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Summer 2009 | Volume 32, Number 2 | Features

A Conversation With Robert Shiller

Robert Shiller
During a 2007 hearing on the subprime housing crisis, Robert Shiller waits to testify before the Joint Economic Committee on Capitol Hill.
Downing: What is your view of the relationship between the way people think and feel, and the performance of the economy — the subject of your book Animal Spirits?

Shiller: It seems like most people think of themselves as completely rational and responding to an economic situation, rather than as a source of fluctuation in the economy. But then you have to ask: Why does the economy fluctuate anyway? And what’s causing these movements? In the book, we argue that ultimately the movements are substantially coming from people and their psychology.

In the immediate circumstance, it might be true that people are responding. For example, why are people not spending now in this recession? Well, it’s because they don’t have a job, and you know they don’t have security. Or they’re worried they might lose a job, or their income is down, or the stock market is down. Real things like that … . But then, if you go back further and you ask why all these things are happening, it goes back to psychology.

Downing: And your book title refers to [John Maynard] Keynes, who first wrote about the importance of ”animal spirits” or human psychology in relation to the Great Depression?

Shiller: Yes. I think Keynes was right, although we have a better understanding of it now, 70 years later — because of more research in psychology and other social sciences.

Downing: Maybe that research will help us as we figure out what to do to recover from this crisis?

Shiller: I think that’s absolutely right. You have to understand the crisis before you know how to get out of it.

Downing: How did human psychology contribute to this recession?

Shiller: I think the fundamental problem of this crisis has been speculative bubbles in the housing market and in the stock market. And those were about over-optimism. People really thought that home prices never go down. And they really thought that the stock market is a magical investment. They thought that these may go down for a short time but they can’t stay down. And this led to complacency.

What’s a “Speculative Bubble”?

According to Webster’s New World Finance and Investment Dictionary, a speculative bubble is a rapid but often short-lived run-up in prices that is caused by “irrational exuberance,” rather than the basic underlying fundamentals of the market.


As the speculative bubble increases, more investors are likely to buy, until it appears that “everyone” believes prices will rise further. When the bubble finally bursts, prices fall even faster than they rose, with everyone rushing to sell at the same time, which produces widespread and severe losses.

Downing: Now that the bubbles have burst, people’s psycholchology is very different, negative. How will that affect recovery?

Shiller: A lot of people have the impression that confidence is important to recovery, but they may not understand that it’s a subtle problem of how to manage confidence.

I think talk is not very effective. If, for instance, the president gets up and says the economy is going to do very well, that won’t have a very big effect on confidence. That’s the Herbert Hoover strategy. He tried to do that in the early Depression. It ended up making him a laughingstock, because he just kept being wrong so many times about the economy recovering that they just stopped believing him. So I don’t think that’s what a president should do. I think the government has to take concrete actions on things like fiscal policy and credit policy.

I don’t mean to say that what the government says doesn’t matter — it does matter. But putting on a false sense of optimism is not the right thing.

Downing: How does trust — in people and institutions — matter to the economy, particularly in the current situation?

Shiller: I think it’s central. Because in a boom-time, when trust is generally high, people feel that they’re ready to believe. That means they will invest in enterprises on the word of another person, and so we have a lot of entrepreneurship.

In a time like this, when people have become mistrustful, they don’t believe entrepreneurs, and not just entrepreneurs, but also any business prospect, looks suspicious to them. And so that’s part of the reason that credit dries up. It’s partly because of the macro situation that the whole economy is bad. But it’s also because we don’t trust each other.

Downing: You spoke of taking concrete actions to restore confidence. The problems we’ve had involved risk: excessive risk, underestimated risk, and misallocated risk. Lenders didn’t have to worry about the risk of the loans they were making to people. What are some things we can do to make sure that risk is properly dealt with in the future?

Shiller: There are a lot of different financial engineering things that have to be done and are being done. One problem, which you mentioned, that underlies this crisis, at least partly, is that originators of mortgage loans didn’t care that much whether the mortgages paid off. That was because they were selling them off to mortgage securities, and after they sold them said, “It’s not in my department anymore; I don’t care whether it turns out good or not.” And there was too much trust in the rating agencies that would rate the securities and that apparently weren’t alert to this problem.

Those are things, however, that we can deal with. We can work out a better incentive system for mortgage originators so that this doesn’t happen again — and also a better incentive system for those people who rate mortgage securities.

So I don’t think that these problems are fundamental to capitalism, as some people suggest. They’re specific problems that we have to work on and get better financial structures to deal with.

Downing: Speculative bubbles are an area of expertise for you. When people see a bubble developing, what can be done to stop it without causing a lot of damage everywhere else?

Shiller: It’s difficult to manage bubbles, but it’s not impossible. One thing that we’ve lost in recent years is the practice of national leaders speaking out against the bubble. It used to be that the chairman of the Federal Reserve would tell the world when they thought the market was getting speculative. The problem is that, starting around the 1970s, the academics, or the intellectuals behind the financial market, began to express great confidence in a theory called “efficient markets.” And this theory is that the markets are smarter than any single person. That no one knows as much as the markets, because the markets pool all the information of all the smartest people. And so leaders haven’t felt that they’ve had any authority to intervene in the market, because the market is smarter than anybody. I think this ultimately colored [former Federal Reserve Chairman] Alan Greenspan’s thinking, although he gave this one speech in 1996 when he referred to “irrational exuberance.” He didn’t repeat that. I think he really thought that markets are efficient, that he should stay hands-off.

So, speaking out is one thing we can do. Another thing would be to tighten monetary policy somewhat in a time of burgeoning markets. And there are other policies that could be used, such as margin requirements or uptick rules. Until recently — and that’s different — the general policy arsenal has not been used at all to try to prevent bubbles. In terms of a real estate bubble, I think one of the policy tools that the Federal Reserve and other agencies have is their regulation of mortgages and lending standards.

A Silver Lining in the Global Economic Crisis?

Douglas Downing, associate professor of economics at SPU, sees “reasons to be optimistic and reasons to be pessimistic” about the international economic crisis. About a billion people still suffer extreme poverty, Downing notes, “but due to efforts like microfinance, a large number of people are now less poor, particularly in China and India.”

In a recent campus lecture, Downing cautioned against the consequences of taking our national wealth for granted. But he also added that the U.S. has “learned enough to avoid another Great Depression.”

Downing: In your recent book Subprime Solution you talk about the role that financial markets could potentially play in dealing with bubbles. Would you describe that?

Shiller: I think that we need to broaden our financial markets. I said “democratize” them — that is, make them work for the people better. One example is that single-family homes are the major asset for typical families. That’s what their life savings are in, and yet they don’t have any risk management for that. In fact, they tend to take leveraged positions in that market. That is, they borrow with a fixed-rate mortgage to invest in housing and, of course, if the price goes down, they’re wiped out. And that’s just what’s happened.

It’s not very smart. Yet it was conventional wisdom that that’s what most people should do. I guess it was based on the remarkable assumption that home prices can never fall. Though now that they have fallen, we know that that was a mistake.

So what we need to do is develop financial markets and retail products so that people can be better protected against that kind of thing. This is something I talked about in the book, and I’ve also tried to take action on. In 2006, the Chicago Mercantile Exchange created single-family home prices futures markets which would allow hedging of home price risk. Those have been going for three years now. But we’re hoping that eventually retail products will be developed … products like home-equity insurance, or what I call in my book “continuous-workout mortgages,” that protect homeowners against the kind of tragedy we’ve seen recently — where their whole equity is destroyed and may become negative because of a decline in the housing market.

Downing: Even if the president or his advisors come up with good economic policy recommendations, they must go to Congress. And Congress faces pressure from many different directions. What advice do you have for our government in this economic situation?

Shiller: The president is in the same situation that Franklin Roosevelt was in the Great Depression in that he has a Congress that is likely to support what he does. But even so, I think he has to be careful. He does have political constraints. ... Ultimately, any president has to worry about his public support. And that’s a problem with the stimulus package. Like in the Great Depression, when the Depression was new, Roosevelt had more support for economic stimulus than he did later in the Depression when many people were concluding that it wasn’t working. That’s the risk that we have. That people will think in a few years that if the economy is not really picking up that the stimulus package didn’t work. When in fact the problem was the stimulus package should probably have been bigger — so we might go in the wrong direction.

Downing: What do you think are some of the most important lessons we have learned about the causes of and remedies for this crisis?

Shiller: You have to realize that it’s a remarkable phenomenon, the view that the housing market and the stock market were wonderful investments that would make us all rich. It doesn’t make a lot of sense from economic theory. They’re not going to make us all rich. What makes us rich is our work — that we do things and we make things — not that we all speculate in markets. Somehow that thought got lost, and it affected all sorts of policies: not only individual investing policies, but also government regulatory policies. So we all lost our focus on the real things.

The real things are that we have to educate our students. We have to research and develop our products. We have to get people motivated and working and innovating. That’s what makes us richer. I think that, in a sense, this kind of experience may bring us back to reality if we learn properly from it. And we will ultimately do better.

iTunes U

iTunesWatch Associate Professor of Economics Douglas Downing’s May 12, 2009, campus lecture, “Hope and Fear: Reasons for Optimism and Pessimism in Today’s Economy.”

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