Seven Questions: How to Deal with Irrational Exuberance

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The reckoning: U.S. housing markets are paying the price for eight years of irrational exuberance.

FOREIGN POLICY: Youve acquired the moniker, Mr. Worst-Case Scenario and its mainly due to the book Irrational Exuberance, which hit bookstores in March of 2000 just as the 1990s stock market bubble was beginning to pop. Until recently, weve had a similar real estate bubble in the United States that now appears to be popping. What do you think is going on, and how much of the problem is related to subprime mortgages?

Robert Shiller: The basic problem is human psychology. Human psychology drives economies much more than is generally recognized. Most of the movements in the stock market have a social psychological origin, and so the housing market has also become very speculative. People dont generally recognize that they are part of society when theyre thinking about prices. They imagine that prices are determined by some esoteric forces rather than by you and me. The stock market has been speculative since its early history; we went through a rather remarkable but not unique stock market bubble in the late 1990s. The interesting thing thats developed since 2000 is a perception among many people around the world that housing is a speculative investment just like stocks, one that offers tremendous profit opportunities to investors. That has helped drive the boom.

The subprime crisis is just one of the minute consequences of the boom. Lending standards go down in booms, and they tend to mess up in the aftermath. In Irrational Exuberance, I emphasize feedback: Any economic system feeds back into itself, and one thing leads to another. The subprime crisis is not exactly an exogenous force; its a product of earlier events. But subprime loans are a small part of the market. It goes beyond subprimes. Eventually, if home prices keep falling, well see large defaults among prime mortgages as well.

FP: What kind of aftershocks do you expect to see? What kinds of effects on the broader economy might people not be thinking about yet?

RS: So far, housing prices havent fallen very much, and stock prices are down only a relatively small amount from their peak. We set new nominal records in July. And so not much has happened yet. The thing that might happen is that there could be a shaking of confidence. There was a lot made of the decline in the Conference Boards consumer confidence index on Tuesday, but its still in the middle range; its not low. But if home prices continue to fall, consumer confidence might also falland that could help bring on a recession.

FP: In 1996, former Federal Reserve Chairman Alan Greenspan famously observed, We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability. Judging by the performance of current Fed Chairman Ben Bernanke, does he have a different view? How would you rate Bernanke as a crisis manager?

RS: I dont know what hes going to do. Were at the beginning of a crisis, as I view it. So far, Bernanke hasnt cut the federal funds rate, though he did cut the overnight lending rate by 25 basis points. It seems that he is resisting moving swiftly to protect markets, but I think that quite likely the Fed will be cutting rates before long. Of course, the Fed shouldnt be in the business of stabilizing speculative prices, or at least not keeping them high.

FP: Financial Times columnist Martin Wolf has been arguing that lowering rates will only reward bad behavior.

RS: Thats absolutely right, and its what weve been doing as a matter of public policy clearly since 1987. Thats the Greenspan put. For people at the helm of the monetary system, their natural instinct is to avoid crises. The problem is that we have gotten into such extraordinary booms that were vulnerable to crises. I think they shouldnt act too fast to support markets if they start falling. The Feds job is to maintain the integrity of the financial system so that there isnt any systemic crisis, other than just a correction.

FP: It sounds like you dont necessarily see this as a crisis just yet. But if it does become a crisis, would you see a large drop in housing prices to be a permanent structural change or just a correction, a transitory adjustment?

RS: Historically, home prices have moved in long waves. The recent boom in home prices began around 1997 and didnt start slowing down until around 2005. So we had eight years of acceleration, which is quite remarkable. Its been decelerating for over two years, so I think its kind of long term. So we could seeand Im not necessarily forecasting thisbut we could see gradual declines extending over five to 10 years. That kind of pattern could contribute to weakness of the economy, but if the Fed does its job right and the central banks around the world manage this right, it probably wont be anything too terrible. Well have a recession, but weve had recessions and we get through them.

FP: What kind of winners and losers do you foresee from a decline in housing prices and the turmoil in the financial markets?

RS: Unfortunately, people dont hedge their risks. Ive been campaigning over the years to get people to hedge their home-price risk so there wouldnt be so many winners and losers. We started a futures market at the Chicago Mercantile Exchange in May of 2006. Unfortunately, not that many people trade there. Its one of the mysteries of human nature that we have this huge crisis generated by real estate prices, and we create an option to hedge the risk, and people dont do it, except for a very tiny percent.

FP: For people who arent financial experts, what do you mean by hedging your risk?

RS: There are two main ways of protecting yourself. One is to buy insurance, and another way is to diversify your portfolio. Weve been campaigning for years for home-equity insurance so that people could buy an insurance policy on the loss of value of their home. And were working on that; I think its coming.

The other thing is portfolio diversification. People have very concentrated wealth in housing. For most people its the dominant asset that they retire with, and its all in one city. We have seen substantial drops in home prices in the past, and we run the risk of that again. This exists now: One can buy a put option on home prices that will pay you if they decline, or you can take a position in a futures market, which is a venerable financial method thats been around for well over 100 years. Its always been, however, a very sophisticated method that the general public doesnt appreciate.

The one thing about insurance is that you have to buy insurance on your house before it catches on fire, not after. Already, the futures markets are predicting between 3 and 8 percent declines in home prices over the next year. So thats already priced in and alreadyyou might saylost. You cant protect yourself against the first 3 to 8 percent losses in the futures market, because the markets expecting them. So we would be planning for the next crisis, whenever that comes.

Robert J. Shiller is Stanley B. Resor professor of economics at Yale University, cofounder of MacroMarkets, LLC, and author of Irrational Exuberance (Princeton: Princeton University Press, 2000).

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