Monday, November 24, 2014
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Democratizing Capitalism

Capitalism is the world's engine of growth. But its very dynamism--its "creative destruction"--tends to produce great uncertainties. Unsuccessful firms are tossed aside to make way for new and better firms, and individuals who become economically less productive (often through no fault of their own) can also be "discarded" by the market, their careers interrupted and their investments cut to a fraction of their previous value.

This uncertainty has been at the root of demands for the state to intervene and protect the individual against the market's mercilessness. Beginning with Bismarck's social security system in 19 th century Germany, through the American New Deal of the 1930's, to the social-democratic policies of postwar Europe, many countries created a "mixed" welfare state in which governments control and temper market forces, providing an extensive "safety net" for individuals.

But despite its achievements, many people believe that the welfare state comes at too high a price in terms of dampening economic dynamism. The prospect raised by today's new technologies in finance and information is that some of the "market failures" at the root of state involvement in the economy may cease to exist. Indeed, the "creative destruction" that generates unacceptable risk to individuals is poised to deliver the means for tempering these same risks.

In fact, the most important capitalist mechanisms for blunting the impact of risk on individuals--insurance, diversification, and hedging--have been around for centuries. But broader application of these tools has accelerated with the advent of new information technology, which also allows us to apply these tools without undermining people's incentive to work.

Indeed, the world seems to be entering an age in which the basic principles of finance will be integrated into the world capitalist economy, and our lives, in a more thoroughgoing way than ever before. Aided by advanced information technology, financial institutions will be democratized and made available to everyone, which will go a long way toward solving today's problems of increasing inequality and declining economic vitality.

An example of recent progress illustrates what I mean. For most middle-class people in developed countries, the home they own is their most valuable asset. Although the postwar population boom and heavy regulation meant that real estate prices in many countries went up more often than down, a sudden collapse of the property market--such as happened in Japan a decade ago--may dramatically reduce the value of most people's savings.

Such a financial "hit" may affect their consumption patterns, complicate their retirement plans, and even bring them to the brink of indigence. Yet, until recently, one could insure one's home against fire or other damage, but not against a loss in market value.

That is changing. Two recent developments indicate the shape of things to come, although neither has attracted much notice.

First, in October 2001, the spread-betting firm City Index created futures markets on home prices in the United Kingdom. In May 2003, the investment bank Goldman Sachs created options markets for home prices, for the UK as a whole and for Greater London, with both to be traded on the London Stock Exchange. Theoretically, homeowners can use these new instruments to protect themselves against their home losing value. But these instruments are rather sophisticated--too sophisticated, in fact, for most homeowners to embrace.

Second, in July 2002, the city of Syracuse, New York, in conjunction with the Neighborhood Reinvestment Corporation, the Yale School of Management, and Realliquidity, LLC, created home equity insurance that pays out if an index of city home prices declines. Like the British options and futures market for home prices, this novel insurance policy is also, for the time being, a limited development, made possible by new information technology in the form of electronic databases of home prices and characteristics.

Someday, these two institutions will be brought together in one country. Regulators permitting, insurance companies will then be able to write policies against loss of home value for individuals, and then will be able protect themselves against the risk to which these policies expose them by taking offsetting positions in the futures or options markets. This should make them willing to offer such policies to millions of people in different localities.

Home equity insurance will clearly not solve all the problems of individual risk, but it will solve a very big one. Moreover, it is only one example of the democratization of finance now underway. Further advances along these lines will follow.

Many risks are gradually being added to the list of those that can be insured against. The types of risks traded on electronic marketplaces are steadily expanding. Trading platforms are being improved to allow more complex trading. Databases are rapidly improving in depth, and are becoming more deeply integrated with personal financial-planning Web sites. Even systems of taxation and social welfare are more sophisticated in using new tools of insurance, finance, and information technology.

As a result, our mechanisms for dealing with risk can become increasingly differentiated and complex. With modern computers and information technology, it will be possible to deal individually with a million different risks. The combined effect of many different financial innovations will be to blunt the impact of capitalist risk on our individual lives, helping to reduce economic uncertainty and inequality.

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    1. Portrait of Hosein Maleki

      CommentedHosein Maleki

      Although an "individual" can diversify away certain types of risk, risk still exists in the aggregate level and systematically, cannot be diversified.

      Application to this article: a home-owner can buy put options on the value of his property (or any other type of insurance) but as the economy is hit, there is no guarantee that the financial insurance is actually going to "pay": like what is happening to the CDS market on Greek bonds.

      In other words, it is still very likely that an individual pays the premiums but would not be compensated, at the end of the day.

      (One certain note to help understand why, is that large economic shocks most often affect the whole economy, therefore both individuals having bought or issued the "insurance" or the insurance firms go down together (AIG for example) )

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