Unconventional Wisdom: An Interview with Robert Shiller

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Irrational and non-economic behavior can disrupt entire economies in the same way it disrupts financial markets, says Yale economist Robert Shiller. Ignoring that fact, he adds, has proven to be a recipe for disaster.

Editors’ Note: Few macroeconomic prognosticators have been as publicly right as Yale’s Robert Shiller, whose first and second editions of the book Irrational Exuberance laid bare, with remarkable timing, the speculative bubbles forming first in the Internet-crazed stock market and next in residential real estate. Shiller, who is also the co-founder of investment firm MacroMarkets LLC, recently teamed with Nobel laureate George Akerlof to write Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. In the following interview and excerpts from the book, Shiller describes the role of “animal spirits” in the economy, how their existence should inform the government response to the crisis, and what his latest views are on equity and housing prices.

This interviewed was conducted on July 30, 2009.

Your new book was years in the making. What was the impetus for finishing it as the financial crisis started to unfold?

Robert Shiller

Robert Shiller

Our feeling is that classic economic orthodoxy, which seeks to minimize as much as possible departures from pure economic motivation and from rationality, does a poor job of explaining why speculative excesses form and is a key reason nearly everyone was caught off guard by the crisis. The public, the government, and most economists had been reassured by an economic theory that said we should trust markets and suggested to many that nothing dangerous could happen.

To understand why excesses build and then reverse you need also to consider the less rational – but no less important – drivers of economic activity, which Keynes described as “animal spirits.” We think that provides a much better explanation for how the economy works.

Why has that type of thinking been met with resistance among your peers?

There is a growing behavioral economics movement, but it has so far had limited impact. The resistance has to do with the kinds of people who are attracted to economics and what kind of work is seen as career-enhancing. Economists as a group are not fond of the softness and imprecision of psychology.

It’s sort of common sense that individual and collective levels of confidence, for example, are important drivers of the economy. Newspapers and the evening news refer to it all the time. But if you go to an academic seminar, the word “confidence” never comes up. If you look at the index in a finance textbook for the word “bubble,” it’s almost never there. These notions, rooted in individual behavior, are considered vaguely unprofessional and flaky for serious economists to pay attention to.

You write at length in the book about the importance of confidence in economic decision-making. Elaborate on that.

The basic point is that because the world is always evolving in ways that don’t perfectly mirror the past, the future is fundamentally uncertain and no amount of probabilistic thinking can fully quantify what’s the right thing to do next.
To make business or financial decisions, then, people have to rely as much on their intuitive sides as their quantitative sides to judge the future. How confident they are – which is both emotional and rational – plays a fundamental role in the decisions made.

Why does that necessarily lead to booms and busts?

Humans have a tendency toward overconfidence, which may be reinforced by the stories that are prevalent at any given time and by the fact that we tend to act on a biased information set to make decisions. The list of facts we retain in our consciousness very likely excludes other facts we either aren’t observing or choose to ignore. That’s a big reason people become overconfident, which plays a big role in bubbles forming.

Talk about the importance of stories in fueling animal spirits.

The human mind is built to think in terms of narratives, of sequences of events with an internal logic and dynamic that appear as a unified whole. Social psychologists have found that people’s memories of essential facts are indexed in the brain around stories and that the facts that are most remembered are attached to stories. Much of individual motivation actually comes from living through the story we’ve created of our own lives.

The confidence of a nation, or of any large group, also tends to revolve around stories. The 1990s stock market boom was driven by a global story that was very motivating – capitalism triumphant, with communism on the run – coupled with how the invention and exploitation of the Internet was propelling the economy into a brand new era, with inspirational stories about new companies and their entrepreneurial founders who were changing the world and getting rich. Such new-era stories tend to accompany major booms in stock markets.

More recently, the stories that captured people's attention were about smart real estate speculators, and these stories reinforced the notion that home prices everywhere could only go up. The conventional wisdom became that because there is only so much land, population pressures and economic growth should inevitably push real estate prices strongly upward. Those arguments were demonstrably false, but it didn’t matter because people wanted to believe. That tends to happen during boom times, making them last much longer than they should.