Merryn Somerset Webb talks to Yale professor and Nobel Prize winner Robert Shiller about the bond market, and how the power of ‘stories’ drives the global economy, and creates financial bubbles.
• If you missed any of Merryn’s past interviews, you can see them all here.
Merryn: I’m here today with Professor Robert Shiller, Yale professor, Nobel Prize winner, author of one of our favourite books, Irrational Exuberance, which is just out in its third edition. Look out for that – we will put details up at the end.
He’s also the inventor of Cape, which regular readers will know we are very, very impressed by and depend on a lot for our recommendations to you, and he is president-elect of the American Economic Association. That’s quite a long list, but I think what we’re going to talk about now is slightly more simple than that long list of names.
We were talking earlier about stories and how the economy is really just a series of stories and it’s a matter of interpreting those stories; can we talk a little bit about what you mean by that?
Robert Shiller: The human mind, the human brain, seems to be, according to some psychological literature, organised around narratives. We tend to base our thinking, especially thinking that motivates us and excites us, in terms of stories – and typically human interest stories.
You have a sense of identity; you want to know, “What is my life story?” Most people have a sense that it’s so interesting, “My story,” and they want to tell people about it. But they take motivation to act based on stories that ignite emotions like, for example, envy. If you hear the story about someone who’s done brilliantly investing, that is motivational.
Merryn: OK, so all these individual stories can create what you call a ‘collective consciousness’ that makes whole nations or groups of investors behave in the same way, simply as basically a result of, I don’t know, seeing property programmes on television, or this kind of thing.
“Greece matters because of the story it generates. It’s really not that important to the European Union, but it’s a story.”
Robert Shiller: Right.
Merryn: That, as I understand it, is how you think perhaps bubbles begin to build.
Robert Shiller: Yes, bubbles in financial markets are a special case of what sociologists have called ‘social epidemics’. I’ve started lecturing to my class out of medical textbooks –there are mathematical epidemiology textbooks – when you read those stories, they can be applied directly to the economy as well.
It’s that ideas have contagion. There’s what have been called ‘thought viruses’ that spread from person to person, or ‘memes’ as Richard Dawkins called them. I think I’ve traced that idea back to the 19th century, but it’s never really invaded the economics profession that feels that all this psychological talk is undignified. They want to talk about central bank monetary policy, things that have a crisp sound to them, although the profession is changing; there is more and more interest now in behavioural economics.
Merryn: And d you think that there is a story doing the rounds at the moment that has become part of our consciousness that is driving markets?
Robert Shiller: There’s a number of them. I was recently talking about Greece as a story. My first reaction in hearing about Greece is, “What’s the population there anyway?” It’s tiny, so it can’t matter. Turns out it can matter because of the story it generates.
The reader doesn’t necessary think about or know how big Greece is. Greece just sounds awfully important, doesn’t it? It’s the ancient origin of our philosophy and science. It’s really not that important to the European Union, but it’s a story.
I think that the European sovereign debt crisis is really an amplification of the Greek story. It all started there, and it didn’t have to have all these repercussions if it weren’t for the power of the story.
Merryn: The power of this particularly bad story in one small area that then gets taken to represent the whole story, making it much worse than it really is.
Robert Shiller: Right. Stories are especially powerful if they tap into our sense of identity: “Who am I?” Identity is an extremely important motivational for us. People want to know, “Why am I a good person? Why am I better than another?” They wouldn’t like to put it that way, but in reality they’re competitive.
The Greek story had something about Greeks being entitled – I’m not saying that, I’m saying this is the story – thinking that they should be bailed out by other people for their own profligacy. That’s a powerful accusation and it’s a story that ignites interest, but it also ignites fears that Greece might default, and then once you get on that line of stories it amplifies to other countries as well.
Merryn: This gives an impression for the investor of Europe that is not necessarily correct.
Robert Shiller: Yes.
Merryn: Again, you were saying earlier that the Cape for Europe at the moment is half that of the Cape for the US, the cyclically adjusted P/E ratio, so the impression given is that Europe is worth half what America is worth, and that’s not necessarily the case.
Robert Shiller: When you think of American investors, what do they know about Europe? There was a recent study where investors – people, random Americans – were asked to find Ukraine on the map. It was horrible; they have no idea. They think it’s in Australia or something. Greece, it’s just a story and they start to think, “It must be representative of Europe.”
Merryn: The point being that it has pushed, possibly, valuations in Europe much lower than they should have gone, so if you follow your general idea that the Cape is mean reverting buying Europe, even now, is a perfectly reasonable proposition.
Robert Shiller: I think Europe is a good investment now and the US is not so good, but of course I could be wrong. I just can’t imagine that American stocks should have twice the valuation of European stocks.
“The government should be borrowing heavily and investing in anything that yields a positive return.”
Merryn: In the first edition of Irrational Exuberance you talked about the stockmarket, in the second you talked a bit about the housing market, and the third one you were saying that there is a piece on the bond market. What does that tell us?
Robert Shiller: The bond market is strangely high in value right now. If you look at inflation-indexed gilts here in the UK, they’ve been negative on and off for several years, even at 20 years, so people are willing to lock up their money for 20 years at a guaranteed negative return.
Merryn: This is something that is very much affected by quantitative easing, so it’s very hard to tell what prices should be, given the amount of intervention from central banks’.
Robert Shiller: Another way of putting the puzzle is if I can borrow at a negative interest rate, I ought to be able to do something with that. The government should be borrowing, it would seem, heavily and investing in anything that yields a positive return. Wouldn’t you think that the UK government could find more to invest in that would have some positive return?
Merryn: It’s very hard to find infrastructure investments that have long-term positive returns, though, isn’t it?
Robert Shiller: Yes. Incidentally, that comes back to another proposal… It’s really Franklin Delano Roosevelt’s proposal in 1942. No-one remembers this. Do you remember? Do you know what I’m talking about?
Merryn: Not yet.
Robert Shiller: In 1942 President Roosevelt created a government agency called the ‘Public Work Reserve’, and what it was going to do was to take long-term planning for infrastructure projects that would hire the unemployed after the war was over to prevent another depression. He recognised that these infrastructure projects don’t just leap out at you. If you’re going to build a new highway, do you know how long it takes to plan a new highway? You’ve got to get legal permits. So, he said, “Let’s do long-term planning”.
Unfortunately, the war was too much of a distraction and the agency was just shut down, but that was the idea. I’ve been advocating and Professor Shubik at Yale has been advising, “Let’s do it again. Let’s create a government agency whose charge is, ‘Think big and spend money planning and getting permits and doing the soil tests.’ Let’s think.”
That isn’t happening anywhere; no country has that. We’re not thinking like investors facing a negative interest rate. Even the corporate sector, you might think, would be investing at a very high pitch. They’re not, so something is amiss.
Merryn: Is it that they don’t want to borrow going into a deflationary environment?
Robert Shiller: Apparently something like that is inhibiting them. They are investing something. I don’t have a complete story of why it is; it’s a puzzle of our time. It’s described as a ‘secular stagnation regime’. That’s what you were saying, I guess, that somehow we’re stuck in a horrible economy. Nobody wants to invest; there are no investment opportunities. Somehow, I’m sceptical of that, but I can’t prove that. I think that put me in charge of a public work reserve for the UK; I can find projects.
Merryn: Projects that you can be sure will make us a long-term positive return? We have form on this, you know.
Robert Shiller: OK. Anyway, I shouldn’t be so arrogant as to say, “I know”, but it’s a puzzle of our time that that apparently can’t be done. How can it be that there aren’t projects like that?
Merryn: We should go back to investing. One of the reasons we’re talking today is that you’ve just designed a new ETF with Barclays, which uses your Cape work on a sector basis to create, effectively, an ETF that combines momentum and value.
Robert Shiller: Correct.
Merryn: Can you just tell me a little bit about it?
Robert Shiller: Yes, it’s a variation on the value investing idea. Value investing has often used price-to-book value of a stock. They do individual stocks. They create a portfolio of supposedly undervalued, and apparently they are undervalued because value investing has now a long history of success.
We have a different way of looking at it, using sectors instead of individual stocks. We pick low-priced sectors, based on this Cape ratio that I’ve developed.
Merryn: When you developed it, you didn’t think about it in terms of sectors, did you? It was purely thought about in terms of country, so this is a departure for the work on Cape.
Robert Shiller: Back in the 1980s, when John Campbell and I developed Cape, we only applied it to whole countries. Now we are working on sectors, right, but it’s the same idea. It’s still not drilling down to individual stocks, though I don’t think the thing, the Cape method, works as reliably on individual stocks; we need some modification of the method.
The Cape ratio is price – real price – divided by a ten-year average of real earnings, but many individual stocks don’t even have earnings, or they don’t have a ten-year history. Even if they do, it’s very uneven for a single company.
Merryn: It works for sectors.
Robert Shiller: It works for sectors.
Merryn: The way this works is, as I understand it, you pick the five most undervalued sectors in the market, chuck out the one with the least momentum, and so the index always has four undervalued sectors in it.
Robert Shiller: That’s right, yes.
“I’ve got Italy in my personal portfolio. I have Spain too. Spain and Italy are very civilised countries. They have a long history of greatness. They’ve done amazing things.”
Merryn: We were asking earlier if you would do that for countries.
Robert Shiller: Yes, that was the original idea, to do it for countries. We are still working on that. The sector index seemed, for various reasons, to be the thing to launch first. When you get into countries, you have to deal with exchange rate problems.
Merryn: Yes. Can you imagine someone going out today and buying the four lowest Cape countries?
Robert Shiller: Yes, I can tell you what they are.
Merryn: Yes, please, tell us what they are.
Robert Shiller: According to Barclays research, the lowest Cape country in the world is Greece. It has a Cape of something like 3.7, as of earlier this month. The second lowest is Russia. Portugal and Hungary, I think, are the other two.
Merryn: Would you, personally, be reasonably confident that if you bought a basket of those four stock markets and held them for a decade, you’d be richer, not poorer, at the end of that decade?
Robert Shiller: No, I’m not reasonably confident. You picked the worst four; I think the next one up is Italy. I’ve got Italy in my personal portfolio. I have Spain too.
Robert Shiller: I think Spain and Italy are very civilised countries. They have a long history of greatness; they’ve done amazing things in the past, but again it’s all as part of a diversified portfolio.
Merryn: I can’t let you go without asking you if you have any views on the UK housing market, with which, of course, in the UK we are completely obsessed.
Robert Shiller: Yes, I think the remarkable thing is the similarity between the UK housing market and the US housing market. If you take a plot of London home prices and Boston, for some reason Boston is the closest major city to London and it looks pretty much the same.
Merryn: But the London market is very different to the UK market as a whole, or certainly has been during this cycle. Prices in Boston and in London are at a level where you think they should come down, where they will come down, what?
Robert Shiller: No, I’m not as clear on London, but in Boston they’ve gone way up, and they’ve come way down, and they’re going up again. That’s sort of London too, yes?
Merryn: London is now plateauing a bit; I think we’ve peaked.
Robert Shiller: So has Boston. Our latest data on it is showing slight declines in Boston.
Merryn: So you’re not buying any houses in Boston at the moment?
Robert Shiller: I don’t know that I have any strong forecast for Boston or London. It’s not in an intense bubble phase right now.
Merryn: Thank you very, very much for talking to us; we really appreciate it.
Robert Shiller: My pleasure.