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VIEWPOINT: KAUTILYA
Mad Dow Disease
An economist ignored when markets were booming is now
being rediscovered
By Jairam Ramesh
Generally speaking,
economists and financial markets do not mix well, Charles Kindleberger's
1978 all-time classic Mania, Panics and Crashes being the outstanding
exception. Irving Fisher is considered to have been America's greatest
economist in the first third of the 20th century and is immortal for his
research on inflation. But John Kenneth Galbraith writes in his The Great
Crash, 1929 that in the autumn of 1929 just before the onset of the Great
Depression, Fisher gained enduring fame for his widely reported conclusion
that "stock prices have reached what looks like a permanently high
plateau". In contemporary times, we have had the example of two Nobel
laureates in economics, Robert Merton and Myron Scholes, who were closely
associated with the hedge fund Long Term Capital Management that rocked
markets by going bust in September 1998, inviting a huge $4 billion bail-out
operation masterminded by the US Federal Reserve Bank. In India too, barring
perhaps Ajay Shah, economists have neither worked on nor helped in understanding
financial markets. That Shah has done so could be due more to his ethnic
background.
Thus, when Robert Shiller's book Irrational
Exuberance first appeared last year, it was greeted with acclaim as a
fine piece of scholarship but as a poor guide to what was happening or
would happen in the real world. These were months when the Dow had crossed
five digits, the Nasdaq was in the 5000-6000 range and the "new economy"
mania was at its peak. When the stock markets were booming, here was a
Yale University professor, no doubt brilliant as a theorist, indulging
in blasphemy and heresy by suggesting, on the basis of solid empirical
and unusually innovative historical, psychological, cultural and sociological
analysis that the US market was overvalued by historical standards and
that poor performance was inevitable sooner rather than later. Now that
the Nasdaq has fallen to the 2000 zone, Shiller is being rediscovered.
His hardcover book has been issued as a paperback edition-the ultimate
"market" accolade for an academic economist.
 The
title of Shiller's work is taken from the most famous quote of Alan Greenspan,
chairman of the US Fed, who in the course of a speech delivered on December
5, 1996 to a Washington think tank mused, "But how do we know when
irrational exuberance has unduly escalated asset values, which then become
subject to unexpected and prolonged contractions as they have in Japan
over the past decade." Ironically, Shiller writes that just two days
before Greenspan posed the question publicly, he had himself testified
before the Fed chairman and his colleagues that market levels were irrational.
When Greenspan spoke thus the Dow was hovering around 6000. By March 1999,
it had zoomed to 10,000.
Shiller's main thesis is that the stock market
boom of the 1990s in the US displayed all the standard features of a speculative
bubble, which he terms as a "situation in which temporarily high
prices are sustained largely by investors' enthusiasm rather than by consistent
estimation of real value". Twelve factors are identified as having
contributed to the self-fulfilling prophecy of a roaring bull market in
the US. These are the arrival of the Internet, triumphalism and the decline
of foreign economic rivals, born-again materialism, a Republican Congress
and capital-gains tax cuts, the baby boom, a proliferation in media reporting
of business news, increasingly optimistic analysts' forecasts, the expansion
of defined contribution pension plans, the growth of mutual funds, the
decline of inflation and the effects of money illusion, expansion of trade
volumes and a rise in gambling opportunities.
There is more to stock prices than present or
future earnings or dividends calling into serious question one of the
tenets of modern economics-the efficient markets theory. Shiller concludes
that the market was high because of the combined effect of indifferent
thinking of millions of investors motivated largely by their own emotions,
random attentions and perceptions of conventional wisdom and influenced
heavily by the news media and market analysts enjoying a nexus with investment
banks or brokerage firms. An example of such wrong thinking is the belief
that stocks must always outperform other investments such as bonds over
the long run. Picking mutual funds that have done well also has much smaller
benefits.
Shiller argues that the eventual bursting of
speculative bubbles may, on balance, be a good thing. In this light, he
sees the East Asian financial crisis of 1997-98 as a sanity check. The
Nasdaq's precipitous fall is a return to reality. Shiller recognises that
societies cannot be protected from the effects of waves of irrational
exuberance or irrational pessimism. While guarding against the latter,
the challenge is to put in place policies and institutions to minimise
the probability of recurrence of the former.
(The author is with the Congress party.
These are his personal views.)
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