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July 29, 2003
Book Review--The New Financial Order: Risk in the 21st Century
    by William Baue

A Yale economist proposes innovative ways to use risk management as a tool to counteract economic inequality and livelihood uncertainties, among other things.

Many institutional investors employ socially responsible investing (SRI) as an innovative form of risk management. Among other things, SRI identifies companies that have progressive social and environmental practices, and these practices can lower the risk of losses from lawsuits, regulation, and reputation damage.

In his new book, The New Financial Order: Risk in the 21st Century, Yale economist Robert Shiller laments that risk management is an underutilized yet powerful tool. Instead of limiting risk management to financial markets, Dr. Shiller applies it to aspects of our personal lives and our collective social life that carry great risks. He proposes half a dozen innovative forms of risk management as well as the technology to support them. Several of his propositions address social issues, and may be of interest to social investors from a philosophical perspective.

For example, Dr. Shiller proposes the establishment of "inequality insurance," which is meant to counteract gratuitous, random, and painful economic inequality. Dr. Shiller believes that the economic inequality created by the capitalist system is not inherently bad, but rather that gross inequality needs to be tempered. For this reason, he suggests a type of insurance that is fixed to the degree of inequality in the system: the greater the inequality, the more those on the losing end receive in financial insurance compensation.

"Democratizing finance means effectively solving the problem of gratuitous economic inequality, that is, inequality that cannot be justified on rational grounds in terms of differences in effort or talent," Dr. Shiller writes in the book.

Dr. Shiller also proposes several other solutions to unpredictable economic hardships that hit individuals disproportionately. Livelihood insurance decreases the risk of entering a profession with unclear prospects, such as classical violin or biochemistry. Prospects in these arenas could dry up after someone has committed many years to them, a fact that deters many from making such career choices.

However, the risk that such a career might prove less-than-lucrative could be hedged away by insuring it through a highly diversified portfolio that could spread the risk across a broad enough spectrum of international investors and investments. Social investors may find this approach interesting not only from a philosophical perspective, but also from a practical perspective, as these types of investments may represent socially responsible vehicles.

Dr. Shiller points out the irony that securities tied to corporate profits account for the majority of investments, while the lion's share of economic value in society exists outside the stock markets in incomes and home equity. Dr. Shiller's propositions thus create potential value not only for the individuals whose risks would be better managed, but also to investors who can responsibly extract value from these untapped resources.

Besides inequality and livelihood insurance, Dr. Shiller also proposes several other innovative risk management mechanisms. These include income-linked loans, with interest rates and repayment schedules that vary according to income level, and intergenerational social security, which would allow risk to be shared across ages.

The types of risk management that Dr. Shiller proposes all require vast quantities of archived and updated information, an obstacle that made them inconceivable until now. However, technology has progressed far enough to allow for the gathering and indexing of the information necessary to support such progressive innovations. In order to facilitate ongoing progress, however, Dr. Shiller proposes the construction of "global risk information databases," or GRIDs, which would provide the statistical infrastructure for new risk management mechanisms.

Readers may find themselves finishing this book ready to believe that risk management can solve all the world's problems. Dr. Shiller makes no such claims.

"It may seem remarkable that all of these ideas would be implemented," he writes. "But we must start somewhere."

"If we can achieve but one of them, in some form, it would be a major improvement," Dr. Shiller adds. "And the ideas feed upon and support one another, so that implementing one makes it easier to implement another."

Perhaps in the not-too distant future, institutional investors may be diversifying their portfolios in ways that solve not only their own risk management problems, but also those facing individuals and society as a whole.


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