What Is the New Economics?

The efficient-markets theory is to the economics profession and its benefactors on Wall Street what belief in God is to the Catholic Church: an article of faith. "It never sounded right to me," Shiller says. "So I proposed a statistical test that compared the volatility of stock prices with the volatility of dividends. And what I found was that the stock-price volatility is way beyond anything that has ever been justified by the subsequent dividends. This got me into a statistical controversy, and there's no end to the criticism that I've received. The profession doesn't want to hear that the efficient-markets theory is wrong."

For anyone who's looking for evidence in this ongoing debate, the popping of the dotcom bubble and the NASDAQ crash of April 14, 2000 proved Shiller's point beyond any reasonable doubt. On that date, no new public information suddenly surfaced to cause the stock market to rocket downward. It was nothing more than the day before tax day. Tax selling became a rout, the news spread, the zeitgeist changed, and before long, companies such as Yahoo and Sun Microsystems had lost more than half of their value. Nothing at those companies had changed. No new critical economic data was added to the market. What had changed was the context in which those companies were understood. And when the context shifted, the psychology shifted, and when the psychology shifted, well, you know the rest.

This leads to Shiller's third lesson: The economic profession has to do a much better job of explaining economic behavior and events. "We don't want to rely on the statistics alone," he argues. "They're too narrow in their focus. The biggest puzzle about stock markets -- or about any historical event -- is trying to figure out the contributing factors and their relative weight. Why did World War II happen? Why did the Roman Empire fall? History has very complicated answers that tend to look like a list of factors. I think that's how human history works: When something major happens, it's because a lot of the factors are moving in one direction. One of the criticisms that I have of economics departments is that they like to emphasize rigor to the point where they feel they can't rigorously handle so many different factors at once, and so they just focus in on one. Then those departments lose their vitality, because what's actually happening is driven by many things."

A large section of Irrational Exuberance is devoted to Shiller's attempt to identify the key factors that moved the market to such unprecedented heights. "I came up with a list," he says. "The idea is that the market has behaved exceptionally, and that's not necessarily true for one simple reason -- there are many reasons. Some economists would say, 'I want to know which reason is right.' But it's never that only one reason is right. They're all right to varying degrees."

Shiller's fourth lesson is that there is such a thing as the new economy -- notwithstanding the Internet bubble. And there's a corollary: The new economy will soon have too many old people. The emblem of change in the new economy, Shiller notes, is the Internet. "The Internet continues to be an incredible focal point, and public attention is what drives the market. I don't know what your house is like, but when I walk home, I can see that people aren't sitting in front of the TV, they're sitting in front of the Internet."

But, says Shiller, if the new economy has growth potential, it's the soon-to-increase number of old fogies who will slow things down: Counterbalancing the new economy's potential is the aging of the baby-boom generation. "The baby boomers are a reason for pessimism over the long run, because those people are going to get old," Shiller says. "And the next generation of middle-aged people -- the baby busters -- are going to be involved in nursing-home management and in other things that won't feed as much back into economic growth. Two things are conspiring: the baby boom and medical research, which is extending life in costly ways. It's a truth that we'll have to come to grips with. And it's going to transform our society."

Lesson number five: Think of the Internet -- and the technology that enables the Internet -- as more of a social force than a market force. For example, the Web ultimately might not substantially increase productivity, but it may dramatically reduce tax evasion. This is the subject of Shiller's next book, and he gets animated as he warms to the topic. "In this book, I want to think about how the new technologies provide an opportunity to improve our society," Shiller says. "I'm worried about a deterioration of income distribution. I want to see how we might improve the way that we share in our society."