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Sunday, November 8, 
12:09 am

Did Shiller really go against the crowds?

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Robert_Shiller_SM.jpg Robert Shiller, the man who predicted both the dot-com crash and the more recent real estate bubble, penned an interesting editorial in Sunday's New York Times, where he examined why so many so-called experts managed to miss the signs of a housing bubble. The reason is that outside-the-box thinkers like professor Shiller face a lonely and pressure-filled existence where their theories are at best not taken seriously and at worst viciously attacked by naysayers who drank the Kool-Aid. This, in short, leads them to clam up and keep their feelings to themselves.

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Going against the wisdom of crowds is certainly very difficult, as Republicans in New York City can attest Wednesday morning. And Shiller has undoubtedly made some very unpopular predictions in his time. Calling the bubble in tech stocks looks obvious in hindsight, but at the time it was anything but. He presciently adapted these theories to the housing market with the second edition of "Irrational Exuberance" in 2005. But he didn't quite call this.

In the Times article, Shiller writes that

in the second edition of my book "Irrational Exuberance," I stated clearly that a catastrophic collapse of the housing and stock markets could be on its way. I wrote that "significant further rises in these markets could lead, eventually, to even more significant declines" and that this might "result in a substantial increase in the rate of personal bankuptcies, which could lead to a secondary string of bankruptcies of financial institutions as well" and said that this could result in "another, possibly worldwide recession."

Fine and good. Only, that's not how things played out. The bankruptcies of Lehman Brothers Holdings Inc. and Bear Stearns Cos. among others were not caused by personal bankruptcies but by haywire derivatives contracts. Specifically, the credit default swaps financial institutions were relying on to protect them from subprime exposure turned out to be worthless. Many financial institutions on Wall Street and elsewhere might have even profited from the subprime crisis, had there been a settlement mechanism in place for CDS, as there is for options and other derivatives.

Now let's take a look at what Shiller has said about these very instruments. In an article published this March by Project Syndicate, he wrote the following:

Some of the innovations associated with the subprime crisis ­ notably option-ARM's, when extended to borrowers who couldn't handle them ­ seem to have little redeeming value. But others ­ those involved with the securitization of mortgages ­ were clearly important long-run innovations, because they can help spread risks better around the world.

Uh huh. They can spread risks all right. Who would have thought that companies like American International Group Inc. had exposure to this stuff? You've got these long-run innovations to thank for that one.

By the way, if Shiller tries to claim at some later point (if he hasn't already) that lack of financial regulation got us into this mess, he will be changing his tune. In the same article, he wrote that "while it does sometimes appear that the current crisis is due, at least in part, to financial innovation, financial-market liberalization has been shown to be a good thing overall." He added that "we should not slow down financial innovation in general. On the contrary, some of the fixes that result from the subprime crisis will probably take the form of still more innovation, further increasing the sophistication of our financial markets."

Obviously this does not mean we should discredit Shiller entirely (or at all, even). His research and insight has been nothing short of groundbreaking. He remains an authority on financial matters great and small -- and justifiably so. But the alarming depth and range of the financial crisis appears to have confounded even him. Which is entirely understandable. Just don't let him claim otherwise. - Nathaniel E. Baker

See op-ed story from The New York Times

Nathaniel E. Baker is The Deal's middle market editor.





Comments

From: Gary,

It is a bit myopic to assume that because the Lehman and Bear bankruptcies were not caused by personal bankruptcies that Shiller is wrong in his statement that “these markets could lead, EVENTUALLY, to even more significant declines” resulting in personal bankruptcies and a “SECONDARY string of bankruptcies of financial institutions.” We are only recently seeing the effects of a collapsed housing market on consumer spending and the broader economy. It may take several more quarters of a recessionary environment before personal bankruptcies collapse additional financial institutions as unemployment increases and homeowners can no longer access home equity lines of credit. But surely as Americans binged on housing credit, they have binged on personal credit as well, and the time will come to pay the piper.


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