Prof. Robert Shiller Lectures on Bubbles at the Great Mirror of Folly Conference

Bubbles are mysterious things. Ever since the Dutch tulip trade rose to dizzying heights and then crashed in 1637, bubbles of one kind or another have become standard, if confounding, economic reality. Just look at the most recent boom/busts in America: the 2000 tech stock crash, or the current subprime crisis. Few predicted the crashes, certainly not the former head of the Federal Reserve, Alan Greenspan — who in 1996 suggested the market was suffering from “irrational exuberance" but quickly returned to a sunny outlook toward the boom—or his successor Ben Bernanke. "Did he have any clue what was coming?" asked Robert Shiller, Stanley B. Resor Professor of Economics, asked about Bernanke. "Somehow these events come and they are invisible to people who should know."

Shiller was delivering the keynote address on April 17 for a symposium cosponsored by the SOM International Center for Finance and the Beinecke Rare Book and Manuscript Library titled The Great Mirror of Folly: Finance, Culture and the Bubbles of 1720. The Great Mirror of Folly is a manuscript that records reactions to nearly simultaneous stock crashes in France, England, and the Dutch Provinces, a series of events that caused a financial panic throughout Europe and its colonies. Rather than a dry historical document, it is divided evenly between texts and images and includes plays, poems, songs, and prospectuses for new equity issues, as well as satirical and allegorical prints, maps, and decks of playing cards. The symposium brought together a diverse group of scholars to study the manuscript — and the crash it chronicles — from a variety of perspectives. "This is an amazing time to have this conference," said Will Goetzmann, Edwin J. Beinecke Professor of Finance and Management Studies and the director of the International Center for Finance. "The markets are in free fall. Mortgage-backed securities are falling apart. Lawyers are planning law suits of financial institutions in real time." Goetzmann said that the Great Mirror of Folly is a starting point for this larger discussion. "We’re hoping to take the themes that this volume talks about and consider them more broadly. For example, what is a bubble? We’ll use it as a lens to look at what is happening today."

Shiller, who predicted the bursting of both the tech and housing bubbles through the various editions of his book Irrational Exuberance, studies behavioral finance, stressing that the irrational side of people often drives economic trends as much as the cold rationality of the market. He has helped put together the S&P/Case-Shiller Home Price Indices, which measure fluctuations in the residential real estate market, for the past 20 years. Shiller is currently working on a new book, tentatively titled Subprime Solution, which will take a deeper look at the latest global financial crisis. For the Great Mirror of Folly symposium, which used the 1720 stock crashes in France and England as a jumping off point for a broader discussion on bubbles, Shiller discussed how he saw the turmoil of earlier centuries linked to the obscure financial derivatives that helped trigger the current financial crisis. "Bubbles are mysterious because we don’t have a good reason for why they get started and we don’t know exactly what causes them to burst," he said.

But Shiller has some ideas how they can get inflated. With the subprime crisis, he pointed to the actions and words of self-interested parties such as appraisers, mortgage lenders, and realtors, who all pushed the notion that credit was easy and cheap, and that there was no reason to worry about the very mortgages that are defaulting today. And when he read through the annual Reports to Congress of the Office of Federal Housing Enterprise Oversight on Fannie Mae and Freddie Mac, Shiller was amazed not by what he found but by what he didn’t. "There was no reference, not even once, to the possibility that market psychology was getting out of control," he said. "No one wants to be the spoiler."

One correlation that has interested Shiller is how similar the boom/bust cycle in any speculative market is to an epidemic, calling bubbles "thought viruses" and stressing how the rise of prices can actually spur more people to buy, which pushes prices higher and causes even more buying. Like a virus, the bubble grows exponentially, infecting even those considered the most immune to irrational thought. It’s when the “smart people” get caught up in a bubble that it really gets going. "People start believing the story because they hear it so often from the smart people," Shiller said. "In order to understand a speculative bubble we have to look at human interaction. People convey excitement — it’s not something you can see by looking at data from the SEC."

As part of his research for the symposium, Shiller looked deeper into the earlier bubbles, searching for a connection between that time and this one. He came upon a fictional dialogue between a speculator and a weaver written in 1637, just as the tulip industry imploded in Holland. The speculator insists to the weaver that investing in tulips entices him with returns of up to 1000%. When the weaver expresses concern, and states he’s surely missed out on the chance to get rich, the speculator assures him. “It’s never too late to make a profit," he tells the weaver. "People make money while sleeping." The weaver still hesitates, the speculator pushes harder: "Look at all the gardeners who used to wear grey-white outfits who now wear new clothes."

The end of the story is a familiar one nearly 400 years later. Just at the moment the weaver has been swayed to invest in tulips, his wife runs in the room and declares that tulip prices have crashed. The weaver is saved; the speculator is ruined. After finishing reading the dialogue to the audience, Shiller looked up and smiled. "How people get caught up in something afterwards looks crazy," he said.