"Economists and Other Humans Don’t Always See Eye to Eye"

Austan Goolsbee says loss aversion may make the housing crash worse:

A Reality Check for Home Sellers, by Austan Goolsbee, Economic View, NY Times: Economists and other humans don’t always see eye to eye. “Economists tend to think people are crazy because they won’t sell their houses for less than they paid for them — and people think economists are crazy for thinking things exactly like that,” said Professor Christopher Mayer ... at Columbia Business School and an authority on real estate economics. ...

Classical economics can’t explain this behavior. That’s because people who refuse to sell their houses for less than they paid for them are violating a cardinal rule of the market: stuff is worth what it’s worth. It doesn’t matter what you paid for it. But when Professor Mayer and his co-author, David Genesove ... at the Hebrew University ... studied the Boston condominium market in the 1990s — scene of one of the biggest real estate busts in recent American memory — the actual patterns of human behavior did not seem to follow the standard rules at all.

From 1989 to 1992, prices in Boston fell sharply, with condominium prices dropping as much as 40 percent. For a great many of those who bought condominiums during that period, selling could be done only at a significant loss. And, basically, many people refused to sell. ...

[P]eople who had bought at the peak and were facing a loss generally listed their properties for significantly more than those who had bought at a time when prices were lower. Properties listed above the market price just sat there..., much of the market went into a deep freeze as many people held out for market prices that no one would reasonably pay.

In classical economics, that’s not supposed to happen, but the episode did comport with the behavioral economics theory of loss aversion: people have a visceral — some might say “irrational” — hatred of losing money. They try to avoid doing so, even when it goes against their own best interests.

Move ahead to September 2007. Many regions may be starting down a path like that of Boston’s market freeze of the 1990s. Wherever prices decline, look for lots of sellers holding out for unrealistic prices in a vain attempt to recoup their losses. It’s a hang-up that people have, and it can cause big problems. A number of houses with high prices just sit on the market while everyone waits. ...

[E]conomists ... keep close tabs on this kind of behavior because the purchases of durable goods like furniture, appliances and televisions tend to run hand in hand with home purchases — and durables have a disproportionate influence on the business cycle. Further, because the freezing of the housing market makes it harder for people to move, it reduces the likelihood that they can quickly relocate for higher-paying jobs. Dysfunction in the housing market can spill over into the job market, too.

So by being hung up about whether your condominium will sell for what you ... may be threatening the very performance of the economy... — provided that many others behave in a similar way.

What is to be done? Well, if you are holding out for an above-market price to recoup your losses, perhaps you would do well to hear the advice that Professor Mayer gives his own family members.

“If you want to sell your house then you list it at the market price and you sell it,” he said. “If you don’t really want to sell then don’t put it on the market. But don’t say you want to sell and then set the price so high that you spend the year cleaning up every morning, having people walk through your living room and look in your medicine cabinets and reject you. That’s just painful — and expensive.” ...

Comments

[Stephen Heyer]

Err... Shouldn't that read "Economists and humans don’t always see eye to eye". :)

Sorry guys, couldn't resist it.

[John]

Dr. Thoma,

from the article:

In classical economics, that’s not supposed to happen, but the episode did comport with the behavioral economics theory of loss aversion: people have a visceral — some might say “irrational” — hatred of losing money.

I think the author makes too much of what the classical economists would say. The work of the Marginalists in the late 1800s, like Menger and Marshall, laid this incomplete idea about value to rest....didn't they?

Things are worth what the subjective value of them is. The fact that people wouldn't pay higher prices simply shows this basic truth. It also shows that people act "rationally" with choices about self-interest. Again, done deal. We see both simple ideas at play from a simple positive observation. I'll venture to say that people who could hold out did. Those who simply couldn't, made a rational choice and took the loss because holding on was more painful.

[save_the_rustbelt]

Economists are working with statistics.

Real transactions require real difficult decisions with real consequences.

And hope springs eternal, it just takes one buyer........

Not to worry Mark, you are still our favorite.

[marcello]

People //cannot see into the future// , so they cannot be sure that prices won't rise within their selling time frame.
They can guess, pundits and "experts" can give their views, but still they cannot be sure. Its only in retrospect that you can say "damn, shoulda sold XX months/years ago".

one's odd of making a good guess rise with the amount of research one does (e.g. reading this and other blogs ;-) but really, most people don't have the time, means, or desire to do that. They are too busy living, raising kids, building careers. To dump on them and call them irrational is just plain irrational.

[Idaho_Spud]

Do these economists take into account the fact most housing is not owned 'free and clear'? Last time I checked, a lot of recent homeowners used 100% financing.

This puts people in the position of *needing* to sell for what they paid, or else having to bring a truckload of cash for the lender when they sell at a loss.

My suspicion is that if they used 100% financing, they don't have that kind of cash to begin with, ergo sticky downward prices on the part of some homeowners/speculators.

[Robert Edele]

People's tendency to buy a house with no intention of keeping it for even 3 years is pretty idiotic too from an economist's point of view.

The transaction costs of buying and selling a speculative house with a mortgage are at least 10% between real estate agent fees (both for selling and buying, since you are doing 2 transactions), mortgage origination fees, early termination fees, extra penalty for investment buying, appraisers, title insurance, etc. If the house is held for 3 years, then that comes out to over 3% per year.

When transaction costs are high, it makes sense to either stay put with your current assets (to avoid churn) or to move to more liquid assets, such as REITs.

[KnotRP]

Idaho Spud - exactly -- cash at closing, during a major retrenchment (40% down
is probably upsidedown for many), is probably an impossibility for other humans.
Who's going to loan you money, with no collateral, to pay cash at closing? No one.
Who's going to put that cash on a credit card at usury rates? No one.
So humans keep paying the mortgage instead, because it's all humans can muster,
and they simply stay put until they are no longer upside down.

New title: Economists don't live in the same world as other humans?

[John]

Idaho Spud, while what you;re saying may make sense in terms of personal finances, how does this change the fact the homes are worth what they're worth regardless of the owner's equity position?

It's not like economists aren't aware of this. Who wouldn't be?

[Winslow R.]

Just curious about the eyes of economists that work for banks with all their MBS securities and corporate loans they can find 'no market' for so they hold on to them.

No one likes to sell at 'fire sale' prices. Only certain sectors of society can avoid selling during times of market illiquidity. Not everyone has access to cash at the fed window.

By the way those that refused to sell in 1992 and held out until 2004 did just fine. House markets since the 50's tend to be cyclical with a long-term trend upward due to population growth then inflation then falling interest rates.

Next phase is up to Bernanke but my hope is inflation, as falling interest rates have pretty much run their course and I really don't like deflation.

[KnotRP]

Homes may be "worth what they are worth" but there is a big difference between "selling with cash at closing or worse no cash at closing" vs "holding onto shelter at an affordable monthly cost with an unrealized accounting loss gathering dust off-balance sheet".

It's sort of like being unable to pay off a credit card in total,
but deciding to charge this weeks groceries -- why would anyone
voluntarily destroy their credit and simulaneously starve,
just to realize what would otherwise be an unrealized loss?

People don't run towards financial destruction...they walk...and drag their feet.

[Antti Kaipainen]

Many economists work on a wrong scientific assumptions.

Theory is formed based on data, assumed causation and sometimes, unfortunately, ideology.

Then when theory and reality do NOT match, part of reality is labelled "irrational" or "sub-optimal", i.e. not behaving as it SHOULD.

Anyone who has completed and understood his Philosophy of Science 101 should know what this means.

A physicist, biologist or a chemist would be ashamed to act like this.

When theory and reality do not meet, theory must be fixed, if it is to attempt to portray and predict reality.

That is, if it is to be considered science, and not a collection of ad hoc exceptions.

[Laurent GUERBY]

Ah economists and reality.

Soon economists will say that's inefficient to have (stock or other) markets when you can put a bid or ask price freely, including far from the current spot price.

Selling at 70% of price P now or selling at price P in five years are value equivalent at current nominal interest rates, costs of maintenance of empty house for five years are likely to be small against price P and gives you a chance to do a sell. If you don't list you won't sell.

People who can afford it are just rational to list their price and wait.

[Robert Edele]

"costs of maintenance of empty house for five years are likely to be small." The costs for holding a house in for 5 years are enormous. You have to hire a landscaper to keep the lawn mowed. You need to do general maintenance. You generally need to keep paying utilities (gas, water, electric - at least in my climate and assuming the lawn is irrigated). You must pay taxes. You run a far higher risk of break ins and vandalism than with an occupied house. You run a far greater risk of internal flooding and fire than with an occupied house, which is reflected in either higher insurance premiums or a higher chance of losing the house. In all, the holding costs are upwards of 5%/year.

[calmo]

Stephen tickles us Err... Shouldn't that read "Economists and humans don’t always see eye to eye". :) [evidence for this interpretation: ":)" and this concatenation of characters "Sorry guys, couldn't resist it."]
But I wonder if the host had something else in mind. (Beware gentle readers, it B WayoffBase calmo possibly shooting in the dark) Where have we seen "seein eye to eye" or "looked into his eyes" or similar (strange brews of mysticism (1%) and tripe (99%)) before?
Right. Oratory from The President, man of beady eyes, experienced in seein eye to eye with so many (here esp Putin) and on so many issues with such devastating results.

Mark's "other" had you in mind Stephen.
Tdid.

[Free the Market]

Sales of durable goods related to home purchases could be improved by simply eliminating non safety zoning regs. Youngsters wouldn't have to wait around for older homes to become reasonably priced, they could just build their own. As an added bonus, they could get the size home they really want, instead of what someone else wants. The environment would benefit because many singles would build much smaller homes, if allowed to. Less heating fuel would be needed, so global warming would be slowed.

[Lord]

There is always a lot of emphasis on sellers, but I really think it is about buyers not wanting to buy anything they expect to be cheaper tomorrow and only doing so if the discount is large enough to cover feared losses. This expectation can exceed any retrospective real loss in value. Values are always poorly determined when selling at low volumes or at rapidly rising prices. Perhaps we should have an article on how irrational sellers were that sold in 2002-2004.

[Lafayette]

Human selfishness

I can't imagine why the article does not mention that another alternative exists (if one must vacate a house but won't sell it at a loss). It's called rental.

This should apply particularly to the condominium markets in both downtown areas and places that enjoy seasonal rentals.

Do the maths: If one can keep the property and yet break even on the expenses, why not wait till a market recovers? Does that take decades? Not typically.

If, in vacating premises, one must purchase another, then admittedly the prospect is more difficult. But, then, it is due to the fact that American perceptions on real estate have changed. That is, Americans thought, during this period of blatant speculation, that they could flip-a-condo like they purchase and sell stocks. More so, there is, as I understand the pertinent taxation, no tax on the sale of secondary residences. (Which is not the case in Europe, and therefore brakes such speculation considerably.)

If that is the case, then they have misunderstood the inherent difference between liquid and illiquid assets. The sub-prime mess is, after all, a salutary lesson for the dorks who didn't appreciate sufficiently the risks of investment ... thinking that real estate was like printing money.

On the one hand, we admire the liberalism of a free-market economy where the ability to wheel and deal is lubricated by both tax regimes and the financial system. On the other hand, we lament that such lubricants lead inevitably to uncontrolled speculation, which prompt damaging economic bubbles.

Human selfishness is always dormant and when it becomes insuppressible, the consequences become entirely predictable. To those watching, that is.

[Firozali A.Mulla MBA PhD]

Economist do not see eye to eye. They may have the theory of their own monetary conceptions or as we call this cannons. Let me elaborate. The American Economist writing books write about the America only. A little splash is thrown in as the general concepts of Pareto theory and demand, supply, choice, the differential curve. The American economist in his book will not or will avoid quoting the English Economist books and English will not talk of the American economist except as the USA economist do.
The reason is simple.
Each has the problem and solutions and the small phrase I have put in will help. The politicians always mess up the encomiasts. See Alan Green Span. He after leaving the offices, like Colin Powel, talks about the Iraq war was never to be there. It was for oil. The Spanish president said same and he withdrew the troops very fast. Mr. Tone Blaire exaggerated the issue of WMD in his dossier so bad that all though he was right then. Robin Cook now dead had stated like Putin that the Iraqi sand dunes are no football.
The trouble with democracy, September 8th

A losing battle sir:
When I think of democracy I see the people view the constitutions and their rights of voting and their say in anything they would like to have the say including the politicians’ views and the economics views.
Also I see VETO in many places that stops me thinking.
What is veto? A force by someone to make me think that I am wrong that not needed. The other party's views are right or they have to be right.
This is going three steps up and falling two down, sir.
I see no democracy working in full steam.

I thank you
Firozali A.Mulla MBA PhD
P.O.Box 6044
Dar-Es-Salaam
Tanzania
East Africa