What Is the New Economics?

Yale economist Robert J. Shiller wrote the defining book on the Internet bubble. Now he’s busy rewriting the laws of economics, where emotion and psychology dominate data and numbers. (And in his spare time, he’s busy worrying about his own dotcom.)


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.”

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.”

Robert Shiller’s sixth lesson is that there is a next big thing. “Robotics,” he says. “Maybe 10 or 20 years down the road, robotics will be a really big deal. A lot of things will be automated. I think that automation should be a real national concern because of the potential for disruption of income distribution. Common-labor wages will be harmed by the invention of robots that can do simple tasks.” To underscore the seriousness of his point, Shiller brings up . . . RoboSoccer.

RoboSoccer? “They had it on TV,” he says, genuinely excited. “It’s an annual event. You have to design a robot that plays soccer, and then there’s an indoor soccer arena, and your robot can’t be radio controlled. The robots have to play entirely on their own, and they have to know how to follow the rules somehow. I saw segments of the soccer game, and it actually looked like a soccer game. You could see them playing.”

Shiller chuckles at the inanity of the idea of robotic soccer — do robots really need exercise? But then he turns to the larger point. “The program quoted someone who said that RoboSoccer today is what computer chess was 20 years ago, when the games were laughable. The computers were easily defeated. But, the show said, within 50 years, no human soccer team will be able to defeat a robot team. I don’t know whether that’s true or not, but I can see advantages that computer robots might have as a team compared with humans. I can easily believe that a robot team could beat any human team.”

Shiller then draws a picture of your new neighborhood. “In the near future, half of the ‘people’ you encounter will be robots. They’ll be out on errands for somebody. Every now and then, a robot will stop you and ask you for directions. Robots have already taken over a substantial part of the world. It’s computer technology that, I think, is a really big thing.”


Shiller’s seventh lesson is experiential: If you really want to understand something — really understand it — don’t just analyze it, do it. According to Shiller, there’s no substitute for experience. And so, although this academic is best known as the man whose prose helped puncture the Internet bubble, he is himself a partner in a dotcom company. “In 1991 we founded Case Shiller Weiss Inc.,” Shiller says. “At that time, Allan Weiss was the president and only employee. The company has grown to about 20 employees now. We wanted to create futures markets or some kind of derivative market in real estate. And we wanted to provide indexes for contract settlement. That was the initial idea — which, unfortunately, still hasn’t happened.” In other words, Shiller’s company sounds exactly like any other startup dotcom.

“But I’m still hopeful that it will happen,” Shiller continues. “So we constructed what we call ‘by-zip-code real-estate price indexes.’ Then we got this idea to create an automated valuation model using our indexes for individual houses. We created a Web site where you can type in the address of any home, and, for a price, we’ll tell you an estimated value of the house. So we’re a dotcom company with the same issues that other dotcom companies have — competitors can steal your list.”

Overall, Shiller says, the dotcom experience has deepened his appreciation for life in the new economy — and added to his criticisms of life in the university. “I view the world through the eyes of a dotcom entrepreneur,” he says. “We don’t know who is going to set up a competing Web site within the next few days. And if our competitors are giving it away on their Web sites, what does that mean for us? In the past, universities have not exactly been thrilled when professors got involved with business. But I think it’s been a great thing for me, because it changes my perspective on the world. I get shaken out of my overly academic perspective. I can talk with Allan Weiss on the phone, and then I can go to some seminar right afterward where there’s a professor giving a talk about the mathematics of the economics of infinity (if I explained the topic to you, you wouldn’t believe me).”

And the eighth and final lesson that Professor Shiller has to offer? “Well,” he says, thinking like a teacher again, “one thing that I believe is that people exaggerate the speed with which things will happen. I like to use the example of the movie 2001: A Space Odyssey. It’s based in exactly this year. The movie came out in 1968. When I watch it, it still looks like the future to me. It doesn’t look like 2001. People are traveling to Jupiter, after all, and that computer, HAL, has abilities that no computer has today. At the time, there was a lot of talk about spin-offs from NASA technology, things such as communications satellites. It happened — but not as fast and not as dramatically as people thought it would. So the reasonable assumption is that robotics, as I said, is coming. It is coming. And maybe in 30 years, robots will be beating us in soccer. But then again, it might take a good 100 years.”

And then Shiller adds, “Incidentally, 2001 came out during another peak in the market.”

John Ellis (, a regular Fast Company columnist on digital matters, is a writer and consultant based in New York. Find out more about Robert Shiller on the Web (