Robert Shiller’s Own Cognitive Dissonance

I need to start off by saying I am a big fan of Robert Shiller’s. “Irrational Exuberance” and “Animal Spirits” were excellent books, pointing out so many of our cognitive shortcomings in all things financial. And “Irrational Exuberance”, which was strongly recommended to me by David Lipton in March of 2000, about a month before the peak of the Tech Bubble, probably saved me a good deal of money as well. Moreover, these books came at times when the reigning ideology was ‘the freer the market the better’. Shiller was certainly swimming upstream by driving home the point that markets fail. The growing relevance of behavioral finance owes a lot to his work.

At the same time we have Robert Shiller, financial evangelist. He has long been a font of ideas on how financial education and innovation might make our lives better. And this brings us to the problem: How can a man who believes human nature is magnetically drawn to stories over facts, momentum over mean reversion, believe, for example, that encouraging the average person to hedge his/her home value in a futures market will not likely, at some point, end badly? If markets do fail, and if the frequency of market failure seems to be positively correlated to financial innovation, why would anyone want to give people even more weapons with which to hurt themselves?

This at its core is really a version of the very same problem Alan Greenspan had some years back. On the one hand, Greenspan asserted that financial innovation in general and derivatives in particular would be used to dampen market risk, not increase, because banks’ were profit maximizers, and their incentives meant we could trust them to self-regulate. And we know how that turned out. On the other, however, his book “The Age of Turbulence” explained various market crises under his watch by pointing out that the psychology of crowds, when under pressure, cannot be counted on to do the rational thing. Often, he argued, this negative psychology was self-reinforcing and there was little one could do to stop it.

It is conceivable that Shiller is at some level just being naïve, and that he believes with sufficient education we can overcome our animal spirits. Personally, I think it is a bridge too far, and Robert Shiller, like Greenspan, by advocating democratization of financial innovation while arguing that human nature is hard wired to make bad decisions, has succumbed to his own little version of cognitive dissonance.

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