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The Yale Alumni Magazine is owned and operated by Yale Alumni Publications, Inc., a nonprofit corporation independent of Yale University. The content of the magazine and its website is the responsibility of the editors and does not necessarily reflect the views of Yale or its officers. |
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| Comment on this article In 2000 he said the dot-coms would go bust. Internet entrepreneurs scoffed. In 2005, he said the housing boom would cause a
recession. Mortgage lenders laughed. Sometime in the mid-1980s, Robert Shiller and John Campbell '84PhD created The Chart. It wasn't especially complicated. It showed average stock prices, relative to corporate earnings, going all the way back to the late nineteenth century. Wall Street analysts produce charts along these lines all the time. The measure is called the price-earnings ratio, and it is the single most common analytical yardstick of the stock market. The yardstick that Shiller and Campbell created, however, came with a twist -- a twist that transformed their little chart into The Chart. Today, The Chart stands as one of the signature pieces of economic research of the past generation. It is rigorous enough to have appeared in the Journal of Portfolio Management and simple enough to be understood by those of us who are behind on our Portfolio Management reading. Anyone who heeded the central lesson of Shiller and Campbell's analysis -- as well as the lesson of a subsequent chart, created by Shiller, on the housing market -- could have avoided some of the worst pain of the financial crisis. If Alan Greenspan had taken The Chart seriously during the late 1990s, Greenspan's reputation might be in better shape today. So might the United States economy. Nouriel Roubini, the doomsday-prophesizing finance professor at New York University who has lately become a media darling, credits The Chart for much of his clairvoyance. The Chart and its co-creator happen to have much in common. At first glance, they both seem simple enough. It is just a series of numbers, depicted on a piece of paper. He, as his old teacher, the Nobel Laureate and textbook author Paul Samuelson, has said, is "a long-jawed, serious fellow" -- "like a hayseed boy off a farm with a straw in his mouth." The Arthur M. Okun Professor of Economics, who has taught at Yale since 1982, Shiller has a hesitant, almost shy, manner. But don't be fooled by that. When Wall Street analysts talk about the price-earnings ratio -- the P/E ratio -- they generally base their analysis on a very short-term measure of corporate earnings. They typically look at earnings over the past year or at forecasts of earnings over the coming year. They then divide the price of a company's stock by this measure of earnings, to judge whether the stock is fairly valued. The same can be done for the market as a whole: the Standard & Poor 500 index, for instance, divided by the average earnings of the companies in the index. Shiller and John Campbell, a former Shiller student and longtime Harvard professor who now runs Arrowstreet Capital, had come to believe that such measures were fatally flawed. Earnings over any given 12 months can fluctuate wildly, depending on whether the economy is booming or busting. Forecasts of earnings are even more problematic, given Wall Street's unimpressive forecasting record. No P/E ratio based on only 12 months of earnings will tell you much about the long-term prospects of American companies, which is precisely what stock prices are meant to capture. So Shiller and Campbell did something that, on its face, did not make much sense. To get a better glimpse of the future, they looked further in the past. They compared stock prices at any given time with average corporate earnings over the previous ten years. Later on, they would discover that a classic investment textbook, Security Analysis, published in 1934 by Benjamin Graham (a mentor to Warren Buffett) and David Dodd, had advocated this same approach. Investors, Graham and Dodd wrote, should look at earnings for "not less than five years, preferably seven or ten years." But there is no record that the two men ever published such a data series themselves. Until Shiller and Campbell came along, long-term P/E ratios were virtually absent from public discussion. Their version of the ratio entered the discussion, loudly, in December of 1996. They were both among a group of economists and stock market analysts invited to the Federal Reserve to speak with Greenspan, who was then its chairman. During their presentation, they distributed a handout containing a version of The Chart. Rather than simply showing their P/E ratio over time, this version showed the relationship between the ratio at a given time and the performance of stock prices over the next decade. The pattern was clear: the higher the ratio, the lower that future returns tended to be. Even in late 1996, more than three years before stocks peaked, this pattern was foreboding. The P/E ratio was then above 25, higher than it had been at any time since 1929. Wall Street's standard P/E ratios missed this development, because corporate earnings were also soaring at the time, making the ratio look almost normal. But earnings are highly cyclical. They rarely stay very high for very long. The Shiller-Campbell ratio showed that stock prices were now based on the idea that earnings had reached a new, permanent level. Otherwise, stock prices were headed for a fall. Investors, Shiller told Greenspan, had become irrational. Greenspan listened without betraying his own views, and Shiller headed back to New Haven assuming that he hadn't persuaded the chairman. Three days later, while driving his son to school, Shiller heard a radio report that stocks around the world had begun to drop. Investors were reacting to a speech Greenspan had given at a dinner in Washington the night before. "How do we know," he asked, "when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?" After that one speech, however, Greenspan didn't continue to sound the alarm. Soon enough, stock prices resumed their rise. The long-term P/E ratio peaked at 43 in 2000. If you believed The Chart, stocks were then more than twice as expensive as could be justified by their economic fundamentals. History suggested that they would eventually drop by more than 50 percent. In 2000, only weeks after the market peaked, Shiller published a book making his argument. He called it Irrational Exuberance. The Chart appeared in the first chapter. Over the next few years, Shiller moved on to another subject: housing. In the wake of the dot-com crash, which helped make Shiller a public figure, Americans turned their financial attention from stocks to real estate. House prices were rising rapidly, and people had begun to see real estate as a can't-miss investment. Shiller wanted to know what history might say about that, but he realized that data for house prices didn't exist going back more than a few decades. "Clearly," he has written, "no one was carefully evaluating the real estate market and its potential for speculative excess." So he began compiling data himself, from a patchwork of various government surveys and newspaper real-estate advertisements. (In 1991, he and a fellow economist had begun compiling an index to track the market in real time. Known as the Case-Shiller index, it is now among the most closely followed housing statistics.) Shiller's historical data were hardly perfect. The data from 1934 to 1953, based entirely on ads, are "the weakest link," as Shiller says. But for all their limitations, the numbers still seemed to tell a compelling story. Over the long term, house prices tend to rise at the same rate as household income. If prices increase more slowly than income for a few years, they soon catch up. If they rise more rapidly than income, they eventually come back to earth. In early 2005, Shiller published a second edition of Irrational Exuberance, which added a chart on house prices. That summer -- which turned out to be the very peak of the housing bubble -- Shiller and I had lunch in New York. He told me that day that over the coming generation, he expected inflation-adjusted house prices to decline by 40 percent. In all likelihood, he said, the bursting of the housing bubble would at some point cause a recession. What's striking, in retrospect, is just how radical a position this was at the time. By the summer of 2005, even Shiller's famous stock market prediction was no longer looking quite so smart. The Standard & Poor 500 had rallied sharply from its lows in the wake of the dot-com crash. Shiller had predicted in 2001, as the crash was happening, that the market might fail to keep pace with inflation over the coming decade. Instead, it began rising in 2002 (on its way to a new, much-hyped record high in 2007). Yet here, in 2005, was Shiller -- who has been called both Mr. Bubble and Dr. Doom -- publicly forecasting another cataclysm. Wall Street cheerleaders were only too happy to point out his spotty record as an investment adviser for the masses. By 2005, stock prices were twice as high as they had been when Greenspan gave his "irrational exuberance" speech. And the real estate- industrial complex -- real estate agents, mortgage brokers, home builders, and the like -- was similarly dismissive. During an interview I did in 2005 with Robert I. Toll, the chief executive of Toll Brothers, a large, high-end home builder, he brought up Shiller's name without my having asked. "Shiller is predicting the mountain goes into the sea," Toll said. "He's selling himself." Even many of us who found Shiller's dispassionate, history-based analysis to be persuasive had trouble going quite so far as he did. I had had my own little revelatory experience with The Chart when first reading Irrational Exuberance in 2001. (I remember where I was: sitting on a sofa in my Manhattan apartment one sleepless night.) Later, Shiller's research on real estate helped persuade me the country was in the midst of a real estate bubble that was destined to burst. I wrote articles in the New York Times suggesting as much and advising people to consider renting a home, instead of owning it, until prices came down. At a high school reunion in 2005, a classmate who was a real estate agent asked me to please stop. Still, these articles typically included a caveat that softened the message: even if house prices in some areas began to fall at some point, most economists thought that the declines were not likely to cause a recession. After all, as Greenspan liked to remind people who worried about the existence of a housing bubble, house prices nationwide had not fallen since the Great Depression. Shiller himself also couched his message carefully. He always specified that a long-term stagnation, in which prices fail to keep pace with inflation, might be the most likely outcome. But the implications were still serious. Housing had become an enormous part of the American economy. If it were in the midst of a bubble -- "the biggest boom we've ever had," as he said in 2005 -- it was going to create big problems. Roubini, the NYU economist, was one of those people who grasped this. He had long been a pessimist, but Shiller's housing chart persuaded him to ratchet up his pessimism to a new level, he has told David Ignatius, a Washington Post columnist. Like Shiller, Roubini ended up sounding like an extremist. When he delivered his forecast at an International Monetary Fund meeting in 2006, "he sounded like a madman," as one economist told the New York Times Magazine. We know how the story ends. House prices have indeed fallen across the nation. In some cities, like Miami and Las Vegas, they have fallen a stunning 50 percent. The stock of Toll Brothers has fallen more than 60 percent from its high. The housing bust has helped to cause not merely a recession, but the worst recession in at least a generation and the worst financial crisis since the Great Depression. And that stock market rally that followed the dot-com crash? It too has ended with a crash. In mid-August, the S&P 500 was trading at slightly more than half of its 2000 peak, adjusted for inflation. Thirteen years after Shiller had lunch with Greenspan -- a period in which the economy and corporate earnings have both grown substantially faster than inflation -- stock prices, in real terms, are right back where they were. Shiller and I sat down again recently, in Washington, where he had come to give a talk, and I began our discussion by suggesting that he could finally stop worrying about bubbles. The bubbles he had spent so much of the last 15 years thinking about had largely disappeared, it seemed. He replied that gold seemed to be in the midst of a bubble. "But that's inconsequential," he added. This means that -- at the age of 63 -- Shiller is in many ways beginning a new stage of his career. He is no longer Mr. Bubble. His predictions have won him renown. Indeed, he has become one of a handful of Yale professors today with some claim on national fame. For the paperback edition of one of his recent books, the publisher put a picture of Shiller -- hand on chin, in front of one of those big Corinthian columns in Beinecke Plaza -- on the cover. But now that he has an audience, what is he going to say to it? "What is the thing that should be on our mind now?" as Shiller put the question. "It's how to preserve this sense of justice and good feeling that we have in this country -- this feeling that I am willing to operate and do business in good faith because I feel that's what people are doing and that's what a good citizen should be doing." Survey data from around the world have shown that economies grow more quickly when people trust their fellow citizens. But the financial crisis and the recession have left many Americans with a sense of distrust, Shiller said. A prolonged period of high unemployment -- which now appears to be the most likely scenario -- could aggravate the situation. The United States, in other words, may be heading into a period of irrational pessimism. Figuring out how to avoid this outcome is Shiller's new project. Since Irrational Exuberance, Shiller has published three other books. The most recent, and in many ways the broadest, is Animal Spirits, a collaboration with George A. Akerlof '62, an economist at the University of California-Berkeley. Akerlof shared the 2001 Nobel Prize in economics, with A. Michael Spence and Joseph Stiglitz, largely for work that has come to be known as the "lemons" research. In Akerlof's portion of the research, he argued that the market for used cars suffered from an inherent flaw. The quality of used cars varied enormously, but only sellers typically knew which were the good ones and which were the lemons. Akerlof's essay on the subject, "The Market for Lemons," was published in 1970. Five years later, Congress passed the Magnuson-Moss Warranty Act -- known as a lemon law -- which was meant to protect buyers of used cars. Much like Shiller's work on bubbles, the lemons research challenged the basic idea of neo-classical economics: that markets generally function well. The discipline of economics concedes that markets have imperfections, but has long considered the flaws to be mere anomalies, which will be eliminated during the normal give-and-take of market transactions themselves. (This is the "invisible hand" of the markets, in Adam Smith's famous phrasing.) Yes, there might be the occasional dishonest used-car dealer, but he will be driven out of business because consumers will catch on to him. And, yes, there might be the occasional bubble, but it won't get too big. Investors, acting out of rational self-interest, will not let it happen. Akerlof and Shiller disagree. They argue that flaws and excess are inherent to a market economy -- and that they are not minor. "The economics of the textbooks seeks to minimize as much as possible departures from pure economic motivation and from rationality," Akerlof and Shiller write. "Our book marks a break with this tradition. In our view economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and can be observed." The common thread that runs through these deviations is human emotion -- or, as the early twentieth-century economist John Maynard Keynes described it, "animal spirits." Over the past generation, a group of scholars, who have become known as behavioral economists, have helped change the discipline by pointing out just how important human emotion is. People are not, in fact, computers who analyze the offers sent by mutual funds or health clubs and always make the rational choice. (Advertising executives, it should be noted, have long understood this.) People are deeply affected by how the options are framed and how their ultimate decisions make them feel. They are driven, Akerlof and Shiller write, by trust and confidence, by notions of fairness, and by compelling stories about how the world supposedly works. Shiller credits his wife, Virginia Shiller, for much of his evolution from a more traditional view of economics to a more behavioral one. She is a clinical psychologist at the Yale Child Study Center who, he says, has persuaded him that psychology is at the heart of economics. Psychology, not the hyperrational models of economics, helps explain why people continued to buy stocks in 1999 and Las Vegas condominiums in 2005. The buyers had come to believe the stories about how the future would be different. Dot-com companies didn't need to make profits. Home prices didn't have to be tied to the level of household income. It was a new era! Shiller argues that these stories were compelling partly because they contained a nugget of truth. A market system -- that is, capitalism -- has in fact proven to be the most successful way to organize an economy. The U.S. economy continues to be the richest the world has ever known. Asian economies that have moved toward a more market-based system, like China, India, South Korea, and Singapore, have experienced phenomenal gains in living standards. Individuals left to their own devices usually make rational choices. Yet over the past generation policy makers have come to assume that the departures from rationality are so minor as to be nearly irrelevant to government. "If we thought that people were totally rational, and that they acted almost entirely out of economic motives," Shiller and Akerlof write in Animal Spirits, "we too would believe that government should play little role." In recent years, no one came to embody the laissez-faire idea more than Greenspan. "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief," he told a congressional committee during a humbling appearance last fall. He had, he admitted, found "a flaw" in his theory. Shiller has been arguably Greenspan's best foil over the past decade and a half. With the big bubbles largely gone, Shiller is now arguing for an approach to economic policy that takes animal spirits far more seriously. And it isn't just about bubbles. "Whenever the public endures a crisis, ordinary citizens start to wonder how -- and whether -- our institutions really work," Shiller wrote in the Washington Post last September, two weeks after Lehman Brothers collapsed and financial markets froze. "We no longer take things for granted. It is only then that real change becomes possible." Shiller argues that the United States has gone through six major shifts in the way that people think about the economy: during the Revolution, during Andrew Jackson's presidency, during Abraham Lincoln's, at the end of Reconstruction, during the Great Depression, and during Ronald Reagan's presidency. These shifts were often connected to some kind of crisis. When Reagan was elected, the economy was suffering through its second severe downturn in less than a decade. Oil shocks had played a big role in those downturns, but the government deserved some blame, too. In the 1960s and '70s, policy makers overestimated their ability to fine-tune the economy, and their mistakes helped cause stagflation. The Reagan Revolution reasserted the role of the market -- of laissez-faire economics -- in American society. But it is now clear that the revolution went too far. (True believers insist the problem was that the revolution didn't go far enough, but that's what true believers -- be they on the right or the left -- always insist.) The tax cuts of the past decade did not bring about the nirvana of economic growth that was promised. In fact, average annual growth in the current decade, even before the downturn began in late 2007, has been slower than in any decade since before World War II. And the crisis, as Greenspan himself has said, undercut the notion that individuals left to their own devices will always create a well-functioning economy. In the wake of the crisis, Shiller argues, the country is entering its seventh major shift. "We're going through a seismic change," he said, "and our sense of support for capitalist institutions is not going to be the same." His proposed solutions can be seen as part of a larger societal effort to recalibrate the balance between government and the market. Liberals, obviously, are happy to have this discussion. But so are some conservatives, like Richard Posner '59, the federal judge and University of Chicago professor who recently wrote a book titled A Failure of Capitalism. Above all, this recalibration is at the heart of the current White House's agenda. President Obama has filled his economic team with market-friendly Democratic centrists -- including Austan Goolsbee '91, '91MA, Jeffrey Liebman '89, Gene Sperling '85JD, and Andrew Metrick '89, '89MA, a School of Management professor -- who are nonetheless trying to give the government a greater role in regulating that market. It makes sense, then, that Animal Spirits has became a "new must-read in Obamaworld," as Michael Grunwald wrote earlier this year in Time. Peter Orszag, Obama's influential budget director (and a son of former Yale math professor Steven Orszag), has said that the book "really applies to all the big areas where we need change." For all the radicalism of Shiller's past predictions, many of his current ideas are fundamentally conservative. He does not believe that the democratization of finance -- the rise of 401(k)s and the like -- went too far. He thinks it did not go far enough. Finance is essentially about the management of risk, he says. Investors around the world can each take a tiny slice of the risk that comes with starting a new company and, in the process, give that company far more resources than any single entrepreneur with a good idea would otherwise have. Yet many of the risks that individuals and families face cannot be managed that way. Most Americans have a huge share of their net worth in their house. They have no way to diversify this risk. Many teenagers and young adults postpone or simply avoid making the investments, like a college education, needed to pursue the career they really want. They can't quite figure out how to pay for college -- how to tap into their future income as a college graduate -- or they worry that their dream job is too risky. Shiller wants people to have the same ability to manage risk in their everyday finances that investors do with their assets. He fleshed out his ideas in a 2003 book, The New Financial Order, and he talks about them frequently. He has suggested the creation of a market for something called livelihood insurance, which would allow people to take out policies protecting them from a future decline in their income, much as fire insurance already allows them to pay small amounts of money in exchange for protection against financial calamity. Along similar lines, he wants homeowners to be able to hedge against the possibility that their home values will drop. He wants them, and other investors, to be able to "short" the housing market -- that is, to bet that prices will drop. If people don't have the ability to make such bets, he told me, "there is nothing to stop bubbles created by zealots, even if the smart money knows they are bubbles." Of course, any of these new markets would be subject to the same human irrationalities and imperfections that created the current mess -- and that Shiller has spent his career identifying. So along with more and more markets, Shiller also wants more and better regulation. He is particularly drawn to the notion of a Financial Products Safety Commission, which the Obama administration recently proposed. Its charge would be to look out for consumers, day by day and new product by new product, in a way that a static regulation never could. One reasonable critique of Shiller's ideas is that they may work better on paper than in practice (much like the elegant theories of neo-classical economics). The New Yorker, in reviewing The New Financial Order, wrote: "There is a mad-scientist quality to some of these proposals, and the technical and political obstacles to their implementation seem insurmountable." Shiller has experienced some of these obstacles. In 2006, a company he owns, called MacroMarkets, created a market for real estate futures contracts on the Chicago Mercantile Exchange. They have not been very popular. Shiller acknowledges this, but he has pressed on. In June, MacroMarkets created the first real estate securities -- which would allow investors to short housing prices. He hopes that he has begun laying the groundwork for a less risky, less bubble-prone economy of the future. Of all his policy ideas, the broadest is one that he calls the "Rising Tide Tax System." Developed with Len Burman, a Syracuse University economist who spent years in Washington, it is essentially a form of inequality insurance. Under such a system, tax rates would automatically adjust along with levels of income inequality. If the incomes of the middle class and the poor were growing at a faster pace than the incomes of the rich -- as happened during the 1950s and '60s -- tax rates on the rich would fall. But if the incomes of the rich were growing the fastest -- as has happened over most of the last 35 years -- their tax rates would rise. The opposite, in fact, has happened in recent years. The wealthy have received both the largest pretax raises and the largest tax cuts. The middle class and poor have not done nearly so well. That combination, Shiller worries, has created disaffection. And the disaffection has made it harder for policy makers to take steps, such as removing trade barriers, that would lift the economy and enlarge the nation's economic pie. The inequality tax would have the potential to cure this disaffection. It would allow Washington to promise voters that they would be not be denied a fair share of the nation's economic bounty. If large economic forces caused middle-class incomes to stagnate, tax policy would help out -- not erasing the effect of those forces but at least ameliorating them, Shiller says. The tax idea connects directly to Shiller's conception of how an economy works. The Rising Tide Tax System is meant to make people feel that the economy is fair, that they can trust the institutions around them, that they can have the confidence to take risks that, in the end, will benefit the larger economy. "I think these are exciting ideas," Shiller says. "But they're not going anywhere." "Maybe someday," he adds. You can take that as the lament of an academic who
realizes his ideas are never likely to spread beyond the ivory tower. Or you
can take it as the musings of a man who has known what it's like to be ahead of
his time.
I received the September/October 2009 issue of the Yale Alumni Magazine the same day that Yale admitted how much of the endowment was lost in the bubble. Yale's managers did not listen to its own renowned prognosticator, but Yale was not alone. I have a handout (now a classic), dated February 2005, by Rick Rieder, then one of Lehman's chief strategists. He forecast that innovation in risk-avoidance (the whole alphabet soup of CDO's etc.) would cause higher leverage with increased systemic risk. His conclusion: "It would be no surprise to anyone if that bubble burst at some point. . . . It always does." He was wrong. His employer, like Yale, was surprised (terminally in their case). Andrea Zana '96 worked in Mr. Rieder's department at the time. He told me that Lehman parted with Mr. Rieder and cashed out his stock and options near the high. Looks like Mr. Schiller will also do well in spite of his employer's lack of timely recognition.
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How "The Chart" Works Imagine that, in December 2007, Company X's stock was selling at a record $60 per share. Its earnings for the previous year had been better than ever before, at $4 per share. So its price-to-earnings ratio was 15. That's a comfortably low number on the price-to-earnings scale -- showing, apparently, that Company X's record stock price was reasonable. The price, said its CEO, simply demonstrated that investors appreciated Company X's increased profitability. But 2007 was a boom year. What if Company X's big profits were only temporary? Then its good price-to-earnings ratio was illusory, and its stock might be seriously overvalued. Shiller and Campbell account for the booms and busts by using earnings figures for the previous ten years. Company X's average earnings for the past decade had been $1 per share. By the ten-year calculation, its price-to-earnings ratio was alarmingly high at 60. Unless there were a concrete reason to think the recent high earnings should continue, many investors would see that number as a red flag signaling SELL. Shiller and Campbell applied their method to stock indices like the S&P 500, which tracks the share prices of 500 large U.S. companies. When they graphed a price-to-earnings ratio using average earnings of the S&P companies over ten years, they found that the highest numbers often predicted the steepest falls. |
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