Irrational Exuberance

Shiller capitalises on the stock market boom in the run‐up to the new millennium – but before it collapsed earlier this year – and succeeds in his aim to provide a broad study of the recent boom and to place it in the context of stock market booms in general. The book’s main suggestion is that stock market prices reflect more than the sum of available economic information‐prices may indeed be subject to irrational exuberance. Shiller asks whether or not the value that investors have ascribed to the market is in fact real. In trying to find an answer to this question, Shiller explores several fields, e.g. demography and sociology, that may account for irrational exuberance. The book first examines factors outside the stock market, so‐called precipitating factors, then cultural factors and psychology are discussed.

The precipitating factors are claimed to contribute to the self‐fulfilling psychology of a roaring stock market. Among the factors mentioned are the Internet, the baby boom, increased media coverage of business, the rise of 401(k) plans and feelings of victory over foreign economic rivals. Although the majority of factors are concerned with developments in the USA, some, such as the developments in information technology or media coverage, are certainly applicable to markets elsewhere. At any rate, the account appears circumstantial.

The book proceeds to examine ways in which the influence of these precipitating factors can be amplified. Here, Shiller explains how investor confidence and investor expectations for future market performance work as an amplifying mechanism via a feedback loop. This feedback takes place, because past price increases generate higher investor confidence and/or generate expectations for further rises. As for related influences, Shiller mentions increased attention to the market and the emotional state of investors when they make investment decisions. Claims of this nature are mainly supported by evidence from investor surveys.

Shiller goes on to present a set of cultural factors that may explain speculative bubbles. In this section, the impact of the news media on market events and new era economic thinking are discussed. The main influence of the media is seen to be their ability to foster stronger feedback from past to future price changes, and to foster attention cascades. New era thinking refers to the perception that the future is brighter or less uncertain than it was in the past. According to Shiller, “[c]onventional wisdom interprets the stock market as a reaction to new era theories. In fact it appears that the stock market often creates new era theories, as reporters scramble to justify stock market price moves” (p. 99). Thereafter, Shiller presents an overview of new eras and bubbles from around the world. The analysis up to that point had concentrated on the USA, whereas this section illustrates that very large stock price movements are quite common by world standards. Interestingly, the USA does not appear among the entries in the tables of largest stock price changes. As Shiller points out, our view of human nature and its ability to judge consistently and independently will shape the conclusions we draw from the evidence he presents. In the following section, Shiller therefore discusses fundamental psychological factors that bear on the plausibility of our view of speculative bubbles. First, psychological anchors are introduced. Psychology research has documented patterns of human behaviour that suggest the existence of particular anchors for the market, which one would not expect to find in rational markets. Quantitative and moral anchors are distinguished, and further psychological patterns of behaviour, such as over‐confidence and magical thinking, are presented. Shiller emphasises, however, that these anchors can only influence the whole market, if the same thoughts enter the minds of many. He then analyses tendencies towards herd behaviour and the contagion of ideas. The presentation draws on psychological evidence regarding the influence of majority views and on information cascade theories. These points conclude Shiller’s case for the plausibility of irrational exuberance as a driving force in stock markets. The argument is placed in historical context, and the psychological evidence is most interesting. Nevertheless, one is left with the impression that most of the evidence is only circumstantial.

In the next part of the book, Shiller gives the stage to the opposition, and discusses attempts to rationalise the recent high stock market levels. The discussion focuses on the efficient market hypothesis (EMH), and arguments of investor learning. Shiller points out that EMH does not state that markets cannot experience periods of significant mispricing lasting years or longer. He presents evidence that earnings growth and price growth do not correspond well, nor do dividend movements and price movements. Although Shiller questions the link between fundamentals and stock prices, he does not point out how EMH and rationality are related. The argument of investor learning is summarised by Shiller as follows. “The market was not efficient a few years ago; it was too low; but (maybe) it is efficient now” (p. 191). Furthermore, Shiller questions whether or not people have really learnt something novel, since the idea of superior performance of stock investments has been raised in the past. From an academic point of view, this chapter does not sufficiently address the subject of efficient markets; however, bearing in mind the general public as a target audience, it gives a good, concise presentation of the main ideas.

In the final part of the book Shiller turns to the question of what one should do when faced with irrational exuberance. He emphasises the need for proper diversification, and criticises 401(k) plans, since – in his opinion – they encourage people to invest too heavily in risky investments. There are also calls on foundations and college endowment funds to review their payout policies. Furthermore, Shiller believes that the authorities should further facilitate free trade, as well as generating greater opportunities for people to invest in more and more open markets. This suggestion seems to contradict a point made in the first part of the book, where increased trading opportunities were viewed as a precipitating factor for irrational exuberance. This contradiction is not addressed. In addition, Shiller points out that he does not favour the use of aggressive tightening of monetary policy to deal with speculative bubbles, nor does he support the use of measures to interrupt or discourage trading for this purpose. According to Shiller, the most important issue is to encourage proper risk management and to facilitate trading, and not to be distracted from these tasks by the current bubble. The recommendations in this chapter are made with the US market and its structures in mind, but the more general points are applicable to other markets.

Regardless of whether or not one agrees with Shiller’s argument that irrational exuberance is at work in stock markets, he has managed to present a very interesting picture of stock markets today in an accessible way, synthesising ideas from very diverse fields. The book would, however, have benefited from the inclusion of a summary or conclusion chapter to recap the main points of the argument. Given the recent market drops, Shiller’s predictions of a bleak market outlook after the bubble will probably attract a more attentive audience now than a few months ago.