Eight years ago, when he predicted a looming bust in the stock-market bubble in Irrational Exuberance, his bestselling book, Barron's magazine called Yale economist Robert Shiller "the new Dr. Doom." The nickname still applies as Shiller muses that the steep slide in housing prices—with the collateral damage on Wall Street—could end up exceeding that of the Great Depression.
Since blurting out his scary scenario last week at the New Haven Lawn Club—in a speech that prompted gloomy headlines around the country—the professor has been trying to sooth shattered nerves (including those of his business partners, who are trying to get the Securities and Exchange Commission to sign off on a new financial instrument to join Shiller's two-year-old housing futures on the Chicago Mercantile Exchange).
The 62-year-old Shiller has been an academic superstar for years, largely because of the Standard & Poor's/Case-Shiller home price indexes, which he developed with Wellesley College economist Karl Case as the nation's most authoritative source on housing price trends. But when Portfolio.com caught up with him in Manhattan for an exclusive interview last week, Shiller was chastened and cautious, noting that he better not make any more predictions during the S.E.C.'s required "quiet period" before the registration of the new instrument.
"I don't even really remember what I said exactly," he protested. "I always think the opposite of people around me," he added. "That's sort of an oppositional personality."
Lloyd Grove: How did you get into this line of work?
Robert Shiller: You mean property derivatives?
L.G: No, I mean how did you become interested in economics and being a market theorist?
R.S.: Well, I think I'm a polymath. I'm interested in everything. When I was a senior in college at the University of Michigan, I was dazzled by the choice set that we had. Young people, you can do whatever you want, and I was disappointed that I had to choose one, realistically. You like to be a renaissance man and do everything. I took long walks trying to decide whether I wanted to be a physicist or a medical doctor or a sociologist, whatever-a scientist, an astronomer.
L.G.: Did you grow up in Michigan?
R.S.: I grew up in Michigan. My father was an engineer in Detroit, and we moved to the suburbs, Southfield, when I was 13. Actually, I'm a product of the auto industry in the important sense that in 1914, Henry Ford—I don't know if you know this history—he announced that he was paying $5 a day for assembly-line workers, which was twice the going rate. This was a very bizarre thing for him to do, and it got a deluge of applicants. So one of my grandparents was living in Gardner, Massachusetts, working in a stove shop, and my other grandfather was a tailor, operating in Chicago. And they both responded and came to the same River Rouge plant, and both took the jobs. If they hadn't converged in Detroit, my parents never would have met, and I would not exist. So it turns out that Henry Ford—it was really kind of a dumb thing—is responsible for my being here. He was a little bit of a loose cannon, but he was saved by inflation. Because World War I came right after that, and he never had to cut back. Otherwise, he couldn't have afforded to pay those salaries, as my understanding of history goes.
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L.G.: Right, and $5 a day—that's big money.
R.S.: It was twice what my grandfather was making in Gardner, selling stoves. So the auto industry has always been in our family, except my father worked for an industrial-oven company that sold ovens that did things like bake the paint enamel on the car body.
L.G.: Is there any hope for the American auto industry?
R.S.: Maybe in the long run, they will prevail. I know they're having hard times now. And they're a manufacturing industry, and they did have a labor-cost disadvantage as compared with other countries. That may not be insurmountable. But in the long run, in these other countries, I'm hopeful that their wage costs will go up too. So maybe American ingenuity will prevail in the end.
L.G.: You were among the first people who were warning about a crash in the housing market.
R.S.: Right. In 2003, I published a Brookings [Institution] paper with Case, which was titled with the question "Is There a Bubble in the Housing Market?" [in Brookings Papers on Economic Activity 2: 2003]. He's the same guy who worked with me on the Case-Shiller indexes. We had been doing a survey on home buyers, to try to assess their attitudes. In 2003, we noted in our paper that people had very high expectations for future home-price appreciation. We thought then that it might help explain the boom that was emerging. If people were having high expectations, then maybe they're willing to pay more for houses. But we didn't reach a conclusion-well, it was all carefully worded back then. We thought that there might be a bubble.
L.G.: Back in 1996, at a lunch meeting with Alan Greenspan, you warned about a stock-market bubble. And then a few days later, he used the words "irrational exuberance," which became the title of a book of yours. By 2005, you were already sounding the alarm about housing.
R.S.: Right. You can see that in the book Irrational Exuberance, in the second edition, in 2005, I raised the possibility of there being a major crisis.
L.G.: And that was ahead of a lot of people, obviously.
R.S.: It was.
L.G.: So then you had meetings with various quasi-government entities—Freddie Mac and Fannie Mae. What did you tell them?
R.S.: That they should be hedging their portfolio risks for the possibility of a decline in home prices. We just never really got their attention. We told them they had a portfolio that was heavily exposed to real estate risk and that it would be sensible for them to take hedging positions that would offset that risk, especially given their public G.S.E. [government-sponsored enterprise] status. The government officially disavows any guarantee to Fannie and Freddie. However, their debt tends to have a lower yield than other corporates. And people believe that they will be bailed out if there's ever a problem. So we were arguing that they have an obligation to the public to manage their risks.
L.G.: And their reaction was to listen politely?
R.S.: Yeah, that's what happens all the time. We'd talked to insurance companies 15 years earlier about home-equity insurance. And sometimes it's a little bit more than polite listening-they actually sounded enthusiastic at the meeting. So we told insurance companies, "You have homeowners' insurance, insurance against fire. So what if you expanded that to cover and insure against losses on the home? Wouldn't that expand your business a lot?" Actually what they typically said—I think it's mainly what Fannie and Freddie said—is, "Well, there isn't an established market for home-price risk. So we couldn't hedge the risk." And I suppose that's also what Fannie and Freddie thought, that they have a portfolio measured in billions, and we're just talking very hypothetically because we didn't have any market price, and we didn't have any obvious ability to make a risk-management contract of any size. So it came across to them as just a pipe dream. And I suppose that's just the general thing.
L.G.: Were you visiting them in your capacity as a company?
R.S.: Yes, our company, Case-Shiller Weiss, was publishing indexes, and we were advocating for risk management.
L.G.: And some of the people who met with you said that they've been doing their own due diligence. Tell me about that.
R.S.: I had a conference at Yale, and it was Frank Nothaft [the chief economist of Freddie Mac] who told about the risk management. And this is actually in my book that's coming out-I'm scooping my book here.
L.G.: Well, we'll flog your book and make sure people know it's coming out in two months.
R.S.: That would be good.
L.G.: Princeton University Press—what's the title of it?
R.S.: The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About It.
L.G.: Consider it flogged.
R.S.: Flogged? What does that word mean?
L.G.: I guess flogged is what happens in Singapore if you spit on the sidewalk. So, okay, go ahead and scoop your book some more.
R.S.: I have a publicity manager, and he said I shouldn't talk too much about it.
L.G.: Okay, but why don't you tell me that story at least.
R.S.: Well, that story was that Frank Nothaft claimed that they had considered price declines as much as 13.5 percent. And I said, "What if it was worse than that?" And he said, "It's never been worse than that." And then he corrected himself. "Except for the Depression." I don't remember exactly what I said to that, but plausibly it was something like, "Well, that could happen again too." So again, I started to sound at that point too academic-something like this isn't real anymore.
L.G.: Why do you think people just have trouble listening to these things?
R.S.: Well, I can talk as a sociologist—which I'm not trained to do—but there's a social construction of reality that happens. This is a basic principle of sociology. We have a "collective consciousness," to quote sociologist Maurice Halbwachs. As far as I know, he coined the term. And the point is, we talk so much. The human species is incessantly talking, and this incessant talk reinforces certain memories and facts. And other facts are not reinforced because no one's talking about them. So they elude our consciousness, and then we can't remember them. We can't act on them anymore, and so a certain sort of reality-construct forms. It's also informed by some kind of intuitive thinking. In the case of real estate, people think that the growing population is inevitable, and that means home-price increases are inevitable. And these are not economists thinking clearly about what that means. An economist who thinks about that would say, "Yes, but that doesn't make them a good investment." If everything is priced at the present value of the cash flow with the same interest rate, then it doesn't matter whether the cash flow is growing or not, and then everything is equally good as an investment. That's not something that the general public understands.
L.G.: The people who were getting into subprime mortgage-backed securities presumably understood all this. They're very sophisticated people. So what was driving them?
R.S.: Some of them were very sophisticated people [laughs], and there was a failure to communicate and a failure to put all this information together and act on it in a systematic way. There's a famous book written by Irving Janis, who's a psychologist, about 30 years ago, called Groupthink. He's a social psychologist, and he points out how even expert groups can make very colossal errors. He did a number of case studies in the book, and what tends to happen—suppose you imagine yourself and a group of experts who seem to have converged on an enlightened opinion which has arguments to support it, and it has prominent influential people saying that. It can be difficult for someone to stand up in that room and air what seem to be half-baked or half-formed doubts about it. It can be kind of damaging to your reputation. And you imagine that they have a reason to dismiss these doubts. But you don't want to be responsible for bringing it up—especially when they're reaching a decision. Sometimes they're trying to make an important decision. And at that time, you would think that people who have doubts should stand up and thrust them to the fore. But, in fact, they often retreat at that point, because they may just have a sense that they're being annoying, that they will lose status in the group. If we're close to a decision on something, and I'd raise doubts, and they're going to go ahead anyway and do it, you might think that's good—because it could be a disaster, and they'll remember that you had doubts. But the likelihood is to focus on, instead, "Now I'm kind of the party pooper," you know. "When they're going to implement this plan, they're not going to turn to me because I was the guy who doubted." Things like that went through peoples' minds, and they don't air doubts. And when Janis interviewed people afterward and asked them their memories of the discussion, they would say things like, "I think we had a very open and fair discussion, and everyone raised their views." That was their memory of what happened, but they couldn't remember the other arguments. So it wasn't happening—there was somebody who was expressing doubts, but not effectively. And so I think that's the kind of thing that happens when there's just a general presumption which becomes repeated everywhere.
L.G.: And do you think that's the sort of dynamic that might've been operating, not only in quasi-government agencies like Fannie Mae and Freddie Mac, but also in the banks on Wall Street?
R.S.: Yeah, I mean, it became the idea that risk was just not there.
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