Surveying the Economic Horizon: A Conversation with Robert Shiller

In this McKinsey video, economist Robert Shiller discusses four aspects of the current crisis: regulating for financial innovation, reducing trust in models, redesigning institutions, and the time line for turnaround. His perspectives are informed in part through his research that psychology — particularly an understanding of human irrationality — can play a key role in explaining economic breakdowns and exploring effective solutions.

Robert Shiller is a professor of economics at Yale University and cocreator of the Case–Shiller House Price Index, which is now one of the most widely used methods of measuring performance in that industry. He also introduced into intellectual circulation the phrase "irrational exuberance," which was picked up famously by Alan Greenspan in 1996.

Click here to watch the video, or read the transcript below:

Regulating for Financial Innovation

I think the government has to take an attitude that it is the sponsor of innovation, both of scientific innovation and of financial innovation. The government learned that years ago, just after World War II, when they created the National Science Foundation — and the government aggressively supports scientific innovation. We have to have the same attitude toward financial innovation.

And, unfortunately, the problem is financial innovation is difficult to measure, and to evaluate, because a lot of the outcomes that are promised by financial innovations are outcomes that take place years in the future. And it's possible to be misled and deceived by some supposed financial innovations. And the government finds it difficult to regulate them. But, unfortunately, it's necessary.

I think the US government is actually a world leader in financial regulation, even though people say this financial crisis started in the United States. I think good financial regulation also started in the United States; and the Securities and Exchange Commission has had a long history of regulation that has been basically supportive of financial innovation, but we have to carry that further now. And I think that the kind of new regulation that we need is, as [former US Treasury Secretary Henry Paulson] called it, objectives-based regulation — we have to be thinking more expansively about where we're going and how we can encourage financial innovation that gets us there. And we have to think less bureaucratically.

I don't want to see us killing off innovation, and this is what may get lost — and I hope it doesn't get lost — in the current crisis. Ultimately, let's not forget that we've learned lessons that a capitalist economy is an economy that promotes entrepreneurship, and entrepreneurship is not the province for government bureaucrats.

The business has to be that we have a sort of creative destruction. We have people trying things. And what does an entrepreneur do? You go to a number of different investment banks or venture capital firms, present your idea. And most people can't recognize an important, new idea, but some can. And that process, which is a free-market process, is really an important source of economic growth, and it can't be taken over by the government. And I think we will remember that. We are in a crisis situation, and these claims that we're at the end of capitalism are misplaced. I don't think that anything like that is going to happen.

• To read the full article on The McKinsey Quarterly, click here »