Infectious Exuberance

Financial bubbles are like epidemics— and we should treat them both the same way.

How can we inoculate ourselves against a recurrence of this whole awful cycle? Government officials today are rightly pushing regulatory reform to prevent lending abuses and reckless behavior among financial institutions. But that doesn’t address our psychological vulnerability to bubble thinking, which seems greater than it’s ever been. During the stock-market boom of the 1990s, the national psyche, long infused with a Protestant work ethic, seemed to undergo a transformation, and the idea arose that we could expect to make a lot of money by investing. At the same time, the proportion of Americans owning stocks and homes was increasing. We should be happy that more people are investors and homeowners today, but those latest to the game are often the least sophisticated players, most susceptible to irrational optimism—one reason why the most-recent stock and housing bubbles grew so large.

Irrational exuberance is bound to pop up from time to time; we can’t stop it altogether. But we probably can limit it, preventing some bubbles and keeping others smaller. Boom thinking is carried along by bad arguments and bad information. The key to keeping the transmission rate low and the removal rate high, if you will, is better dissemination of reliable information—something the government should focus on over the coming years.

Many households have access to very little financial insight. In most cases, the only financial professionals they come into contact with are trying to sell them something, whether it’s a mortgage or a stock. Independent financial advisers, who provide more-comprehensive advice, have typically been available only to the relatively wealthy. The questions most people need answered are elementary: How risky is this investment? Have prices ever gone up this fast for this long before? Can I afford this loan if interest rates rise? But they’re not getting straight answers to these questions.

Financial advice is in some respects like medical advice: we need both on an ongoing basis, and failure to obtain either can impose costs on society when our health—physical or financial—suffers. There’s a strong case to be made that the government should subsidize comprehensive financial advice for low- and middle-income Americans to help prevent bubbly thinking and financial overextension. One way to do this would be through co-pay arrangements like those in place for Medicare or for private health insurance. Accredited advisers, charging a flat fee, would be partially reimbursed by the government; the moderate costs to consumers would create a much broader market for their services.

We also need to get better—and more—information to more-sophisticated investors and financial professionals. In real estate, one important way of doing that is by further developing the financial market rather than focusing only on regulating it or reining it in. For instance, real-estate futures markets, which have existed since 2006 but are still in their infancy, have the potential to tame future housing bubbles. Without them, there is no way for skeptical investors who think they see a rising bubble to express that opinion in the market, except by selling their own homes. If futures markets grow, then any skeptic anywhere in the world could profit from a bubble in, say, Las Vegas, by short-selling real estate there. Substantial short-selling would reduce bubbles, and provide information to home builders, ratings agencies, and others. In turn, builders, for instance, might not overbuild if they see that most of the money in the futures markets is being bet on price declines.

Subsidized financial advice and the encouragement of real-estate futures markets are just two examples of the sorts of actions that could limit future bubbles. The larger point is that increasing the amount, accessibility, and reliability of information about investments should be a high priority for policy makers. Epidemiology suggests that even very small changes to the transmission rate of a disease can make the difference between an epidemic and a low-incidence disease. If better information inoculated even relatively few people against boom thinking, that could prevent many bubbles from rising.

There’s another, more urgent reason to focus on the idea of social contagion today. Like booms, many busts are magnified by group thinking. And once busts become severe enough, they prompt changes in the national mood that ramify well beyond economic affairs. Benjamin M. Friedman, in his 2005 book, The Moral Consequences of Economic Growth, cites abundant historical evidence that when economic prospects look bleak—especially for long periods of time—intolerance, racism, and other reactionary impulses flourish. As more people experience hardship, trust between them tends to diminish, and the social fabric itself seems to fray.

If home prices keep dropping, more bailouts of banks and broker-dealers likely will be necessary to prevent the paralysis of the financial system and a severe loss of confidence in our economy and economic institutions. And if we aim to stop foreclosures, with all their ugly consequences, from spreading further, many, many homeowners are going to need loan refinancing—which will need to be provided or backed by the government. Bailouts of investors and prospective bailouts of unwise or unlucky home buyers have stirred a lot of controversy, and indeed, financial bailouts are, for many reasons, unsavory. But given the severity of the current financial seize-up, they are needed—not to prop up Wall Street profits or housing prices, but to prevent a fundamental loss of economic confidence and to maintain a sense of social justice for those of modest means. Losses of confidence and trust can mount with surprising speed, and beyond a certain point they become very difficult to recover from.

We recently lived through two epidemics of excessive financial optimism. I believe that we are close to a third epidemic, only this one would spread irrational pessimism and mistrust—not exuberance. If that happens, our economic problems will become much worse than they need to be, and our social problems will multiply. Only if we heed the lessons of the boom can we keep the bust from causing lasting damage.

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Robert J. Shiller is a professor of economics at Yale University. This article is drawn from his forthcoming book, The Subprime Solution, to be published in August by Princeton University Press.

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