http://chronicle.com/weekly/v55/i32/32b00601.htm
From the issue dated April 17, 2009
HOW DID THIS HAPPEN?
How 'Animal Spirits' Wrecked the Housing Market
By GEORGE A. AKERLOF and ROBERT J. SHILLER
Real-estate markets are almost as volatile as stock markets. Prices of
agricultural land, of commercial real estate, and of homes and
condominiums have gone through a series of huge bubbles, as if people
never learned from the previous ones.
Such events — in particular the recent housing bubble — are driven by
what John Maynard Keynes called animal spirits, a naïve optimism at the
intersection of overconfidence, corruption, storytelling, and money
illusion (another Keynesian term, for views warped by currency's nominal
value instead of its purchasing value).
For some reason, in the late 1990s and early 2000s, the idea that homes
and apartments were spectacular investments gained a stronghold in the
public imagination in the United States, and in many other countries as
well. Not only did prices go up, but there was palpable excitement about
real-estate investments.
It was the biggest home-price boom in U.S. history. It extended over
nearly a decade, beginning in the late 1990s. Prices nearly doubled
before the bust began, in 2006. While it lasted, this spectacular boom,
mirrored in other countries, too, helped drive the entire world economy
and its stock markets. In its wake, it has left the biggest real-estate
crisis since the 1930s — the so-called subprime crisis — as well as a
global financial crisis whose full dimensions have yet to be grasped.
What caused such a boom-and-bust event? What really drove people's thinking?
A good place to start is How a Second Home Can Be Your Best Investment,
by Tom Kelly (a radio-show host) and John Tuccillo (former chief
economist of the National Association of Realtors). It was published in
2004, when home prices were rising the fastest. The book explained:
"Look at it this way: If you think a house is good enough to live in,
someone else will too, and they'll pay you for the privilege. The
ownership of a real-estate investment, particularly property that you
can personally enjoy — a vacation home, your retirement residence — is
the most profitable investment within the reach of the average American."
Despite those assertions, the book is singularly devoid of arguments as
to why real estate is the best investment. Kelly and Tuccillo pointed
out that real-estate investments are typically leveraged investments.
But that is not an argument for high returns; leveraged investments can
turn spectacularly bad if prices go down, as homeowners have recently
discovered. The possibility of a national home-price decline was not
even mentioned.
That kind of thinking is, of course, characteristic of speculative
bubbles. In lieu of rational argument, the book was filled with stories.
For example, Ken and Nedda Hamilton had lived in Pennsylvania all their
lives. They had dreamed about a home in Florida for years, but they took
action only after their grown son Fred laid out a case for such an
investment and offered to be a co-investor. A real-estate agent allowed
them to spend nights in each of several homes near Naples, Fla. They got
hooked on one, bought it, and were very happy. A sequence of stories
like that one allows the reader to choose the story that is most
congenial to him and that best serves as a model for his own behavior.
But even if the authors felt no need to explain why homes were the best
investment, why were investors so convinced of that even before they
read the book?
It appears that people had acquired a strong intuitive feeling that home
prices everywhere can only go up. They seemed really sure of this, so
much so that they were ready to dismiss any economist who said
otherwise. If pressed for an explanation, they typically said that,
because there is only so much land, population pressures and economic
growth should inevitably push real-estate prices strongly upward. Those
arguments are demonstrably false. Home prices have fallen before. For
instance, land prices fell 68 percent in real terms in major Japanese
cities from 1991 to 2006. But investors didn't want to hear that sort of
talk.
The impression that homes are spectacular investments probably stemmed,
in part, from money illusion. People tend to remember the purchase price
of their home, even if it was 50 years ago. But they do not compare it
with other prices from the same era. One hears statements like "I paid
$12,000 for this house when I came home from World War II." That
suggests enormous returns on the purchase of the house — partly because
it fails to factor in the tenfold increase in consumer prices since
then. The real value of the home may have only doubled over that
interval, which would mean an annual appreciation of only about 1.5
percent a year.
So there is no rational reason to expect real estate to be a generally
good investment. It is so only at certain times and in certain places.
But the myth can be amplified by a number of factors, and in this most
recent boom, it was.
Two feedback cycles that bloated stock prices also bloated realestate
prices: Increases in home-selling prices fueled buying prices, and vice
versa, in a loop; similarly, increased home prices swelled GDP
estimates, which, in turn, appeared to validate the higher home prices.
That is, if everyone is ostensibly more productive and richer, then it's
seemingly more likely that they'll be able to afford ever more expensive
homes. As home prices rose faster and faster, they reinforced the folk
wisdom about increasing value and imbued that folk wisdom with a sense
of spectacular opportunity. And the 1990s bubble in the stock market
apparently set the psychological stage for such contagion by creating in
people a view of themselves as smart investors.
People had learned the vocabulary and habits of investors, they had
increasingly begun subscribing to investment periodicals, and they
watched television shows about investing. When the stock market soured,
many people thought that they had to transfer their investments into
another sector. Real estate looked appealing. The accounting scandals
accompanying the stock-market correction after 2002 caused many to
mistrust Wall Street. But homes, especially their own, were something
tangible that they could understand, see, and touch.
As the boom progressed after 2000, the way in which we thought about
housing changed. Newspaper articles about houses as investments
proliferated. Even our language changed. New phrases like "flip that
house" or "property ladder" became popular. (Those two were even used as
the titles of popular television shows.) The old phrase "safe as houses"
acquired a new currency. The phrase actually dates back to the 19th
century, when it seems ships were compared to houses. A sailor might try
to reassure a terrified passenger during a violent storm: "Don't worry,
these ships are as safe as houses." But in the 21st century the term
moved into the investment context, with the meaning "Don't worry, these
investments are as safe as investments in houses." And the boom seemed
to connect this phrase with the further thought "and so a highly
leveraged investment in houses is a sure winner."
Why was the home-price boom after 2000 so much bigger than any other
before it? Partly because of the evolution of economic institutions
related to housing.
Institutions changed because of the belief that the opportunities to
take part in the housing boom were not being shared fairly among all
elements of the population. Martin Luther King III, the son of the great
civil-rights leader, lamented in a 1999 editorial titled "Minority
Housing Gap; Fannie Mae, Freddie Mac Fall Short" that minorities were
being left out of the boom. He wrote, "Nearly 90 percent of all
Americans, according to surveys by HUD, believe that owning a home is
better than renting one." Like everyone else, minorities deserved this
opportunity for wealth.
The allegation of unfairness led to an almost immediate, and uncritical,
government reaction. Andrew M. Cuomo, secretary of the Department of
Housing and Urban Development, responded by aggressively increasing the
mandated lending by Fannie Mae and Freddie Mac to underserved
communities, even if that meant lowering credit standards and relaxing
the requirements for documentation from borrowers. He wanted results.
The possibility of a future decline in home prices was not his concern.
He was a political appointee. His charge was to secure economic justice
for minorities, not to opine on the future of home prices.
There was never any serious examination of the premise that this policy
was in the best interest of minorities. In the overheated atmosphere, it
was easy for mortgage lenders to justify loosening their own lending
standards. A number of those new mortgage institutions became corrupt at
the core. Some mortgage originators were willing to lend to anyone,
without regard to their suitability for the loan. Corruption of that
sort tends to flourish at times when people have high expectations for
the future.
Or maybe corruption is too strong a word. Is making a loan that you
suspect will eventually default corrupt? After all, you didn't force the
mortgagor to take out the loan. You didn't force the investor to whom
you were selling the securitized mortgages to buy the investment. And
who really knows the future anyway? There was money to be made giving
all these people what they thought they wanted. No regulator was telling
you not to do it. As we have already seen, there was an economic
equilibrium that linked the purchasers of snake-oil houses with the
purchasers of the snake-oil mortgages that financed them.
For evidence of the effect of subprime lenders on the housing boom of
the 2000s, consider that low-price homes appreciated faster than
high-price homes. And then after 2006, when prices fell, the prices of
low-price homes fell faster.
Residential investment (mostly construction of new homes and apartment
buildings, as well as improvements in existing homes) rose from 4.2
percent of U.S. GDP in the third quarter of 1997 to 6.3 percent in the
fourth quarter of 2005, then fell to 3.1 percent by the fourth quarter
of 2008, making it a significant factor in the recent U.S. boom and bust.
The housing market touched on all aspects of the animal spirits
identified by Keynes — confidence, fairness, corruption, storytelling,
and money illusion. It's clear, in this market and many others, that
those animal spirits help drive the economy and that, to steer it
safely, economists and policy makers will have to study such behaviors
further and take careful account of them in devising new incentives and
reforms.
George A. Akerlof is a professor of economics at the University of
California at Berkeley and winner of the 2001 Nobel Memorial Prize in
Economic Science. Robert J. Shiller is a professor of economics at Yale
University and author of the Princeton University Press books Irrational
Exuberance (2000) and The Subprime Solution (2008). This essay is
adapted from their new book, Animal Spirits: How Human Psychology Drives
the Economy, and Why It Matters for Global Capitalism (Princeton
University Press, 2009).
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