What Is the New Economics?

The thing is, it's supposed to be the other way around. Academics are supposed to be the impractical ones: the theorists. Practitioners -- those hard-bitten, steely-eyed professionals, as they imagine themselves -- are supposed to be the realists.

Except that two years ago, the whole world was turned upside down. Two years ago, analysts and bonus babies on Wall Street were head over heels in love with every technology and dotcom company that could generate any kind of an offering document. Venture capitalists were throwing money -- hundreds of millions of dollars -- at business plans that were hardly more than pipe dreams. Reporters and editors were churning out reams of copy about high-flying stocks that were destined, they told us, only to fly higher. It was a time, in Alan Greenspan's memorable phrase, of irrational exuberance.

And during that time, in the most delirious fever of the feverish delirium, Yale University economist Robert J. Shiller -- nothing less than the Stanley B. Resor Professor of Economics -- was holed up in his modest office on Hillhouse Avenue in New Haven, Connecticut, banging away on a Gateway computer. He was writing a book. More than that, he was working against a deadline that, in his mind, was always one day away. Shiller knew in his bones that a major stock-market "correction" was imminent. He had learned from harsh experience that his book would be irrelevant if he didn't get it done in time (he had been halfway through a book on risk management when the stock market crashed in October 1987). So he just kept firing away at his new book, writing day and night, until it was finished.

The book he wrote, archly entitled Irrational Exuberance, said that the great roaring bull market of the late 1990s was a speculative binge: an irrational, self-propelled, self-inflated bubble. Of course, many people described the run-up in the markets as speculative. But no one built the case, point by point, with anything approaching Shiller's thoroughness. And only Shiller found a way to make economics and business accessible, compelling, understandable -- human. Shiller's writing and analysis made the book a tour de force. Timing made it a best-seller. The Standard & Poor's 500 Index peaked at 1527 on almost the exact day that Irrational Exuberance appeared in bookstores.

After the fever broke and the markets began their slide, it was Shiller, not the Wall Street professionals, who emerged as the E.F. Hutton of the new economy. When Shiller spoke, people listened. Although, as Shiller is the first to point out, when people and economics intersect, listening, learning, and acting differently don't automatically follow -- largely because, contrary to conventional wisdom, economics isn't about data and numbers. In Shiller's view, economics is about emotion and psychology. In fact, for the past 10 years or so, Shiller has been at the forefront of what has come to be called "behavioral economics" -- the real new economics of the real new economy.

Irrational Exuberance is perhaps Shiller's clearest explication of what behavioral economics implies: What drove the astonishing run-up in stock prices in the latter half of the 1990s had little to do with earnings or dividend growth. Instead, it was a reflection of human psychology -- a kind of collective belief that almost anything was possible and that financial gravity did not necessarily apply. (And by the way, Shiller notes, the same forces of human psychology can drive the economy into a downward spiral, with equal disregard for economic data.)

The way Shiller sees it, there is such a thing as the zeitgeist -- the spirit of the times -- and it is an enormously powerful force in the markets. Shiller can lay out an ironclad case for why the stock market is overpriced. Everyone in the room will nod in agreement and know that on some profound level, Shiller is correct in his analysis of the situation. But no one will change their behavior. The pension-fund manager will not lighten up his client's holdings. Endowment heads will not sell or short a single stock. The behavioral power of human forces that compel people to do what they do will triumph. If the basic force is optimism or greed, then markets will remain exuberant. If the basic force is pessimism or fear, then no earnings or dividend increase will assuage it. This is lesson number one in Professor Shiller's class in new economics.

Lesson number two is that the efficient-markets theory is, well, bullshit. The efficient-markets theory asserts that all financial prices accurately reflect all public information at all times. "In other words," Shiller explains, "given what is publicly known, financial assets are priced correctly at all times. Prices may appear to be too high or too low at times, but, according to the efficient-markets theory, this appearance must be an illusion."