The US Federal Reserve HQ

Robert Shiller interview: when the markets next collapse

It’s not a case of if, but when
June 17, 2015

“High prices are a sign of vulnerability and we have a heightened risk of a collapse,” said Robert Shiller, the Yale economist. “But I am just not in the mood to say it’s coming soon.”

Shiller was awarded the Nobel Prize in economics in 2013 for his work on the analysis of asset prices. He predicted the financial crises of 2008 by correctly identifying the fragility of the housing boom in the United States, so his comments are regarded with particular interest. He spoke to Prospect when global stock, bond and house prices were all close to historic highs.

He was deeply concerned at the high valuations, especially of Government bonds. These are contracts sold by governments, which promise buyers a series of interest payments, and eventually the repayment of the cost of the bond. Governments use bond markets for borrowing. Analysts believe that bond prices are due for a fall. In May, financial markets began selling government bonds, especially those of Germany, prompting fears that the collapse had begun. That global sell-off continued into June and the possibility of a collapse in bond prices is now seen by specialists as a grave threat, even if, like Shiller, they do not know when it might occur.

When it does, the consequences could inflict severe damage on the global economy, already weakened by factors including Greece’s inability to pay its debts and the slowing Chinese economy. Governments would find it much harder to borrow and interest rates could rise sharply.

“The bond bubble, if it’s a bubble, has proceeded further, beyond what it was in either 2000 or 2005,” said Shiller, drawing a comparison with cases where financial asset prices have risen to unsustainable heights. In both cases, inflated asset prices prefigured a sharp economic reversal. “So there is this worry about another massive collapse,” says Shiller. What has caused such high asset prices? The creation of new money—quantitative easing (QE)—by central banks, including the Federal Reserve in the US, has had an upward effect on the value of assets, including bonds. But high prices cannot be ascribed to QE alone.

“There’s a figure showing how interest rates—and real interest rates—have declined gradually over 20 years,” said Shiller. Lower interest rates tend to coincide with higher bond prices, meaning that current high values have origins going back decades. “QE is part of it, but not necessarily the greater part of it,” he said. “The news media tend to focus on central bankers because they’re people and it creates a better story and it’s very concrete. They constantly generate news so it becomes over-focused.”

The history of bond markets and their behaviour makes it hard to predict sudden movements in price. “I have a chart showing a total return index for corporate bonds in the US since 1857,” says Shiller, “and it has never crashed. The biggest episode was in the early 1980s when governments in the US and other countries as well decided to stop inflation.” At that time, Paul Volcker, then Chairman of the Federal Reserve, repeatedly hiked US interest rates until they reached the almost unimaginable level of 20 per cent, to counter surging inflation. He succeeded, and inflation fell. According to Shiller a side-effect was a fall in bond prices of 12-13 per cent, which Shiller says remains the sharpest ever correction in the value of bonds.

Could an increase in interest rates later this year cause similar market convulsions? The US Federal Funds rate is barely above zero per cent. The expectation is that Janet Yellen, the current Chairman of the Federal Reserve, will announce an increase in interest rates in the autumn. Though the rise will be nothing like the harsh medicine meted out by Volcker in 1980, markets remain intensely sensitive to the Federal Reserve’s slightest move, even if it turns out to be the expected quarter, or half a percentage point increase. When in 2013 Ben Bernanke, then Fed Chairman, suggested that the Fed might start to reduce its QE programme, the result was turmoil in global markets, most notably in emerging markets, which panicked.

“The thing about the history of central bank policy is they tend to do increases incrementally,” said Shiller. “So if they change, it’s that first increase that might be thought then to have great significance.” From then on the market will expect a series of further rises. “It’s somewhat unpredictable how they will react to that. There is a possibility that they will start a crash, especially since this is unlike other episodes.”

“We have had seven years of near zero rates and now if we see them going up it’s really hard to predict what kind of thought process [will arise],” said Shiller.

“I think it is possible that, even if it’s increased as expected,’ said Shiller, “there will be a big market reaction.”