What really influences the financial system?

Robert J. Shiller

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, 2013 (shared)

In March 2000, Robert J. Shiller published his soon-to-be bestseller ‘Irrational Exuberance’. The timing was perfect: that very month, the dot-com bubble burst, just as Shiller had predicted in his book. The Yale professor was thrust into the spotlight, and stayed there. He was right a second time when he warned against a collapse of the American housing market, long before prices dropped. Shiller has been a celebrity economist ever since.

Not your everyday academic

A New York Times columnist, public philosopher and Nobel Laureate, Shiller is also a child of immigrants from Lithuania – he argues against barriers to immigration. He has even proven his entrepreneurial skills, setting up his own company to launch the Case-Shiller home price index.

There are two things that those close to Shiller say about him: one is that even though he’s incredibly busy, he finds it hard to say no to anyone or anything – and the other is that he’s very talkative. And when we meet him on the Yale campus where he’s been a professor of economics since 1982, you can easily understand why his wife Virginia (“Ginny”), a psychologist, believes he might have Attention Deficit Disorder. As a child, his teachers even threatened to tie him to his chair. That was a long time ago of course, but even now there’s a certain look in his eyes, as if he was following several trains of thought at once – without ever losing one.

Incorporating psychology into economics

Shiller is one of the founders of behavioral economics – behavioral finance in particular. He, along with two other economists, Daniel Kahneman and Richard Thaler, were leading figures who created a new approach that profoundly challenged existing thinking. For decades, they’ve emphasized the importance of taking a broad view and incorporating other academic disciplines into economics.

I tend to think of the behavioral economics revolution as a counterrevolution against excessive specialization, and a return to a normal discourse among the social sciences.

At a glance

1946, Detroit, Michigan, USA

Financial Economics

Prize-winning work: 
Empirical analysis of asset prices

Favorite Bob Shiller stories: 
Misplacing his car; got a D in citizenship in school; is not able to do anything half-heartedly; generally interested in the most unusual topics (like migration of birds to South America)

Best wife in the world: 
Allowed him to mortgage their house to invest in his company (it was a success, fortunately)

The major theme of his work:
Fighting for a new financial order

Lesson learned:
Never leave an economics professor and a camera operator unattended on a humid day - they’ll return completely soaked

It’s no surprise that a man described by his friends as someone interested in basically everything would crack open the field of economics and take a thorough look at other disciplines as well. When Shiller entered college, he had one big reservation: declaring a major. "It meant I had to give up my childhood dreams of doing everything." He describes how painful it was for him to choose, never knowing whether he’d made the right decision (though most people today would say he absolutely did). It was economics, in the end, but his interest in many sciences would pave the way for a rather different approach to his chosen subject.

Challenging the status quo

It was during his undergraduate studies at the University of Michigan that Shiller first had the idea that psychological insights had to be included into economic analysis. Eventually, thanks to his wife’s encouragement, he dug deeper. “She nudged me back into thinking about psychology,” Shiller remembers. “I might not have been the economist that I ended up as without her influence.” A focal point of his research became the idea that finance and the global economy were driven by people’s behavior and thinking. Back in the 1970s and 1980s, when Shiller first arrived on the scene, economics had become very mathematical. He believed it was wrong to be too rigid about what was a very human field.

Why financial markets aren’t efficient

"Economists look at the stock market, they see it going up and down, and usually they don’t have the foggiest notion why. They think they need an excuse, so they figured out a theory that excused them from not knowing." Shiller is talking about the efficient market hypothesis. He wanted to give “a more truthful account” which, ultimately, led to his first highly influential paper in 1981. His longtime friend and colleague John Campbell at Harvard University still remembers the moment he read that paper. He was waiting at a train station in New Haven, and immediately wanted to meet its author.

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A radical idea

"Bob had this very simple insight," Campbell explains. "If you looked at stock prices, they seemed to be much more volatile than the stream of future dividends that they’re supposedly forecasting. But if the forecast is moving around too much, that means that people are changing their mind in a way that is predictable and, therefore, irrational." Shiller, willing to go out on a limb at a time when rational expectations models were predominant, had a boldness that appealed to many young economists. At the same time, however, he came under harsh criticism. Ginny remembers how, back in the early days, her husband would come home feeling disheartened.

It was a tough road, also because there was a conservative revolution going on. Margaret Thatcher, the Iron Lady, ruled in the UK; Ronald Reagan was president of the United States. There was, as Shiller points out, the general belief that “governments should just stay out of markets completely”. Many took the view that we have to look to markets as if they were oracles, giving us a fundamental truth. So, when the market moves, we would ask: “What in its infinite wisdom did the market think of today?” But this didn’t sound right to Shiller. He had a more skeptical view of finance, arguing that markets didn’t accurately reflect all available information, so they were inefficient.

Can the financial industry help create a better society?

There were times when Shiller wished he’d never written his 1981 paper (though it became central in winning the Nobel Prize in 2013, together with Eugene Fama and Lars Peter Hansen). But, nevertheless, he continued arguing that the market is mostly driven by foolishness, “non-economic things, people’s fears, prejudices, reactions to news-stories, elections and campaigns.” He went further, adding, “So to think markets are the best thing that could ever be for human welfare, that’s just wrong”.

Shiller fights against the belief that markets should be left alone and advocates for different types of regulation, and the creation of new financial markets and institutions. He knows that after the financial crisis of 2008, people’s trust is still diminished, and the risk of another crisis remains.

His wish, however, is not to simply condemn the financial industry but to see it as a powerful tool for creating a better society. “What we need is a society that encourages financial innovation rather than being hostile to it, but that is skeptical and involves government regulators who will police efforts to deceive.” Shiller has often described how, in human history, finance has contributed to society’s wellbeing through different inventions. That’s why today he’s looking for ways of using finance to address the huge problems of inequality that are so apparent in many countries.

For all of the very specialized work he’s done on financial markets, he’s always cared more deeply for the welfare of society.

Peter Dougherty, Shiller’s editor at Princeton University Press

How can we address inequality with financial tools?

Shiller is especially worried about how technological progress might threaten our jobs in the future and lead to even worse inequality. To explain this, he uses a very vivid example given by Russian economist and Nobel Laureate, Wassily Leontief. “Let’s think about horses. They used to be everywhere. Where did they go? Well, I can tell you what happened to them: they died, we don’t need them anymore. The same thing could happen to people who somehow don’t get linked into the modern economy.”

Future-proofing employment against the machine age

Shiller has a radical proposal for the looming machine age: a new way of insuring people. Insurance against early death or disability has been common for decades. But it might not be adequate in the high-tech world of the near future.

The risk of losing your job to a computer is bigger than the risk of your losing the job because you’re hit by a car and paralyzed.

Shiller has suggested changing the system, developing new financial tools like long-term insurance against losing your job to a robot. He’s absolutely sure that future prospects in the Second Machine Age have to be discussed now, but he fears people might focus too much on more pressing events instead of thinking about tomorrow. It’s a problem in politics too, with politicians who, says Shiller, “are facing a narrow problem of maintaining their support” and so “tend to focus on problems they can solve in the short-run”.

Predicting bubbles

Shiller knows that he might sound alarmist at times, but he doesn’t care. After all, predicting market crashes is why he became famous. During an interview in 2005, he told the reporter housing prices would fall by half in real terms. “He called me back later that day and said: I’m gonna quote you on that.” Was he sure about what he had said earlier? “I thought about that and said: You know, I really do think that, so yes, go ahead.” Shiller suspects that there were many more economists who shared his thinking. But they weren’t going to come out and risk saying as much.

The idea of a housing bubble was regarded as kind of unprofessional. The bubble could be in newspapers, but not in scholarly work.

Rumor has it Shiller’s co-laureate, Eugene Fama, even canceled his subscription of The Economist because the word ‘bubble’ was in there too often. But Shiller thought there was some truth behind the idea: “It reflects human nature, when prices start going up, people get excited and some of them will rush in and buy, and prices will go up more. But it’s unsustainable. Eventually, it’s going to burst.” That’s what he thought was happening twice – and he was willing to go out on a limb to say it. It sounds like a bold thing to do, but Shiller has a good explanation for it: “It goes back to a philosophy that I gradually acquired. It’s morally important that you take risks. Someone could humiliate you by pointing out something you’ve missed, a counter-argument, but you have to do it.”

Having a Nobel Laureate admit they might not always be right is a reassuring thought. And there’s no doubt that Shiller is absolutely serious about it. “Bob really has been driven by his curiosity and his open-mindedness,” his colleague William Goetzmann explains. “Unlike many people in the profession who think about their long-term reputation, what I’ve seen from him is just enthusiasm, not worrying too much about where the boundaries are, but letting his interest in human nature guide the questions he asks.”

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