Shiller’s Research Should Bring on A Reconsideration Of The Great Depression

Great Depression

There are two big historical events that took place in 1929. One was the beginning of the Great Depression. The other was the gigantic stock crash that began on Black Friday. Pretty much everyone believes that they were related in some way. It would be too much of a coincidence for these two massive economic developments to take place at the same time strictly by chance.

But I do not believe that until now we have possessed a clear understanding of the connection. Robert Shiller’s Nobel-prize-winning research of 1981 showing that valuations affect long-term returns greatly clarifies things.

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The Cause Of The Great Depression

The story told by most economists is that misguided trade policies caused the Great Depression and the prospect of an economic contraction caused investors to lose confidence in stocks. That certainly seems to follow logically. The publication of Shiller’s research puts things in a new light, however.

Stock prices were very high prior to the Great Crash. The CAPE value hit “33,” the highest level we had seen prior to the onset of the bull market that is still ongoing today. If it is true that valuations affect long-term returns (I believe that it is), then a huge crash was entirely predictable at that time.

Investors were fooling themselves into thinking that their stock portfolio was worth far more than its real and lasting value. As the irrational exuberance disappeared into the mist (as it always does sooner or later), trillions of dollars of consumer spending power went “Poof!”

Wouldn’t the sudden disappearance of trillions of consumer spending power cause a massive economic contraction? It sure seems to me that it would.

The trade policies of the time might well have been misguided, Those trade policies may have been a contributing cause of the Great Depression. But the disappearance of the trillions of irrational exuberance almost certainly was the far more significant factor at play. It would be hard to imagine how the loss of trillions of dollars of irrational exuberance would not at the least bring on a severe recession.

It’s important to identify the true cause of the economic calamity. We obviously do not want something like that to happen again. Economists often bring up the depression experience when warning of the dangers of overly restrictive trade policies. If Shiller’s research is legitimate, it would make more sense for them to warn of the dangers of high stock prices, something that they rarely seem to do.


I believe that the problem is one of institutional resistance to advances in our understanding of how economics works. Shiller was awarded a Nobel prize for a good reason – his work revolutionized the field. But, as of today, the Shiller Revolution has not really caught on.

Most people possess at best a vague appreciation of the far-reaching implications of his work. Economists who were trained from textbooks written in pre-Shiller days feel more comfortable offering the explanations that seemed adequate in an earlier era.

Keeping CAPE Values Down

The good news is that, when we do begin taking Shiller’s research findings more seriously, we stand to make some large advances in our understanding of the economic realities very quickly. Say that the primary cause of the Great Depression was that CAPE value of 33.

That suggests that the high CAPE values of the 1960s played a big role in bringing on the stagflation of the 1970s and thag the high CAPE values of the early years of this Century played a big role in bringing on the economic crisis of 2008.

Keep CAPE values down (by encouraging investors to engage in market timing when it is needed to keep their risk profile constant over time) and you avoid all of the human misery that follows from a breakdown of the economic system.

People tell me that I am a dreamer, that today’s understanding of how the stock market and the economy works has been in place for a long time and that no Nobel prize is going to bring about a change. I don’t buy it.

Today’s CAPE value is at a level likely to bring on another economic crisis. I am confident that there are many economists who are concerned about today’s crazy stock prices for just that reason but who try hard to keep it zipped because they believe it would be career death to speak openly about these matters given the institutional resistance to the thought of making large steps forward in our understanding.

The pressure to keep prices up is strong today. But that pressure will of course be gone once prices have fallen. I believe that at that time we may hear a number of prominent economists saying things about the importance of Shiller’s work that they have been reluctant to say until now.

It was irrational exuberance that served as the primary cause of the Great Depression. Had investors been reminded throughout the 1920s to engage in market timing in a responsible way, we might well have avoided that horrible and frightening chapter of U.S. history.

Rob’s bio is here.