Infectious Exuberance
Financial bubbles are like epidemics— and we should treat them both the same way.
by Robert J. Shiller
Atlantic Monthly
July/August 2008

Many households have access to very little financial insight. In most cases, the only financial professionals they come into contact with are trying to sell them something, whether it’s a mortgage or a stock. Independent financial advisers, who provide more-comprehensive advice, have typically been available only to the relatively wealthy. The questions most people need answered are elementary: How risky is this investment? Have prices ever gone up this fast for this long before? Can I afford this loan if interest rates rise? But they’re not getting straight answers to these questions.

Financial advice is in some respects like medical advice: we need both on an ongoing basis, and failure to obtain either can impose costs on society when our health—physical or financial—suffers. There’s a strong case to be made that the government should subsidize comprehensive financial advice for low- and middle-income Americans to help prevent bubbly thinking and financial overextension. One way to do this would be through co-pay arrangements like those in place for Medicare or for private health insurance. Accredited advisers, charging a flat fee, would be partially reimbursed by the government; the moderate costs to consumers would create a much broader market for their services.

We also need to get better—and more—information to more-sophisticated investors and financial professionals. In real estate, one important way of doing that is by further developing the financial market rather than focusing only on regulating it or reining it in. For instance, real-estate futures markets, which have existed since 2006 but are still in their infancy, have the potential to tame future housing bubbles. Without them, there is no way for skeptical investors who think they see a rising bubble to express that opinion in the market, except by selling their own homes. If futures markets grow, then any skeptic anywhere in the world could profit from a bubble in, say, Las Vegas, by short-selling real estate there. Substantial short-selling would reduce bubbles, and provide information to home builders, ratings agencies, and others. In turn, builders, for instance, might not overbuild if they see that most of the money in the futures markets is being bet on price declines.

Robert J. Shiller is a professor of economics at Yale University. This article is drawn from his forthcoming book, The Subprime Solution

full article in the Atlantic Monthly Online