A Conversation With Robert J. Shiller

Friday, March 4, 2016
Reuters/Michelle McLoughlin
Robert J. Shiller

Sterling Professor of Economics, Yale University; Recipient, 2013 Nobel Memorial Prize in Economic

Peter R. Orszag

Vice Chairman of Corporate and Investment Banking and Chairman of the Financial Strategy and Solutions Group, Citigroup, Inc.; Former Director, Office of Management and Budget, White House

Introductory Speakers

Co-Chairman, Council on Foreign Relations; Former Secretary of the U.S. Treasury

Robert J. Shiller discusses the importance of economic irrationality, crowd behavior, and other elements of behavioral finance in understanding the global economy and making effective economic policy.

This symposium, presented by the Maurice R. Greenberg Center for Geoeconomic Studies, is made possible through the generous support of Robert B. Menschel.

RUBIN: Good afternoon. I’m Bob Rubin, co-chairman of the Council on Foreign Relations, and I’m delighted to welcome you to the first annual meeting of the Robert B. Menschel Symposium on Economics.

Bob and I were partners for many years at Goldman Sachs. Bob, in addition to running a very successful and very important part of the firm, was a very successful investor in those days, and is to this day. And my recollection of Bob as an investor is that the key, or at least a key, to his success was that he would look at an irrational world and rationalize. And that leads straight to Bob’s endowment to the Council for an annual symposium dealing with behavioral economics.

As all of you know, economic modeling is based on the assumption of a rational person. And as all of you also know, that is pretty much unrelated to reality. The market, in the shorter run, is—at least in my view but I think it’s a broadly held view—is a psychological phenomenon, and even if over time—over a longer period of time it averages out to reflect fundamentals. And psychology and confidence are certainly key factors with respect to how economies function.

The economics profession—again, as all of you know—is now very much focused on behavioral economics and on trying to capture the psychology of markets, the psychology of economies. It seems to me that there is some question as to how effectively that will ever be done, but clearly this work is enormously important. And we are very, very grateful to Bob for endowing this symposium.

An example in the policy arena—one that I was very involved with when I was at Treasury—is the question of what effect fiscal conditions have on an economy. And one of the issues there was what is the—what are the psychological effects of intermediate and longer-term unsound fiscal conditions as we, for example, today face?

On the forecasting front, Fischer Black—who, as you know, was the co-author of the Black and Scholes model for pricing options—spent many years at MIT and then he came and he joined us at Goldman Sachs. And Fischer famously said, in later years—when he was asked why he had moved away from the Fischer market theory with respect to markets, said that markets looked very different from the banks of the Hudson than they had from the banks of the Charles.

And I thought that captured very well—(laughter)—the contrast of the realities of markets and what people think about in places like Cambridge and perhaps even some people in New Haven who knows Bob. (Laughter.) Clearly, trying to understand the psychology of markets is extremely important for investors, business people, and policy makers. And again, we are very, very grateful to Bob for endowing this symposium to enable all of us to get a better sense of those sets of questions.

We are extremely fortunate, in having this symposium, to have a truly extraordinary and outstanding group of discussants today. In accordance with Council practice I will not recite from their résumés. They’re in your materials and they speak for themselves. I’ll simply say that as moderators we have Peter Orszag, who was sort of the wunderkind of the Clinton administration in the years when I was there. And I still speak to Peter a lot and will ask Peter to help me understand the fallacies of the views of various friends of ours, especially one of our friends. (Laughter.) And Gillian Tett, who is one of those rare journalists whose views and insights are very much followed by all of us.

Both sessions will consist—each session will consist half of the discussion and then half of questions from all of you. If you have a question, please raise your hand. If you’re called on, somebody will bring you a microphone. Identify yourself and then state your question. The briefer the questions, the better because then we can have more questions. This session—or both sessions will be on the record.

And with that, I will turn the stage over to Peter and Bob.

ORSZAG: Good afternoon, everyone. I don’t think we could start off a session on behavioral finance with a better person than the person to my left, your right, Bob Shiller. He’s the 2013 co-winner of the Nobel Memorial Prize in Economics. He’s the Sterling Professor of Economics at Yale University. He’s the president-elect of the American—

SHILLER: President.

ORSZAG: —the president now—president—these things move fast—(laughter)—president of the American Economic Association and, perhaps most relevantly for our purposes today, is really one of the fathers of behavioral finance in particular, and behavioral economics more broadly.

So we’re going to be talking a lot about that topic. But before we turn to that topic, you’re also very well known for your work—in fact, that was part of the Nobel Prize—on pricing of asset markets. And it probably would not go unnoticed in this room that we have been experiencing some volatility in that pricing recently.

So I’m wondering if you can give us some insight. You have a concept called the cyclically adjusted price-to-earnings ratio, which you’ve used to try to evaluate whether equity markets are more likely to have a correction in the future. Can you inform the audience about what that is and where that stands today, and therefore perhaps what might happen in the near future?

SHILLER: That is something that I have written about—and my co-author John Campbell—that has attracted a lot of attention. And I’m behind it, but not as much behind it as you might think because it’s only one valuation measure. But John Campbell and I, in the late 1980s, were describing these time series properties of the stock market using data back to 1871.

The simple story has been that it’s a random walk. Now, everyone will admit that’s oversimplified, but it’s popular to think that that’s basically what it is. A random walk is like the walk of a drunk who is so drunk that every step is independent of the others. (Laughter.) And the drunk will seem to—you’ll imagine, oh, he wants to go that way, but it’s completely random. It’s just an illusion that there’s any direction to it.

What Campbell and I discovered is that it’s as if the drunk has a bit of elastic tied to his ankle and the elastic is tied around a lamppost. So as he gets further from the lamppost he’s drawn back, but imperceptibly until he gets really far and then maybe you could start to notice it.

So we developed a vector autoregressive model—this is econometrics—but the variable that was in there that was predicting things was a different price earnings ratio. It was real price divided by a 10-year average of real earnings. It’s different from a regular price earnings ratio in that we smooth the earnings over a long time period. And the simple, intuitive idea is that annual earnings are too volatile. They jump around. So let’s smooth them for 10 years, take the ratio price to that.

Now, a lot of people would say, but you’re using data that’s 10 years out of date. Well, we are, and we think that it just gives a better indication of the valuation of the market, the long average of earning. So we found that that actually doesn’t predict short-run price changes very much, but long-run price changes five or 10 years in the future it has—it predicts something like a third of the variants of returns. So the idea of a random walk is just wrong. The stock market is not a random walk. And when it gets high relative to average earnings it tends to come back.

ORSZAG: So in this assisted drunk walk that we now have with the tethering, I think everyone wants to know, so where are we? Is the drunk going to be pulled back to the lamppost or what?

SHILLER: So right now the price earnings ratio, the CAPE price earnings ratio, as we call it, is in the mid-20s. The historical average has been in the teens or, like, 15 (percent), 17 (percent), depending on sample period. So we’re high, but we’re not at the highest. The highest we ever got to was in the mid-40s in the year 2000. I call that the millennium bubble. It peaked right at the turn of the millennium.

So if you look at our forecasting equation, it doesn’t predict really bad returns even now, because it—yeah, the tether isn’t pulling that hard. It’s pulling us back. So we don’t expect the normal 7 percent real returns that you would get historically. It’s something like 3 (percent) or 4 percent. So it’s still outperforming other assets in expected value, although it’s risky. It’s not until it gets up really high, in the 30s (percent) or the 40s (percent) that you would have an expected negative return.

You know, so what it means to me is the stock market isn’t as good an—in the U.S. I’m talking only about the U.S. at the moment with this. The stock market isn’t like the great investment it has been historically, and one of these years it will correct down, very likely, but it’s not something that I would completely avoid.

ORSZAG: OK. So now let’s turn to—(laughter). “Not something I would completely avoid.”

Let’s turn to your most recent book. You’ve written several books, but your most recent book, “Phishing for Phools,” co-authored with George Akerlof, otherwise known as Mr. Yellen—(laughter). I don’t want to cut into your book sales, but if you could give the audience some—effectively the Cliff Notes version of the point of that book, I think that would be helpful.

SHILLER: Well, we wanted to elaborate on a theme that you may have heard about. It’s not completely original, but we call it a “phishing equilibrium.” We use the word “phishing” in our title. We use the word “phishing” in a slightly broader sense than—it means any trick or manipulation by business, in our book. A phishing equilibrium is a free-market equilibrium without regulation and without business chambers of commerce or Better Business Bureaus that impose order from the business community.

A phishing equilibrium is an equilibrium in which some tricks are being played that you don’t feel good about at all in business, but most of you in business have to do it too because: Hey, we have to compete. Our profit margins are tight. We can’t not do it.

So the most famous example is the candy bars at the checkout at the grocery store. Some parents have complained that the store puts candy bars right there when you’re standing in line as a temptation. And George was pointing out, he went to a grocery store and he said, you know what, they even put it at eye level for the child. (Laughter.) So you’ve brought—you’ve brought the child shopping. You’re at your worst moment. You’ve been there for 45 minutes and now you have to stand with your child looking at candy.

So why do stores do that? Well, we found in the newspapers from the 1980s there was a backlash against this and there were some grocery stores saying, we won’t do that. But you know what? Take a look next time you’re in a grocery store. They’re doing it again. So for a while there was some shame in this practice when the newspapers were publicizing it but, you know, you just wait a while and they’ll forget and you go back to doing it. And you have to do it.

So the theme of phishing equilibrium is that if you ever manage a grocery store, I can predict what—I know you’re idealistic. You’re coming to a seminar like this. You wouldn’t do that. (Laughter.) No, you would. You would because you’re in charge of a grocery store. You have these employees who depend on you. And you really will go out of business. Maybe you could avoid this trick, but there are many other tricks. You’ve got to—you’ve got to really be narrow in your choice of what tricks you won’t play.

And that’s our metaphor for a lot of things that go on. And our book spends time describing various phishes, putting them all together into a view of the world.

ORSZAG: And let’s be clear that this is P-H-I-S-H—

SHILLER: Oh, yes, I should have said.

ORSZAG: —not fishing like that.

SHILLER: Well, it is related to fishing in some sense, in the sense that when you’re fishing you throw out a lure and—this is on the cover of our book—and most fish swim by and apparently think, I’m not going to bite that; that looks fake. But sooner or later someone will be off-guard and will bite it. And that’s the way a lot of this manipulation works.

ORSZAG: So maybe we can turn that example, the candy example. How do you—what are the applications or the manifestations of these phenomena in financial markets? How do you see the same—


ORSZAG: —tendencies play out?

SHILLER: Well, the financial crisis is maybe a good example that there were people in the financial community who discovered that the rating agencies weren’t paying attention as adequately in rating of mortgage securities, and also were accepting payment from these people who were issued—it’s like—you know, John Moody said in his autobiography: One principle I have is we never take money from the people we rate. And that principle lasted until 30 years after he died. You know, it lasted for a while. You have a culture that—but then they started accepting money.

And for a while it was all right, even—you know, I’m not completely blaming Moody’s. I’m just saying that corporate culture only has its limits, and eventually, after a long period of time, you’ll find some people who arrive that don’t even know about it, and so they got good ratings for bad securities. And they kind of had a deniability. You know, this was what all the ratings agencies are doing. People just kind of forgot about the complexity of mortgage securities and the attention to detail that’s needed to properly rate them.

So there’s an example of phishing. But it was—you know, again, I don’t like to—some people ask why—Phil Angelides is just now coming out with the complaint that after they wrote this FCIC report detailing how horrible the crisis was still nobody has gone to jail. But the problem is that I don’t think most of it was a jailable offense. It’s a phishing equilibrium. You live in the business. You are waiting for the regulator to put a clamp on but no regulator is doing that. No one seems to be paying attention. And so you kind of say, I have to do this, this is—to stay competitive.

So I don’t think that—it’s not—you want a scapegoat for these things. Our book is not about scapegoats. Our book is in somewhat—in some respects similar to Vance Packard’s in the 1950s, “The Hidden Persuaders,” about marketing. But the difference is Van Patrick (sic; Packard) kind of was angry at these people and, like, labeling them as a conspiracy. We’re not angry at individuals. So it’s more about the need for society and business community to put standards on. And otherwise rational, well-meaning people will end up phishing.

ORSZAG: But if phishing is an equilibrium, and if you clamp down on the rating agency bias, the—you know, it will show up somewhere else. What specifically can we do to try to minimize the harm from this natural candy bar tendency?

SHILLER: Well, we still have the candy bars, but that’s a minor problem.

ORSZAG: Yeah, I understand. (Laughter.)

SHILLER: We’ve made big progress. One thing we talk about is the founding of the Food and Drug Administration in 1906. Actually, I had to speak to an audience in the U.K. so I better—I said, I better check that the U.S. was first. You know, the U.S. is a great leader but actually the U.K. did it in 1899, I think it was. So advanced countries seem to come around to this idea that we need regulation.

In medicine, the regulation in the 19th century was absolutely essential because most medicines that were sold were worthless or harmful. There was no standard for—so you get Dr. Swaim’s Panacea claiming to be literally a panacea: This will cure anything. Now, that’s stupid, as anyone—intelligent person in the 19th century would have known. But it was going after the fools, and there were a lot of fools then.

So in order to protect people that we love, we need a Food and Drug Administration and it has to impose standards: You can’t sell a medicine if there is no scholarly literature, there is no scientific study showing that it has an effect. You can’t just claim it based on testimonials. So that’s an example.

Our book isn’t really focused on giving policy prescriptions because that would get us into a lot of—that would be a lot of little things. Our book is more of a history of the—and a thought piece on the nature of phishing.

ORSZAG: So I’m also just kind of curious, as one of the fathers of behavioral economics, how—what has surprised you most about how this literature has developed and the interest in it? Is there something that—you know, has this surpassed your expectations, or do you think this was going to happen all along?

SHILLER: Well, it surpassed my expectations in the sense—I’m the second-in-a-row president of the American Economic Association who’s a behavioral economist. It suddenly—and Dick Thaler gave his presidential address and had a huge crowd. And I thought they seemed to like it. But Dick Thaler, in his own address, was giving a history of thought from behavioral economics, and he came to the same conclusion that I.

Who was the first behavioral economist? Well, we’ll give that to Adam Smith, the writer of “The Wealth of Nations,” who is widely described from the book “The Wealth of Nations” as a promoter of unregulated free markets. Well, he was that. He wrote that—there’s a paragraph in that book where he says the—I’m not quoting exactly, but the free-market system is like an invisible hand that directs resources to the right use and the products to the right person. So we like that. We love that book, by the way. (Laughs.)

But the same guy wrote another book in 1759, even earlier, called “The Theory of Moral Sentiments.” And it’s really behavioral economics. In fact, as Dick Thaler pointed out in his presidential address, which you can read in the AER if you want, a lot of the concepts that we talk about today as if they’re new are in that 1759 book, like, for example, overconfidence, which is a psychological principle.

But it seemed to lie dormant. I really think Adam Smith was a perspicacious person, and his—people didn’t pick up on everything that he—it seemed to lie fallow until maybe the 1920s. And then A.C. Pigou, which was a writer at the time of Keynes, he made a famous statement in his “Theory of Industrial Fluctuations” that about half of the business cycle is due to fluctuations in confidence.

And then George Gallup, in the—I’m going on to this maybe too long—was the first survey person to survey consumer confidence. Then Richard Katona—George Katona at Michigan created the consumer sentiment index in the 1950s. But all this was sort of—well, something happened. This is social psychology, I guess. Something happened starting around the 1990s, and suddenly there was a huge burst.

If I do an N-grams plot for any of these terms, you’ll see a huge increase, starting in the `90s, of public interest. I think it was a scientific revolution. And also do an N-gram search for “Theory of Moral Sentiments.” You know what N-grams is. It’s the Google site that tells you how often words appear by year in books. Nobody—people had—I can tell you from N-grams that people had forgotten Adam Smith’s 1759 book until sometime in the 1990s, and it’s exploding. It’s not on the bestseller list yet, but I bet it will be before long.

ORSZAG: Working on it.

SHILLER: So I don’t know why—this is one of the mysteries of understanding the economy as well. There are human trends. Certain bits of wisdom are appreciated at some times but not others. It’s because of—

ORSZAG: And that affects even economists.

SHILLER: Right. Well, see, there are—

ORSZAG: Astonishingly.

SHILLER: And it affects economics like—it’s—again, it’s a fishing equilibrium. You’re a young economist. Say you’re getting a Ph.D. You want a job somewhere. And you’re going to write a—are you going to write a dissertation on the psychology in economics? Well, you know that a few people did that in the last 30 years, and none of them did well. (Laughter.) So you don’t do that. That’s a flaky topic or something. You know, you don’t even look at it. You don’t even think about it, because I’m going to be an economist. And it becomes an identity thing.

Something—some psychology like that works. You want to kind of be in the swim with the good guys. And so you don’t even look at the alternative. I think that a lot of people in all walks of life have the impression, of course, that I specialize in something. I can’t—I don’t have the time to read other things. I’ll just go to pure entertainment when I’m relaxing, and then I’ll come back to my pure specialty. That produces—that attitude produces idiot savants, unfortunately. (Laughter.)

ORSZAG: So let’s talk about some of your—the ideas that come out of your work in behavioral economics. So, for example, you have written previously that providing a safety net and things like wage insurance may actually help people take additional risks in other parts of their lives, so starting new businesses and what have you, which is a perspective that you often don’t hear.


ORSZAG: So, for example, evaluating a program like Social Security, which is traditionally done by looking at the marginal tax rate and the disincentive for work and what have you, could be missing a big piece to the extent that it—by having a base level of retirement or disability income or what have you encourages people to take more risks in their careers or what have you. Could you explain that concept a little bit?

SHILLER: Just before—I should say I was just almost ready to quote Gillian Tett, who has a wonderful new book—she’s coming on later—called “The Silo Effect,” about overspecialization in modern society. So she’ll—maybe we can get her to talk about that.

ORSZAG: We can do that, but go ahead.

SHILLER: But the other thing—you were asking about social insurance—


SHILLER: —and how it affects people’s motivations. You mentioned specifically wage insurance. I’m very interested in wage insurance. I have been for close to 20 years. But it was President Obama who brought it up again. It’s in his 2017 budget and it was in his State of the Union address.

Wage insurance is a government program to compensate people who lost their jobs not by unemployment insurance, which only pays them when they’re out of the workforce, but by compensating them for the loss of income if they’ve had to accept a job at a lower pay. So this is designed around incentive.

Now, I think Jason Furman at the Council—who’s head of the Council of Economic Advisers, wrote a blog about this. And it’s in the budget proposal. I don’t know if that means anything these days. The president—

ORSZAG: No, but it’s still better than nothing.

SHILLER: But the idea is it used to be—it used to be that when you become unemployed, you want to stay unemployed for a while because your benefits will cut off when you get the new job. But you really shouldn’t be staying on unemployment. This is enlightened thinking, I think, about what actually happens. People who stay unemployed for a long time start to look like damaged goods and they don’t get such good offers. Also they’re not learning anything. Most learning is on-the-job learning.

So what they really should do is take that job that’s at a pay cut, which is demeaning and humiliating, but just do it and get back into the labor force. But wage insurance will compensate you from the government for a fraction of the income you lost, to encourage you to get back into the swim.

So I think this is really—now, actually, we already have wage insurance. It came in in 2002, but only limited to people over 50 and to trade-related job loss. But what Obama wants to do now is generalize it, to cut those restrictions.

ORSZAG: But you’ve gone beyond just that application—

SHILLER: I go way beyond it.

ORSZAG: Right. Tell us the broader vision of why you think people would take more risk if we had a different social-insurance structure?

SHILLER: Now, I wrote a book in 2003 called “New Financial Order,” which was an appreciation of the financial, including insurance, sector. People tend to think of these people as money grubbers who are hoarding for themselves, when in fact they are—you might describe them in completely opposite terms as the most kindhearted people in the world in terms of what they get done.

Who are working against inequality the most? Insurance people, because the insurance people are out there in a big way protecting people whose house burns down, who have an illness or an early death in the family. All these things that really matter are being driven by an insurance solution. That’s why I like wage insurance as one such idea.

But most of this is private sector. And I—so what I’m thinking in my book, “New Financial Order,” which is kind of a futuristic book that is not about immediate proposals for the president but thinking about where we’re going, that over the centuries we have been reducing the risks in our lives. We haven’t—you can’t get rid of the shocks completely, but people live much more stable lives than they used to.

When your house burns down, in the past you didn’t have a house. In fact, that happened to my grandparents, who didn’t have insurance on their farmhouse in Michigan. It burned down one—they came home from a trip and the house just wasn’t there. Nobody even noticed it burned down. They moved into the chicken coop for that night.

Well, you don’t have to move into the chicken coop anymore. It’s standard. But we still don’t insure a lot of risk. And the big risk that I’m worried most about is this fourth industrial revolution with new technology, which is disrupting our human capital investments and creating great risks.

So we have to start thinking about how we can ensure human capital risks. And that’s what wage insurance is just the beginning of doing. It doesn’t have to be the government. So I’m trying to think of—with our new big-data economy and with much more ability to manage complex processes, maybe we can insure and reduce inequality even without government; just with maybe regulatory compliance, nothing more.

ORSZAG: Since you brought up housing, let’s also talk about that for a moment. I think the audience would be interested both in your analysis of where the housing market is, and then I also want to talk about a couple of ideas that you’ve had and where they stand to try to make the housing part of people’s portfolio work better for them. But let’s start with the state of the housing market today.

SHILLER: Well, I have home-price indices that Karl Case of Wellesley College and I devised getting close to 30 years ago, Case-Shiller. Now they’re being sold by Standard & Poor, so the Standard & Poor/Case-Shiller home price indices.

These indices had their biggest increase—well, I take my data back to 1890. There was the biggest boom in home prices in that—since 1890 occurred from 1997 to 2006. That was the huge bubble that preceded the financial crisis. And then it dropped dramatically, as, you know, close to 50 percent in real terms. And now it’s moving up again.

With the latest data in the last few months it’s been flat, not really going up. But that’s just a seasonal. If you correct for seasonality, it’s still going up. This is the slow season, the winter, for housing. It’s still going up close to 1 percent a year. So it’s—we’re still seemingly in a boom—a boom but not a bubble. Well, it’s not as high as it was. In real terms it’s not as high as it was in 2006. Is it a bubble? I have a little trouble—that term bubble is not well-defined. (Laughter.) In fact—

ORSZAG: Is it disproportionately likely that prices will correct in the next five to 10 years? (Laughter.)

SHILLER: Well, see, this is the same issue that I talked about with Kate, that they go up like this, and it’s very hard to know the turning point. So I can imagine them going up quite a bit more before a turning point. I try to look for signals of a turning point. The turning point in the last cycle, I think, came—the first signs of it came around 2005 when The Economist Magazine did a cover story about falling home prices. It had a brick on the cover and it said “Home Prices,” and it showed a brick falling. But, in fact, in 2005 home prices were going up in London, New York, and all over still.

But I think there was a change in attitude. What you started to see then was a lot of articles about foolish investors, bubble investors. They would tell—the media jumps onto a story when it looks like the public is right for it, ready for it. So they put in lots of stories about flippers, people who would buy a house and hope to fix it up and sell it a short time afterwards. But they were describing them not as investing geniuses but as maybe suckers. You can—but I don’t see that happening now. I don’t see any signs that it’s looking foolish. In fact, it’s building. I see more talk about how to profit from real-estate price increases.

ORSZAG: So one of the ideas you had or have with regard to housing is to move towards a different model for sharing risk between the homeowner and everyone else, so whether in the form of a shared-appreciation mortgage, where the homeowner will share some of the upside—


ORSZAG: —potential with the lender. Tell us about sort of new ideas in housing finance and what might help to mitigate the risks for individual homeowners if we do have another cycle like what we lived through.

SHILLER: Well, I wanted there to be insurance for—we called it home-equity insurance. Right now you can buy insurance on fires or hurricanes or other disasters, but those disasters mostly are kind of rare and not important. They were more important in the 19th century before they had fire-retardant building materials and building codes and inspectors and good fire departments. But we’re still living in the legacy of that issue.

So I think our homeowners’ policies could include something for loss of market value, and without encouraging any moral hazard if it was based on a home-price index for your region. So I’ve tried to get insurance companies interested. And some people have tried to sell it. There was an experiment in Syracuse, New York. There are others. They’re happening still now. It hasn’t caught—I think you need marketing or there has to be some marketing to—the problem is people seem to not worry about it. Is anyone here worrying about your home price falling in value? It just doesn’t seem real, right? They’re going up, right?

ORSZAG: Someone is.


ORSZAG: There you go.

SHILLER: We’ve got one person. Anybody else?

ORSZAG: Thank you.

SHILLER: So another thing that we did with the Chicago Mercantile Exchange is create a futures market. Well, the CME did it with our involvement. They launched a futures market for 10 U.S. cities in 2006. One of them is New York. So it’s based on our index. And you can take a—there’s a website, HomePriceFutures.com. And they also have options.

I don’t profit from this, by the way. I know you’re smiling. I—so but the problem is it hasn’t caught on. It’s the same problem that we saw with other forms of insurance in the past. Life insurance really was invented in the 1600s, but hardly anyone got it for centuries. And then it came in; the same thing with fire insurance. My grandparents—I didn’t mean to put them down. Most farmers didn’t buy fire insurance. But you would—you started in the 1930s to be forced to buy it by mortgage lenders, and then they would require you to buy it. And then, once you got it, you probably kept it.

So it’s things like that that drive progress forward. And I’m hopeful that before long we’ll have home-equity insurance. Right now it doesn’t exist, or hardly exists.

ORSZAG: So in what may be an insight from behavioral economics, I’ve been firmly instructed not to refer to the following as opening it up to the audience, because you’re members. So we’re going to have a member conversation as opposed to opening it up to the audience. But we have a lot of very knowledgeable people who are members. And so let’s take some of your questions. And we can start over here. Just please, again, ask a question.

Q: Yes, sir. Hi. Saqib Rashid with The Abraaj Group.

I’d like to get your views on the sharing economy and whether you see this—whether you’re studying this from a behavioral economic perspective and whether you see this as something that will fundamentally disrupt a lot of industries or just—


Q: —something that’s overstated?

SHILLER: Right. Well, the most salient example of that is Uber, that allows people to use—they use their own cars, I guess, to—and they may work part-time at a job of driving a taxi. This unfortunately has dislocation effects, because other taxi drivers may have spent a huge amount of money for a medallion. Any time you have change, it costs somebody. Somebody is a loser.

But the sharing economy—or another one is Airbnb, which rents out apartments or houses. You can rent out—has anyone done this? Anyone here done—one? OK, we have—

ORSZAG: A bunch of people, actually.

SHILLER: So but what it’s doing is allowing us to use the existing capital stock more effectively. When you’re away on vacation—I’ve never done this; it seems awfully hard to imagine—but you can get someone else to move into your house for a few days. Now, you might think this is crazy. How can this work? But it works because of improved technology.

For example, we have computers that keep track of the record of the—both sides of it—and Uber does this too, both the passengers and the drivers. And if you’re not nice, you’ll get cut off. So that’s the sharing economy.

But beyond that, I think it goes into other things like crowdfunding, which is beginning to develop, which is a website that you might get on and instead of investing in establishing corporations, you read the prospective of young start-up companies that are trying to find some people who understand their business plan and will invest in it. So it’s appealing directly to the broad public. Now, this creates opportunities for phishing, as Akerlof and I define it, so it’s something that needs to be regulated. The SEC has just come out with proposed regulations for crowdfunding in the U.S. I don’t think they’re finally approved yet. It’s coming in a matter of months. And it’s exciting.

But another sharing—I don’t know if you call Wikipedia part of the sharing economy. It is, in the sense that—I don’t know how many people write. How many people have ever gone in and corrected or written for Wikipedia? OK, well, that’s good. (Laughter.) But that’s a sharing economy in the sense that it’s not—you do that for nothing, right? And somehow we’re all sharing our information.

ORSZAG: But I think one of the big questions, just on the sharing economy—so there’s some clear things, like the question for an Uber driver of when they are driving their own car back to their home, is that part of the commercial insurance or part of their personal insurance? There’s all these kind of detail questions. But more broadly, Airbnb might be a great example, do you think that there are a new set of rules and regulations that are absolutely necessary, precisely because of the phishing equilibrium, or should we just kind of let this play out and adjust as necessary? Would you be acting more aggressively now, I guess?

SHILLER: Well, I am sure there are regulatory issues for any of these businesses. I looked at the SEC proposed rules for crowdfunding, and it was typical of the SEC. I don’t know how many pages was it, 800 pages or something like that? That’s because it’s a very complicated business. And off-hand I’m going to think, what kind of regulation does Uber need? It has competitors barking at its heels but, yeah, probably—I’m just not coming up with any in my mind. But probably we do need to regulate them. It’s because the phishing equilibrium is universal. There’s always an opportunity to manipulate and deceive people. And given people’s psychological weaknesses, if you have expertise in that, you can go after that. So it is an equilibrium. And it won’t correct itself by competition. So you need some regulation. But you want regulators who appreciate free markets and have a sense of when they’re doing good things.

ORSZAG: So there are two right here. We’ll go side by side, Esther and I think it’s Dan.

Q: Hi. Esther Dyson.

I want to go back to the candies in the store, and ask you to think about two things in that context. One, insurance can spread risk, but it’s even better when it reduces risk—like commercial insurance that goes and inspects for rags, health insurance that’s beginning to focus on prevention. And the second is charging for externalities. If you have big data and you can actually calculate the cost of the candy in terms of health costs and perhaps other costs due to poor health, can you talk about that and what you would do with it?

SHILLER: Yeah. Well, externalities is a familiar example in economics. That’s what everyone has agreed upon since—I don’t know, when did that come in? We should do an (engrams ?) on that. Probably Alfred Marshall in the 1890s did that. So nobody disagrees on that. But the problem with externalities is that it tends to be viewed by economists in a knee-jerk fashion as the only justification for government intervention, and it’s not. The other thing that you mentioned is about insurance, and about how that helps not just by managing the risk, but also by reducing the risk.

So fire is an example. When you get fire insurance on your house, you have to get an inspection. And the insurance company may say, this is unsafe. And improve the structure so that it won’t be as vulnerable to fire. That’s really important. And if you look at the difference between—consider earthquakes, and consider the Haitian earthquake that we had some years ago. Compare that with any U.S. earthquake. There was recent earthquakes in, you know, California. The fatality rate was so much higher in Haiti, where there isn’t much insurance. So it goes exactly to say it actually saves lives. That’s a very important part of insurance, the inspection and supervision it brings on.

 Q: Dr. Shiller, you touched on something very, very important, which is job displacement from the tech economy. This is an ill that people, voters, can’t really figure out when they hear the president in the State of the Union talking about how the economy is in great shape and they look around and are seeing something very different than their own experience. You talked about it in the context of wage insurance. And I was thinking critically about the whole concept of wage insurance as potentially another economic distortion, like negative interest rates in monetary policy. But apart from that, how do you provide wage insurance to people who are being displaced from the job force or from their jobs in particular?

SHILLER: How do we do it?

Q: How would it work? In other words, how would wage insurance apply to somebody that doesn’t have a job at all—not a lower-paying job, but no job?

SHILLER: Oh, right. The wage insurance program that was brought in 2002, and that must have been George W. Bush who assigned that, so it’s bipartisan. Insurance is bipartisan. Nobody objects to that. It was very limited. And that’s why you don’t hear much—and it’s still in force today, with a different name. Then it was called Alternative Trade Adjustment Assistance. And then it was called Reemployment Trade Adjustment Assistance. And now Obama just calls it Wage Insurance. But it was limited. But if you look at it—

ORSZAG: It was limited—but just to be clear—it was limited mostly by the cause of the job displacement. It had to be directly linked—

SHILLER: Right, it had to be a verifiable clause—

ORSZAG: But can you explain how the broader vision of wage insurance would work, that doesn’t—you know, is not related to trade, necessarily? How would you do it?


Q: Is it kind of—is it job retraining—

SHILLER: No, that’s separate. That’s separate.

ORSZAG: No, he—no. Explain what it does in your concept. Not in the Obama proposal, what your concept is.

SHILLER: Oh, my concept. But I tend to be more futuristic in thinking about future decades. (Laughter.)

ORSZAG: Go big. Let’s dream.

SHILLER: So I think that we need to develop—they could be private—insurance protection against inequality, that insurance companies would be selling lifetime—it’s like disability. Insurance companies today offer disability insurance. And what it says is if you suffer an injury, then for the rest of your life you will be supported. If you become paralyzed, that insurance policy covers the rest of your life. So it’s somewhat expensive because although not many people get paralyzed, some of them do. And you have to pay a premium that covers the cost of that. I’m thinking that the disability insurance could be just extended to cover career risks as well. You’re shaking your head.

Q: That would be a very expensive—

SHILLER: It might be very expensive, but maybe you’d pay for it. I think that—again, you have to market insurance. Let’s think about life insurance, OK? In the 19th century, the average age death for most people was something like 45—mid-40s. Married couples had a very substantial probability that either the husband or wife will die, and the other will be a single parent. And they also had lots of babies. But that insurance had to be expensive, because if they’re going to really cover you for that risk, it’s costly. And everyone’s dying. A lot of people are dying very young in those days.

But they did manage to sell it. And people were benefiting from it. It was a difficult thing to sell until the public got used to the idea. And so there was a marketing thing that—there was a marketing revolution in the 19th century that studies how people respond to insurance proposals and rephrased it in ways that were meaningful to them. And they did get people to buy it. So I’m thinking that a lot of things look difficult at first, but they do work out eventually.

Q: By the way, I’m sorry I didn’t reintroduce myself. I’m Daniel Arbess from Xerion Investments. We last talked in my office a year ago.


ORSZAG: Let’s go two rows back.

Q: OK. Chris Brody, Vantage Partners.

I wanted to go back to your home insurance—home equity insurance. If it had been a tradition and been in place going back 20 or 30 years, who would the counterparties have been? And how might it have affected what became the mortgage crisis? Would there have been a bubble-dampening effect as you would envision how it might have worked?

SHILLER: All right, this is a—this is a fundamental finance question. When you pool risk, it doesn’t disappear, it just is shared differently. So who would be the counterparties? Well, I would be a counterparty. I would be diversifying my portfolio. And I don’t—I have—I don’t mean to boast. I have more money than just my house. And I would want to put something into this. So people who rent would be logical counterparties. I think more people should be renting than there are now, because it’s a way of professionalizing your home provision. Instead of doing your own odd jobs and mowing the lawn yourself and fixing things up and worrying—it’s advantageous to live in a rental unit. So I think a lot of people should be—more people should be renting than today. And it would be natural for them to be the receivers of some home price risk.

Now, incidentally, to the extent that different cities are uncorrelated with each other, and there are differences across cities, that risk can be diversified down to a low risk for an investor and an insurance company. But there is some world risk to housing. And that can’t be diversified away. But someone will still bear that risk. This is the beauty of financial theory. I just wish it worked out better according to the theory than it really does. (Laughter.)

ORSZAG: Kind of inconvenient. Let’s go way in the back.

Q: If it had been in place, would it have served as a dampening effect on the mortgage crisis, because you had counterparties who were actually pricing risk?

SHILLER: Well, if we had futures—well, we did have. Our futures market opened in 2006. We had a market maker who thought initially that it should be a normal, upward sloping futures curve. And he lost several million dollars and gave up. It then went into backwardation. So it was—our futures market predicted the decline in real estate markets. So there’s a certain amount of price discovery that happens.

The problem with homes—this is something Edward Miller pointed out—there’s a problem of short sale constraint. If there are no ability to sell short, then anything can get overpriced if there are a minority of people who are zealous and really believe in something. They’ll buy it and bid up the price unless there’s somebody else who can—who can short the thing and then offset the overpricing. So we created a futures market which would enable people to short the housing market, in effect. And it then did produce the price discovery. And it would have helped prevent the bubble from even forming.

ORSZAG: Let’s go way in the back there, yeah, right, the white paper.

Q: Hi. Henry Jacklin.

Dr. Shiller, you were at the very beginning of understanding how bad the thing could be, and you saw the whole housing crisis come. And from your vantage point, when you talked about the rating agencies you said you didn’t want to single them out. And from what we know of the housing crisis, there’s so much blame to go around you don’t end up with a single culprit. There are multiple culprits. I would only argue that if you—if you do that, you even out the risk perhaps a little too much, and that the rating agencies have always been the foundation of a self-regulating market. And they have worked brilliantly.

So you had regulation breaking down on the government side because everybody believed in a self-regulating market, and then the body that was supposed to be the key to the self-regulating market fell apart. Now, would you ascribe more blame to the rating agencies and the private sector than to anyone else? Everyone has blame—everyone has blame. It’s a matter of degree.

SHILLER: Yeah. I don’t know—yeah, you want me to say who has the most blame?

ORSZAG: Blame, yeah. (Laughter.)

SHILLER: I don’t know. It also comes to my mind is some mortgage lenders who apparently encouraged people to lie on their mortgage applications and tried to cover up the risk. I mean, there are—did you ever see the movie, “The Big Short”? (Laughter.) I took my students to that. But, yeah, I—

ORSZAG: Let me ask the question a different way. How well do you think the rating agencies are performing today? So we’ve cleaned up some of the biases that existed previously, but how well do you think they are performing today in terms of serving as the foundation of a moderately well-functioning financial market?

SHILLER: Well, this is a complicated story. And I’m not 100 percent on top of it. But it started when the New York attorney general put some new restrictions in rating agencies just early in the crisis. Rating agencies issued statements about how they were changing their methods, putting firewalls between different divisions. Is it really effective? I can’t say that I’m an expert on that.

ORSZAG: OK. Let’ go right here. Mr. Malpass.

Q: David Malpass with Encima Global. Hi.

So inflation is much lower now. And so we’ve been through a period where for 40 years it was a major factor. How does that change finance and your CAPE view? And could you talk about net present value calculations in negative interest rate environment, that kind of issue going forward? (Laughter.) How do you do finance when inflation is really low these days?

SHILLER: Yeah. This is, by the way, an early topic in behavioral finance. Irving Fisher, who’s a Yale professor, wrote a book in the 1920s called “The Money Illusion.” Actually, it goes back even further. Claiming that people don’t understand inflation, it goes back even earlier to some writers in the 19th century, that people are confused by inflation.

So I think it affects—it has a lot of subtle effect. One of them is the impression that home prices always go up. Now, people don’t know that because most people never look at data. But maybe they’re reminded when someone—an elderly grandparent dies and they have to sell the house. And they look at the papers. They bought this house for $20,000 back in 1953—amazing! But they’re not correcting for inflation when they—so it encourages all kinds of mistakes like that. It may encourage bubble thinking because you see more prices are more salient than others.

So I don’t know, your question brings in so many things that people—I’ve been advocating indexation in my writings, even creating and indexed unit of account, like Chile has, called the Unidad de Fomento, which is a—people have trouble dealing with, even understanding inflation. So if you sign a contract you just do it in dollars. I promise to pay you so many dollars in 10 years or whatever. But you don’t know what that’s going to be even worth. It should be tied—it should be corrected for inflation. This is behavioral finance. People can’t seem to grasp that you can write a formula into a contract. It scares them off.

So in Chile they have the Unidad de Fomento, which is indexed to inflation. You can put into your contract: I’ll pay you so many UFs. And that helps. I think we do need to try to not just rely on the central bank to, in its wisdom, adjust interest rates, but allow for people to avoid being exposed to inflation risk.

Q: Negative rates?

SHILLER: Well, I don’t think it’s a big thing because they’re not going to get that negative. We’ve been just about zero. And they’re a little bit negative. It spooks people out. There was an article in The Wall Street Journal this morning about how insurance companies will fare with negative rates, because they tend to want to pay their premiums out of their interest income. But maybe it won’t be so bad. They’re smart. They’ll figure it out. They’ll raise their premiums or something for you.

ORSZAG: All right, last question.

Q: All right. Thank you, Peter. Charles Cobb with Partners for Affordable Excellence.

Can you explain how your concept of insuring for human capital risk might apply to college students who make four-year investments, end up with six-figure debt, and don’t have a job? Is there a market to address the problem? Thank you.

SHILLER: I think that young people are given a very difficult decision, especially now in the fourth Industrial Revolution. You have to pick a major in college, or in graduate school a more narrow specialty. So what do you do? Well, you can go to the U.S. Department of Labor website, which has forecasts for demand for various specialties, but I don’t think those forecasts are very meaningful. It’s just somebody extrapolating.

It’s not—it would be better if we had some kind of market for occupational income indices—why not; we have other kinds of futures markets—where you’d have a prediction, and also an insurance policy that you can buy. So let’s say you are thinking of dentistry as your profession. Already dental profession has been harmed by fluoridation of water. You know, you just don’t know. You prepare a career in dentistry, you just don’t know what’s going to happen. There might be some little thing that—

ORSZAG: There are lot of heads nodding. (Laughter.)

SHILLER: So you should be able to buy an insurance policy on your human capital investment.

ORSZAG: So I actually had mistaken the end time. We will have time for a couple more questions, so let’s go ahead and take some. Let’s go over on this side. Back there, sorry.

Q: Yeah, I’m Scott Pardy (ph).

I’ve spent 15 years in a—in a liberal arts college with a bunch of people in the Economics Department who are behavioral economists. They weren’t doing anything what you’re doing. They were bringing students into labs, giving them a few dollars, and then having them negotiate things, and writing articles. Tell me about behavioral economics and how we can get back to the kind of definition that you’re using, rather than the definition that these people are using.

SHILLER: Actually, the graduate course I teach at Yale is called “Behavioral and Institutional Economics.” I’ve always felt that I want to get things done. I want to change the world. Other behavioral economists do—like Dick Thaler has all sorts of proposals for how we can make for a better world.

But, yeah, I think that—this is, again, back to Gillian Tett’s theme that we don’t want to live in a silo. We want to recognize that we have to work together with people in other fields. So I like to work with people in finance because I think there’s tremendous power in that technology. I like to work with psychologists. We just have to somehow connect and make things happen.

ORSZAG: Let’s go far in the back. Sir? Yes, please.

Q: Hi. Peter Stegall (sp) at First Data.

Talk to us about neuroeconomics. I know you’ve written about it. What is it? (Comes on mic.) Talk to us about neuroeconomics. What is it? And what excites you about neuroeconomics?

SHILLER: Well, I am very excited about neuroeconomics, and so are lots of other people, because we’re on a cusp of a scientific revolution.

I went to the Society for Neuroeconomics Conference. They called me in as a speaker. They wanted me to talk about neuroeconomics from my perspective. But I was shocked; that convention had 26,000 people attending it, and they had—they had a post-session for papers. I’ve never seen anything like it. They had this huge invention center, and it was all filled up with bulletin boards and young researchers with little bulletin-board presentations of what they were doing. And someone was guiding me around. He said, see that aisle there? There’s a hundred papers being presented: bird brains. (Chuckles.) That’s all people studying bird brains. (Laughter.) Why are they studying bird brains? Well, that’s a way to get insights about the human brain.

There’s just so much going on. And what it’s doing—that, in parallel with the computer revolution, we’re understanding how the human brain works. I think that in 10, 20 years we’ll have very different views of ourselves. We’ll be thinking in terms of the circuits in our brain that do various things, produce various emotions, make us vulnerable to certain mistakes. So it hasn’t—I think most of the advances are—will be in the future. But again, it will give a concreteness to behavioral economics. We will know the exact mechanism in the brain that causes certain human behaviors.

ORSZAG: OK, let’s take—this will be the last question. Let’s take one—how about right there?

Q: Arthur Rubin with SMBC Nikko.

To what extent do you think that booms and busts in the housing market have been amplified by government interventions in markets? And to what extent is the fear or concern that future government interventions subsidizing credit to housing and that sort of thing make it such an irrational market that your idea of having futures around it is never going to fly, or people won’t have confidence in the way that those markets would function?

SHILLER: Well, government intervention has had an impact on markets. I was just reflecting on the new qualified—well, they’re not that new anymore; I think they’re 2014. Dodd-Frank asked for regulations defining the qualified residential mortgage, which is exempt from the 5 percent retention rule, and now that’s going to be the basic standard for most mortgages. In 2014, the regulatory agencies said that a qualified residential mortgage has to have a debt-to-income ratio—DTI—less than 43 percent. So what is DTI? It’s the monthly payment divided by your monthly income. So that means that your payment can’t be more than 43 percent of your monthly income. Well, this imposes by law a relation between long-term interest rates and the demand for housing. So if the long-term interest rates go down, as they have in recent years, it’s built right into the formula that you can lend more against it. So there’s a regulatory response which makes for a different home-price level.

But I don’t think it’s—I don’t know how to quantify how much is government and how much isn’t. There are people who have argued that the home-price boom—Wallison at AEI argued that the home-price boom was largely due to government standards for low-income mortgage lending, but he has a lot of critics saying that(’s) overstating the case.

So I think—I tend to think of it as mostly people. The government is responding to people anyway. And it wasn’t some villainous regulator who made this happen.

ORSZAG: On that note, let me also just join Mr. Rubin in thanking Bob for facilitating the focus on these issues.

A second announcement is that my understanding is we’re going to take a short coffee break, and the second panel will begin at 2:30. It is a star-studded panel, so please be back here on time.

And then, finally, if we could all thank Professor Shiller for sharing—(applause).


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