The Subprime Solution By Robert J. Shiller (Princeton University Press, 196 pages, $16.95)

In recent times, investment bankers have used "financial engineering" to design ever more complicated ways to manage risk. Such efforts, though, helped to bring about the current mortgage-default debacle: Bankers, overestimating the powers of their own sorcery, deluded money managers into thinking that there were safe ways to invest in subprime home loans, even the ones granted to flagrant deadbeats at the peak of a housing bubble.

With "The Subprime Solution," Robert J. Shiller offers his formula to protect us from repeating such disasters: more financial engineering. It would be easy to sneer at this idea, but Mr. Shiller, an economics professor at Yale University, always deserves a hearing. He was among the first well-known economists to predict that the U.S. housing boom would end with crashing prices rather than with the more or less soft landing promised by Realtors, home builders, mortgage bankers and Wall Street financial engineers. Some say that Mr. Shiller's jeremiads were premature, but investors and builders would be better off today if they had listened to him.

Mr. Shiller also helped create the S&P/Case-Shiller home-price indexes, among the most closely watched gauges of changes in housing costs. Many Realtors now claim that these indexes exaggerate the rate at which prices are dropping. Curiously, the same Realtors did not warn us against exaggeration in the first half of this decade, when the Case-Shiller indexes were soaring.

In what he describes as a "brief manifesto," Mr. Shiller argues that bailouts of distressed borrowers are inevitable to avoid wrecking our economy and shredding our social fabric -- even though bailouts may punish the prudent (say, through higher taxes) while comforting those who gambled on real estate and lost. "Much as we might like to," Mr. Shiller writes, "we cannot quickly and reliably sort out who is at fault and who is not."

He joins others in calling for a new federal agency modeled on the Home Owners' Loan Corp., created in 1933 to refinance mortgages and keep people in their homes. One of the best things about this agency was that it was designed to be temporary and, when it was wound down in 1951, managed to return a small surplus to the Treasury, as Alex Pollock, of the American Enterprise Institute, pointed out in an essay last year.

Looking beyond immediate fixes, Mr. Shiller expresses immense faith in the potential for financial technology to "stress-proof the whole economy." Here he is partly talking his own book: He is a founder of a company that creates risk-management tools, such as futures contracts tied to home prices. Such contracts haven't yet attracted much trading, but Mr. Shiller hopes that they will develop into a means of hedging against real-estate busts. If people could use futures to sell the housing market short -- that is, to bet that prices will fall -- bubbles would be less likely, he believes. This claim is debatable: Investors can sell stocks short, but that did not prevent the tech-stock bubble of the 1990s.

Mr. Shiller also calls for new types of insurance to protect people from the risks of falling home prices or from a long-term loss of income resulting from economic changes that render certain jobs obsolete or less lucrative. (But who would pay for this insurance and how much would it cost?) Among his many other ideas, Mr. Shiller wants government subsidies -- perhaps in the form of tax credits -- so that ordinary people can afford unbiased financial advice. As things now stand, home buyers rely too heavily on the advice of real-estate agents, mortgage brokers and others whose interests are often at odds with their own.

Americans make poor financial choices, Mr. Shiller argues, in part because they don't take inflation into account. That oversight leads them into the error of believing that houses have been a great long-term investment. His answer is to supplement the consumer price index with a new unit of measurement based on the value of a "basket" of common goods and services. Buyers and owners could then use these baskets to get a better grip on how much things really cost once inflation is stripped out.

My favorite proposal is Mr. Shiller's call for the creation of a standard, consumer-friendly home- mortgage contract, leaving out the booby traps that ensnared people during the boom (e.g., penalties for paying off a mortgage early). This standard contract could be the choice for people who lack the time or ability to read hundreds of pages of fine print. Mortgage bankers might howl that such an approach would inhibit innovation. But consumers could always choose a nonstandard contract if they could be persuaded that lenders weren't out to gouge them. The rest of us could play it safe.

Mr. Hagerty writes about housing and mortgages for The Wall Street Journal.

See all of today's editorials and op-eds, plus video commentary, onOpinion Journal.

And add your comments to theOpinion Journal forum.

Now, Amdavad Realtors go for Chicago

Home Sales Rise in Hard-Hit Areas

Housing Supply Declined in May