Our Interview with Robert Shiller September 9, 2008 Robert J. Shiller is the Arthur M. Okun Professor of Economics at Yale University, and Professor of Finance and Fellow at the International Center for Finance, Yale School of Management. He has written on financial markets, financial innovation, behavioral economics, macroeconomics, real estate, statistical methods, and on public attitudes, opinions, and moral judgments regarding markets. He is the co-originator of the S&P Case Shiller Home Price Index, the leading index of home price values. His most recent book, The Subprime Solution, is available through the link above. In your book, you note that you are often asked for economic forecasts, but rarely asked the following question: What should be done to solve the fundamental problems highlighted by the subprime crisis, and how can we set up new or reformed institutions that might help insulate our society against the fundamental problems that underlie the crisis? Your book is devoted to answering this question, but perhaps you can discuss a few of your recommend changes those that you consider most important. The subprime crisis is the result of a bubble and of the failure to manage the risks of that bubble. The best way to improve our ability to manage those risks is to develop better markets and better financial information systems, and to improve the capabilities of retail banking institutions. I have a distinctive take on the problem. Many people are unsympathetic to financial markets. But I believe they represent the opportunity to avoid crises like this in the future. Risk management must be more thorough and people must be able to better understand the markets. If I must assign priorities to potential solutions based on the urgency of the crisis, then we will be talking about bailouts, of which I am less enthusiastic. But, if we look at the long term threats posed by this crisis, then the root problem was a failure to manage risk. This crisis might have been prevented by good financial advice. I would like to see financial advisors better positioned to provide advice to lower income people.
Currently, the wealthy are well-served by advisors. The internet is improving our access to knowledge, but people need personal attention when it comes to complex financial decisions. With better financial advice, consumers would have been able to avoid dangerous subprime mortgages. There might still have been a bubble, but it would have been less severe. Part of the problem is that uneducated consumers took on products they couldn t afford or understand Advisors would have mitigated the severity of this. You say that the response today has been totally inadequate to the subprime crisis. What would you have done differently, at least in the early stages of the crisis? In the early stages, say in 2005, I would have liked to see action from the monetary authorities. They should have had more concern for the emerging housing bubble. They didn t see it, and they kept real interest rates at a negative level in midst of the housing boom. They should have spoken out against it and tightened policy to raise interest rates. On top of that, the bailout of low income borrowers should have been bigger. It took a year to get the FHASecure bailouts enacted to help foreclosed homeowners. But it is still not enough. It amounts to less than 2% of the single-family guaranty book of business of Fannie Mae. You state that bailouts should focus most intensely on preventing distress among people of modest means. Along these lines, did you support the bailout of Bear Stearns? Yes, because we were facing the risk of a systemic crisis. It is within the purview of the authority of the Federal Reserve Bank. The Fed was created in 1913 in response to the banking crisis of 1907. There is a history of providing credit at the right time. Bear Stearns was not a bank, but going bank to 1930s, Congress gave the Fed authority under unusual and exigent circumstances to take these kinds of actions. Bernanke had necessary authority and was right to do what he did.
One of your most challenging (and somewhat paradoxical) insights is that it is not in the public s interest to keep housing prices high. Can you explain why this is so? There is a tendency to think high housing prices are a good thing. But that is true only for shortsighted people. Most people are, or should be, concerned with their children, grandchildren, and future generations, and their ability to afford a nice house. You may own an expensive home today, but more broadly, for society, it is unnecessarily expensive. If we can bring housing prices down, you will still have the same house, and future generations will benefit. On the subject of high housing prices, the Case Shiller index shows a drop in of approximately 20% since the market peak in 2007. However, prices on private label mortgage securities have dropped 40%-50%. Is there a possibility that the index is understating the erosion in prices, perhaps because so many houses are not selling at their listed prices? This a difficult question to answer. The secondary mortgage market is highly complex, with so many securities with multiple tranches. Part of the reason for low prices in the secondary market may be liquidity-related, or it may be due securities being dumped by institutions faced with high leverage. I can t be very precise. A lot of people are saying - and I don t doubt this - that prices have overreacted and there are now buying opportunities. That is plausible based on behavioral finance, and on the existence of a systemic crisis, and that may create buying opportunities. The mortgage market is a complex business and beyond anyone that is not a serious analyst. One of your recommendations for preventing future crises is the implementation and/or expansion of liquid markets to allow trading in securities linked to housing prices. However, such markets existed prior to the dot-com bubble, but did little to prevent it. How do you explain this? I am not saying these markets will stop all bubbles. Derivative markets for housing are important because housing is imperfect and illiquid. Derivative markets will allow the development of new products, such as continuous-workout mortgages and home equity insurance, which I discuss in my book. We don t have liquid markets for housing. We will get there eventually, and they may take different forms, for example involving swaps or forward contracts.
The situation we were in, leading to the subprime crisis, was that ordinary people were in highly leveraged and concentrated, undiversified investments. These investments took a bad turn and now they and the rest of us are suffering. You say that the aftermath of the subprime crisis has involved considerable fingerpointing, yet your book has a very limited discussion of the role of the ratings agencies in the crisis. It seems the ratings agencies were the institutions with the purest degree of culpability they simply failed to do their job. How would you reform them? Think of it as another manifestation of the same problem: nobody thought home prices could fall. It is hard to fathom in retrospect. I know this because I asked high ranking officials whether they thought home prices could decline. They denied it could happen, because it had never happened before. I said it did happen in the Depression, and their reaction was that we will never see another Depression. If you live in that environment, there is nothing wrong. Ratings companies based their analysis on recent loss estimates. One has to use intuitive judgment when rating risk. You can t rely only on historical data. It takes courage to overrule quantitative analysis with intuitive judgment, and it is hard to see an institution, such as the ratings agencies, doing that. Incidentally, the role of financial advisors is to do exactly this. They need to use their intuitive judgment to take into account history and the role of the markets. Advisors have a much broader function than the role of a ratings agency. You discuss the possibility that the oil markets have been in a bubble. Do you still see that happening? The oil bubble has burst. Paul Krugman [who writes for The New York Times] thinks there wasn t a bubble. We saw volatility in the oil markets just like the housing market. Oil was driven by the same kind of speculative thinking.
You comment that we are running a bullet train on an ancient track, in regard to the ability of our current systems to deal with these sorts of crises. Do you see either of the Presidential candidates as more likely to carry out the programs you advocate? I am not endorsing either candidate. I like them both. I don t think either candidate has expressed a vision along the lines I advocate. Hopefully one will. It is not their fault, but the fault of the way our election campaign operates. It is difficult to express creative new ideas in a campaign. You are talking to the broad public, and everything has to be carefully vetted. Roosevelt did not propose the details of the programs he enacted in the New Deal while he was campaigning. Hopefully the next President will be forthright and innovative. We are set up for it. The next President will enter office at a time of crisis and will have the opportunity to make some important decisions. Thank you very much. www.advisorperspectives.com For a free subscription to the Advisor Perspectives newsletter, visit: http://www.advisorperspectives.com/subscribers/subscribe.php