The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It

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By Robert J. Shiller
Princeton University Press, 2008, 208 page

Robert J. Shiller, the Arthur M. Okun Professor of Economics at Yale University, famously predicted the bursting of the dot-com bubble in Irrational Exuberance (Princeton University Press, 2000). In the past few years, just as presciently, he predicted the bursting of the housing bubble as well. His new book, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It, which appeared in September 2008, both explains the dynamics of investment bubbles and reveals why government efforts to stop the ensuing meltdown have failed.

After a brief review of the his­tory of U.S. housing policy, Shiller contrasts the comprehensive mea­sures taken in the early 1930s to stabilize that decade’s collapse in the housing market with what he calls the “ad hoc, band-aid” remedies administered since the current collapse began in the fall of 2007. He suggests three goals for any lasting solution to the problem: improving the financial information infrastructure; extending the scope of financial markets to cover a wider array of risks; and creating retail financial instruments such as “continuous-workout mortgages” and home-equity insurance to provide greater security to consumers. He outlines several ways of accomplishing these goals and reinforcing the social contract — the implied agreement that a society will protect its members from major misfortune. His contribution to the first goal has been to assemble data on the long-term performance of U.S. house prices, something that had not been available before. It reveals that between 1997 and 2006 real house prices (i.e., net of in­flation) grew by a staggering 85 percent. They will fall — it seems certain — for some time.

Shiller is a disciple of the pros­pect theory of Daniel Kahneman and Amos Tversky and the field of behavioral economics that it has spawned. (See “Daniel Kahneman: The Thought Leader Interview,” by Michael Schrage, s+b, Winter 2003.) He suggests that the housing bubble arose through some astonishingly casual — and false — assumptions about the history and future of housing prices, fueled by “social contagion,” a complex of social psycho­logical mechanisms that can overwhelm rational calculation, even in professional investors. These mechanisms were given free rein under the libertarian regulatory philosophy espoused by key policy­makers, such as then U.S. Federal Reserve Chairman Alan Greenspan, who essentially ignored them. The author suggests that studying models of the way diseases spread is a better way to understand this contagion than using the paradigms of neoclassical economics.

The Subprime Solution was perfectly timed to capture the demand for explanations of the housing market turmoil in 2007 and the first three quarters of 2008. But it was too early to cover the dramatic events of October 2008 and the much larger global crisis that followed. The author’s views, however, do presage what was to come. No doubt he is already working on a sequel, which will command a deservedly large readership.

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