From Visionary to Innovator
| Author | Paolo Mauro |
| Position | Division Chief in the IMF's Fiscal Affairs Department |
| Pages | 4-7 |
Page 4
Robert J. Shiller has often been described as a visionary. In some of his best-selling books, Macro Markets and The New Financial Order, he has made the case for creating new fi nancial markets in which individuals would be able to diversify away the most important risks affecting them, such as income or house prices. He refers to this as the democratization of fi nance, or making financial markets work for the benefi t of the common person.
With two patents for financial innovation to his name, in recent years Shiller has started turning his vision into reality:
In 2006, futures on home prices for 10 U.S. metropolitan areas, as well as an average nationwide price, started trading on the Chicago Mercantile Exchange. Shiller's reputation as a visionary in finance and macroeconomics is probably even better established with the general public for his work on irrational behavior in financial markets-especially for his admirable ability to identify "irrational exuberance" and speculative bubbles at an early stage, for both the stock market and housing prices.
Of course Shiller remains, first and foremost, a highly respected academic (he is the Arthur M. Okun Professor of Economics at Yale University and Professor of Finance at the Yale School of Management). But he is as close to a celebrity as it gets within the field of economics: his books on financial markets and the subprime crisis have made him a household name, and he has appeared in a series of fullpage retirement-planning advertisements in the U.S. popular press.
First, the facts on Shiller's ability to identify asset price bubbles. In 1996, he noted that the price/earnings ratio on the stock market was at a historical peak, and argued (admittedly, four years too early) that the stock market was overvalued and likely to crash. He articulated this view in the impeccably timed fi rst edition of Irrational Exuberance, published in March 2000, just as the dot-com bubble burst: in particular, he provided a cogent analysis of the psychological factors underlying the formation of speculative bubbles.
In a 2003 Brookings Papers study with Karl Case and in the second edition of Irrational Exuberance (2005), Shiller showed that house prices had begun looking like a "rocket taking off,"Page 5 despite the absence of developments in fundamental factors such as building costs, population, or interest rates that could explain the takeoff. Indeed, using a data series of home prices spanning a century that had not previously been assembled, Shiller showed that home prices were rising faster than ever before as a ratio of housing rents or personal income.
Shiller's view of why bubbles arise is much influenced by psychology. He credits Virginia, his wife of three decades and a PhD clinical psychologist, with introducing him to the field of psychology at an early stage in his career, and adds that "in a healthy marriage, you tend to come to a shared worldview."
Thus at the origin of financial bubbles, according to Shiller, is the fact that "humans are social animals, and we influence each other," resulting in "social contagion." In times when asset price bubbles are growing, stock prices rise because of "new era" stories; similarly, sustained house price increases reinforce the collective belief that house prices can only rise, thereby perpetuating a seemingly inevitable upward trend.
As Shiller emphasizes, this is not to say that fundamentals don't matter. On the contrary, he considers the efficient markets hypothesis to be essentially valid in the sense that a sufficiently important change in fundamentals will eventually lead to changes in asset prices. But, depending on what people happen to be focusing on, it may take a long time for asset prices to respond to fundamentals.
As everybody knows, home prices in the United States have fallen dramatically since 2006. In this regard, Shiller has been called a Cassandra-unfairly, he thinks, because, although the recent decline in housing prices has imposed massive costs on financial institutions and the economy more generally, under more normal circumstances most people would usually be happy when homes become more affordable.
Shiller did not coin the term "irrational exuberance"-the title of one of his best-selling books-but came pretty close. The term was used by Alan Greenspan, chairman of the Federal Reserve Board, at a black-tie dinner speech in Washington on December 5, 1996. Greenspan asked: "But how do we know when irrational exuberance has unduly escalated asset values, which then...
To continue reading
Request your trial