«It’s been a surprise that these low interest rates lasted as long as they did» says Robert Shiller.
In the field of economic sciences there is a revolution going on. At its core, this radical change is not about how markets would behave if they were perfectly rational but how they actually behave. At the vanguard of this movement is Robert Shiller. The Nobel laureate is worried about the rise of populism and sees early signs for an awakening of animal spirits in the financial markets.
Professor Shiller, around the world you’re well known as an influential economist. But in your spare time, you are also an avid astronomer. What do you think economists from another galaxy would say if they took a look at planet Earth?
It’s an interesting question. There must be civilizations on other planets. I bet their economy resembles ours: They quote interest rates and they have speculative markets, at least some of them do. Economics is often thought of as a universal science. It’s almost like a branch of mathematics.
What do you mean by that?
In any civilization that has scarce resources there should be prices to manage them. That means they’ll probably also have a currency. In this area right here, 500 years ago the Algonquian tribes had a real economy before the Europeans arrived. They had money made out of seashells called wampum. That’s not as remote as other planets. But it shows that the same ideas occur in different intelligent minds.
So what would those aliens say about the economy on our planet?
The latest thing, of course, is the rise of demagogues in politics. A way to understand this development is narrative economics. A narrative is basically what people are talking about and according to narrative economics, fluctuations in the world’s economies are largely due to the stories we hear and tell about them. These popular, emotionally relevant narratives sometimes inspire us to go out and spend, start businesses, build new factories and hire employees. At other times, they put fear in our hearts and impel us to sit tight, save our resources and reduce risk.
And what does this mean with respect to the rise of demagogues?
Narratives are stories people tell but they are not necessarily the truth. An example would be that Barack Obama was born in Kenya and therefore does not qualify to be the President of the United States. That’s a narrative. It’s also called an urban legend because it just isn’t true. Anyone can check on it and find out that he has a birth certificate. But such narratives can circulate like viruses. You can trace this concept back to 1895 when the French sociologist Gustave Le Bon wrote his book called »The Crowd». In that book he talks about idea microbes. He didn’t use the word viruses because they had not been discovered yet. But microbes are basically the same idea.
How dangerous are such thought-viruses?
People always had crazy ideas. But today, the epidemic spread of them is faster because the internet has expanded their unmanaged transmission. It used to be newspapers like « Finanz und Wirtschaft» and other established media outlets that people trusted. But now, we have all these websites and it’s leading to a troublesome loss of factuality. On top of that, there’s a growing myth that the press can’t be trusted. Also, people try to plant narratives. They create them and that’s a part of modern living. We all have our websites and we participate in social media which have the potential to be more contagious. So to me it’s troublesome where we are going.
President-elect Trump used such «fake news» masterfully during the elections. Why were so many people drawn to his campaign?
One thing that’s often pointed out is that inequality has been getting worse. Additionally, the progress that we have seen lately in information technology is so dramatic that we have worries about losing our jobs. For example, it used to be that when you lost your job you could still be a taxi driver. But soon there are going to be driverless cabs everywhere. So those jobs are all going. Another thing that came out just recently is Amazon Echo and Google Home. These are devices you put in your home and you can just ask for something, like «Alexa, what time is it? » That reminds me of the movie « 2001: A Space Odyssey» where HAL was like a voice in the room you could talk to. These might be exciting times if you’re a computer expert or the founder of an online social media company. But from the perspective of an average person those career trajectories are reserved only for hotshot young people and geniuses. As a regular person I have to fear that I’m losing out and I’m worried where I’m going to be.
And how does Donald Trump play to that?
In the US and in other developed countries as well, a lot of white men have had good jobs in factories doing heavy, manly work and earning a good income. But now those jobs are disappearing and they end up having to take less attractive jobs. That is not something that appeals to most men and you can imagine that they look for someone who will save them. So what demagogues around the world are doing is offering those people false hope that their problems are due to immigrants and globalization whereas they are ignoring the information technology side of it because they can’t do anything about that.
Then again, as a real estate billionaire from New York you would think Mr. Trump has not much in common with blue-collar workers from the industrial Midwest.
Those people don’t want welfare. They want to be strong. And that’s exactly the persona that Donald Trump produced in his TV show « The Apprentice». It was always about a strong business man who works miracles and is like a stern father: Eventually, he will fire you but before that he gives you some last kind words and advice and sets you off and maybe you will do better the next time. That’s his narrative which he was able to spread very effectively and which has such power. On top of that comes the mistrust of the authorities, of the scientists, of the press and the narrative that they’re all in a conspiracy.
What is going to happen if Trump disappoints his supporters?
This narrative can also backfire. I worry we’re about to see that in the US. Once there is a narrative that a guy like Donald Trump is a genius then he feels that he has to live up to it and he doesn’t really know what he’s doing. On the other hand, it’s possible that he will inspire people. I wasn’t inspired by him but I look around and see how many people were. In this election he had an amazing effect on animal spirits, the social phenomena John Maynard Keynes described as spontaneous urge to action rather than careful and deliberate calculation.
Signs of animal spirits are also in sight when you look at Wall Street. For instance the yields on ten year treasuries have skyrocketed since the elections. Is this the end of low interest rates?
Interest rates have risen, but historically they’re still low. There isn’t any received wisdom about just exactly why they are so low. It’s natural to put it on to the financial crisis of 2007/08. That’s because it’s a dominant narrative that everything today must be due to the financial crisis. But the downtrend in interest rates has been going on for over thirty years. So it doesn’t look like it’s just because of the financial crisis. That’s why I’m inclined to think that is has something to do with technology. We are living in a time where we are worried about our future because of rising inequality and jobs being replaced by robots. So people want to save but they don’t actually end up saving because they bid up prices of assets like bonds that look safe.
What would it take to change the psychology of the financial markets?
It’s been a surprise that these low interest rates lasted as long as they did. So you might think it’s time – even without Trump – for interest rates to start going up. For instance, in the US the Federal Reserve was already talking about raising rates even before the election. Another thought is that there is more worry about a possible default on US debt. I don’t think that’s very likely but there might be some concern because Donald Trump had bankrupt businesses many times. So he doesn’t look like someone who would go to the wall to defend the integrity of the US debt.
And what about the stock market? For US equities, the cyclically adjusted price-to-earnings ratio, also known as CAPE or Shiller P/E, is now at around 28. Such rich valuations were only seen before the market plunges in 1929, 2000 and 2008.
Honestly, I don’t know what to make of US stocks right now. President-elect Trump might actually boost the market even further. First of all, he wants to cut the corporate profits tax. That’s an immediate direct feed into the stock market. Secondly, he doesn’t care about the environment or other quality of life things. He just wants corporations to succeed. That’s also bullish for the stock market. And then thirdly, he is an inspiration to many people. So maybe they start spending more and maybe someone will try businesses that were considered too risky before. So I’m tempted to be optimistic for the short run and I can I imagine that US stocks go up from here for a while even though valuations are at a high level.
If emotions like greed and euphoria take over at the stock market, it usually ends ugly for investors. Nevertheless, one can observe such kind of excesses quite regularly. How come?
Well, part of the dynamics is what’s called wishful thinking by psychologists. People believe to some extent what they want to believe in and what justifies their actions. They want to think of themselves as moral and smart. So once they’ve taken a position they start to bias their thinking toward believing in a successful return on their investment.
One of the most stunning market exaggerations happened during the dotcom bubble. Fed chairman Alan Greenspan warned already at the end of 1996 of «irrational exuberance». What exactly happens during such periods?
This could be 1996 again. That would mean we have four more years of stock price increases. That’s a lot of time. But you also have to remember to get out and it’s hard to spot the turning points.
What’s your explanation of what’s going on in the late stages of a bubble like at the end of the nineties?
When Greenspan presented his speech a lot of people already had the internet at home. So it was all the talk and excitement at that time. The stock market was already high but it was going to go higher. Also, we had the new millennium coming which encouraged optimistic thinking. Of course, that’s completely irrational. The year 2000 is just an arbitrary choice somebody made a long time ago as the result of the probably incorrect dating of Jesus’ birth date. Nevertheless, it sounds real and important. So there were a lot of animal spirits growing at that time. But then it gets beyond bounds and it starts to look crazy. That’s why I wrote my book « Irrational Exuberance». For the first edition I called up my publisher and urged to rush this book into print because I was just worried that the market would crash before it came out.
The book was published in March of 2000, right at the peak of the dotcom bubble. But such kind of exaggerations shouldn’t even exist if you believe in efficient markets.
The problem is that the world is too complicated. Part of what drives markets, people believe, is what other investors are doing. So as an investor you end up trying to predict what other investors are going to do. It’s like a game we’re playing. That’s why it’s not going to work out that everything is optimally priced and stable.
Even so, until a few years ago, the efficient market hypothesis was dominating economics. Why?
The arguments for efficient markets are not that everyone is smart but that there is smart money. So if there was a profit opportunity they would cash into it aggressively and that should eliminate this opportunity. Basically, the efficient market theory says that markets are efficient because the smart money has put so much effort into predicting that everything is perfect. But my impression is that there is not a whole lot of really smart money. Also, according to the efficient market theory there is all this smart money putting an effort in trying to figure everything out. But then again, there is no profit to be made. So why would they be doing it? If they’re smart they should be doing things like music, writing poetry, art, microbiology or whatever is meaningful. So it’s not as easy as you might think. If you are smart there is something to be gained by putting effort into investing because not everyone is smart.
So how far should we rely on free markets?
Actually, we’ve never tried 100% free markets because the governments had always some regulatory impact. For instance, if you look at the 20th century versus the 19th century, in the the 20th century people were better off partly because of regulation. For instance, if you go back to the 19th century, most of the patent medicines you could buy in a drug store were fraudulent. In the United States there was a drug called «Swaim’s Panacea» that claimed it cured everything. You have to be skeptical of that, right? People are dying, so are they not taking «Swaims Panacea»? Finally, when they set up the Food and Drug Administration they found out that there was really nothing in those «Swaim’s Panacea». So rather than being essentially benign and always creating the greater good, markets are inherently filled with tricks and traps.
How do such traps in today’s financial markets look?
I think financial service providers may have more of an opportunity to trick people than say lunch providers. When you eat lunch you pretty quickly know whether you like it or not. But you don’t find out about your financial investments until many years have gone by. So that creates more of an opportunity to deceive people. A typical illustration would be high fees charged by some financial service companies not being justified – and there are many examples of that.
So how should investors place their bets?
This sounds very trite but I want you to hold a diversified portfolio. For instance, there is a tendency for auto workers to invest in their own company. Maybe that’s a good sign, maybe it’s a sign of loyalty and it will encourage them to do well on their job. But from a risk management standpoint it’s backwards.
If you want to manage risk your human capital is probably more important than your stock market investments. So you want to use the stock market as an insurance mechanism against your occupation. Therefore, theoretically, a manager at a car manufacturer should short the stock of his own company because his career is so tied up with one sector. Also, you should sell short your own country. This is something that has been advocated, yet it sounds so unpatriotic that most people would never do that. I’ve never sold America short. But more generally, you want to invest around the world in a diversified portfolio and not worry too much.
How are you positioned personally against this background?
My portfolio is diversified across asset classes and around the world. At this time, I have more money in Europe than in the US because I just look at the valuations and they are a lot lower for Europe than for the US. Hence, right now I think Europe generally is a better investment for the long run. So I believe in Europe, eventually. I guess that’s probably also because I’m European when it comes to my ancestors.