The Subprime SolutionHaving effectively called the top of the dotcom bubble with his first book, Irrational Exuberance, and documented the emerging US housing bubble in his second edition of the same, you’d think that Yale economist Robert Shiller would have been treated with significant reverence by our economic and financial institutions (both public and private) over the past few years. And you’d think that he would already have been asked to make a material contribution to resolving the crisis. In fact, you’d think that writing Irrational Exuberance would alone have been enough to forestall the second crisis. But then, if you thought that, you’d be me. And you’d be wrong. Again.

If you’re unfamiliar with Robert Shiller then understand that he is perhaps the most eminent and considered examiner of modern investment bubbles. It was two days after Shiller and a colleague testified before the Federal Reserve Board in December 1996 that then Fed Chairman Alan Greenspan sent stock markets into a mini-crash by coining the now legendary phrase “irrational exuberance” in the context of stock market behaviour. Influential indeed. Shiller’s book Irrational Exuberance came out in March 2000, after which the dotcom boom finally collapsed.

As Shiller tells it, the world of political and economic authority just does not work the way you might have hoped when it comes to emergent investment bubbles. And yesterday I took a look at one or two of the more popular economics websites to remind myself of how well they responded to the notion of a US housing bubble, and their level of reference to Shiller’s work. Even at the peak, these sites were looking for reasons why we were not in a bubble. It made me think that if you desperately want to sell your house these days you should do no more than find an economist or central banker and just name your price: they’ll tend to believe excessively in market efficiency and won’t even haggle with you. In fact, they really don’t seem to be very savvy at all; in the way Shiller observes Greenspan‘s ideological devotion to Ayn Rand (pp 43), they would seem to be honour-bound to reward your heroic selfishness.

Shiller’s new book, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It (publication date: September 1), is a concise attempt to elaborate in just seven short chapters the genesis of the housing bubble (a psychological carry-over from the dotcom bubble), explode its myths (‚Äúprices always go up”), explore its scale and the dangers of its deepening impact (it’s bad), assert the need to maintain confidence in our economic and financial institutions by aggressive action (comparing the US and European responses to the Great Depression), and then explore longer-term, more fundamental reforms and innovations that will create a population much more attuned to economic risk.

Case Shiller Home Prices
How the US housing bubble looked at the peak. (Source: Irrational Exuberance website)

If you were among those who’d imbibed his dotcom analysis, or just lived the visceral torment of trying to swim against the tide of this particular mania, Shiller’s narrative of the social psychology of the housing bubble is all too familiar. By the way, if you think you already paid a high enough price for being prudent and that you may now cash in, Shiller has more bad news: you’re gonna have to pay for the inevitable bailouts too.

We have to be ready for the possibility that many more tax rebates will be necessary, perhaps for years to come. These rebates may eventually have a significant negative impact on the national debt. That possibility can be accepted only if we truly recognize the seriousness of the problem.

The book describes the process of the contagion of ideas, likening the spread of bubble mentality to a disease epidemic. Like a disease, the epidemic grows as the infection rate exceeds the removal rate; in other words, positive beliefs about the market outnumber more negative perspectives. For instance, there was the irrational belief that housing always appreciates, born of the inflation-ignoring money illusion; the increasing salience of particular “new era” narratives; regional or city patriotism that implied a particular area was somehow intrinsically different — where “everyone” wanted to live — justifying the inexorable local market rise. These ideas also inform the stock of media coverage, and are woven into reports of market gains in an attempt to explain what has little or no real fundamental basis:-

Most persons can be forgiven for not seeing that the sense of economic prosperity that usually attends a major speculative bubble is actually caused by the bubble itself.

But what is particularly telling is how this infects not just the private institutions, who stand accused of complicity in creating the subprime mess, but also our public institutions: political, monetary and regulatory. For example, describing conversations with the officials from the US Office of the Comptroller of the Currency and The Federal Deposit Insurance Corporation when he was urging prompt action to curb the then excessive lending:

I had the feeling that many of them viewed me, with my argument that the bubble would burst, as an extremist who deserved a skeptical response.

The problem Shiller complains of now, though, is that he is too readily characterised as a Cassandra. Mirroring the positive feedback loop that attends market rises, Shiller describes how journalists now invite him to describe how deep and how long a recession might be, while seeming much less interested in the solutions and frameworks that he proposes as a response to the economic and market disaster that is unfolding. He argues that this negative feedback loop — the increasing salience of bad news stories — serves to undermine confidence, and deflects attention from the scale and detail of the remedies needed. And I can attest to that; I may no longer eat breakfast cereal but am obliged to consume an oversized portion of Credit Crunch every morning c/o BBC Radio 4′s The Today Programme.

More than just an academic observer, Shiller is a practitioner. He has designed institutional and market frameworks to help avoid the economic catastrophes which tend to follow bursting bubbles. For instance, discovering that there was no long-run continuous data series to analyse the activity of this most important of asset markets, he set about researching and building the now widely used (one could say “benchmark”) S&P/Case-Shiller house price index, which charts the housing market in the US back to 1890. It’s on the basis of this data, Shiller shows, that US house prices rise with inflation over the long-run and are not the one-way bet of popular imagination. With colleagues, he also devised a domestic property futures market on the Chicago Mercantile Exchange.

So, Shiller is not really in the business of I-told-you-so, nor here to knock markets. He’s passionate about understanding the individual and group psychology of investment, and designing market mechanisms that better serve us as citizens — that will enable us to take more informed risks, and so perhaps lead us toward more creative lives.

And it is worth reminding ourselves why Shiller thinks it’s important that markets send us the right signals. In this, from Irrational Exuberance, one need only substitute “dotcoms” with “new granite worktops”:-

If we exaggerate the present and future value of the stock market, then as a society we may invest too much in business start-ups and expansions, and too little in infrastructure, education and other forms of human capital.

But in The Subprime Solution, Shiller argues against those who call for a retreat to a simpler financial age. He suggests a range of options that can trickle down to the ordinary person to democratize finance, provide them with the security of home-ownership (where appropriate), and insulate them from some of the risks to their longer-term earnings profile. One interesting point he makes is that some people, lacking the means to offset their socio-economic risks, may become far too cautious in their choice of employment, thus depriving society of their more creative endeavour.

I especially liked his defence of mathematical finance as an important new technology. When we think of technology we too often think of gadgets and software rather than applied knowledge and know-how. It’s clear that some mathematical models have been erroneously applied, and I take Paul Wilmott‘s blog as my guide for insights on how that has happened. But, in simple terms, I’d venture that this is not greatly different from the misapplication of GPS: use it with common sense, and know how to navigate without it when it doesn’t work. Shiller reminds us not to throw the baby out with the bath water.

At less than 200 pages of wide-margined type, lightly annotated and with no bibliography, there is something of the emergency pamphlet about this book. And Shiller is advocating a much speedier and more deep-rooted response to the crisis, which, as of a few weeks ago, he felt was still not being taken seriously enough. I suspect the effective collapse of Fannie Mae and Freddie Mac into government support since then has helped change that, but the policy response still seems some way from the kind of discussion Shiller is trying to lead here.

Shiller notes as his inspiration John Maynard Keynes‘ 1919 best-selling critique of The Treaty of Versailles The Economic Consequences of the Peace. And there is a strong moral imperative running through Shiller’s advocacy, no doubt reflecting the increasing severity of the social consequences that can compound very quickly if the policy response is half-baked. Of Keynes’ book, Shiller says in an accompanying release:-

This says something important about human emotions and drives, and a weakness that can cause people to careen blindly into huge catastrophes. In an important sense, we see the same human weaknesses again with the subprime crisis. The resolution to this problem calls for the kind of integrated thinking involving economic, political and moral dimensions that Keynes brought to the crisis of his time. In this sense, Keynes’ great book is an inspiration to me.

There are many examples in the book of how our financial understanding can be re-framed over the long-term. One that definitely seems worthy of further examination is the unidad de fomento used in Chile and copied elsewhere in Latin America where prices are quoted in a standard inflation-indexed basket measure rather than hard currency to reveal to the individual the intrinsic value of a commodity or asset over time rather than its nominal, currency-based value. For it is the rise in nominal values over time to which Shiller attributes the recent sense that you can’t go wrong with housing. Shiller describes Chile as the most inflation-sensitive population in the world.

There are many more recommendations, but if this book has the ambition of Keynes’ earlier work, and the scale of the problem is as suggested, I’d argue that the book is as accessible as you are going to get from such a modern behavioural economics guru. It’s a book that everyone who lives in a house (and who is of reading age) should own; just don’t buy ten and try to rent them out to friends.

Shiller links

  1. The Atlantic Monthly has an exclusive feature article by Shiller, drawn from the book.
  2. You can read Shiller’s occasional New York Times pieces here.
  3. A publisher’s video interview of him is here.
  4. His Yale lectures are being made available to the public later in the year at Open Yale.
  5. the Irrational Exuberance homepage is here.

The book should also be available on Amazon’s Kindle from August 18, two weeks prior to print publication:-

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