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Solving the Subprime Crisis of Financial Democracy


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With everyone an investor—and exuberance in short supply—does the U.S. need a new New Deal? Yale economist Robert J. Shiller says we do

The Subprime Solution:

How Today's Global Financial Crisis Happened,

and What to Do about It

By Robert J. Shiller

Princeton; 196 pp.; $16.95

The stock market is down sharply from its peak. Bank failures are rising. The federal government is taking extraordinary actions to shore up a beleaguered economy. In the midst of the crisis, a government official reflects: "We cannot stand by when a house is on fire to engage in lengthy debates.... In such a situation, we instinctively seize upon and utilize whatever method...offers assurance of speediest success."

Quick: Is that Federal Reserve Board Chairman Ben Bernanke speaking before Congress? U.S. Treasury Secretary Henry M. Paulson Jr. on the bailout of mortgage giants Freddie Mac (FRE) and Fannie Mae (FNM)? No, it was Henry B. Steagall, chairman of the House Committee on Currency & Banking—in 1932.

Quoting Steagall, economist Robert J. Shiller asserts that today's crisis requires remedies every bit as fundamental as those impelled by the Great Depression. In his new book, The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It, the Yale University professor sounds an alarm that the credit crunch, now early in its second year, poses a dire risk. His text is a stimulating, rapid response to current events—and a forceful demand for dramatic action from Washington, where, he says, the White House and Congress have been "totally inadequate" to the task. Generally accessible, although at times assuming too much economic expertise on the part of the reader, the book offers numerous proposals for avoiding future crises. These are provocative, but many are too sketchy.

So, how did we get here? Like most other observers, Shiller puts the real estate boom and bust at the epicenter of his explanation, but the foibles of human psychology play an unusually large role in his scenario. Adapting the argument first offered in a previous book, Irrational Exuberance, the author notes that, over the past several decades, financial democracy spread until we all became investors. That made society ever more vulnerable to the mass psychology of bubblenomics. Rising real estate prices fed "new era stories" about how the old rules for valuation no longer applied; those tall tales drove prices even higher, and more yarns were spun justifying the upward spiral; eventually the irrational investment fever spread contagiously; and then, finally, the fever broke.

Clearly, psychology matters, although this approach seems to neglect such economic fundamentals as demographics and interest rates. More persuasive is the author's adroit puncturing of the all-too-common notion that real estate prices inevitably go up over time. Along the way, he emphasizes a valid point that's too rarely made: "It is in no way bad news if home prices fall" so long as our incomes are rising.

The time for society to be concerned is when prices drop rapidly, like now. Shiller calls for a bold bailout involving measures that range from creation of a new organization modeled after the 1933 Home Owners' Loan Corp. to the possibility of federal tax rebates for years to come. Although I remain skeptical, it's one of the best cases I've read for New Deal-scale short-term intervention by Washington.

His approach to the long term is more persuasive—even if it's sometimes insufficiently detailed. Opposed to both heavy-handed regulation and misguided attempts to return to some simpler time, Shiller advocates tapping into modern technologies and information systems to advance the democratization of finance. Among his ideas: the creation of new insurance products for hedging against major personal finance risks, a financial products safety commission, and improved financial disclosure.

Another particularly intriguing idea: federal subsidization of independent financial advice to make it available to everyone. This might take the form of a co-pay arrangement similar to Medicare and private health insurance. "We need both medical and financial advice on an ongoing basis, and failure to obtain either ultimately imposes costs on society when our health—medical or financial—suffers," Shiller writes.

As with universal health care, it could be some time before our society adopts such measures. Nevertheless, a storehouse of valuable, provocative ideas awaits the reader of The Subprime Solution.


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