Robert Shiller Explains the Financial Crisis in One Paragraph
The following comes from Shiller’s recent interview in Social Science Space. It’s one of the most concise explanations of what happened and why most economists missed it:
“Robert Shiller: That’s right; well conventional economics misrepresents what our best interests are. A great example is the financial crisis that began in 2007. The way it began is home prices started falling rapidly. Many people had committed themselves to mortgages and now the debt was worth more then the house was worth,they can’t come up with the money to payoff the mortgage and so it kind of lead to a world financial crisis. So why did that happen? Conventional economics theory can’t seem to get at the answer, which I would say is, we had a speculative bubble driven by excessive optimism, driven by public inattention to risks of such an eventuality. And errors in managing the mortgage contracts that were made. There are no errors in conventional economics: it’s all rational optimisation.”
The rest of the interview is actually better, but this part stood out due to its simplicity and directness….
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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28 Comments
Argh, I hate it when people confuse ‘then’ and ‘than’.
In any case, it’s actually quite easy to generate a bubble with conventional economics, even assuming rationality (self fulfilling prophecies, misinformation etc…). I dare say even if you are aware of a bubble it is in your rational self interests to play along sometimes.
Yeah, I thought about fixing it, but I don’t know if it’s considered poor to change a quote even if the grammar is wrong….
It’s perfectly alright to fix grammar just add a (sic) immediately before the word that you changed – right inside the quote.
Noted. Thanks!
Well, to be a stickler about it, it should probably be posted something like this:
Robert Shiller: That’s right; [sic] well conventional economics misrepresents [sic] what our best interests are. A great example is the financial crisis that began in 2007. The way it began is home prices started falling rapidly. Many people had committed themselves to mortgages and now the debt was worth more then [sic]the house was worth,they [sic] can’t come up with the money to payoff [sic]the mortgage and so it kind of lead [sic]to a world financial crisis. So why did that happen? Conventional economics theory can’t seem to get at the answer, which I would say is, we had a speculative bubble driven by excessive optimism, driven by public inattention to risks of such an eventuality. And errors in managing the mortgage contracts that were made[sic]. There are no errors in conventional economics: it’s all rational optimisation[sic].
Yeah, I’m being a smartass because of all the mistakes in that one little paragraph.
These were most likely errors that occurred during transcription of the voices in the interview (probably automated).
You could actually just put one “[sic]” at the end of the quote and be done with it.
http://en.wikipedia.org/wiki/Sic
So the question I have is… “is the stock market a bubble (compliments of Fed policy), and is there room to play?
Shiller’s one of the few people who understands human psychology and economics. He’d be a better fed chair than Bernanke.
Thats what this website suggested Will Robert Shiller Replace Ben Bernanke As Next Fed Chairman? http://www.valuewalk.com/2010/01/will-ben-bernanke-lose-his-renomination-bid-will-robert-shiller-be-the-next-fed-chairman/
The bust happened because there was a speculative bubble?????
And what explains the speculative bubble?
Shiller is conventional; he confuses causes with effects.
Actually economics is all about positive feedback loops that look rational on the surface and are iirational only if one stops for a moment and looks at the big picture.
What happened is Fed lowers rates too much -> debt rises -> people feel wealthy, economic conditions are good -> take more debt etc. Until the debt bubble burst with a trigger of bad mortgage debt showing its true nature.
The stock market IS in a bubble. A 3rd 50% decline is coming. But this time it will stay down, where it belongs as profit margins revert to historical means…
The question is that if economics cannot really help preventing this, what is the use of it.
While in conventional wisdom it was obvious that a large amount of (asset) bubbling was done.
Therefor what is the use of economics if it isnot able to state that there is a substantial risk in the real estate market and conclude the most important financial consequences thereof.
At the end of the day it should simply work and it clearly didnot and nobody gives a @#%* if no errors were made.
Might be a good start to start realizing that we are living in a real world were also other non-econic issues matter. Doubt however if that will matter, signs are pretty worrying.
The establishment (including top economists) is “invested” in the status quo of blowing bubbles to help Wall Street privatize gains and socialize losses. That is why it is against admitting and using this reality rationally and prefers to pretend it is not there.
In that sense it is not economics that is flawed, it is its users / manipulators.
Conventional economics theory also states that the FED is an independent entity. That efficient markets determine price levels, yet we all know that this is not the case. What about the fact that Ben would lose his job if he was to implement his mandate without regards for financial markets or the politician that will decide his fate at the helm of the FED?
What about the fact that for most company valuations, intangible assets represent about 70% of the share price and cannot be measured accurately?
Conventional economics theory is mostly useless in such a framework and only helps economists build a narrative for the latest market failure while pushing their own agenda at the same time.
I’m still a believer in Sorros’s reflexivity theory. With the help of MR you can get a hint at what’s coming your way.
Almost forgot: LIBOR manipulation is also not part of Conventional economics theory
I think on the one hand he is right – it is the irrational element that is at fault. On the other hand he is wrong – it was the debt bubble, and debt levels are something that conventional econ does not look at.
The interview is a must-read in its entirety. Shiller sums up neatly what wrong with mainstream economics. His summary analysis also implies why the conclusions most economists draw are pretty useless for trading, and why listening to them can be dangerous to your portfolio. But most traders have likely figured this out already.
Yes, but there was that matter of a “small war” waged by Russia against the former Soviet republic of Georgia that had attempted to annex South Ossetia, a matter that triggered a spike in oil prices that had initiated the cascade that, you know the rest of the story.
It is the question whether WW-I (and by extension WW-II, the Cold War, and even some of the mess we are dealing with in the Global War on Terror) was the fault of assassin Gavrilo Princip? The fault of Austria and Serbia getting into tests of their respective national honor over a terrorist act (against Austria) in a third country/territory (Bosnia)? The fault of the German Kaiser for backing his Austrian pal the Austrian Kaiser? The fault of the Western powers (Britain, France) in standing by alliances/security guarantees to Serbia and other European states on “the other side” of Germany. The fault of the generals for thinking that any general war (between France and Germany) would be resolved quickly and “cleanly” as the 1870 war between Prussia and France?
For all of this talk about “bubbles” and how rational actors should “know better”, there are such things as “failure cascades” in complicated non-linear systems such as the global economy (now), the network of European alliances (1914) or such as continent-wide electric power grids (the power failure in India over the weekend).
Cullen, you have been advocating more than anyone else that a lot of things from Classical Economic Theory, including a lot of what a certain political faction is campaigning on regarding the “unsustainable debt” can be wrong. At the end of the day, the functioning of the economy is that people get up in the morning, engage in various activities of doing things and consuming and producing “stuff” in the process of fulfilling a network of promises and committments to each other that we call “the economy”, go to bed at night, and start the whole thing over the next day. Money and debt and loans are not “stuff” but rather the control signals guiding this process, and who is to say that the U.S. housing market prior to the South Ossetia affair was unstable? That is, until Pooty Poot threw in a brick?
OK, OK, there is the matter of “prudence” that in my line of work as a research engineer are called “design principles” or architects and home builders call “building codes.” As an engineer, you leave in a certain amount of “design margin” or specify a certain “factor of safety” to allow for the “unknown unknowns.”
In financial terms, you buy a house with at least 20 percent down, acquired by dint of austerity and scrimping and saving or help from your parents in purchasing your first house. You borrow at a fixed rate for whatever length of time you think it takes, maybe going for a 15-year mortgage because you can make a slightly higher payment owing to the habits of saving in accumulating your down payment in the first place. If you are making mortgage payments, you set aside some “rainy day” savings in case you face a major house repair or in case you are unable to make payments from your income stream for, say, a year.
So the people who did all of those things weren’t able to afford a house, so you relax those standards. Who is to say that the traditional “design margins” and “factors of safety” are fixed in stone? Engineers relax those margins all of the time, and in building rockets, you have to go with slim margins or no margins at all otherwise the rocket will be too heavy to do its job, and yes, rockets blow up all the time.
But who is to say what the proper “design margins” are on home mortage debt? The whole point of design margins is that they are all boojum and guesses and made up because if you had an exact engineering science to determine the margins, you would be able to generate a design that didn’t need margins.
And who is to say that the pre-2008 economy wasn’t sustainable? The whole point about the economy (and about the electric power grid) is that yes, the amount of production of “stuff” (or electricity) has to be matched to the amount of “stuff” consumed, either directly or into inventory or stockpiles, and that wasn’t happening in 2008? Yes, that didn’t happen as a result of the Georgia war either interrupting the supply of oil or at least creating the impression on commodities traders that it would, leading to a cascade of people who couldn’t fulfil various sorts of obligations to produced and consume “stuff” throughout the economy.
Who is to say the folks in India (or the U.S.) should have more generating plants and more transmission lines to make “the grid” more robust to the kind of event that can move the grid into another “stable equilibrium” (i.e., the current Global Economic Crisis or the India blackout)? But how much margin, keeping in mind that design margin consumes capital resources, loan restrictions restrict meaningful economic activity, costing jobs and levels of personal income in the end? The 20-percent-downpayment fixed-term-mortage have-a-year’s-expenses-in-liquid-savings is a made-up rule, that is a product of tradition and that-is-the-way-we-have-done-things as much as whatever factor of safety is built into a bridge.
There is a reality, and there is a perceived reality. All others are theories to explain the reality. A theory tends to generalize, and therefore tends to be partially right and partially wrong. Housing bubble is so called a general phenomenon, and people are trying to use every known theory to explain it. To each individual, it’s the income to debt ratio. You have your pay check every month, and that’s reality, not perceived reality. Its usually pretty clear how much you can purchase. But people don’t want to see and admit the reality, since reality sucks. They prefer something better. That’s where it’s gone wrong.
Really what Shiller misses entirely is the pervasive fraud perpetrated in the mortgage bubble. How does economics deal with fraud? Either assuming it away as irrational or ignore it.
The mortgage industry saw a nation in decline and the opportunity for massive profit through fraud with a lack of oversight and regulation; they went for the gold and they got it, leaving us poorer and worse off and them wealthy and beyond punishment.
Excessive optimism is a bullshit explanation. Poor capital allocation and mortgage fraud by both financial institutions and borrowers is probably a better one IMHO. Regulator and Finance circle jerks is another better one.
If I walk into a bank and am excessively optimistic about my ability to service credit or about collateral value I should be shown reality or the door. Poor capital allocation and regulator ineptitude ignorance of what can loosely and exactly be termed fraud is probably a better explanation in my opinion. Also, I’m curious what efficiencies are realized by having a private mortgage market. Its pretty straight forward. Income + regulated leverage + taxable collateral value + 3% markup of g bonds rates, all more readily verifiable by gvt. Plus in Canada the gvt guarantees all mortgage risk.oh yeah, they do that in US too. What purpose is served by having risk capital focused on housing since clearly finance is not good at it. The only reason I can think of is its part of the big finance subsidy that is required for banks to operate like gvt bonds.
What is not explained is why house prices started falling. Was it the banks rejecting demand or there was no longer enough people who could purchase even begin to purchase at the high prices……….
I’m a Realtor and back then I noticed on a few occassions that demand slackened – I had been reading reports on the “bubble” at the time and each time demand slowed I said to myself “here we go”. But each time the market got hot all over again “proving” that there was no bubble after all. I finally stopped fighting it – right about when it finally did pop (I’m a great contrarian indicator – if only I could figure out how to market my epic lack of timing
At the time I had no idea why it kept going higher when I thought for sure it was going to drop, but in researching much later I noticed the correlation of new loan program and/or ease in qualifying and those past spikes. The higher prices got, the fewer people qualified, so it took a new way to get in a new group of buyers. Obviously that had to stop eventually.
It’s been a while since I’ve been on Steve Keen’s blog – but he’s been predicting a housing crash in Australia forever… but the Aussie’s didn’t stop with their incentives when the U.S. did… they kept throwing fuel on the fire so the last time I checked, most market participants there still thought “it’s different here”. So when will it pop? Well, it keeps trying as prices and debt service far outpace incomes – but give buyers free cash to buy, or lower rates, or allow them to qualify if all they have to prove is that they can breath…. and the bubble continues… until there are no more incentives possible.
hangemhi,
My partner is a realtor and worked through those times. She had to hire help to be able to cope. They were long days and weekends were chaotic.
I remember people wanting to buy (first time buyers, lots of them) all scared they wouldn’t be able to buy a house if prices went on up.
I also remember the disbelief as couple after couple got approved for financing and then got financing to close the deal.
It was all about making money while the sunshined.
So thanks for answering the question.
The schemes seemed to get more absurd as more and more ineligible buyers came into the market towards the end of the bubble.
Some people had to sell as we reached the top of the bubble and the only way the buyers were going to get financing was if the price fell. That is still happening today. Appraisals are still coming in lower that the agreed price. But there is a market today, which is good.
I think he misses a major point.
When home prices fell, institutions who had bought mortgage-related investments with leveraged money got a the mother of all margin calls.
The actual rise and fall of home prices has very little effect on homeowners. Some of us benefitted from higher prices and some suffered when the prices returned. In my case, it was both — I sold and bought at the top.
Home prices would be best in the long run if they stayed where they are now and started going up 2 or 3 percent, whatever the price is. But because so many institutions are leveraged in these loans, they are screwed if prices don’t go back up. So we have a Fed policy of trying to blow up the bubble so the Fed, which stupidly bought up this toxic mortgages, doesn’t get stuck with them … not to mention the banks are involvent if real estate doesn’t go back up.
Conventional economics doesn’t understand the concept of unearned income. The National Income and Product Account treats recipients of rents and interest as providing a servie, and economic contribution equal to whatever the rentiers recieve as “earnings.” That means there are no categories for unearned income or speculative price gains.
Rents are prices that are above the necessary cost of production. Rentiers are financial speculators, monopolists, or other who engage in trying to extract a free lunch for themselves at the expense of the producers.
A quasi rentier would be an entrepeneur who figures out a way to make some product more efficiently, but does not lower his price below the market value. (I’m ok with that for awhile, as long as patent rights allow. But the idea is that not all income is the same, or as valuable to the economy. Financial speculation is hugely damaging to productivity and real wealth production.)
Credit making bankers, who actually borrow the debtors credit, and then like to attach debtors land to the ledger, are and have been the worst rentiers, which explains their outsized profits despite their ease of production; where the production is simply engaging in making money and assessing risk.
Most credit loans have land attached. In order to increase the asset base, then the law can be changed allowing that to happen. Graham Leach Blily and Shadow Banking together caused the bubble, and it was vested financial interests who lobbied for the law changes.
By making a high rate of change in credit formation, that then causes asset inflation, particularly in land which doesn’t follow supply and demand curves.
Sorry Shiller, conventional economics is mostly bunk. You have to go back to the classical period to get a handle on things.
Herding and social identification is the simple answer. It’s very deeply embedded in human psychology. Behavioural economics tries to incorporate some of the last 70 years of learning in psychology (social/authority cues, mass psychology, decision making etc.). But, the housing bubble is no different than the Nazi bubble, the nuclear weapon bubble, the rugby pants bubble, the Pokemon bubble, the terrorism bubble …