The arrival this week of Robert Shiller’s revised edition of his wonderful book [amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] was timely, because it came in the wake of Aditya Chakrabortty’s radio programme about the teaching of economics. One of the the bizarre claims made in the programme is that mainstream economics is fixated on rational choice models. Shiller’s work on finance, for which he received the Nobel Prize of course, serves as Exhibit One in showing this claim to be incorrect. (Tony Yates blogged about this and other issues with the programme.)
[amazon_image id=”0691166269″ link=”true” target=”_blank” size=”medium” ]Irrational Exuberance[/amazon_image]
The new preface to [amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] begins: “One might think that years after the bursting of the speculative bubbles that led to the 2007-9 world financial crisis, we should be living in a distinctly different post-bubble world. One might think that people had learned their lesson, and would not again pile into expanding markets.” But no. Although the situation isn’t as fragile now as in 2000 (ahead of the 1st edition) or 2005 (2nd edition), Prof Shiller clearly thinks there is renewed potential for a crash somewhere. The bond market is clearly a leading candidate. One substantial addition to the book is a chapter on the bond market, which he believes has a high probability of currently being in a bubble, vulnerable to bursting. But it isn’t just bond markets that could be bubbly, but also equities: the ratio of real share prices divided by the ten-year average of real earnings in the US is higher than it has been at any time except 1929, 2000 and 2007.
Interestingly, the book suggests that the psychology of bubbles is not one of firm belief that a crash cannot happen, but rather one of inattention to evidence that it might or will do. This is in line with work Paul Seabright at the Toulouse School of Economics has beein doing on attention – or its lack. A second kind of addition to this 3rd edition is the integration of Shiller’s thinking on psychology since his book [amazon_link id=”069114592X” target=”_blank” ]Animal Spirits[/amazon_link] co-authored with George Akerlof. Akerlof has continued to work on this too, including his very interesting work with Rachel Kranton on the role of identity in economic choices, in [amazon_link id=”0691146489″ target=”_blank” ]Identity Economics[/amazon_link].
[amazon_image id=”069114592X” link=”true” target=”_blank” size=”medium” ]Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism[/amazon_image] [amazon_image id=”0691146489″ link=”true” target=”_blank” size=”medium” ]Identity Economics: How Our Identities Shape Our Work, Wages, and Well-Being[/amazon_image]
[amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] is a classic and it is essential reading on economics and financial markets; for anyone who hasn’t yet read it, this 3rd edition brings the contextual information up to date and expands on the psychological insight of the original. I should add, Robert Shiller is the most prominent exemplar of economists using decision assumptions and frameworks other than ‘rational choice’ but he has plenty of company in the profession – in fact, it’s pretty mainstream nowadays.
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“One might think that people had learned their lesson, and would not again pile into expanding markets.” I think that what is going on this time in the stock market is quite different. Executives are giving themselves options, and they are using earnings and debt to do large-scale share buybacks, thus driving share prices ever higher. They then exercise their options and thereby greatly enrich themselves. Compare this to the the irrational exuberance that occurred in the 1990s: options were used then as now, but share prices were driven to unprecedented values by a widespread mania that prices could only continue to go up. The same attitude held in the housing bubble. Today, executives who are doing share buybacks have no illusions about what is going on: they are burdening the corporations they run with immense debt; they are sacrificing future growth by investing little in these businesses; and they are creating much of the earnings growth used to finance that debt by means of costs cuttings–significantly, of employees–and they are knowingly doing these things for the short-term benefit of themselves–and of course for the short-term benefit of other shareholders.
Nonetheless, having read Shiller’s “Irrational Exuberance” when he first published it, I look forward to reading the latest edition.
Thank you for the blog. It’s one of my very favorites.
Thank you!