Troubles with bubbles - they all have to burst eventually

Irrational Exuberance is the second edition of a well-received book published by Robert J. Shiller, a Yale University economics professor, in 2000. The first edition correctly warned readers of the 2000 stock-market collapse. The second edition goes to some pains to explain the realities of the market excesses that threaten to destabilise the economy and disrupt our lives. Shiller believes that overconfidence can lead to instability, and that as with the stock market in 2000, so now the housing market is significantly overvalued. He warns that the housing market is likely to collapse in much the same way as the stock-market bubble of the late 1990s.

If this happens, he predicts that house prices might well decline for many years to come.

He offers a host of other warnings, too, all focused on Alan Greenspan's now-famous phrase "irrational exuberance", which was used in an after-dinner speech in 1996 to describe the frenzied behaviour of stock-market investors. Shiller believes that any continued rise in these markets could lead to a substantial rise in the rate of bankruptcies, a decline in consumer and business confidence and, possibly, a worldwide recession. Although this is not inevitable, he feels that the risk in the current situation is much more serious than is widely acknowledged.

Shiller defines his aim thus: to attempt to extend the argument in the first edition "that variations caused by changing attitudes, irrational beliefs, and foci of attention are an 'important' factor in our changing economic lives, and to examine the consequences for our own economy and our future".

Two introductory chapters analyse the fluctuations in both the stock market and the property market in historical context. This allows readers to get an overview of what appear to be remarkable variations. In 2000, Shiller pointed out the structural factors that drive market bubbles. It was a timely warning, as the stock markets of a great many countries dropped by almost 50 per cent from their peak with little recovery. When stocks plummeted in 2000, many disillusioned investors moved their money into housing - a move that inflated prices not only in America but around the world.

Irrational Exuberance is a clinical and unnerving study of the psychological origins of volatility in financial markets, including real estate. "Structural Factors", "Cultural Factors" and "Psychological Factors" are the headings of the first three parts of the book, while a fourth deals with "Attempts to Rationalise Exuberance".

There are some frightening disclosures. One is that the stock-market boom has coincided with an extraordinary growth in the mutual funds industry. In 1982, there were only 340 equity mutual funds in the US, but by 1998 there were as many as 3,513 mutual funds - more equity funds than stocks listed on the New York Stock Exchange. By 2000, there were 164.1 million mutual fund shareholder accounts - or about two accounts for every US family.

Shiller reminds us that mutual funds (the US equivalent to unit trusts)are a new name for an old idea - "investor trusts". After the stock-market crash of 1929, many of these so-called trusts became worthless and a betrayed public soured on these collective forms of investment. The Investment Company Act of 1940 then helped to restore some public confidence, and the industry was given new impetus by the Employee Retirement Security Act of 1974, which created individual retirement accounts.

But they needed a new name - "mutual funds", which sounded similar to the more reassuring and scandal-free mutual savings banks and mutual insurance companies. Naive investors have since been encouraged to participate in the market in these pooled "funds" hoping that the experts managing these funds will steer them away from pitfalls - a sometimes dangerous assumption. The decline of inflation, too, has been viewed as a sign of economic prosperity boosting public confidence and stock-market valuation, which is a confusing misinterpretation of values.

In the fifth part of the book, "A Call to Action", Shiller reminds us that his first edition cautioned that "real losses in the stock market could be comparable to the total destruction of all the schools in the country, of all the farms in the country, or possibly even all the homes in the country". Since then, the US stock market has indeed lost more than $6 trillion (£3.4 trillion) - an amount equal to about 60 per cent of the value of householders' real-estate holdings. If therefore the stock market continues to decline, or the boom in real estate falters, then "individuals, foundations, college endowments, and other beneficiaries of the market are going to find themselves poorer, in the aggregate, by trillions of dollars". As an example, Shiller cites the Ford Foundation, which cut its endowment from $4.1 billion to $1.7 billion after the 1974 stock market crash. The University of Rochester lost half its endowment between 1973 and 1974. "The same or worse could happen today to foundations and universities that have invested too large a share of their portfolios in the stock market."

Although this book is directed at the US reader, its recommended solutions can be adjusted for international use. Shiller makes eight basic points to investors and policy-makers. These are as follows: portfolio diversification to reduce investment risk; increase savings rate; retirement plans should be put on a sounder footing; the design of social security should be improved; monetary policy should gently lean against bubbles; opinion leaders should offer stabilising opinions; institutions should encourage constructive trading; and the public should be helped to hedge risk.

Each of these recommendations, aptly explained in the book's conclusion, should be studied, discussed and debated. It will not be easy. Shiller is certain that the US housing market is a speculative bubble that will burst.

It is only a matter of time. His book is a powerful antidote to the plethora of get-rich-quick investment recommendations and vehicles plaguing an unwary public.

Christopher Ondaatje is a retired investment banker, an author and a trustee of the National Portrait Gallery.