On Monday, the Nobel Prize committee awarded three American economists, Eugene Fama, Lars Peter Hansen, and Robert Shiller, the world's leading economic prize. Shiller won for his work explaining some of the limits of the hypothesis -- advanced in no small part by Fama -- that financial markets are efficient. Shiller, a professor at Yale, spoke with me by phone on Monday afternoon. Below is a lightly edited transcript.
Neil Irwin: Congratulations. So, tell me about your morning.
Robert Shiller: I was in the shower. I just got out and heard the phone ring. I had to rush downstairs and get the phone. It was a bit of a surprise.
NI: You were confident it wasn’t a prank call?
RS: I was wondering. I’ve been warned that other people worried that. It sounded very real to me because, first of all, they had very distinguished Swedish accents. It sounded completely real. I certainly believed it.
NI: I guess for a lot of people the surprise is not that you have won the prize but that you’ve won alongside Eugene Fama, where many view the two of you as coming to opposite schools of thought on efficient markets. How do you think of his work and the ways it informs or relates to yours?
RS: Eugene Fama was the person who really set the example for efficient markets. He wrote a survey article in 1969. "Efficient Capital Markets: A Review [of Theory and Empirical Work]." He put a slant on it. I think even in that article he found some contradictions in the efficient markets hypothesis. He put a slant on it that nothing important contradicts it. It’s a question of what you think is important. I had a sense that the contradictions were very important and could lead to financial crises. But we did disagree.
But I trust him to report what that data says honestly. That’s how research goes. I read a lot of his papers. It’s not like I disagree with him on everything. It’s more that I'm after a different thing. There’s a kind of idea that has been especially prevalent at [the University of Chicago]. The other two people in this prize are from Chicago, where the prevalent view is to find the rational side of human nature very compelling.
I guess it’s a different worldview than I have that I don’t find it quite so compelling. When I look around, I see a great deal of foolishness, and I can’t believe it’s not important economically.
NI: So, is the old view that Fama and some of the other founders invented modern finance with the [capital asset pricing model] and efficient markets, and you and the behavioralists smashed it to smithereens wrong?
RS: The capital asset pricing model is a view of how to form an optimal portfolio. That is an interesting model. People who do portfolios ought to study mean variance model as a first approximation to what they should be doing in terms of portfolio management. But they took a next step, which is saying that everybody already does that. That's where I start to part company. They assume people are already doing that. That can’t be right, because nobody understood it when the model was first developed. There’s an element of absurdity that they refuse to acknowledge. They fell in love with the model too much.
NI: What do you see as the biggest implications of your conclusions on these market inefficiencies for policy and how policymakers should think?
RS: I have a very idiosyncratic recommendation. I talk about it in my book "Subprime Solution."
People should be encouraged to get professional help with their investing. We should be subsidizing financial advisers. In this country we seem to have come around to the idea that there might be a role for the government in subsidizing medical advice, though that is controversial, too. There might also be a role for subsidizing financial advice.
It’s already tax deductible, but that only helps people with significant incomes. The system is not arranged so that low-income people have any subsidy for financial advice. That should change. I'd like to see more low-income people getting good financial advice.
NI: Ironically, the shift away from pension plans and toward defined contribution retirement plans like 401ks is a shift in the other direction. With a traditional pension, a low-income worker did in effect have professional management.
RS: Here’s where we made big mistakes. Here’s where the efficient markets hypothesis gets you into trouble. The idea that everyone will manage their 401k plan optimally is really not right. What was discovered by some of the behavioral finance research is people are inertial. They don’t do anything. If they have to sign up for the plan, they won’t do it. If they do sign up, they'll put their money in whatever asset seems to be recommended and leave it there the rest of their lives. You would think it’s kind of obvious, that some people aren't that interested in managing their portfolios.
If you press Gene Fama or Lars Hansen on this, I suspect they would give in. They’d have to admit that's what the evidence shows. But it’s not their habit to emphasize it. That’s where we differ, perhaps. It's what do you want to emphasize that divides them from me.
Gene Fama once told me that he is actually sympathetic to behavioral finance and that in fact he is proud to have accepted many of the journal articles or written referee reports accepting publication for articles that are important in the field. And I believe that's true. I think he's an open-minded person.
Somehow people get into certain research directions that emphasize a certain interpretation of results, but nonetheless trustworthy interpretations of data. Fama has done a lot of important things. I’m pleased to be united with both [Fama and Hansen]. I am an admirer of both of them, and it is an honor to be associated with them in this way.
NI: So, what led you to make a career studying behavioral finance and market inefficiencies? What did you see as a grad student or young scholar that made you think it would be a fertile field for study?
RS: I married a psychologist. That’s part of it -- Ginny, my wife. Also I think I have a basically cynical, maybe not cynical but skeptical, personality. When everyone else agrees that something is true, I don’t just jump in and assume the same.
I’ve always felt that people like to exaggerate their certainty about theories that their ego is involved with. I think something is suspect there when someone has such overwhelming certainty.
It’s also a philosophy of science. As a child I wanted to be a scientist. Maybe I'm trying to do that as as social scientist. I had a view that emerged as a child really that science is about respect for the facts, about really studying nature and trying to take into account all the facts. No legends or myths or self-serving stories. I wanted to know the real facts. I thought that’s what a scientist does. You devise an experiment if there's any confusion.
When I was getting started I thought a lot of economics wasn’t in that mode. It was more storytelling. We have this model. We test it, but we’re really not testing it. We just love these models. We’ll lionize and publicize the facts that are consistent with the model, and anything that’s inconsistent with it, we’ll put in some ad hoc fix.
That has often bothered me about the economics profession.
NI: Your model of how the financial markets work, with large effects from psychological swings in confidence, held up better than a lot through this last decade. What has the crisis made you reconsider about how the world works, though?
RS: I suppose things I was not as schooled in, namely systemic interconnectedness. That was something I didn’t think much about. It turned out to be really important in this crisis. The lack of regulators having information about, or really anyone having information about, how interconnected everything was. How the failure of one Lehman Brothers could bring down the whole market.
That is something people knew about but didn’t put it on their research agenda. The federal government didn’t have statistics about interconnectedness it needed. That's something that the Dodd-Frank Act tries to deal with by creating the Office of Financial Research at the Treasury Department.
NI: So, you've won the big prize. What’s next for your research?
I’m writing another book with George Akerlof. [Akerlof is also a Nobel laureate, is co-author with Shiller of "Animal Spirits," and, as it happens, is the husband of Federal Reserve chair nominee Janet Yellen.] It’s about manipulation and deception in economics.
This doesn’t fit in with an efficient market theory, either. Of course, efficient markets people will admit that people are manipulative and deceptive. But it’s not part of their canonical story.
Update: An earlier version of the post misspelled the first name of Shiller's wife, Virginia "Ginny" Shiller.