 02:04.010 --> 02:05.320 So that's what I want to talk about. 02:05.320 --> 02:08.430 I'm going to give you some examples of invention and talk 02:08.430 --> 02:13.330 about how they solve the risk problem. 02:13.330 --> 02:17.030 The fundamental problem of maintaining incentives in the 02:17.030 --> 02:19.240 face of risk. 02:19.240 --> 02:21.890 But before I start this lecture, I wanted to just 02:21.890 --> 02:25.790 briefly review the last lecture, which was a very 02:25.790 --> 02:29.550 important lecture for this course, because it talked 02:29.550 --> 02:35.180 about the underlying probability theory and 02:35.180 --> 02:37.610 applications of probability theory to finance. 02:37.610 --> 02:41.150 So, let me just mention some of the concepts that I talked 02:41.150 --> 02:42.390 about last time. 02:42.390 --> 02:44.600 The first one was return. 02:44.600 --> 02:48.740 We talked about the return on an investment which has two 02:48.740 --> 02:52.100 components, the capital gains, which is the increase in the 02:52.100 --> 02:55.040 price of the investment, and the other is the dividend, 02:55.040 --> 02:58.660 which is something that comes separately in the form of a 02:58.660 --> 03:01.410 check maybe, or electronic entry. 03:04.080 --> 03:08.090 But we then moved quickly to probability theory. 03:08.090 --> 03:10.300 We talked about random variables. 03:10.300 --> 03:14.160 A random variable is a quantity that's created by 03:14.160 --> 03:18.980 some kind of experiment or event that is uncertain in 03:18.980 --> 03:21.310 advance and becomes known later. 03:21.310 --> 03:25.390 And then, we talked about measures of probability 03:25.390 --> 03:26.800 distributions. 03:26.800 --> 03:30.580 We talked about central tendency, we talked about the 03:30.580 --> 03:35.530 average or mean, and the geometric average, and we 03:35.530 --> 03:42.270 talked about measures of risk, notably variance. 03:46.980 --> 03:49.410 But then, there are also measures of co-movements 03:49.410 --> 03:51.000 between two random variables. 03:51.000 --> 03:54.960 We talked about covariance and correlation, and we talked 03:54.960 --> 03:57.300 about regression. 03:57.300 --> 04:03.340 And then finally we talked about distributions of random 04:03.340 --> 04:09.140 variables, and the normal distribution, which is famous. 04:09.140 --> 04:12.730 It's the famous bell-shaped curve, which is thought by 04:12.730 --> 04:17.430 many people to represent a typical distribution. 04:17.430 --> 04:20.840 And then finally, we talked about failures of the -- 04:20.840 --> 04:24.870 the idea of independent random variables that are normally 04:24.870 --> 04:27.880 distributed is a powerful idea. 04:27.880 --> 04:31.210 That we have some idea that there's a bell-shaped curve. 04:31.210 --> 04:34.630 We know something about what relates to something and what 04:34.630 --> 04:36.190 doesn't relate to what. 04:36.190 --> 04:39.670 These ideas are partly intuitive, and 04:39.670 --> 04:40.650 they're partly wrong. 04:40.650 --> 04:45.130 And so, the concluding element of the last lecture was that 04:45.130 --> 04:49.750 the financial crisis that has enveloped the world starting 04:49.750 --> 04:54.360 around 2007 seems to be related to people's failure to 04:54.360 --> 04:57.930 understand the limits of the independence assumption they 04:57.930 --> 05:03.750 were making, and also to the limits of the normal 05:03.750 --> 05:06.010 distribution. 05:06.010 --> 05:07.930 Namely, failure to consider outliers. 05:10.570 --> 05:12.770 So let's just think about independence 05:12.770 --> 05:14.830 briefly for a moment. 05:14.830 --> 05:18.800 It's inherent in the intuitive view we have of the world. 05:18.800 --> 05:22.580 When you toss a coin, every time you toss it, you think 05:22.580 --> 05:24.520 each toss has to be independent of 05:24.520 --> 05:25.710 the previous toss. 05:25.710 --> 05:28.690 They're not going to come up the same, because there's 05:28.690 --> 05:30.900 nothing relating the two tosses. 05:30.900 --> 05:34.280 So you have a strong intuitive sense that some events are 05:34.280 --> 05:36.570 independent. 05:36.570 --> 05:41.520 You might also think that returns on the stock market 05:41.520 --> 05:44.780 from day to day are independent. 05:44.780 --> 05:45.620 Why is that? 05:45.620 --> 05:48.320 Because they relate to news, right? 05:48.320 --> 05:50.830 What changes the stock market on any day? 05:50.830 --> 05:54.470 Its news, and by definition news has to be new. 05:54.470 --> 05:56.720 So it can't just be yesterday's news. 05:56.720 --> 05:59.110 So it has to be something fresh. 05:59.110 --> 06:03.110 And I showed you a plot of the stock market and of Apple 06:03.110 --> 06:09.240 stock, and in this plot it came out that the stocks look 06:09.240 --> 06:12.810 roughly independent, the returns from day to day. 06:12.810 --> 06:15.150 But they're not necessarily independent, and they can 06:15.150 --> 06:19.180 surprise you, and that's when crises occur. 06:19.180 --> 06:20.490 We also talked about idiosyncratic 06:20.490 --> 06:23.440 risk and market risk. 06:23.440 --> 06:27.840 Remember we regressed Apple stock's returns on the stock 06:27.840 --> 06:33.450 market's returns and we got a fitted value, which was beta 06:33.450 --> 06:35.170 times the market return. 06:35.170 --> 06:38.400 And that's the market component of Apple risk. 06:38.400 --> 06:43.420 And then we saw that the extra component, idiosyncratic, is 06:43.420 --> 06:45.290 uncorrelated with the market risk. 06:45.290 --> 06:48.340 But in this case it's uncorrelated by construction, 06:48.340 --> 06:51.600 so it has to be uncorrelated. 06:51.600 --> 06:53.870 Oh by the way, I don't know if you caught the news. 06:53.870 --> 06:56.990 It's just coincidence that I mentioned Apple stock in my 06:56.990 --> 06:57.620 last lecture. 06:57.620 --> 06:59.120 You must've heard the news. 06:59.120 --> 07:03.460 It was headline news on the Wall Street Journal. 07:03.460 --> 07:06.120 We had a three-day weekend because of the Martin Luther 07:06.120 --> 07:12.290 King holiday in the U.S. and, over the weekend, Apple 07:12.290 --> 07:19.280 announced that Steve Jobs is taking a long leave of absence 07:19.280 --> 07:22.400 from Apple because of his health. 07:22.400 --> 07:28.660 And so, we talked about that Steve Jobs is viewed by a lot 07:28.660 --> 07:32.920 of people as the genius behind Apple, and the last time he 07:32.920 --> 07:35.570 left for a long time Apple didn't do well. 07:35.570 --> 07:38.960 And so, you wondered what would happen to the stock. 07:38.960 --> 07:43.350 Well, since they announced it on a day just before the 07:43.350 --> 07:48.790 market was closed, and so it opened in Europe and there was 07:48.790 --> 07:54.330 a 7% drop in Germany of Apple shares. 07:54.330 --> 07:58.860 It opened down 5% on Tuesday in the U.S., but then it 07:58.860 --> 08:01.180 recovered and it wasn't really down that much, probably 08:01.180 --> 08:02.730 because there was good earnings 08:02.730 --> 08:05.060 news at the same time. 08:05.060 --> 08:08.400 That's just completing our little story about Apple. 08:15.440 --> 08:19.720 I don't know if I gave enough emphasis to the central limit 08:19.720 --> 08:22.110 theorem last lecture. 08:24.750 --> 08:32.250 This is a fundamental theorem from probability theory, which 08:32.250 --> 08:44.890 says that if you have independent identically 08:44.890 --> 08:47.770 distributed random variables. 08:54.340 --> 08:58.620 That is, every random variable is independent of the other, 08:58.620 --> 09:02.050 and they're all of the same distribution, and if it has a 09:02.050 --> 09:10.930 finite variance, then the distribution of an average of 09:10.930 --> 09:17.090 these variables converges to the normal distribution as the 09:17.090 --> 09:21.510 number of elements in the average is increased. 09:21.510 --> 09:25.020 In other words, averages are approximately normally 09:25.020 --> 09:26.120 distributed. 09:26.120 --> 09:30.910 The bell-shaped curve works as well as it does, because so 09:30.910 --> 09:34.350 many things we observe in nature are averages. 09:34.350 --> 09:38.160 So many things that we observe are the sum of many affects. 09:38.160 --> 09:40.270 This is what history is all about. 09:40.270 --> 09:44.070 Anytime big events occur, it's probably because a number of 09:44.070 --> 09:47.470 things chanced to happen at the same time. 09:47.470 --> 09:52.480 And that's why probability Theorists think that we kind 09:52.480 --> 09:56.450 of know the probability distribution, and that's this 09:56.450 --> 10:02.640 bell-shaped curve which I had on the slide last period. 10:02.640 --> 10:05.420 The critical thing about the bell-shaped curve is that the 10:05.420 --> 10:08.720 tails drop off really fast, after you get a certain 10:08.720 --> 10:10.520 distance up on either end. 10:10.520 --> 10:11.710 They essentially hit zero. 10:11.710 --> 10:12.750 They never hit zero. 10:12.750 --> 10:14.860 The probability is never zero. 10:14.860 --> 10:22.200 Anything can happen with a normally distributed variable. 10:22.200 --> 10:29.880 But the normal distribution does not have fat tails. 10:29.880 --> 10:33.440 After two or three or four standard deviations, basically 10:33.440 --> 10:36.190 the probability is zero that that kind 10:36.190 --> 10:38.500 of thing will happen. 10:38.500 --> 10:39.230 That a return -- 10:39.230 --> 10:42.070 if we're applying it to returns, 10:42.070 --> 10:46.760 that that would occur. 10:46.760 --> 10:50.480 So, the problem with the central limit theorem is that 10:50.480 --> 10:52.900 it's only as good as its assumptions. 10:52.900 --> 10:56.950 And it assumes that the underlying variables have a 10:56.950 --> 11:01.140 finite variance, that they themselves are not so 11:01.140 --> 11:06.220 fat-tailed that the variance of them in infinite. 11:06.220 --> 11:09.850 And in fact, that assumption might be wrong, because we 11:09.850 --> 11:15.390 see, especially in finance, we see big outliers coming from 11:15.390 --> 11:16.640 time to time. 11:19.180 --> 11:21.920 And so I present a theory, and I must say I like the theory. 11:21.920 --> 11:24.480 The central limit theory is an important theory, but it's 11:24.480 --> 11:25.550 also wrong. 11:25.550 --> 11:29.030 And that's the problem with financial theory. 11:29.030 --> 11:33.070 It's not quite as good as the theory that physicists or 11:33.070 --> 11:33.950 chemists use. 11:33.950 --> 11:37.550 It has its limitations. 11:37.550 --> 11:39.850 Nonetheless, that's what we have to talk about. 11:39.850 --> 11:43.670 We have to make do with that as much as we can. 11:48.020 --> 11:50.980 I'm almost done with my review of the last lecture. 11:50.980 --> 11:54.650 I wanted to just correct what I said. 11:54.650 --> 11:57.880 I said that fat-tailed distributions were discovered 11:57.880 --> 12:03.540 by Benoit Mandelbrot, but that's -- 12:03.540 --> 12:05.410 I have to give credit properly. 12:05.405 --> 12:08.315 It's actually his teacher, so I've got this now. 12:14.840 --> 12:23.710 Paul Pierre Levy was a mathematician who lived from 12:23.710 --> 12:29.400 1886 to 1971, who really first developed a theory of 12:29.400 --> 12:31.570 fat-tailed distribution. 12:31.570 --> 12:38.760 And he was at the Ecole Polytechnique in France. 12:38.760 --> 12:46.890 And his student was Benoit Mandelbrot, who was one of the 12:46.890 --> 12:48.690 great mathematicians -- 12:48.690 --> 12:51.260 they're both among the great mathematicians of the 12:51.260 --> 12:52.510 twentieth century. 12:56.726 --> 13:00.626 Our knowledge of fat-tailed distributions comes down to us 13:00.630 --> 13:03.030 through word of mouth. 13:03.030 --> 13:06.570 From Levy, who was Mandelbrot's teacher, to 13:06.570 --> 13:09.590 Mandelbrot, to me, and then to you, I think. 13:09.590 --> 13:13.780 So, we don't require any printed word to know this. 13:13.780 --> 13:16.370 That's the way the history of thought goes. 13:19.450 --> 13:23.270 There's an old joke about the normal distribution. 13:23.270 --> 13:25.180 The joke goes as follows. 13:25.180 --> 13:31.790 The mathematicians think that the normal distribution is 13:31.790 --> 13:35.390 ubiquitous in nature, because applied workers have 13:35.390 --> 13:39.140 discovered that everything is normally distributed. 13:39.140 --> 13:43.140 But applied workers think that the normal distribution is 13:43.140 --> 13:46.620 ubiquitous in nature, because mathematicians have proved 13:46.620 --> 13:49.040 that it's ubiquitous in nature. 13:49.040 --> 13:53.000 In fact, it's sort of ubiquitous, but it sort of 13:53.000 --> 13:53.880 surprises you. 13:53.880 --> 13:54.530 And that's one of the 13:54.530 --> 13:58.080 fundamental lessons in finance. 13:58.080 --> 14:01.040 The fundamental lesson in finance is that you might go 14:01.040 --> 14:04.900 through years observing some random return, or some random 14:04.900 --> 14:08.040 variable in finance, and you kind of think you know how it 14:08.040 --> 14:10.890 behaves, and you've learned some confidence. 14:10.890 --> 14:13.830 There will come a day when it defies all of your 14:13.830 --> 14:17.660 expectations, and that's what fat-tails are all about. 14:20.720 --> 14:27.570 OK, I want it to move on now to today's lecture, which is 14:27.570 --> 14:30.440 about invention, and 14:30.440 --> 14:32.580 particularly financial invention. 14:38.550 --> 14:39.800 How should I start here? 14:50.470 --> 14:55.900 Let me start by recalling how much finance has 14:55.900 --> 15:03.830 changed since 1970. 15:03.830 --> 15:06.780 OK, that's 40 years ago. 15:06.780 --> 15:15.530 In 1970, there were no options exchanges. 15:15.530 --> 15:18.040 Well, there were options, but they were not 15:18.040 --> 15:20.870 traded on any exchange. 15:20.870 --> 15:25.340 There were no financial futures. 15:31.080 --> 15:34.470 There were no swaps. 15:34.470 --> 15:38.890 I haven't defined what these things are for you. 15:38.890 --> 15:40.420 What else did they not have? 15:40.420 --> 15:46.840 They didn't have electronic trading. 15:46.840 --> 15:49.630 They would do trading by word of mouth. 15:49.630 --> 15:52.810 They would meet together on the floor of an exchange and 15:52.810 --> 15:55.710 shout at each other and talk. 15:55.710 --> 15:59.320 I guess they had telephones, but it was all words and 15:59.320 --> 16:03.490 people and writing on paper. 16:03.490 --> 16:10.410 So, the proliferation of financial instruments in 40 16:10.410 --> 16:13.460 years is stunning. 16:13.460 --> 16:17.870 So I wanted to use that as a springboard to think about 16:17.870 --> 16:21.150 what is the next 40 years going to be like? 16:21.150 --> 16:23.760 And if any of you go into finance, this 16:23.760 --> 16:25.500 would be your career. 16:25.500 --> 16:28.290 I think that it's reasonable to suppose that the 16:28.290 --> 16:32.330 transformation that we see in the next 40 years is going to 16:32.330 --> 16:37.340 be just as dramatic as the last 40, or more so, because 16:37.340 --> 16:40.890 technical progress doesn't slow down. 16:40.890 --> 16:43.830 I don't see any reason to think that it's slowing down. 16:47.280 --> 16:50.470 So, I like to think about the future, but it's hard to talk 16:50.470 --> 16:53.280 about the future, because we're not there yet. 16:53.280 --> 16:54.490 I've written a couple of books. 16:54.490 --> 16:58.420 One of them is about the future of finance. 16:58.420 --> 17:04.900 One of them is called Macro Markets, which I wrote in 1993 17:04.900 --> 17:05.940 about the big market. 17:05.940 --> 17:09.300 Macro means big markets that we'll be seeing in the future. 17:09.300 --> 17:11.620 And the other one was called The New Financial Order, which 17:11.620 --> 17:15.420 I wrote in 2003, and we have the introductory chapter there 17:15.420 --> 17:18.850 on the reading list for this lecture. 17:24.840 --> 17:28.360 What I see as happening with all of these -- 17:28.360 --> 17:32.100 Incidentally, we have a lot of questioning of these 17:32.100 --> 17:35.840 inventions now, because they kind of blew up on us in this 17:35.840 --> 17:37.520 financial crisis. 17:37.520 --> 17:40.930 So, it's a little bit like after an airplane crash. 17:40.930 --> 17:43.100 People are kind of critical of the aeronautical 17:43.100 --> 17:45.490 engineers for a while. 17:45.490 --> 17:49.850 Or when they invented steam engines, some of them blew up, 17:49.850 --> 17:51.020 and it was bad. 17:51.020 --> 17:54.050 You know, when a boiler blows up, it scalds all the people 17:54.050 --> 17:56.300 around it, awful. 17:56.300 --> 17:59.140 So people were mad at them for a while. 17:59.140 --> 18:01.810 I think that's what we're going through now. 18:01.810 --> 18:07.020 And people are angry about some of these inventions, but 18:07.020 --> 18:11.540 that's just part of progress. 18:11.540 --> 18:13.620 Well, it doesn't mean that we don't want to regulate them. 18:13.620 --> 18:17.560 We regulate boilers and airplanes right now to prevent 18:17.560 --> 18:21.980 crashes, and we need to regulate our financial markets 18:21.980 --> 18:23.230 just as well. 18:30.470 --> 18:42.610 The financial markets that we have, they're based on 18:42.610 --> 18:43.970 mathematical models. 18:43.970 --> 18:46.950 This is a mathematical discipline, but the 18:46.950 --> 18:52.270 mathematical models depend only on certain intuition. 18:52.270 --> 18:56.440 Maybe, a core part of the intuition that underlies 18:56.440 --> 19:02.870 financial inventions is the idea of independence. 19:05.750 --> 19:08.760 I'm going to try and talk in really basic terms. If risks 19:08.760 --> 19:11.440 are independent of each other, then we can pool 19:11.440 --> 19:13.630 them and they go away. 19:13.630 --> 19:15.050 That's the core idea. 19:18.030 --> 19:21.220 But how to make that happen, requires some thought, and 19:21.220 --> 19:22.900 some devices. 19:25.410 --> 19:29.230 The intuitive idea that we can exploit independence to 19:29.230 --> 19:33.290 improve our lives goes back to ancient times, actually. 19:33.290 --> 19:38.220 A lot of things that people do are done in recognition of 19:38.220 --> 19:41.260 what is independent and what is not. 19:41.260 --> 19:45.050 I think, even the big causes that people get emotional 19:45.050 --> 19:49.280 about over the ages are causes that -- 19:49.280 --> 19:52.240 I can think of them as examples of the application of 19:52.240 --> 19:54.710 probability theory in modern finance. 19:54.710 --> 19:58.630 So, you might not agree with me, but this is my view of it. 19:58.630 --> 20:00.660 Think of socialism. 20:00.660 --> 20:02.210 What is socialism? 20:02.210 --> 20:05.430 Well, you know it was invented by the philosopher, 20:05.430 --> 20:06.930 entrepreneur Robert Owen. 20:06.930 --> 20:09.490 The word was invented by him in the 20:09.490 --> 20:11.350 early nineteenth century. 20:11.350 --> 20:11.870 What is it? 20:11.870 --> 20:15.320 It is that society gets together and pools all of its 20:15.320 --> 20:17.200 activities. 20:17.200 --> 20:19.080 I think, well, why would you want to do that? 20:19.080 --> 20:22.530 One reason you'd do that is that it improves human 20:22.530 --> 20:26.330 welfare, because it shares risks, and we're all in it 20:26.330 --> 20:29.180 together, and, you know, we won't have rich and poor. 20:29.180 --> 20:32.420 I think that's part of Robert Owens' idea. 20:32.420 --> 20:34.980 He was worried about inequality, that some people 20:34.980 --> 20:38.870 are much better off than others, and that's bad, and so 20:38.870 --> 20:41.760 let's create a socialist society. 20:41.760 --> 20:45.240 So, he had an invention of sorts, but it didn't seem to 20:45.240 --> 20:46.750 be a very -- 20:46.750 --> 20:51.780 in his form is was not a very successful invention, because 20:51.780 --> 20:53.260 it didn't work somehow. 20:53.260 --> 20:57.410 He set up a town called New Harmony in the United States, 20:57.410 --> 21:00.040 which was supposed to be harmonious, by the name of the 21:00.040 --> 21:02.570 town, and everything was shared. 21:02.570 --> 21:05.420 And unfortunately, they ended up arguing and fighting 21:05.420 --> 21:07.470 amongst each other, and they were not happy. 21:07.470 --> 21:09.310 He didn't get it figured out right. 21:09.310 --> 21:13.140 He was trying to pool risk, but he didn't do it. 21:13.140 --> 21:16.360 There are other idealistic societies that try to do it, 21:16.360 --> 21:18.620 like the kibbutzim in Israel. 21:18.620 --> 21:21.570 That's one of many where people get together and form a 21:21.570 --> 21:25.050 community, and they pool everything, and it kind of 21:25.050 --> 21:26.730 works for some people. 21:26.730 --> 21:30.660 But only a tiny fraction of the population in Israel lives 21:30.660 --> 21:32.370 on a kibbutz now. 21:32.370 --> 21:33.160 Why not? 21:33.160 --> 21:36.300 I think most people just don't fit in that way. 21:36.300 --> 21:39.370 We share everything. 21:39.370 --> 21:41.160 After a few months living there you might 21:41.160 --> 21:43.170 think, I'm out of here. 21:43.170 --> 21:44.670 I don't want to share everything with everybody. 21:47.490 --> 21:48.890 So, people do things. 21:48.890 --> 21:55.010 In the Old West, the pioneers in America, they had a kind of 21:55.010 --> 21:57.910 a social contract, that, if one farmer's house burned 21:57.910 --> 22:01.820 down, everyone will come by and help and erect a new house 22:01.820 --> 22:02.970 for that person. 22:02.970 --> 22:04.720 So that's, again, risk management. 22:04.720 --> 22:05.570 That's it. 22:05.570 --> 22:06.610 And it works. 22:06.610 --> 22:10.680 It sounds almost like a moral thing, but it works only, 22:10.680 --> 22:13.010 because they don't all burn down at the same time. 22:13.010 --> 22:17.570 It would be totally worthless if they all did. 22:17.570 --> 22:20.500 And so, there are primitive ideas of insurance that 22:20.500 --> 22:23.320 underlie that, but the ideas aren't worked out well. 22:23.320 --> 22:26.560 And it doesn't perhaps work well to do it on such an 22:26.560 --> 22:27.850 informal basis. 22:27.850 --> 22:33.310 So, our society has particular inventions that, we call them 22:33.310 --> 22:35.820 financial or insurance inventions, that make these 22:35.820 --> 22:37.070 things work better. 22:44.210 --> 22:47.430 What we're talking about is motivated by theory, the 22:47.430 --> 22:49.720 mathematical theory of finance, but that's not the 22:49.720 --> 22:51.510 subject of this course. 22:51.510 --> 22:54.400 I want to in this course talk more about the inventions 22:54.400 --> 23:03.000 themselves and in particular we'll be talking about risk 23:03.000 --> 23:05.410 management. 23:05.410 --> 23:08.750 Now, this brings up a basic issue about finance. 23:08.745 --> 23:11.295 Is finance good? 23:11.300 --> 23:14.900 Is it helpful to people? 23:14.900 --> 23:19.940 You know, a huge issue in the history of humankind is 23:19.940 --> 23:21.170 inequality. 23:21.170 --> 23:25.560 And that people get upset when it seems like other people 23:25.560 --> 23:28.270 have an unfair advantage over us. 23:28.270 --> 23:31.790 But inequality is something that you'd think finance works 23:31.790 --> 23:35.610 against. Modern finance is about risk management. 23:35.610 --> 23:39.020 So, you can get rid of the purely random elements in 23:39.020 --> 23:42.660 people's lives, that should make people more equal. 23:42.660 --> 23:43.640 It should be a good thing. 23:43.640 --> 23:45.490 That is the way I view it. 23:45.490 --> 23:48.680 But the other side of finance is that it also creates 23:48.680 --> 23:53.380 opportunity, and opportunity is very important also. 23:53.380 --> 23:56.410 We can all be equal and living in poverty, and we don't 23:56.410 --> 23:58.370 particularly like that. 23:58.370 --> 24:05.390 So that's why financial inventions eventually inspire 24:05.390 --> 24:07.350 and get people excited. 24:07.350 --> 24:10.460 I always remember Deng Xiaoping's famous statement in 24:10.460 --> 24:15.110 the late 1970's, when China was adopting 24:15.110 --> 24:16.700 modern financial methods. 24:16.700 --> 24:22.300 And some people were getting rich, and someone asked Deng, 24:22.300 --> 24:26.390 isn't this inconsistent with our ideology? 24:26.390 --> 24:30.150 And he said, well, and I'm quoting approximately, we're 24:30.150 --> 24:32.350 all going to get rich, but somebody has to get rich 24:32.350 --> 24:34.750 first. And that's the way it is. 24:34.750 --> 24:39.140 Financial markets do manage risk. 24:39.140 --> 24:42.380 But they also create opportunities and that can 24:42.380 --> 24:45.960 actually increase inequality. 24:45.960 --> 24:48.790 So, you have to consider both sides of it. 24:53.630 --> 24:56.120 Maybe the most important concept in 24:56.120 --> 25:00.300 finance really is risk. 25:00.300 --> 25:05.610 And risk is all about limiting inequality, or at least the 25:05.610 --> 25:11.740 random, gratuitous inequality, right? 25:11.740 --> 25:19.120 People are troubled by inequality if it's arbitrary, 25:19.120 --> 25:22.350 but, you know, most people wouldn't begrudge someone who 25:22.350 --> 25:27.470 works very hard and shows real genius and insight, and makes 25:27.470 --> 25:29.220 a lot of money, most people say that's all right. 25:33.890 --> 25:39.250 Part of the way we deal with risk is our taxes, tax and 25:39.250 --> 25:40.500 welfare system. 25:44.960 --> 25:47.550 I'm going to come back to that, mostly in our second to 25:47.550 --> 25:48.800 last lecture. 25:51.040 --> 25:54.640 We have a progressive income tax that taxes rich people 25:54.640 --> 25:57.250 more, and we have welfare. 25:57.250 --> 25:59.320 And we also have, I should add, it's not counted as 25:59.320 --> 26:04.540 welfare, but free public education, which is a form of, 26:04.540 --> 26:07.130 I wouldn't call it welfare, but it's an equalizing 26:07.130 --> 26:08.710 expenditure. 26:08.710 --> 26:11.060 These are actually our most important 26:11.060 --> 26:13.690 risk management devices. 26:13.690 --> 26:17.510 That's what makes life tolerable in modern society, 26:17.510 --> 26:24.140 that we do have progressive taxes and welfare. 26:24.140 --> 26:26.490 But we don't rely on those exclusively. 26:26.490 --> 26:30.860 And so, finance is getting into the other dimensions. 26:30.860 --> 26:34.390 And we kind of want to let insurance, private insurance, 26:34.390 --> 26:37.220 rather than social insurance, flourish. 26:37.220 --> 26:41.710 Because when the government handles everything, it doesn't 26:41.710 --> 26:46.450 seem to work as effectively or creatively as it can if we let 26:46.450 --> 26:48.970 private entrepreneurs handle things. 26:52.350 --> 26:59.890 So, what we're talking about here, and to always put it in 26:59.890 --> 27:03.640 perspective, what we're talking about in this course, 27:03.640 --> 27:09.440 is about something that is an add-on to an existing welfare 27:09.440 --> 27:10.900 and tax system. 27:10.900 --> 27:16.410 But an add-on that is, we hope, particularly effective. 27:16.410 --> 27:22.280 And it's added-on by people in their own self-interest, or 27:22.280 --> 27:27.700 maybe for their own purposes, but something that ultimately 27:27.700 --> 27:32.110 contributes to a, I think, a better world. 27:32.110 --> 27:34.400 That's what I want to. 27:38.190 --> 27:39.970 I have several themes in this lecture. 27:39.970 --> 27:42.670 The first is a risk theme, which I've just discussed. 27:45.350 --> 27:49.710 Another theme I want to talk about here is a framing theme. 27:57.130 --> 28:00.330 Psychologists use the term framing to refer to the 28:00.330 --> 28:07.790 context and associations that we have with some thing. 28:07.790 --> 28:15.210 So, the way people use things depends on what they see them 28:15.210 --> 28:22.210 associated with, because people can't think through to 28:22.210 --> 28:24.540 the fundamental theory all the time. 28:24.540 --> 28:27.430 So, we have to frame things in a way that's 28:27.430 --> 28:28.690 convenient to people. 28:28.690 --> 28:31.040 And this is part of financial engineering. 28:31.040 --> 28:34.200 I'll come back to that in a minute. 28:37.770 --> 28:40.480 Framing has to do with language, names 28:40.480 --> 28:42.010 that we give to things. 28:42.010 --> 28:48.020 We have to design inventions, so that they're 28:48.020 --> 28:50.380 framed in good ways. 28:50.380 --> 28:51.760 I'll explain that in a minute. 28:51.760 --> 28:56.130 And then, I have a device theme, that finance is really 28:56.130 --> 29:01.560 about devices like steam engines. 29:01.560 --> 29:05.340 We call them financial contracts. 29:05.340 --> 29:16.160 Devices are complicated structures that we set up for 29:16.160 --> 29:22.740 a certain purpose, like airplanes or automobiles, and 29:22.740 --> 29:30.170 we learn through time how to make them better and better. 29:30.170 --> 29:35.680 And they tend to come on the world with 29:35.680 --> 29:37.780 a flourish or surprise. 29:37.780 --> 29:40.790 There's some new invention. 29:40.790 --> 29:43.950 You know, when the Wright Brothers first exhibited the 29:43.950 --> 29:47.740 airplane in the Paris Air Show in 1904, I 29:47.740 --> 29:49.770 think, people were stunned. 29:49.770 --> 29:52.250 They were actually flying. 29:52.250 --> 29:54.550 And it immediately set up around the world 29:54.550 --> 29:56.390 the aircraft industry. 29:59.570 --> 30:00.770 If you look around the world, these 30:00.770 --> 30:03.080 devices look very similar. 30:03.080 --> 30:05.150 Automobiles, airplanes they look almost the 30:05.150 --> 30:07.300 same in every country. 30:07.300 --> 30:12.160 But that's because they have an internal logic to them that 30:12.160 --> 30:14.300 makes them work well. 30:14.300 --> 30:18.810 And the logic may not be apparent to you. 30:18.810 --> 30:23.180 You might not, probably don't, fully understand why a device 30:23.180 --> 30:25.580 works as well as it does. 30:25.580 --> 30:28.740 Well, I have an example of a simple invention. 30:28.740 --> 30:32.770 I was curious, I haven't used this example before, how many 30:32.770 --> 30:35.620 of you use this invention? 30:35.620 --> 30:37.430 You know what a gimlet is? 30:40.370 --> 30:44.150 How many of you own a gimlet? 30:44.150 --> 30:44.820 Nobody. 30:44.820 --> 30:46.480 Nobody owns a gimlet. 30:46.480 --> 30:48.480 Can someone tell me what a gimlet is? 30:52.100 --> 30:53.350 It's amazing. 30:58.040 --> 31:01.340 A gimlet is a simple tool that everyone used to 31:01.340 --> 31:05.080 have 100 years ago. 31:05.080 --> 31:08.750 And what does it look like? 31:14.972 --> 31:17.102 It's made out of wire. 31:25.920 --> 31:28.620 This is a handle. 31:28.620 --> 31:31.250 OK, do you have a gimlet now that I've drawn 31:31.250 --> 31:32.500 a picture of it? 31:35.580 --> 31:37.790 So what you did with those -- they were really cheap. 31:37.790 --> 31:41.700 You could buy one in 1820, go to a hardware store in 31:41.700 --> 31:42.680 downtown New Haven. 31:42.680 --> 31:44.100 They'd have a whole set of them. 31:44.100 --> 31:46.590 And you use it to make holes. 31:46.590 --> 31:48.000 And it works really well. 31:48.000 --> 31:49.640 I find you can buy them on the internet. 31:49.640 --> 31:53.050 I bought one out of curiosity, and now I use it. 31:53.050 --> 31:57.840 The point it that inventions come and go. 31:57.840 --> 32:02.870 The nice thing about a gimlet is, it's really nice, it comes 32:02.870 --> 32:04.530 to a pin point. 32:04.530 --> 32:08.220 And if you want to make a hole in wood, you just push it in, 32:08.220 --> 32:11.230 and it goes exactly where you want it. 32:11.230 --> 32:12.780 And then you just turn it a little bit and 32:12.780 --> 32:15.350 it goes right in. 32:15.350 --> 32:18.610 But we have electric drills now, right? 32:18.610 --> 32:20.110 We're kind of used to them. 32:20.110 --> 32:22.230 The problem, you know, once you start using a 32:22.230 --> 32:23.680 gimlet, you love it. 32:23.680 --> 32:26.920 Because you can control it so well. 32:26.920 --> 32:29.230 That drill, when you start drilling, it kind of bounces 32:29.230 --> 32:32.110 around, and it doesn't make the hole where you want it. 32:32.110 --> 32:37.000 So, there's something good about this invention. 32:37.000 --> 32:40.430 But you can go out and buy one now for very little money on 32:40.430 --> 32:41.240 the internet. 32:41.240 --> 32:43.350 It'll be mailed to you. 32:43.350 --> 32:45.700 Now that I have it, I'm thinking about it all the time 32:45.700 --> 32:46.720 for using it. 32:46.720 --> 32:48.750 But somehow it comes and goes. 32:48.750 --> 32:51.690 Inventions are part of our culture that appear and 32:51.690 --> 32:54.000 disappear through time. 32:58.750 --> 33:02.340 I wanted to talk about another invention. 33:02.340 --> 33:04.910 This is by way of inspiration. 33:04.910 --> 33:07.830 I'm getting to finance in a minute, but I have to do 33:07.830 --> 33:09.100 these simple -- 33:09.100 --> 33:10.880 Maybe someone will reintroduce the gimlet. 33:10.880 --> 33:11.940 I don't know. 33:11.940 --> 33:14.160 It's probably gone forever. 33:14.160 --> 33:17.740 It illustrates the fact that modern electronic technology 33:17.740 --> 33:20.140 has given us something maybe better. 33:20.140 --> 33:22.700 But if you were used to using this, you'd want it. 33:22.700 --> 33:25.060 You know, I just don't want to use that electric drill, 33:25.060 --> 33:30.660 because I know how to use this, and I can control it. 33:30.660 --> 33:34.860 I'll give you another example of an important invention 33:34.860 --> 33:39.060 which I saw come in my lifetime and 33:39.060 --> 33:40.310 that's wheeled suitcases. 33:42.990 --> 33:45.210 OK, I bet you have one of these. 33:45.210 --> 33:48.830 Right, a suitcase with wheels on it? 33:48.830 --> 33:52.990 When I was a boy there were absolutely none. 33:52.990 --> 33:54.200 Nowhere. 33:54.200 --> 33:57.630 No one had a wheeled suitcase. 33:57.630 --> 33:58.820 Isn't that strange? 33:58.820 --> 34:00.770 You'd be carrying these suitcases around. 34:00.770 --> 34:06.230 You put it on wheels, and so I looked up the 34:06.230 --> 34:08.780 inventors of this. 34:08.776 --> 34:10.246 It's not that long ago. 34:16.320 --> 34:19.510 The wheeled suitcase was invented by 34:19.510 --> 34:30.210 Bernard Sadow in 1972. 34:30.210 --> 34:32.900 And his was the first one. 34:32.900 --> 34:36.240 He had a suitcase with little wheels, four little wheels, 34:36.240 --> 34:38.940 and you had a strap and you'd pull it, and it would trail 34:38.940 --> 34:40.570 behind you. 34:40.570 --> 34:44.070 But then the other, the really important invention, was by 34:44.070 --> 34:46.430 Robert Plath. 34:46.430 --> 34:49.010 This isn't finance, but I kind of think of it as finance. 34:52.680 --> 34:55.600 It was 1991. 34:55.600 --> 34:57.210 And he called it the RollAboard. 34:57.210 --> 34:58.260 This is what you own, right? 34:58.260 --> 35:00.580 You own a RollAboard, right? 35:00.580 --> 35:05.450 It has a rigid handle that collapses into the suitcase, 35:05.450 --> 35:07.380 and has two wheels that are horizontal. 35:07.380 --> 35:10.880 The problem with Bernard Sadow's invention is that it 35:10.880 --> 35:11.920 tended to flop over. 35:11.920 --> 35:15.840 You're pulling it with a strap behind you, and then you look 35:15.840 --> 35:17.520 back and it's flopped over. 35:17.520 --> 35:19.690 You can't go around corners very well. 35:19.690 --> 35:23.770 So, we lived with Sadow's for 19 years. 35:23.770 --> 35:29.900 It took 19 years to invent the modern RollAboard. 35:29.900 --> 35:32.340 I actually heard from Bernard Sadow. 35:32.340 --> 35:34.560 I wrote about him in The New Financial Order. 35:34.560 --> 35:37.810 And I got a letter from him about two weeks ago, 35:37.810 --> 35:39.230 or email from him. 35:39.230 --> 35:42.760 And he said, I heard about your book and that you talked 35:42.760 --> 35:44.860 about me in your book. 35:44.860 --> 35:47.460 And he said you he'd like to get me to 35:47.460 --> 35:49.030 autograph it for him. 35:49.030 --> 35:51.950 So I said fine, I'll send you the book. 35:51.950 --> 35:54.580 And I sent him an autograph with appreciation. 35:54.580 --> 35:57.020 That just shows, it's not long ago. 35:57.020 --> 36:00.550 So I guess, I could ask you to reflect, why didn't people 36:00.550 --> 36:01.800 have wheeled suitcases? 36:04.520 --> 36:06.420 But you weren't born yet, right, so you 36:06.420 --> 36:07.640 can't reflect on it. 36:07.640 --> 36:09.960 I'm thinking back to myself. 36:09.960 --> 36:11.090 You know, it's almost something 36:11.090 --> 36:12.230 that I would do myself. 36:12.230 --> 36:13.700 I would put wheels on it. 36:13.700 --> 36:14.950 But I guess you were embarrassed 36:14.950 --> 36:15.860 to do it back then. 36:15.860 --> 36:19.270 Because maybe it seemed sissy. 36:19.270 --> 36:21.310 But was everybody worried about being a sissy? 36:21.310 --> 36:22.010 Not everybody. 36:22.010 --> 36:23.710 Why didn't anybody do it? 36:23.710 --> 36:27.170 Well, Bernard Sadow, I had my student interview him, and he 36:27.165 --> 36:31.375 had listened to objections, and people told him in 1972, 36:31.380 --> 36:33.610 no one's going to buy that. 36:33.610 --> 36:38.830 Because if the suitcase is too heavy, you just get a redcap. 36:38.830 --> 36:40.080 You know what a redcap is? 36:42.860 --> 36:46.840 A redcap is someone, a poorly paid person, who stands around 36:46.840 --> 36:49.720 at train stations, with wearing a red cap, and helps 36:49.720 --> 36:51.230 you with your luggage. 36:51.230 --> 36:51.960 Right? 36:51.960 --> 36:53.380 That's not a good answer, right? 36:53.380 --> 36:56.700 There isn't always a redcap to help you, and so obviously you 36:56.700 --> 36:59.100 need wheels on suitcases. 36:59.100 --> 37:01.610 But this illustrates how technology moves. 37:01.610 --> 37:04.320 It moves sometimes slowly. 37:04.320 --> 37:07.840 I'll give you a couple other examples from my book about 37:07.840 --> 37:09.800 the slowness of inventions. 37:09.800 --> 37:12.080 One is just the invention of wheels. 37:12.080 --> 37:16.150 Did you know that in the Americas before Columbus there 37:16.150 --> 37:17.030 were no wheels? 37:17.030 --> 37:18.880 No wheeled vehicles. 37:18.880 --> 37:23.400 The American Indians had no wheeled vehicles at all, not 37:23.400 --> 37:24.320 even suitcases. 37:24.320 --> 37:24.770 Nothing. 37:24.770 --> 37:25.790 No wagons. 37:25.790 --> 37:27.150 Nothing. 37:27.150 --> 37:31.310 And then to complicate it, they've discovered, from the 37:31.310 --> 37:34.280 late classical period in Mexico, they've discovered 37:34.280 --> 37:35.770 wheeled toys. 37:35.770 --> 37:39.450 And if you go to a museum in Mexico you can see them. 37:39.450 --> 37:41.060 They made toys for their kids. 37:41.060 --> 37:44.170 They're not cars, they're little jaguars and animals, 37:44.170 --> 37:46.050 and you could roll them along the floor. 37:46.050 --> 37:47.680 So they made the toys, why didn't they 37:47.680 --> 37:49.630 think of making a wagon? 37:49.630 --> 37:52.310 It just never occurred to them. 37:52.310 --> 37:55.610 And another example I give in my book that I really like is 37:55.610 --> 37:57.420 the movie subtitle. 37:57.420 --> 37:59.480 This is an amazing thing. 37:59.480 --> 38:00.710 When they invented movies -- 38:00.710 --> 38:03.120 I gave you a Thomas Edison sound movie, 38:03.120 --> 38:04.430 but it didn't work. 38:04.430 --> 38:05.900 He couldn't make a sound movie. 38:05.900 --> 38:07.760 They didn't find out how to make sound 38:07.760 --> 38:09.930 movies until the 1920's. 38:09.930 --> 38:12.880 So they did, in order to give dialogue to a movie, they'd 38:12.880 --> 38:15.030 give what they called intertitles. 38:15.030 --> 38:16.890 They would show the movie, you know what I'm saying? 38:16.890 --> 38:18.910 Then they'd stop the movie and there would be a title with 38:18.910 --> 38:22.050 some phrase that someone said, and then it would 38:22.050 --> 38:23.300 go back to the movie. 38:25.895 --> 38:28.675 But it's obviously better just to put subtitles on the bottom 38:28.680 --> 38:29.510 of the screen, right? 38:29.510 --> 38:31.330 Let the movie proceed. 38:31.330 --> 38:33.100 You've seen movies with subtitles, right? 38:33.100 --> 38:34.610 It works fine. 38:34.610 --> 38:37.470 Well, it turns out that someone tried it in 1920. 38:37.470 --> 38:40.100 There was a movie called The Chamber Mystery. 38:40.100 --> 38:45.050 And someone made us a subtitled silent movie, but 38:45.050 --> 38:46.780 the response was bad. 38:46.780 --> 38:48.900 It seemed like nobody liked it. 38:48.900 --> 38:50.880 And so, it wasn't for another -- 38:50.880 --> 38:53.420 subtitles didn't come in until after 38:53.420 --> 38:55.740 sound movies were invented. 38:55.740 --> 38:58.530 After sound movies were invented, they wanted to make 38:58.530 --> 39:01.660 movies in one language and show them in another country, 39:01.660 --> 39:04.210 so they had to put subtitles in, so that people in another 39:04.210 --> 39:06.300 country could see the movie. 39:06.300 --> 39:10.100 And then that's how it came in. 39:10.100 --> 39:12.050 There's a slowness to understand 39:12.050 --> 39:13.690 or appreciate invention. 39:13.690 --> 39:21.080 Anyway, I want to move to invention in finance, and the 39:21.080 --> 39:25.490 analogies that I just talked about are important. 39:25.490 --> 39:29.200 So let me start with an important invention in finance 39:29.200 --> 39:31.970 that goes way back. 39:36.160 --> 39:39.930 Well, I think I mentioned last time, the very simple idea of 39:39.930 --> 39:43.740 setting up a company and dividing up shares in the 39:43.740 --> 39:45.880 company, that's a really old invention. 39:45.880 --> 39:47.760 That's thousands of years old. 39:47.760 --> 39:50.380 All right, you and your friends are going to do a 39:50.380 --> 39:54.170 business, how do we divide up the profits? 39:54.170 --> 39:56.930 Well, let's give shares to each of us. 39:56.930 --> 39:59.820 And the guy who's contributing more gets more shares, right? 39:59.820 --> 40:03.500 And someone who's contributing less gets less shares. 40:03.500 --> 40:06.030 But then, we all have an incentive to make the company 40:06.030 --> 40:12.930 go, and that's the idea of a corporation. 40:12.930 --> 40:16.670 Corporation comes from the Latin word 40:16.670 --> 40:18.970 corpus, which is body. 40:18.970 --> 40:24.950 It becomes like a slave owned mutually by all the people in 40:24.950 --> 40:26.150 the company. 40:26.150 --> 40:29.390 And your share in the company is determined by the number of 40:29.390 --> 40:31.230 shares that you own. 40:31.230 --> 40:33.520 But I wanted to focus here -- that's an old idea. 40:33.520 --> 40:34.760 It's an invention. 40:34.760 --> 40:36.140 But I wanted to really focus on a 40:36.140 --> 40:40.360 particular nuance that developed. 40:40.360 --> 40:43.410 It's limited liability. 40:53.566 --> 40:58.946 A limited liability corporation is a corporation 40:58.950 --> 41:05.110 that guarantees that you as a shareholder will not be liable 41:05.110 --> 41:08.000 for the debts of the company. 41:08.000 --> 41:10.370 In England, they sometimes will put limited. 41:10.370 --> 41:15.030 The name of the company, after it we'll say limited. 41:15.030 --> 41:19.360 But in the U.S., we just say incorporated, so that tells 41:19.360 --> 41:22.800 you that it's limited liability. 41:22.800 --> 41:26.390 What it's talking about, limited liability means that 41:26.390 --> 41:31.190 somebody's sues the company, and the company can't pay, 41:31.190 --> 41:33.050 they can't go after the stockholders. 41:35.880 --> 41:39.370 limited liability has kind of a complicated history. 41:39.370 --> 41:45.670 But according to a history by David Moss, who was a Yale 41:45.670 --> 41:50.770 history graduate student when he wrote this, but is now at 41:50.770 --> 41:56.500 Harvard Business School, limited liability really took 41:56.500 --> 42:06.530 hold in 1811 with a corporate law in the state of New York 42:06.530 --> 42:11.130 which represented a significant invention. 42:11.130 --> 42:15.630 The corporate law of New York in 1811 actually had two 42:15.630 --> 42:17.730 important components. 42:17.730 --> 42:21.210 The first component was, anybody can start a 42:21.210 --> 42:22.460 corporation. 42:24.130 --> 42:28.310 Just file the papers with the government of New York, and 42:28.310 --> 42:29.890 you've got a corporation. 42:29.890 --> 42:33.230 There may have been some regulatory requirements, but 42:33.230 --> 42:36.700 the point was, you didn't need an act of congress, or an act 42:36.700 --> 42:38.430 of parliament, to start a corporation. 42:38.425 --> 42:42.515 It used to be very hard to start a company, because 42:42.520 --> 42:44.870 people would say, well, what's your purpose? 42:44.870 --> 42:48.730 And you know, we don't just do this automatically. 42:48.730 --> 42:51.950 That was the first part of the New York law in 1811. 42:51.950 --> 42:55.470 But the second part is particularly interesting. 42:55.470 --> 42:59.190 They said under no circumstances can the 42:59.190 --> 43:01.140 shareholders be sued. 43:01.140 --> 43:04.200 You put in your money to the company, that's it. 43:04.200 --> 43:05.800 You are protected by the law. 43:05.800 --> 43:10.070 No worries about that. 43:10.070 --> 43:14.100 Now, this was the first corporate law in the world, 43:14.100 --> 43:18.310 according to Moss, that imposed limited liability as a 43:18.310 --> 43:20.770 clear right of the shareholder. 43:20.770 --> 43:24.070 There were limited liability clauses before, but it was 43:24.070 --> 43:26.750 never so crystal clear. 43:26.750 --> 43:31.950 At the same time, around 1811, other states in the United 43:31.950 --> 43:35.800 States were looking at New York and saying, you're crazy. 43:35.800 --> 43:36.950 What are you doing? 43:36.950 --> 43:38.550 You can't sue the shareholders? 43:38.550 --> 43:42.430 They could do something irresponsible. 43:42.430 --> 43:44.690 And so, the state of Massachusetts, at around the 43:44.690 --> 43:48.360 same year, made a completely opposite law. 43:48.360 --> 43:51.970 They made it clear that the shareholders are responsible. 43:51.970 --> 43:54.990 You invest in a company, you're responsible. 43:54.990 --> 43:57.860 And that's the only way it's fair, they thought. 43:57.860 --> 43:59.610 Well, guess what happened? 43:59.610 --> 44:02.840 New York became the financial center of America. 44:02.840 --> 44:06.770 Nobody wanted to set up a company in Massachusetts 44:06.770 --> 44:09.950 anymore, because they couldn't raise money. 44:09.950 --> 44:16.030 The capitalists were at risk. 44:16.030 --> 44:19.640 If you bought one share in a company in Massachusetts, and 44:19.640 --> 44:22.660 the company did something criminal, let's say, or bad, I 44:22.660 --> 44:26.360 don't know, something bad, then they come, they might sue 44:26.360 --> 44:29.470 the company, and then come looking for anybody who is 44:29.470 --> 44:30.330 among the shareholders. 44:30.330 --> 44:32.650 You owned one share in the company, so we can take 44:32.650 --> 44:33.920 everything from you. 44:33.920 --> 44:35.870 We can take your house, your car. 44:35.870 --> 44:37.280 Well, you didn't have a car. 44:37.280 --> 44:41.500 Take whatever you have. So the rule was, be really careful 44:41.500 --> 44:43.020 before you invest in any company. 44:43.020 --> 44:45.210 And you've got to watch them all the time. 44:45.210 --> 44:46.560 But you know what that did? 44:46.560 --> 44:49.020 That kept Massachusetts down. 44:49.020 --> 44:50.920 Because nobody wanted to do that. 44:50.920 --> 44:53.440 I mean you'd only invest with trusted friends. 44:53.440 --> 44:56.030 You'd never invest in just some random company. 44:56.030 --> 44:59.150 But what happened in New York was that companies started 44:59.150 --> 45:02.360 appearing rapidly because of this. 45:02.360 --> 45:06.860 And as many critics said, a lot of these companies are 45:06.860 --> 45:09.280 fly-by-night, they're going to go under, we're going to find 45:09.280 --> 45:11.930 out that they weren't doing a good business. 45:11.930 --> 45:13.540 They were just show-offs. 45:13.542 --> 45:16.362 And they go bankrupt. 45:16.360 --> 45:19.520 But some of those companies did extremely well, and they 45:19.520 --> 45:25.040 created a powerful New York economy. 45:25.040 --> 45:28.550 Then people learned, well, you could invest in 100 companies. 45:28.550 --> 45:29.980 And 99 of them will go under. 45:29.980 --> 45:31.630 They're all wild. 45:31.630 --> 45:32.550 Not all of them. 45:32.550 --> 45:34.810 There's one of them that would be the Walmart 45:34.810 --> 45:38.000 and make you rich. 45:38.000 --> 45:41.750 So, the example set by New York was eventually copied by 45:41.750 --> 45:46.790 Massachusetts, by every state in the United States, by every 45:46.790 --> 45:50.720 country in Europe, and now every country in the world. 45:50.720 --> 45:57.810 See, it was an experiment that might not have gone well. 45:57.810 --> 46:00.190 You know what David Moss thought, and this has to do 46:00.190 --> 46:01.790 with framing again. 46:01.790 --> 46:05.800 Moss thought that, why is it that New York became such a 46:05.800 --> 46:07.020 capital of finance? 46:07.020 --> 46:08.460 Because of this law. 46:08.460 --> 46:12.150 And because it made investing fun. 46:12.150 --> 46:14.290 And this is a matter of framing. 46:14.290 --> 46:19.240 Moss emphasized that when you buy share in a company, and 46:19.240 --> 46:23.160 it's limited liability, you know that you have already put 46:23.160 --> 46:26.250 out all the money that you'll ever put out. 46:26.250 --> 46:28.990 But you could get an infinite amount, well, there's no limit 46:28.985 --> 46:31.585 to the amount of money on the upside. 46:31.590 --> 46:36.200 And he thought that just framed better as a 46:36.200 --> 46:38.850 psychologically appealing gamble. 46:38.850 --> 46:40.570 It's like a lottery ticket. 46:40.570 --> 46:43.110 People like lottery tickets, right? 46:43.110 --> 46:44.700 They just enjoy the thought. 46:44.700 --> 46:46.780 I don't do this, but apparently a lot 46:46.780 --> 46:47.690 of people do it. 46:47.690 --> 46:50.100 You go and you spend a dollar for a lottery ticket, or two 46:50.100 --> 46:53.830 dollars for a lottery ticket, and then you think, tonight I 46:53.830 --> 46:57.610 could be a millionaire, all right? 46:57.610 --> 47:00.820 That's just so much fun that you want to do it again. 47:00.820 --> 47:03.780 But if the lottery ticket said, well you have a small 47:03.780 --> 47:06.220 probability of being a millionaire, but you also have 47:06.220 --> 47:08.550 a small probability of going bankrupt. 47:08.550 --> 47:11.240 We're going to come after you and take everything. 47:11.240 --> 47:12.090 You wouldn't like that. 47:12.090 --> 47:14.480 That wouldn't be so much fun. 47:14.480 --> 47:19.600 You like to savor the possibility of getting rich. 47:19.600 --> 47:22.750 And so, people flock to these stocks. 47:22.750 --> 47:23.740 It's like a sport. 47:23.740 --> 47:29.670 It's an invention of something fun to do for a lot of people. 47:29.670 --> 47:32.730 But it has this productive side to it that it funnels 47:32.730 --> 47:35.730 capital to where it's needed. 47:35.730 --> 47:39.350 So, that was an important invention. 47:39.350 --> 47:44.360 I want to give you another example that is a 47:44.360 --> 47:47.460 variation on this. 47:47.460 --> 47:49.690 I'm going to move forward in time. 47:49.690 --> 47:52.490 My next invention is the--uh, I'm breaking chalk here. 47:57.870 --> 48:01.100 PROFESSOR ROBERT SHILLER: This goes now to China, Township 48:01.100 --> 48:14.500 and Village Enterprise or TVE. 48:14.500 --> 48:17.940 I'll try to say it in Chinese. 48:17.940 --> 48:22.770 Xiang zhen qi ye, did I say that right? 48:22.770 --> 48:25.850 Close anyway. 48:25.850 --> 48:28.140 So what was this? 48:28.140 --> 48:33.050 When China emerged from a communist, strictly communist 48:33.050 --> 48:38.300 state, in the early period in the -- 48:38.300 --> 48:43.370 maybe starting in the late '70s, but more in the 1980's, 48:43.370 --> 48:46.740 the Chinese economy increasingly became built on a 48:46.740 --> 48:53.240 certain kind of organization called a township or TVE. 48:53.240 --> 48:58.260 And the TVE was like a company, a corporation, except 48:58.260 --> 49:03.030 that it always involved the town. 49:03.030 --> 49:05.990 So in other words, if you wanted to start a business, 49:05.990 --> 49:10.850 making something, making toys for export to the world, you 49:10.850 --> 49:13.050 wouldn't just start a toy company. 49:13.050 --> 49:16.890 You would go to the mayor of your town, and you'd talk to 49:16.890 --> 49:21.010 the mayor and say, I want to start a toy company as this 49:21.010 --> 49:24.810 town's enterprise, and I want to share the profits with you, 49:24.810 --> 49:26.870 with the whole town. 49:26.870 --> 49:29.500 Now, this is kind of unique. 49:29.500 --> 49:31.260 Well, I don't know if it's unique, but we don't see this 49:31.260 --> 49:33.380 in the United States. 49:33.380 --> 49:34.790 But it proliferated. 49:34.790 --> 49:39.530 It was actually the invention that led to initial successes 49:39.530 --> 49:41.850 of the Chinese economy. 49:41.850 --> 49:47.580 By 1985, I believe, I have the statistics here, there were 12 49:47.580 --> 49:49.720 million TVEs in China. 49:52.350 --> 49:58.290 By the mid-1990's, most of the industrial production of China 49:58.290 --> 50:01.550 was done by TVE. 50:01.550 --> 50:03.520 So then you have to ask why -- 50:03.520 --> 50:04.960 this is an invention, but we don't 50:04.960 --> 50:08.170 see it in other countries. 50:08.170 --> 50:10.140 Why in China? 50:10.140 --> 50:13.450 Well, people who look back on it think that it was inventing 50:13.450 --> 50:18.920 around certain constraints at the time in China. 50:18.920 --> 50:23.010 And that the invention got around a legal constraint. 50:23.010 --> 50:27.610 That China, having been a communist country, did not 50:27.610 --> 50:30.760 have all these financial lawyers. 50:30.760 --> 50:36.070 And they did not have courts that enforced legal contracts 50:36.070 --> 50:37.630 the way we do in the U.S. 50:37.630 --> 50:44.440 And that entrepreneurs in China were inhibited from 50:44.440 --> 50:46.420 starting an enterprise, because they thought it would 50:46.420 --> 50:49.270 just be usurped by the village. 50:49.270 --> 50:52.970 You live in a village, you start a toy company, as soon 50:52.970 --> 50:56.670 as you start making money, they'll just put a tax on you. 50:56.670 --> 50:58.340 They'll take it. 50:58.340 --> 50:59.620 That was your worry. 50:59.620 --> 51:02.030 So you had to involve them. 51:02.030 --> 51:06.040 It was a fact of life, a very important fact of life. 51:06.040 --> 51:08.760 You had to involve the whole community. 51:12.600 --> 51:14.900 You could not start a business without 51:14.900 --> 51:16.480 involving the community. 51:16.480 --> 51:20.510 But it was a very successful invention, because it actually 51:20.510 --> 51:30.280 led the Chinese economy on its first huge successes. 51:33.410 --> 51:38.360 I'm going to move to another example now of an innovation 51:38.360 --> 51:39.590 in finance. 51:39.590 --> 51:47.380 I want to talk about inflation indexation. 51:51.910 --> 51:55.890 And I can pick many. 51:55.890 --> 51:58.500 These are examples that I like personally. 51:58.500 --> 52:00.870 There's an infinite number of examples. 52:00.870 --> 52:04.360 It doesn't matter exactly which example we pick. 52:04.360 --> 52:10.830 But there's a fundamental financial problem, and that is 52:10.830 --> 52:13.890 that the value of money changes through time. 52:13.890 --> 52:17.990 We have inflation measured by a Consumer Price Index. 52:17.990 --> 52:22.760 And when inflation proceeds, the prices go up, and so the 52:22.760 --> 52:25.030 buying power of money goes down. 52:25.030 --> 52:26.390 And it's uncertain. 52:26.390 --> 52:37.720 There's inflation risk that we face because of the 52:37.720 --> 52:39.340 uncertainty about prices. 52:39.340 --> 52:43.780 This is an inflation risk that's under concern right now 52:43.780 --> 52:46.310 after the quantitative easing that the Fed -- 52:46.310 --> 52:47.590 We'll come back to that. 52:47.590 --> 52:52.670 The Federal Reserve is expanding the money supply 52:52.670 --> 52:55.560 dramatically in an effort to deal with this crisis, and 52:55.560 --> 52:58.880 some people are worried about inflation risk. 52:58.880 --> 53:00.530 But it's a longstanding worry. 53:00.530 --> 53:04.190 It goes way back in time. 53:04.190 --> 53:17.920 Most debts are done in nominal terms. And that means they're 53:17.920 --> 53:23.980 written in currency units, and if the currency becomes 53:23.980 --> 53:26.920 worthless, you're wiped out. 53:26.920 --> 53:31.180 Why do people write contract in currency units? 53:31.180 --> 53:33.540 Well, it's because it's familiar with them, and so 53:33.540 --> 53:34.680 it's framing. 53:34.680 --> 53:39.340 We're used to thinking in terms of money and so we write 53:39.340 --> 53:41.430 contracts in terms of money all the time. 53:44.170 --> 53:48.620 So the idea is, maybe we should start something else. 53:48.620 --> 53:51.860 Let's not write contracts in terms of money, let's write in 53:51.860 --> 53:53.730 terms of something else. 53:53.730 --> 53:56.500 And that's an invention. 53:56.500 --> 53:59.970 But it's another invention that seems obvious. 53:59.970 --> 54:02.730 Let's index our debts to some measure of inflation. 54:05.580 --> 54:12.670 The invention I want to talk about first goes back to 1780. 54:12.670 --> 54:17.670 I believe that the first indexed bond was issued in the 54:17.670 --> 54:24.410 state of Massachusetts in 1780 by the Massachusetts 54:24.410 --> 54:25.660 government. 54:28.590 --> 54:31.480 And that was an indexed bond. 54:35.600 --> 54:38.640 They defined a consumer price index, they didn't call it 54:38.640 --> 54:47.620 that, and they said that the bond would pay you so many 54:47.620 --> 54:49.810 pounds, they weren't using dollars yet, they were using 54:49.810 --> 54:54.980 pounds, British pounds, and the amount of pounds you would 54:54.975 --> 54:59.905 get would be increased if inflation were to start. 54:59.910 --> 55:03.390 So, they defined an index of commodities 55:03.390 --> 55:04.750 that you might purchase. 55:04.750 --> 55:12.360 And that index was used to input a formula that created 55:12.360 --> 55:16.510 inflation correction to the bonds. 55:16.510 --> 55:21.840 So, these bonds were issued in 1780. 55:21.840 --> 55:25.030 And it served an important purpose, because the U.S. was 55:25.030 --> 55:28.390 fighting a war with the United Kingdom at the time, and there 55:28.390 --> 55:30.700 was tremendous inflation. 55:30.700 --> 55:32.690 So they were very important. 55:32.690 --> 55:36.910 But after the war, after the Revolutionary War ended, they 55:36.910 --> 55:40.830 stopped issuing these bonds, and they forgot about them in 55:40.830 --> 55:45.070 the United States until 1997. 55:45.070 --> 55:47.390 It's amazing. 55:47.390 --> 55:50.670 Why did the invention disappear? 55:50.670 --> 55:51.750 It's like gimlets. 55:51.750 --> 55:54.160 I think maybe gimlets will make a reappearance. 55:54.160 --> 55:56.230 Maybe some of you will buy a gimlet. 55:56.230 --> 55:59.600 They're very cheap, by the way. 55:59.600 --> 56:00.850 And very useful. 56:05.210 --> 56:08.600 It seems like there's a psychological barrier toward 56:08.600 --> 56:11.450 adopting something that's a little bit complicated. 56:11.450 --> 56:16.180 And people have trouble understanding index bonds, and 56:16.180 --> 56:26.500 they have trouble understanding, 56:26.500 --> 56:28.060 how the formula works. 56:28.060 --> 56:30.930 They think, you know, I just want money. 56:30.930 --> 56:37.040 But, then you ask, well, why didn't people learn? 56:37.040 --> 56:40.050 If you look through history, we've had bouts of inflation 56:40.050 --> 56:43.260 so many times, in so many different countries. 56:43.260 --> 56:46.380 And you know, if you buy a nominal bond, it's risky, 56:46.380 --> 56:47.980 especially if you buy a 30-year bond. 56:47.980 --> 56:50.710 People are doing that even today all over the world. 56:50.710 --> 56:54.210 They buy these 30-year bonds denominated in dollars or 56:54.210 --> 56:58.240 euros or some other currency, and what's going to happen to 56:58.240 --> 56:59.760 those currencies? 56:59.760 --> 57:01.850 So, why don't you denominate your bond in 57:01.850 --> 57:03.980 something more realistic? 57:03.980 --> 57:08.990 Well, after 1997, the introduction in United States 57:08.990 --> 57:14.060 of index bonds, the reintroduction in 1997, seem 57:14.060 --> 57:15.800 to be started by one person. 57:15.800 --> 57:19.410 Larry Summers, who is Assistant Treasury Secretary, 57:19.410 --> 57:21.020 just believed in this. 57:21.020 --> 57:22.220 And he did it. 57:22.220 --> 57:23.670 And so, we still have them. 57:23.670 --> 57:27.650 It got up to over 10% of the U.S. debt. 57:27.650 --> 57:33.260 Now, under Bush and Obama, they're kind of letting them 57:33.260 --> 57:37.900 sag now, they're down to 6% of the U.S. debt. 57:37.900 --> 57:40.160 But it really should be 100% of the U.S. 57:40.160 --> 57:41.210 debt should be indexed. 57:41.210 --> 57:45.370 So, this is a kind of example of progress that is made 57:45.370 --> 57:46.480 gradually through time. 57:46.480 --> 57:51.070 And maybe you'll see that in the next 40 years. 57:51.070 --> 57:54.440 I'm trying to think of how we can make these things happen. 57:54.440 --> 58:01.470 That's an agenda for people, younger people who can start 58:01.470 --> 58:04.000 innovating and changing our financial system. 58:10.570 --> 58:13.490 I wanted to talk about an invention that particularly 58:13.490 --> 58:19.860 intrigues me that comes from the country of Chile. 58:24.240 --> 58:28.890 It's a financial invention, that overcomes framing 58:28.890 --> 58:31.530 problems. Psychologically salient -- 58:31.530 --> 58:35.410 it's an important invention, and illustrates some of the 58:35.410 --> 58:36.990 basic concepts. 58:36.985 --> 58:39.635 So let me talk about Chile. 58:39.640 --> 58:41.210 We're jumping around the world here. 58:43.970 --> 58:50.160 Chile had a problem with, like many Latin American countries, 58:50.160 --> 58:53.460 especially of that time, with inflation. 58:53.460 --> 59:01.650 So, they had a currency called the peso which inflated 59:01.650 --> 59:03.170 enormously. 59:03.170 --> 59:05.910 It went up, I don't have the numbers on it, but it went up, 59:05.910 --> 59:07.990 you know like, prices went up a thousand-fold. 59:10.670 --> 59:14.200 And people were saying, we can't trust anything. 59:14.200 --> 59:17.060 I wouldn't take a contract paying pesos. 59:17.060 --> 59:19.760 The peso is gradually becoming worthless. 59:19.760 --> 59:24.830 So, Chile switched to another currency called 59:24.830 --> 59:30.410 the escudo in 1960. 59:30.410 --> 59:32.520 They said, OK, we're starting fresh, we're not 59:32.520 --> 59:33.650 going to have inflation. 59:33.650 --> 59:34.890 And this is brand new. 59:34.890 --> 59:36.840 Now we're an escudo country. 59:36.840 --> 59:38.090 No inflation. 59:40.110 --> 59:46.920 Then, in 1975, they switched back to the peso. 59:46.920 --> 59:50.060 The exchange rate, peso to escudo, was one escudo was 59:50.060 --> 59:51.580 1,000 pesos. 59:51.580 --> 59:52.670 OK? 59:52.670 --> 59:53.750 Because they'd had something like a 59:53.750 --> 59:55.950 1,000-fold price increase. 59:55.950 --> 1:00:00.230 And then, in 1975, the exchange rate was one new peso 1:00:00.230 --> 1:00:01.970 is 1,000 escudos. 1:00:01.970 --> 1:00:05.890 So, a new peso was a million old pesos. 1:00:05.890 --> 1:00:07.640 OK, this is getting embarrassing. 1:00:07.640 --> 1:00:12.140 I mean like, can we trust anything or anybody in Chile? 1:00:12.140 --> 1:00:16.150 So, the invention started in 1967. 1:00:16.150 --> 1:00:19.980 People in Chile were saying, we just want stability. 1:00:19.980 --> 1:00:22.040 You know, this is crazy, our prices. 1:00:22.040 --> 1:00:23.750 If I owned one peso -- 1:00:23.750 --> 1:00:29.940 I have a nice 1,000 peso note from 1955 and I pull it out in 1:00:29.940 --> 1:00:32.500 1975 and it's worth nothing. 1:00:32.500 --> 1:00:34.840 It's not even worth the paper it's printed on. 1:00:34.840 --> 1:00:37.390 So we've got to get stability somehow. 1:00:37.390 --> 1:00:41.790 So, somebody in Chile had the idea, all right, maybe we 1:00:41.790 --> 1:00:44.830 can't protect, we don't know how to protect the currency, 1:00:44.830 --> 1:00:48.960 but we can create a unit of account that 1:00:48.960 --> 1:00:49.910 is stable in value. 1:00:49.910 --> 1:00:52.980 And let's write contracts in this unit of account rather 1:00:52.980 --> 1:00:54.480 than pesos. 1:00:54.480 --> 1:01:01.400 So, in 1967, in Chile they created something called the 1:01:01.400 --> 1:01:06.690 Unidad de Fomento. 1:01:06.690 --> 1:01:10.670 That's Spanish for Unit of Development. 1:01:10.670 --> 1:01:15.430 But what it was, was a unit of account that 1:01:15.430 --> 1:01:17.360 is indexed to inflation. 1:01:17.360 --> 1:01:20.110 And they said, write your contracts in terms of -- 1:01:20.110 --> 1:01:24.840 and they called them UFs, okay? 1:01:24.840 --> 1:01:29.320 So, everything could be written in UFs. 1:01:29.320 --> 1:01:32.530 Forget pesos, because you don't trust pesos anymore. 1:01:32.530 --> 1:01:39.260 Let's write contracts in terms of something else. 1:01:39.260 --> 1:01:40.510 And that stuck. 1:01:44.770 --> 1:01:52.470 It started out as 100 escudos. 1:01:52.470 --> 1:02:10.730 I think it was one UF was 100 escudos in 1967, but, by 1977, 1:02:10.730 --> 1:02:17.640 a UF was 450 new pesos. 1:02:17.640 --> 1:02:20.830 Now, if you want to know what a UF is worth now, you just go 1:02:20.830 --> 1:02:25.400 on the internet and it gives it for every day. 1:02:25.400 --> 1:02:28.690 And the website is -- 1:02:36.930 --> 1:02:44.330 I think the website is valoruf.cl, but 1:02:44.330 --> 1:02:46.880 that's from my memory. 1:02:46.880 --> 1:02:52.500 And so, I looked up what a UF is worth today, and it's, I'll 1:02:52.500 --> 1:03:00.820 use the dollar sign for pesos, 21,468 pesos. 1:03:00.820 --> 1:03:07.720 So, that means that since 1977 prices have gone up about 1:03:07.720 --> 1:03:10.240 50-fold in Chile. 1:03:10.240 --> 1:03:11.990 OK. 1:03:11.990 --> 1:03:15.790 But if you signed a contract written in UFs, you're 1:03:15.790 --> 1:03:19.310 completely protected from that. 1:03:19.310 --> 1:03:24.950 And so, it's a very important invention. 1:03:28.380 --> 1:03:30.370 Why is it an important invention? 1:03:30.370 --> 1:03:33.300 It's important, because without it 1:03:33.300 --> 1:03:35.650 Chileans wouldn't index. 1:03:35.650 --> 1:03:38.350 We don't index much in the United States, nothing, almost 1:03:38.350 --> 1:03:41.250 nothing is indexed to inflation. 1:03:41.250 --> 1:03:41.920 Why not? 1:03:41.920 --> 1:03:42.430 I don't know. 1:03:42.430 --> 1:03:44.510 It's like resistance to wheeled suitcases. 1:03:44.510 --> 1:03:46.660 You almost can't figure it out. 1:03:46.660 --> 1:03:48.940 It's so obvious. 1:03:48.940 --> 1:03:50.970 When you rent an apartment, they 1:03:50.970 --> 1:03:52.400 should index it to inflation. 1:03:52.400 --> 1:03:56.650 They should tell you, our apartment rent goes up every 1:03:56.650 --> 1:03:59.400 month, or down, depending on the price level. 1:03:59.400 --> 1:04:02.080 When you advertise a house for sale, it should 1:04:02.080 --> 1:04:03.800 be indexed to inflation. 1:04:03.800 --> 1:04:05.700 Otherwise you're just making it crazy. 1:04:05.700 --> 1:04:07.650 You're just making -- 1:04:07.645 --> 1:04:10.425 Yale tuition should be indexed to inflation. 1:04:10.432 --> 1:04:12.572 It should go up and down with the level of inflation, that 1:04:12.570 --> 1:04:14.980 keeps its real value constant. 1:04:14.980 --> 1:04:18.380 But we don't seem to do it, because we can't -- 1:04:18.380 --> 1:04:21.460 something is blocking our thinking about it. 1:04:21.460 --> 1:04:24.510 So, we have to do something like this, I believe. 1:04:24.510 --> 1:04:27.710 And so, that's what Chile has done. 1:04:27.710 --> 1:04:30.980 So, this is the way things are done today in Chile. 1:04:30.980 --> 1:04:33.650 It became an invention that took hold and 1:04:33.650 --> 1:04:35.860 never left that country. 1:04:35.860 --> 1:04:39.860 If you rent an apartment in Chile, good chance that your 1:04:39.860 --> 1:04:43.120 rent will be quoted in UFs, OK, and if you're paying a 1:04:43.120 --> 1:04:45.720 monthly rent check, this is what you do. 1:04:45.720 --> 1:04:49.970 So your rent is I don't know how many UFs. 1:04:49.970 --> 1:04:57.090 You go to valoruf.cl, you find out how many pesos it is, you 1:04:57.090 --> 1:04:59.950 write out a check for that number of pesos. 1:04:59.950 --> 1:05:01.130 OK? 1:05:01.130 --> 1:05:05.560 And they do this out of habit. 1:05:05.560 --> 1:05:09.430 The amazing thing I discovered is that in the United States, 1:05:09.430 --> 1:05:11.660 and in just about every country in the world except 1:05:11.660 --> 1:05:15.430 Chile, alimony payments are defined in 1:05:15.430 --> 1:05:17.550 currency, all right? 1:05:17.550 --> 1:05:19.020 You get a divorce. 1:05:19.020 --> 1:05:23.060 The mother, let's say, has to support children. 1:05:23.060 --> 1:05:26.190 The father is required to pay alimony for the next -- 1:05:26.190 --> 1:05:28.910 until the children grow up, or indefinitely. 1:05:28.910 --> 1:05:29.190 All right? 1:05:29.190 --> 1:05:30.310 That's a long-term contract. 1:05:30.310 --> 1:05:31.850 What if there's inflation? 1:05:31.850 --> 1:05:35.770 What does it do to the value of the alimony? 1:05:35.770 --> 1:05:39.540 Well, of course, the real value goes down. 1:05:39.540 --> 1:05:44.090 So, shouldn't courts just index it to inflation. 1:05:44.090 --> 1:05:46.030 Well, they do in Chile. 1:05:46.030 --> 1:05:51.100 Because they've got a habit of doing things in terms of UFs. 1:05:51.100 --> 1:05:55.520 So, this is an important financial innovation. 1:05:55.520 --> 1:06:00.540 By the way, guess how much consumer prices have gone up 1:06:00.540 --> 1:06:04.380 in the United States since we created a consumer 1:06:04.380 --> 1:06:07.240 price index in 1913. 1:06:07.240 --> 1:06:09.630 It's 22-fold. 1:06:09.630 --> 1:06:13.640 We've had a lot of inflation in this country. 1:06:13.640 --> 1:06:19.940 22-fold. 1:06:19.940 --> 1:06:24.870 Something that cost $1 in 1913 will cost $22 today. 1:06:24.870 --> 1:06:28.010 That means, if you held cash between 1913 and today, 1:06:28.010 --> 1:06:30.480 basically you're completely wiped out. 1:06:30.480 --> 1:06:34.340 But the inflation rate is only 3% a year. 1:06:34.340 --> 1:06:37.940 That's 3% a year for almost 100 years 1:06:37.940 --> 1:06:41.520 is a 22-fold increase. 1:06:41.520 --> 1:06:45.180 So, we're living with this kind of uncertainty in the 1:06:45.180 --> 1:06:46.830 United States today. 1:06:46.830 --> 1:06:52.000 We have not adopted the Chilean invention of UFs. 1:06:52.000 --> 1:06:55.360 It's interesting that this invention spread, somewhat, 1:06:55.360 --> 1:06:58.290 throughout Latin America. 1:06:58.290 --> 1:07:00.620 And it stopped at the Rio Grande. 1:07:00.620 --> 1:07:03.190 Mexico has something called UDI. 1:07:03.190 --> 1:07:05.000 Which is the Mexican version. 1:07:05.000 --> 1:07:07.970 It's U-D-I. Which is the Mexican version 1:07:07.970 --> 1:07:10.110 of Unidad de Fomento. 1:07:10.110 --> 1:07:12.400 But the rest of the world doesn't want 1:07:12.400 --> 1:07:14.360 to copy this idea. 1:07:14.360 --> 1:07:15.490 Why is that? 1:07:15.490 --> 1:07:19.920 I think it's partly because this idea emerged out of 1:07:19.920 --> 1:07:21.080 embarrassment. 1:07:21.080 --> 1:07:23.710 Chile had had massive inflation which is 1:07:23.710 --> 1:07:27.490 embarrassing, and nobody wants to copy anything from someone 1:07:27.490 --> 1:07:29.810 having that bad experience. 1:07:29.810 --> 1:07:32.960 It's also cultural, that we're not used to 1:07:32.960 --> 1:07:34.190 Latin American things. 1:07:34.190 --> 1:07:36.050 Just like we're not used to using gimlets. 1:07:36.050 --> 1:07:39.110 So, we don't have them. 1:07:42.340 --> 1:07:44.520 Let me just give one more invention. 1:07:44.515 --> 1:07:45.625 It's important. 1:07:45.630 --> 1:07:47.960 And then I'll stop. 1:07:47.960 --> 1:07:53.090 This is another financial invention, more recently. 1:07:53.090 --> 1:07:55.530 It's the invention of the swap. 1:07:55.526 --> 1:07:59.386 I like to give this example, because it relates to a couple 1:07:59.390 --> 1:08:02.150 of our speakers. 1:08:02.150 --> 1:08:05.130 What is a swap? 1:08:05.130 --> 1:08:11.050 Well, the swap is a financial contract that was invented by 1:08:11.050 --> 1:08:19.110 none other than David Swensen, who will be speaking soon. 1:08:19.110 --> 1:08:22.320 He is the Chief Investment Officer for Yale University. 1:08:22.320 --> 1:08:24.920 He invented this before he came to Yale, when he was 1:08:24.920 --> 1:08:28.400 working for Salomon Brothers, which was a major Wall Street 1:08:28.400 --> 1:08:31.930 investment bank that no longer exists. 1:08:31.930 --> 1:08:36.890 But back then, in the early 80's, he apparently -- 1:08:36.890 --> 1:08:38.140 I've got a couple of sources. 1:08:38.140 --> 1:08:40.490 I think he is the real inventor of it. 1:08:43.470 --> 1:08:44.690 What is a swap? 1:08:44.690 --> 1:08:48.600 It's a contact between two parties, usually a fairly 1:08:48.600 --> 1:08:52.250 long-term contract, to exchange cash flows. 1:08:52.250 --> 1:08:55.600 So the simplest swap would be a currency swap 1:08:55.600 --> 1:08:58.230 where one country -- 1:08:58.230 --> 1:09:00.930 There's two parties. 1:09:00.930 --> 1:09:03.370 Two different companies, let's say. 1:09:03.370 --> 1:09:09.050 One of them who promises to exchange euros for dollars 1:09:09.050 --> 1:09:12.380 every month for the next five years, and the other one 1:09:12.380 --> 1:09:16.640 promises to exchange dollars for euros every month for the 1:09:16.640 --> 1:09:18.330 next five years. 1:09:18.330 --> 1:09:22.180 It's a swap, but we decide in advance on what the conversion 1:09:22.180 --> 1:09:26.940 is, what the swap rate is, between euros and dollars. 1:09:26.940 --> 1:09:30.730 So that's useful for risk management purposes, because 1:09:30.730 --> 1:09:34.200 somebody, someone in Europe may be getting dollars revenue 1:09:34.200 --> 1:09:35.200 in their business. 1:09:35.200 --> 1:09:37.130 They know they're going to get this revenue over the next 1:09:37.130 --> 1:09:37.720 five years. 1:09:37.720 --> 1:09:40.970 It's kind of a long-term contract, long-term business 1:09:40.970 --> 1:09:41.240 they're in. 1:09:41.240 --> 1:09:43.220 They might want to go twenty years. 1:09:43.220 --> 1:09:46.680 But they don't know at what rate they can convert it back 1:09:46.680 --> 1:09:47.990 into euros. 1:09:47.990 --> 1:09:51.270 And then, on the other side, we have the Americans who may 1:09:51.270 --> 1:09:54.400 be doing business in Europe, and they get euro income and 1:09:54.400 --> 1:09:56.070 they want to convert it to dollars. 1:09:56.070 --> 1:10:04.060 So, they can make a contract that swaps these cash flows. 1:10:04.060 --> 1:10:05.460 And that was the invention. 1:10:05.456 --> 1:10:07.956 And it didn't come until the 1980's. 1:10:07.960 --> 1:10:12.900 It's amazing that these simple ideas weren't out there. 1:10:12.900 --> 1:10:14.180 And why weren't they out there? 1:10:14.180 --> 1:10:19.180 Well, it may have something to do with legal uncertainty, 1:10:19.180 --> 1:10:22.570 regulatory uncertainty. 1:10:22.570 --> 1:10:25.230 There's something called ISDA which was 1:10:25.230 --> 1:10:28.170 founded since the 1980's. 1:10:28.170 --> 1:10:31.720 That's the International Swaps and Development Association. 1:10:31.720 --> 1:10:35.600 And what it does is, it lobbies lawmakers for laws 1:10:35.600 --> 1:10:41.540 that permit swaps to work efficiently and effectively. 1:10:41.540 --> 1:10:46.120 And so, you need an organization like ISDA that 1:10:46.120 --> 1:10:50.720 will make these contracts work as effectively as they are. 1:10:50.720 --> 1:10:56.660 Now swaps are a hugely important contract. 1:10:56.660 --> 1:11:02.430 My last example, which is a sub-example from this, is the 1:11:02.430 --> 1:11:09.120 credit default swap, which is something that I won't put 1:11:09.120 --> 1:11:11.990 David Swensen's name. 1:11:11.990 --> 1:11:22.360 The credit default swap is a -- 1:11:22.360 --> 1:11:26.810 again a contract between two parties that has to do with 1:11:26.810 --> 1:11:30.610 the risk of a credit event. 1:11:30.610 --> 1:11:33.780 So, there's a protection buyer. 1:11:33.780 --> 1:11:34.860 There's two parties. 1:11:34.860 --> 1:11:38.380 One we'll call the protection buyer, and the other is a 1:11:38.380 --> 1:11:41.470 protection seller. 1:11:41.470 --> 1:11:45.370 And it would have to do with -- 1:11:45.370 --> 1:11:51.910 basically the buyer promises to pay the seller, at regular 1:11:51.910 --> 1:11:58.480 intervals for some period of time, and the money just flows 1:11:58.480 --> 1:12:01.300 regularly from the buyer to the seller, 1:12:01.300 --> 1:12:02.830 until some event occurs. 1:12:02.830 --> 1:12:05.250 We could say a bankruptcy of some company. 1:12:05.250 --> 1:12:07.000 It's defined in the contract. 1:12:07.000 --> 1:12:10.400 In which case, then, the protection seller has to pay 1:12:10.400 --> 1:12:11.650 the protection buyer. 1:12:14.720 --> 1:12:16.280 Now you might ask, isn't this just like 1:12:16.280 --> 1:12:17.770 an insurance contract? 1:12:17.770 --> 1:12:19.580 Wouldn't you call this insurance? 1:12:19.580 --> 1:12:27.350 If I'm paying regular payments to somebody else, and then, if 1:12:27.350 --> 1:12:30.850 an event occurs, I'm getting insurance against default by 1:12:30.850 --> 1:12:32.140 some company. 1:12:32.140 --> 1:12:34.140 And I maybe doing business with the company, or I may be 1:12:34.140 --> 1:12:37.400 investing in the company's bonds, so I may want this 1:12:37.400 --> 1:12:38.250 protection. 1:12:38.250 --> 1:12:40.410 But it looks like insurance, right? 1:12:40.410 --> 1:12:44.300 Well actually, there's something else called credit 1:12:44.300 --> 1:12:52.920 insurance, which goes back to the nineteenth century. 1:12:56.360 --> 1:13:00.620 There were companies in like 1880 that would allow you to 1:13:00.620 --> 1:13:05.880 buy insurance against default, or some failure of a company. 1:13:05.880 --> 1:13:08.710 So, this was an institution and an invention of the 1:13:08.710 --> 1:13:10.480 nineteenth century. 1:13:10.480 --> 1:13:13.750 But credit defaults swaps are -- 1:13:13.750 --> 1:13:15.140 what's the difference? 1:13:15.140 --> 1:13:19.370 Well, the difference is, that there is a whole culture and 1:13:19.370 --> 1:13:21.860 regulatory environment developed around credit 1:13:21.860 --> 1:13:25.130 insurance that limited it. 1:13:25.130 --> 1:13:26.710 They didn't have ISDA. 1:13:26.710 --> 1:13:30.110 They had state insurance regulators, OK, and they just 1:13:30.110 --> 1:13:32.330 didn't have the same conceptual framework. 1:13:32.330 --> 1:13:34.330 It's complicated. 1:13:34.330 --> 1:13:39.780 The credit default swap was boosted by ISDA and other 1:13:39.780 --> 1:13:42.070 thinkers, who thought of how to make this into 1:13:42.070 --> 1:13:46.250 a huge, huge business. 1:13:46.250 --> 1:13:50.620 Credit insurance ended up being kind of limited in its 1:13:50.620 --> 1:13:52.140 application. 1:13:52.140 --> 1:13:58.000 And often the credit insurers were more like consultants. 1:13:58.000 --> 1:14:01.420 They would say, we'll insure your credit. 1:14:01.420 --> 1:14:04.450 It will insure you against the default by someone 1:14:04.450 --> 1:14:06.100 you lend money to. 1:14:06.100 --> 1:14:10.980 But we want also to be involved in helping you avoid 1:14:10.980 --> 1:14:14.500 making bad contracts like that. 1:14:14.500 --> 1:14:17.670 So, the credit default swap became huge. 1:14:17.670 --> 1:14:19.440 Let me just conclude with this. 1:14:19.440 --> 1:14:22.790 This brings us back to one of our outside speakers. 1:14:26.490 --> 1:14:31.830 Hank Greenberg is going to talk about his company AIG, 1:14:31.830 --> 1:14:35.470 which failed because of errors -- it didn't fail, it got 1:14:35.470 --> 1:14:37.250 bailed out by the government. 1:14:37.250 --> 1:14:39.920 It got bailed out because of errors made in 1:14:39.920 --> 1:14:41.790 credit defaults swaps. 1:14:41.790 --> 1:14:45.090 I don't think that these errors were his fault, because 1:14:45.090 --> 1:14:47.280 this happened after he left the company. 1:14:47.280 --> 1:14:49.660 But I just want to mention this, because it's all part of 1:14:49.660 --> 1:14:50.590 a big picture. 1:14:50.590 --> 1:14:53.720 We had a financial invention, the swap. 1:14:53.720 --> 1:14:56.270 Then we had the credit default swap. 1:14:56.270 --> 1:14:59.160 And these are important invention. 1:14:59.160 --> 1:15:02.460 They caused a leap forward in our ability to do risk 1:15:02.460 --> 1:15:02.960 management. 1:15:02.960 --> 1:15:05.210 But they created attendant risks. 1:15:05.210 --> 1:15:06.560 They were new, and they weren't 1:15:06.560 --> 1:15:08.030 understood well enough. 1:15:08.030 --> 1:15:11.250 And so, a big part of what happened in this crisis was a 1:15:11.250 --> 1:15:14.620 failure of the credit default swap market. 1:15:14.620 --> 1:15:17.360 But that's not to me an indictment of financial 1:15:17.360 --> 1:15:18.240 innovation. 1:15:18.240 --> 1:15:21.090 I think the credit default swap was an important 1:15:21.090 --> 1:15:25.330 innovation, and we will see more like it, and it will help 1:15:25.330 --> 1:15:27.050 make for a better world.