Shiller's cluebat

A bit of me hopes that the US does fall into recession. This isn't because I'm a misanthrope. It's because I hope a recession will be a cluebat, which beats into people the lessons of Robert Shiller's New Financial Order.
He's shown how markets can, in theory, insure us against a recession. Imagine a US GDP security whose price was linked to national income. People worried by recession could sell this short. They would therefore profit if GDP fell, thus insuring their other assets - their human capital, house or business - against recession.
So, why isn't there a big market in such securities? It can't be because a recession isn't painful for some people; we know unemployment makes people very unhappy (pdf).
Nor, I think, is it that people won't want to go long of such securities, and expose themselves to recession. At least two groups should want to do this. Retirees on fixed incomes would benefit from the lower inflation which recession often causes. And there are those who just don't think a recession will happen: equity analysts, bless 'em, expect earnings per share to grow 13.9 per cent (Excel) next year.
Instead, I reckon there are (at least) three obstacles to an active market in GDP securities:
1. Wishful thinking. People - especially perhaps Americans - like to look on the bright side. They don't think disaster will strike them.
2. The first-mover problem. Although a market in GDP securities would be in everyone's interest, it would not necessarily be in anyone's particular interest to start one. In this marvellous book, Donald Mackenzie describes how Leo Melamed, chairman of the Chicago Mercantile Exchange, used non-economic forces to build the market in S&P index futures:

A market, says Melamed, "is more than a bright idea. It takes planning, calculation, arm-twisting, and tenacity to get a market up and going. Even when it's chugging along, it has to cranked and pushed."...Even once the Merc's S&P index futures were launched (on April 21, 1982) the political work of market construction did not end. Financial derivatives exchanges are subject to virtuous and vicious cycles: if trading volumes are high, exchanges are liquid and attractive places to trade, further enhancing volume; if volume starts to slip, liquidity can dy up and exchanges become fatally unattractive....
So "all chits were called in" by Melamed to ensure the success of the Merc's S&P futures. All those for whom he had done favours over the years were asked to return them by trading the new contract. Every member of the Mercantile Exchange was asked to spend at least 15 minutes every day in the S&P pit, and Melamed led the way by spending as much of every day as he could in the pit himself.

3. Inequality. Many of those who need insurance against recession are those who don't have the wealth which which to buy it - unskilled and young workers, who are often the first to be sacked in a downturn.
A recession should be the cluebat that disposes of point one. Points 2 and 3, however, suggest that a market in GDP securities requires some kind of intervention - maybe the energy of a Melamed, maybe the donation by the government of free short positions to the poor.
Until this happens, my view of a free market economy is much like Gandhi's opinion of western civilization - it would be a very good idea.

Comments

[Piyush]

Can't you effectively insure against recession today by shorting or buying put options on an S&P 500 index fund given the close correlation with industrial output in recent years. And obviously some people do this.
For this insurance to be worthwhile, the prospect of a recession must not be a widespread and generally agreed view otherwise it seems to me that the premium paid for this insurance would be unacceptably high.

[Jason Ruspini]

I prefer my tax futures http://riskmarkets.blogspot.com/2006/08/why-we-dont-have-tax-futures.html to GDP-linked securities. The former address special interest problems and should have a strong attraction for libertarians.

Shiller notes his ideas' (especially "inequality insurance") similarity to those of John Rawls. Both have to tangle with the problem of removing "random" differences without lowering average or aggregate wealth.

Hedging is usually done to lock-in an otherwise variable spread that corresponds to some profit margin, which in turn causes wealth to accumulate. Even before transaction fees, hedging directly against an upwards drift (like GDP) is likely to result in less domestic wealth, long-term — unless the situation is quite morbid, in which case the hedge is only treating symptoms.

[Andy]

I believe Ghandi's comment was a response to the question (asked in the light of his advocacy of Hinduism) "What do you think of Christianity?" He meant, ironically, that it would be good if alleged Christians would actually try acting like Christians.

[chris]

Andy - that was the analogy I was hinting at. It would be good if so-called "free marketeers" tried to increase the scope of the market economy, rather than use free market principles as merely an ideological defence of inequality.

[james higham]

"... rather than use free market principles as merely an ideological defence of inequality."

Run that one by me again, for the slow on the uptake, Chris. Do you believe free market principles defend inequality and in whose favour - the weaker nations? I saw a case for this recently.

[chris]

James - I don't think the free market necessarily causes inequality; quite the opposite.
What worries me is that some people (like Deepak Lal) appeal to free market principles to defend inequality.
There's no inconsistency here.
Take for example the minimum wage. Free marketeers say this is bad for the low-paid, as it cuts demand for their labour. Defenders of inequality stop at this point. However, I think a better way to help the poor is to have a (high) basic income.
Free markets and redistribution are therefore consistent.

[dsquared]

[Retirees on fixed incomes would benefit from the lower inflation which recession often causes]

so why would they want to double up this risk by going long a security which paid off in the event of a recession but cost them money in the event of no recession?

in any case, since there already are inflation linked bonds with futures and options on them (of a sort), which work in a kindasorta way, why would someone who had an inflation risk want to hedge it through GDP or unemployment futures, at any other than ruinous premium?

Futures markets are basically insurance markets, with the insurance contract made standardised and liquid. They work for short term fluctuations where good liquidity can be established. For longer periods they don't work so well as traded instruments (look at the oil futures curve beyond the front couple of years). And when they compete with existing conventional insurance markets, they rarely do well (cf catastrophe bonds which have been the Next Big Thing for my entire career). Since there is already an unemployment insurance scheme, I don't see this market ever taking off. GDP risk is the sort of risk that is best pooled by an insurance mechanism, rather than by pretending that it can be turned into a liquid claim.