Institutions for managing risks to living standards.

• Author: Shiller, Robert J.

Do our existing institutions for investment, hedging, and insurance allow individuals to manage risks to their living standards effectively? How effectively can people manage risks to the various components of U.S. household wealth? Figure 1 shows a breakdown of U.S. national wealth in 1996 ($114 trillion), which here includes human capital, or the present value of labor income, which usually is ignored in wealth computations. Human capital accounts for 73.7 percent of estimated national wealth; financial assets account for 16.2 percent; real estate wealth accounts for 7.9 percent; and consumer durables account for 2.2 percent.(1)

Of these major components, only financial assets - 16.2 percent of the total - have well-developed liquid markets that allow ready hedging and diversification. There are no hedging or diversification vehicles for human capital. For real estate, particularly single family homes, there are no large liquid markets: One cannot hedge the risk in one's own home and cannot invest easily in a truly diversified world-wide real estate portfolio.

Can one use existing financial markets to hedge risks to total wealth? Hedging income risks seems to entail shorting one's own country's stock markets in massive amounts, as Baxter and Jermann argue.(2) But we have no assurance that there will be a positive covariance between financial asset returns and returns on claims on aggregate incomes. Bottazi, Pesenti, and van Wincoop estimate that the covariance has been small and negative for U.S. aggregates.(3) In terms of managing real estate risk, note that existing financial assets tied to real estate - real estate investment trusts and securitized mortgages - are not representative of overall real estate price risk and do not provide a vehicle for hedging of local real estate price risk. To hedge risks, it is much better to write risk management contracts directly in terms of the risks to be hedged.

Macro Markets

In my 1993 book Macro Markets: Creating Institutions for Managing Society's Largest Economic Risks, I argue that markets could be set up for long-term claims on aggregate incomes.(4) These could be privately managed futures, options, or swaps markets for national incomes, or they could be markets for government national income-denominated bonds. Although such markets are unknown today, they could become extremely important. Given the relative importance of non financial components of national wealth, they could someday be much larger and more important than existing financial markets.

These markets are important because of the uncertainty that people face with regard to risks to national income. based on data for 49 countries, Stefano Athanasoulis, Eric van Wincoop, and I estimated that there is an 89.4 percent probability that the unweighted average real per capita GDP of the seven best performing countries relative to that of the seven worst performing countries will triple in 35 years.(5) Thus, we can expect to see substantial winners and losers in terms of national income, and the livelihoods of individuals in these countries will be very different, depending on the fortunes of their country.

To reduce the effects of such risks, the social security trust funds of each country could invest in national income-denominated debt of foreign countries and could borrow by issuing its own such debt. Social security benefits then could be indexed to world income, allowing optimal risk management for...