Loungani: The U.S. stock market crashed in 2001 as you had predicted but has now recovered from those lows. Is the correction over?

Shiller: People seem to think the correction is largely over. My opinion surveys show many people are quite optimistic. Many seem to be thinking: the recession of 2001 is over, and we only seem to get recessions about once every 10 years now, so there’s no reason why the stock market should not be up. They are not thinking about stock market crashes as a possibility. But I’ve been advising people to diversify and not have too intense an exposure to the U.S. stock market. The market is vulnerable if there is some bad economic news.

Loungani: What kind of news would cause another correction?

Shiller: One kind of bad news that worries me is about the U.S. labor market. It has done poorly. We are down over two million jobs in the past three years and down nearly one million jobs from the end of the 2001 recession. Since World War II, the only other labor market contraction as protracted as this occurred around the time of the great recessions of 1980 and 1981-82. But back then people knew that the cause of the contraction was the Fed [Federal Reserve Board] policy. This time, the cause is less clear. Labor market fears can weigh on investors, destroying confidence. That’s what happened in the 1930s. We could also get a burst of inflation, as we did in January when the consumer price index went up an annual rate of nearly 6 percent. If the Fed decides the increase is more than a onetime blip, it will react. Interest rates will go higher, and then the stock market won’t look like such a good investment.

Loungani:: Could further corporate scandals also take a toll?

Shiller:: On that score I’m actually somewhat sanguine. The United States has done enough that U.S. investors at least have got some reassurance from it. [New York State Attorney General] Eliot Spitzer has been going after corporate crime as aggressively as Eliot Ness, the guy who went after the gangster Al Capone. Combine that with people like [Massachusetts Secretary of the Commonwealth] William Galvin and William Donaldson, Chair of the Securities and Exchange Commission [SEC], and it adds up to a lot of people who are really doing their jobs. The budget for the SEC has really been increased; for 2004, it was over $800 million, more than double what it was five years ago. And people can see what a price Martha Stewart paid for acting on a tip. This is the U.S. solution: the United States has generally handled financial scandals aggressively.

But a lot will depend on how foreign investors in the U.S. stock market react. Foreign holdings of U.S. shares have gone down. It’s a question of whether foreigners continue to invest in this country in the face of more scandals, particularly if we have other events going on at the same time, like an unstable dollar. All that could cause a drop in the U.S. stock market.

Loungani: Are you willing to forecast how big a correction it could be?

Shiller: The P/E [price-to-earnings] ratio is quite high. It’s about 28 the way I calculate it, which is to divide the stock price by a [moving] average of corporate earnings of the past 10 years. The historical average for the P/E ratio is only 15. So stock prices can come down quite a lot before we hit that point. In fact, the P/E ratio could even go below the historical average if the news is sufficiently bad.

Loungani: Could U.S. housing prices also go through a correction?

Shiller: I’m not exactly sure what’s going on with housing prices. People still report that a major consideration for their buying houses is that they think it is a good investment; that is, they expect house prices to appreciate. But fewer people report buying houses just to make a profit from speculation. I think the thought process a lot of homebuyers are going through right now is more like: I know prices are too high, but that’s what I thought last year and prices still went up. I better buy now before I’m totally priced out.

Obviously, in both the stock market and the housing market, a lot will depend on how people assess the news that comes in. We know that people can overreact to attention-grabbing news and let some really fundamental piece of news slip by. I don’t think economists are at the point yet where we can forecast how investor behavior will play out in response to news.

Loungani: But behavioral finance has been at this for nearly twenty years now....

Shiller: And we’ve learned and accomplished a great deal. A lot of investor behavior that seemed anomalous from the perspective of purely economic frameworks—rational expectations and efficient markets—is better understood when we bring in psychology. We know the role that overconfidence and wishful thinking play in driving financial markets. But psychological theories have still not been completely integrated into economics. Human behavior is very complex, and economists have been in the mood to simplify it, and simplify it heroically. We will have to change our whole approach to prob-lems—our methodology and our tool kits—if we are serious about grappling with the complexity of human behavior.

Loungani: Are graduate students today more open to different ways of modeling economic problems?

Shiller: When I talk to our graduate students, I get the feeling that they look at behavioral economics and think: well, if that’s what I wanted to do, I chose the wrong department. Shouldn’t I capitalize on the methods I have learned in economics? Graduate students are looking out for their own careers and thinking about their own human capital. It just doesn’t seem to be as good an investment to them to learn psychological research.

Loungani: How did you turn out to be so rebellious?

Shiller: I wasn’t much of a rebel as a graduate student. My dissertation was on rational expectations. But I was always a bit skeptical about conventional economic theory. An early formative influence was George Katona, who wrote the book Psychological Economics in 1975. I never took one of his courses, but I sat in on one of his lectures and was impressed. It seemed fine to me, then, that there were only a few people like Katona who wanted to sit halfway between economics and psychology. It wasn’t as clear to me then as now that psychology should be central to economics.

Much later, Stan Fischer [former IMF First Deputy Managing Director] invited me to write a review essay critiquing the rational expectations revolution for a conference he’d organized. Writing that essay awakened further doubts about rational expectations, which I always thought of as a construct that had some interest but was a small part of a big picture.

This became evident to me one day when I was talking to some people at the Federal Reserve Bank of Philadelphia about why long-term interest rates were so volatile. I remember thinking that the theory we had about long-term interest rates—the expectations theory of the term structure—did not get them very far. That led to me to write a paper for them about excess volatility in long-term rates. After the work on the bond market, I thought that the problem had to be even worse with the stock market. That work became better known, and so most people associate me with the theory of excess volatility in the stock market.