Question: What motivated Robert Shiller’s unique economic views?
Justin Fox: Shiller, in a lot of ways, was a pretty conventional economist. He was trained at MIT in the late 60’s and early 70’s. His dissertation adviser was Franco Modigliani, who accidentally coauthored a couple of papers that led the way to the rise of rational market finance and economics. So it wasn’t like he was being educated by a bunch of hippies out in an Ashram or something. He was getting a very mathematical, conventional economic education. But at the same time, as told in the book, this idea rose simultaneously—and there was a lot of cross pollination at MIT in Chicago, but in MIT, there was always this sense of “Here is this great model for understanding how the market works, and we totally agree that the market is pretty hard to outsmart. We don’t know that it’s smart, but it is hard for other people to outsmart, but we we’re not sure that means that it is all working perfectly.” Whereas in Chicago, it became a project to show how great markets were and how much better they were than any government bureaucrat. So, all along, in MIT, from the beginning, it was this weird co-existence of this very rationalist theory of how the world worked coupled with this understanding, and a lot of classroom discussion about how the world didn’t work quite the way it was described in the mathematical models in the classroom.
So you see you [have] people coming out of MIT, and Shiller’s classmate, Robert Merton, a Nobel Prize winner—sort of a high priest for a while of this rationalist finance—was there at the same time, and came out with a very different world view. So Shiller came out with this conventional training, but he sensed that all these theories and models weren’t entirely right. He had a lot of computer skills and empirical skills and so he started during the 70’s to just try to test some of these theories about market behavior against the data, and initially he was looking at bond prices and didn’t come up with anything all that is explosive, but then starting [in] the late 70’s, he started looking at stock prices, and was trying to come up with measure [of] whether they reflected the fundamental value of the stocks themselves. He just compared stock prices to subsequent dividend payments, and found that the dividend payments were a lot less volatile than the stock price movement. And that [was] not proof of anything, a lot of people argued, all companies tried to keep their dividends [steady], therefore it shouldn’t mean that much. But other people did similar examinations of earnings, comparing [them] with stock prices, and basically the lesson was there [was] a lot of unexplained volatility in the stock market.
Later on, other people, including the pretty conventional finance scholars like Richard Roll of UCLA, basically confirmed Shiller’s observation, and so then Shiller actually went and paid attention to real estate for about ten years. But when he came back to paying attention to the stock market again in the middle-late 90’s, it was with this idea that [there was] this period when prices went off in directions that had less to do with anything going on with the fundamentals than [with] mood swings. That led him by the late 90’s to be this really prominent doubter about the bull market of those days. And then he came out with—he totally admits this was luck—the most spectacularly timed book of all time. In March 2000, he published Irrational Exuberance, and March 2001 is exactly when that exuberance started to tail off and end.
Question: What is Shiller’s take on the current crisis?
Justin Fox: So he wrote Irrational Exuberance in 2000, and then he went back to paying attention to real estate. And then wrote a new version of the ebook that came out in 2005, making the point that, “Wow! Real estate prices had gone really crazy by historical standards, and we can probably expect sometime in the next few years a collapse in real estate prices.” And so he is now even more of a guru than ever before, because he really did it at some level predict what happened. Not the details, not the timing, but he—at a time when conventional wisdom was that the real estate market was not a big danger—he was saying it [was] everyday.
What’s interesting about Shiller is his lesson that he takes from all this is not that we somehow need to shut down markets or regulate them vastly more. However, I think he will be in favor of some more regulation. But he seems to think that if we only had even more financial products, if we’re all buying and selling real estate derivatives betting that our house prices might fall, then we would have been better off. So it sort off comes back around to that MIT belief in markets and conventional economics in the end. And so he’s very often paired with Nasem Taleb, an options trader turned bomb-throwing market philosopher. And Shiller comes across as the conservative or the moderate in all these discussions now.
Question: Does the crisis disprove Shiller’s belief in the power of developed economies?
Justin Fox: His belief is continued growth of the financial system is a good thing: we just have these shakeouts where we figure out what doesn’t work. I guess my one caveat to that is, after he said that, I went back, and was trying to look at it—because finance people always bring this up—and there’s a lot of comparative global research showing that countries with better developed financials do better than those without them. But [that’s] mostly research about developing countries, and it sort of stands to reason that a country where nobody has a bank account is not going to progress as fast economically as one with their banks and loans available. But I think once you get to a well-developed economy with big financial system, I’m sure there’s some point of diminishing returns, and it’s pretty clear we reached that in the US over the past decade: where you get a financial system that sort of takes on a dynamic of its own and it is no longer serving the economy as a whole, but it’s just kind of turning towards it’s own path and sucking off lots of money from the system. I imagine we will start getting a lot of research now about whether there is any way to tell what’s that one point where financial system has gotten too big. And I don’t think Shiller would disagree [with] that. He just, in the end, still believes in finance and [that] it can do good things for the people.
Recorded on: June 30, 2009