American Journal of Economics and Sociology, The: Irrational Exuberance. - Review

Shiller, Robert J. 2000. Irrational Exuberance. Princeton University Press. Princeton, NJ. ISBN 0 691 05062 7. Index.

In the author's words, this book is about "the enormous recent stock market boom. [This book] takes as its specific starting point the current situation, it places that situation in the context of stock market booms generally, and it makes concrete suggestions regarding policy changes that should be initiated in response to this and other booms" (p. xi). According to Shiller we are looking directly in the face of an enormous "speculative bubble" and the question is not whether stock prices will fall but when!

I do not want to give the reader the impression that this is a polemical "airport" book, designed for a quick read by executives on the move who are trained not to think too deeply about the financial world and the way it works. It is nothing of the sort. Shiller has produced an excellent and at parts quite eloquent tract for our times. I learned a great deal from this book and ended up quite persuaded by its message.

The book is written to engage the tribe of fellow economists who often pride themselves as critical thinkers. To this end, Shiller draws liberally from the emerging field of "behavioral finance." These insights are nicely laid out in chapter 7. Financial markets are not always driven by animal-like frenzy that has come to be associated with John Law's famous bubble (see The American Journal of Economics and Sociology 57(October) frontispieces). Indeed, the psychology of the present-day boom is founded on much more subtle moorings. Here Shiller invokes the insights of Amos Tversky's and Daniel Kahneman's anchoring heuristic.

The anchoring heuristic for shareholders is the "most recently remembered price" (p. 137). During the October 19, 1987 crash of stock prices, the percentage fall in market capitalization was nearly the same as that which occurred during October 28-29, 1929 (p. 138). Apparently, past patterns can exert a psychological effect on the present. When the stock market investors were satisfied that the market collapse of 1987 rivaled in magnitude and direction the one in 1929, their confidence that the downturn had reached bottom was contagious and the revival occurred almost according to script.

Shiller has something to say about "magical thinking" and its impact on the stock market as well (p. 143). The aggregate intelligence of stock investors is not much better than the weekend gambling casino visitor. Some roulette experts "know" that if a certain number or color has not come up recently, it will come up soon, and bet accordingly. With the stock market the average "remembers" that it is destined to break the next impossible ceiling and, remarkably, does so. Shiller described the "essence" of his argument as follows, "it is irrational exuberance [that] is at work in producing the elevated stock levels we have seen recently" (p. 167).

The phrase "irrational exuberance" is identified with an important speech that Chairman (of the Federal Reserve Board) Alan Greenspan gave on December 5, 1996. It is not well known that it was none other than the author of this book (Professor Shiller) who invented this phrase and used it to brief Greenspan two days before Greenspan used it publicly. Greenspan learned his lessons well. One thing is quite clear--Shiller can see nothing in the way of fundamentals about the companies themselves or the economy as a whole that can justify these elevated stock prices. The combinations of capital goods represented by the companies just don't warrant such high priced assessments. Whatever goes up, especially on paper, can easily come down. The Shiller-Greenspan position must surely be that the reverse movement is coming sooner rather than later. It has been almost four years since Greenspan's speech and for much of this time he has pursued a "soft landing" for the economy.

Perhaps the modern investor believes as against Shiller that the old rules of the stock market do not really apply. It is so common to hear talk about the "new economy" and perhaps new economies come with ever-rising stock market prices. Shiller, like most professional economists, does not think that the "new economy" is all that new and that the principles by which bills are paid and wage contracts are satisfied are not much different for Bill Gates than they were for John D. Rockefeller. But there are some new regulations and institutional considerations that might explain the bullish trend that seems to go on forever. In Chapter 2, Shiller analyzes the "precipitating factors" that have prolonged the boom. They range from the new rules governing the defined pension benefit programs to the reluctance of many stock analysts to "bad mouth" the bull market for fear of jeopardizing the cash flow of the brokerage companies that hire them. Shiller points out that many of the analysts are hired by firms that under write securities (p. 30). Finally, and definitely "last but not least," Shiller reminds us that we live in an age of ferocious gambling and casino enterprise. According to Shiller, "in 1999 there were nearly 100 riverboat and dockside casinos and 260 casinos on Indian reservations . . . [and nearly] 125 million Americans gambled in 1998--a figure that represents most of the adult population" (p. 41). These factors and many others discussed in the book add up to what Shiller dubs "naturally occurring Ponzi processes" (p. 44). It will end as all roller coaster rides must, with an exciting, heart-stopping drop. The problem is when the drop is expected to happen.

There is one refuge for the stock speculator--"the long run." The way I learned it is that in the long run stock investments outperform bonds. Unfortunately, this is another "old folk tale" without much basis in fact. The empirical record demonstrates that "times of low dividends relative to stock prices in the stock market as a whole tend to be followed by price decreases (or smaller than usual increases) over long horizons" (p. 13). By this test, current share prices are too high, since the earnings record of the modern large corporations has left much to be desired over the last ten years.

This book is the book of a bear. Shiller expects stock market prices to fall but this is not the main purpose of the book. Irrational Exuberance is an essay in persuasion and a reminder that our responsibility as social scientists is not to suspend disbelief and join the chorus of erstwhile optimists. If we cannot give reasons for our beliefs, reasons founded on the mechanisms at work in the economy of real production of goods and services, then our beliefs are made of sugar beets and plums. If Shiller is wrong and the stock market flounders but only a little bit and only for a short time, it will be because the mechanisms that he refers to do not work in the same way as they did only a few decades ago. Although such a finding would be sensational, it is strange but true that no one is really interested in learning whether or not this is the case. Everyone is interested in the market with the only issue being how much higher things can go.

This book is a must read for all those social scientists who value critical thinking, rich historical description, and analytic insights. Shiller has written a tract for our time, coined a phrase for the 1990s--our age of Irrational Exuberance--and provided a scholarly work that will long endure. This book makes an especially valuable addition for outside reading in any one of a number of college courses in economics, sociology, psychology, or business finance.