Greg Ip reports from the Federal Reserve conference at Jackson Hole on the tension between those who believe in bubbles and those who believe in more traditional explanations of rapid price escalation:
The Tension Between Traditional Economics and Bubbles, by Greg Ip, WSJ Economics blog: Economists, in particular those at the Federal Reserve, are loathe to believe asset markets have become bubbles because bubbles seem inconsistent with rational investor and consumer behavior, the bedrock of economic analysis. “The notion of a speculative bubble is inherently sociological or social-psychological, and does not lend itself to study with the essential toolbag of economists,” says Yale University’s Robert Shiller in a paper presented Friday at the Federal Reserve Bank of Kansas City’s research symposium in Jackson Hole.
Mr. Shiller has made a career out of trying to incorporate irrationality, psychology and bubbles into economic thinking. His book Irrational Exuberance was a timely warning on the stock bubble. For some years he has made similar warnings about the housing market. In his new paper he cites several historic episodes in which surges in real-estate values coincided with an intensifying public belief in ever-rising prices: in U.S. houses in the 1950s, in U.S. farmland in the 1970s.
For the latest decade, he argues that because home prices have so rapidly outstripped the growth in rent and construction costs, they must be “driven largely by extravagant expectations for future price increases.”
Yet Mr. Shiller’s paper may not convince skeptics. He does marshal interesting examples of how popular obsession with real-estate prices coincides with bubbles. ... He cites surveys he and a colleague conducted in both 1988 and 2006 that found attitudes in Los Angeles about future price gains in that city were highly correlated with recent history at the time.
But it isn’t surprising that expectations of prices — whether for real estate, stocks or goods and services — are heavily influenced by the recent past. The real question is, is that expectation itself an overwhelming factor in continuing to drive prices yet higher, the essence of a bubble? Perhaps, but he presents no empirical evidence of that. To be sure, designing an economic experiment that proves how a state of mind affects economic outcomes is hard. Perhaps that simply proves Mr. Shiller’s point: proving or disproving bubbles is still, for now, beyond the ability of mainstream economics.
Jim Hamilton has more on the conference, and he can be counted as among the skeptical:
...Yale Professor Robert Shiller ... struck fiercely iconoclastic tones...:
...a significant factor in this boom was a widespread perception that houses are a great investment, and the boom psychology that helped spread such thinking. In arguing this, I will make some reliance on the emerging field of behavioral economics. This field has appeared in the last two decades as a reaction against the strong prejudice in the academic profession against those who interpret price behavior as having a psychological component....
These principles of psychology include psychological framing, representativeness heuristic, social learning, collective consciousness, attention anomalies, gambling anomalies such as myopic loss aversion, emotional contagion, and sensation seeking.
One thing I have never understood is the source of Shiller's confidence that he is able to rise above these cognitive pitfalls in a way that market participants can not. Nor does his quantitative evidence help me to understand his position any more clearly. He notes for example a 1988 survey which found that the median new homebuyer in Los Angeles expected 11% price appreciation over the next 12 months, whereas the median buyer in Milwaukee expected only 5%. Since the OFHEO house price index shows a 13.9% appreciation for Los Angeles and a 6.2% appreciation for Milwaukee during 1989, it's hard for me to see how these survey results are supposed to convince us of people's lack of rationality. I also am unsure how Shiller's concept of real estate price bubbles in "superstar" cities is to be reconciled with the fact that the problems with mortgage defaults initially proved to be most serious in rustbelt areas where there had been very little real estate price inflation. ...