Robert Shiller’s Irrational Exuberance is probably one of the best and most important works of the past quarter-century — in economics or in any other field. In contrast I found his new book Animal Spirits (written with George Akelrof) to be somewhat hastily put-together and certainly less persuasive. Nevertheless, Richard Posner’s critique of the latter work — and by extension, the discipline of behavioral economics — strikes me as rather shallow.
People buy common stock when stock prices are rising. They (notoriously) bought houses during the early 2000s when house prices were rising. Since almost no one can predict the ups and downs of the stock market or the housing market, these purchases must have been motivated, Akerlof and Shiller argue, by something other than a rational investment strategy. But this is not at all obvious, or implied by Keynes’s usage. Stocks have generally been a good investment, at least when held for a considerable period. And since no one is able to time market turns, no one knows when the market is overpriced and therefore when one should sell rather than buy. Indeed, the idea of selling at the “top” of the market is incoherent, because if it were known that stock prices had peaked, no one would buy. Buying stock, or buying a house, is at any time a guess about the future, a venture into the unknown. Yet that does not imply irrationality.
Stop there. First of all, the notion that “no one is able to time market turns” is not really true. It is notoriously difficult to predict whether the market will go up or down tomorrow. But it is not necessarily all that difficult to predict whether an above-average or below-average return can be anticipated from the market over the medium-to-long term. As Shiller demonstrated in Irrational Exuberance, there has in fact been a fairly strong predictive relationship between the price-to-earnings ratio exhibited by the market at any given time and its long-term average return:
There really are times when stocks are cheap and expensive. When P/E ratios are low, one tends to make a better return in the market; when they are high, one tends to earn a lesser one (though not necessarily to take a loss). The mystery that Shiller is trying to solve is how a pattern like this can manage to sustain itself. It is a mystery precisely because the patterns are relatively obvious — just as the housing bubble was in fact relatively obvious when one looks at something like price-to-rent ratios.
In the early 2000s, interest rates were very low because of a mistaken decision by Alan Greenspan (but who knew?); and since a house is a product purchased with debt (a mortgage), houses became a more than usually attractive investment. The housing stock expands only slowly because it is so durable, so the increase in demand for houses outran the increase in supply (new housing starts), causing prices to rise. Since very few economists and no government officials warned of a bubble, it was not irrational for people to think that houses were a good investment, even though house prices had risen steeply since the 1990s.
They were wrong. But mistakes and ignorance are not symptoms of irrationality. They usually are the result of limited information. Ben Bernanke, in October 2005, just before the housing bubble began to leak air, denied that the rise in housing prices was a bubble. Was he irrational? That the errors of experts can lead to disaster is hardly a novelty, but it does not follow that only an irrational person would heed the advice of experts.
Posner’s argument seems to be: the “experts” were wrong, so who can blame the common folk for listening to them?
One immediate problem with this is that quite a lot of experts — Shiller, Paul Krugman, Nouriel Roubini, Dean Baker, just to cite a few — were calling the housing bubble well in advance. Many others weren’t, of course. So one question is why the optimistic experts tended to be listened to by the markets while the pessimistic ones weren’t. And here, I think behavioral and institutional explanations must play a role, including things like optimism bias and status quo bias. It takes a lot of intellectual energy to claim that the collective wisdom of the markets is incorrect, but much less so to rationalize their behavior.
Moreover, even if there were some kind of demonstrable consesnsus among experts that housing prices were A-ok, this does not really rebut Shiller’s argument so much as it shifts its burden. Instead of asking why the people were wrong, we instead need to ask why the experts were wrong. Posner’s assumption seems to be: these people are experts — how could they possibly have been wrong (at least given what they knew at the time)? I would suggest that in Posner’s question therein lies the answer: it is precisely the tendency of experts to consider themselves infallible that frequently leads them astray.
Finally, Posner makes a big deal about the distinction between “irrationality” and “limited information”. This reminds me of the old experiments in which a student is intentionally fed misleading information by his (supposed) peers and winds up providing an incorrect (and perhaps even ridiculous-seeming) response to a question as a result. Is the student in fact being “irrational” when he does this? Or is he merely being naive — making the best decision he can based on the information provided to him, given that the heuristic “when in doubt, trust the opinions of your peers” is usually fairly useful?
I would argue that it does not actually matter all that much; the point is that he has made an objectively poor decision. Likewise, the ultimate question raised by Shiller is to what extent we can count on markets to efficiently (i.e. correctly) price different types of commodities. If there are market failures, whether we attribute them to “irrationality” or “imperfect information” seems to be a somewhat (although not entirely) semantic discussion.
Where Posner’s critique is more successful is in questioning what specific policy prescriptions should follow if Shiller’s thesis are correct; this too was something that I found somewhat wanting in Animal Spirits. Ultimately, the implications may be more pedagogical than political: we need to encourage individuals to engage in a certain amount of de-programming, and to question the world around them at every stage of their lives, including both the judgment of experts and their own assumptions and thought processes. But this conclusion may be uncomfortable for a lot of people, possibly including Posner.