How We Can Escape This Mess

This Yale economist says you need to understand human behavior to break boom-and-bust cycles.

Robert Shiller knows us better than we know ourselves. In his bestseller, Irrational Exuberance, the Yale economics professor popularized the idea that Internet stocks represented a dangerous bubble that would end badly for investors. His timing was flawless: The book came out in March 2000, just as the great bull market of the 1990s was ending and many Internet stocks in particular were about to slide into a death spiral. A later edition of Irrational Exuberance, published in 2006, warned of the housing bubble that triggered our current misery.

Shiller says it's his knowledge of human behavior, not numbers and economic theory, that has allowed him to identify bubbles and warn of subsequent meltdowns. But he is also a heavyweight when it comes to analyzing the numbers. He helped develop the Standard & Poor's/Case-Shiller Home Price indexes, which are the standard in tracking home-price changes in the U.S.

In his latest book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton University Press, $25), Shiller deftly picks apart the failings of traditional economics. He and his coauthor, Nobel Prize-winning economist George Akerlof, show how we ignore issues such as trust, overconfidence and fear at our peril, and they suggest ways to prevent us from being our own worst enemies.

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To get Shiller's take on the current financial zeitgeist, and on the nation's economic woes and how to fix them, we recently visited him in New Haven, Conn., in his office at Yale.

KIPLINGER'S: This is a fine mess we've gotten ourselves into.

SHILLER: That's a quote from Oliver Hardy, of Laurel and Hardy fame. I wonder if he coined it during the Depression.

Do you think we could fall into a depression?

Unfortunately, we might. We don't have any examples of a government extricating a country from a crisis like this one -- especially when you consider that the crisis has spread around the world. Some of the recovery hinges on what other nations do. I'm hopeful there will be a worldwide stimulus, but that's not happening. We need to run up a big national debt to do a major stimulus. The reason we didn't stimulate more during the Great Depression -- when we needed to -- is that it just didn't work initially. That made it politically difficult to continue the stimulus.

When do you think the housing market will stabilize?

I don't actually forecast home prices, although I used to. And one thing I learned is that when prices move in one direction, they tend to continue in that direction for a while. So when officials in the Obama administration talk about a best-case scenario of a 17% decline in housing prices in 2009 and a 4% decline in 2010, they are, I believe, taking into account this momentum behavior. On the other hand, the economy could turn on good news, as it did after the Gulf War ended successfully in 1991.

What do you think of federal programs to help distressed homeowners?

Those are the kinds of things we need. I think we should reinstate the Home Owners' Loan Corp., a New Deal program that guaranteed new mortgages.

People need to have a sense of fairness and justice. That sense is damaged as each month of high foreclosure rates passes. People feel they've been treated unfairly because they followed the government's advice that they should buy a home, and now they're being evicted. This feeling of injustice is heightened when they hear stories of bonuses paid to Wall Street professionals. They are really angry, and you don't want to toy with that.

How does that anger hurt the economy?

Anger hurts confidence. Restoring confidence is not necessarily just about getting the stock market to go up; it's also about promoting a sense of trust in our economic institutions and in one another. When trust is damaged the way it is today, people won't do business in a million different ways, and that harms economic growth.

Can the economy rebound if housing prices don't stabilize?

If home prices stop falling soon, they'll be back to the level at which they've always been -- adjusted for inflation, that is. Prices have been at a fairly stable level for 100 years. If prices stabilize, they won't be a drag on the economy. But there's a risk that housing prices will overshoot, and that could hurt the economy further.

So housing prices haven't increased at all in 100 years, when adjusted for inflation?

Correct -- they follow inflation. People think that because we have only so much land, and it is getting scarcer, housing prices must rise. But offsetting that is the decline in construction costs, so it balances out.

Are you holding a wad of cash that you're waiting to invest?

Yes, I'm thinking of moving more money into the stock market. I've been pretty much out of the market, but it's a very ambiguous situation because the market could still fall by half.

Even though the market rallied strongly in March and April?

Be wary of thinking we turned the corner and from here on we'll be fine. Investors' low confidence is too fundamental to be corrected by short-term events.

What type of investment will do best in the next ten years?

It doesn't serve well for me or any adviser to claim that he or she knows what asset class will do best. It might be the stock market because it's so volatile, and it could be the housing market. But I think the best thing for people to do is diversify because of the uncertainty.

Many bulls cite your work to justify the view that stocks are cheap now. but earnings just keep dropping. Who's right?

I have the same conflict in my own mind. Our measure of market value uses data that goes back to 1871. We looked at price-earnings ratios using average earnings over ten-year periods. Based on those figures, if the stock market is highly priced, it tends to go down over the ensuing years. And if it's low-priced, it goes up. The figures show that the market is relatively low-priced now. Based on history, we should get something like 10% real [after-inflation] annual returns from stocks for years to come.

So, when will it be safe to jump back into the market?

It will be safe when people think it's safe to invest. It's ironic: The feeling that the stock market is not safe is a major cause of it not being safe.

Are efforts to stimulate the economy putting us at risk of a problem with inflation down the road?

I do worry about that possibility. I see a scenario in which inflation picks up because people start to expect it. The Federal Reserve would then be in a tough spot because it would be tempted to tighten the money supply to combat inflation while the economy was still weak. That could lead to stagflation -- inflation and a stagnant economy.

Many Americans now think that secretive financial arrangements have helped to wreck the economy. What do you think?

The idea that the stock market is rigged is still a minority opinion, but one that's probably taking root. To restore trust, we should change the system. For starters, we should change our mortgage institutions so that we don't put people in leveraged, risky positions and end up with more than 12 million of them owing more than their homes are worth. I've been working for close to 20 years to launch the concept of home-equity insurance.

I bet many people would be interested in that kind of insurance now.

What else should be done to improve the nation's financial system?

More regulation, especially for banks. The system also needs more transparency. People were shocked to see the astronomical number of credit-default swaps -- essentially, insurance against debt issuers going bankrupt. But that was largely because there was no clearinghouse for these contracts. That's being addressed.

You've written that people rushing into Internet stocks and taking out big mortgages represented a kind of mob mentality. How do we modify that kind of behavior?

To some extent, the system will correct itself. We used to believe that big names such as Bear Stearns and Lehman Brothers were almost godlike. Now we know they were anything but. The giants had feet of clay. So we'll be more careful.

You're also a proponent of better financial education. People will, as you say, "limp along with practically medieval financial insight."

It's good that the media are talking more about finance. The problem is that the media talk too much about investing when the market is rising. That makes investors overconfident and they start looking for guaranteed 10% returns.

We should create a financial incentive for people to get professional financial advice. The simplest approach would be to provide a refundable tax credit for the cost of financial advice. It would be available to anyone, regardless of income. Also, we can help prevent people from making bad decisions. In Europe, there's an institution called a civil notary. Before you sign a contract, you must see a civil notary, a lawyer by training who reads the contract. Before witnessing a signature, the notary confirms that you understand what you're signing.

We've experienced back-to-back bubbles In the past ten years. What can we do to prevent financial bubbles?

Bubbles represent enthusiasm for entrepreneurship, so it's not clear that all bubbles are bad. Even though many Internet companies failed during and after the first bubble, we were still left with and eBay and other great success stories. The French philosopher Montesquieu said that history is littered with wars and that it would be great if we could create some peaceful methods of diverting humans from their aggressive tendencies. Business is one peaceful alternative.

So we shouldn't make an extra effort to prevent bubbles?

It would be better if booms had a firmer foundation -- that they were less speculative -- so that's why investor education is so important. I wish investors would focus more on fundamentals. People don't think much about what the economy does; they're thinking about what the next fool will do. We should be looking at investments for the cash flow they will generate over the next 20 years.

Some people think that Treasury bonds are in bubble territory because of their super-low yields.

You could say there's a bubble there. It's possible that that market will crash.

Why do you say "stories" are so important in our economic thinking?

Social psychologists argue that the human brain is organized around stories. It's a memory device -- we tend to remember things that are tied to stories. The impact of stories on behavior is a major omission from economic theory. The main story line of the 1990s was the idea that capitalism was triumphant and people didn't want to be left out. The same thing happened with the housing market this decade. People were worried that they'd be left out, so their egos compelled them to take part in the housing boom.

That's probably why the Bible is filled with parables.

Yes, there aren't a whole lot of numbers in the New Testament.

The story of Capitalism's preeminence certainly has taken a beating.

Yes, but our attitude toward business changes from time to time. We hit low points in the 1970s, 1980s and 1990s, and today there's a sense big business was involved in a conspiracy. Anger about that will result in more regulation.

Do you see Americans adopting new values as a result of the turmoil?

It's hard to predict. But I'm hopeful that people will start valuing friendships more and material things less.

Bob Frick
Senior Editor, Kiplinger's Personal Finance