Shiller on Boom, Bust and Human Nature

Wendy Carlson/Getty Images Robert J. Shiller at a news conference Monday in New Haven after being named a Nobel laureate.

Since 2007, Robert J. Shiller, one of this year’s Nobel laureates in economic science, has been a regular contributor to the Sunday Business section of The New York Times. He started in that role just as the downturn in the housing market was becoming apparent.

Mr. Shiller notably called attention to the bubble that had inflated the housing sector and explored the psychology â€" not always rational â€" that was driving the markets. Bucking the conventional wisdom of the time, he also suggested that the housing downturn could help bring down the financial markets and the economy. Here are excerpts from some of his Sunday columns that diagnosed the turn in the economy, with a postscript from his most recent column assessing the lessons learned â€" or not.

Aug. 26, 2007: Trouble Signs in Housing

Prices have been falling, and our survey over the last few months shows that in Los Angeles and San Francisco, the median 10-year expected price increase among recent home buyers has come down to 5 percent a year â€" a number that is likely to decline further if prices continue to drop. As price expectations fall, homeowners lose the incentive to pay off a mortgage on a home they are realizing is beyond their means. They decide to default. We thus have the beginnings of a mortgage crisis.

The problem is fundamental, tied to the imbalance caused by irrationally high home prices and declining optimism that the prices will go higher. Cutting interest rates will not change this basic situation.

Oct. 14, 2007: What a Recession Feels Like

A recession has much the same pattern as the flu â€" starting with vague feelings of malaise and quickly building in misery until a patient’s activities are drastically curtailed. Then, all too gradually, comes an extended period of recovery, accompanied by lingering symptoms of discomfort.

With the unemployment rate up to 4.7 percent in September from 4.4 percent in March, the economy is feeling a chill. Is it descending into recession?

Most economists seem to be concluding that the current unpleasantness is a false alarm. They point to some good vital signs: the stock market is up, the dollar is cheap, the rest of the world is strong and the Fed is ready to respond.

But there are worrisome symptoms, and they bear close watching. The most important is a creeping sense of malaise that could turn into a general loss of confidence. The downturn in the housing market and the repercussions in financial markets are critical factors.

Nov. 25, 2007: Addressing the Root Causes

We have to consider the possibility that the housing price downturn will eventually be as big as that of the last truly big decline, from 1925 to 1933, when prices fell by a total of 30 percent.

As of this August, domestic home prices were already down 5 percent from their peak 14 months earlier, according to the S.& P./Case-Shiller Composite Home Price Index, and prices were falling at a faster rate in the months leading up to August. . . .

In light of modern financial theory, this would also be a good time to think about the nature of the implicit subsidies given to government-sponsored enterprises like Fannie Mae and Freddie Mac and whether they provide enough incentives for them to properly manage their own risks as guarantors of mortgages. We should think about whether the F.H.A. should be encouraged to take on a bigger role that might compete with activities of the subprime lenders that have grown so rapidly over the last decade. We might create a new consumer-oriented regulatory authority, like the Financial Products Safety Commission that Elizabeth Warren, a professor at Harvard Law School, has been advocating. It would monitor financial products for consumers and draft regulations to prevent practices like the recent widespread issuance of adjustable-rate mortgages to low-income borrowers who couldn’t afford the rate resets.

The real estate appraisal industry needs to rethink its methods. How did it happen that appraisers acquiesced in valuations that were more and more discordant with economic fundamentals? Basic concepts and procedures need change.

March 2, 2008: The Herd Mentality

The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world. If people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.

Were all these people stupid? It can’t be. We have to consider the possibility that perfectly rational people can get caught up in a bubble. In this connection, it is helpful to refer to an important bit of economic theory about herd behavior. . . .

Suppose that there is a 60 percent probability that any one person’s information will lead to the right decision.

In other words, that person’s information is useful but not definitive â€" and not clear enough to make a firm judgment about something as momentous as a market bubble. Perhaps that is how [the former Fed chairman, Alan] Greenspan assessed the probability that he could make an accurate judgment about the stock market bubble.

The theory helps explain why he â€" or anyone trying to verify the existence of a market bubble â€" may have squelched his own judgment.

The fundamental problem is that the information obtained by any individual â€" even one as well-placed as the chairman of the Federal Reserve â€" is bound to be incomplete. If people could somehow hold a national town meeting and share their independent information, they would have the opportunity to see the full weight of the evidence. Any individual errors would be averaged out, and the participants would collectively reach the correct decision.

Of course, such a national town meeting is impossible. Each person makes decisions individually, sequentially, and reveals his decisions through actions â€" in this case, by entering the housing market and bidding up home prices.

Sept. 29, 2013: Did Lessons Go Unheeded?

I see no signs that home buyers have learned the lesson I tried to convey in the second edition of my book “Irrational Exuberance” in 2005. That message was that existing-home prices have shown virtually no tendency to trend upward in real, inflation-corrected terms over the last century. While land is limited, it’s only a small component of home value in most places. New construction often brings down the value of older homes, which wear out and go out of fashion, dragging down prices.

It’s as if people are applying to housing an idea described by Frederick Lewis Allen in his 1931 book, “Only Yesterday.” Before the stock market collapsed in 1929, he said, people thought that “every crash of the past few years had been followed by a recovery, and that every recovery had ultimately brought prices to a new high point. Two steps up, one step down, two steps up again â€" that was how the market went.”

Well, people have certainly been right that there will always be steps up and down. Unfortunately, there is no certainty that the ups will outnumber the downs.

People who are now inclined to buy a home are most often just thinking that we are gradually recovering from a recession and that this is a good time to buy. The mental framing still seems to be about economic recovery and the likelihood that interest rates will rise. People mostly don’t seem to be prompted by the anticipation of another housing boom.

That’s the thinking at the moment. But whether these attitudes mutate into a national epidemic of bubble thinking â€" one big enough to outweigh higher mortgage rates, fiscal austerity in Congress and other factors â€" remains to be seen.