Shiller is right. Derivatives are not bad but how they are used in US was bad. US as an economy was probably hedging risks within itself which means all financial firms in US were seem to hedge their risks by transferring it to other firms in US and so it collapsed. What US firms need to understand (and they might do as well) is that when they are buying services and products from outside US with less exports to balance the outlow of money then over a period of time there will be systemic risks building due to this outgoing money creating enough vacuum that might show up as losses in jobs, collapses of banks, etc. It looks like bad real estate debts created problems or derivatives created problem but it is actually excess outflow of money from US to other worlds. Now when you are buying services or products from out of US then you are actually paying for their growth and you need to ensure that what you pay out should be more as an investment in their growth rather than payment for service and products. One way to do this is to assume that your effective cost per hour is 5% more and that 5% is invested in derivatives of the country that you are paying money to. For eg, if you pay 20$ / hour for a chinese or Indian software programmer then assume that you are actually paying 21$s (5% more) and invest 1$ in the derivatives of Indian and Chinese economies (stocks of the companies you are paying to) in 6 monthy contracts and as they are grow from your money.... this 5% investment in derivatives would be equivalent to 100% of actual and hence you will get your 20$s back soon by investmenting in this way.
Summary is that US firms need to become investors in foreign economies by the route of derivatives and thus keep a balance. In a way, US would need to become investor in emerging markets rather than mere payer for services in order to sustain in longer term. US would be investing in the growth of the world and without compromising their own financial health because you would have stake in the growth of foreign country.
Above is not possible without derivatives.
The Case for Derivatives
Economist Robert Shiller believes they could help solve the crisis.
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They've been dubbed financial weapons of mass destruction, attacked for causing the financial turmoil sweeping the nation and identified as the kryptonite that brought down the global economy. Derivatives have become the universal symbol of Wall Street greed, yet few Main Streeters really know what they are—namely, financial contracts between a buyer and a seller that derive value from an underlying asset, such as a mortgage or a stock. That hasn't stopped public opinion from turning forcefully against them. Most experts believe that Barack Obama needs to put an end to the financial alchemy that turned low-quality mortgages into trillions of dollars of high-priced derivatives. There seems to be near consensus that derivatives were a source of undue risk.
And then there's Robert Shiller. The Yale economist and financial soothsayer believes just the opposite is true. A champion of financial innovation and an expert in management of risk, Shiller contends that derivatives, far from being a problem, are actually the solution. We need more of them, not less, he says, and warns about the dangers of misguided regulation (though he agrees some regulation is vital). Shiller has an impressive track record of getting real-world things right. He published "Irrational Exuberance," which became a bestseller, just as the stock-market bubble burst in March 2000. He was eerily prescient in sounding the alarm about the housing bubble and the effects of its bursting on global financial markets.
Derivatives, Shiller says, are merely a risk-management tool the same way insurance is. "You pay a premium and if an event happens, you get a payment." That tool can be used well or, as happened recently, used badly. Shiller warns that banishing the tool gets us nowhere. Instead, he envisions a world where derivatives become as common as cash.
What separates Shiller from the majority of economists is his lack of faith in the "efficient-market hypothesis." That belief, which also guides the hand of most money managers, holds that the market will price assets according to their fundamental value and that those prices reflect all pertinent information. Shiller instead follows those, like John Kenneth Galbraith, who hold that market prices reflect "animal spirits" and popular passions, not perfect information. That is why bubbles form, and that, for Shiller, is why financial innovation, and not just government regulation, is imperative.
For all the trillions in derivative trading, there were very few traders. Almost all the subprime mortgages that were bundled and turned into derivatives were sold by a handful of Wall Street institutions, working with a small number of large institutional buyers, ranging from the Bank of China to HSBC to sovereign wealth funds. And as we now know, these derivatives were black boxes whose contents were known by neither the sellers nor the buyers. It was a huge but illiquid and opaque market.
Meanwhile, the system was built on the myriad decisions of individual homeowners and lenders around the world. None of them, however, could hedge their bets the way large institutions can. Those buying a condo in Miami or Marbella had to believe that the market was going up, and had no way to protect themselves if the market went down. When it did, millions were left with homes they could not sell, even for less than they paid.
Derivatives, according to Shiller, could be used by homeowners—and, by extension, lenders—to insure themselves against falling prices. Say you bought a house for $300,000, hoping its value would increase to $350,000. In Shiller's scenario, you would be able to go to your broker and buy a new type of financial instrument, perhaps a derivative that is inversely related to a regional home-price index. If the value of houses in your area declined, the financial instrument would increase in value, offsetting the loss. Lenders could do the same thing, which would help them hedge against foreclosures.
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