Robert J Shiller: The Sublime Solution

The author, a professor at Yale University, turns out to be no ordinary prognosticator.

When he called the bursting of the dotcom bubble in his 2000 book Irrational Exuberance, Robert Shiller for a brief moment became a household name, one of those often-fleeting stars either lucky or good enough to sound the alarm well in advance of financial catastrophe. But Mr Shiller, a professor at Yale University, turned out to be no ordinary prognosticator. A couple of years later, he updated Irrational Exuberance to include his take on what he saw as an inflating property bubble. Investigating property price trends in the US going back to 1890, he found that after removing inflation from the equation, home values tended to rise at a rate of, well, nearly zero over long stretches of time.

He argued that the decade-long stretch of rapidly rising property prices was anomalous, a stance proven correct with the bursting of the bubble in 2006 and 2007. Given this record, Mr Shiller would seem an ideal candidate to piece together the US subprime mortgage crisis and offer remedies. In The Subprime Solution, a slimmer and more hastily put-together volume than usual for Mr Shiller, he mostly accomplishes this, with a couple of caveats.

His explanation for the crisis- that Americans got caught up in a self-reinforcing wave of optimism about property prices fed by an all-too-willing media - is slightly controversial. But the solutions he proposes might strike some readers as a tad more outlandish. In the long term, he argues that the remedy for financial engineering gone wrong is more financial engineering. With better risk-management tools at the disposal of investors, he says bubbles will be less likely to form. If people had easy ways to bet against home prices using derivatives, for example, home prices may not have gone up so much.

Mr Shiller may well be right. With the means to bet on a wider variety of financial assets, investors might help smooth out returns and prevent overheating in frothy markets. Unfortunately, such solutions are not likely to attract many backers these days, when suspicion of Wall Street's financial mavens has hardly been more palpable.

Publisher: Princeton University Press, 2008