good morning. Today I decided not
to use PowerPoint, I'm using index cards. This is traditional
lecture style. I want to talk today about -- this is our third lecture
for financial markets. I wanted to talk today about
invention in finance. I think of finance, I don't
know whether this will encourage you to be interested
or not, but I think of it as a form of engineering. Finance is all about
inventions. Devices that solve problems and
that help people do things and get on with their
purposes in life. And the inventions have
many small details, just like any invention. Like an airplane. You look at an airplane, how
many parts are in there? How many different people worked
on the different parts? And it's so complicated that you
might have disbelief that this whole thing is
going to work, but somehow it does work. And another part that I want
to emphasize in today's lecture is that engineering
requires a human element. Engineers know that their
devices will be run by people, and people are imperfect. And so, they have a course in
engineering schools called Human Factors Engineering. And that's about designing
machines, so that human beings won't mess up when they
try to use them. That gets us into psychology. To me, when we talk about
behavioral finance, which is going to be a theme of this
course, human psychology and finance, it's fundamental to the
inventive side of finance. So that's what I want
to talk about. I'm going to give you some
examples of invention and talk about how they solve
the risk problem. The fundamental problem of
maintaining incentives in the face of risk. But before I start this lecture,
I wanted to just briefly review the last lecture,
which was a very important lecture for this
course, because it talked about the underlying probability
theory and applications of probability
theory to finance. So, let me just mention some of
the concepts that I talked about last time. The first one was return. We talked about the return on
an investment which has two components, the capital gains,
which is the increase in the price of the investment, and
the other is the dividend, which is something that comes
separately in the form of a check maybe, or electronic
entry. But we then moved quickly
to probability theory. We talked about random
variables. A random variable is a quantity
that's created by some kind of experiment or event
that is uncertain in advance and becomes
known later. And then, we talked about
measures of probability distributions. We talked about central
tendency, we talked about the average or mean, and the
geometric average, and we talked about measures of
risk, notably variance. But then, there are also
measures of co-movements between two random variables. We talked about covariance and
correlation, and we talked about regression. And then finally we talked about
distributions of random variables, and the normal
distribution, which is famous. It's the famous bell-shaped
curve, which is thought by many people to represent
a typical distribution. And then finally, we talked
about failures of the -- the idea of independent random
variables that are normally distributed is a
powerful idea. That we have some idea that
there's a bell-shaped curve. We know something about what
relates to something and what doesn't relate to what. These ideas are partly
intuitive, and they're partly wrong. And so, the concluding element
of the last lecture was that the financial crisis that has
enveloped the world starting around 2007 seems to be related
to people's failure to understand the limits of the
independence assumption they were making, and also to the
limits of the normal distribution. Namely, failure to consider
outliers. So let's just think
about independence briefly for a moment. It's inherent in the intuitive
view we have of the world. When you toss a coin, every time
you toss it, you think each toss has to be
independent of the previous toss. They're not going to come up
the same, because there's nothing relating
the two tosses. So you have a strong intuitive
sense that some events are independent. You might also think that
returns on the stock market from day to day are
independent. Why is that? Because they relate
to news, right? What changes the stock
market on any day? Its news, and by definition
news has to be new. So it can't just be
yesterday's news. So it has to be something
fresh. And I showed you a plot of the
stock market and of Apple stock, and in this plot it came
out that the stocks look roughly independent, the returns
from day to day. But they're not necessarily
independent, and they can surprise you, and that's
when crises occur. We also talked about
idiosyncratic risk and market risk. Remember we regressed Apple
stock's returns on the stock market's returns and we got a
fitted value, which was beta times the market return. And that's the market component
of Apple risk. And then we saw that the extra
component, idiosyncratic, is uncorrelated with
the market risk. But in this case it's
uncorrelated by construction, so it has to be uncorrelated. Oh by the way, I don't know
if you caught the news. It's just coincidence that I
mentioned Apple stock in my last lecture. You must've heard the news. It was headline news on the
Wall Street Journal. We had a three-day weekend
because of the Martin Luther King holiday in the U.S. and,
over the weekend, Apple announced that Steve Jobs is
taking a long leave of absence from Apple because
of his health. And so, we talked about that
Steve Jobs is viewed by a lot of people as the genius behind
Apple, and the last time he left for a long time Apple
didn't do well. And so, you wondered what would
happen to the stock. Well, since they announced it
on a day just before the market was closed, and so it
opened in Europe and there was a 7% drop in Germany
of Apple shares. It opened down 5% on Tuesday
in the U.S., but then it recovered and it wasn't really
down that much, probably because there was good earnings news at the same time. That's just completing our
little story about Apple. I don't know if I gave enough
emphasis to the central limit theorem last lecture. This is a fundamental theorem
from probability theory, which says that if you have
independent identically distributed random variables. That is, every random variable
is independent of the other, and they're all of the same
distribution, and if it has a finite variance, then the
distribution of an average of these variables converges to the
normal distribution as the number of elements in the
average is increased. In other words, averages are
approximately normally distributed. The bell-shaped curve works as
well as it does, because so many things we observe in
nature are averages. So many things that we observe
are the sum of many affects. This is what history
is all about. Anytime big events occur, it's
probably because a number of things chanced to happen
at the same time. And that's why probability
Theorists think that we kind of know the probability
distribution, and that's this bell-shaped curve which I had
on the slide last period. The critical thing about the
bell-shaped curve is that the tails drop off really fast,
after you get a certain distance up on either end. They essentially hit zero. They never hit zero. The probability is never zero. Anything can happen with a
normally distributed variable. But the normal distribution
does not have fat tails. After two or three or four
standard deviations, basically the probability is zero
that that kind of thing will happen. That a return -- if we're applying
it to returns, that that would occur. So, the problem with the central
limit theorem is that it's only as good as
its assumptions. And it assumes that the
underlying variables have a finite variance, that they
themselves are not so fat-tailed that the variance
of them in infinite. And in fact, that assumption
might be wrong, because we see, especially in finance, we
see big outliers coming from time to time. And so I present a theory, and
I must say I like the theory. The central limit theory is an
important theory, but it's also wrong. And that's the problem with
financial theory. It's not quite as good as the
theory that physicists or chemists use. It has its limitations. Nonetheless, that's what
we have to talk about. We have to make do with that
as much as we can. I'm almost done with my review
of the last lecture. I wanted to just correct
what I said. I said that fat-tailed
distributions were discovered by Benoit Mandelbrot,
but that's -- I have to give credit
properly. It's actually his teacher,
so I've got this now. Paul Pierre Levy was a
mathematician who lived from 1886 to 1971, who really first
developed a theory of fat-tailed distribution. And he was at the Ecole
Polytechnique in France. And his student was Benoit
Mandelbrot, who was one of the great mathematicians -- they're both among the great
mathematicians of the twentieth century. Our knowledge of fat-tailed
distributions comes down to us through word of mouth. From Levy, who was Mandelbrot's
teacher, to Mandelbrot, to me, and
then to you, I think. So, we don't require any printed
word to know this. That's the way the history
of thought goes. There's an old joke about
the normal distribution. The joke goes as follows. The mathematicians think that
the normal distribution is ubiquitous in nature, because
applied workers have discovered that everything
is normally distributed. But applied workers think that
the normal distribution is ubiquitous in nature, because
mathematicians have proved that it's ubiquitous
in nature. In fact, it's sort of
ubiquitous, but it sort of surprises you. And that's one of the fundamental lessons in finance. The fundamental lesson in
finance is that you might go through years observing some
random return, or some random variable in finance, and you
kind of think you know how it behaves, and you've learned
some confidence. There will come a day when
it defies all of your expectations, and that's what
fat-tails are all about. OK, I want it to move on now to
today's lecture, which is about invention, and particularly financial invention. How should I start here? Let me start by recalling
how much finance has changed since 1970. OK, that's 40 years ago. In 1970, there were no
options exchanges. Well, there were options,
but they were not traded on any exchange. There were no financial
futures. There were no swaps. I haven't defined what these
things are for you. What else did they not have? They didn't have electronic
trading. They would do trading
by word of mouth. They would meet together on the
floor of an exchange and shout at each other and talk. I guess they had telephones,
but it was all words and people and writing on paper. So, the proliferation of
financial instruments in 40 years is stunning. So I wanted to use that as a
springboard to think about what is the next 40 years
going to be like? And if any of you go
into finance, this would be your career. I think that it's reasonable
to suppose that the transformation that we see in
the next 40 years is going to be just as dramatic as the last
40, or more so, because technical progress doesn't
slow down. I don't see any reason to think
that it's slowing down. So, I like to think about the
future, but it's hard to talk about the future, because
we're not there yet. I've written a couple
of books. One of them is about the
future of finance. One of them is called Macro
Markets, which I wrote in 1993 about the big market. Macro means big markets that
we'll be seeing in the future. And the other one was called The
New Financial Order, which I wrote in 2003, and we have the
introductory chapter there on the reading list
for this lecture. What I see as happening
with all of these -- Incidentally, we have a lot
of questioning of these inventions now, because they
kind of blew up on us in this financial crisis. So, it's a little bit like
after an airplane crash. People are kind of critical
of the aeronautical engineers for a while. Or when they invented steam
engines, some of them blew up, and it was bad. You know, when a boiler blows
up, it scalds all the people around it, awful. So people were mad at
them for a while. I think that's what we're
going through now. And people are angry about some
of these inventions, but that's just part of progress. Well, it doesn't mean that we
don't want to regulate them. We regulate boilers and
airplanes right now to prevent crashes, and we need to regulate
our financial markets just as well. The financial markets that
we have, they're based on mathematical models. This is a mathematical
discipline, but the mathematical models depend only
on certain intuition. Maybe, a core part of the
intuition that underlies financial inventions is the
idea of independence. I'm going to try and talk in
really basic terms. If risks are independent of each other,
then we can pool them and they go away. That's the core idea. But how to make that happen,
requires some thought, and some devices. The intuitive idea that we can
exploit independence to improve our lives goes back to
ancient times, actually. A lot of things that people do
are done in recognition of what is independent
and what is not. I think, even the big causes
that people get emotional about over the ages
are causes that -- I can think of them as examples
of the application of probability theory in
modern finance. So, you might not agree with me,
but this is my view of it. Think of socialism. What is socialism? Well, you know it was invented
by the philosopher, entrepreneur Robert Owen. The word was invented
by him in the early nineteenth century. What is it? It is that society gets together
and pools all of its activities. I think, well, why would
you want to do that? One reason you'd do that is
that it improves human welfare, because it shares
risks, and we're all in it together, and, you know, we
won't have rich and poor. I think that's part of
Robert Owens' idea. He was worried about inequality,
that some people are much better off than others,
and that's bad, and so let's create a socialist
society. So, he had an invention of
sorts, but it didn't seem to be a very -- in his form is was not a very
successful invention, because it didn't work somehow. He set up a town called New
Harmony in the United States, which was supposed to be
harmonious, by the name of the town, and everything
was shared. And unfortunately, they ended
up arguing and fighting amongst each other, and
they were not happy. He didn't get it figured
out right. He was trying to pool risk,
but he didn't do it. There are other idealistic
societies that try to do it, like the kibbutzim in Israel. That's one of many where people
get together and form a community, and they pool
everything, and it kind of works for some people. But only a tiny fraction of the
population in Israel lives on a kibbutz now. Why not? I think most people just
don't fit in that way. We share everything. After a few months living
there you might think, I'm out of here. I don't want to share everything
with everybody. So, people do things. In the Old West, the pioneers in
America, they had a kind of a social contract, that, if
one farmer's house burned down, everyone will come by and
help and erect a new house for that person. So that's, again,
risk management. That's it. And it works. It sounds almost like a moral
thing, but it works only, because they don't all burn
down at the same time. It would be totally worthless
if they all did. And so, there are primitive
ideas of insurance that underlie that, but the ideas
aren't worked out well. And it doesn't perhaps work
well to do it on such an informal basis. So, our society has particular
inventions that, we call them financial or insurance
inventions, that make these things work better. What we're talking about is
motivated by theory, the mathematical theory of finance,
but that's not the subject of this course. I want to in this course talk
more about the inventions themselves and in particular
we'll be talking about risk management. Now, this brings up a basic
issue about finance. Is finance good? Is it helpful to people? You know, a huge issue in the
history of humankind is inequality. And that people get upset when
it seems like other people have an unfair advantage
over us. But inequality is something that
you'd think finance works against. Modern finance is
about risk management. So, you can get rid of the
purely random elements in people's lives, that should
make people more equal. It should be a good thing. That is the way I view it. But the other side of finance
is that it also creates opportunity, and opportunity
is very important also. We can all be equal and living
in poverty, and we don't particularly like that. So that's why financial
inventions eventually inspire and get people excited. I always remember Deng
Xiaoping's famous statement in the late 1970's, when
China was adopting modern financial methods. And some people were getting
rich, and someone asked Deng, isn't this inconsistent
with our ideology? And he said, well, and I'm
quoting approximately, we're all going to get rich, but
somebody has to get rich first. And that's
the way it is. Financial markets
do manage risk. But they also create
opportunities and that can actually increase inequality. So, you have to consider
both sides of it. Maybe the most important
concept in finance really is risk. And risk is all about limiting
inequality, or at least the random, gratuitous inequality,
right? People are troubled by
inequality if it's arbitrary, but, you know, most people
wouldn't begrudge someone who works very hard and shows real
genius and insight, and makes a lot of money, most people
say that's all right. Part of the way we deal with
risk is our taxes, tax and welfare system. I'm going to come back to that,
mostly in our second to last lecture. We have a progressive income
tax that taxes rich people more, and we have welfare. And we also have, I should
add, it's not counted as welfare, but free public
education, which is a form of, I wouldn't call it welfare,
but it's an equalizing expenditure. These are actually our
most important risk management devices. That's what makes life tolerable
in modern society, that we do have progressive
taxes and welfare. But we don't rely on
those exclusively. And so, finance is getting into
the other dimensions. And we kind of want to let
insurance, private insurance, rather than social insurance,
flourish. Because when the government
handles everything, it doesn't seem to work as effectively or
creatively as it can if we let private entrepreneurs
handle things. So, what we're talking about
here, and to always put it in perspective, what we're talking
about in this course, is about something that is an
add-on to an existing welfare and tax system. But an add-on that is, we hope,
particularly effective. And it's added-on by people in
their own self-interest, or maybe for their own purposes,
but something that ultimately contributes to a, I think,
a better world. That's what I want to. I have several themes
in this lecture. The first is a risk theme, which
I've just discussed. Another theme I want to talk
about here is a framing theme. Psychologists use the term
framing to refer to the context and associations that
we have with some thing. So, the way people use things
depends on what they see them associated with, because people
can't think through to the fundamental theory
all the time. So, we have to frame things
in a way that's convenient to people. And this is part of financial
engineering. I'll come back to that
in a minute. Framing has to do with
language, names that we give to things. We have to design inventions,
so that they're framed in good ways. I'll explain that in a minute. And then, I have a device theme,
that finance is really about devices like
steam engines. We call them financial
contracts. Devices are complicated
structures that we set up for a certain purpose, like
airplanes or automobiles, and we learn through time how to
make them better and better. And they tend to come
on the world with a flourish or surprise. There's some new invention. You know, when the Wright
Brothers first exhibited the airplane in the Paris
Air Show in 1904, I think, people were stunned. They were actually flying. And it immediately set
up around the world the aircraft industry. If you look around
the world, these devices look very similar. Automobiles, airplanes
they look almost the same in every country. But that's because they have an
internal logic to them that makes them work well. And the logic may not
be apparent to you. You might not, probably don't,
fully understand why a device works as well as it does. Well, I have an example
of a simple invention. I was curious, I haven't used
this example before, how many of you use this invention? You know what a gimlet is? How many of you own a gimlet? Nobody. Nobody owns a gimlet. Can someone tell me
what a gimlet is? It's amazing. A gimlet is a simple tool
that everyone used to have 100 years ago. And what does it look like? It's made out of wire. This is a handle. OK, do you have a gimlet
now that I've drawn a picture of it? So what you did with those --
they were really cheap. You could buy one in 1820,
go to a hardware store in downtown New Haven. They'd have a whole
set of them. And you use it to make holes. And it works really well. I find you can buy them
on the internet. I bought one out of curiosity,
and now I use it. The point it that inventions
come and go. The nice thing about a gimlet
is, it's really nice, it comes to a pin point. And if you want to make a hole
in wood, you just push it in, and it goes exactly
where you want it. And then you just turn
it a little bit and it goes right in. But we have electric
drills now, right? We're kind of used to them. The problem, you know, once
you start using a gimlet, you love it. Because you can control
it so well. That drill, when you start
drilling, it kind of bounces around, and it doesn't make the
hole where you want it. So, there's something good
about this invention. But you can go out and buy one
now for very little money on the internet. It'll be mailed to you. Now that I have it, I'm thinking
about it all the time for using it. But somehow it comes and goes. Inventions are part of our
culture that appear and disappear through time. I wanted to talk about
another invention. This is by way of inspiration. I'm getting to finance in a
minute, but I have to do these simple -- Maybe someone will reintroduce
the gimlet. I don't know. It's probably gone forever. It illustrates the fact that
modern electronic technology has given us something
maybe better. But if you were used to using
this, you'd want it. You know, I just don't want to
use that electric drill, because I know how to use this,
and I can control it. I'll give you another example
of an important invention which I saw come in
my lifetime and that's wheeled suitcases. OK, I bet you have
one of these. Right, a suitcase with
wheels on it? When I was a boy there
were absolutely none. Nowhere. No one had a wheeled suitcase. Isn't that strange? You'd be carrying these
suitcases around. You put it on wheels, and
so I looked up the inventors of this. It's not that long ago. The wheeled suitcase
was invented by Bernard Sadow in 1972. And his was the first one. He had a suitcase with little
wheels, four little wheels, and you had a strap and you'd
pull it, and it would trail behind you. But then the other, the really
important invention, was by Robert Plath. This isn't finance, but I kind
of think of it as finance. It was 1991. And he called it
the RollAboard. This is what you own, right? You own a RollAboard, right? It has a rigid handle that
collapses into the suitcase, and has two wheels that
are horizontal. The problem with Bernard Sadow's
invention is that it tended to flop over. You're pulling it with a strap
behind you, and then you look back and it's flopped over. You can't go around
corners very well. So, we lived with Sadow's
for 19 years. It took 19 years to invent
the modern RollAboard. I actually heard from
Bernard Sadow. I wrote about him in The
New Financial Order. And I got a letter from him
about two weeks ago, or email from him. And he said, I heard about your
book and that you talked about me in your book. And he said you he'd
like to get me to autograph it for him. So I said fine, I'll
send you the book. And I sent him an autograph
with appreciation. That just shows, it's
not long ago. So I guess, I could ask you to
reflect, why didn't people have wheeled suitcases? But you weren't born
yet, right, so you can't reflect on it. I'm thinking back to myself. You know, it's almost something that I would do myself. I would put wheels on it. But I guess you were
embarrassed to do it back then. Because maybe it seemed sissy. But was everybody worried
about being a sissy? Not everybody. Why didn't anybody do it? Well, Bernard Sadow, I had my
student interview him, and he had listened to objections, and
people told him in 1972, no one's going to buy that. Because if the suitcase is too
heavy, you just get a redcap. You know what a redcap is? A redcap is someone, a poorly
paid person, who stands around at train stations, with wearing
a red cap, and helps you with your luggage. Right? That's not a good
answer, right? There isn't always a redcap to
help you, and so obviously you need wheels on suitcases. But this illustrates how
technology moves. It moves sometimes slowly. I'll give you a couple other
examples from my book about the slowness of inventions. One is just the invention
of wheels. Did you know that in the
Americas before Columbus there were no wheels? No wheeled vehicles. The American Indians had no
wheeled vehicles at all, not even suitcases. Nothing. No wagons. Nothing. And then to complicate it,
they've discovered, from the late classical period in Mexico,
they've discovered wheeled toys. And if you go to a museum in
Mexico you can see them. They made toys for their kids. They're not cars, they're little
jaguars and animals, and you could roll them
along the floor. So they made the toys,
why didn't they think of making a wagon? It just never occurred
to them. And another example I give in my
book that I really like is the movie subtitle. This is an amazing thing. When they invented movies -- I gave you a Thomas Edison
sound movie, but it didn't work. He couldn't make
a sound movie. They didn't find out
how to make sound movies until the 1920's. So they did, in order to give
dialogue to a movie, they'd give what they called
intertitles. They would show the movie,
you know what I'm saying? Then they'd stop the movie and
there would be a title with some phrase that someone
said, and then it would go back to the movie. But it's obviously better just
to put subtitles on the bottom of the screen, right? Let the movie proceed. You've seen movies with
subtitles, right? It works fine. Well, it turns out that someone
tried it in 1920. There was a movie called
The Chamber Mystery. And someone made us a subtitled
silent movie, but the response was bad. It seemed like nobody
liked it. And so, it wasn't
for another -- subtitles didn't come
in until after sound movies were invented. After sound movies were
invented, they wanted to make movies in one language and show
them in another country, so they had to put subtitles in,
so that people in another country could see the movie. And then that's how
it came in. There's a slowness
to understand or appreciate invention. Anyway, I want to move to
invention in finance, and the analogies that I just talked
about are important. So let me start with an
important invention in finance that goes way back. Well, I think I mentioned last
time, the very simple idea of setting up a company and
dividing up shares in the company, that's a really
old invention. That's thousands of years old. All right, you and your friends
are going to do a business, how do we divide
up the profits? Well, let's give shares
to each of us. And the guy who's contributing
more gets more shares, right? And someone who's contributing
less gets less shares. But then, we all have an
incentive to make the company go, and that's the idea
of a corporation. Corporation comes from
the Latin word corpus, which is body. It becomes like a slave owned
mutually by all the people in the company. And your share in the company is
determined by the number of shares that you own. But I wanted to focus here
-- that's an old idea. It's an invention. But I wanted to really
focus on a particular nuance that developed. It's limited liability. A limited liability corporation
is a corporation that guarantees that you as a
shareholder will not be liable for the debts of the company. In England, they sometimes
will put limited. The name of the company, after
it we'll say limited. But in the U.S., we just say
incorporated, so that tells you that it's limited
liability. What it's talking about, limited
liability means that somebody's sues the company,
and the company can't pay, they can't go after
the stockholders. limited liability has kind
of a complicated history. But according to a history by
David Moss, who was a Yale history graduate student when
he wrote this, but is now at Harvard Business School, limited
liability really took hold in 1811 with a corporate
law in the state of New York which represented a significant
invention. The corporate law of New York
in 1811 actually had two important components. The first component was,
anybody can start a corporation. Just file the papers with the
government of New York, and you've got a corporation. There may have been some
regulatory requirements, but the point was, you didn't need
an act of congress, or an act of parliament, to start
a corporation. It used to be very hard to
start a company, because people would say, well,
what's your purpose? And you know, we don't just
do this automatically. That was the first part of
the New York law in 1811. But the second part is
particularly interesting. They said under no circumstances
can the shareholders be sued. You put in your money to
the company, that's it. You are protected by the law. No worries about that. Now, this was the first
corporate law in the world, according to Moss, that imposed
limited liability as a clear right of the
shareholder. There were limited liability
clauses before, but it was never so crystal clear. At the same time, around 1811,
other states in the United States were looking at New York
and saying, you're crazy. What are you doing? You can't sue the
shareholders? They could do something
irresponsible. And so, the state of
Massachusetts, at around the same year, made a completely
opposite law. They made it clear that the
shareholders are responsible. You invest in a company,
you're responsible. And that's the only way it's
fair, they thought. Well, guess what happened? New York became the financial
center of America. Nobody wanted to set up a
company in Massachusetts anymore, because they couldn't
raise money. The capitalists were at risk. If you bought one share in a
company in Massachusetts, and the company did something
criminal, let's say, or bad, I don't know, something bad, then
they come, they might sue the company, and then come
looking for anybody who is among the shareholders. You owned one share in the
company, so we can take everything from you. We can take your house,
your car. Well, you didn't have a car. Take whatever you have. So the
rule was, be really careful before you invest
in any company. And you've got to watch
them all the time. But you know what that did? That kept Massachusetts down. Because nobody wanted
to do that. I mean you'd only invest
with trusted friends. You'd never invest in just
some random company. But what happened in New York
was that companies started appearing rapidly
because of this. And as many critics said, a
lot of these companies are fly-by-night, they're going to
go under, we're going to find out that they weren't doing
a good business. They were just show-offs. And they go bankrupt. But some of those companies did
extremely well, and they created a powerful
New York economy. Then people learned, well, you
could invest in 100 companies. And 99 of them will go under. They're all wild. Not all of them. There's one of them that
would be the Walmart and make you rich. So, the example set by New York
was eventually copied by Massachusetts, by every state in
the United States, by every country in Europe, and now every
country in the world. See, it was an experiment that
might not have gone well. You know what David Moss
thought, and this has to do with framing again. Moss thought that, why is it
that New York became such a capital of finance? Because of this law. And because it made
investing fun. And this is a matter
of framing. Moss emphasized that when you
buy share in a company, and it's limited liability, you know
that you have already put out all the money that
you'll ever put out. But you could get an infinite
amount, well, there's no limit to the amount of money
on the upside. And he thought that just
framed better as a psychologically appealing
gamble. It's like a lottery ticket. People like lottery
tickets, right? They just enjoy the thought. I don't do this, but
apparently a lot of people do it. You go and you spend a dollar
for a lottery ticket, or two dollars for a lottery ticket,
and then you think, tonight I could be a millionaire,
all right? That's just so much fun that
you want to do it again. But if the lottery ticket said,
well you have a small probability of being a
millionaire, but you also have a small probability
of going bankrupt. We're going to come after
you and take everything. You wouldn't like that. That wouldn't be so much fun. You like to savor the
possibility of getting rich. And so, people flock
to these stocks. It's like a sport. It's an invention of something
fun to do for a lot of people. But it has this productive side
to it that it funnels capital to where it's needed. So, that was an important
invention. I want to give you another
example that is a variation on this. I'm going to move
forward in time. My next invention is the--uh,
I'm breaking chalk here. PROFESSOR ROBERT SHILLER: This
goes now to China, Township and Village Enterprise or TVE. I'll try to say it in Chinese. Xiang zhen qi ye, did
I say that right? Close anyway. So what was this? When China emerged from a
communist, strictly communist state, in the early
period in the -- maybe starting in the late '70s,
but more in the 1980's, the Chinese economy increasingly
became built on a certain kind of organization
called a township or TVE. And the TVE was like a company,
a corporation, except that it always involved
the town. So in other words, if you wanted
to start a business, making something, making toys
for export to the world, you wouldn't just start
a toy company. You would go to the mayor of
your town, and you'd talk to the mayor and say, I want to
start a toy company as this town's enterprise, and I want to
share the profits with you, with the whole town. Now, this is kind of unique. Well, I don't know if it's
unique, but we don't see this in the United States. But it proliferated. It was actually the invention
that led to initial successes of the Chinese economy. By 1985, I believe, I have the
statistics here, there were 12 million TVEs in China. By the mid-1990's, most of the
industrial production of China was done by TVE. So then you have to ask why -- this is an invention,
but we don't see it in other countries. Why in China? Well, people who look back on it
think that it was inventing around certain constraints
at the time in China. And that the invention got
around a legal constraint. That China, having been a
communist country, did not have all these financial
lawyers. And they did not have courts
that enforced legal contracts the way we do in the U.S. And that entrepreneurs in China
were inhibited from starting an enterprise, because
they thought it would just be usurped by
the village. You live in a village, you start
a toy company, as soon as you start making money,
they'll just put a tax on you. They'll take it. That was your worry. So you had to involve them. It was a fact of life, a very
important fact of life. You had to involve the
whole community. You could not start
a business without involving the community. But it was a very successful
invention, because it actually led the Chinese economy on
its first huge successes. I'm going to move to another
example now of an innovation in finance. I want to talk about inflation
indexation. And I can pick many. These are examples that
I like personally. There's an infinite number
of examples. It doesn't matter exactly
which example we pick. But there's a fundamental
financial problem, and that is that the value of money
changes through time. We have inflation measured by
a Consumer Price Index. And when inflation proceeds, the
prices go up, and so the buying power of money
goes down. And it's uncertain. There's inflation risk that
we face because of the uncertainty about prices. This is an inflation risk that's
under concern right now after the quantitative easing
that the Fed -- We'll come back to that. The Federal Reserve is expanding
the money supply dramatically in an effort to
deal with this crisis, and some people are worried
about inflation risk. But it's a longstanding worry. It goes way back in time. Most debts are done in nominal
terms. And that means they're written in currency units, and
if the currency becomes worthless, you're wiped out. Why do people write contract
in currency units? Well, it's because it's familiar
with them, and so it's framing. We're used to thinking in terms
of money and so we write contracts in terms of
money all the time. So the idea is, maybe we should
start something else. Let's not write contracts in
terms of money, let's write in terms of something else. And that's an invention. But it's another invention
that seems obvious. Let's index our debts to some
measure of inflation. The invention I want to talk
about first goes back to 1780. I believe that the first indexed
bond was issued in the state of Massachusetts in 1780
by the Massachusetts government. And that was an indexed bond. They defined a consumer price
index, they didn't call it that, and they said that the
bond would pay you so many pounds, they weren't using
dollars yet, they were using pounds, British pounds, and the
amount of pounds you would get would be increased if
inflation were to start. So, they defined an index
of commodities that you might purchase. And that index was used to input
a formula that created inflation correction
to the bonds. So, these bonds were
issued in 1780. And it served an important
purpose, because the U.S. was fighting a war with the United
Kingdom at the time, and there was tremendous inflation. So they were very important. But after the war, after the
Revolutionary War ended, they stopped issuing these bonds, and
they forgot about them in the United States until 1997. It's amazing. Why did the invention
disappear? It's like gimlets. I think maybe gimlets will
make a reappearance. Maybe some of you will
buy a gimlet. They're very cheap,
by the way. And very useful. It seems like there's a
psychological barrier toward adopting something that's a
little bit complicated. And people have trouble
understanding index bonds, and they have trouble
understanding, how the formula works. They think, you know,
I just want money. But, then you ask, well, why
didn't people learn? If you look through history,
we've had bouts of inflation so many times, in so many
different countries. And you know, if you buy a
nominal bond, it's risky, especially if you buy
a 30-year bond. People are doing that even
today all over the world. They buy these 30-year bonds
denominated in dollars or euros or some other currency,
and what's going to happen to those currencies? So, why don't you denominate
your bond in something more realistic? Well, after 1997, the
introduction in United States of index bonds, the
reintroduction in 1997, seem to be started by one person. Larry Summers, who is Assistant
Treasury Secretary, just believed in this. And he did it. And so, we still have them. It got up to over 10%
of the U.S. debt. Now, under Bush and Obama,
they're kind of letting them sag now, they're down to
6% of the U.S. debt. But it really should
be 100% of the U.S. debt should be indexed. So, this is a kind of example
of progress that is made gradually through time. And maybe you'll see that
in the next 40 years. I'm trying to think of how we
can make these things happen. That's an agenda for people,
younger people who can start innovating and changing
our financial system. I wanted to talk about an
invention that particularly intrigues me that comes from
the country of Chile. It's a financial invention,
that overcomes framing problems. Psychologically
salient -- it's an important invention,
and illustrates some of the basic concepts. So let me talk about Chile. We're jumping around
the world here. Chile had a problem with, like
many Latin American countries, especially of that time,
with inflation. So, they had a currency called
the peso which inflated enormously. It went up, I don't have the
numbers on it, but it went up, you know like, prices went
up a thousand-fold. And people were saying, we
can't trust anything. I wouldn't take a contract
paying pesos. The peso is gradually
becoming worthless. So, Chile switched to another
currency called the escudo in 1960. They said, OK, we're starting
fresh, we're not going to have inflation. And this is brand new. Now we're an escudo country. No inflation. Then, in 1975, they switched
back to the peso. The exchange rate, peso to
escudo, was one escudo was 1,000 pesos. OK? Because they'd had
something like a 1,000-fold price increase. And then, in 1975, the exchange
rate was one new peso is 1,000 escudos. So, a new peso was a
million old pesos. OK, this is getting
embarrassing. I mean like, can we trust
anything or anybody in Chile? So, the invention
started in 1967. People in Chile were saying,
we just want stability. You know, this is crazy,
our prices. If I owned one peso -- I have a nice 1,000 peso note
from 1955 and I pull it out in 1975 and it's worth nothing. It's not even worth the
paper it's printed on. So we've got to get
stability somehow. So, somebody in Chile had the
idea, all right, maybe we can't protect, we don't know how
to protect the currency, but we can create a unit
of account that is stable in value. And let's write contracts in
this unit of account rather than pesos. So, in 1967, in Chile they
created something called the Unidad de Fomento. That's Spanish for Unit
of Development. But what it was, was a
unit of account that is indexed to inflation. And they said, write your
contracts in terms of -- and they called them
UFs, okay? So, everything could
be written in UFs. Forget pesos, because you don't
trust pesos anymore. Let's write contracts in terms
of something else. And that stuck. It started out as 100 escudos. I think it was one UF was 100
escudos in 1967, but, by 1977, a UF was 450 new pesos. Now, if you want to know what a
UF is worth now, you just go on the internet and it gives
it for every day. And the website is -- I think the website
is valoruf.cl, but that's from my memory. And so, I looked up what a UF is
worth today, and it's, I'll use the dollar sign for
pesos, 21,468 pesos. So, that means that since 1977
prices have gone up about 50-fold in Chile. OK. But if you signed a contract
written in UFs, you're completely protected
from that. And so, it's a very important
invention. Why is it an important
invention? It's important, because
without it Chileans wouldn't index. We don't index much in the
United States, nothing, almost nothing is indexed
to inflation. Why not? I don't know. It's like resistance to
wheeled suitcases. You almost can't
figure it out. It's so obvious. When you rent an
apartment, they should index it to inflation. They should tell you, our
apartment rent goes up every month, or down, depending
on the price level. When you advertise a house
for sale, it should be indexed to inflation. Otherwise you're just
making it crazy. You're just making -- Yale tuition should be
indexed to inflation. It should go up and down with
the level of inflation, that keeps its real value constant. But we don't seem to do it,
because we can't -- something is blocking our
thinking about it. So, we have to do something
like this, I believe. And so, that's what
Chile has done. So, this is the way things
are done today in Chile. It became an invention
that took hold and never left that country. If you rent an apartment in
Chile, good chance that your rent will be quoted in UFs,
OK, and if you're paying a monthly rent check, this
is what you do. So your rent is I don't
know how many UFs. You go to valoruf.cl, you find
out how many pesos it is, you write out a check for that
number of pesos. OK? And they do this out of habit. The amazing thing I discovered
is that in the United States, and in just about every country
in the world except Chile, alimony payments
are defined in currency, all right? You get a divorce. The mother, let's say, has
to support children. The father is required to pay
alimony for the next -- until the children grow
up, or indefinitely. All right? That's a long-term contract. What if there's inflation? What does it do to the
value of the alimony? Well, of course, the real
value goes down. So, shouldn't courts just
index it to inflation. Well, they do in Chile. Because they've got a habit of
doing things in terms of UFs. So, this is an important
financial innovation. By the way, guess how much
consumer prices have gone up in the United States since
we created a consumer price index in 1913. It's 22-fold. We've had a lot of inflation
in this country. 22-fold. Something that cost $1 in 1913
will cost $22 today. That means, if you held cash
between 1913 and today, basically you're completely
wiped out. But the inflation rate
is only 3% a year. That's 3% a year for
almost 100 years is a 22-fold increase. So, we're living with this kind
of uncertainty in the United States today. We have not adopted the Chilean
invention of UFs. It's interesting that this
invention spread, somewhat, throughout Latin America. And it stopped at
the Rio Grande. Mexico has something
called UDI. Which is the Mexican version. It's U-D-I. Which is
the Mexican version of Unidad de Fomento. But the rest of the
world doesn't want to copy this idea. Why is that? I think it's partly because
this idea emerged out of embarrassment. Chile had had massive
inflation which is embarrassing, and nobody wants
to copy anything from someone having that bad experience. It's also cultural, that
we're not used to Latin American things. Just like we're not used
to using gimlets. So, we don't have them. Let me just give one
more invention. It's important. And then I'll stop. This is another financial
invention, more recently. It's the invention
of the swap. I like to give this example,
because it relates to a couple of our speakers. What is a swap? Well, the swap is a financial
contract that was invented by none other than David Swensen,
who will be speaking soon. He is the Chief Investment
Officer for Yale University. He invented this before he
came to Yale, when he was working for Salomon Brothers,
which was a major Wall Street investment bank that
no longer exists. But back then, in the early
80's, he apparently -- I've got a couple of sources. I think he is the real
inventor of it. What is a swap? It's a contact between two
parties, usually a fairly long-term contract, to
exchange cash flows. So the simplest swap would
be a currency swap where one country -- There's two parties. Two different companies,
let's say. One of them who promises to
exchange euros for dollars every month for the next five
years, and the other one promises to exchange dollars for
euros every month for the next five years. It's a swap, but we decide in
advance on what the conversion is, what the swap rate is,
between euros and dollars. So that's useful for risk
management purposes, because somebody, someone in Europe may
be getting dollars revenue in their business. They know they're going to get
this revenue over the next five years. It's kind of a long-term
contract, long-term business they're in. They might want to
go twenty years. But they don't know at what rate
they can convert it back into euros. And then, on the other side, we
have the Americans who may be doing business in Europe, and
they get euro income and they want to convert
it to dollars. So, they can make a contract
that swaps these cash flows. And that was the invention. And it didn't come
until the 1980's. It's amazing that these simple
ideas weren't out there. And why weren't they
out there? Well, it may have something to
do with legal uncertainty, regulatory uncertainty. There's something called
ISDA which was founded since the 1980's. That's the International Swaps
and Development Association. And what it does is, it lobbies
lawmakers for laws that permit swaps to work
efficiently and effectively. And so, you need an organization
like ISDA that will make these contracts work
as effectively as they are. Now swaps are a hugely
important contract. My last example, which is a
sub-example from this, is the credit default swap, which is
something that I won't put David Swensen's name. The credit default
swap is a -- again a contract between two
parties that has to do with the risk of a credit event. So, there's a protection
buyer. There's two parties. One we'll call the protection
buyer, and the other is a protection seller. And it would have
to do with -- basically the buyer promises to
pay the seller, at regular intervals for some period of
time, and the money just flows regularly from the buyer
to the seller, until some event occurs. We could say a bankruptcy
of some company. It's defined in the contract. In which case, then, the
protection seller has to pay the protection buyer. Now you might ask, isn't
this just like an insurance contract? Wouldn't you call
this insurance? If I'm paying regular payments
to somebody else, and then, if an event occurs, I'm getting
insurance against default by some company. And I maybe doing business with
the company, or I may be investing in the company's
bonds, so I may want this protection. But it looks like insurance,
right? Well actually, there's something
else called credit insurance, which goes back to
the nineteenth century. There were companies in like
1880 that would allow you to buy insurance against default,
or some failure of a company. So, this was an institution
and an invention of the nineteenth century. But credit defaults
swaps are -- what's the difference? Well, the difference is, that
there is a whole culture and regulatory environment developed
around credit insurance that limited it. They didn't have ISDA. They had state insurance
regulators, OK, and they just didn't have the same conceptual
framework. It's complicated. The credit default swap was
boosted by ISDA and other thinkers, who thought of
how to make this into a huge, huge business. Credit insurance ended up being
kind of limited in its application. And often the credit insurers
were more like consultants. They would say, we'll
insure your credit. It will insure you against
the default by someone you lend money to. But we want also to be involved
in helping you avoid making bad contracts
like that. So, the credit default
swap became huge. Let me just conclude
with this. This brings us back to one
of our outside speakers. Hank Greenberg is going to talk
about his company AIG, which failed because of errors
-- it didn't fail, it got bailed out by the government. It got bailed out because
of errors made in credit defaults swaps. I don't think that these errors
were his fault, because this happened after he
left the company. But I just want to mention this,
because it's all part of a big picture. We had a financial invention,
the swap. Then we had the credit
default swap. And these are important
invention. They caused a leap forward
in our ability to do risk management. But they created attendant
risks. They were new, and they weren't understood well enough. And so, a big part of what
happened in this crisis was a failure of the credit
default swap market. But that's not to me an
indictment of financial innovation. I think the credit default
swap was an important innovation, and we will see more
like it, and it will help make for a better world.
