How We Can Make the System Fairer

In his latest book, Yale’s Robert Shiller offers his ideas for fixing the world of finance.

Robert Shiller has made some unusually prescient predictions about America’s financial system. In his March 2000 bestseller, Irrational Exuberance, the Yale economics professor popularized the idea that Internet stocks, which had skyrocketed in the late 1990s, were dangerously overpriced. The bubble soon burst. A 2005 edition of Irrational Exuberance warned of the housing bubble that sparked the 2008 financial collapse.

In Shiller's latest book, Finance and the Good Society (Princeton University Press, $25), he explains how the "democratization" of finance has worked in favor of most people -- as well as how parts of the financial system have become broken and corrupt. He also offers ideas for fixing the problems.

We spoke to Shiller recently about the health of the financial industry and about economic opportunity and inequality.

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Despite the recent problems, the financial-services industry has done a lot of good over the years, hasn't it?

Originally, financial arrangements weren't even open to most people; you needed something like an act of Parliament to set up a company. It wasn't until 1811 that the state of New York made it easy to start a new company. The savings bank movement in the 19th century brought banking to the people, and mutual funds, which were invented in the 1920s, made it easier to invest in stocks and other assets.

And now it's hard to imagine a world without mutual funds and a bank branch on every corner.

Yes, although still only about half the U.S. population invests in stocks, so we have a way to go.

Your book centers on the march of finance, both as it affects individuals and drives economies around the globe. Is it so revolutionary?

I think so. The most amazing thing is how the whole world is becoming part of financial capitalism -- finance is the lead engine driving capitalism. The world is getting more financially sophisticated, and that has led to rapid economic growth in China, India and other nations. Hundreds of years from now, historians will look back at our time and recognize financial capitalism as a major turning point in world history.

But with growing wealth has come a concentration of capital and power. Should we do something about it?

The Dodd-Frank financial reform legislation has some language about limiting the size of financial corporations, but it is very gentle. Dodd and Frank [former Sen. Chris Dodd and Rep. Barney Frank, authors of the Dodd-Frank Wall Street Reform and Consumer Protection Act] are not Teddy Roosevelt, who broke up Standard Oil and other corporations. So that's something we have to consider.

Is there a danger in storming the castle and breaking up big finance?

We live in a big world. Big financial corporations benefit from economies of scale. If we break them up, we will be at a disadvantage compared with foreign financial companies. But we have to weigh that risk against the risk of too much power being concentrated in a few financial firms. It's important that people feel they can really participate in the economic system -- that they can start a business that can grow. The company may end up getting split up when it gets really big, but that's all right.

What's needed to restore faith in the financial system?

We have to bring finance back to the people. We don't want absolute equality, but we have to have a sense that every person is important and that we have a fair and just society. We had a better feeling in this country in the years after World War II, partly because we had a more progressive tax system but also because economic inequality was less common than it is now. I think that's a better world for everyone, including the rich.

Because they don't want their castles stormed?

Yeah, you don't want people resentful of you.

Many people think the rich have so much influence that we'll never be able to reform the financial system.

My impression is that the problem isn't as severe as you might think. Businesses hire lobbyists, but we still get legislation such as Dodd-Frank and Sarbanes-Oxley [a 2002 act that increased regulation of the boards of directors of all publicly traded U.S. companies and their managements and of major accounting firms], which are certainly not laws that business dearly wanted. So it seems that we do have a functioning democracy.

You write that human nature isn't as programmed for greed as many might think. How so?

I know this may sound naïve to some people, but one of the themes of the book is that I don't think that people are relentlessly selfish. Adam Smith, the inventor of modern economics, is often described as a laissez-faire economist. But he said that people are not completely selfish by nature and that they want to be part of a good society.

Smith also warned about the bankers and lenders getting too much power.

Well, Dodd-Frank does seek to limit a further concentration of power.

The democratization of finance doesn't extend to certain investments reserved for the rich, including venture capital, private equity and hedge funds. Should the government do something about that?

Wealth shouldn't qualify you for owning such investments; knowledge should determine eligibility. It has been proposed that anyone should qualify to make such investments by passing an exam. That sounds logical to me.

You write that CEOs have incentives to take big risks because of how their pay is structured. How should compensation be changed?

One idea -- admittedly, an imperfect one -- that's already been tried is to give CEOs shares in their company that would vest in the future rather than paying them immediate bonuses. Then executives would focus on the long-term value of the shares and not just immediate profits that might be made at the expense of future profits. I was part of the Squam Lake Working Group on Financial Regulation [15 academics who offered guidance on financial reform], and we came out for the idea of deferring CEO salaries. If a CEO caused the bankruptcy of a company or it required a government bailout, the CEO wouldn't collect his or her salary.

That could give people a sense that justice has been done.

Right. It's important that people feel that there's some basic fairness to the system.

You propose that the tax system be indexed for inequality. How would that work?

First of all, I'm not opposed to even substantial income inequality. But there's a risk that it might get much worse than it is now, and I think we have a sense as a society that we don't want that to happen. So we should legislate plans for the future to raise taxes on the rich if much more wealth gets concentrated at the top. It would be easier to do that now than to wait until after it happens.

The rich might not be too enthusiastic about your plan.

It wouldn't be so bad for them because they'd still be rich, just not so phenomenally rich. And if they're self-interested, they shouldn't fear this. Less inequality is the better outcome because, ultimately, being rich isn't so good if you're not appreciated by other people.

Bob Frick
Senior Editor, Kiplinger's Personal Finance