Robert Schiller On Why Economists Miss Economic Bubbles

Robert Schiller just published an interesting article in the NY Timers on why human beings, and especially top economists miss diagnosing a market bubble until it is too late. The answer shouldn't surprise anyone.

In 1999, Robert Schilller argued that tech stocks were selling far ahead of any rational valuation.  He diagnosed the tech bubble.  His book on the subject, Irrational Exuberance, became a classic.  In the late 2000s he often wrote on the dangers of inflated housing prices.  Along with a fellow economist, Carl Case, he went on to found the Case/Schiller housing index, which is considered one of the more reliable methodologies for tracking housing prices.

He just wrote an interesting article in the NY Times which asks why so many economists, Alan Greenspan included, missed the housing bubble.  As late as last summer, many economists thought the economy was fine and that housing prices would begin to recover. 

He provides two answers to this question:

1. Economists tend to be rational and mathematically oriented.  They have trouble imagining that people would act irrationally and display the kind of behavior that leads to the creation and perpetuation of bubbles.  In other words, they believe that in a system of rational actors, a bubble can;t appear because rational buyers and sellers wouldn't allow it to form.

He states:

"It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing."

That may be so but it doesn't seem like a persuasive reason.  Surely, economists saw the rise of the tech bubble just a few years earlier and were able to adjust their own worldview.  It doesn't take a PhD to see that irrational decisions are made all of the time.

2. The second reason is a bit more persuasive.  Groupthink.  Or in Schiller's words:

"The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group."

A smart economists is not the same as a courageous one.  Many knew the truth but were unwilling or afraid to speak about it.  When things are going good, you become labeled a pessimist or a troublemaker.

This is the problem with listening to "experts."  Very few have the personal courage to call it like it is.  Often, economists and other experts hedge their predictions and issue wishy-washy forecasts.  The same is true for stock analysts.  They would rather perform like their peers than be courageous and go against the grain.

 What does it mean for you?  It means your hunches and insight are every bit as valid as the best economists.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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  • Richard Segal

    January 31, 2010

    Shiller may be a Yale economist and everything, but when I see him on CNBC he looks like a bumbling idiot. His big thing is supposed to be real estate, but he refuses to take a position on whether it is going up or down or even going to remain stable this year.

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