From: Robert Shiller
To: Wen Stephenson
Date: 1/24/2002
Subject: Beyond the Bubble

One of the points the FRONTLINE documentary makes is that the myth of the Internet as a great "democratizing" force, "leveling the playing field" and all that, has been exposed, at least when it comes to financial markets. You may or may not agree with that premise, and I'm curious to hear your reaction to it.

The Internet, and related information or communications technology, is helping to integrate world markets -- not just financial markets, but every market, even the labor market. People in remote places of the world are no longer so cut off from the world economy. People in Calcutta or Shanghai can now do office and telephone work for New York and Hong Kong. Maybe you could call this "leveling the playing field."

But, in thinking about this, we must remember that some of us may be the losers when we face new competition from afar. The Internet certainly breaks up the playing field, creating new losers and new winners. But, this effect may not be to level incomes. On the contrary, it may make them more unequal. Improved information technology can enhance a "winner-take-all" economy, where a few people are able to monopolize the market better.

Is there something about the Internet itself, as a medium, that fed the bubble?

Public impressions of technological progress are heavily influenced by our personal involvement in the new technology. When radio stations first started appearing in the United States in the early 1920s, and when radio shows began to be as engaging as our modern TV shows (though without the picture) by the late 1920s, people had the very visceral sensation that important new technology arrived. The Internet has given a similar sense of remarkable progress. But, this sense is substantially exaggerated in our minds.

Regarding the term "new economy." It's become a kind of cliché that the "new economy" thinking drove the Internet boom and that the concept was revealed as hollow once the bubble had burst. What role did the "new economy" thinking really play in the Internet boom and bust?

There has always been a "new economy," every decade since the beginning of the industrial revolution. There have been so many important inventions over the last century that brought us from the horse-and-buggy days to the pampered situation we find ourselves in now, and brought life-expectancy up from 45 years to 80 years. If the next decade is as good as those of the last century, we should count ourselves very lucky. And I think that there is a good chance that the new information economy can help sustain this same level of economic growth that we saw for the last century.

What do you think we've learned, or failed to learn, about the Internet's real importance? And what might this suggest about the true cost of the Internet bubble, not just in economic terms, but in social and even political terms? That is, what was the "opportunity cost," so to speak, of lavishing so much money, energy, and media attention on the Net economy?

The Internet is a very important invention that will have important consequences. But the extent of the consequences is very hard to quantify. The quantitative importance of the Internet will never be fully known, even after another century has gone by.

By analogy, what was the real importance of the invention of the railroad for the 19th-century economy? There was a famous debate on that topic between Prof. Robert Fogel of the University of Chicago and Prof. Albert Fishlow of UC Berkeley in the 1960s. They tried to figure out what the relative costs of other modes of transportation were, what canals would have been built if there had been no railroads, and so on. Fogel concluded that the railroad raised gross national product by less than 5 percent total over the century, while Fishlow thought it raised GNP by more than 15 percent. No one has ever resolved the discrepancy between their two numbers. The repercussions of any such major technological advance are so manifold, and we can never know what alternative technology would have invented around the problems that the railroad solved.

The same will be true of the Internet. The repercussions of the Internet will be complex, involving whole new lines of business, even businesses that have no obvious connection to the Internet. When the information infrastructure changes, all manner of new businesses become feasible and many old businesses will fail.

Since Sept. 11, concern about the economy has only deepened. But putting short-term predictions aside, as you look back over the past year or 18 months, what connection do you see between the dotcom crash and the current recession? The whole story of the Internet economy has been eclipsed by Sept. 11, but what shape do you think the economy would be in today if the events of Sept. 11 had never taken place? In other words, in terms of the economy, what's the more important story?

I think that in the long run we will decide that the end of irrational exuberance was a more significant event for the economy than was September 11.

September 11, 2001, was a unique event in U.S. history. We have never seen such an attack before. Immediately after the attack, there was great anxiety, since there was fear of an invisible enemy that might have increasingly diabolical plots against us. The anthrax scare heightened that, when we believed it was from the same source. But, I think that this anxiety has been very short-lived. The remarkable success of our war efforts have allayed most fears. As long as there are not some flamboyant terrorist attacks, people will see little reason from this not to spend.

The end of irrational exuberance is more likely to be significant now, because its reasons for curtailing spending are still with us, and because the lack of exuberance is shared all over the world. During the exuberance, people thought there was every good reason to spend now -- and to take big risks based on very insubstantial reasons to expect future reward. That feeling will be gone for a long time.

What about current stock valuations versus what they were before the bull market ended? One of the major points you make in Irrational Exuberance is that price-earnings ratios in the late 1990s were historically way out of line. A year and a half after Nasdaq peaked, what's the story on price-earnings ratios?

The conventionally defined price-earnings ratio on the Standard & Poor 500 recently hit 41.4. This is not only a record high, it is stratospheric. In 1929, when the previous record was set, the ratio only reached half as high. Maybe the market isn't quite so much more overpriced as this ratio suggests. There are some risks in trusting any comparison with the past, as the definition of earnings has evolved over time, and recent earnings have been affected by some aggressive write-offs. But, I think that the evidence is pretty strong that the overall market is still very overpriced.

Is it possible that the bubble will reinflate once the economy starts growing again?

This is a very different, and difficult, question. Have people really changed their psychology in fundamental ways? There isn't a clear enough theory of market psychology for us to say whether they have or have not. Survey evidence on investor psychology haven't shown any unambiguous picture. But, my guess is that, since the irrational exuberance of the late 1990s was such an extraordinary event in our history, we should not expect that to repeat again soon.

Do you think that the charges of IPO abuses, coupled with the very public outcry over analyst conflicts of interest, have left a lasting stain on Wall Street's record? Has the public's trust in Wall Street has been significantly shaken? Should these IPO investigations -- and the 1,000-plus law suits currently pending, involving something like 263 IPOs -- be seen as the true legacy of these years on Wall Street, as much as the bubble itself?

I don't think that these abuses were as bad as the ones of the 1920s. After the 1929 crash, public preoccupation of those abuses led to some changes. The Investment Act of 1940 made fundamental changes. Mutual funds, which differ from the investment trusts of the 1920s in that they were not secretive and treated all investors equally, proliferated.

We've already seen some government reaction to the abuses of the 1990s from the SEC. Notably, Regulation FD, instituted in 2000, made for a more level playing field, and reduced the power of analysts. I think that changes like these can restore public confidence.