The Real Mandate Is to Bridge the Wealth Gap By ROBERT J. SHILLER

The New York Times
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November 9, 2008
The Real Mandate Is to Bridge the Wealth Gap By ROBERT J. SHILLER

THE new president will have a clear mandate to redress economic inequality. During the campaign, John McCain made sure that voters clearly heard Barack Obama say “spread the wealth around,” and they elected him anyway.

Indeed, there has been a significant, decades-long trend toward greater inequality that needs to be corrected. The president-elect needs to seize the opportunity and to do something really effective to prevent inequality from getting much worse.

The financial crisis that afflicts the country is largely a result of speculative bubbles, built on false hopes, in the housing and stock markets. Many Americans thought that they would rise in the economic hierarchy from one or another of these investments, and their disappointment is profound. As dreams have been lost, the gap between the wealthiest and those struggling to provide basic items for their families will become more evident and more painful.

The best way to battle gratuitous inequality is to make our financial institutions better embody the true principles of risk management. Financial theory is all about incentives for people to work effectively, and diversifying against random shocks by sharing them among many investors. At its essence, finance is really more about helping and sharing than “beating the market.”

Traditional mutual funds and retirement saving plans, as well as insurance plans for loss of one’s home due to fire or flood, or of one’s income due to disability, are actually risk management vehicles that help reduce inequality. The new president’s important mission should be to broaden these plans.

It may seem paradoxical to try to lessen inequality by relying on the institutions that are most blamed today, but it is only through these institutions that inequality reduction can really work well in a capitalist economy. Enhanced financial institutions could serve the real purpose that financial theory proposes: serving the people.

This would mean transforming the kind of ad hoc measures now used to help economically stressed people in the current crisis into permanent measures that are grounded in solid financial theory and augmented with an understanding of human nature.

In my book “The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do About It,” I outlined three areas of action that would democratize finance — make it work better for the people — and help prevent future crises. We must improve the information infrastructure, encourage broader and more robust risk markets, and develop better retail financial products. Each of these goals would require work by both the government and the private sector, and all would generalize and privatize the emergency measures already taken, so they become systematic.

To improve the information infrastructure, we need to subsidize financial advice for the common man. The crisis we are in is largely due to investor ignorance. Some emergency measures, like the Hope Now Alliance, have been set up essentially to offer such help, but these will presumably be dismantled after the crisis, and they are not well designed for serving investors’ broad needs. We need some permanent subsidies to get the full scope of financial advice out to the people.

Second, we need to broaden financial markets to improve risk management. We need sophisticated systems that will act as insurance plans against unexpected risks. The government could lead the way to a historic development of financial infrastructure.

Third, we need to change retail financial institutions, notably those that grant and service mortgages. Recent government policy has encouraged workouts for defaulting mortgages — again an impromptu, after-the-fact measure. These workouts should have been spelled out in the original of what I have called a “continuous workout mortgage.” Then workouts could be systematic, automatic and free-market, with costs priced into the original mortgage rate.

A fourth and more radical step would be to index the tax system to income inequality. The system would automatically become more progressive if inequality became more acute. Changes in tax rates would be made in the future, not now, easing the transition’s shock to the public. Leonard Burman, a former Treasury official for President Bill Clinton and now head of the Tax Policy Center in Washington, has been working with me to transform this idea into a sketch of a program we call the Rising Tide Tax System. We found that if such a program had been instituted 30 years ago, even in a partial form, we could have lessened economic inequality.

In short, the best thing that President-elect Obama can do is to set up permanent new structures to harness the innovations of finance to improve people’s lives on Main Street. Americans will support a president who works hard both to maintain incentives central to our capitalistic economy, and to ensure fundamental fairness. If Mr. Obama does both, he will leave a lasting legacy.

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