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Subprime lessons for emerging markets

Ryan Hahn's picture

In the July/August edition of the Atlantic, Professor Robert Shiller of Yale University discusses the Infectious Exuberance that spawned the subprime crisis in the U.S. housing market. In Shiller’s view, financial bubbles “are primarily social phenomena.” He compares a bubble to an epidemic, arguing that when the “transmission rate” of irrational exuberance exceeds the “removal rate” of that exuberance, we then have a bubble on our hands. Investors - many of them novices in the case of the U.S. housing market - become overly enthusiastic.

Shiller doesn’t connect the question of financial bubbles to emerging markets, but I think the parallels are obvious. In these markets, ever more people are becoming potential and actual investors. To give but one example, individual investors in Brazil’s primary stock market, Bovespa, now account for about 23 percent of the total value of trades, and over 230,000 individual investors are making trades on this stock exchange. Participation by individual investors also appears to be substantial in other emerging markets in eastern Europe, India, and China. And I would wager that many of these individuals, much like speculators in the American housing market, are novices who are basing their investment decisions not on the underlying value of companies, but on hearsay, rumor, and speculation – in short, all those things that can lead to irrational exuberance.

The wages of irrational exuberance are paid out in the severe pains of boom and bust. Professor Shiller offers a proposal to head off this outcome:

Financial advice is in some respects like medical advice: we need both on an ongoing basis, and failure to obtain either can impose costs on society when our health—physical or financial—suffers. There’s a strong case to be made that the government should subsidize comprehensive financial advice for low- and middle-income Americans to help prevent bubbly thinking and financial overextension.

Presumably, a similar type of policy could be adapted to the particular circumstances of Brazil, India, or other emerging markets. Unfortunately, the professor seems to be contradicting himself with this particular proposal. Earlier in the article, Shiller argues that investor exuberance is infectious—so infectious, in fact, that it leads even sober analysts to excesses. As he argues, “[f]ew people seem immune to boom thinking.” If even the financial experts are susceptible to this infection, why should we believe that they can help prevent novice investors from becoming infected?

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