Davos Notebook

Shiller sees a new paradigm

January 31, 2009

Robert Shiller, the Yale economics professor who identified the housing bubble early, scents a profound change at Davos this year.

 ”There seems to be a paradigm shift underway in our thinking about the economy. I was surprised to see how similar other people’s thinking was to my own,” he said.

 ”The efficient markets theory really is not going to sell any more. You think about teaching an MBA class and talking with unhedged praise about the efficient markets theory you’d be in trouble. The students just wouldn’t accept it.”

Shiller has long argued that markets are susceptible to bubbles, in part because the psychology of rising markets becomes embedded in people’s thinking, prompting them to pour more cash into rising assets irrationally and without regard to their fundamental ability to generate cash or other value.

“Markets aren’t efficient and we are vulnerable to bubbles.” The new paradigm “kind of puts us back to a somewhat earlier stage of capitalism. We are not abandoning capitalism but we are acknowledging its imperfections. There will be a bigger role for government.”

On U.S. housing, Shiller notes that research he does on attitudes towards house prices still showed long term optimism about prices last July.

“I bet we might see some more significant drops (in optimism) when we do our next survey in several months.”

Shiller’s work on long run house prices showed that in the U.S. they stayed comparatively flat for the 100 years to 1990 in real terms, before soaring. We are now more than half way back to that long run level.

He doesn’t make house price predictions, so I’ll have to. An overshoot is not out of the question and if it comes will make whatever bank insurance schemes now being born an irrelevance.

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