Jonathan Clarke,  February 27, 2015

The Economist as Culture Hero: Robert Shiller’s Irrational Exuberance

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A third edition of Robert Shiller's Irrational Exuberance
A third edition of Robert Shiller’s Irrational Exuberance

Once creatures of the faculty lounge, bearing fuzzy sweaters and mugs of oolong, academic economists are now increasingly men and women of the world, moving in and out of elite policy roles, penning meme-establishing best sellers, mixing business and pleasure in Aspen. The dismal science has suddenly developed sex appeal.

One of the new rock star economists, Yale professor Robert J. Shiller, has recently issued a slightly updated edition of the work that first brought him to the public’s attention: Irrational Exuberance (Princeton University Press, 392 pages, $29.95). The first edition, published in early 2000, correctly predicted the market correction that year would bring. The decision to re-issue the book smacks a bit of triumphalism; Shiller’s ideas and those of his allies in behavioral economics have recently been in ascendance. The text of the book itself, however, is a model of tolerant discourse.

For this, his third edition, Shiller has added a new preface, a chapter on the functioning of the bond market, and a slightly edited version of his Nobel lecture. Otherwise, Irrational Exuberance remains largely as it was first published. This is the gesture of a man confident in his position.

Throughout, Shiller is piqued by the various forms of charlatanry and opinion-mongering that pass for wisdom about the financial markets. Error is offensive to him, manipulation more so. His ultimate subject, however, is how and why markets fail—not to conform to models or predictions, but to achieve the human ends to which they are properly put. In his December 2013 Nobel lecture, he said:

The overarching theme of [my work] is that we need to democratize and humanize finance in light of research on human behavior and the functioning of markets. Democratizing finance means making financial institutions work better for real people, dealing with the risks that are most important to them individually, and providing opportunities for inspiration and personal development. Humanizing finance means making financial institutions interact well with actual human behavior, taking account of how people really think and act.

Behavioral economics does not tell us merely that we tend to be irrational in our thinking about finance; that much is obvious. (Do you max out your 401(k)? Did you buy a biotech stock on your brother-in-law’s advice alone?) But its more interesting claim is that we are systematically and pervasively irrational, such that rational actors do not necessarily appear to profit by our folly and return asset prices to their proper level.

Put another way, we all crowd into the same hot nightclub, and when someone shouts “Fire!” we all rush for the same exit. This is how bubbles are created. Bubbles result in inefficient capital allocation—throwing good money after bad. The most notorious recent example is the trillions invested in dubious enterprises during the dot-com boom of the late nineties, dollars that might otherwise have been built roads and schools. Inefficient capital allocation makes nations poor, and economists very unhappy.

The implications of behavioral economics are potentially vast, but capturing their value depends upon economists’ willingness to integrate learning from adjacent fields in the social sciences, like sociology and psychology—fields that some of them regard as discreditable. Since the 1940s, in seeking to invoke the prestige of the hard sciences, economics has drifted far from its humble origins in the decidedly human “sciences” of politics and moral philosophy.

Some of the foundational figures in the field lacked any formal training in economics. Adam Smith would not have recognized it as an independent discipline; Karl Marx studied law and philosophy, and his co-author Friedrich Engels was a muckraking journalist. Even the bellweather economists of the early twentieth century had broad humanistic interests: J.M. Keynes was a member of the Bloomsbury Group; J.K. Galbraith published several satirical novels; and Joseph Schumpeter threaded his enigmatic concepts of history and sociology through “Capitalism, Socialism, and Democracy.”

Shiller is something of a liminal figure in the struggle over the basic orientation of economics. He does not dispute the value of mathematics and statistical modeling—indeed, his work makes ample use of them—but he is at heart an empiricist. He wants to make true statements about the world as it actually is, and as he said in his Nobel lecture, he wants to democratize finance. He is a famously witty and engaging teacher. He also strives to maintain a degree of epistemological humility, with an acknowledgement that the statements made by economists (even rock stars) are inherently subject to historical and ideological bias. Shiller is a virtuoso who also “feels the music” of economic history.  

He has done well by doing good. Populist critics of Wall Street in the era of deregulation have generally been right in principle—but occasionally short on understanding—with regard to how markets function and fail. That is not to say that one needs to have graduate training in finance or economics to be a trenchant observer of the financial markets. The SIFI banks and the Federal Reserve should be accountable to the rest of us, not the other way around. But much of the prestige of finance, and also much of the arrogance of the banks, arises from the mistaken belief that the work that is done on Wall Street is too complicated for the rest of us to understand—and therefore beyond our competence to criticize. Books like Irrational Exuberance help level the playing field.

Jonathan Clarke is a lawyer and critic living in New York.

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