BOOK REVIEW: Shiller's Subprime Solutions

Long-Term Solutions

Shiller suggests harnessing the power of information technology as the long-term solution, saying that the U.S. and the world have experienced incredible change through the IT revolution. Information could be used to democratize the financial sector, decreasing the risk of future bubbles.

A new information infrastructure proposed by Shiller includes six changes: 1) Comprehensive financial advice for everyone; 2) New financial watchdog like the Consumer Product Safety Commission; 3) Default-option financial planning to avoid poor choices; 4) Improved financial disclosure; 5) Improved financial databases to share information; 6) New system of economic units of measurement.

The most complicated solution offered by Shiller is a proposed system to measure prices based on inflation-indexed units. It would represent a "basket" of goods and services that accurately reflects current prices. This kind of system is already used in Chile and other countries in Latin America. Shiller attributes the run-up in real estate to inflation as much as anything else. That could have been avoided if homes had been indexed for inflation.

Shiller also says new financial markets are needed. First and foremost would be greater use of the futures markets. Such liquidity would allow savvy investors to "short" real estate and would keep prices in check.

Another area of market innovation he proposes would help homeowner's hedge risks. This would start with new mortgage contracts, which could be applied immediately to those facing foreclosure. Shiller calls it a "continuous workout mortgage." Terms of the contract would modify on a monthly basis according to the amount a borrower can afford to pay. Regional indices would standardize payments at minimum levels to reduce the risk of "gaming the system" - for example by quitting a job to reduce the monthly payment. Workouts" could be applied to other debt products like credit cards.

Homeowners could also be protected by developing homeowners' equity insurance. Real estate has long been an illiquid yet precious asset for many, and equity insurance would guarantee the value of a home as an asset. This would protect a homeowner from negative equity. Moreover, an owner wouldn't resort to a fire sale that undermines the value of comparable homes in a neighborhood.

Shiller's Subprime Solution is well worth the read for individuals and private enterprise looking to understand current real estate bubble. It should be required reading for public policy makers who need to take immediate action to solve the subprime crisis.