Bubble Buster

The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About ItBy Robert J. ShillerPrinceton University Press,

The Subprime Solution:
How Today’s Global Financial Crisis Happened,
and What to Do About It

By Robert J. Shiller
Princeton University Press, 196 pages, $16.95

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Different year, different boom, same Cassandra.

Robert Shiller, the Yale economist who borrowed Alan Greenspan’s phrase “irrational exuberance” for the title of a 2000 book predicting the collapse of the dot-com bubble due to fatally flawed “boom thinking,” has applied the same theory to the short-lived, 85 percent run-up in real estate prices between 1997 and 2006. Repeatedly invoking the Great Depression, he argues that as a corrective, policy makers need to “think and act on the scale of New Deal-era reformers.”

Mr. Shiller intends the reforms not to shore up home or equity prices, but rather to cushion the blow of the recessionary hammer brought down by the bust—and also to minimize disillusionment with the financial system. The idea of invoking the Depression and the rise of fascism (and Eleanor Roosevelt trekking through the D.C. mud in 1933 to placate a communist-inspired militia) may strike some readers as alarmist, but Mr. Shiller’s prognostications and reform package deserve careful consideration—after all, he’s been right before.

The Subprime Solution, his postmortem on irrational exuberance in the real estate market, is superb, even for general-interest readers otherwise confused by the whole mess. Though his introduction reads a bit like an arid position paper, his insistence on the fundamentally psychological, rather than economic, basis of the boom is supple and fascinating.

The over-valuation of real estate was brought on, he argues, by a “contagion” of bad thinking: Americans as a whole became convinced that real estate fundamentals such as personal income, the cost of building materials and the ratio of home values to rent no longer mattered. Repeated endlessly, the “real estate myth” of homes as an asset destined to appreciate indefinitely due to economic growth, scarce land and a swelling population became a truism, even though it was wrong—as we’re all finding out now.

As Exhibit A, Mr. Shiller includes an expanded version of a key chart that he created for the second edition of Irrational Exuberance. The chart tracks the real value of a typical American house from the 19th century to the present—in comparison with population size, building costs and interest rates. While the other factors appreciated moderately over the century, home prices exploded in 1997, like a “rocket taking off.” In other words, home prices took off due to the psychological contagion of boom thinking, rather than for any economic reason. In a passage perhaps most shocking to those of us blinded by the real estate myth, Mr. Shiller points out that typical homeowners grossly overestimate the real appreciation in home value by failing to adjust for inflation: “We get the false impression that homes have been a spectacular investment when in fact their increase in value … even over many decades, would generally have been—at least until the recent housing boom—nil.” Nil!


IN ADDITION TO emphasizing the crooked timber of human psychology during the bubble, Mr. Shiller has an insightful sociological observation to make. He worries that the emphasis on quick fortunes during the tech and real estate booms has eroded the Protestant work ethic. Instead of valuing how well a person does his or her job, whether it’s plumbing or corporate governance, Americans now tend to admire wealth accrued by any means necessary. According to boom thinking, a person who spent the past 15 years working steadily at a job rather than riding the NASDAQ or flipping condos isn’t admirable—he’s kind of a loser. Why settle for laboring at a calling when you can watch your net worth double merely by sitting in your house? Or so went the conventional wisdom through 2006.

Along with devaluing work in favor of wealth, the real estate boom caused and was fueled by a decline in lending standards, particularly where unsophisticated low-income borrowers are concerned. To protect these unfortunate victims from ethically challenged lenders and their own bad judgment, and because collateral damage from foreclosures, loss of equity, huge write-downs and bank failures has sinister knock-on effects in the world economy, Mr. Shiller argues for his “subprime solution”—a broad package of short and long-term bailouts and reforms. He freely admits that bailouts are unfair to prudent borrowers and lenders, but suggests that the overall threat to the economy is too great to for us to cling to laissez-faire principle.

As a form of intensive care to those on the edge of foreclosure, Mr. Shiller favors the formation of an agency patterned on the Depression-era Home Owner’s Loan Corporation (HOLC). His new HOLC would loan money to troubled lenders on the condition that they offer mortgages on more stable terms. For example, Roosevelt’s HOLC insisted that any new mortgages be 15 years in duration, and have fixed-rate, monthly payments, with no large sum due at maturity. Mr. Shiller also suggests that we be ready to fund more tax rebates.


HIS LONGER-TERM PACKAGE of reforms reads like an extended wish list: He wants the government to subsidize financial planning for lower-income consumers, who generally receive only self-interested advice from biased sources like realtors or stockbrokers; a financial products consumer “safety” watchdog, and default mortgage conventions that make safe, conservative terms standard; improved electronic disclosure by finance companies so that investors can see the “guts” of mortgage-backed securities; and home-equity and livelihood insurance, with benefits perhaps formulated with the help of a national database of fine-grain details about each citizen’s financial state.

Mr. Shiller believes that better capitalization of the housing futures market (which he helped develop) would allow investors to express skepticism about future bubbles, and he would like to see federal debt indexed to G.D.P. Lastly, in what he admits would be a “revolutionary step,” he’d like to see the U.S. follow the lead of Chile and change to an inflation-adjusted unit of exchange, helping people to see money in real terms.

Given Mr. Shiller’s demonstrated ability to cut through the ocean of self-justifying nonsense in the area of economic forecasting, we have to accept that the consequences of the real estate boom and bust may be every bit as dire as he thinks. But if he’s going to agitate for dramatic changes—he cites the Marshall Plan as a precursor—he needs to better explain why the consequences of inaction will be calamitous. They may be obvious to him, but to the man on the street they’re not. Robert Shiller knows full well that his readers are prone to irrational exuberance—his book would have been even better had he spent more time showing why it’s too late to hope that prosperity is just around the corner.

Andrew Rosenblum’s writing has appeared in Mother Jones, Popular Science, Slate and Jazz at Lincoln Center Radio. He can be reached at books@observer.com.

Bubble Buster