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.
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The Case for Derivatives
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The idea is to make the housing market more liquid. In the United States alone, housing is (or was) a $20 trillion market, and there are few ways to unlock profit when the market falls. But for stocks, because of the use of derivatives and options, money can be made when markets fall, which significantly increases the potential number of buyers and sellers at any given point. And more buyers and sellers—according not just to Shiller but to most finance scholars and traders—means that markets stay liquid and functional even under pressure.
Shiller has been exploring ways to put this theory into practice for nearly 20 years. With business partners he created the Case-Shiller U.S. Home Price Index, a measure of the national housing market that can be traded on the Chicago Mercantile Exchange. But so far it has attracted mostly gamblers and speculators who want to take bets on whether average home prices are going to go up or down.
Some critics dismiss Shiller's basic premise that more derivatives would make the housing market more liquid and more stable. They point out that futures contracts haven't made equity markets or commodity markets immune from massive moves up and down, and may have made such moves steeper, sharper and more rapid. They add that that Shiller has never had to manage a portfolio or a trader's book, and that a ballooning world of home-based derivatives wouldn't lead to homeowners' insurance: it would lead to a new playground for speculators.
Given that these ideas are untested in the real world, it's impossible to know who's right. But Shiller's radical ideas have a parallel in the thinking of the influential Peruvian-born economist Hernando de Soto. De Soto's pathbreaking observation was that the Western world began to outstrip the rest of the world when its legal and banking systems allowed people to turn land into cash. The contemporary system of using property as collateral for loans is the result, and it has given the Western world a huge advantage.
In essence, Shiller is laying the intellectual groundwork for the next financial revolution. We are now suffering through the first major crisis of the Information Age economy. Shiller's answers may be counterintuitive, but no more so than those of doctors and scientists who centuries ago recognized that the cure for infectious diseases was not flight or quarantine, but purposely infecting more people through vaccinations. "We've had a major glitch in derivatives and securitization," says Shiller. "The Titanic sank almost a century ago, but we didn't stop sailing across the Atlantic."
Of course, people did think twice about getting on a ship, at least for a while. But if we listen only to our fears, we lose the very dynamism that has propelled us this far. That is the nub of Shiller's call for more derivatives and more innovation. Every major crisis in capitalism is met by calls to return to an earlier, mythic time when life was more secure and things were better. Shiller's appeal is a tough sell at a time when derivatives have produced so much havoc. But he reminds us that the tools that got us here are not to blame; they can be used badly and they can be used well. And trying to stem the ineffable tide of human creativity is a fool's errand.
Karabell is President of Rivertwice Research.
© 2009
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