Sunday, March 19, 2000

Economist Shiller Warns of Validity of
'Irrational Exuberance'

By David Warsh, The Boston Globe

If anyone can be said to speak the accumulated learning technical economics on the subject of today's stock market, it is probably Robert J. Shiller. He is centrally located in the profession: trained at Massachusetts Institute of Technology, professor at Yale University, a deacon of the famous Cowles Foundation for research in economics. He is distinguished: In 1996 his "Market Volatility and Macro Markets" won the first Paul Samuelson Award for the year's best writing on finance. He is practical, a partner in the prosperous firm of Case Shiller Weiss Inc., which sells market data to the real estate industry. He's still young enough (53) that when he makes a prediction his reputation is at stake.

Most significantly, he is self-aware. Shiller operates in the shadow of what surely is the most famous prediction by an economist in the 20^th Century. It was in October 1929 that Yale's Irving Fisher -- the best known economist of his day -- pronounced his opinion that stocks had reached a new and permanently high plateau.

That he lost a considerable personal fortune in the ensuing crash only buttressed Fisher's place in history as a symbol of the shortcomings of economists. The very real contributions Fisher had made to deepening economic understanding were overlooked for the rest of his lifetime.

Thus it is an event of some significance that Shiller has written a crystal-clear and tough-minded critique of the factors that have driven U.S. stock markets to their current levels and called his book "Irrational Exuberance." In it, he argues that Federal Reserve Chairman Alan Greenspan had it exactly right when he uttered the famous phrase in a speech in 1996.

The current high levels of the market don't represent a consensus judgment by a cadre of sober experts, says Shiller. Instead, today's market is sky-high because of wishful thinking by millions of people, egged on by professionals in and around Wall Street whose incentives all run in the direction of the more the merrier.

The speculative frenzy is comparable to periods during which the stock prices peaked (measured in terms of price-earnings ratios) in 1901, 1929 and 1966, says Shiller. It simply is not likely to last. And though he is careful not to say when he expects the fever to break, he is clear that lie expects it within the next few years.

The Dow Jones industrial aver-aged tripled between 1994 and 1999. Nothing else in the economy tripled during those years.

Shiller's book is a fascinating tour of insights gleaned from anthropology, sociology, psycliology and other skiens that recently have been joined to form the field known as behavior finance. (Shiller is co-director with Richard Thaler of the University of Chicago of a pioneering project in the field sponsored by the Russell Sage Foundation.) Suppose you accept Shiller's analysis. What should investors do now? Lighten up on stocks, of course -- rigorous diversification is always a good idea. But we can't all got out of the market, he rightly observes. And those who have bought at market highs have already made their mistake. So the single best step that individuals can take would be to increase their personal saving rate -- as much as an additional 10 percent of pretax income maintained for a number of years.

Shiller acknowledges in his book that he runs a substantial risk of embarrassment by arguing that stock market returns will be low or negative in coming years.

Irving Fisher, it should be remembered, modified his views as the Great Depression deepened. In 1932 he characterized the problems an innovation-led boom that got out of hand, culminating in a recession, aggravated by poor monetary policy and heavy debt burdens into a depression -- an analysis that stands up quite well today.