All Commentary
Sunday, July 1, 2001

Irrational Exuberance by Robert J. Shiller

Theories about Economic Debacles Must Observe the Role of Government Policy

Princeton University Press • 2000 • 296 pages • $27.95

It is nothing new for an author to scare his readers with predictions of economic calamity and financial collapse. During the 1970s it was Howard Ruff’s How to Prosper During the Coming Bad Years. In the 1980s it was Gary Shilling’s After the Crash, Recession or Depression? During the 1990s we had Ravi Batra with Crash of the Millennium and George Soros’s Crisis of Global Capitalism, among others. Those are just a few predictions of economic debacles, none of which materialized.

Now enter Yale economics professor Robert Shiller with yet another market chiller, Irrational Exuberance. Is this the real thing? The downward plunges of the Dow and especially the NASDAQ have some people convinced that it’s 1929 again.

Shiller considered the stock market to be in a very overbought condition as we entered the 21st century. He has penned a well-organized treatise on the speculative bubble that has deflated if not burst. It is instructive to follow Shiller’s dirty-dozen factors that he claims contribute to unsustainable market enthusiasm.

Readers will find Shiller’s treatment of the current market’s vulnerability to sudden retrenchment compelling and rational. Most powerful are the author’s historical references to similar periods when market optimism preceded punctured hopes and societal gloom in the wake of market smashups. But on the other hand, readers may be confounded by Shiller’s generalization that “stocks are not safe”; annoyed at his omission of any reference to Washington’s heavy tax and regulatory burdens, which have a strong impact on risk-reward ratios that enter into stock price valuations; and astounded at his ignorance of the debilitating effects of inflation on equity markets.

Shiller examines trends in price-earnings ratios and inflation-adjusted earnings since 1871 and compares today’s peaks with the prior peaks of 1901, 1929, and 1966. Some of his conclusions and warnings certainly square with much of the conventional wisdom (for example, stay out of the market when P/Es are at or above 40). He is empirically supported by 119 years of data showing average dividend returns of 4.7 percent and average capital gains of 5.3 percent. (By contrast, today’s dividends on equities average only one percent and stock valuations early in 2000 were at their highest levels in the last 150 years.)

Shiller’s main point is that investor psychology is myopic and fragile. There are literally scores of shocks—political, economic, and military—that could rattle markets, both domestic and international. He reminds readers that, discounting inflation, the annual return on equities in the wake of the three aforementioned peaks was 0.2, 0.4, and 1.9 percent, respectively. And not just for a year or a decade, but for 20 years! This is a radically different perspective for some so-called investors whose long-term market expectations equate to “after lunch.”

It is certainly true that human beings are prone to psychological swings and sometimes fall for bad advice from clever salesmen and financial “gurus.” But since human fallibility is always present, theories about economic debacles such as depressions and market crashes need to account for the abnormally high degree of bad decisions that lead to them. Here Shiller disappoints, as he fails to observe that government policy can and has led to clusters of errors in the past and ought to take at least some of the blame in this case. We know that, owing to Alan Greenspan’s worrying over the predicted “Y2K bug” cataclysm, Fed policy turned very expansionary in 1999. Inflation has been the precursor to our past economic turmoils and seems to have played a starring role in the market’s run up to its early 2000 peak.

But Shiller doesn’t just ignore inflation—he tries to dismiss it. He quotes former Fed chairman Arthur Burns as saying, “No country that I know of has been able to maintain widespread economic prosperity once inflation got out of hand.” That statement he quickly labels “unsupported.” Yet 40 centuries of recorded economic history amply support Burns’s observation.

Lastly, Shiller kowtows to the old Clinton-Gore proposal that Washington direct a portion of Social Security payroll taxes into the stock market. That would bring about the de facto nationalization of U.S. equity markets and is preposterous in light of the author’s warnings elsewhere about an overbought stock market and the fallibility of advice from Wall Street’s self-anointed gurus. If investors are sometimes foolish with their own money, just imagine letting Washington do the investing!

David Littmann is senior vice president and chief economist with Comerica Bank in Detroit, Michigan.

  • David L. Littmann is senior economist with the Mackinac Center for Public Policy, a research and educational institute headquartered in Midland, Mich., and the largest state-based free-market think tank in the country.