Robert J. Shiller: How to Distinguish Between Science and Non-science in Economics?

                                         Robert J. Shiller                                              Interviewer: Zhang Jun

                                        Sterling Professor of Economics,                      Director, China Center for Economic  

                                          Yale University, USA                                        Studies, Fudan University; Vice

                                           2013 Nobel Laureate in Economics                  Dean, Fudan Development Institute

“we think that a bubble is a time when irrational investors are dominating the market and the market prices get too high. I’d like to define it as a kind of fad, just as we see fads in other things, like clothing.”

Zhang Jun: Everyone is talking about the fact that the Nobel Prize was awarded to both you and professor Fama at the same time. People think professor Fama actually rejects any idea of a bubble in the financial and housing market, whereas you are seen as the creator of the theory of the bubble. Why do you think you and Fama were given the prize at the same time? What does it mean? And do you find it surprising?

Robert Shiller: I don’t know why they did it, but they have done things like this before. In the 1970s they awarded the Nobel Prize jointly to Friedrich Hayek and Gunnar Myrdal. Hayek was very much like Fama, and maybe even more extreme free market. Gunnar Myrdal was an advocate of the welfare state. Myrdal thought it was horrible that we let poor people suffer. Morally we must lift them out of their suffering. So there was a total difference back then. I think that to some extent they think that the kind of debate we see is itself illuminating, even if it hasn’t reached the final conclusion. No one is going to resolve the free market versus welfare state split any time soon, but we would like to see people talk about it.

The other thing is that I spent a whole week in Stockholm. I didn’t know it was like this until I went through it, but what the Nobel Foundation does, is that they offer all of the Nobel Prize winners a free week in Stockholm. During that whole week I had the opportunity to talk many times with Fama. And when I talked to him one on one, I didn’t feel that there was such a chasm between us. We agree on the facts. And Fama and I agree that the stock market is somewhat predictable, especially over longer horizons. Not necessarily tomorrow, we cannot tell what it is going to do tomorrow. But he just thinks differently about what that means. He doesn’t like the word bubble.

Zhang Jun: You created another word for the bubble?

Robert Shiller: Well, I tried to create another definition – a clearer definition of what a bubble means. The word bubble apparently became popular in the year 1720, because there was a big international stock market crash in 1720 in Europe, and the word bubble has stuck.

Nobody knows exactly what it means, but we think that a bubble is a time when irrational investors are dominating the market and the market prices get too high. I’d like to define it as a kind of fad, just as we see fads in other things, like clothing. For example, around the year 1950, people started wearing blue denim pants, which had been work clothes. It's kind of a social contagion. People are faddish – it is human nature.

In a stock market bubble, it’s very hard to discern why everyone is buying into the stock market. They’ll give you a reason that sounds plausible. Typically, there are new era stories that develop. But you have to reflect that those stories are developing in reaction to the market, and they are not really sound stories, although there’s usually an element of truth in them. Valuing the stock market would require balancing all of the arguments, but that is not what most people do. They hear some arguments that seem talked about a lot and they react to that.

Zhang Jun: But the efficient market hypothesis is quite consistent with the fundamentals of economics. How do you challenge that? When you met with Fama, who would be more convincing?

Robert Shiller: Fama coined the term efficient market hypothesis and he is famous for that. At the Nobel week I was saying that that is an important theory. It’s not a hundred percent right, but it is an important theory, and I believe that. But I did a thing that really annoyed Eugene Fama. I told him various times during Nobel week that I wanted to congratulate him on being one of the most important voices in how to beat the market. So, he had a graduate student named Booth who founded a company called Dimensional Fund Advisors, and Booth asked Eugene Fama to be research director for that fund. Since then, the fund has acquired well over three hundred billion dollars in assets, making it a top fund, because of its good performance. It has beaten the market. And in fact it has made so much money that Booth went back to the University of Chicago and offered a three hundred million dollar gift, and they changed the name of their business school to the Booth School.

So where did that money come from? It came from Eugene Fama’s brilliance at learning how to beat the market. So I said that to him in front of a crowd and he looked so annoyed. I said, “I’m congratulating you, Eugene, you are an amazing expert in how to identify bubbles.”But he doesn’t think of it that way. He has his own way of describing it. And he thinks of it as him having identified risk factors, and that the markets are completely rational all the time. And that is not inconsistent with his being able to be a good investor.

You have to ask him to explain it, but if I had to take his side in the debate, I would say his theory is that there’s a good reason why markets are predictable. And that predictability is not an opportunity for everyone. But for some investors who have a different risk profile, there are opportunities, and he is offering a special service to those investors. And logically, that’s a perfectly sound reaction to the elements. And by the way, I admire Fama, just like you can admire someone from a different political party. When he does research I read it, because he is honest and he is very clever in how to do research. There is so much bland research that you don’t want to read. When you see a paper by him, you think this is likely going to be something I want to know.

Zhang Jun: How does he evaluate your work?

Robert Shiller: I have been involved for twenty-five years in advancing the cause of behavioral finance – psychology and finance, or more broadly, social sciences and finance. He told me once, that he is very proud of his role in behavioral finance. And his role was not to reject articles that were submitted. He was a referee for many of the classic behavioral finance articles and recommended publication. The other thing about Fama is that his most cited article of all times is his review of Behavioral Finance. So he doesn’t dismiss it. He has a perspective on it that is not as warm as my perspective on it, but he doesn’t dismiss it. I think any researcher has biases. As long as you don’t let it affect your publishing results. As long as you say, this is what I did and these are my results. You can have at the end of an article some interpretations, and people can take it or leave it.

Zhang Jun: You write for the Project Syndicate and I remember you had an article there saying that people always challenge economics on whether or not it is a science. Why is it called economic science? Can you explain a little more about that?

Robert Shiller: Yes, there has always been a tension – in any science – between the real researchers and the frauds. At various times in history they had to make a distinction. In the nineteenth century you would hear, for example, about chemical science. We assume that anyone who does chemistry is a scientist, today. But back then you had these alchemists and you had people who had religious and all kinds of motivations. They made potions and compounds and so on. They weren’t scientists, so you had to distinguish a chemical scientist from an alchemist. It is the same thing with medical sciences, because there were all kinds of dealers that claimed to have magical powers. I don’t mean to dismiss it. China is known for folk medicine, and actually we could learn from these people, but most of them are not scientists.

When the Nobel Prize in economics was created in 1958, they named it the Prize in Economic Sciences. And I think it was because economics still has a lot of practitioners who are not in any sense scientists, and they are very politically involved and motivated. So we should be able to write papers in economics that everyone of any political persuasion will read and find instructive.

But there is one problem with a scientific basis for economics, which is that some people go too far, or rather, it’s a problem of pseudo-science. Some people like to look at mathematical equations and they write down nonsense. There are tensions like this in the physical sciences too. There are physicists, who argue that the physics profession is going off track. I can’t evaluate this, but there are complaints within physics, that there are many physicists who want to be the next Albert Einstein and put out theories that will never be tested, because there is no way to test them and they have no implications.

Zhang Jun: Do you know Shing-Tung Yau, the Chinese-American, who is a professor of mathematics at Harvard University and has worked on the String Theory?

Robert Shiller: That’s right, yes. That is controversial among physicists. They don’t have a way to test it, apparently. But they might figure out something. You know, Albert Einstein wrote his theory of relativity in 1905. It wasn’t until 1919 that an experiment confirmed one of his implications when there was an eclipse of the sun. Maybe with String Theory it will take longer. You never know for sure what is science and what is not.

Zhang Jun: So how can you distinguish between science and non-science in economics?

Robert Shiller: A lot of people complain about economics, that there shouldn’t be a Nobel Prize for it because it’s not really a science. I don’t think that’s right, but I think economics is more vulnerable. It’s a hard discipline to pursue methodically because the economic world is so complicated. It involves people, and there are so many different ways of looking at it and so many different ways of collecting evidence.

What sometimes happens is that people think that only certain kinds of evidence are scientific, and they would throw out obvious facts as being not scientifically proven and ignore it completely. And that’s in some sense what happened in the bubble that led up to this recent financial crisis. Eugene Fama had so much authority saying markets are efficient, that no one wanted to consider the possibility that investors were getting overly excited and pushing prices up too much. Simple evidence, which you get by just talking to people and listening to their reasons for buying, is not admissible because it’s not scientific. So I like to get evidence from taxi drivers.

Zhang Jun: I remember you said you returned from Columbia and you had talked to the taxi driver, tolearn what happened in the housing market there?

Robert Shiller: Exactly and he pointed out as we were driving, “Do you see that house there? Five million US dollars”he said, “it’s just amazing. It’s going totally crazy in Columbia.”I was also in Miami, Florida, and the cab driver was pointing out to me all the buildings that were going up, and he said, this is going to end badly. They’re building too much. Then I go to my meeting of economists in Florida and they are writing all these mathematical equations, and how could I possibly bring up what the taxi driver told me. Of course I don’t, but secretly I was thinking, maybe the taxi driver has a better understanding of the real estate market. I don’t mean that generally, but it sometimes happens.

Zhang Jun: Let me ask you about something different which you have also discussed in your writings on the financial sector. In both the US and even in developing countries today, it seems the talented and smart young people are all rushing into the speculative industry like investment banks and securities, and this sector seems to be growing comparatively to the conventional financial sector. Do you think that is inevitable?

Robert Shiller: It might be a bubble. There was a bubble in the financial sector in the 1920s that led to the 1929 stock market peak and then a crash. And we have been going through one, especially before this crisis. Salaries were rising rapidly, and many people were moving into it. We have to remember that these things have happened before and came to an end in the past.

I also am a big believer in physical sciences. There is so much going on. To be a young person today I would feel very attracted to medical science and biological sciences. Neuroscience is exploding; there is so much happening there. In fact I think one revolution that is happening now is coming from the medical schools. The neuroscientists are learning about the human brain, and they’re starting to get interested in economics. I’m actually going to a conference in another month with neuroscientists and economists, about collecting data and integrating neuroscience data on a big scale with economic data. So I think that economics is not really isolated in the sciences anymore.

Zhang Jun: Do you think that economics is going to integrate more with other sciences?

Robert Shiller: In the 1700s, a lot of economics was done in philosophy, by philosophers. Adam Smith was a moral philosopher and David Hume was a philosopher. Maybe they’re also coming back. My son is a graduate in philosophy, and he reports things to me that look like something I have seen in economics discussions. And actually neuro-philosophy is developing now. We have to take account of how the human mind works, and it changes philosophy.

Zhang Jun: If you had to predict the development of economic science over the next half century, what would you say?

Robert Shiller: I find it very difficult to predict what goes on in any academic discipline, but as I was saying, I think neuroscience will change our view of human nature. For example, you have Paul Glimcher, who is a New York University neuroscientist. He says economic science has been built on the idea that people are utility maximizing – moreover, expected utility maximizing. Then he says, if that’s happening there has to be structures in the brain that are doing that. So he wants to find the structures. It might not exist, but this is a research project that will take decades. My guess is, that they will find out that there isn’t a utility function optimizer in the brain, but maybe something analogous, that we can’t conceptualize yet.

Zhang Jun: I also wanted to mention the book by Thomas Piketty, The Capital of the 21st Century, which has drawn a lot of attention, both in the US and in China. I think the reason why it got so popular here in China is that they used a very interesting name in Chinese, because it’s parallel to Karl Marx’s Das Capital.

Robert Shiller: Well I thought of that too. I got a copy in the mail, and I thought it looks like Marx. The nice thing about Piketty’s book, like Marx’s book, is that it’s also very readable, and it tells you about a long sweep of history. It’s a very readable history about inequality. It also has another similarity with Marx, that it’s about the poor people and their oppression in some sense, so it even has a similar theme.

Piketty’s view of inequality emphasizes wealth accumulation, and that’s another Marxist thing, because Marx said that the concentration of the ownership of capital was the problem. My view of inequality is that it has multiple causes. He talks about the top one percent, and that’s important, but what about the difference between the average or the median worker and someone in the bottom ten percent? Maybe that’s more important.

I’m thinking that part of what’s happening in the world today is that the real working class, people who are not educated and don’t have special skills, seem to be suffering, and it has something to do with modern technology, like the internet and computers. This is an old theme. It goes back to the Luddites in 1811 in England, who thought that mechanization of weaving was leaving people unemployed. Two hundred years have gone by and that idea hasn’t ever taken hold, but I think the way computer technology is advancing now maybe shows that the Luddites were just two hundred years too early.