Popular Economics Weekly

Although much of what Yale economist Robert Shiller writes is about the importance of financial markets, he won the Nobel Prize in Economic Sciences for studying how financial markets misbehave. He is a pioneer in the new field of Behavioral Economics, or behavioral finance, as he has sometimes calls it.

“Mr. Shiller, 67, later introduced an important caveat to the idea that markets operate efficiently, finding that stock and bond prices show greater predictability over longer periods,” said the New York Times, in commenting on the award to Dr. Shiller, Eugene Fama, and Lars Peter Hansen. “Mr. Shiller and other economists see evidence that these movements cannot be entirely explained by rational decision-making, and instead reflect the irrational behavior of market participants.”

His recognition will ultimately swing the pendulum of economic thought away from the so-called Austrian school of free market economics that conservatives have long worshipped to justify their belief that small government and little taxes were the most “efficient” way to distribute wealth. We know the result of those theories—Inequality For All, to paraphrase Robert Reich’s latest book and film now in theatres.

He also boosted Keynesian economics with Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, written with Nobelist George A. Akerlof in 2009, which documented how financial behavior is tied to the vagaries of human nature, a clear tribute to John Maynard Keynes and his theory of animal spirits—today termed a greater or lesser confidence in an unknown future.

His biggest claim to fame comes from his 2000 book, since revised, Irrational Exuberance, which predicted the dot-com bubble bust. In it he looked at the empirical behavior of stock prices over the past 100 years. It showed that S&P price-to-earnings ratios had soared to unsustainable levels—as much as 44 to 1, almost double that of the Black Monday stock market collapse at the beginning of the Great Depression.

“The high recent valuations in the stock market,” said Shiller in Irrational Exuberance, “have come about for no good reasons. The market level does not, as so many imagine, represent the consensus judgment of experts who have carefully weighed the long-term evidence. The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom.”

He also specialized in real estate and wrote books such as The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It, and with Karl Case set up the S&P Case-Shiller Home Price Index that tracks national same-home sale prices for 10 and 20 metropolitan districts.

But I predict that he will become known for an even greater contribution to economic thought. It is for his book, The New Financial Order, Risk in the 21st Century, Princeton U. Press (2003). In it, he uses his empirical knowledge and Big Data to tell us how to create hedging and insurance mechanisms that protect against major risks that have pummeled the financial markets.

“…the insights of finance have been applied in only a limited way,” says Professor Shiller in his introduction. “Finance has substantially neglected the protections of our ordinary riches, our careers, our homes, and our very abilities to be creative as professionals. We need to democratize finance and bring the advantages enjoyed by the clients of Wall Street to the customers of Wal-Mart”.

And that will continue to be is his real contribution to a world where equality is good for everyone. Understanding how markets misbehave will rip the shroud away from those who have been able to profit from the public’s lack of knowledge about how financial markets actually perform.

Harlan Green © 2013

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