Reforming U.S. Financial Markets: Reflections Before and Beyond Dodd-Frank by Randall S. Kroszner and Robert J. Shiller

All that sounds intriguing, but this is one of the more misbegotten texts I've read lately. The biggest problem, which is implied, but never clearly laid out, is that this book exists simultaneously and uneasily in two time periods: April 2009, when the symposium took place, and sometime after Dodd-Frank passed in July 2010, when the presenters seem to have amended their papers. This is disconcerting since it's never made clear, even in Friedman's introduction, what's going on. The papers generally are vague on a number of fronts, and the comments are scattershot, though Kaufman and Scott manage to squeeze in some specific issues. But it's disorienting: One minute you think the generalities stem from the actual date of the symposium -- only months after the crisis -- the next minute they're yakking about Dodd-Frank.
 
The book is also a kind of two-headed beast. Shiller argues that fixing what ails us is a matter of "humanizing and democraticizing finance." This is a subject he's touched on before, though he's short of specifics. The gist of it is that we need to provide "democraticized" risk management tools to ordinary people and to design regulatory processes with the insights of behavioral finance in mind. In a fairly typical formulation, Shiller suggests, on the subject of systemic regulation, that "We have to humanize policy regarding speculative bubbles and leverage, so that regulators' judgments based on their theory of mind can be applied." If you can explain that, you're better than I.  
 
Kroszner, on the other hand, takes a more standard approach. He sketches a series of problems that need to be fixed -- the credit rating process, securitization, resolution authority, clearinghouses for derivatives. This may have been an interesting list in April 2009, but by mid-2010 every one of these items had been debated and discussed to death. Kroszner offers up what David Skeel in his insightful book on Dodd-Frank calls a corporatist approach. He does not defend that view as much as  explain it. He essentially argues that we need to fill in regulatory gaps but, as he pleas far too many times, mostly in reference to the credit raters, "Don't throw the baby out with the bathwater." This seems to be his regulatory philosophy.
 
So it's a strange mix: Shiller reaches for abstraction and transformation. Kroszner hugs the ground and focuses on specifics. Both economists mostly whiff at the most pressing questions: too-big-to-fail, regulatory capture, moral hazard and resolution authority.
 
In many ways the biggest disappointment here is Shiller who repeatedly mentions "Animal Spirits," his most recent book, written with George Akerlof, on behavioral finance (published in January 2009)  and argues for a fundamental change in the way we regulate. Shiller summarizes Dodd-Frank, but he ignores most of its major initiatives, with the exception of the consumer agency. Too-big-to-fail doesn't seem to concern him, and regulatory capture seems to be an issue that can be rectified by having regulators adopt a "theory of mind." He is aware of a populist backlash, but he proposes schemes that will inevitably be shredded by toxic politics. He does make one striking statement, though he does so to support his own behavioral approach: "The efficient markets hypothesis is one of the most remarkable errors in the history of thought, given its impact on our economic institutions and on the economy," he writes. "Perhaps it is better to say that it is one of the most remarkable half-truths in the history of economic thought."
 
Shiller's paper offers the strengths and weaknesses of the behavioral school. Its strength is that basic psychological insights into how men and women deal with (or fail to deal with) financial matters provides a powerful critique of efficient markets. For instance, it's very clear that prices don't always reflect all the available information. And it's amazingly obvious that people do not always act in a rational, self-interested, utility-maximizing way. Humanity is prone to biases and blind spots; limitations on gathering and processing information; sheer disinterest or active aversion; overshooting, undershooting and herding. But given that, how can you create a regulatory regime that takes these into account? As Pozen points out, it's a little hard to imagine providing the public risk management tools when many employees have to be nearly tricked to sign up for 401(k)s, which they then claim not to understand all the while ignoring educational materials. Pozen's comment cuts deeper than just retirement savings. Given what we know about ordinary folks and their relationship with matters financial, what real psychological truths can we discover that will help us help them, or that will apply to a large enough group of people to be useful? How do we balance oversight and freedom? Do we really understand psychology deeply enough to establish real truths?
 
Shiller is a true believer in psychological research and in the rationality of the human animal. He sees no problem in translating complex, often ambiguous, even paradoxical financial information and concepts to Main Street, as long as it's done with some knowledge -- and he believes it is knowledge -- of psychology. "Had people been watching these markets," he writes, arguing for a plan to sell real estate futures to homeowners as a hedge on their property, "they would have seen the crisis coming, and presumably taken steps to prevent it. For example, builders may never have let the phenomenal housing construction boom, which peaked in 2006, continue, and so there would not be the huge inventory of unsold homes that is depressing the economy today." (The key to that sentence is "presumably.") But that, of course, suggests a rational response to credible information. What if millions of Americans were speculating on real estate, and only needed a few months to flip their home; or what if they refused to believe the signs in the market? (Shiller rejects efficient-market signals but then expects them to be widely used as risk-management tools.) Who will make them pay attention? Why should Main Streeters be more prescient than Wall Streeters, who did have access to data and ignored it?
 
Is it reactionary to believe that for all the good work Shiller and his colleagues have done, we do not yet possess a robust-enough theory of mind upon which to erect a humanized and democratized (which differs significantly from democratic) regulatory system? Is it mean-spirited to suggest that, as a replacement for efficient markets, behavioral economics would create just as much of an ideology, just as much of an imprisoning system and just as much of a disaster, in perhaps a shorter time, as anything Milton Friedman or Alan Greenspan dreamed up? Perhaps there's a half-truth lurking there. - Robert Teitelman