From the June 2009 issue of Research Magazine • Subscribe!

June 1, 2009

Yale's Shiller Keeps an Eye on Bad Behavior

And for the second straight time, the economist has called the peak of a bubble.

Who: Robert Shiller, Arthur M. Okun Professor of Economics, Yale University

Where: Gente, 153 West 45th Street, New York City; April 17, 2009

On the Menu: Minestrone, ravioli and bursting market bubbles

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Economists are generally good at forecasting economic trends. It's their timing that often stinks, which of course can make even the most accurate forecast useless.

Not so in the case of Yale University economist Robert Shiller. In his famous appearance on a CNBC show in 2005 he argued that in the long run house prices should increase no faster than construction costs, which tend to track inflation. As became evident later, his appearance closely coincided with the peak of the housing bubble, even though most economists at the time expected house prices to rise further and then plateau at high levels. After all, house prices had not declined in this country since the Depression.

"My retort to them was that they had never before risen so high, either," says Shiller.

But even earlier, in 2003, in his book The New Financial Order: Risk in the 21st Century, Shiller had raised the possibility of a global financial crisis.

"I don't know," he shrugs coolly. "It may have simply been dumb luck."

However, it's the second straight time that Shiller has called the peak of a bubble. His national bestseller Irrational Exuberance came out in March 2000, the very month the Nasdaq Composite index topped out above the improbable-sounding 5,000 mark. One instance of perfect timing may be fortuitous, but two out of two begins looking like a system.

Skeptical of Efficiency

Shiller credits his uncanny ability to call market peaks to his interest in behavioral macroeconomics, which in addition to conventional economic analysis adds insights gleaned from the study of individual and collective behavior with the help of psychology, sociology and other "soft" social sciences. Or rather, he blames the fact that so few economists in academia, the government and financial institutions were able to anticipate the deflation of the housing bubble and the subsequent financial crisis on the dominance of the efficient-market theory.

"If you believe that the market price reflects the rational view of all market participants, then it is going to be hard for you to identify bubbles," he observes. "Economists are used to modeling economic variables. Nobody was modeling failures of regulatory oversight, the spread of cynicism in the financial services industry and other factors."

Behavioral finance, says Shiller, has taken root in recent decades. Finance professionals, including asset managers, financial advisors and stockbrokers -- in other words, those who earn a living by trying to outsmart the market -- have taken interest in behavioral finance research. Shiller has contributed to its early popularity with his analysis of stock price movements going back to the Depression, which convinced him that market volatility has been far too high to be justified by rational expectations of future dividends.

But behavioral macroeconomics is another matter. Shiller and his collaborator George A. Akerlof have been giving seminars in behavioral macroeconomics since 1994, but a real academic discipline has yet to emerge. Now, they have co-authored a new book advocating behavioral macroeconomics, titled Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.

The current crisis has demonstrated that, as Shiller puts it, the study of macroeconomics needs to undergo a revolution, becoming less quantitative and more psychological and sociological instead. The importance of psychology recently has been on display as officials at the Federal Reserve and in the Obama Administration take pains to bolster consumer sentiment and instill more optimism about the economy's prospects.

Shiller agrees that business and consumer psychology is what will eventually end the recession. But he is skeptical that the attitudes of his academic colleagues will change.

"Perhaps it takes so much effort to learn all the aspects of conventional economics that nobody has time to dig into psychology," observes Shiller sarcastically.

His longstanding fondness for taking all kinds of surveys among investors, consumers and homeowners has got him no points from other economists, Shiller complains. With the exception of economists at the University of Michigan and a few other places, economists don't seem to want to know what ordinary economic players think or how they act.

But Shiller has not been deterred. His Investor Behavior Project at Yale has been collecting data on stock market confidence since 1984, by conducting questionnaire surveys among U.S. investors.

One problem, which Shiller readily admits, is that behavioral macroeconomics doesn't enable categorization and modeling quite as easily as classical economics does.

"I'm not saying that we have all the answers," responds Shiller. "We have raised the issues, but it will take a lot of time and a lot of effort to develop the field."

Building Markets

Shiller has become a household name -- literally so -- thanks to one of his indices, the S&P/Case-Shiller home price gauge, which provides authoritative data on single-family resale prices in 20 major metropolitan markets around the nation along with unified nationwide indices.

Shiller is currently on a sabbatical from Yale, and he uses his free time for some practical purposes. At end-April, two weeks after our lunch, MacroMarkets, a company he co-founded and named after his 1993 book, would launch on the Big Board two financial instruments based on the Case-Shiller national house price index, MacroShares Major Metro Housing Up (NYSE: UMM) and MacroShares Major Metro Housing Down (NYSE: DMM). These products are designed to let investors bet on single-family home prices over a five-year horizon. For example, they could be used by individual investors to gain exposure to rising real estate prices without getting involved with taking out mortgages or owning any houses. Another set of users Shiller envisages are real estate investors and developers who will be able to manage their medium-term exposure.

Instruments like this, offering a way to hedge macroeconomic variables, were lacking before the current crisis hit, says Shiller. This will be only the first offering in a series, since MacroMarkets plans to introduce products based on the CPI component for health care and education.

The Chicago Mercantile Exchange already trades futures and options based on the Case-Shiller index -- but without much success. There has been a problem of attracting sufficient liquidity, admits Shiller. This time around, he is using his insights from the behavioral finance field to design a more attractive product

"Investors are more comfortable with exchange-traded products with characteristics that are similar to a stock," he says. "The products will pay dividends, because we found that investors prefer shares that pay dividends."

When trading started on the Chicago Merc three years ago, Shiller found that the futures contracts were already in backwardation; in other words, futures prices were below spot prices for the housing index -- even though the housing price bubble was still inflating in the real world.

It seems that markets were already forecasting the bursting of the bubble back then. Doesn't it mean that the efficient-markets theory has at least some validity?

"Of course, I like financial markets," says Shiller. "The only problem is that they are prone to exuberance, which the efficient-markets theory refuses to admit."

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past six years, 2004-2009.

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PHOTO BY Leeza Semionova.

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