Robert Shiller was one of the few economists to actively warn of the housing bubble. However, unlike me, he is prepared to absolve Alan Greenspan of the charge of unbelievable negligence for failing to take steps to combat the housing bubble. In an NYT column today, Shiller argues that Greenspan could have been misled by the wrong views of others. While there is some logic to Shiller's argument, it only applies to situations where we can't know the underlying fundamentals. This can be seen with a simple example. Suppose that we were watching a person flipping a coin, where a whole group of people was betting on the outcome. Suppose most of the bets on the first flip were for "heads" and the coin did in fact come up heads. Suppose a second, third, fourth, and fifth flip each turn up heads. Suppose that each time, the amount bet on heads increases. If we derive all our information on the outcome of the coin flip from the opinions of others, then of course we would bet very heavily that the sixth flip would be heads. However, we also know that a fair coin will come up heads half the time and tails half the time, and this is not affected by either the prior five coin flips or the view of the betters that the sixth flip will also be heads. Similarly, we have fundamentals that we could examine to determine whether there is reason to believe that house prices should diverge from the 45 year trend in government data and the 100 year trend in Shiller's data, that shows no real increase. There was no one in the debate that came up with any story that remotely passed the laugh test as to why house prices should have suddenly began to explode in the mid-nineties. Given the absence of any plausible explanation based on fundamentals, Greenspan should have been able to ignore the views of those betting on a sixth head coming up and recognized that there was a housing bubble that would burst, and that it would not be pretty. If he couldn't see this, then he should not have been chairman of the Federal Reserve Board.
--Dean Baker
