Yale economist Robert Shiller has a well-deserved reputation for a measure of prescience, especially when it comes to financial bubbles. He warned against the Internet-based stock bubble (witness his book Irrational Exuberance) and was among the earliest counseling caution about the recently popped real estate bubble (see his The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It).
His record benefits from Shiller’s long-held skepticism about the theory of efficient markets, long the conventional wisdom in the economics profession. Instead, he harvests insights offered by behavioral economics about how people really behave, which is not always efficient or even rational. His most recent book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, co-authored with George Akerlof, a 2001 Nobel laureate and economics professor at University of California, Berkeley, explores this more fully.
In a phone interview with Miller-McCune.com from his Connecticut home, Shiller spelled out the difficulties of defying conventional wisdom, why economists are still not being as helpful as they should be in the current crisis, why the crisis could continue for five or more years, what Wall Street’s future looks like, and why the government should strive to prevent the “scarring of our confidence from ever happening.”
He also laid out a few of his own financial innovations he hopes will propel what he discerns is a long-term trend in the democratization of finance.
Swimming Against the Tide
At the core of the efficient markets theory, Shiller explained, is the idea that “you can’t be smarter than the market,” and those that question this are regarded as arrogant. This was popularized in New Yorker columnist James Surowiecki’s book, The Wisdom of Crowds, with its subtitle “Why the many are smarter than the few and how collective wisdom shapes business, economies, societies, and nations.” The book came out, Shiller notes, in 2004 — the very height of the twin housing and stock market bubble.
“You could say the markets are overreacting, but then you run right into the efficient market theory — a very scholarly literature that says the markets are smarter than anyone, so lie back and relax and watch the markets go up. You wouldn’t get any good response if you said anything else,” he recalled, “so people kept those doubts to themselves.”
Even those best positioned to recognize a bubble — economists — are constrained by convention and the fear of being wrong. That’s true even if you are a budding iconoclast, Shiller found. “I didn’t know what was going to happen. I raised it (a crash) as a possibility. I could see these were huge bubbles and I thought that the crash of the housing and stock market would have a chance of bringing on a worldwide recession and large, wide-scale bankruptcies of individual and companies. I said that in 2005, and it was a prediction of this, but I felt very uncomfortable doing that,” he admitted.
“It’s partly because people who make wild predictions and then turn out to be wrong are kind of reviled in our society; it is like being a prophet of doom.”
Then there is also maintaining professional appearances. When interviewed on TV he was expected to demonstrate professional technical expertise, but he always felt the economy was much “more idiosyncratic” than most economic models allowed. That’s why he and Akerlof have been hosting workshops on behavioral economics — an area of study always on the fringe of the profession — for 15 years.
But he admits that he largely caved in to the expectations of conventional wisdom in his teaching.
“When I taught macro courses, I didn’t teach much of this because I thought my colleagues would frown on it,” he said. “They would say: ‘You are teaching something that is yours, and that is not the received wisdom of the profession. You have to teach the standard stuff’ — and so I used to dutifully do that and not mention, or downplay, my doubts about this framework. That’s the power of conventional wisdom.
“Nothing I did (professionally) was ever part of the core theory (but) I had to downplay my own beliefs. I couldn’t get up there and say a depression was coming, not in front of the students. I would have been considered unprofessional.”
But as the bubbles continued to swell, he grew more outspoken, especially to rebut other economists denying that the public was overly exposed to leveraged real estate risk.
“I tried to point this out over the years, but I couldn’t get any attention to it — it has to really happen. People wrote papers saying it doesn’t exist. There are these professors at Wharton (Business School) who wrote a paper saying that people already have the optimal exposure to real estate. I couldn’t believe it!” But that is also the power of conventional wisdom — a phrase, he notes, that came into use from John Kenneth Galbraith’s 1958 book, The Affluent Society.
You Can’t Get There From Here
If conventional wisdom blinded us to the coming crisis, it has also obscured solutions for getting out of it. There has been conflicting policy advice from economists about just how much we should rely on government spending — fiscal expansion — to get out of the current downturn. Shiller favors setting aggressive credit and full employment targets on a scale far larger — and far faster — than we have done so far. That we haven’t done this so far he blames on economists in part, and on politics.
Not, he believes, that the government’s performance so far has been all bad. Shiller cites the help extended to the mortgage market by putting Freddie Mac and Fannie Mae under government conservatorship.
“I think the government deserves credit for stepping in and moving fairly fast, in some cases, to deal with this … but still we are in the downward spiral because it hasn’t been aggressive enough, and now we are in a more difficult situation because our confidence has been damaged.”
At the same time he says policymakers and the public need to be mindful that managing an economy is at all times, in effect, an unfolding experiment. “This is more of an experiment than people realize — an ongoing, evolving experiment that can blow up. That’s the problem.” He says that’s something we have lost sight of because of the “incredible stability of the U.S. economy since World War II.”
The potential for blowing up, or melting down, derives from the economy’s often-forgotten psychological underpinnings, which are just as important, if not more so, than the rational part. (These are part of our “animal spirits.”) In the current economy, some financial de-leveraging needs to take place — a rational part of the wind-down from the bubble. But the decline is abetted excessively by the psychological dimension of lost confidence. “Nobody can predict how these things will go; these are chaotic systems,” Shiller commented.
Relying on past solutions can give false hope. He noted, for instance, that Americans in the 1930s were lulled into a false sense of security by the existence of the Federal Reserve Bank, which had been created in 1913 in response to an earlier economic crisis. “People really believed that we have solved these problems because the Fed would step in, (but) it didn’t work and (now) we are back in it. And while today we have a better Fed, a smarter Fed, that’s what people believe, there is still a danger of complacency,” he cautioned. “(The Fed) have stretched their original power (to manage the money supply) to the limit, they have cut interest rates to zero, and yet confidence hasn’t come back.”
In a sense, he said, “the fiscal expansion that the world is trying now (even if Europe is not pulling its fair share) is yet another experiment because it was never really tried with sufficient force in the Great Depression and has rarely been tried since, so we don’t really know for sure.”
Not Just the Numbers But The Narrative
Shiller is particularly concerned about the housing market, which has been a key research area for the co-creator of the Case-Shiller Index of national home prices. The $275 billion the Obama administration recently set aside to support the market was a “step in the right direction,” but he said there must be more willingness to reduce mortgage principal.
“We are probably going to see a high foreclosures rate for some time, so I wish it were stronger, but it is moving in the right direction,” he said. ”Foreclosures, in my mind, are a very important issue because it is such a vivid story that it creates, and it is a story of innocent people.” This is important because people understand their reality through narratives, and being displaced can be particularly searing experience, especially for children in families losing their homes.
Plus, the government’s half-measures are likely to mean the crisis will linger for years, Shiller said. The Great Depression, he noted, lasted almost 10 years, from 1931-1940. “We are doing better on stabilization, but I think it might last 10 years, that we might see an unfortunate lack of confidence that inhibits the growth of the economy for a long time. The problem has been going on for 15 months — this could be just the beginning.”
He foresees double-digit unemployment before long, but not as high as the Great Depression’s average rate of 17 percent, and suspects those high jobless figures could linger for five years or more. He likens today’s situation to the Japanese experience: After its housing and stock markets burst in the 1980s, the nation saw nearly 20 years of disappointing growth of around 1 percent a year, which was much lower than their historical average — or that of the United States.
“That is a more plausible outcome,” he suggested for the U.S., circa 2009. “Maybe not for 20 years, maybe for five years — that’s a likely scenario.”
Shiller credits President Obama and his economic team with creative thinking, although they are stymied by politics and the dilemma of just how much to publicly accentuate the dangers. “The moment you do that you get criticized for shouting fire in a crowded theater, so I think he is walking a delicate rope,” he said. Still, Shiller favors a bigger stimulus package and even temporarily nationalizing some banks (creating “bridge banks” — the U.S. euphemism for this step) and then directing them to lend more aggressively.
“We have to do bailouts now, but the whole system should be redesigned to reduce the likelihood of this happening again,” he said.
That redesign will take a long time. “You have to remember that the reforms that were spurred by the Great Depression were not just in Roosevelt’s first 100 days, it was a decade-long phenomena,” he said. “In 1907, there was a terrible financial crisis and it set in motion a national debate that resulted in the founding of the Federal Reserve — but that didn’t happen for six years. That’s the way it goes — 10 years from now we will be seeing new legislation that will advance the economy.”
Nowhere to Go But Up
Viewed this way, the current crisis is also an opportunity to modernize a financial system that is not nearly as perfect as it had been portrayed. That some 12 million homeowners have lost all of their savings in homes that are worth less than their mortgages is a stark reminder of how our system failed in one of the elementary principles of finance — diversification.
In Subprime Solutions, Shiller lay outs the need for “better mortgage institutions that allow people to manage their mortgage risk.” Among his innovations: a “continuous workout mortgage” that would build in the chance to routinely make adjustments in the original mortgage to reflect changing conditions. He also proposed — in 1994! — some form of home equity insurance, an idea recently taken up by the government, albeit in a limited way (setting aside $10 billion for mortgage lenders who do workouts).
Another proposal envisions publicly funded financial advisers for everyone, as a means of restoring trust and confidence. “My proposal is that we create something like Medicare or Medicaid for financial advice,” he explained. “… Right now, they only get financial advice from a salesperson; I want disinterested financial advice.”
Advice would not come directly from the government but from private companies subsidized by public funding. “It seems to me that if people were given help on their financial decisions that it would create a better feeling. Right now, people are feeling victimized — these big Wall Street guys, they have their expensive advisers who charge them $200 an hour — but most people don’t have this, so they don’t know what is going on; I would like to see a new America where everyone has a financial adviser. ”
That would advance what Shiller sees as “a centuries-long trend towards the democratization of finance,” in which an ever larger segment of the population enjoys the benefits of financial understanding or theory. “I can see a world in which we respect financial opportunities more and we use financial technology to protect people from the type of crisis that we are in.”
For that reason, he is surprisingly bullish about Wall Street. “I think Wall Street has a great future in the long run because finance is an important risk-management technology,” he said, adding that it’s an incentive for people “stymied” by risk or uncertainty to do business well.
But even after the economy revives, there will be other challenges, including widening income inequality.
“That’s another huge issue that has been getting worse and threatens to get worse again,” said Shiller, who has another proposal (worked out with the Urban Institute’s Len Berman to change the tax system so that it is indexed against inequality. Taxes would automatically adjust if inequality gets worse.
The proposal is known as “The Rising Tide Tax System,” from President John F. Kennedy’s memorable phrase that “a rising tide lifts all boats” — coined to defend his pro-growth policies that may not directly benefit lower-income people. “The problem is that a rising tide has not been lifting all boats,” Shiller noted. “Our proposal is to make sure that happens.”
As Shiller explained in a discussion paper for The Tobin Project, if the income gap continues to widen, the “rising tide” system would increase the tax rate on higher incomes proportional to a set goal of total tax revenue.
“That is the kind of thing that might possibly come in the next 10 years — it’s a real innovation that would confront head on the huge crisis of inequality that the world is going through these days,” he said with just a hint of uncharacteristic immodesty.
But taxation is still a power exercised only on a national level. “People say if you raise the taxes on the rich, then the rich will leave your country. That’s why some international coordination would be helpful there, but that is a political problem, so what I was proposing is just for individual countries.” So far, that is.
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