Shiller: Against Market Fundamentalism

Far too often, debates devolve into black-and-white affairs, with strawmen on both sides taking a pummeling. Robert Shiller's latest piece in the Wall Street Journal takes on this type of Manichean thinking, as he adopts the Herculean task of convincing economic conservatives that not all financial regulation is bad. From the WSJ:

The principal long-term result of the current financial crisis should be improved financial regulation. After the immediate crisis is over, we need to restructure our fragmented system. This process will take years to complete since, if properly done, it should get at the heart of the regulatory structure.

This is not as radical as it sounds, for while many observers equate U.S.-style capitalism with unconstrained free markets, the story is more complicated. Americans have long understood that for the economy to work well, government must play an important supporting role. They've also long understood the important role that self-regulatory organizations (SROs), such as trade associations and exchanges, play in cooperation with government regulation.

An understanding of animal spirits -- the human psychology and culture at the heart of economic activity -- confirms the need for restoring the role of regulators as guiding hands in a healthy, productive free-enterprise system. History -- including recent history -- shows that without regulation, animal spirits will drive economic activity to extremes....

Such a world of animal spirits justifies the economic intervention of government. Its role is not to harness animal spirits but really to set them free, to allow them to be maximally creative. A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents. While the sports of baseball and football haven't changed much in the last century, the economy has -- and American financial regulation hasn't had an overhaul in 70 years. The challenge for the Obama administration, along with the U.S. Congress and our SROs, is to invent a new and better American version of the capitalist game.

You might think this is an uncontroversial point. Unfortunately, it is not. What was that about Dark Ages again?

Shanty Towns

As foreclosures continue to devastate communities, and unemployment mounts, it seems like more stories like this one from the Today show about the rise of shanty towns - or Bushvilles - in Sacramento, Seattle, Reno, and Nashville will become more commonplace.

Any governor who has threatened to reject any stimulus money, particularly extended unemployment benefits, should be forced to go visit these encampments.

Now what can we do to prevent these settlements from exploding in size? Creating jobs is the obvious first step. Hopefully, the stimulus and the benefits aimed at the most at risk within society will help. But we also need debt reduction for insolvent households, primarily by writing down the face value of mortgages to reflect current prices. With so many borrowers underwater on their mortgage - and many more likely to find themselves there over the next few years, as housing prices most likely still have 20-30% to fall - there will be a terrible incentive to do jingle mail, and simply walk away. This will cause housing prices to overshoot on the downside. Reducing mortgage debt will not only mitigate foreclosures, but boost aggregate demand. Nouriel Roubini has long called for a reincarnation of the HOLC of the Great Depression to buy up mortgages, in order to refinance/renegotiate the terms. Roubini elaborated on this point on CNBC yesterday.

Why can't we find a job in the Treasury department for Roubini? And Krugman, Stiglitz, Shiller, and Simon Johnson as well, for that matter?

Time to Buy Stocks?

Um, no. While Buttonhood at the Economist cites research claiming "the US market has only been cheaper for 26 months in the last 140 years," conventional measures like Robert Shiller's 10 year cyclically adjusted P/E ratio suggest that stocks still have a ways to fall. Shiller's method uses ten years of earning data to mute the effect of short term earnings swings either up or down in valuing a stock. Applying this method to historical data gives an average stock price of 16X earnings. Today, the S&P 500 just dipped below 12X. So stocks are cheap, right? Not necessarily. Looking at past big bear markets, stocks typically overshoot on the downside and go to 5-8X. By this measure, there is a nontrivial chance stocks could go down 50% from present day value. James Glassman was right all along - if you erase a zero. Dow 3600!

But it gets worse. As Henry Blodget notes, we are exiting a fifteen year period where stocks have been enormously overvalued. At the peak of the dot com bubble, stocks were 45X. This was unprecedented. Even after the tech bubble collapsed, stocks remained elevated by historical standards, at roughly 25X. Considering we just witnessed the greatest speculative boom in US stock market history, it is certainly possible, as Blodget hypothesizes, that we could well have a longer and deeper trough in the markets than there were after past bubbles.

And this brings us to the notion that the Dow is somehow President Obama's "scorecard." Yes, Obama's economic team could have been much clearer with their plans for fixing the financial system. Their vagueness has certainly contributed to the uncertainty in the markets. But the markets declining from their New Year highs in the 9000s has nothing to do with Obama, and everything to do with the fact that there was a bear market sucker's rally that has since ended. We are exiting a credit bubble that overinflated asset prices across the board - these prices must fall. The president can not artificially inflate the Dow, just as he cannot artificially inflate home prices. Too much of the debate surrounding Obama's housing plan was whether this would "fix the housing market" and "stem the decline in home prices." This is nonsense. Home prices were a bubble; they were much higher than the fundamentals of supply and demand would dictate. Now they are falling, as they must. However, the Obama administration is correct in trying to help homeowners avoid foreclosure. That is where the focus should be, first with refinancing and ultimately writing down the principal for underwater borrowers. This will mitigate any overshooting on the downside with home prices, and ease the devastating social blow foreclosures have on families and communities.

For families facing trillions in lost wealth in the stock market and in home values, this is not welcome news. But it is the truth. That paper wealth is gone and is not coming back. We must get back to actually making things, and lay the foundation for real, sustainable growth in the future with investments in energy and infrastructure.

Update: For what it's worth, CNBC had Louise Yamada on today, talking about the possibility of the Dow going to 4000.