Ongoing Crisis Could Last Years, Says Robert Shiller

Robert Shiller, a well-known economist and professor at Yale University, said the ongoing financial crisis could last for years. He said blaming monetary policy for the crisis is simplistic and misleading, and called for three solutions to prevent a similar crisis in the future.

"I think this crisis has the potential to last for years and years and we have to think more about the long term in how we have to deal with it," Shiller said at the London School of Economics on Wednesday evening.

Critiquing the notion that lax monetary policy caused the crisis, Shiller pointed out how "remarkably similar" the situations in the U.S. and the UK have been over the past decade, despite "substantially different" monetary policies. In addition to detailing the similarities in their housing markets, he said in both countries the stock market peaked in 2000, moderated in 2003, and collapsed in 2007.

If the outcome is so similar despite such variation in policy, blaming governors from the FOMC won't help in pinpointing causes of the crisis, he said.

Instead, Shiller blamed "group think" in part for the crisis, explaining that too few people challenged incorrect assumptions that were taken for granted as correct. "So few people predicted it - it came totally out of the blue," he said. Shiller added that an "inflation of confidence" took hold in the late 1990s with the dot-com bubble, and resumed with the housing bubble earlier this decade.

Shiller, who was once an adviser to Timothy Geithner, Obama's choice for Secretary of the Treasury, was critical of responses that appear to be only short-term solutions, such as bailout packages. He said such deals "offend the sense of justice of a lot of people," adding that "there doesn't seem to be any theory behind them - it's just patching holes in a ship."

Indeed, in "Anatomy of a Meltdown," the New Yorker piece on the financial crisis from last Sunday, it was noted that Fed Chairman Ben Bernanke and his colleagues referred to early attempts to stem the crisis as the "finger-in-the-dike" strategy.

Shiller was equally critical of a Keynesian stimulus package and the models that back them up, noting that Keynes himself was skeptical of economists who attempted to quantify the benefits of his proposals.

Instead, Shiller said longer-term solutions modeled on previous successes need to be created. Deposit insurance, for instance, was implemented after the Second World War and remains a vital component of the financial system today.

"I think that we want a new deal now, something that makes fundamental changes in our financial institutions, and I think, ultimately, that is the kind of thing that will work best to restore confidence," he said.

In the first of three proposals, Shiller said finance needs to be democratized. He said "a good part of the problems we have is because individuals aren't able to get good financial advice." To remedy the situation, he said the clientele for financial advice needs to be extended beyond the wealthy. As it stands now, many people deal only with salespeople such as real estate agents - people who won't be there after the sale and who have an incentive to complete the transaction quickly.

Shiller said the government could sponsor subsidized financial advice so that people could pay an hourly rate for advice from experts who don't work for any particular company.

Secondly, he said the present crisis resulted from a failure to manage risk, which the housing industry was particularly susceptible to. Even when he pointed out to Fannie Mae several years ago that they were exposed to a possible housing bubble, the government-sponsored enterprise replied that there was no way for them to hedge risks.

"Ultimately, I think it helps to have some kind of government support for any financial innovation, and so something that would help create markets for real estate would be fundamentally transforming to the economy," he said.

Thirdly, Shiller said the housing sector is too dominated by tradition. He said the long-term fixed rate mortgage is the norm, not because it is optimal but simply because it isn't challenged. He said that a mortgage should be written around the risks that homeowners face, meaning that mortgage payments would adjust to economic factors. If home prices fell, the mortgage balance would be reduced automatically.

Shiller, who heads the Case-Shiller index of home prices, said such innovation is difficult for the private sector to introduce, but with government help such ideas could receive widespread support.

Shiller's lecture was part of a media tour for his book "The Subprime Solution," where his ideas can be read in more detail.

By Patrick McGee and edited by Sarah Sussman
©CEP News Ltd. 2008