Economists mistakenly assume that investors are rational, says Yale economist Robert Shiller, co-founder of the Case/Shiller index — but nothing could be farther from the truth.
Feelings of fear and disappointment, as in the current economic environment, lead inexorably to a mood of powerless in which investors fail to pay attention to their own best interests, Schiller says.
“The fears themselves are an integral part of the problem,” Schiller writes in The New York Times.
“Post-boom pessimism is a factor driving the economy, and it is likely to be associated with attitudes that may be enduring.”
“Today, after the speculative bubbles in the housing market, we are leaving a time of irrational exuberance when many people and financial institutions bet their future on speculative trading, not on genuine economic contribution.”
Emotions can engulf institutions as well as individuals, Schiller notes.
“If banks do not have the confidence to make loans, business cannot proceed, and the lack of confidence becomes a self-fulfilling prophecy,” he says.
“Speculation is a healthy capitalist activity, but there is a problem if it becomes a national obsession, as it did in the boom before this crisis.
President Obama’s proposed Volcker Rule, which seeks to limit bank risk-taking, may be seen as a response to widespread disillusionment with excessive speculation,” he says.
Failure to enact financial reforms to curb large banks' risky activities and allow them to fail without broad market disruptions will make the financial system even more fragile in the future, according to Obama administration adviser Paul Volcker, Reuters reports.
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