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Irrational
Exuberance
(2000)
Robert
J. Shiller
The current importance of
Professor Robert J. Shiller’s prescient publication in March 2000, right
near NASDAQ topping out around 5000, is to see what relevance it has for us
today. He begins with 12 factors he believes played a major role in creating
the bull market/boom/bubble of the late 1990s, and ends with an assessment
of which of those 12 will continue to play an influential role going
forward. That, too, should be our concern.
First, let me say that his
deconstruction of the “efficient market theory” probably has more
lasting importance in the financial world than his assessment of whether we
had an overvalued stock market, and should be taken to heart by everyone who
wants to make money in the stock market. In over a decade as a member of two
securities exchanges, I never found any evidence that the random walk or
efficient market theories had any significance in real world finance. An
ivory tower construct, for sure.
Prof. Shiller’s 12
reasons for the 1990s boom and their current/future influence:
1. The Internet: It remains
a viable growth engine, but got ahead of itself. The Internet continues as a
strong influence on business and the stock market.
2. Decline of foreign
competition: Our victory over communist economies is waning. New competition
(
China
) will emerge on the world scene.
3: Pro business culture:
Could easily turn against the market.
4. Pro business
governmental policies: Could easily turn against the market.
5. Life cycles – Baby
Boomers: He expects the positive effect to diminish.
6: Financial press
reporting: Probably will continue but not show much growth.
7: Optimistic analysts: Can
easily turn negative.
8: Retirement plans: Social
Security is a potential plus if redirected into stocks.
9. Growth of mutual funds:
Difficult to ascertain.
10: Decline of inflation:
Can’t get lower; can only get worse.
11: Day trading/increased
public participation: Likely to continue. More people’s access could
elevate prices.
12: Rise of national
gambling culture: He admits the connection between gambling and the stock
market is weak.
Prof. Shiller is
pro-markets. His concern is whether outrage over the bursting of irrational
bubbles might do irreparable harm including turning our society against our
capitalistic and free-market institutions. On this point he eloquently
states, “Speculative markets perform critical resource-allocation
functions (a point I have taken for granted and have not focused on in this
book), and any interference with markets to tame bubbles interferes with
these functions as well. Ultimately, in a free society, we cannot protect
people from all the consequences of their own actions. We cannot protect
people completely without denying them the possibility of achieving their
own fulfillment. We cannot completely protect society from the effects of
waves of irrational exuberance or irrational pessimism – emotional
reactions that are themselves part of the human condition.” (p233)
Perhaps this is why under
the subject of what role government might play in cooling down irrationality
before it becomes destructive, I did not notice any reference to the FRB’s
role of setting margin rates on stock purchases. This power (Reg T) was
created precisely to cool down speculative markets when they get too hot.
Greenspan, for whatever reason, chose not to invoke this tool during the
boom.
In the end, Prof. Shiller
blames investors for their blind exuberance and predicts more difficult
times ahead. Indeed, his fears have been borne out the past 3 years. But
even he does not rule out another run based on new factors and old
psychology because not only is it human to err, but also it is human to be
irrational. The solution? In his words, “It may
be that the best stabilizing influence on markets is to broaden them,
allowing as many people to trade as often as possible.” This is why
in his next book, “The New Financial Order: Risk in the 21st
Century” (2003) (see my review), Prof. Shiller confronts how government
and society can work together to mitigate future emotional disruptions to
our everyday lives through market-based instruments.
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