November 02, 2008
Robet Shiller’s Goblins
Posted by Mike Guttentag

Robert J. Shiller should be applauded for being one of the few economists to consistently explore the potential ramifications of “irrational exuberance.”  In today’s New York Times Shiller asks why so few economists acknowledge the extent to which investor psychology can affect stock market prices.  The problem, I would argue, is not with the other economists, but with the inadequacy of Shiller’s explanations of the link between investor psychology to price instability.

Shiller’s analysis of the seeming blindness of most economists to the influence of investor psychology begins with the assertion that the “bubble” in residential real estate markets over the past few years was obvious.  According to Shiller, most economists were oblivious to this fact for two reasons: groupthink and inattention to “the recently developed field of behavioral economics.” Neither explanation is convincing.

I think Shiller overreaches when he points to groupthink as an explanation for the hesitancy of “mainstream economists” to accept his claims.  Thanks to Irving Janis’ path-breaking work we know a lot about groupthink, but this body of knowledge applies primarily to the operation of small groups.  A more appropriate reference for Shiller’s claim might be Thomas Kuhn’s work on scientific paradigms.  According to Kuhn’s analysis, a given paradigm becomes embedded within a field, and this paradigm is only rejected when a new approach develops, which is able to explain previously anomalous phenomena.  However, it appears that a Kuhnian revolution, consisting of an effort to incorporate more behaviorally realistic models of human behavior into economic analysis, is occurring in economics. The growth of this new mode of thinking in economics does not support Shiller’s accusation that groupthink has led to an unwillingness among economists to recognize the presence of market bubbles. 

Shiller’s second claim, that mainstream economists have ignored findings from behavioral economics, is also lacking in support.  Behavioral economics is a popular and widely growing area of research.  In 2002 Daniel Kahneman and Vernon Smith won the Nobel Prize in economics for their work in behavioral economics.  It seems unlikely that most economists are caught in the swirls of groupthink and are, therefore, cavalierly ignoring a now large body of research that has steadily grown over the past thirty years.

Instead, I would argue, the reason Shiller’s explanation of the connection between investor psychology and market volatility is not more widely accepted has to do with limitations in Shiller’s analysis.  Economists are not just willing, but eager, to use laboratory and field research to better understand the nuances of human behavior.  However, economists strive to create economic models which are both cognizant of the growing body of knowledge regarding human behavior and also systematic and rigorous.  We know that people will behave in unexpected ways, but we also have hundreds of years of experience suggesting that supply will equal demand in an active market.  Shiller’s irrational exuberance story does not provide a convincing link between these two insights.  The explanation of how markets crash, which I offered in previous posts, provides the kind of link between observed behavior and plausible micro-economic dynamics, which is missing from Shiller’s discussion. I show how the preferences revealed by the popularity of strategies such as portfolio insurance can turn financial assets into Giffen goods, which, in turns can lead to disparate multiple equilibrium prices and price instability.  Unlike Shiller’s explanation, the model I present does not require suspending the laws of supply and demand, and does not rely on the type of either/or choice that Shiller presents between irrational exuberance and mainstream economic analysis.

The absence of a convincing link between investor psychology and market crashes in Shiller’s analysis is not just a matter of academic interest.  Shiller’s explanation of why markets crash implies a different regulatory approach, as compared, with my explanation of why markets crash.  If you agree with Shiller’s analysis, “irrational exuberance” needs to be regulated, and it is not apparent how this can be accomplished.  However, explaining market crashes in terms of potentially destabilizing investment practices, as my analysis does, can lead to specific regulatory strategies.  As I have argued in earlier posts, three principles provide guidance for regulating destabilizing and risky investment strategies: 1) don't panic, 2) require minimum reserves for products that have the salient features of an insurance product, and 3) intervene to discourage certain investment practices, such as using portfolio insurance or purchasing risky assets largely with borrowed funds.

Shiller raises important questions about the potential links between investor psychology and market behavior.  The best way to further Shiller’s research agenda is by providing a more robust micro-economic analysis that links investor psychology with market instability.  Only such an analysis can result in useful guidance on when and how to regulate the demand for risky assets.

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