LATELY, a lot of attention has been focused on the stockmarket bust after the 1990s boom and on the short-term state of the economy, now teetering in and out of recession. Look ahead, though, and there is every reason to think that there are bigger, equally unpredictable economic risks on the way. Perhaps the biggest such issue in the next ten years will be the quick pace of change in the economic status of individuals. Advances in technology, in particular, have increased the chances both of striking it lucky, and becoming very wealthy—but also of being unlucky, and becoming very poor. The likely outcome is both greater economic uncertainty and greater inequality. But there is good news too: the financial tools that will allow ordinary folk to cope with increased uncertainty, and to insure against adverse economic events, are already being developed.
Inequality has been on the rise in virtually all rich countries in recent decades. This increase appears to be due, in large part, to changing technology, such as rapidly advancing communications, information and control technology, and its effects on an interdependent world economy. It is true that, by some measures, world income inequality has been decreasing—notably because China and India have been catching up. But there are reasons to expect a longer-run tendency towards much greater inequality.
Advanced technology often means that a smaller number of skilled people supply their services over a wider area, producing a “winner-take-all” effect, where only the best do well, and these lucky few command enormous incomes. The invention of the phonograph did this for singers, and the invention of the motion picture did it for actors. Proliferating communications and information technology may do the same for many other occupations in the future.
So far, a good deal of public resentment about increasing inequality has centred on the most visible highly paid people. Recently, public policy has focused on preventing a few unscrupulous top executives from unfairly enriching themselves at investors' expense. However, we are likely to discover that this, while helpful, does relatively little to mitigate the forces that make or break fortunes, which are much bigger than any fraud or malfeasance that we see today. Why? Because new technology produces far more pervasive and important changes in fortunes than those caused by dishonest boards or accounting shenanigans. Such changes stem from the very stuff of capitalism, undramatic events that unfold over many years: word processors replacing secretaries, industrial robots replacing assembly-line workers, and online-learning sites replacing professors.
Although new technology can mean that jobs are replaced by machines, it has often created as much employment as it destroyed, albeit of a different type. When Cyrus McCormick's automatic harvester replaced field hands in the mid-19th century, the invention promoted greater prosperity and helped to create a variety of other jobs, like turning grains into fancy breakfast cereals and packaged baked goods.
Now, though, with the pace of technological progress increasing, there is a high degree of uncertainty whether lost jobs will ever be replaced with others that are as remunerative. We have moved from the field to the factory to the service sector, but as technology relentlessly advances, it isn't clear where we will be heading next. A possible dearth of good career alternatives for many people could generate great inequality in coming decades.
Yet, paradoxically, the same technology that is creating this inequality could also reduce it. It got us into the problem and it can get us out. This technology needs to be coupled with the science of risk management, which combines elements of finance and insurance to help deal with the possibility of adverse events, in much the same way as bankers and financiers minimise the risks of doing business by using fancy financial arrangements such as currency hedging and interest-rate swaps.
Most of us do not think of inequality as a risk-management problem akin to those that financiers or insurers deal with. However, if our purpose is to reduce gratuitous inequality—ie, inequality that cannot be justified in terms of individual talent or effort—then we should reduce the random economic shocks that affect our lives, such as random shifts in the market for our labour. The most basic principle of finance and insurance is that spreading risks over large numbers of people can reduce their impact. The challenge today is to discover how to make this principle work for the greatest economic risks that most people face.
By coupling risk management with technology, society can much more thoroughly reduce the negative impact of future risks. This will require some innovation, but we can achieve this, and we are already trying.
Today, investment banks use sophisticated financial instruments to help business clients hedge against changes in such things as the value of currencies or in commodity prices. For example, a company that uses oil as an input in production can buy an option to purchase it at a predetermined price and thus eliminate the risk that oil will get too expensive. An American firm that has a cash inflow denominated in euros can, with the help of an investment bank, sign a swap contract that exchanges this euro income for dollars at a predetermined exchange rate, thereby eliminating currency risk. Similarly, venture-capital firms help young start-up companies by setting up a compensation structure that shields employees from some of the greatest risks of the business and yet offers them enough potential rewards to stimulate them to work hard. The employees are able to pursue a very risky business without worrying that failure will put their families on the streets.
Investment banks and venture-capital firms are willing to help clients mitigate these risks because they have a great deal of information on which to base their decisions. Exchange rates and oil prices are well-understood and well-measured risks, for which there are large and deep markets with prices that can be observed on a second-by-second basis. When dealing with large companies, it is well worth the investment banks' efforts to understand their clients' problems and educate managers in risk-management principles. Venture-capital firms are able to reduce risks for start-up businesses because they have control over the terms of the deal, carefully laid out by lawyers, and with accurate accounting of the goings-on in the company.
In the future these same general risk-management techniques could be applied to every individual worker, as information becomes more available, as automation reduces the costs of tailoring risk-management contracts to individual needs, and as new technology is developed to deliver such services widely.
The same information technology that helps big businesses manage risks is providing greater detailed information about individual economic risks, allowing us to form thousands and thousands of indices of incomes and prices. We are developing huge databases of information about individual incomes, and their correlation with other economic variables. These databases are increasingly accurate and up-to-date, so that they can provide the bases for settlement of risk-management contracts.
For most individuals, the biggest risks are not euro-dollar exchange rates or oil prices. Instead, they are their pay packets or the price of their homes. It is reasonable to suppose that, in coming years, our personal financial-services software, with the assistance of professional organisations or trade unions and pension funds, will allow people to make essential contracts to reduce income risk. Individuals may be able to create financial swaps of average incomes in their region (as measured by a regional income index), thereby reducing risk. It will also be possible to create home-equity insurance contracts that protect them against a decline in the market value of their homes.
We will also be able to expand the complexity and coverage of existing insurance, notably disability insurance. Right now, disability insurance covers specific medical problems. It could be expanded to cover a much wider range of risks to an individual's career. Employees could get insurance against losing their jobs to an emerging technology or cheap overseas workers. Currently, insurance companies do not cover such risks, primarily because the risks are not objectively verifiable or measurable. But, as our database technology and our ability to track individuals through time grow, the scope of insurance should widen dramatically.
It will also be possible to create for individuals contracts that provide incentives for them to advance their own individual careers. These would be analogous to the kind of contracts that venture-capital firms draw up for the management of young companies. An individual may then go forth and develop a highly risky personal career, acquiring specialised skills that also have a small probability of being extremely important but carry as well a risk of becoming useless. Such individual contracts could be a breathtakingly important stimulus for our economy, if they free people from career risks and allow them to be more adventurous in all aspects of their careers. We may then expect to see an explosion of individual creativity and diversity.
The same information technology will allow us to produce large international markets for a complex array of aggregated risks that today are not traded at all. In the not-too-distant future, we can have what will in effect be online auctions for occupational-income indices, for gross domestic product and for swaps between the GDPs of different nations. These international markets can be used by insurers and other retailers of individual risk-management services to lay off the risks that they incur by helping individuals with their risks.
When will we have the ability to insure ourselves—our jobs, our homes, our lives? Today there are a few early indicators of innovative risk-management techniques, some of which could grow to have a large impact.
In October 2002, Goldman Sachs and Deutsche Bank created a new electronic market (www.gs.com/econderivs/) for economic indices that represent substantial economic risks, such as nonfarm payroll (a measure of job availability) and retail sales. This new market was made possible by a sophisticated trading technology, developed by Longitude, a New York company providing software for financial markets, called the Parimutuel Digital Call Auction. This is “digital” in the sense of a digital option: ie, it pays out only if an underlying index lies in a narrow, discrete range. In effect, Longitude has created a horse race, where each “horse” wins if and only if the specified index falls in a specified range. By creating horses for every possible range of the index, and allowing people to bet on any number of runners, the company has produced a liquid integrated electronic market for a wide array of options on economic indices.
Ten years ago it was virtually impossible to make use of electronic information about home values. Now, mortgage lenders have online automated valuation models that allow them to estimate values and to assess the risk in their portfolios. This has led to a proliferation of types of home loan, some of which have improved risk-management characteristics.
We are also beginning to see new kinds of insurance for homes, which will make it possible to protect the value of what, for most people, is the single most important component of their wealth. The Yale University-Neighbourhood Reinvestment Corporation programme, launched last year in the city of Syracuse, in New York state, may be a model for home-equity insurance policies that rely on sophisticated economic indices of house prices to define the terms of the policy. Electronic futures markets that are based on econometric indices of house prices by city, already begun by City Index and IG Index in Britain and now being developed in the United States, will enable home-equity insurers to hedge the risks that they acquire by writing these policies.
These examples are not impressive successes yet. But they stand as early precursors of a technology that should one day help us to deal with the massive risks of inequality that otherwise will beset us in coming years.
Robert Shiller is professor of economics at the International Centre for Finance, Yale University, and the author of “Irrational Exuberance” (Princeton University Press, 2000). His new book, “The New Financial Order: Risk in the 21st Century” (to be published by Princeton University Press on April 2nd; $29.95 and £19.95), on which this article is based, lays out a vision for the future of finance, insurance and social welfare.
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