Shiller: Long-Term Perspectives on the Current Boom in Home Prices

Robert Shiller and Dean Baker have articles in the latest Economists' Voice about the housing boom and its sustainability in the near and longer terms. Here's Shiller with a long-term perspective gained from looking at over 100 years of housing data in a variety of countries. I cut quite a bit, but it's still fairly long as it has lots of interesting things to say:

Long-Term Perspectives on the Current Boom in Home Prices, by Robert J. Shiller, Economists' Voice: Homeowners want to know: Is the current boom in home prices temporary? Is a crash possible? And if prices do fall, will they come back up fairly soon, or will they stay down for many years? Some have written reassuringly, downplaying concerns about possible price falls... Angell and Williams, for example, concluded that “In over 80 percent of the metro-area price booms we examined between 1978 and 1998 the boom ended in a period of stagnation… the expectation would be that metro-area home price busts will continue to be relatively rare.” But they reach their conclusion based only on a twenty-year period of United States data.

Indeed, all these studies confined themselves to no more than a few decades’ recent data. Such data simply cannot provide useful insights to homeowners planning to occupy homes for thirty or forty years, and wondering whether a general uptrend in home prices will inevitably carry them over any possible price declines.To answer the important questions, we first need to find out if there have been other booms similar to this one, and what happened after such booms ended. Until now long-term price indexes have not been generally available to allow us to do this. I have constructed one...  The news is not good for homeowners. According to our data, homeowners face substantial risk of much lower prices that could stay low for a long time after. Luckily, though, derivatives products, notably a futures market, are being developed that they will soon be able to use to insure against this risk.

The data show no long-term uptrend in real home price
Figure 1 shows three long-term series of real home prices. All attempt to control for changing size and quality of homes; all are corrected for inflation in consumer prices.

I constructed the United States series 1890-2005 ... Piet Eichholtz constructed the Amsterdam series 1628-1973, ... based on selling prices of homes along the Herengracht canal, a small region of Amsterdam which was originally zoned for large lots and expensive homes and for which data have been carefully maintained. Homes are thought to have remained relatively unchanged there for centuries. Øyvind Eitrheim and Solveig Erlandsen constructed the Norway series 1819-1989, ... this time based on individual home sales data for Bergen ..., Oslo ..., Kristiansand ..., and Trondheim.... Note the enormous current boom in home prices in the United States since 1997. The magnitude of the current boom is practically unique in history, making it difficult to predict what comes next based on historical examples. Amsterdam and Norway have also seen sharp upswings since 1997, but these price indexes terminate before 1997, and so are not visible on Figure 1.

Figure 1. Real home price indexes for the United States 1890-2005 (Shiller 2005), Amsterdam 1628-1973 (Eichholtz 1997) and Norway 1819-1989 (Eitrheim and Erlandsen 2004)

Do real home prices have a substantial long-term uptrend? The chart suggests not. First, what about the United States? It’s notable that until the recent explosion in home prices, real home prices in the United States were virtually unchanged from 1890 to the late 1990s. The Amsterdam data show lots of ups and downs, but only the slightest hint of an uptrend. Prices approximately doubled, but it took nearly 350 years to do so, implying an annual average price increase of only 0.2% a year. The Norway data do suggest such an uptrend, but viewed from the longer perspective of the Amsterdam data, that uptrend seems to be merely part of a long cycle from the early 19th century to the late 19th century. And even leaving the context added by Amsterdam aside, Norway’s real price growth is, on average, negligible: only 1.3% a year.

Accounting for the current boom: an historical comparison
If the current boom doesn’t reflect a long-term uptrend in real home prices, when will the market correct for this short-term discrepancy? And will the correction be smooth or drastic? The only other time the United States has experienced a large home price boom was around the end of World War II. According to these data, real home prices went up 60% from 1942 to 1947, and then leveled off into a “soft landing,” ... The current boom is of a similar and even greater magnitude. From the first quarter of 1997 to the first quarter of 2005, real home prices went up 71% according to the Case-Shiller index, and by 52% according to the OFHEO repeat sales index. Will this boom end in a soft landing as the prior boom did? Possibly...

Recession: only way current boom can end? Not necessarily.
Many think that only a recession can end a home price boom, and no recession is on the horizon: therefore, a soft landing is most likely. But this comforting syllogism is an over-extrapolation from the last two real estate cycles. The magnitude of the current boom is much greater than past booms, and so the way the boom ends, may be more unpredictable and dramatic. Figure 2 shows a longer view, giving unemployment rates and home prices since 1890. Two things stand out: first, the current boom is far more dramatic than its predecessors, and second, even prior booms do not necessarily track the unemployment rate such that their ends are signaled by recessions.

Figure 2. U. S. real home price index 1890-2005 (Shiller, 2005, updated) and U.S. unemployment rate 1890-1930, source: Bureau of Labor Statistics, Current Population Survey, and, before 1930, Romer (1986).

Granted, the real estate boom-bust in the late 1970s and early 1980s does match up roughly with fluctuations in the unemployment rate. And so does the boom-bust of the late 1980s and early 1990s. But that is not true if we look at a longer time span. ... Although the last two real estate boom cycles did end in recession, that is not the rule historically.

Real rents, the rent-price ratio, and real interest rates
It is striking that, while there does not seem to be a genuine long-term uptrend in real house prices, there does seem to be a genuine long-term downtrend in real rents.

Indeed, according to BLS data, real housing rents have been in decline—falling about 50% in total—ever since the Consumer Price Index was created in 1913. See Figure 3. ...

Figure 3. U.S. real rent of primary residence, January, 1913-2005 (Bureau of Labor Statistics) and real home price, 1913-2005, Shiller 2005.

It is thus surprising that the real price of American housing, also shown in Figure 3, has had an uptrend since 1913—although, as noted above, there is no long-term uptrend if pre-1913 years are taken into account. ...

In theory, real rents and real home prices might be expected to track each other
In theory, one might expect real home prices to represent the present discounted value of future rents. After all, people can move from renting to owning with relative ease. And while there’s an obvious tax advantage to owning..., that advantage could be easily valued and taken into account in the calculations. If [so]..., then prices should closely track rents. ... In practice, however, the situation is very different: Not only do real home and rent prices fail to track each other, but the rent-price ratio has shown a remarkable downtrend since 1913. (See Figure 4). But why?

Figure 4. Real interest rate is defined as long-term government bond yield described in (Shiller 2005), minus the rate of change of the consumer price index for the preceding year. The index of the rent/price ratio is defined as the U.S. consumer price index for rent of primary residence, 1982-4=100, divided by the Shiller [2005] U.S. home price index, and the result rescaled to 1980=1.

Interest rates are not the explanation, as some have suggested... The rent-to-price-ratio downtrend is not matched by a downtrend in real long-term interest rates, ... Also, real rates today, while much lower than in 1980, do not appear low by historical standards. The recent divergence between real interest rates and real rental-price ratios suggests the possibility of an irrational overpricing today and a huge fall in home prices in coming years. However, more study of these series in association with present value models and other data would be warranted before drawing strong conclusions ...

The character of the current boom: a glamour city boom more than a land boom
Nationwide, there is something of a land price boom going on too. Using data from the United States Department of Agriculture, the U.S. real (CPI inflation-corrected) estimated market value of cropland per acre rose a total of 29% between 1997 and 2005. Over the same period, real average cash rents per acre for cropland were virtually constant, so the agricultural land boom shows up in the price-rent ratio as well.

But, the 29% increase in real agricultural land prices is a lot less than the 71% increase we saw in Figure 1 in real home prices. Moreover, some of this land price boom is from acreage that is in the immediate vicinity of urban areas, and so some of this boom is just the same urban real estate boom that we have already seen.

The cause of the home price boom does not seem to be an unsatisfied hunger for land services or housing services, above other goods and services: We saw in the preceding section that rents have not been increasing as much as consumer prices. Expenditure on housing services in the United States as a share of GDP has been relatively constant at about 15% since 1929. Expenditures have kept up with rising incomes not because rents or prices have been increasing but because we have increased the amount of real housing services that we buy. ... the average size of new houses increased from 1100 square feet in the 1940s to 2150 square feet in 1997 as the number of people per household dropped from 3.67 in 1940 to 2.64 in 1997. ...

We appear to be seeing growth in a different kind of hunger: a hunger for investments in real estate that can be expected to do extremely well. The home price boom is in large measure a boom in investments in glamorous urban areas and vacation spots that appear to investors to have sharp appreciation potential. According to the National Association of Realtors, 36% of all homes purchased in 2004 were second homes: investment properties or vacation homes. ...

Particular examples bear out the general thesis that the boom is very strong in desirable cities and vacation spots. Consider that the Case-Shiller Indexes show that from the first quarter of 1997 to the first quarter of 2005, when nationwide real home prices went up 71%, real home prices rose 93% in Boston, the home of universities and intellectuals, and 151% in Los Angeles, the home of movie stars. Over this same interval, real home prices went up 137% in Barnstable County, Massachusetts—the elite area of Cape Cod summer homes, and 114% in Collier County, Florida, one of the most exquisite vacation areas in the United States, and with the beautiful Ten Thousand Islands.

A “soft landing” after all? The safety-valve hypothesis
The variance across regions of home prices, relative to construction costs, has increased over this interval in the United States, and is very high by world standards.

Goldman-Sachs chief economist Jan Hatzius believes this variance creates a greater safety valve in the United States: homeowners can move to lower-priced land to build their houses. ... The process takes time: businesses have to move with people, and new urban areas have to be planned and built. If he is right, then the housing boom, if it cools, may have a “slow crash,” instead of a “soft landing.”

Figure 5 shows that residential investment has tended to be high when the home price index that I constructed for 1890-2005 has been high. That conclusion makes sense: When houses seem to be a good investment, more is spent on them. This investment is essential to the process that brings home prices back down when they are high.

Figure 5: Residential investment as a share of GDP 1929-2004 from National Income and Product Accounts, Table 1.1.10, and real home price index for the United States, Shiller [2005].

High prices in some cities appear to be related to local zoning restrictions that inhibit construction in those cities. ... Zoning changes can be intentionally used by local governments to slow a potential bust in the housing market. On the other hand, zoning changes could inadvertently accelerate the bust: If such changes make big cities less desirable, owing, for instance, to more of the type of high-rise apartment buildings disliked by wealthy residents – then we may see price declines in the boom cities.

It seems likely that some neighborhoods of unique value will see their value protected by zoning laws, even into the distant future. The neighborhoods of Georgetown, in Washington DC, of Beacon Hill, in Boston, ... The beautiful cities of Aspen Colorado or Santa Fe New Mexico have unique ambience that would be disrupted by high-density housing or high rises, and voters there know that. ...

But, these are rare places. Most neighborhoods are not so unique or special that they will necessarily encounter resistance from residents if an economically advantageous offer is made. Studies of zoning laws, such as that by Fischel (2004), show that we have only imperfect understanding of the political forces that shape zoning laws, and we cannot make a case that there is any fundamental force that will keep zoning very tight in the future.

Zoning laws do appear to have become gradually more effective over the course of the twentieth century, according to the research of Edward Glaeser and Joseph Gyourko 2005. But still they are local, and still there is an incentive for communities somewhere to welcome economic development. Even if the rare places can’t be built up more, upward pressure on their prices can be relieved by new construction elsewhere, even far away. ...

The history of world real estate has been like this for centuries. Zoning laws have not stopped new construction and newly-valuable urban areas keep appearing. We still see the glamour areas persist indefinitely ... but we will see more and more of such places appearing ... The glamour areas are likely to be like ever expanding and replicating mesas of value rather than ever-rising mountains of value as the conventional urban land model is often taken to suggest.

At some point, with prices high relative to construction costs in big cites, and construction proceeding quickly outside the cities, a decline seems likely to follow. Whether the landing will be hard or soft, remains to be seen.

Fads can fade fast
The preceding discussion did not touch upon behavioral economics. I argued in Irrational Exuberance that there is substantial evidence that there is a strong psychological element to the current housing boom. While the boom may continue for some time, the psychological element is likely to die away as thinking changes and current folk expectations for further price increases are lost. I argued that the current home price boom is best thought of as a social epidemic: a fad of sorts. And yet social epidemics are not even mentioned by most of those who say reassuringly that there is no reason to worry about home prices. Social epidemics can unwind sharply as psychology changes, suggesting the worrisome possibility of a rather hard landing.

With the housing market riskier than it seems, hedging instruments are invaluable
The outlook for home prices is not so certain ... The “fundamentals” ... are surprisingly weak ... The market for homes is a very risky place. The recent tremendous boom in home prices shows that there are risks on the upside: people who are underexposed to real estate may miss out on a rising market. And, the historical tendency for booms to be reversed eventually shows that there are risks on the downside: people who are overexposed to real estate may suffer when prices collapse.

It is vitally important that vehicles be created to hedge these risks and to allow people to manage their exposure to the real estate market. Creating hedging vehicles that will protect agents from such major risks will enable them to act without the hindrance of idiosyncratic risk... There have been a number of efforts over the years to create hedging instruments for real estate price risk, but none of these has really caught on to date. ... But one failure, and other failures or half successes, do not disprove the concept of real estate risk management. The Chicago Mercantile Exchange ... has announced plans to create futures markets for home prices in ten U. S. metropolitan areas. ... The contracts will be launched spring, 2006 ...

There is a basic principle here: there really are substantial risks to the market value of homes, and so major risk management tools will be central mechanisms of our future economy. When home value risk management is finally made possible, we will see some fundamental economic transformations as a result.

Update: See also Dean Baker: Government Should Preemptively Burst the Housing Bubble, also from Economists' Voice.

Update: Michael Mandel at BusinessWeek Online's blog Economics Unbound adds:

By my calculations, a drop of 10% in national housing prices over the next few years would put home values back on the long term trend line. See my piece here.

Comments

[Emmanuel]

According to our data, homeowners face substantial risk of much lower prices that could stay low for a long time after. Luckily, though, derivatives products, notably a futures market, are being developed that they will soon be able to use to insure against this risk.

Egad, this suggestion disturbs me. Not only will homeowners be laden with ARMs and interest-only mortgages, but they soon will be able to buy put options on their homes. Why, this isn't home investment, it's casino capitalism! [I gesticulate wildly, feigning righteous indignation.]

But then again, they do balance each other out in theory, assuming that premiums won't be too costly.

[anne]

Increasingly Robert Shiller may need to look to inward in such writings. Shiller's company in developing the derivatives products for ostensible protection against the end of the world in housing. The end of the world in investing has been in order for Shiller for a decade, but never have I found a resonable suiggestion of how a portfolio might be structured to avoid the end of the world, that is before housing derivatives that "I" am developing for "you."

[anne]

Interestingly enough, the Vanguard real estate investment trust index is up 16.3% this year; little touched by the moderate rise in long term interest rates. The REIT index has gained over 15% a year for the last decade, over 12% a year for the last 3 decades. Let's assume the REIT index is a loose proxy for overall gains in housing prices. A decline in the price of REITs or housing should be readily weathered by long term investors or homeowners.

[jm]

Emmanuel writes part of what I would like to say, but ends with, "But then again, they do balance each other out in theory, assuming that premiums won't be too costly."

The catch is that it's pretty hard to profitably buy insurance against events which are nonrandom and which nearly all the sellers believe is sure to happen, and impossible if most of the sellers overestimate their probability and/or severity. Since the sellers of insurance intend to make a profit, they will demand premiums greater than the anticipated loss.

Many times over the years I've read articles which, when the market for some stock is roiled by rumours, say something like, "but you can protect yourself against that by buying a put on the xxx exchange." But then you look at the options prices, and see that you'd have to pay so much for the puts you'd be better off just selling the stock.

Puts are a good buy only when the sellers are excessively optimistic that they won't be exercised Since one of the main causal factors in a crash is that sentiment turns excessively pessimistic, you can't effectively hedge against one once it's actually underway. That was the portfolio insurance concept flaw that produced the 1987 crash -- which portfolio insurance was supposed to protect against, but didn't exactly because no one was going to sell insurance against a crash right in the middle of one.

[Fred Hapgood]

> The end of the world in investing has been in order for Shiller for a decade ...

At least. His story is an object lesson in the hazards of relying on the predictive power of the past. In the case of real estate, the market in my city has been so radically globalized -- 56% of all housing purchases in the last year were made by non-citizens -- that the behavior of the centuries when only local people participated has been rendered next to irrelevant.

Except perhaps in the longest possible run.

[bailey]

I think Shiller's a pretty good read, so I'll write this off as promotion cost.

[anne]

Fred Hapgood:

"In the case of real estate, the market in my city has been so radically globalized -- 56% of all housing purchases in the last year were made by non-citizens -- that the behavior of the centuries when only local people participated has been rendered next to irrelevant."

Important observation, readily extended through real estate. American investment houses, by the way, are buying European assets solely to get at the real estate.

[Robert]

To play devil's advocate for a moment, though modernity may change some things, many others remain the same. And it's worth highlighting that there never been a modern real estate boom that has been accompanied (and facilitated) by "interest-only mortgages", ARM's, etc. (in the proportion they've been written) in addition to a whole range of other mortgage-facilitating products that have helped people "reach" in terms of affordability. Nor has such a boom been party to the wholesale separation of origination and securitisation. Jimmy Stewart's (It's a Wonderful Life) S&L cannot be of munificent help to a borrower anymore. Those days are gone.

So before one trumpets the new benefits of globalization upon the real estate asset class (the more things are different), the more one needs to look carefully at the illiquidty, wide-bid/offer spreads, high transactions costs, and high covariance amongst borrowers to the same event risk (macroeconomy, interest rates, etc.), the more things remain the same) to see that those who cavalierly discount the risks in this asset class, do so at their peril.

It is amazing how fast one's equity can disappear when a few forced & distressed sellers (mortgage holders) mechanically hit the bids in an illiquid market characterized by an overhang of supply and a dearth of demand. Oh how fast the direction of the wind can shift....

And Anne, the investment houses are mostly buying assets in Germany where prices, spiked dramatically upon unfication and have been dribbling sideways to lower since finally creating a situation where yields are tolerable AND there finally is a glimmer of capital gain in the immediate future. Only investors most desparately trying to diversify out of USDs and turn paper into hard assets are tempting their fates in inflated, low yield markets like UK, Ire, Neth, Fra. Spain Switz....

[anne]

Robert, thank you :) A more careful comment would be that beyond steadily buying European stocks and housing, American investment companies have been buying assets that offer interests in European real estate; Germany and beyond, though German real estate seems relatively attractive. Germany is in need of a real estate spurt. American investors have in general been moving to international assets, with considerable reason. Of course, there has been quite a run in international asset prices and there is always reason for care about valuations.

[anne]

What impresses me is how well general growth is holding internationally through a dramatic rise in energy prices; how well housing prices are holding from Europe to Australia in this cycle; the powerful and comprehensive international bull stock market. But, there is always the long term bond market to worry about :)

Oh, the only negative stock market internationally last year was Venezuela; negative in an explosive Latin America, but what a difference this year for Venezuela. What I am wondering is whether this reflects significant Venezuelan growth.

[anne]

What has long annoyed me with Robert Shiller is not the endless bearishness, but never setting down ideas as to what an intelligent portfolio might be for those who increasingly need such ideas. Rather the point has been cash cash cash through years of gains in asset prices. Watch Shiller wander the dunes behind a new Connecticut beach house by the way.

[save_the_rustbelt]

A couple of observation:

For many of us there is no housing boom and therefore our risk tends to be created by job losses.

Second, as anyone who has ever worked with personal financial planning knows, people make some incredibly stupid decisions, including real estaste decisions.

I believe it was ABC News recently that had a feature about 1 million American home owners being in line for foreclosure. Many bought homes well out of there budget range because they could get ARMs at very low rates. Well, it is time to pay the piper.

And the middle class people who bought multiple condos on speculation in Florida, well, they are likely to get what they deserve for taking huge risks with a small financial foundation.

[anon]

I think Shiller needs to look at things in the U.S. on a state-by-state basis. His paper alludes to differences across regions and trends behind glamour areas, but Shiller does not look at recent trends on a state-by-state basis. He (Shiller) needs to be more systematic about regional differences in the U.S.

If you do look at things on a state-by-state basis, you will probably find that appreciation is correlated to median income. That is, states with high median incomes tend to appreciate faster than states that have lower median incomes. (Florida is a notable outlier to the regression of median income and home price appreciation: median income in Florida is below average yet home price appreciation is significant and high. Thus, Florida may be more likely to be a bubble, yet this is not the entire U.S.)

This, to me, suggests a "sorting out" process in the U.S. and network effects. And I think the fundamental relationship of income to home prices may be in-tact more than many bubblists want to acknowledge.

Some regions of the U.S. are bargains. Shiller does not explore this enough. People in some parts of the U.S. need more leverage to be risk-neutral (probably not California).

[Robert]

Yes, Anne, the optimists have [mostly] triumphed over the past decade or so, though not without some tense and nervous moments. And of course there is always tomorrow when Shiller may proved more correct than yesterday.

I would argue people are far more pedisposed (by nature) towards bullishness and bearishness than theorists, or they themselves might care to admit, since most people like to believe they arrive where they do, logically through reason and with good cause.

Understanding the true nature of one's disposition and its role in crafting their investment decisions is of great importance and something many people don't discover until they've lost a fortune (or two).

[anne]

http://www.nytimes.com/2006/03/05/magazine/305tulips_shorto.1.html?ex=1299214800&en=bb369c2505b1c24f&ei=5090&partner=rssuserland&emc=rss

March 5, 2006

This Very, Very Old House
By RUSSELL SHORTO

In 1625, a carpenter named Pieter Fransz built a house on the outskirts of Amsterdam. He was young, ambitious and lucky enough to belong to one of history's greatest generations: his life spanned the course of his country's golden age, when tiny Holland became an empire and Amsterdam grew into Europe's wealthiest city. Fransz walked the streets with Rembrandt; he saw a forest of masts grow in the harbor, as ships returned from the East Indies laden with pepper and nutmeg, a sack of which could make a man wealthy for life. He and his family prospered along with the city; 17 years after building his house, he was rich enough to buy the one next door, into which his daughter and her husband moved. In 1683 he was still listed as the owner of both properties. Happiness isn't registered in municipal archives, but the image of this one not terribly consequential human life that remains on the palimpsest of time speaks of contentment: a man who has lived beyond the normal life span of his era, surrounded by family, financially successful.

Most of us leave no lasting traces that recall our stay on the planet, but through accident and fate, Fransz left something that has endured the centuries. His house — an elegant redbrick step-gable, its facade ornamented with sandstone bands and wooden cross-framed windows, a building that has more of the Renaissance than the Baroque about it — still stands. Napoleon and Hitler conquered Amsterdam in their separate centuries; later, postmodern architects and the sex and soft-drug industries made their marks. Pieter Fransz's house withstood all.

The Dutch have always been meticulous recordkeepers, so it is possible to follow this house, and others nearby it on Amsterdam's famous Herengracht, or Gentlemen's Canal, as they make their way through the centuries: to watch the succession of doctors, diamond cutters, confectioners, merchants and politicians move in and out, to glimpse the births and deaths, to watch careers and families unfold. More to the point, it's possible to follow the successive property transactions in this area of Amsterdam from the time it was developed to the present.

In itself, this isn't exceptional: other European cities have land registers that date to the Middle Ages. What makes Pieter Fransz's neighborhood unique — and uniquely interesting to some economists who are studying today's global real-estate boom and wondering whether the bubble that has been expanding for the past decade and more is in the process of bursting — is what real-estate experts call a constant quality index. Cities change over time; neighborhoods fall out of favor, and new ones come into vogue. Comparing property values in Greenwich Village a century ago with those of today might be interesting as part of a study of a changing neighborhood — the transformation of a low-rent, working-class community into a tony and sophisticated enclave — but not as a way of understanding how real-estate value changes over time.

From the time the Herengracht was developed in the early 17th century, however, it has been Amsterdam's prime real estate, the place where power brokers — 17th-century merchants dealing in spices and slaves or 21st-century bankers and international consultants — have chosen to base themselves. Looking at real-estate transactions over four centuries on this canal on which Pieter Fransz built his home gives a quality constant of unparalleled duration.

This is what attracted Piet Eichholtz, a professor of real-estate finance at Maastricht University in the Netherlands, to study the Herengracht in the 1990's. Eichholtz's work — the so-called Herengracht index — has become a touchstone in recent discussions about real-estate prices. He began with a sense of frustration. "If you look at most research on real-estate markets," he said, "papers will typically say they are taking 'a long-run look,' and then they go back 20 years. I wasn't impressed with that. I thought you had to go back further to get a really good picture of what a housing market performs like."

Eichholtz's study of the Herengracht came to international attention when the Yale economist Robert J. Shiller relied on it in the second edition of his best-selling book "Irrational Exuberance," which was published in 2005. After the first edition came out in 2000, Shiller became famous for predicting, correctly, that the stock market's explosive rise was about to end. The book's title — a phrase made famous by the former Federal Reserve Board chairman Alan Greenspan — referred to Shiller's argument that the market's rise of the 1990's was based more on herd mentality than on common sense.

In the new edition, Shiller applies the same thinking to global real-estate prices and argues that the phenomenal increases of recent years — especially in places like New York, San Francisco, Sydney, London and Paris, but also more broadly — amount to another instance of irrational exuberance. Taking the long-range view, he says, led him to conclude that real-estate prices are destined to fall. "The data just are not there to support the idea that housing prices will continue to soar out of sight," he said.

Not everyone agrees with Shiller's irrational-exuberance thesis. "I just don't see it that way," said Richard Peach, a vice president at the Federal Reserve Bank of New York and an author of a study in 2005 that concluded that the sharp rise in home prices is in line with economic conditions — that it indicates not a skewed vision of reality but a strong economy. In fact, Peach says, in the past 20 years family buying power has grown faster than housing prices. "We sometimes wonder why home prices haven't increased much more, given the tremendous increase in the size of mortgage the average family can finance," he said.

Like-minded experts include Christopher Mayer of Columbia University and Joseph Gyourko and Todd Sinai of the Wharton School, who focus on what they call "superstar cities," places so desirable that they not only are not headed for a correction but they also can sustain "ever-increasing" prices compared with less-sought-after cities.

What such optimists are missing, Shiller says, is a long historical perspective. "The fundamentals that they cite in support of their reassuring assessments are surprisingly weak at explaining historical prices," he writes in a recent paper. Reading the data as an economist leads Shiller to conclude that the market will go south. In addition, he says that studying the erratic but rhythmic rising and falling of prices over time — in other words, acting more like a historian than an economist — reinforces this conclusion. "Looking at the Herengracht data is very instructive," he said to me, "because you can see 50-year intervals of growth, then it turns around. That's more realistic than the superstar-cities argument."

Piet Eichholtz says he doesn't think the long-term data alone necessarily suggest that a collapse is coming. But at the same time, like Shiller, he is skeptical of those who claim that property values can continue to increase ad infinitum. "Some people say economies in the past were very volatile and didn't have safeguards that we have now, so we aren't likely to experience any major crises that will causes prices to crash," he said. "I'm doubtful." Looking through the history of the Herengracht, he says, you can see similarly rosy assessments made over and over, which are then quashed by circumstances.

Eichholtz's Herengracht index turns on one of the basic questions of the discipline of history: how applicable is the past to the present? What can a study of one small part of the world centuries ago say about actions in a 21st-century global economy? Or, put another way, just how special are we today? ...

[anon]

for Dean Baker

The Fed's primary goal is to maintain price stability and fight inflation. The Fed is not necessarily supposed to go around intentionally popping bubbles.

The true "bubble" is "talk" of a bubble - not real estate. It is fashionable to talk about a real estate bubble. Too bad this were not the case for tech stocks in 1999 or 2000. Where was bepress in 1999?

In interest of fair and balanced (and to reduce possibility of looking silly), bepress needs to print a column that explains why there is no widespread, nationwide housing bubble. This would truly pop the bubble (see 2 columns on housing bubble in current bepress).

[Plymouth]

Shiller suggests that rental prices have been trending down, while home prices are trending up, and that this is a disconnect explainable only by irrational pricing. That is a specious argument. This disconnect is explained by a larger section of the population choosing to own, rather than rent (though the most recent runaway prices are not).

He suggests that a "fad" is responsible for driving up urban prices, when in fact, housing prices have risen dramatically in the suburbs as well.

He also suggests that zoning laws are responsible for the widespread price increases. This would make sense, if San Francisco, Boston, New York, Seattle, Los Angeles, Las Vegas, Phoenix, and every other major city with a housing bubble had the same zoning laws.

He also fails to address the impact of more exotic financial instruments (IO loans for 103% of the value of the home, ARMs, home equity loans) and their impact. He doesn't mention the trillions of dollars in ARMs whose rates will adjust in 2007, meaning cash-strapped home buyers will soon become cash-strapped defaulters.

I agree with the premise of the article, but for almost none of the reasons he provides. I can see that he put a lot of work into examining the figures, but absolutely no thought into a broad analysis of the actual problem.

Then at the end of his article, he tries to sell new financial instruments to hedge the housing market. There's nothing I loathe and mistrust more than some financial guru who bends numbers to breaking point so that he can con people into buying is poorly constructed financial products.

Shiller is a good name for this guy.

[anon]

http://www.finfacts.com/costofliving.htm

Global perspective: The U.S. is still a bargain. Only 1 in the top 20 most expensive cities above is in the U.S.

So how "special" are we? Diversify internationally (exorbitant privilege?) and other ways, and sleep easy-

The Economist:
The US has the highest level of output in the world, with GDP valued at US$12.5trn in 2004. The economy experienced a short recession in 2001, which triggered a massive relaxation of fiscal and monetary policies. Economic recovery got fully under way in 2003 but imbalances in the economy that built up during the boom years of the late 1990s, including a low propensity to save and an unprecedented current-account deficit, still persist and so undermine macroeconomic stability. Inflationary pressures have been kept in check by both structural and cyclical factors.

[anne]

The article traces the history of the wonderful Amsterdam house that Robert Shiller often refers to in thinking of long long term housing price trends.

Also, we should be perfectly clear that a price earning ratio of 36.7 for the Vanguard REIT index, along with an earnings growth rate of negative -4.8% over the last 3 years, and a record low adjusted dividend of 3.33% amounts to an asset that is surely "expensive." But, for other than those who would time the market, there is the reason for diversifying.

[nate]

http://njk42.blogspot.com/2005/07/housing-bubble-malarky-or-real.html

[anon]

If the Economists' Voice had a bunch of articles published by authors in states and regions with low price appreciation, then I might be more likely to believe there is a housing bubble in the U.S.

Where do the columnists for Economists' Voice live and what is the housing appreciation rates in these regions? How does this compare to the overall U.S.?

[Belfour]

Anon and Anne, go to school about the now dead Housing Bubble. It is over. Prices have dropped signifigently during March(after a small fall in February)which is the classic pop.

Shiller is quite right.

So the boom is over, the bubble has burst and now this summer the first 'bad' economic effects will begin to slither in, than by this fall, a little more will creep up, then by 2007, the full impact will be felt. Deal and move on.

[Lord]

Some points -

Ah, a national house, such a great location! ;-)
Extrapolating historic national statistics from a rural, small town, city, existence to a time of megapolises can be hazardous. The real long-term increase in home prices can only occur when constriction due to zoning and commuting limits appear.

The auto presumably kept appreciation down for some time, while increasingly high real energy prices may increase appreciation more, commuting becoming less efficient. The teleporter will drop the bottom out though, if cheap enough.

REITs are largely commercial realty which is still behind residential.

Apparently a substantial amount of the liquidity created during WWII went into real estate, as quite a bit of current liquidity has.

He is quite right about real rents falling due to real estate investment returns. For property to plateau for decades means growth must fall beneath mortgage rates. Not a very pleasant environment in any case.

Options are cheap when not needed and very expensive when needed, so I am skeptical of their real hedging value. Of course with options, someone is right and someone is wrong and timing is all important.

[anne]

Ah; there may or may not have been a housing bubble in this or that region and it may or may not be over. I will usually be the last to know. But, the need is to have a portfolio that well insulates against the effects of a lengthy period of flat or even declining housing or even general real estate prices and such a need can be readily met. The selective bursting of the information technology stock bubble in 2000, was ridden through nicely with well constructed portfolios :)

[anne]

http://www.nytimes.com/2005/08/08/opinion/08krugman.html?ex=1281153600&en=5712579cabaf3faa&ei=5090&partner=rssuserland&emc=rss

August 8, 2005

That Hissing Sound
By PAUL KRUGMAN

This is the way the bubble ends: not with a pop, but with a hiss.

Housing prices move much more slowly than stock prices. There are no Black Mondays, when prices fall 23 percent in a day. In fact, prices often keep rising for a while even after a housing boom goes bust.

So the news that the U.S. housing bubble is over won't come in the form of plunging prices; it will come in the form of falling sales and rising inventory, as sellers try to get prices that buyers are no longer willing to pay. And the process may already have started.

Of course, some people still deny that there's a housing bubble. Let me explain how we know that they're wrong.

One piece of evidence is the sense of frenzy about real estate, which irresistibly brings to mind the stock frenzy of 1999. Even some of the players are the same. The authors of the 1999 best seller "Dow 36,000" are now among the most vocal proponents of the view that there is no housing bubble.

Then there are the numbers. Many bubble deniers point to average prices for the country as a whole, which look worrisome but not totally crazy. When it comes to housing, however, the United States is really two countries, Flatland and the Zoned Zone.

In Flatland, which occupies the middle of the country, it's easy to build houses. When the demand for houses rises, Flatland metropolitan areas, which don't really have traditional downtowns, just sprawl some more. As a result, housing prices are basically determined by the cost of construction. In Flatland, a housing bubble can't even get started.

But in the Zoned Zone, which lies along the coasts, a combination of high population density and land-use restrictions - hence "zoned" - makes it hard to build new houses. So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think that prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. In other words, the Zoned Zone is prone to housing bubbles.

And Zoned Zone housing prices, which have risen much faster than the national average, clearly point to a bubble....

[anon]

"Prices have dropped signifigently during March(after a small fall in February)which is the classic pop"

i do not see this in my area.

[anne]

No; reading the housing market at any given time is even more difficult than reading the stock market. I still find signs of strength in markets I pay close attention to, though there may already have been a topping. My guess is that prices in prime markets will at least be sticky for quite a while, as they have been in other prime international markets in recent years even as housing activity and price increases have slowed. And, there has been significant international real estate purchase in these markets I follow.

[Robert]

"Bubble" or "no-bubble", meaningful nominal price destruction in the absence of continued fed (or market-induced) tightening or an about-face in fiscal policy towards narrowing the gap between revenue & expenditure (or both), remains less than a good bet. Of course in real-terms, or with respect to opportunity cost in relation to other asset classes, it (as The Economist pointed out in their Survey) is a whole other matter...

A longer slow "hiss" in real terms may be the higher probability bet in the more desirable and supply-constrained markets (excepting for the appearance of a more major Macro accident).

[anon]

I hear the market is U shaped where I am. Starters and high-end are booming. The middle is a little soft and people are stretched.

[jm]

When people are allowed to speculate in assets with nearly infinite leverage, insane bubbles are inevitable. The looseness of lending standards over the last five years or so has been astonishing. It began with the scams through which builders enabled people to buy with no down payment by channeling the money through Nehemiah, then intensified as the Asian governments flooded the US with low-interest long-term money.

One of the consequences is that the home ownership rate is now five percentage points above the 64% level it held with slight fluctuations for decades. That means about 4 million people now "own" homes who wouldn't if the level had continued at its historic average. Of course this increase has come among those least able to afford a mortgage -- have we any reason to believe those people economically better off than they were in 1995, when the takeoff began? In particular, do we have any reason to believe their incomes more secure?

I suspect the home ownership rate and pace of new home sales are both to revert historic levels. If so, a large fraction of those 4 million excess "owned" homes will appear back on the market at the same time that the new home sales pace drops more than 400,000 below its current rate (to raise the home ownership rate 0.5 percentage points a year for ten years as it did, the pace had to be averaging 400,000 above the level justified by household formation and destruction of old housing).

For the first 20 years I was asociated with Japan, all I heard from friends and acquaintances was that Japanese real estate could never decline in value. Banks would make real-estate secured loans at more than 100% of value, as sure-to-rise prices would quickly cover any deficiency if the loan went bad. Then one day about 15 years ago the music stopped, and it's only in the last year that prices have shown signs of even bottoming out, let alone recovering. How long will recovery back to the bubble peak take? Since in most areas around Tokyo condos fell 75-80+% from the peak, it's likely to be a while. The "we're priced out forever!" panic that used to prevail is utterly gone.

[ilsm]

There is no bubble in the two housing markets I observe.

However, when I look at a property, usually with no urgent intention of buying, I multiply the list price by .6 and figure that is what I would offer.

Economic decisions are individual.

When enough individuals in a market start using a 60% price factor in a market, prices decline, or sale go down and inventories go up.

Each deal is a trend setter.

[jm]

Last night I looked a bit at the local listings on www.realtor.com. Of course couldn't examine many, as their interface is absurdly clumsy, but I found that starting in the middle of the 440 listings for single-family homes* puts me already over the $570,000 level in asking prices.

Though the total number of listings for my Chicago-area suburb is now one shy of 1200, most are for the condos and townhomes that have sprung up like mushrooms in recent years. Going to the middle of the listings there puts one just shy of $200,000 asking (for older buildings, nearly twice the asking prices of five years ago).

Over in the Market Conditions area at Inman's realtytimes.com, a local realtor who's not quite with the program frankly states, "Buyers are finally starting to come back into the market in ..., after most of them dried up from November through mid-February. Sellers have held to their prices for the most part - and many of those sellers may realize sales (finally) in the March - May timeframe when things start to green ... [but sellers far outnumber buyers and if sales don't pick up soon, prices will drop.]" Not surprising considering how weak the job market is here for the many engineers who used to work at Motorola, Honeywell, etc., and for their ex-managers. I think it was the same fellow who a month ago had a posting there saying not a single home in the $400-450k range had sold in this suburb (population > 65k) in months.

Signs of speculation and it-always-goes-up mentality include a surprising number of multiple listings of the same home**, photo sets that show homes utterly vacant or apparently "staged" to not appear so (e.g., $600k homes with cheesy (rental?) furniture and no draperies, no books/magazines or other signs of life).

But the condo-shrooms continue to sprout apace.

*To do this you need to set "snum=220" manually in the URL.
**What percent of realtors is so incompetent they can't take the old one off? If there are so many cases where they haven't, how many more second-listings must there be where they have?

[Ken Houghton]

ilsm - If there is no bubble in your area, how do you explain the list price being 2/3 higher than what you would consider a market-clearing transaction? (Or at least 1/4, if we assume you would split the difference?)

[baileyman]

I wish Shiller would use log scale charts. He never does, so his hockey-sticks are exaggerated, though his points are valid using more sober presentation.

His globalizing demand is interesting. Someone should look into the effect of the global high income class buying extra houses in numerous favorite markets to live and vacation in. Perhaps as goes Davos, so goes housing.

[TonyC]

In the US anyway, isn't there a rule that one's equity in one's stock holdings must be at least 50% of the stock's value, or something like that? That is, I can't borrow more than $50 to buy $100 worth of stock?

This rule is there because it's seen as too risky to be more leveraged than that, right?

But, given this, why do we see it as conservative to put 20% down on a house? 5% down is common. 0% down is happening a decent amount nowadays. Why the tight regulations for financng stock purchases, but not for financing house purchases?

[RN]

Anne, Hapgood et. al -

Your critiques of Shiller are so very hollow. You criticize him because the results he expects eventually haven't materialized yet. That's sort of like saying the weatherman's incompetent because he predicts rain and it's not raining now. I mean, really...

You say:

"His story is an object lesson in the hazards of relying on the predictive power of the past."

Yet this is precisely what you yourselves are doing! Rather than arguing against his premises, you're simply saying that because he hasn't been right for X years, he must not be right now.

Such illogic really makes me laugh, especially when stated with the haughty pretentious tone you all use.

Shiller may be completely correct, and the fact that housing prices haven't fallen simply means that others (the market) haven't discovered it yet. Likely you all disparaged and laughed at his "irrational exuberance" call. When he made it, in your view, he was "wrong" because the market continued to go up for a while. Of course he was right all along, the market just hadn't caught up yet. That's the inherent byproduct of having more foresight than the markets.

I'd encourage arguing against Shiller on the merits of the arguments and evidence of his rather well-argued and empirically supported case. Indeed he may be more right now than ever.

Also, as a side note, given the time frames involved in his analyses, ten years is a very short time indeed.

[anne]

Agreed :) I am being arbitrary, but what I am really doing is trying to emphasize that to build investments we must look to a range of value and diversity rather than timing markets or insuring what will be too costly for all but the fewest to insure.

[PeterA]

A couple earlier posters have observed on the leverage point. I have also been concerned about with the housing price boom. As more speculators and primary home buyers have been adoping ARM's with minimal down-payments, the market is increasingly exposed to excess leverage risks. The problem arises as we see more people who no longer buy on the intrinsic value of the home(in relation to an equivalent rental housing service), but as a leveraged investment vehicle, which they cannot afford if prices remain stable or decline.

As the mainstream media has increasingly been picking up on the possiblity of housing slowdowns, one could expect to see speculators and lower-income homeowners greasing the wheels for a downhill run on selling the properties, to avoid a sustained loss on a "soft landing", with elevated interest rates.

To me, the danger in any such boom arises not with the value based investors who can afford to hold their acquisition, but the leveraged speculators who need to flip the property quickly, due to the heavy cost of loans. I think the key to the question of how the regional bubbles will play out is to know what proportion of a housing market is held with primary residences on one extreme(which I would expect to provide price-stickyness on a decline), vs. speculative holdings(which I would expect to be on the leading edge of a decline).

I wonder if we may start seeing legislation on tighter leverage/down-payment restrictions for home purchases, as a market safeguard for home-owners against a leverage induced sell-off.

[loki]

Back in March there seemed to be a lot of denial about a bubble. Things are a little different now...

says...

What a difference a year makes, eh loki?

[JS]

wow already a year and the results........ =[