by Lars Syll At the beginning of the year 2000, a book titled Irrational Exuberance was published. The American economics professor and Nobel laureate Robert Shiller warned that the extensive deregulation in the financial market that had taken place since the Thatcher-Reagan era had led to a rapid credit expansion. Banks and financial institutions saw a skyrocketing increase in lending, and the pursuit of gaining larger market shares led to neglecting creditworthiness checks and accepting poor customer relationships. Above all, the values of IT stocks were disproportionately high. It would inevitably lead to a financial crisis. Shiller was proven right. Less than two months after the book was published, the usual happened. The bubble burst, and the financial market crisis became a
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Lars Syll
At the beginning of the year 2000, a book titled Irrational Exuberance was published. The American economics professor and Nobel laureate Robert Shiller warned that the extensive deregulation in the financial market that had taken place since the Thatcher-Reagan era had led to a rapid credit expansion. Banks and financial institutions saw a skyrocketing increase in lending, and the pursuit of gaining larger market shares led to neglecting creditworthiness checks and accepting poor customer relationships. Above all, the values of IT stocks were disproportionately high. It would inevitably lead to a financial crisis.
Shiller was proven right. Less than two months after the book was published, the usual happened. The bubble burst, and the financial market crisis became a reality.
Because human memory is short, new concerns reappeared after a few years. The crisis that the American economy once again found itself in had its origins in the speculative bubble that developed in the American housing market between 1997 and 2006. Despite falling interest rates and construction costs, housing prices rose by an average of 85 per cent over the ten years when the bubble was inflated.
The underlying pattern is the same in almost all financial crises. For some reason, a shift occurs (war, innovations, new rules, and more) in the economic cycle that leads to changes in banks’ and companies’ profit opportunities. Demand and prices rise, pulling more and more parts of the economy into a kind of euphoria. More and more people get involved, and soon speculative frenzy – whether it’s about tulip bulbs, properties, or mortgages – becomes a reality. Sooner or later, someone sells to cash in their profits, triggering a rush for liquidity. It’s time to jump off the carousel and convert securities and other assets into cash. A financial emergency arises and spreads. Prices begin to decline, bankruptcies increase, and the crisis accelerates, turning into panic.
To prevent the final crash, credit is tightened, and calls for a lender of last resort who can guarantee the supply of the demanded cash and restore confidence arise. If that fails, the crash becomes a reality.
Like his predecessors Hyman Minsky and Charles Kindleberger, Shiller emphasizes that bubbles are an inevitably recurring feature in an economy with essentially unregulated markets. But Shiller also argues that our contemporary reevaluation of work and wealth plays a role. Over the past decades, people’s perception of their role in the economy has undergone a decisive transformation. From viewing work as the foundation of our well-being based on a Protestant work ethic, the idea of expecting to make money through investments has spread increasingly. Today’s hero is not the hardworking industrial labourer but the smart investor for whom money is no longer a means but an end in itself. According to Shiller, this rethinking is the underlying cause of the crisis. This is where the heart of darkness lies.
That Shiller emphasizes the psychological aspects is not surprising, considering that he is a leading representative of the research field in financial economics called behavioural finance.
As a young science, economics was closely intertwined with other disciplines such as philosophy and psychology. Adam Smith, for example, was one of the foremost moral philosophers of his time. Over time, many economists deliberately sought to distance themselves from other sciences. Economic science would build on its own foundations instead of relying on the shaky grounds that immature and unscientific psychology could provide.
However, in recent times, more and more economists have realized the need to base their models on more realistic psychological foundations. Behavioural economics has quickly established itself as a sustainable part of the field of economics, with significant influence, particularly in financial economics. Neglecting the deep psychological dimensions of financial markets is increasingly seen as playing ‘Hamlet’ without the Prince of Denmark.
In traditional economic wisdom, the hypothesis of efficient markets has long been central. The hypothesis essentially states that the prices established in financial markets correspond to the fundamental values of the economy because all investors are rational and eliminate the existence of prices that deviate from fundamentals.
However, behavioural finance has been able to demonstrate that the depiction of investors as rational is difficult to reconcile with facts drawn from real financial markets. Investors seem to trade based more on noise than information. They extrapolate from short-term trends, are sensitive to how problems are presented, are poor at revising their risk assessments, and often overreact to mood swings. As a result, an asset’s price and its actual value can deviate for an extended period. Irrationality is not irrelevant in financial markets.
In Irrational Exuberance, Shiller demonstrates, based on his own empirical research on the fluctuations of the financial market, that stock value fluctuations were significantly higher than what is consistent with the hypothesis of an efficient market. And when different types of actors interact with each other, we cannot always expect the market to be efficient. To understand what happens in the financial market, we need to try to gain knowledge of how real investors behave. Behavioural finance has already taken us a long way in that regard.
So, what can be done to minimize the risk of future crises? Financial market participants evidently generate costs that they themselves do not bear. When the foremost economist of our time, John Maynard Keynes, advocated for the introduction of a general financial transaction tax after the stock market crash in 1929, it was because he believed that the market should bear the costs that its instability, imbalances, and disruptions give rise to. Those who, in their pursuit of profit, are willing to take unnecessary risks and cause lasting damage to the economy, must themselves contribute to paying the bill. It should hurt. And it should hurt if the lesson is to be learned.
Shiller emphasizes, just like Keynes, that when it comes to crisis solutions, one must distinguish between the short and long term. In the short-term perspective, it is necessary to mitigate the effects of price declines in housing and other assets through various measures. There are no guarantees that it will help, but fundamentally, there are no sustainable alternatives. Doing nothing would only fuel an already somewhat paralyzing uncertainty. When the house is engulfed in flames, we cannot simply stand on the sidelines and discuss the best method to extinguish it. Fires – like financial bubbles – have a nasty ability to spread.
In the long term, it is clearly beneficial for asset prices to fall back to a level that corresponds to their real value. A decrease in the price of one’s house does not make it less habitable. However, if the wheels of the economy were to come to a halt, the consequences would be very real.
Shiller argues forcefully for a solution he calls financial democracy, which he sees as a powerful remedy. Sound financial principles should be extended to encompass larger parts of society. It’s not only financial market participants who should have access to good information and expertise. Instead of avoiding all risks – which would be devastating to a society’s vitality and creativity – we should learn to manage insurable risks in a rational way. The basic idea is that extensive institutional changes, improved financial advice, increased transparency, freely accessible financial databases, and more should reduce the long-term risk of speculative bubbles emerging.
It is doubt, not belief, that creates new knowledge. Shiller’s research has strongly shown that we cannot both have our cake and eat it too. As long as we have an economy with unregulated financial markets, we will also be prone to periodically recurring crises.
Shiller provides us with both a map and a compass, and his proposals can actively contribute, together with stricter regulation of the financial market, to reducing the risks of costly financial system crises in the long run. However, if we reflexively refuse to see the extent of the problems, we will once again be helpless when the next crisis looms.