Crash Master
By Justin Fox
Economist Robert Shiller has a new book out. You'll be thrilled to learn that it doesn't contain any warnings about a looming market crash. Well, unless you count that bit about the "train of catastrophes" that might ensue if current efforts to stabilize the financial system fail. But that's not really a prediction.
Considering the Yale professor's recent publishing history, this is quite a relief. In March 2000, as stock prices soared to record levels, Shiller released his first general-audience book. Titled Irrational Exuberance, a phrase borrowed from a 1996 Alan Greenspan speech, it made the case that stock-market investors tend to go mad every few years--and that they were at the time in the grips of perhaps their worst psychotic episode ever.
That month, stock prices started to fall. The slide continued for 2 1/2 years. Then, for the second edition of Irrational Exuberance, published in February 2005, Shiller added a chapter on real estate. His argument: House prices had followed the stock market into a flight of fancy that was bound to end badly.
The timing of that market call wasn't quite as spot-on as that of March 2000. But it was close. According to the S&P/Case-Shiller indexes devised by Shiller and Wellesley College's Karl Case, the rise in house prices slowed in the latter half of 2005, then headed south in summer 2006.
You know the rest of that story. House prices are still falling, and Shiller has attained a remarkable status in financial circles. He's the guy who called the past two busts, a hero to market bears everywhere, a fixture on CNBC and in the nation's financial pages.
So is this guy a genius, or just lucky? "There was some luck, but I don't want to say it's just luck," Shiller says. "It was also me thinking something crazy was going on here, and I just wanted to say it." This is not some Wall Street sharpie talking, but a floppy-haired, 62-year-old scholar with a gentle, meandering way of explaining the world. Shiller's new book, The Subprime Solution: How Today's Global Financial Crisis Happened and What to Do About It, offers a succinct sample of this worldview, which we'll get to. First, though, a little intellectual history.
Shiller spent much of his early academic career--he earned a Ph.D. from MIT in 1972 and has been teaching at Yale since 1982--making the case that stock-market prices jump around more than is warranted by economic fundamentals. This may sound obvious, but it was for a time heresy among finance scholars, who believed markets were paragons of informed rationality. Since then, the academic consensus has shifted in Shiller's direction. But identifying exactly when prices have gotten out of hand isn't easy.
Irrational Exuberance may have come out just as the market peaked in 2000, for example, but Shiller had actually begun voicing his worries about high stock prices years before. Fed Chairman Greenspan got an earful from the economist a few days before making his "irrational exuberance" speech in 1996 suggesting the market was overvalued. But prices kept rising, and Greenspan concluded that he shouldn't try to outguess the market. Other economists have since shown that acting on Shiller's bearish advice then would have cost an investor big gains over the subsequent decade. One man was no match for the bull's momentum.
But trusting in the wisdom of stock markets in 2000 or real estate markets in 2005 was a mistake too. In Shiller's view, the biggest dangers in financial markets come from unanimity. In Subprime Solution, he argues that what united the missteps by the Federal Reserve, mortgage brokers, Wall Street bankers and home buyers that together brought on the current financial mess was a shared belief that house prices never go down.
What's the antidote to that kind of mass delusion? Shiller seems to have no interest in substituting his judgment, or the government's, for the market's. Instead, he sees information and innovation as the counter to group think. An active market in house-price futures and options--Shiller has recently helped launch such securities on the Chicago Mercantile Exchange--would let skeptical speculators prick housing bubbles, he argues. If banks wrote continuous-workout mortgages--in which the terms changed depending on house prices, unemployment and the like--homeowners might be less addicted to rising prices. If government subsidized financial advice for the nonrich, salespeople angling for commissions might be less influential.
At least that's the idea. And even if you don't buy it, you can't deny that it's more palatable than another warning that the market is about to crash.
Extra Money? To read Justin Fox's daily take on business and the economy, go to time.com/curiouscapitalist