Irrational Investors
Is the Stock Market Doomed?

By George F. Will

WASHINGTON, May 11 — Perhaps not since the Naval Institute Press published a novel called The Hunt for Red October has an academic press had such a surprise hit on its hands as Princeton University Press has with Robert J. Shiller’s Irrational Exuberance.
     The success of this sober and sobering treatise by a Yale economist suggests that skeptics about the stock market’s current valuation are seeking intellectual ammunition against what the book’s title describes.
     Shiller believes the stock market is overvalued because less-than-diligent investors have unreasonable expectations — expectations not based on careful mastery of relevant research — that earnings will grow extraordinarily fast, thereby producing extraordinary profits necessary to sustain today’s share prices, with their extraordinary price-earnings ratios.
     His book’s publication, which coincided with last month’s market volatility, is fueling two overlapping arguments: Is today’s investor exuberance irrational? And is irrational exuberance always regrettable? The answer to the second question is that irrational exuberance can be bad for the exuberant but good for the economy.

Unfulfilled Prophecy

Two days before Alan Greenspan issued his Dec. 5, 1996, warning against “irrational exuberance,” he met with Shiller. On that Dec. 5, the Dow was at 6,437. Today it is 4,100 points higher. Investors who ignored Shiller’s then widely published forebodings about a coming decade of a flat — at best — market may reasonably think their exuberance was, and remains, more rational than his skepticism.
     Shiller, undaunted, still thinks the market might soon swoon, losing half its current value — equivalent to the value of the U.S. housing stock — and begin a decade of stagnation. His serenity about his (so far) unfulfilled prophecy recalls the follower of Trotsky who said, “Proof of Trotsky’s farsightedness is that none of his predictions have come true yet.”
     However, Shiller is not a professional pessimist: He says there was irrational pessimism in the early 1980s. He is a professional economist whose scholarship aims to correct other economists as much as investors.

‘Herd Behavior’

Economists’ models usually postulate people acting rationally on the basis of ample information. Shiller rightly says such models often bear little resemblance to the behavior that moves markets. Certainly such models do not adequately allow for the herd behavior of a substantial cohort of investors in today’s America, where talk about stocks is as ubiquitous as talk about sports — and CNBC is this cohort’s ESPN. Members of this cohort are almost neurologically connected to the stock market, and are subject to what Shiller calls “attention cascades” triggered by small events.
     However, much investing could be irrational, meaning poorly informed, but not wrong in results. Furthermore, investing that is irrational (arising from unreasonable expectations) and doomed to costly disappointments for some investors may nevertheless be creative irrationality. The tide of such investing may create wealth and opportunity. Extravagant expectations produce an inundation of investment, which lowers the cost of capital, some of which floods into profitable uses that would not have been served in a climate of less exuberance. And exuberance suffuses society with a generally healthy — and somewhat self-fulfilling — sense of enlarged possibilities.
     Capitalism always has been an alloy of rationality and frenzy-calculation and what John Maynard Keynes called “animal spirits.” “Creative irrationality” is no more contradictory than the idea that capitalism involves “creative destruction.” In Capitalism, Socialism and Democracy (1942), Joseph Schumpeter coined that phrase to describe the “perennial gale” that is “the essential fact about capitalism.”

Economic Forecasting

If you want to be usually right in forecasting the weather, predict that tomorrow’s weather will be rather like today’s. But sometimes it isn’t. The same is true in economic forecasting. The question today is: Are we, largely because of productivity increases produced by new information technologies, in a fundamentally new economic era? Shiller thinks there is considerable exaggeration of this.
     However, certainly we are in an unusually robust and durable expansion. And, arguably, expansions are unlike human beings and light bulbs: It is not true that the older expansions are, the more likely they are to die. They usually are killed by policy mistakes, which are apt to be made by people who misunderstand the forces at work.
     Shiller rightly stresses the importance of studying crowd psychology as a crucial variable driving the economy. However, at some a point there is irrationality — and perhaps hubris — in ascribing irrationality to investors whose behavior persists in producing positive results that confound the economic models with which economists are comfortable. As for prophesy, Shiller should remember the wisdom of Zeke Bonura, a first baseman of remarkable immobility who knew that a player will not be charged with an error if he does not touch the ball.