Yale's Shiller Keeps an Eye on Bad Behavior

Economists are generally good at forecasting economic trends. It's their timing that often stinks, which of course can make even the most accurate forecast useless.

Not so in the case of Yale University economist Robert Shiller. In his famous appearance on a CNBC show in 2005 he argued that in the long run house prices should increase no faster than construction costs, which tend to track inflation. As became evident later, his appearance closely coincided with the peak of the housing bubble, even though most economists at the time expected house prices to rise further and then plateau at high levels. After all, house prices had not declined in this country since the Depression.

"My retort to them was that they had never before risen so high, either," says Shiller.

But even earlier, in 2003, in his book The New Financial Order: Risk in the 21st Century, Shiller had raised the possibility of a global financial crisis.

"I don't know," he shrugs coolly. "It may have simply been dumb luck."

However, it's the second straight time that Shiller has called the peak of a bubble. His national bestseller Irrational Exuberance came out in March 2000, the very month the Nasdaq Composite index topped out above the improbable-sounding 5,000 mark. One instance of perfect timing may be fortuitous, but two out of two begins looking like a system.

Skeptical of Efficiency

Shiller credits his uncanny ability to call market peaks to his interest in behavioral macroeconomics, which in addition to conventional economic analysis adds insights gleaned from the study of individual and collective behavior with the help of psychology, sociology and other "soft" social sciences. Or rather, he blames the fact that so few economists in academia, the government and financial institutions were able to anticipate the deflation of the housing bubble and the subsequent financial crisis on the dominance of the efficient-market theory.

"If you believe that the market price reflects the rational view of all market participants, then it is going to be hard for you to identify bubbles," he observes. "Economists are used to modeling economic variables. Nobody was modeling failures of regulatory oversight, the spread of cynicism in the financial services industry and other factors."

Behavioral finance, says Shiller, has taken root in recent decades. Finance professionals, including asset managers, financial advisors and stockbrokers — in other words, those who earn a living by trying to outsmart the market — have taken interest in behavioral finance research. Shiller has contributed to its early popularity with his analysis of stock price movements going back to the Depression, which convinced him that market volatility has been far too high to be justified by rational expectations of future dividends.

But behavioral macroeconomics is another matter. Shiller and his collaborator George A. Akerlof have been giving seminars in behavioral macroeconomics since 1994, but a real academic discipline has yet to emerge. Now, they have co-authored a new book advocating behavioral macroeconomics, titled Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.

The current crisis has demonstrated that, as Shiller puts it, the study of macroeconomics needs to undergo a revolution, becoming less quantitative and more psychological and sociological instead. The importance of psychology recently has been on display as officials at the Federal Reserve and in the Obama Administration take pains to bolster consumer sentiment and instill more optimism about the economy's prospects.

Shiller agrees that business and consumer psychology is what will eventually end the recession. But he is skeptical that the attitudes of his academic colleagues will change.

"Perhaps it takes so much effort to learn all the aspects of conventional economics that nobody has time to dig into psychology," observes Shiller sarcastically.