BOOK REVIEW: The Subprime Solution,Robert J Shiller; Princeton University Press; 2008; €12

ROBERT SHILLER, a Professor of Economics at Yale, blames the subprime crisis on the two preceding bubbles, one in equities, the other in real estate.

Although he doesn't say so explicitly, he probably wouldn't quarrel with the notion that Alan Greenspan, former chairman of the Federal Reserve, should have done much more to calm the irrational exuberance that occurred in both markets.

The author's solution to the subprime crisis consists of two parts: a short-run response involving the bailout of financial institutions on an increased scale, and a longer-term initiative which involves an even greater use of market mechanisms and of financial derivatives.

There have been substantial bailouts to date, including the Fed's lending to distressed institutions under several different programmes, the extension of loan limits by the Federal Housing Agency, and the extension of mortgage ceilings by government-sponsored Fannie Mae and Freddie Mac. The author regards the interest-rate cuts by the Fed as a form of bailout which may cost the average citizen and tax-payer via higher inflation in goods and services in the future.

He is in favour of ramping up these bailouts, as well as tax rebates, because he regards it as vital to maintain confidence in the financial institutions. According to him, the costs of the bailouts should be borne "by the broad public . . . and not dumped into the laps of a small set of investors".

In other words taxpayers should rescue the financial institutions.

The longer-term part of the solution involves using risk-hedging market mechanisms to a much greater extent than ever before. This is broadly equivalent to what economists refer to as "completing the market". Shiller calls it the "democratisation of finance". The idea is that homeowners should be enabled to use risk-management techniques. For example, there should be a futures market in real estate. If a potential buyer thought that house prices were going to go up they could buy a house in a year's time, say at today's price. Market derivatives could be used, such as swaps and options. For example, a houseowner could buy a put option on house prices that would pay off if prices actually fell below the strike price of the option.

The individual would thereby be provided with an insurance policy against price falls.

Shiller also discusses continuous work-out mortgages where mutually acceptable arrangements would be made between the bank and the borrower on an ongoing basis. This would prevent the borrower from getting into extreme difficulty.

The author carries the notion of insurance way beyond the housing market. He talks about general livelihood insurance and even about countries insuring their overall economic performance. One of his general conclusions is that we should "replace many of our charitable institutions with insurance-based institutions". One wonders what charitable institutions he has in mind.

Most of the ideas are interesting but one wonders how practical they are. Most subprime borrowers didn't fully realise they were being charged much higher interest rates than wealthier people. Are they really expected to use futures markets, swaps and options? To be fair, Shiller does argue that it would be necessary to launch a major information campaign and to eliminate vested interests, but still it all seems just a little utopian.

Shiller is well known for embracing the new economics and the psychological aspects which often make markets react in unpredictable ways. He seems to assume that markets in derivative products would somehow not be subject to psychological volatility and panic reactions.

Nowhere are costs discussed. If an exporter wants to hedge foreign currency it will cost him. By the same token if a householder wants to buy a put option on his home or insure the price of it in any other way, it will cost him. And the costs will increase as the perceived risks increase. So, the "democratisation of finance" may not be such a boon after all. In fact the phrase grates a little on the nerves when it is remembered that the salaries of top bankers in the US are over 500 times the average wage.

• Dr Michael Casey is a former senior official with the Central Bank and a former member of the board of the International Monetary Fund.