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 (“prices 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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Tweet Brooke Harrington of the Max Planck Institute will be speaking at the RSA on Thursday 17th April, 1 pm, about the subject of her new book Pop Finance. Anyone hearing the news reported this morning about hormonal excess leading to bad risk-taking in trading will be interested in this from the synopsis of Brooke’s […]

For those following my experimental, ham-fisted attempt at streaming Twitters from Dan Ariely‘s lecture at the London School of Economics on Monday, a full podcast has been made available. He is funny, engaging, and I was sitting next to the guy whose wife was forced to confess she could not think of 10 reasons why she loved her significant other. Had I been younger, single, better looking, less shy, and that kind of man, I would definitely have seen an opportunity there.

It was all like good stand-up. So put it on your listening device for that next long run.

Also, I’m welcoming suggestions for what phone works best for Twits.

PS. To participate in counting the basketballs, pause the podcast and go here. Thanks to Seth Godin’s post here who also credits Bryan and Ken.

Here is a commercial version of the same:-

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rasterised chimpA public service announcement: MIT‘s leading behavioural economist Dan Ariely, who was covered in this post, will be speaking at the LSE on Monday (probably today by the time you see this) March 17th at 18:30. Details here. I’ll be there I hope, so tap me on the shoulder if you pitch up too.

Ariely, author of Predictably Irrational: The Hidden Forces That Shape Our Decisions, has an interesting back-story, but here is a brief synopsis from his website:-

My immersive introduction to irrationality took place many years ago while I was overcoming injuries sustained in an explosion (here is a description of my experiences in the hospital). The range of treatments in the burn department, and particularly the daily “bath” made me face a variety of irrational behaviors that were immensely painful and persistent. Upon leaving the hospital, I wanted to understand how to better deliver painful and unavoidable treatments to patients so I began conducting research in this area (see picture below). After completing this initial research project, I became engrossed with the idea that we repeatedly and predictably make the wrong decisions in many aspects of our lives and that research could help change some of these patterns.”

Professor Ariely also blogs here.

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With it’s playful green and red cartoon dust jacket, Ed Smith‘s What Sport Tells Us About Life: Bradman’s Average, Zidane’s Kiss and Other Sporting Lessons (Penguin Books, £14.99) could easily be taken for a belated Christmas stocking-filler, destined for a long stay in the bathroom’s literature section. But it deserves to be taken seriously. As the inside cover says:

Sport is a condensed version of life — only it matters less and comes up with better statistics.”

I realised this myself some time ago, and periodically spend more time following sports science than business and finance. And it was one of the thematic reasons for starting the Knackered Hack in the first place, to explore what could be learned from sport in general and my own participation in it in particular, without being glib. The road to hell, as they say, is paved with good intentions…

Smith, who is captain of Middlesex County Cricket Club, offers up sport as an under-used analytical resource from which can be drawn a number of intellectual and practical lessons about education, business, politics, the study of history, etc. The book takes the form of a series of essays, each kicking off from one sporting theme and following where any beam of light is usefully shed.

Smith takes in some of the old chestnuts such as: are our sporting heroes what they used to be? (the golden age hypothesis says no) or are our sportsmen and women getting perpetually better? (evolutionary theory says yes); is sport too commercial? — you’ve heard these discussed in the pub no doubt. He also covers some remarkable new ground for me, making some startling and insightful connections.

Before we get into cricket v baseball, as Smith himself explores, know that Smith understands both games well, and bigs up baseball as a crucible for pithy life observation, just as obsessive fans would claim. And he critiques the Moneyball strategy of the Oakland As from a player’s perspective. He also reveals baseball to be most likely a French invention, overtaking cricket for popularity in the Civil War (American of course) because of rough pitches, and then being gamed by some 19th century spin doctor called A. G. Spalding, who touted it that baseball championed the egalitarian, in contrast to the effeteness of cricket. Yes, he was just trying to sell more gear. And it worked. Despite the fact that cricket had enjoyed wide social acceptance in the US earlier in the century, it fell into terminal decline as a national pastime.

I’m no expert on Schumpeter’s oeuvre — though I’ve lived through one or two creative destruction episodes. But after 87 pages of What Sport Tells Us, all I could think of was Schumpeter, Schumpeter, Schumpeter. Smith elaborates on the fluctuating fortunes of sport, not just in terms of games and spectacle. He shows how at an industry (and at a national cultural) level the individual sporting disciplines are so rich themselves in creative destruction, confounding the stereotypes that fans, commentators and team owners all too frequently apply. On page 88, Smith finally drops the great man’s name. For the reader like me it was a back-of-the-net moment, as they say in soccer. Well-scored, Ed! When Penguin offered me the book for review, I hadn’t expected to find a discussion of how the free market has worked its invisible magic to raise the salaries of “left tackles” in American football. These hulks go unwatched on the field of play because all eyes follow the star quarter-back; but their presence determines whether the star player makes the goal or ends up face down in the mud. It all made sense to me. Schumpeter, he the man!

Someone should get Russ Roberts at EconTalk to interview Smith for a podcast. Smith is a broadcaster himself, having fronted a BBC programme called Peak Performance, which is sadly no longer in their online archive. In Roberts’ podcast with Schumpeter biographer Thomas McCraw, he highlights that when we observe an economic phenomenon like income inequality, the dominance of particular corporations (or, I’d suggest, the current credit crunch) we tend to see only the present snapshot in time; we miss the continuum. This can be both positive and negative. Bad news and bad money can drive out the good. But, Smith shows us that in the larger sweep of sporting history as well, so much of the hand-wringing of the short run is misplaced.

He also despatches sporting cliches all over the ground like loose bowling. He sends the concept of professionalism for six, hits a homerun against the notion of talent’s primacy, but saves his best shot for the role of luck and our contradictory and mistaken attitude to how it operates both in games, and also how it influences entire career paths.

Believing that ‘you can be whatever you want to be’, on the other hand, is actually a rather easy doctrine. (At least until you realize the idea has led you up the garden path.) The fallacy that desire and determination hold the keys to all success appeals to the inner adolescent in us that cannot bear the thought of hard work going to waste. I try, ergo I succeed; the world is just, so I will prevail; there is a fair distribution of justice, so I will be lauded. Such a shame that it isn’t true.

Of course, that logic is not reversible. Sitting around waiting for luck to come your way is as misguided as thinking that good things always come to those who ‘want it enough.’ The truth is that determination and desire are necessary but not sufficient. We have to try like crazy; we have to retain a relentless sense of determination; we have to make sacrifices and take the road less travelled. And yet still there are no guarantees. Even after all that, we may come up empty-handed. That is the bleak but unavoidable logic of anyone who has deep ambitions.”

But before we get too depressed by the potential tragedy of it all, he has a whole chapter celebrating the need to retain a sense of amateur love for the game, but not in the long out-dated Corinthian notion. Quoting Simon Barnes, quoting Brazilian World Cup Coach Felipe Scolari:-

Scolari said: ‘My priority is to ensure that players feel more amateur than professional. Thirty to forty years ago, the effort was the other way. Now there is so much professionalism, we have to revert to urging players to like the game, love it, do it with joy.’

[Barnes continues] This is not romantic twaddle. It is a fact that the more important something gets, the harder it is to do it well. We can all walk along the kerbstone in safety, but if the drop were not six inches but six miles, how then would we walk? Football matters too much; it matters to the players too much. As a result, the mattering gets in the way of the playing.”

In Smith’s own words:-

All professional sportsmen battle with their fears and anxieties. And by no means do they always conquer them. We live on the brink of disappointment, of failure, of being dropped, of getting sacked, of retreating back into civilian life with our dreams unfulfilled. That is the parlous state in which most sportsmen usually find themselves. All of us have experienced downward spirals of anxiety and introspection – I am losing form, my place is in jeopardy, my career could be in danger. Often you deny the problem, which secretly increases your anxiety – you are scared of admitting your fears even to yourself – and your form worsens still further.

He continues:-

Remove the obstacles to playing well. Anxiety is one of the obstacles. Worrying is one of the obstacles. Failing to focus simply and only on the job in hand is one of the obstacles [...] Dreading failure is one of the obstacles. Now you are thinking like a player again that is usually a beginning of a return to form.

The exposure to failure that really loving your sport entails is painful. The following paragraph(s) sang out particularly plaintively to the Knackered ears:

Trying desperately hard and not getting what you want is decent summary of what almost all sportsmen go through. The more deeply you compete and the greater the quality of your caring (to lift a line from Larkin), the more it hurts when you lose, or fail, or fall short. Each time a competitor taps into the essence of his personality in an attempt to win a sports match, he takes a risk. The risk is that he will get no reward — in the sense of a win or a personal triumph — for exposing himself to that degree of psychological rawness. It is easy to resent having tried so hard in the first place.

On the other hand, being too disengaged isn’t the answer, as the next paragraph elaborates:-

If it didn’t get us anywhere today, why should I bother to care so deeply next time? One answer is that being prepared and able to experience such deep emotions, and being exposed to that degree of disappointment, is a privilege not open to many. It doesn’t feel like a privilege at the time. It feels like hell. But it makes for a life more fully lived. After ten years playing professional sport, I have come to the startling conclusion that a big part of me actually enjoys caring about sport, even when that caring expresses itself as pain at losing. I wouldn’t rather life was more pallid. It sometimes reminds me that I am not wasting my time — and protects me a little from the resigned emptiness we all dread in sport.”

So don’t be put off from ordering a copy from or to steal a march on any US publication plans that Penguin has. He is good on this stuff, you know. He read History at Cambridge, and because he is younger than me, has been more exposed to counter-factualism, which he uses quite devastatingly to examine some rather controversial sporting triumphs, like England’s unexpected win in the 2005 Ashes cricket series against Australia.

And to show that someone has already deftly combined sport and philosophy, a re-run of one of my favourites. Schumpeter didn’t make the team on this occasion, but then… that was the story of his life.

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