"The Sickness Beneath the Slump"

Economist Robert Shiller of Yale offers some thoughts - and data - on the roots of the financial crisis, the long-term effects on consumer spending, "rational market expectations" and a major failure of his profession in recent decades:

THE origins of the current economic crisis can be traced to a particular kind of social epidemic: a speculative bubble that generated pervasive optimism and complacency. That epidemic has run its course. But we are now living with the malaise it caused.

News accounts of the economic crisis rarely put it in these terms. They tend to focus on distinct short-term developments or on the roles of prominent people like Federal Reserve governors, members of Congress or Wall Street financiers. These stories grab attention and may be supported by some of the economic statistics that the government and private institutions collect.

But the economic situation is primarily driven by hard-to-quantify sociological factors that play out over many years.

The uptick in the unemployment rate, to 9.1 percent from 8.8 percent two months earlier and the drop in stock prices over the last month have attracted notice, yet in a sense they are symptoms of a deeper economic sickness.

Real estate prices have been a significant indicator of this ailment. An unprecedented bubble in American home prices started in 1997 and ended five years ago. Home prices rose 131 percent in that time, or 85 percent in real inflation-corrected terms, according to the S.& P./Case-Shiller National Home Price index. (I helped to develop that index, along with Karl Case of Wellesley College.)

Around the same time, there were bubbles in the nation’s commercial real estate and farmland. And there were real estate bubbles in many other countries, too...

That fed a contagion of optimism and helped to drive the speculative bubble, propelling the economy and the stock market in a feedback loop that repeated year after year…

During the bubble, the sense of rising wealth and high expectations gave people a good reason to spend and a greater willingness to plunge into investment, too. Government policy makers breathed in the same optimism, which no doubt encouraged them to be lax on regulatory restraint.

The mood is far different now…

Our 2011 survey found that the median expectation for home price appreciation next year is just 1 percent. So it won’t be surprising if new home sales remain abysmally low and few jobs are created in the hard-hit construction industry. And it shouldn’t be a shock if the personal savings rate stays at around 5 percent, as it has recently, up from around 1 percent in 2005. This would mean that consumer spending will not drive a strong recovery.

A half-century ago, there was a lively discussion among economists about the dynamics of price expectations. For example, Alain C. Enthoven, then of the Massachusetts Institute of Technology, and Kenneth J. Arrow of Stanford wrote in 1956 that expectations that extrapolate past price increases can produce economic instability. But that thinking was largely cast aside in the 1960s, when my profession embraced the theory that efficient markets formed by people holding rational expectations could explain virtually all economic activity.

As a result, economists in recent decades have not developed expectations theory much further. That needs to be corrected in coming years. In the meantime, this failing helps explain why the current crisis was generally unpredicted, and why its future course is so poorly understood.