From April 2010
An Interview with Robert Shiller
Conducted by Nick Rugoff
Robert J. Shiller is the Arthur M. Okun Professor of Economics, Department of Economics and Cowles Foundation for Research in Economics, Yale University, and Professor of Finance and Fellow at the International Center for Finance, Yale School of Management. He received widespread acclaim for successfully depicting the Internet and housing market overvaluations and predicting their subsequent busts. He is the author of a variety of books, including Irrational Exuberance, The New Financial Order: Risk in the 21st Century, Subprime Solution: How the Global Financial Crisis Happened and What to Do about it, and Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. Along with Karl E. Case, he is the creator of the Case-Shiller Home Price Indices. He received his B.A. from the University of Michigan in 1967 and his Ph.D. in economics from the Massachusetts Institute of Technology in 1972.
You recently expressed concern over a potential “double dip” in housing markets. How can the government wind down policies boosting housing markets without creating another downturn in housing prices?
Well, of course it’s very hard for the government to control markets and it may be impossible. The principal objective of the government is not to control housing prices. The Employment Act of 1946 gave the government a clear role in stabilizing employment, but not in stabilizing home prices. Unfortunately, home prices have the potential, if they fall, to affect unemployment. Historically, we’ve been able to survive fluctuations in home prices without major disruptions in employment. The reason home prices are salient right now is because they affect the balance sheets of troubled financial institutions. In the short run, we may want to continue the government support of these financial institutions, but it doesn’t necessarily mean that we go in and boost the housing market.
Are there any asset classes or markets where you see potential bubbles emerging?
There are real estate bubbles going on right now, notably in China. I’m more than concerned because it is really happening there. There is some enthusiasm coming back and it’s possible that we could have another real estate bubble if the economy continues to recover. There already seem to be bubbles in California. For example, San Francisco’s housing market is up 15% since last year. Californians are very prone to react to the beginnings of a real estate boom, though I still think that the “double dip” is a serious concern right now.
What about gold?
Gold is difficult to forecast as it apparently has something to do with anxiety. It’s reached such amazing prices recently because of anxiety about the economy, which is now going away.
Many acclaimed investors have lost money by betting too early against bubbles. How should investors who wish to bet against perceived bubbles time their investments?
I’ve done research on the time series properties of home prices and looking back, I could have speculated successfully on home prices and it would not have been that difficult. There is such momentum in home prices and they go up for years. In the bubble of the early 2000s, people who were buying houses and then flipping them were ridiculed, but those who knew to stop before real estate began to slow down probably made a lot of money, and maybe they were the smart ones. Historically, there has been a lot of momentum and home prices have gone in the same direction for years. Leveraged investments in homes are almost an obvious way to make money, but the market is changing and has a tendency to surprise people. Something that was a good way to make money five years ago can start behaving very differently when too many people start to exploit it. Right now we have an uptrend in home prices and you might think that it looks like the time to buy, but I am not saying that. The economy is just too uncertain right now and I do not see any way to confidently forecast prices.
Well, there were many smart investors who saw the Internet bubble in the 1990’s, moved too early and lost a lot of money shorting technology stocks. I wonder if you’ve observed any general moments in bubbles that tend to signify a peak.
Real estate bubbles have historically had a very simple technique for signifying a peak: home prices stop rising (laughter) and then they go down. They slow down for a year or so, then become flat, and then start sinking. It looks so predictable. It’s not like that in the stock market at all and it may not be like that in the housing market in the future. Markets tend to surprise.
Should central banks take steps such as raising interest rates to thwart perceived bubbles?
I think that they should take some action against bubbles, but thwart may be a strong word because I don’t think they can expect to be successful. They might reduce the amplitude of bubbles, but they have other objectives and bubbles are often not that harmful to the economy.
How can we remove “too big to fail?”
That is a very important question. If you read the preamble to Senator Dodd’s current bill, it claims to correct this, but I don’t think it does. It’s a very difficult problem because organizations know that they’re big and important, and that the government is not going to let them fail. So, it’s just a fact of life and has been something repeated throughout history in many different countries and is a fundamental problem of capitalism. I think that there are things that can be done to remove some of the risk. These are things that are either in current bills or have been talked about. The capital requirements that we see on banks should be extended to other non-bank institutions as well. In particular, capital requirements should be higher for systemically important institutions, which are not necessarily just big institutions. We need more data requirements by regulators so that they can understand the systemic significance of companies. It’s not just total assets. For example, a company could issue shares and buy a ton of treasury bills and just sit on them. They could get really big doing that, but they would pose no risk to the economy. It’s all about what the company does and we have to start watching companies more carefully and regulating them when they are doing something that is systemically risky. I also think there are other structural changes that could reduce the “too big to fail” problem. We could the way capital is raised so that firms have less of an incentive to go out on a limb because of the “too big to fail” problem. It’s a major structural issue that needs to be addressed, and the current legislation only partially addresses it.
How would you rate the current financial reform bill?
I think it’s a step in the right direction, but there are a million more things that we can and should be doing. This is an episode in financial history that because it didn’t turn out that badly – and I’m assuming it won’t – will be largely forgotten. We will have other crises and the most important thing now is the legacy that we are leaving for subsequent crises. My view is that financial progress is the essential thing to maintain. We should always be focusing on making a better financial system. The bills in Congress do that, but not with the most thoroughness and inspiration.
What is the primary reform you would like to see made to the financial system?
I wrote a book The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about it that discusses this. If you want a one-liner, I thought we should democratize finance, and by that term, I mean we should make it work better for the people. The severity of this crisis has a lot to do with the fact that people were not treated well. They were encouraged to take out mortgages that were leveraged, highly risky investments. With any risky leveraged investment, you run the risk of being wiped out, which has happened to something like fifteen million U.S. households. That’s almost a crime, and it’s just bad finance. Democratizing finance to me means rethinking our financial institutions so that they better manage the risk of people.
Do increasingly complex derivatives such as synthetic CDOs have social value?
I think they do and this is a theme of mine. Synthetic CDOs figured into this John Paulson scandal, where Paulson used a synthetic CDO to express an opinion he had about the housing bubble. He effectively put downward pressure on the housing market because he was creating a way for someone else to invest in the housing market without buying the housing market. That means that some demand for housing was shifted to the synthetic CDO, which should have reduced upward pressure on home prices or the prices of the securities in question there. I think it’s a good thing if we allow people who have negative opinions about a bubble to express them in the market. The fact that he made so much money doing that shouldn’t be a cause for public chastising. That money is his reward for seeing the bubble and that’s how a capitalist system works. Paulson is not under any indictment and I think that what he did is an example of a constructive capitalist response to excesses in the market.
What are your thoughts on the commercial real estate market?
The commercial real estate market went through a boom and is now going through a bust, but it did it all after the residential real estate market. The peak in the single-family home market was in 2006, whereas the commercial market peaked in 2008. I think that we can say with more confidence that the commercial real estate market will continue to fold than we can about the residential market.
The financial industry has taken on heavy criticism from across the globe. What can the industry do to earn back trust?
We’re going through a difficult time in finance, but people ultimately have to uphold ethical standards. What will win back trust is, if for example, it turns out that the SEC loses this case against Goldman Sachs and they don’t find more dirt like this, then we will have discovered that while Goldman may have been selfish and greedy, it wasn’t fraudulent. A few years ago, Harvey Pitt, the chairman of the SEC, demanded that all CEOs of large companies sign their balance sheet and profit and loss statement, and made them subject to criminal prosecution for fraudulent statements. A lot of people wondered what the effects would be, but there was no criminal prosecution. People tend to forget that these examples of fraud and bad behavior – the Bernie Madoff stories – are quite rare. Ultimately, as I tell my students, people have to uphold morals internally, and eventually, as the story fades, trust returns. Even though it seems bad to us, the way we get trust is through ethical behavior. Ultimately, even though people gripe a lot, they want to invest in America because they do trust the American financial system.
What drew you to behavioral finance?
Partly my wife, who’s a psychologist. Beyond that, it’s my eclectic nature. I think scholars have to read widely and I’ve read psychologists, sociologists, and political scientists, and to me, it all seems relevant. I can’t see doing finance without thinking about these other people and what they’re doing.
What role should behavioral finance play in the decisions of individual investors?
I think that individual investors have to recognize their own limitations. Firstly, they need to recognize that there is a problem of overconfidence. One is especially overconfident as a novice investor or a young person. With age you learn that you’re not as smart as you thought. You also have to resist impulses not to diversify. People seem to have a visceral opposition to diversification and risk management. To me, behavioral finance also suggests that individual investors should seek out help, just as some people would go to psychotherapists. While investment advising is very different from psychotherapy, it’s not totally different.
You’ve written about creating new units of measurement for inflation. How would this work and why is it important?
There is a fundamental role for the governments of the world to set and establish units of measurement. It’s even in the U.S. Constitution that the government is responsible for a system of weights and measures. Ultimately the economic system is hampered, probably for behavioral reasons because people can’t function when things are complex and they have to do too many calculations. This is a simplification measure that I have in mind and I think that straightening out our economic units of measurement is one of the most important things governments can do.
Chile created the Unidad de Fomento, which refers to a unit of account that is inflation indexed. You can set prices in these units of account and then everything is automatically indexed. This makes Chile the most inflation-indexed country in the world and we should take that as an example. We’re not accustomed to learning from Chile, but I think good ideas can happen anywhere in the world and the failure to index is a big part of our problems. For example, even in the housing bubble that we discussed, because we don’t express home prices in an indexed form, we have had an illusion that has caused us to exaggerate the return on housing and led us to make mistakes. A more orderly system of units of measurement would prevent that.
Lastly, what is your advice to students entering the financial industry?
I give a lot of advice to students entering the financial industry and it’s a source of pride for me that I have many alumni on Wall Street and have not seen any of my students, as far as I know, indicted for any crime. In very general terms, you have to think of yourself in finance as being in the service of mankind. Making a lot of money is all right, but what matters is what you do with it. Finance is a field that pays well and it’s important that you be charitable and philanthropic. You should take it as a calling and a mission and try to make it work for the people. Of course, be ethical, but beyond that, try to think expansively about how you can serve and improve the lives of the people.
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THE POLITIC — April 2010.
