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Phil: I totally agree that derivatives are, or should be a good thing. The problem, that Shiller (at least as shown in the NW article), didn't address four major problems... the ones that brought down the market.
1. Transparency - As soon as the mortgages were collateralized, they lost identity. Risk models have been proven to be wrong. The is just no reasonable way to backtrack derivatives.
2. Leverage - Actually two parts to leverage... First, the percentage... 10% down to 2%... Encourages day trading which excludes the market, and leaves the profit/loss in the hands of speculators. Speculation is ok and good, but when it's used to play roulette, the results return to the Enron Model.
3. Regulation. This is, and has been purely political. Any economic model can be said to be workable, but it's when there are rules, that it can be successful. (IMO)
4. I believe that Shiller sees the concept of insurance as being viable. I would agree. But the derivative market was, by law, limited to those with extreme wealth. We hear the term "phantom banking". Part of that means that the assets that have been pledged to "back" leveraged bets, aren't liquid. That's where the entire derivative problem arose. When the time came to settle the derivative "swaps", there were not enough liquid assets to pay out. As long as the traders were content to "swap" debt, everything worked fine. The crash came when the counterparties refused to pay obligations with liquidity.
Long and short... free markets are fine, but as long as not everyone can play... as long as the rules are made by the players as they go along, as long as the deals are made in dark rooms, as long as leverage encourages speculation, then there will be abuse.
I think that derivatives came as an extension of the commodity futures market... which stabilized so many industries, and was good for business and the country. Credit derivatives (mainly housing) skipped the collateral step... then as the string played out, credit derivative swaps topped off the re-inflation of the Enron and the Internet bubbles.
We can have all of these financial instruments, but only with regulation. Trust in Free Markets per se, will be a long time coming.
I don't believe that we'll go anywhere in fixing the economy until honest people write the rules. (and that means someone other than politicians and bankers).
