Leave it to Greenspan

by Susan Webber

Yale economist Robert Shiller obviously knows a stock-market bubble when he sees one. He just doesn't know what to do about it.

The German poet Friedrich Schiller wrote, "Anyone taken as an individual is tolerably sensible and reasonable - as a member of a crowd, he at once becomes a blockhead." The economist Robert Shiller would agree, except for the part about individuals.

Shiller, in his Irrational Exuberance, depicts the stock market boom of the 1990s as a speculative bubble. The mid-April Nasdaq massacre, less than a month after the book's release, vividly supported his views.

Irrational Exuberance is an important work: thoughtful, thorough, articulate. What differentiates it from other studies of market excesses is its delineation of the behavioral factors that drive investment decisions Shiller notes that, "Much of the human thinking that results in action is not quantitative, but is based on storytelling and justification," lending itself to manipulation and false inferences.

The best section is on "new era" thinking, Here Shiller mines articles written in earlier booms and finds uncanny parallels between then and now: unbridled enthusiasm for technology, confidence in new tools to manage the economy, optimism about continued international tranquillity. Just as telling are changes in perception. For example, in the 1960s, inflation was considered a plus for stock prices.

Shiller also has an intriguing chapter on "naturally occurring Ponzi processes", which is how investor confidence and high expectations feed on themselves, leading to higher prices, which reinforce positive sentiment, and produce yet more price rises. A bull market thus makes momentum investors of us all.

Despite its merits, Irrational Exuberance falls short of being a great book. First, Shiller does not make an integrated argument, but instead presents a series of supporting factors, relying on the reader to integrate them.

Second, Shiller devotes much of the book to the discussion of market psychology, which though intriguing, is not his strong suit. A member of a small group of "behavioral economists", Shiller is still first and foremost and economist, and the psychological analysis often stays at the anecdotal level.

Third, he sometimes wastes his firepower on tertiary issues. For example, he maintains based on his own survey, that news did not contribute to the 1987 crash and unconvincingly disputes the findings of the far more extensively researched Brady Commission report. Similarly, he claims, "There is no distinction between professional institutional investors and individual investors, since the professionals routinely give advice to the individuals." But aren't day traders a breed apart? In some respects, professional investors are more subject to herd behavior than individuals.

Finally, the chapter on policy implications finesses the tough questions, namely whether this bubble is likely to end badly and should the authorities (namely Federal Reserve chairman Alan Greenspan) have intervened.

Shilller's recommendations are often unrealistic. For example, he suggests having the public gradually save more as one way to escape a disruptive price drop. However, other economists believe that an increase in savings could well trigger a recession.

Shiller also advocates creating new markets to allow for greater diversification of risk. He suggests, for example, trading long-term claims on the incomes of specific occupational groups. Yet without enough natural buyers and sellers, a new instrument will languish. Milton Friedman promoted the idea of contracts based on the Consumer Price Index, which, when finally launched, were a dud. More obvious exchanges, such as those for pollution emission rights, trade only once a month.

The real issue is whether Greenspan should or could have taken action. A May 8 Wall Street Journal article depicts him as almost obsessed with stock prices, first thinking they were too high, then believing them justified by productivity growth, and recently considering whether inflated asset prices might overheat the economy.

Shiller argues that jawboning and interest rate policy have had mixed results in curbing torrid markets. Perhaps, but Greenspan's views appear to have considerable sway, and he certainly believes that interest rate policy influences market prices.

Greenspan's real problem is his need to be liked. One of the Fed's important jobs is removing the punch bowl when things get too boisterous. Greenspan, if anything, is spiking the brew. He has been quick to cut interest rates in the face of sharp declines, as during the Long-Term Capital Management rescue, and has even talked the market up when weakness looked like a possible inflection point, as in September of last year.

Greenspan is not only eager to provide stimulus but also reluctant to apply the brakes. His caution in raising interest rates in 1999 and this year is to avoid a sharp correction. However, perpetuating a bubble makes it harder to engineer a happy ending. And the public, at least until April, appears conditioned to expect the Fed to intervene in markets declines, which leads to buying on dips and forestalls badly needed corrections. Finally, traders in the S&P pits claim that the Fed (called "the Turk") trades S&P futures to influence price levels. If true, the Fed has had a direct hand in the state of the market.

Shiller, who has been fortunate with his timing, may have decided against pressing his luck by taking Greenspan to task. Ironically, Greenspan may prove to have been as susceptible to popular influence as the average investor.