Jewish World Review May 11, 2000 / 6 Iyar, 5760
Shiller believes the stock market is overvalued because less-than-diligent investors have unreasonable expectations--expectations not based on careful mastery of relevant research--that earnings will grow extraordinarily fast, thereby producing extraordinary profits necessary to sustain today's share prices, with their extraordinary price-earnings ratios. His book's publication, which coincided with last month's market volatility, is fueling two overlapping arguments: Is today's investor exuberance irrational? And is irrational exuberance always regrettable? The answer to the second question is that irrational exuberance can be bad for the exuberant but good for the economy.
Two days before Alan Greenspan issued his Dec. 5, 1996, warning against "irrational exuberance," he met with Shiller. On that Dec. 5, the Dow was at 6,437. Today it is nearly 4,000 points higher. Investors who ignored Shiller's then widely published forebodings about a coming decade of a flat--at best--market may reasonably think their exuberance was, and remains, more rational than his skepticism.
Shiller, undaunted, still thinks the market might soon swoon, losing half its current value--equivalent to the value of the U.S. housing stock--and begin a decade of stagnation. His serenity about his (so far) unfulfilled prophecy recalls the follower of Trotsky who said, "Proof of Trotsky's farsightedness is that none of his predictions have come true yet."
However, Shiller is not a professional pessimist: He says there was irrational pessimism in the early 1980s. He is a professional economist whose scholarship aims to correct other economists as much as investors.
Much investing could be irrational, however, meaning poorly informed, but not wrong in results. Furthermore, investing that is irrational (arising from unreasonable expectations) and doomed to costly disappointments for some investors may nevertheless be creative irrationality. The tide of such investing may create wealth. Extravagant expectations produce an inundation of investment, which lowers the cost of capital, some of which floods into profitable uses that would not have been served in a climate of less exuberance. And exuberance suffuses society with a generally healthy--and somewhat self-fulfilling--sense of enlarged possibilities.
Capitalism always has been an alloy of rationality and frenzy--calculation and what John Maynard Keynes called "animal spirits." "Creative irrationality" is no more contradictory than the idea that capitalism involves "creative destruction." In "Capitalism, Socialism and Democracy" (1942) Joseph Schumpeter coined that phrase to describe the "perennial gale" that is "the essential fact about capitalism."
If you want to be usually right in forecasting the weather, predict that tomorrow's weather will be rather like today's. But sometimes it isn't. The same is true in economic forecasting. The question today is: Are we, largely because of productivity increases produced by new information technologies, in a fundamentally new economic era? Shiller thinks there is considerable exaggeration of this.
However, certainly we are in an unusually robust and durable expansion. And, arguably, expansions are unlike human beings and light bulbs: It is not true that the older expansions are, the more likely they are to die. They usually are killed by policy mistakes, which are apt to be made by people who misunderstand the forces at work.
Shiller rightly stresses the importance of studying crowd psychology as a crucial variable driving the economy. However, at some point there is irrationality--and perhaps hubris--in ascribing irrationality to investors whose behavior persists in producing positive results that confound the economic models with which economists are comfortable. As for prophecy, Shiller should remember the wisdom of Zeke Bonura, a first baseman of remarkable immobility who knew that a player will not be charged with an error if he does not touch the
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