Robert J. Shiller on Bubbles, Reflexivity, and Narrative Economics
By Paul Kovarsky, CFA
Robert J. Shiller has shown remarkable prescience over the years. In Irrational Exuberance, he successfully called the dot-com bubble. Less than 10 years later, in the run-up to the financial crisis, he issued similarly accurate warnings about the bloated housing market.
Of course, Shiller is known for more than just his forecasting abilities. The cyclically adjusted price earnings (CAPE) ratio, or the Shiller CAPE, has become a pillar of modern finance and grew out of research that earned him the 2013 Nobel Prize in economics.
It’s been almost two years since he last spoke with CFA Institute, and with talk of inverted yield curves, overvalued stock markets, and imminent recession, the present struck us as an opportune time to see what was on Shiller’s mind.
What follows is a lightly edited transcript of our discussion.
CFA Institute: You issued accurate irrational exuberance warnings before. Does anything worry you today?
Robert J. Shiller: Boy, that’s a big question. What I’ve emphasized recently is a housing market boom and also a stock market boom together. They both show signs of disruption right now, which is a little unusual as these two markets are not very correlated with each other historically.
We had the correction in the stock market from a peak at the beginning of 2000 until 2003, but then the housing market just continued to boom right through the whole thing. It’s a little difficult to speak of the two as two different aspects of the same phenomenon. I am struck though that we have seen since 2009 an extraordinary behavior of the US stock market. Since 2012, we see a pretty extraordinary behavior of the housing market. Also, of course, you add the bond market, which has recently showed some bubble‑like aspects as well.
Three simultaneous bubbles are certainly unprecedented. Of course, some say the term “bubble” itself is overused. Do you think there is a bubble in bubbles?
Popular usage terms come and go out of style. For example, the term “bubble” first appeared long ago in the early 1700s with what they called the “South Sea Bubble,” which was a stock market boom in Europe. The US didn’t even have a stock market that long ago. There was a bubble in bubbles when Charles Mackay published his influential book Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. He renewed interest in bubbles which lasted awhile.
The term has come back especially strong since the late 20th century. It’s kind of a faddish term. It goes in and out. I think maybe it goes in and out correlated with actual bubble phenomena. Is the term “bubble” overused today? I don’t know that we use it too much. The question that people pose — are we in a bubble? — seems to me a little bit vague. We’re always in a bubble somewhere. Maybe there has been a bubble in bubble thinking, but that bubble has lasted for decades now, and it’s correlated with an improved enlightenment I think among some people.
What historic market parallels are currently on your mind?
I like to think of every important dislocation in history. For example, we had a famous panic in 1837. That’s a long time ago. It was preceded not by a stock market boom but a land price boom. It wasn’t a housing boom: The talk of the nation in the 1830s was agricultural land. There were lots of speculators pushing the prices up and then they eventually collapsed. It was associated with the banking crisis.
Then we have 1857, which I think is interesting because it was a panic that might be considered as leading to the Civil War in the United States. We have the 1873, ’79 depression, the 1890s depression, the 1907 panic, and the Great Depression. All of these are different. They tend though to involve some sort of speculation. You have to take into consideration they didn’t always focus on bubbles, or the word “bubble,” but there were things like that going on all the time.
Everyone likes to cite speculation in the lead-up to the Great Depression. Less well-known is the role President Calvin Coolidge played in the 1920s, as you noted in your address to the American Economic Association in 2017. Does the environment then remind you of the US political climate since 2017?
President Calvin Coolidge was an exceptionally pro‑business president. His most famous quote is “The business of America is business.” He was criticized for not bringing artists and classical musicians to the White House. He just brought businessmen. He liked businessmen. He believed in them. Whenever the stock market had a downturn, he would get on the radio — or Andrew Mellon, his US Treasury secretary would. Coolidge thought that was his job, to reassure the Americans that business is sound and profitable. It led to the biggest stock market boom seen at that point in history. I think it shows that political leaders do have an influence on the markets, so we can learn lessons.
The problem is that economists want to standardize the understanding of economic events. They want to have a simple model. The problem is it’s hard to standardize our understanding because ideas change and people’s thinking changes through time. That’s what I’ve been interested in of late, trying to understand how people thought in 1837, or 1893, and so on.
People are thinking a lot about trade wars lately. How would you expect such thoughts to reverberate?
Trade war acquired its clear, present meaning during the Great Depression. They talked about a trade war during World War I, but that had a completely different meaning. The trade war then was carrying on the physical war to disrupt the enemy’s foreign trade.
The 1930s depression, while it was happening, was blamed by many people on the Smoot‑Hawley Tariff, which came in 1930 and led to retaliatory tariffs in other countries. That story has reemerged lately. Most people have kind of forgotten about it, but that is a subject on the minds of investors now. Maybe not so much at the moment. It’s been in and out.
The Great Depression narrative, as I’m describing in my forthcoming book Narrative Economics, has become a legend. It’s become something that is exaggerated in its importance. Since there was a Smoot‑Hawley Tariff then, it becomes natural for many people to think that the Trump tariffs will do the same thing. So far, they’re not that big however, and it’s not Smoot‑Hawley all over again. Not yet. It’s something that’s more affecting our thinking than our actual economic constraints.
You focus on stories and attitudes in Narrative Economics. Why are these narratives so important?
I view this as a convergence of the social sciences. Economists see themselves as trained in economics and are reluctant to get involved in sociology, psychology, anthropology, or history. In fact, at this point in history, the economics profession is not very interested in learning history. If you’re going to be involved with forecasting, you have to use every available perspective to stay in touch with reality.
The theme of my book is that there are new ways of thinking that are encouraged by stories that people tell. We communicate through stories that are salient or that appeal to us in our thinking. Typically they have a human interest component and often a political component. They often affect our thinking and our moral judgment. The one thing I don’t hear from economists very often is that people feel that their expenditure patterns or their investment patterns are related to a sense of proper or moral behavior. A lot of curtailments of spending have nuances of boycott in them: “I’m going to boycott these companies.” It’s part of the emotional tenor that companies may face in bad times.
What do you think of the saying “Bull markets don’t die of old age”? Is there credence to the notion that because an expansion has gone on for X months, a recession is due?
This goes back to an intellectual revolution in the late 19th century, early 20th, when people began to talk about a “business cycle.” It comes partly from meteorology, which was developing then, and the cycles in the weather. It also comes from astronomy.
There was a lot of talk around the turn of the century, 1900, about sun spots and solar cycles. People began to think that recessions come according to a timetable. That’s not completely wrong, but it’s not as strong a timetable. It’s not really driven by the cycle of the sun. It was an intellectual revolution at the time. Now, we’ve gotten past that, because the idea that there’s a rigid cycle no longer has appeal. On the other hand, it’s still true that there is some tendency for recessions to repeat.
It does not have a fixed timing or follow the interval of other cycles. But they do seem to come with some regularity. If you look at the situation right now in the United States, we’re getting close to 10 years of expansion. The business cycle started out in June 2009, so we’re nine and a half years into the expansion. The longest expansion ever was 10 years. That was in the 1990s to early 2000s. I don’t think it’s without merit to say that a cycle is overdue, but it’s weak. We could set a new record, but that would be setting a record.
There are signs. There’s a lot of talk in the air about a recession being overdue, or a recession coming. To some extent, this talk itself can be a self‑fulfilling prophecy. When people think there’s a recession coming, they’ll curtail their spending and put their entrepreneurial ideas on hold. That will make it happen. It looks possible. There’s a lot of talk lately about the inverted yield curve. We’re at that juncture right now. That leads many people to expect a recession, as they have in other times of inverted yield curves. It wouldn’t surprise me at all if we slipped into a recession real soon.
Market valuation metrics — regardless of the forecasts — are important tools. The Shiller CAPE has played its part since the 1980s. How did you turn this largely academic metric into a tradeable product?
It’s been exciting to be involved with the development of the investable CAPE index. It took a really stellar research group. I tend to be a lone academic by training, without access to teams of serious researchers. I’m very pleased with my collaboration with people at Barclays Bank. Partners like these bring insights that are reliable, up to date with trading knowledge as well as marketing capabilities. You have to sell the idea so people can take advantage of it. All these things took place in a new environment for me. They’re thinking deeply about capacity. What can we do that could expand in scope?
Looking at how elevated Shiller CAPE is in the context of the real estate and capital markets, do you see reflexivity playing a role?
The term reflexivity was popularized by George Soros. Once again, he was amplifying an idea that goes back centuries actually. It’s called feedback or feedback loop. It operates in nature as well as in economics.
John Maynard Keynes talked about feedback. When people lose their job, they stop spending. That feeds back into the labor market again because when they stop spending, more jobs are lost. It gets feedback and can amplify itself into a big depression, as Keynes explained.
These ideas are very important. That feedback is a little bit like the feedback that you get with a microphone in a public address system. If someone makes a noise that feeds back into the amplifying system, it can cause a lot of artificial noise. The idea is that those microphone feedbacks are analogous to stock market events or GDP designs. I think that’s a very important insight that we have to keep studying.
Feedback’s role is particularly pronounced after market plunges: in June 1932 when it fell more than 80%, or March 2009 when all these negative narratives were swirling around. How should investors sitting in cash at the moment think about the decision to go back in and start investing?
I’m pessimistic that we’ll ever have the confidence to answer this question. It can’t be that we all will know that the market is timed perfectly for coming back in. I think we can make progress in understanding the origins of stock market movements and major turning points. When we do that, we’ll change the market. That’s okay. That’s what we want. We don’t want crazy fluctuations in the market. If we can prevent markets from ever falling too far or ever going up too much, that’s a good thing.
You mentioned 1932. I’m very interested in what happened. That was the very bottom of the stock market when the CAPE ratio was under six times — really, really low, compared with around 30 times today. What was going on? I go back and read newspapers, even diaries. I’ve been reading one man’s diary about the stock market and trying to figure out how people think. There were people who were trying to figure that out and learn too.
I was impressed by a Pulitzer Prize‑winning author Arthur Krock, who traveled the country in 1932, talking to people, listening, and trying to understand what was driving them. Where did all this extreme pessimism come from? It was related to the presidential campaign between [Herbert] Hoover and [Franklin Delano] Roosevelt. Krock found that trying to talk to people about the candidates’ proposals fell on deaf ears. The talk was more emotional. It was more personal. It was about the neighbors next door: The husband lost a job and they have three kids and they’re in real trouble. Talks like that.
The question is, Where are we right now in this cycle? We’re in a period of high volatility again in the stock market, and concerns about the housing market. It doesn’t seem quite as clear as it does in hindsight, where we are and where we’re going right now. I can look back on the early 2000s, or 2007, when the stock market peaked, and think now that I have a clear idea that that should have been a peak. But it wasn’t so clear when it happened. I don’t have the clarity I would like.
Even though I’ve been studying narratives and changes in human thinking, it’s still relatively new. I believe that economics and finance research will need to be more real‑world oriented and more willing to use information — digitized texts, for example — about how people are thinking and how their thinking changes. We’re not all there yet.
We covered a lot of ground here. Any parting words of wisdom?
Talking about housing: In the years leading up to 2007, there was a very speculative atmosphere that was encouraged by media, like the TV show Flip That House. There were lots of flippers then trading in houses and riding the bubble.
Since then, I’ve been trying to understand where that’s going. A lot of new books have come out about flipping houses in the years since 2012 but that seems to have peaked around 2016. There’s evidence that flipping is declining. This is probably not as dramatic a cycle as we saw in 2006–2007, but something somewhat like that has been going on. There has been speculative interest in the housing market.
In the stock market, there has been intense speculative interest. It has something to do with the presidential campaign of 2016 which focused on economics. We have since seen a Trump boom in the stock market. There seems to be a souring of that, as you well know in 2018, and the momentum is no longer up. I wish I could be more scientific about these things. That’s a mission for us, to make this into more of a science.
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