Irrational Exuberance

by Robert J. Shiller

PrincetonUniversity Press: £17.95

Irrational Exuberance is the second edition of Robert J. Shiller’s well-received book published in 2000. It is an opportunistic update that goes to some pains to explain the realities of the market excesses that are now a frighteningly real threat to destabalise the economy and disrupt our lives. Shiller correctly warned readers of the 2000 stock market collapse and now directs his warning to the recent housing market boom that is likely to collapse in much the same way as the stock market bubble of the late 1990s. If this happens, as seems likely, Shiller predicts that house prices might well decline for many years to come. There are a host of other warnings too, all focused around Alan Greenspan’s now famous phrase “irrational exuberance” used during a Washington dinner speech in December 1996 to describe the frenzied behaviour of stock market investors.

Robert Shiller, a Yale economics professor, has revised this second edition of his book to attempt “to extend its argument that variations caused by changing attitudes, irrational beliefs, and foci of attention are an ‘important’ factor in our changing economic lives, and to examine the consequences for our own economy and our future.” This is a book directed at the U.S. market but its explicit message can easily be adjusted internationally. The issues treated in this book are indeed serious. Shiller’s warning is that overconfidence can lead to instability, and that the stock market, and now the housing market, are significantly overvalued by any standard. He believes that any continued rise in these markets could lead not only to more significant declines, but also to a substantial increase in the rate of bankruptcies, a decline in consumer and business confidence, and possibly a world-wide recession. Although not inevitable, Shiller feels that the situation is a much more serious risk than is widely acknowledged.

Two introductory chapters (one new to this edition) analyse the fluctuations in both the stock market and the real estate market in historical context. This allows readers to get an overview of what appear to be remarkable variations. In 2000 Shiller’s book pointed out the structural factors that drive market bubbles. It was a timely warning as the stock markets of a great many countries dropped by almost 50 percent from their peak with little recovery. This new sequel gives reasons why the same thing could easily happen in the heady housing market too. After stocks plummeted in 2000 many disillusioned investors moved their money into housing – a move which inflated real estate prices not only in America but around the world.

Irrational Exuberance is a clinical and unnerving study of the psychological origins of volatility in financial markets – including real estate. Structural Factors, Cultural Factors and Psychological Factors are the headings of the first three parts of Shiller’s book, with a fourth dealing with “Attempts to Rationalize Exuberance”. There are some frightening disclosures. One of these is that the stock market boom has coincided with an extraordinary growth in the mutual funds industry. In 1982 there were only 340 equity mutual funds in the United States. However by 1998 there were as many as 3,513 mutual funds – more equity funds than stocks listed on the New York Stock Exchange. By 2000 there were as many as 164.1 million mutual fund shareholder accounts – or about two accounts for every U.S. family. Shiller reminds us that mutual funds are a new name for an old idea – “investor trusts”. After the stock market crash of 1929, many of these so-called “trusts” became worthless and a betrayed public soured on these collective forms of investment. The Investment Company Act of 1940 then helped to restore some public confidence, and the industry was given new impetus by the Employee Retirement Security Act of 1974, which created Individual Retirement Accounts. But they needed a new name – “mutual funds”, which were similar to the more reassuring and scandal free mutual savings banks and mutual insurance companies. Naïve investors have since been encouraged to participate in the market in these pooled “funds” hoping that experts managing these funds will steer them away from pitfalls – a sometimes dangerous assumption. The decline of inflation too has been viewed as a sign of economic prosperity boosting public confidence and stock market valuation – a confusing misinterpretation of values.

A fifth part of Shiller’s book is titled “A Call to Action”, and in it he reminds us that the first edition of his book cautioned that “real losses in the stock market could be comparable to the total destruction of all the schools in the country, of all the farms in the country, or possibly even all the home in the country”. Since this first edition was published the U.S. stock market has indeed lost over 6 trillion - an amount equal to about 60 percent of the value of householders’ real estate holdings. If therefore the stock market continues to decline, or the boom in real estate breaks then “individuals, foundations, college endowments, and other beneficiaries of the market are going to find themselves poorer, in the aggregate, by trillions of dollars”. As an example Shiller cites the Ford Foundation which cut its endowment from 4.1 billion to 1.7 billion after the 1974 stock market crash. The University of Rochester similarly took an aggressive stance to the stock market and lost half its endowment between 1973 and 1974. “The same or worse could happen today to foundations and universities that have invested too large a share of their portfolios in the stock market.”

Shiller concludes his daunting but credible treatise by offering a set of eight solutions for both investors and policy makers:

Each of these recommendations, aptly explained in the conclusion, should be studied, discussed and debated in order to be understood. It will not be easy. Shiller is certain that both the U.S. stock market and the housing market are speculative bubbles that are certain to burst. It is only a matter of time. This propitious book is a powerful antidote to the plethora of get-rich-quick investment recommendations and vehicles currently plaguing an unwary public. Buyer beware!