3. Technology and Invention in Finance

Summary

Finance as a public-serving profession

Robert Shiller opens by challenging the idea that finance is inherently greedy or socially harmful. He argues that financial professionals can serve a moral purpose: protecting people’s livelihoods and helping them manage economic uncertainty. Although questionable lending practices can cause serious harm—as highlighted by the subprime crisis—he cautions against treating the entire field as malicious.

Risk pooling is a central purpose of finance

The lecture’s central principle is that people can improve welfare by sharing risks rather than leaving individuals to bear misfortunes alone. In an ideal system, risks would be spread broadly, including across countries, so losses affecting one person or place would have little effect on any one participant. Risks that affect everyone, such as a global catastrophe, could not be diversified away.

Shiller cites research comparing consumption changes across countries. Under perfect international risk-sharing, country-specific shocks would be spread across populations, leaving mainly worldwide shocks. The research he discusses finds that consumption changes are not highly correlated across countries, suggesting that risk-sharing remains limited.

Risk pooling is intuitive: neighbors might agree to help one another if a home burns down. But small, close-knit arrangements cannot spread risks as widely as arrangements among people in different regions and industries. Financial markets can formalize risk-sharing among people who may never meet.

Risk-sharing creates moral hazard

Risk management can change people’s incentives. This is moral hazard: when protection from a loss encourages behavior that increases the chance or size of that loss. A familiar example is fire insurance that might encourage someone to burn down an insured home.

Shiller uses communal and political experiments to show the tension between sharing risk and preserving incentives:

• Robert Owen’s New Harmony sought to organize shared economic life, but conflict and disagreements undermined the community.
• Communal groups, including Israeli kibbutzim and the Hutterites, pursued extensive sharing. Shiller says such arrangements can face disputes, restrictions on personal choice, and incentives to contribute less.
• Communist ideals, including the principle “from each according to his abilities, to each according to his needs,” can be understood as comprehensive risk-sharing. Shiller argues that fully pooling economic outcomes can weaken incentives to work and produce.
• John Harsanyi and John Rawls offered ways to think about justice and distribution under uncertainty. Imagining that people choose society’s rules without knowing their future circumstances makes risk-sharing appealing, but it does not necessarily imply absolute equality. People might accept some inequality if basic needs are protected and incentives remain effective.

Shiller presents modern finance as one evolving way to share risks more widely while designing incentives to reduce moral hazard.

Taxes and welfare are major risk-management systems

The tax-and-welfare system is, in Shiller’s view, one of the most important risk-management arrangements already in place. Progressive taxes and support for people facing hardship redistribute resources and help cushion major income losses. He also points to emergency medical care as a form of protection against severe health-related costs.

These systems are imperfect and can create moral hazard, but he argues that they provide substantial protection and should be understood partly as mechanisms for sharing risk.

Psychological framing affects financial decisions

People may respond differently to economically equivalent choices depending on how those choices are presented. Drawing on research in psychology, Shiller calls this framing.

Examples from the lecture include:

• Lost concert tickets versus lost cash: People often say they would not buy replacement tickets after losing tickets worth $400, but would still buy the tickets if they had instead lost $400 in cash. Economically, the loss is equivalent; psychologically, people place the losses in different “mental accounts.”
• Insurance wording: People may be more willing to accept a contract when it is described as “insurance” than when the same protection is described without that familiar label.
• Money versus real value: People commonly make loans in fixed dollar terms rather than adjusting them for inflation. Shiller argues that an inflation-indexed, or “real,” frame could better reflect purchasing power, but people are accustomed to thinking in money terms.

The lesson is that how financial choices are framed can influence whether people recognize and manage risks appropriately.

Financial products are inventions that solve practical problems

Shiller describes finance as a field shaped by discrete inventions. Financial arrangements are not automatically obvious or easy to implement: they need workable contracts, information, rules, and institutions. Successful ideas are often copied across countries and adapted to local circumstances.

For an insurance system to work, it needs several supporting elements:

• A contract that clearly defines which events are covered.
• Exclusions or other safeguards to limit moral hazard.
• Accurate valuation of insured property, supported by appraisal practices.
• Appropriate limits on coverage or co-insurance so that people do not gain by causing a loss.
• Loss statistics and, for life insurance, actuarial data such as mortality tables.
• An insurer with adequate reserves and a sound way to invest them.
• A means for customers to assess insurers’ reliability, along with regulation to check that they maintain adequate capital.

The basic idea of insurance may seem simple in retrospect, but Shiller emphasizes how many inventions and institutional arrangements are required to make it reliable.

Obvious ideas may take a long time to catch on

Shiller uses the wheel and the wheeled suitcase to illustrate why inventions that seem obvious today may not have seemed obvious earlier.

• Pre-Columbian societies in the Americas made wheeled toys but did not develop wheeled vehicles, according to the lecture.
• Bernard Sadow patented a wheeled suitcase in 1972, but retailers initially resisted the idea. His design could wobble when pulled.
• Airline pilot Robert Plath later developed the more stable two-wheeled “RollAboard,” with a rigid pull handle, and patented it in 1991.

The examples show how convention, social expectations, and design limitations can block ideas that later appear self-evident.

Information technology enables financial innovation

Financial systems depend on collecting, copying, transmitting, organizing, and checking information. Shiller describes nineteenth-century innovations that made those tasks cheaper and more reliable:

• Mechanized paper production and wood-pulp paper reduced the cost of records.
• Carbon paper made duplicate records easier to create.
• Typewriters made documents faster and clearer to produce.
• Standardized forms improved data entry.
• Filing cabinets made records easier to organize and retrieve.
• Civil-service systems and improved bureaucracy supplied more capable administrators.
• The postal service, including mail carried and sorted on trains, created a broad communications network.

Shiller calls the nineteenth-century postal system an “internet” of its time: it connected people and institutions across a country and made large-scale administration more feasible.

Social Security as a product of information infrastructure

Shiller presents Germany’s 1889 Social Security system as an example of financial innovation enabled by information technology and administration. The basic process was:

1. Workers and employers contributed specified portions of earnings.
2. Contributions were documented through the postal system, using stamps placed on a worker’s Social Security record.
3. Records were retained so the government could track each person’s contribution history.
4. At retirement, benefits were calculated according to a formula based on that history.
5. Other countries adopted versions of the system; the United States introduced its own during the Great Depression.

Shiller notes that modern systems use electronic records rather than postal stamps, while retaining the underlying idea of tracking contributions and calculating retirement benefits.

Overall lesson

Finance is presented as a technology for managing long-term risks. Its effectiveness depends not only on financial theory, but also on incentives, psychological understanding, institutions, contracts, and information systems. Shiller argues that progress comes through continual invention and adaptation, with the goal of helping people bear economic shocks without undermining productive incentives.

The lecture closes by previewing a later topic: portfolio diversification as an application of risk management to securities.

Speakers and sources featured

Speaker

• Professor Robert Shiller — the sole speaker identified in the subtitles.

People and works cited or discussed

• David K. Backus, Patrick J. Kehoe, and Finn E. Kydland — “International Real Business Cycles” (1992).
• Daniel Kahneman and Amos Tversky — research on psychological framing and decision-making.
• Robert Owen — social reformer associated with New Harmony.
• Karl Marx — discussed in connection with communism and economic risk-sharing.
• Louis Blanc — source of the principle “from each according to his abilities, to each according to his needs.”
• John Harsanyi — work on welfare, ethics, and distribution.
• John Rawls — A Theory of Justice (1971).
• Edward J. McCaffery — work on cognitive theory, taxation, and framing.
• Bernard Sadow — wheeled-suitcase inventor.
• Robert Plath — inventor of the RollAboard suitcase.
• Charles Babbage — cited for an early nineteenth-century computer design.
• Otto von Bismarck — identified as Germany’s leader when the 1889 Social Security law was introduced; Shiller says others were responsible for the idea.
• The London Times — cited for its 1889 prediction that Germany’s Social Security system would fail.

Institutions and examples discussed

Caisse de dépôt et placement du Québec; New Harmony; Israeli kibbutzim; the Hutterites; the U.S. tax-and-welfare system; the German postal service and Social Security system; and the U.S. Social Security system.