Lecture 3: Technology and Invention in Finance

What this lecture covers

This lecture answers why financial contracts and institutions look the way they do: they are inventions, built and refined over time like airplanes or steam engines, that solve the practical problem of managing risk under human psychology. After a review of the central limit theorem and fat-tailed distributions from the previous lecture, Shiller develops two themes that recur throughout the course: framing (how the presentation of a financial device shapes whether people adopt it) and the device theme (finance as engineered structures that improve gradually).

After watching, you'll be able to explain why some financial inventions like limited liability spread quickly while others like inflation-indexed bonds spread slowly, and describe several concrete inventions, including corporate limited liability, Chinese township and village enterprises, Chilean inflation-indexed units of account, and swap contracts.

Key ideas

• Central limit theorem: the average of many independent, identically distributed random variables with finite variance converges toward a normal distribution, which is why bell-shaped curves recur so often in nature, but this assumption fails when underlying variables are themselves fat-tailed.
• Framing: psychologists' term for how the context and associations around something shape how people use it; financial inventions succeed partly because of how they are presented, not just their underlying logic.
• The device theme: financial contracts are complex engineered structures, similar to airplanes or automobiles, that improve gradually and unevenly, sometimes disappearing and reappearing (illustrated with the gimlet and the wheeled suitcase).
• Limited liability: a shareholder cannot be sued for a company's debts; New York's 1811 corporate law made this an explicit right, which Shiller credits with helping New York, rather than Massachusetts (which held shareholders liable), become a financial center.
• Township and Village Enterprises (TVEs): a Chinese institutional invention where businesses shared profits with local government, working around the absence of enforceable contract law in the early reform era and driving early industrial growth.
• Inflation indexation: contracts, such as Chile's Unidad de Fomento (UF), can be written in a unit of account tied to inflation rather than currency, protecting parties from currency depreciation, though such indexation has spread unevenly around the world.
• Swaps and credit default swaps: a swap is a contract to exchange cash flows (such as one currency for another) invented in the early 1980s, reportedly by David Swensen; the credit default swap is a related contract resembling insurance against a company's default, and its poorly understood risks contributed to the 2007-2008 crisis, notably at AIG.

Walkthrough

Review of probability and the central limit theorem (2:38)

Shiller recaps return, variance, covariance, and the normal distribution from the previous lecture, then explains the central limit theorem and why its assumption of finite variance can fail, leaving financial theory less reliable than physics.

The role of finance in society (14:21)

He surveys how dramatically finance has changed since 1970 (no options exchanges, no financial futures, no electronic trading) and argues that financial inventions, despite public anger after the crisis, are a form of progress akin to aeronautical engineering, requiring regulation rather than rejection. He connects this to the tension between risk management (which reduces arbitrary inequality) and opportunity (which can increase it).

Framing and everyday inventions (28:52)

Using the gimlet and the wheeled suitcase as examples, Shiller illustrates how useful inventions can take decades to catch on or can disappear despite their usefulness, setting up his argument that financial inventions follow a similar, often slow, path of adoption.

Corporations and limited liability (39:14)

He traces the invention of the limited liability corporation to New York's 1811 corporate law, contrasting it with Massachusetts's contemporaneous law holding shareholders liable, and argues New York's approach won out partly because it framed investing as an appealing, lottery-like gamble. He also describes China's Township and Village Enterprises as a comparable institutional workaround for weak contract enforcement.

Inflation indexation (51:33)

Shiller covers the history of inflation-indexed bonds from 1780s Massachusetts to their 1997 reintroduction in the United States by Larry Summers, then focuses on Chile's Unidad de Fomento, a unit of account indexed to inflation that became embedded in everyday contracts like rent and alimony, contrasting it with the U.S.'s continued reliance on unindexed nominal contracts.

Swap contracts (1:07:42)

He explains the swap contract, reportedly invented by David Swensen in the early 1980s, as a way to exchange cash flows such as currencies for risk management purposes, then extends this to the credit default swap, a similar contract resembling insurance against a company's default that played a central role in AIG's near-collapse during the crisis.

Before you watch

• Watching Lecture 2 first is useful, since this lecture opens with a review of variance, covariance, and the normal distribution before extending into the central limit theorem.
• No further prerequisites are assumed beyond the course's general introductory economics background.

Check your understanding

1. Why does the central limit theorem not always guarantee a normal distribution for financial variables?
2. How did framing help explain why New York's limited liability law succeeded while Massachusetts's shareholder-liability law did not?
3. What problem did Chinese Township and Village Enterprises solve in the absence of enforceable contract law, and how does that compare to Chile's Unidad de Fomento?
4. How does a swap contract differ from a credit default swap, and how did the latter contribute to AIG's near-collapse?