Irrational Exuberance

Revised and Expanded Third Edition

Robert J. Shiller

• Publisher: Princeton University Press
• Year: 2015
• ISBN:
  9781400865536
• Edition: 3
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Why the irrational exuberance of investors hasn't disappeared since the financial crisis In this revised, updated, and expanded edition of his New York Times bestseller, Nobel Prize–winning economist Robert Shiller, who warned of both the tech and housing bubbles, cautions that signs of irrational exuberance among investors have only increased since the 2008–9 financial crisis. With high stock and bond prices and the rising cost of housing, the post-subprime boom may well turn out to be another illustration of Shiller's influential argument that psychologically driven volatility is an inherent characteristic of all asset markets. In other words, Irrational Exuberance is as relevant as ever. Previous editions covered the stock and housing markets—and famously predicted their crashes. This edition expands its coverage to include the bond market, so that the book now addresses all of the major investment markets. It also includes updated data throughout, as well as Shiller's 2013 Nobel Prize lecture, which places the book in broader context. In addition to diagnosing the causes of asset bubbles, Irrational Exuberance recommends urgent policy changes to lessen their likelihood and severity—and suggests ways that individuals can decrease their risk before the next bubble bursts. No one whose future depends on a retirement account, a house, or other investments can afford not to read this book.

Part One

Structural Factors

Four

Precipitating Factors: The Internet, the Capitalist Explosion, and Other Events

What ultimately caused the values of the stock markets in so many countries to rise dramatically from 1982 to the remarkable peak around 2000? Why, after two major corrections, are the values of these markets returning again at the time of this writing to those elevated levels? What accounts for the long downtrend in real long-term interest rates in many countries over the past couple of decades? What ultimately caused the boom in real estate markets in so many cities around the world to follow the stock market boom? To answer these questions, and questions like them that will surely be generated in the future, it is not enough to say that the markets in general are vulnerable to bouts of irrational exuberance. We must specify what precipitating factors from outside the markets themselves caused the markets to behave so dramatically.

Most historical events, from wars to revolutions, do not have simple causes. When these events move in extreme directions, it is usually because of a confluence of factors, none of which is by itself large enough to explain these events.

Rome wasn’t built in a day, nor was it destroyed by one sudden bolt of bad fortune. More likely, it owed its fall to a plurality of factors—some large and some small, some remote and some immediate—that conspired together. This ambiguity is unsatisfying to those of us seeking scientific certitude, especially given that it is so hard to identify and isolate the precipitating factors to begin with. But that is the nature of history, and such ambiguity justifies the constant search for new and better information to expose at least the overall contours of causation.

In Chapter 1, we saw some factors that have seemed, at certain times, to “explain” movements in the stock market, notably, long-term interest rates; these might help explain home prices as well. But one of the first lessons of economics should be that there are many factors that seem sometimes to “explain” speculative prices, too many for us to analyze them comfortably. We have to resist the temptation to oversimplify by singling out only one. Anyway, long-term interest rates are not really exogenous factors. They are market phenomena determined by many of the same supply and demand factors that determine the level of prices in the stock market, and their behavior is part of the same market psychology that drives the stock market. We have to try to understand the origins of market psychology itself.

Understanding the factors that precipitate market moves is doubly difficult because the timing of the major market events tends not to be lined up well with the timing of the precipitating factors. The precipitating factors often tend to be medium-term trends that catch the public’s attention only after they have been in place for a long time. The timing of specific market events is, as we shall discuss in the next chapter, directly determined by people’s reactions to the market and to one another, which impart to the market complex internal dynamics. But we must look at the precipitating factors if we are to understand why the market moves.

Those who predict avalanches look at snowfall patterns and temperature patterns over long periods of time before an actual avalanche event, even though they know that there may be no sudden change in these patterns at the time of an avalanche. It may never be possible to say why an actual avalanche occurred at the precise moment that it did. It is the same with the dramatic movements of stock markets and other speculative markets.

Recognizing these limitations, let us look at a list of factors that might be offered to help explain the increase in the value over the past twenty years of worldwide stock prices—and in some cases, of bond and real estate prices as well—as an exercise to help us understand what the future may hold.

These factors make up the skin of the bubble, if you will. I concentrate here mostly on factors that have had an effect on the markets not warranted by rational analysis of economic fundamentals. The list omits consideration of all the small variations in fundamental factors (for example, the growth in earnings, the change in real interest rates) that should rationally have an impact on financial markets. In more normal times or in markets for individual stocks, such rational factors would assume relatively greater prominence in any discussion of changes in prices. Indeed it is thanks to a market’s ability to respond appropriately to such factors, for a variety of investments, that well-functioning financial markets generally promote, rather than hinder, economic efficiency.¹ The list of factors here was constructed specifically to help us understand the extraordinary situations that have occurred recently (and, arguably, are ongoing) in the stock markets and the housing markets, and so it concentrates on less rational influences.

In detailing these factors, I describe the reaction of the general public, not just of professional investment managers. Some observers believe that professional investment managers are more sensible and work to offset the irrational exuberance of the nonprofessional investing public. Therefore, these observers might argue that a sharp distinction should be drawn between the behavior of the professionals and that of the nonprofessionals.² Professional investors, however, are not immune to the effects of the popular investing culture that we observe in individual investors, and many of the factors described here no doubt influence their thinking as well. There is in fact no clear distinction between professional institutional investors and individual investors, since the professionals routinely give advice to the individual investors.

Some of these factors exist in the background of the market, including the advance of capitalism, the increased emphasis on business success, the revolution in information technology, the demographics of the Baby Boom, the decline of inflation and the economics of money illusion, and the rise of gambling and pleasure in risk taking in general. Others operate in the fore-ground and shape the changing culture of investment. These include greatly increased media coverage of business, the aggressively optimistic forecasts of stock analysts, the rise of 401(k) plans, the mutual funds explosion, and the expanding volume of trade in the stock market.

Twelve Precipitating Factors That Propelled the Late Stages of the Millennium Boom, 1982–2000

In the first edition of this book, published in 2000—just before the stock market peak of that year—I listed twelve precipitating factors for the build-up of bullish psychology and of stock prices to enormous levels by the beginning of the year. Here is the list as it was presented then, from the point of view of the zeitgeist of that time; some of these factors are still operative today, others less so.

The Arrival of the Internet at a Time of Solid Earnings Growth

The Internet and the World Wide Web invaded our homes during the second half of the 1990s, making us intimately conscious of the pace of technological change. The World Wide Web first appeared in the news in November 1993. The Mosaic web browser first became available to the public in February 1994. These dates mark the very beginning of the general public’s exposure to the Internet, when only a few people had access to it. Significantly large numbers of users did not discover the web until 1997 and later, marking the very years when the NASDAQ stock price index (which was then even more heavily weighted toward startup high-tech stocks than it is today) soared, tripling to the end of 1999, and the price-earnings ratios took off into unprecedented territory.

Internet technology is unusual in that it is a source of entertainment and preoccupation for us all, indeed for the whole family. In this sense, it is comparable in importance to the personal computer or, before that, to television. In fact, the impression it conveys of a changed future is even more vivid than that produced when televisions or personal computers entered the home. Using the Internet gives people a sense of mastery of the world. They can electronically roam the world and accomplish tasks that would have been impossible before. They can even put up a website and become a factor in the world economy themselves. In contrast, the advent of television made them passive receivers of entertainment, and personal computers were used by most people before the Internet mainly as typewriters and high-tech pinball machines.

Because of the vivid and immediate personal impression the Internet makes, people find it plausible to assume that it also has great economic importance. It is much easier to imagine the consequences of advances in this technology than the consequences of, say, improved shipbuilding technology or new developments in materials science. Most of us simply do not hear much about research in those areas.

Spectacular U.S. corporate earnings growth in 1994, up 36% in real terms as measured by the S&P Composite real earnings, followed by real earnings growth of 8% in 1995 and 10% in 1996, coincided roughly with the Internet’s birth but in fact had little to do with the Internet. Instead the earnings growth was attributed by analysts to a continuation of the slow recovery from the 1990–91 recession, coupled with a weak dollar and strong foreign demand for U.S. capital and technology exports, as well as with cost-cutting initiatives by U.S. companies. It could not have been the Internet that caused the growth in profits: the fledgling Internet companies were not making much of a profit yet. But the occurrence of profit growth coincident with the appearance of a new technology as dramatic as the Internet created an impression among the general public that the two events were somehow connected. Publicity linking these twin factors, the Internet boom and the profit growth, was especially strong because of the advent of the year 2000 and the new millennium, a time of much optimistic discussion of the future.

The Internet is, of course, an important technological advance in its own right, and it, as well as other developments in computer technology and robotics, does promise to have an unpredictable and powerful impact on our future. But one should question what impact the Internet and the computer revolution should have on the valuation of existing U.S. corporations. New technology will always affect the market, but should it really raise the value of existing companies, given that those existing companies do not have a monopoly on the new technology?³ Should the advent of the Internet have raised the valuation of the Dow—which at the time contained no Internet stocks?⁴

The notion that existing companies would benefit from the Internet revolution was belied by the stories of E*Trade.com, Amazon.com, and other upstarts, which did not even exist just a few years before 2000. People might well have thought that still more new companies would appear in the future, in the United States and abroad, and these would compete with the companies in which they invested in the late 1990s. Simply put, the effect of new technology on existing companies can go either way: it can boost or depress their profits.

What matters for a stock market boom is not, however, the reality of the Internet revolution, which is hard to quantify, but rather the public impressions that the revolution has created. Public reaction is influenced by the intuitive plausibility of Internet lore, and this plausibility is ultimately influenced by the ease with which examples or arguments come to mind. If we are regularly spending time on the Internet, then these examples will come to mind very easily.

Triumphalism and the Decline of Foreign Economic Rivals

In the late 1990s, before the 2000 peak in the stock markets, most other countries seemed to be imitating the Western economic system. Communist China has been embracing market forces since the late 1970s. Increasing tolerance of free markets in the Soviet Union culminated with the breakup of that nation in 1991 into smaller, market-oriented states. The world seemed to be swinging our way, and therefore it started to seem only natural that the U.S. stock market should be most highly valued in the world.

These political events unfolded gradually after the bull market began in 1982. And the years after the start of the bull market witnessed the decline in the Japanese market after 1989, the prolonged economic slump in Japan, and the Asian financial crisis of 1997–98, which coincided roughly with the dramatic burst of the U.S. stock market into uncharted territory at the beginning of the new millennium. These foreign events might have been viewed as bad for the U.S. stock market—as the harbinger of bad things to come here—but instead they were seen by many as the weakening of major rivals. The relation between the United States and its economic rivals was often described in the media as a competition in which there can only be one winner, as in a sports event. The weakening of a rival was thus viewed simplistically as good news.

Cultural and Political Changes Favoring Business Success

The soaring of the stock market during 1982–2000 was accompanied by a significant rise in materialistic values. A Roper-Starch questionnaire given to survey participants in both 1975 and 1994 asked, “When you think of the good life—the life you’d like to have, which of the things on this list, if any, are part of that good life, as far as you personally are concerned?” In 1975, 38% picked the option “a lot of money,” whereas in 1994, fully 63% picked that option.⁵

Such feelings transformed our culture into one that reveres the successful businessperson as much as or even more than the accomplished scientist, artist, or revolutionary. The idea that investing in stocks is a road to quick riches developed a certain appeal to born-again materialists.

Stay-at-home mothers, who devote their lives to their families, become less admired, and this is part of the reason women joined the work force in increasing numbers. This then also increased the availability of credit and home financing—starting around the 1970s, mortgage lenders began to count the spouse’s income in qualifying a mortgage, expanding available mortgage credit. This helped propel home prices.

A decline in crime rates also, on the flip side, encouraged materialistic values by making people feel more secure, less worried that they would be robbed or physically harmed. In the United States, the rate of property crimes per 1,000 people fell 49% between 1993 and 2003, and the rate of violent crimes per 1,000 people fell 55%.⁶ One could then more comfortably flaunt wealth, and so wealth became more attractive. Living in an ostentatious home was now more appealing. Fear of terrorism increased, but terrorists did not seem to strike wealthy people preferentially, and generally not in their homes. The declining crime rates in the U.S. made a capitalist lifestyle seem a better model for the entire world.

Note that materialistic values do not by themselves have any logical bearing on the level of the stock market. Whether or not people are materialistic, it is still reasonable to expect them to save for the future and to seek out the be...